On 22 September, Angela Merkel won a third term as German Chancellor, a win that is expected to provide continuity in the leadership commitment to the eurozone. With signs of increasing stability appearing in the second quarter of 2013, it appears as if the region is recovering from its post-2008 recessionary challenges. In light of the positive signs, it is a good time to review the progress that has made in the area as eurozone members continue to move towards full economic integration. In this article, I also discuss some of the issues related to the fixed exchange rate.

Eurozone in perspective

Canadian Nobel laureate economist, Professor Robert Mundell, has been called the father of the euro. As far back as the 1960s, he was writing about the significant economic benefits of using a common currency in an optimal economic area such as Europe, where labour and capital can move freely between countries. On January 1, 1999, the euro was introduced, and the currencies of the eurozone’s 11 founding countries ceased to exist independently. ¹ At the same time, all bonds and government debt from Eurozone issuers were converted to euros. Today, the euro is the official currency of the 17 member states of the eurozone.

To date, the eurozone is the second largest economic group in the world. Its total GDP in 2012 stood at US$12 trillion, representing 17 percent of the world’s GDP weighting and ranking, just behind the U.S. with its GDP of US$16 trillion. By way of comparison, Canada’s GDP in 2012 was US$1.8 trillion.² The importance of the euro in global transactions can be illustrated by the fact that euro accounts for 24 percent of the foreign currency reserve holdings of world central banks, second only to the U.S. dollar at 62 percent of holdings.³

At the same time, the 50 blue chip companies in the Euro Stoxx 50 index now have a total market capitalization of about US$3 trillion.⁴ On the fixed income side, the Barclays Capital Euro Aggregate Bond Index is now comprised of 3,000 issues with total market value of about €8 trillion or US$11 trillion.⁵ (Compare this with the Barclays Capital Canadian Issues Bond Index market value, which is about US$1.2 trillion.)

Sovereign debt crisis: 2010–2013

As the eurozone continues to grow, there remains a sizeable difference in size, GDP per capita, and relative government expenditure/debt levels among the 17 member states. Germany, France, Italy, and Spain together accounted for 77 percent of the GDP of the entire region in 2012, and it is reasonable to believe that leadership and economic activities in these four countries have significant impact on the future of the eurozone. The sovereign debt crisis has perhaps been an inflection point in the move towards full integration in the region.

Chart 1 above right summarizes the weighting of each member state in the eurozone, based on its GDP size in 2012.

Taking the pulse

As the eurozone continues its gradual recovery from the financial crisis, there are opportunities ahead, as well as some potential long-term factors that could constrain growth in the future. The eurozone has limited additional taxing capacity. Its government revenue is already at 47 percent of GDP for 2013, compared to 33 percent for the U.S. and 38 percent for Canada. ² However, overall Eurozone net government debt is at 74 percent of its GDP in 2013, lower than the U.S. at 89 percent. This implies that the eurozone may have greater financial flexibility than the U.S. when it comes to public investment as a tool for economic stimulus in the region. However, it is notable that the net government debt level in Italy has reached 106 percent of its GDP.

At the same time, the common currency unit does not allow for the short-term benefit of reducing trade imbalances among Eurozone members by adjusting exchange rates. To provide for an effective long-term economic union, investment analysts have therefore called for structural changes involving full fiscal and monetary integration in the eurozone. Key proposals related to the eurozone monetary policy and financial sector operations include:

Monetary union – Establish a central treasury role with the ability to use unconventional monetary measures to alleviate extreme market tensions. Unconventional monetary measures may include bond purchases, expanding the money supply, and lowering its exchange rate. Other proposals include a long-term plan for the issuance of joint Eurobonds that would reduce borrowing costs in the region.

Bank union – On September 12, 2013, members of the European Parliament approved the European Central Bank as the single banking regulator for eurozone member states and other European Union members. It is expected that this single supervisory mechanism will be in place by fall 2014. Other analyst proposals include establishing a bank resolution fund and a regional deposit insurance mechanism.

Long-term fiscal policy targets – Establish long-term fiscal policy targets, including a coordinated plan for a long-term reduction of the debt-to-GDP ratios of highly indebted nations in order to attain fiscal sustainability.

Regional economic policy – Establish an integrated regional economic policy to promote economic growth to deal with high unemployment in countries in the eurozone.

Eurozone in crisis*

Below is a summary of the substantial monetary interventions in the Eurozone during the sovereign debt crisis. While these have focused on specific economies, market tensions had been felt in the entire region during the crisis.

Direct lending to member states and banks – In 2012, a permanent facility, the European Stability Mechanism, was set up to administer the financial assistance program for member states and assist in the recapitalization of financial institutions through loans to governments. Key highlights include:

• Total loans extended to member states – €440 billion, or US$586 billion.
• €245 billion assistance to Greece – disbursements expected to be completed in 2014.
• The Greek debt exchange was described as the largest and steepest debt reduction agreement in history. Private sector investors wrote down 75 percent of their Greek bond holdings.
• €78 billion assistance to Portugal – disbursements expected to be completed in 2014.
• €68 billion assistance to Ireland – disbursements expected to be completed in 2013.
• €41 billion assistance to Spain to recapitalize its banking sector.
• €10 billion assistance to Cyprus.
• Bank accounts at Bank of Cyprus with balances greater than €100,000 converted to shares, and capital controls imposed in the Cypriot banking system.

Bond purchases – Outright purchase of sovereign bonds by the European Central Bank (“ECB ”) from states that request financial assistance. Total purchase outstanding as of September 13, 2013 was €190 billion.

Liquidity provision – €1 trillion liquidity support to euro banks through the three-year long-term refinancing operations administered by the ECB in 2011 and 2012.

*www.efsf.europa.eu, www.ecb.europa.eu.

1. The 11 founding members of the eurozone were Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, Netherlands, Austria, Portugal, and Finland. The next six nations that joined were Greece (in 2001), Slovenia (2007), Cyprus and Malta (2008), Slovakia (2009), and Estonia (2011). Qualifying membership in the euro currency union requires the state to be able to meet strict fiscal targets: a budget deficit of less than 3 percent of their GDP and a debt ratio of less than 60 percent of their GDP. Other qualifying economic and social conditions, referred to as the Copenhagen Criteria, include: low inflation (not more than 1.5 percent above the three best-performing countries), interest rates close to the EU average, and a democratic and free market environment with rule of law.
2. International Monetary Fund, World Economic Outlook, April 2013 data, www.imf.org.
3. IMF, Currency Composition of Official Foreign Exchange Reserves. Total amount of foreign exchange (“FX”) reserves is US$6 trillion, June 28, 2013, www.imf.org. The third-largest holding of central bank allocated FX reserves is the Japanese yen, with a weighting of 3.9 percent. The Canadian dollar accounts for 1.8 percent of the total FX reserves surveyed.
4. The Euro STO XX 50 (“SX5E”) index is Europe’s blue-chip index for the eurozone. The index covers 50 stocks from 12 eurozone countries. Bloomberg SX5E index data as of Sept 12, 2013. Euro/US$ exchange rate is 1.3308 as of Sept 12, 2013.
5. Barclays Live database, www.barcap.com, data as of September 12, 2013.