Thoughts on developments in Euro area Ilmārs Rimšēvičs Governor of the Bank of Latvia June 8, 2010

The European dream – a common currency  April 1989 – Delors report: three stages for the establishment of Economic and Monetary Union.  July 1990 – Stage one: capital controls abolished.  November 1993 – Maastricht Treaty operates.

The European dream – a common currency  January 1994 – Stage two: European Monetary Institute created.  May 1998 – The 11 Member States were authorized to introduce the euro.  June 1998 – The European Central Bank was established.

The European dream – a common currency  January 1999 – Stage three: Irrevocable fix of the exchange rates; Non-physical introduction of the euro; The ECB – central bank for the euro; The Stability and Growth Pact comes into force; ERM II replaces the European Monetary System.  January 2001 – Greece joins the third stage of EMU.  January 2002 – Euro notes and coins in circulation.

Initially euro fell below the parity with US dollar, yet it recovered in the subsequent years

Maastricht convergence criteria: a meaningful framework for smooth participation in single currency area

Greece has failed to comply with the Maastricht criteria already from the very beginning

Other large member states have also experienced difficulties with meeting fiscal targets General government budget balance (% of GDP)

The same problem persisted with public debt General government debt (% of GDP)

However, the problem was “solved” by weakening SGP rather than strengthening fiscal positions of the respective member countries The SGP rules were applied inconsistently - the Council of Ministers failed to apply sanctions against France and Germany, despite punitive proceedings being started when dealing with Portugal (2002) and Greece (2005). In 2005, the SGP was reformed: under the pressure of France and Germany - the rules were relaxed; the decision to declare a country in excessive deficit became more conditional (a significant departure from the original emphasis on simple rules and strict compliance). The SGP did not succeed in preventing the occurrence of excessive deficits in many euro area countries; at present, 13 no 16 are subject to EDP.

Result: most EU countries are in excessive deficits General government budget balance (% of GDP)

Result: debt levels are high and raising, above the threshold for the Euro area as a whole General government debt in 2009 (in % of GDP) Maastricht criteria

Result: the Euro area fiscal numbers are clearly outside the “comfort zone” …

… And markets have ceased to tolerate unsustainable fiscal developments 5 year EUR CDS spreads

Response: extraordinary steps taken to remove immediate pressures Temporary European stabilization mechanism established allowing for overall financial support of up to EUR 750 billion from the EU and the IMF, subject to strong conditionality. Extraordinary measures taken by the ECB Suspending minimum rating requirements for collateral eligibility on debt instruments guaranteed or issued by Greece; Injecting liquidity by conducting interventions in the euro area public and private debt securities markets (Securities Market Programme).

Response: fiscal consolidations across Europe Greece: from 13.6% of GDP in 2009 to below 3% in 2014 spending cuts; cracking down on tax evasion; curbing of early retirement schemes; public sector wage freeze; VAT increase Portugal: from 7.3% this year to 4.6% in 2011 pay cuts in public sector; tax hikes (incl. VAT); military spending cuts; big state projects freeze Spain: from 11.2% in 2009 to 6% in 2011 public investment cuts; public pay cuts; pensions freeze; end to cash payouts for new mothers Italy: from 5.3% in 2009 to 2.7% by 2012 delaying retirement dates; state salary freeze; new recruitment freeze; funding to region authorities cuts Ireland: from 12% to 2.9% by 2014 public servants pay cuts; social welfare reductions; investment project cuts; child benefit reduction; introduction of carbon tax

Strong commitment to fiscal consolidation is crucial to achieve fiscal sustainability  A significant tightening of fiscal policy is critical to restore fiscal sustainability and market confidence;  Strict compliance with recommendations under EDP should be ensured;  Economic reforms to raise growth and thereby generate tax revenues are essential;  However, besides the urgent need for fiscal consolidation, the surveillance and prevention of budgetary risks should be strengthened.

The present framework might not be sufficient to ensure fiscal sustainability in medium to long run Sanctions should be strengthened so that they are more severe and effective; A mechanism for the exclusion of an individual member state from the monetary union in case rules are seriously breached might be one of the possible solutions.

Latvia: ambitious fiscal consolidation and adoption of 2010 budget helped to restore calm in financial market; Interest rates down to below pre-crisis level Money market rates (%)

2011 budget will be the centerpiece in restoring confidence and putting economy back on sustainable path General government consolidated budget (% of GDP, ESA’95)

2011 budget scenario Nominal GDP RevenueExpenditureBalance Balance, % of GDP* % Agreed budget deficit target for % = mln LVL Required consolidation to reach deficit target mln LVL BoL: general government budget forecast for 2011, ESA’95 * - no policy change scenario

Meeting fiscal targets would qualify Latvia for Euro introduction in 2014 Measure- ment EURO Budget strategy General government consolidated budget (% of GDP)