Examining the European Debt Crisis and its

FROM: TO: SUBJECT: DATE:

Senate Banking Committee Staff Banking Committee LAs Hearing on “Examining the European Debt Crisis and its Implications ” February 15, 2012

On Thursday, February 16, 2012 at 10:00am, the Senate Banking Committee will hold a hearing entitled “Examining the European Debt Crisis and its Implications.” The hearing will take place in the Committee’s hearing room located in the Dirksen Senate Office Building, Room 538. The witnesses, who will appear on one panel, will be: • The Honorable Lael Brainard, Under Secretary for International Affairs, U.S. Department of the Treasury • The Honorable Robert D. Hormats, Under Secretary for Economic, Energy, and Agricultural Affairs, U.S. Department of State • Mr. Steven B. Kamin, Director of the Division of International Finance, Board of Governors of the Federal Reserve System Overvie w Over the past two years, the Eurozone 1 has grappled with a sovereign debt crisis that threatens economic stability in Europe and beyond. Analysts and investors are concerned that some Eurozone governments could default on their debt in a disorderly fashion; 2 vulnerabilities in the European banking sector could trigger broad financial turmoil; the Eurozone could enter a long and protracted economic recession; and one or more countries could leave the Eurozone. European leaders have held a series of summits and announced several rounds of policy measures to try to resolve the crisis. This past week, the Greek Parliament voted, at the request of the country’s foreign lenders, to approve a package of austerity measures in exchange for new loans to keep Greece from defaulting on its debt. 3 However, questions about the economic, financial, and political stability in the Eurozone persist. This week’s hearing will provide the Committee with the opportunity to receive an update from U.S. officials on recent developments in the Eurozone. The hearing will detail impacts of the European debt crisis on Europe, the United States, and the global economy, and allow the Committee to review the potential implications the European debt crisis has for the United States financial system and economy, and offer insights into events that may unfold over the coming weeks and months. This hearing 1

A total of 17 states of the 27-member Eu ropean Union (EU) use the euro as the single currency. The 17 countries in the Euro zone are Austria, Belgiu m, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Lu xembourg, Malta, the Netherlands, Portugal, Slovakia, Spain, and Slovenia. 2 An orderly default typically refers to a government working out a plan to restructure its debt with private creditors before missing or suspending payments, in contrast with a disorderly defau lt, which typically refers to governments missing or suspending payments without previously working out a plan for repaying at least part of the remain ing debt with cred itors. 3 See “Greek Parliament Passes Austerity Plan After Riots Rage,” New York Times, 2/12/12.

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continues the Committee’s work monitoring this issue, following the Security and International Trade and Finance Subcommittee hearing, chaired by Senator Warner on September 22, 2011. 4 European Policy Responses Over the past two years, there have been disagreements within Europe over the appropriate response to the Eurozone debt crisis, causing uncertainty in the market. Austerity measures have triggered a number of protests in Greece, Ireland, Italy, Portugal and Spain (“GIIPS” countries) and governments in these countries have been replaced. In the Eurozone core, leaders have had to overcome political resistance to providing financial support to the periphery, with critics opposed to the idea of rescuing countries that, in their view, did not exercise adequate budget discipline. European leaders and institutions have implemented a number of policy measures in response to the crisis over the past two years. Some of the steps taken include: • Financial Assistance from other Eurozone governme nts and the IMF. The main crisis lending facility currently in operation is the European Financial Stability Facility (EFSF). It has a lending capacity of €440 billion (about $584 billion), and its resources can currently be used to provide assistance to governments, finance bank recapitalization, or purchase government bonds on secondary markets. The EFSF was created in June 2010, and is a temporary, three-year facility. The EFSF will be replaced by a permanent rescue fund, the European Stabilization Mechanism (ESM). The ESM is due to be launched as soon as Member States representing 90% of the capital commitments have ratified it, which is expected in July 2012. The EFSF and ESM will overlap for a year, during which the total ceiling on EFSF/ESM lending will be raised to €500 billion (about $664 billion), although this ceiling will be reassessed in March 2012. Currently, the EFSF is providing financial assistance, in conjunction with the International Monetary Fund (IMF), to Ireland and Portugal. Greece is also receiving financial assistance from the IMF and other Eurozone governments, but since its program was devised before the creation of the EFSF, Eurozone government support to Greece takes the form of separate bilateral loans from other governments. A second financial assistance package to Greece, pending on-going negotiations, would be funded by the EFSF. • Austerity Programs and Structural Reforms. European and IMF financial assistance comes with conditionality. European and IMF financial assistance to Greece, Ireland, and Portugal has been disbursed to the countries in phases, only after a committee with representatives from the IMF, the European Commission (EC), and the European Central Bank (ECB) – also referred to as the “Troika” – has determined sufficient progress on austerity and structural reforms has been made. Additionally, Italy and Spain have undertaken austerity measures and reforms to regain market confidence. For example, the Spanish government passed a balanced budget amendment in 2011, and the Italian government has announced a similar initiative. • Losses on Greek Bonds. The Greek government is currently negotiating with private investors on the size of voluntary “haircuts” on Greek bonds. If the losses are not accepted voluntarily, but instead are imposed on private bondholders, payment on credit default swap contracts on Greek bonds are expected to be triggered, which could lead to instability in financial markets. As stated at the October Euro summit, the goal is to reduce Greece’s debt level to 120% of GDP by 2020. 5 4

For testimony fro m the subcommittee hearing, see “The European Debt and Financial Crisis: Origins, Options, and Implications of the U.S. and Global Econo my.” A lso, this memo was drafted using materials prepared by CRS experts Rebecca M. Nelson, James Jackson, and Martin Weiss. See lin ks to related CRS reports at the end of this memo. 5 See “Euro Su mmit Statement”, 10/26/11.

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Stress Tests and Bank Recapitalization. The European Banking Authority (EBA) and its predecessor, the Committee of European Banking Supervisors, have conducted multiple stress tests on European banks’ ability to withstand a deep economic downturn. After repeated criticism of the quality of these tests, the EBA conducted a capital exercise and announced in December 2011 that European banks needed to raise €114.7 billion (about $151 billion) in additional capital. This extra capital is intended, according to the EBA, to “provide a reassurance to markets about the banks’ ability to withstand a range of shocks and still maintain adequate capital.” 6 ECB Support. The ECB significantly increased its role in the crisis response in December 2011, when it introduced long-term refinancing operations (LTRO). The LTRO resulted in loans to more than 500 Eurozone banks, totaling €489 billion (about $649 billion), and is the biggest infusion of cash into the banking system since the euro was introduced. The LTRO aims to address the liquidity crunch in the Eurozone banking system and to encourage banks to continue buying Spanish and Italian government bonds. 7 The ECB has planned another LTRO auction for February 29, 2012, and it is reported that European banks are preparing to tap twice as much funding as in the original LTRO auction in December 2011. 8 Additionally, the ECB began buying government bonds on secondary markets in 2010 in an attempt to stabilize bond yields, and the ECB is now believed to be the biggest holder of Greek bonds. 9 The ECB has also provided unusual flexibility in its short-term refinancing operations throughout the crisis. 10 Governance Reforms. In late 2011, EU leaders announced the creation of a new fiscal compact. 11 The primary focus of the fiscal compact is an agreement that government budgets should be balanced or in surplus, and that constitutions should be amended to reflect this rule. European leaders have agreed to a draft text on the agreement, but it will still need to be adopted at the national level, and may require referendums in some countries. The EU also adopted legislation containing additional reforms to economic governance, including greater surveillance of national budgets by the European Commission, and an early warning mechanism that would prevent or correct macroeconomic imbalances within and between member states. Proposals to Increase Funding for the IMF. In December 2011, European leaders pledged to extend €200 billion (about $265 billion) in bilateral lines of credit to the IMF, leaving the possibility open that other countries outside Europe could contribute to the IMF. In January 2012, the IMF announced that it was seeking as much as $500 billion in new money to lend, plus $100 billion as a cash buffer, including the €200 billion (about $265 billion) pledged by European countries. 12 Treasury Secretary Timothy Geithner indicated in a December press conference that the U.S. will not contribute additional funds to the IMF as part of this effort. 13

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David En rich and Sara Schaefer Muñoz, “Few Banks Fail EU Exams,” Wall Street Journal, 7/16/ 11; Liz Alderman, “Stress Test Reveals European Banks Need More Capital,” New York Times, 12/ 8/11; and Eu ropean Banking Authority’s EU-wide stress testing and 2011 EU Capital Exercise websites, which include releases and test results. 7 Economist, “The Eu ro Crisis: Checking In on Eu rope,” 1/20/ 12 8 Patrick Jenkins and David Oakley, “Ban ks Set to Double Crisis Loans fro m ECB,” Financial Times, 1/ 30/12. 9 For example, see Ralph Atkins, “The ECB and its Greek Bonds,” Financial Times, 1/23/12. 10 See generally speech by Jean-Claude Trichet, President of the European Central Ban k. “The Monetary Policy of the ECB during the Financial Crisis,” 6/ 6/11. 11 Though the creation of the fiscal co mpact was announced in December 2011, d iscussions concluded on 1/30/12, whereby 25 of the 27 EU member states joined the fiscal co mpact. The UK and the Czech Republic d id not join. 12 Statement by IMF Managing Director Christine Lagarde Following Executive Board Discussion on the Adequacy of Fund Resources, Press Release No. 12/13, 1/17/12; see also Annie Lowrey, “I.M.F. Seeks $500 Billion More to Lend as It Plans to Cut Growth Forecast,” New York Times, 1/ 18/ 12. 13 Forbes, “Geithner to EU: IM F Will Play a Role, But Without Fed Money,” 12/6/ 11.

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The Prime Minister of China on the other hand has indicated he would consider increasing financial commitments to the IMF in order to support Europe, but analysts wonder what kind of trade or political concessions China may seek in exchange. 14 Potential U.S. Financial and Economic Impact The Eurozone crisis poses various risks to the U.S. economy, both with respect to trade and the financial system. The U.S. and E.U. have the largest and most deeply integrated bilateral trade and investment relationship in the world. In 2010, the United States and the E.U. combined accounted for almost 50% of world GDP, and more than 40% of the world’s trade in goods and services. 15 There has been concern that austerity measures would slow growth in Europe, depressing demand for U.S. exports, and that the crisis would erode confidence in the euro. To date, however, there has not been a substantial sustained depreciation of the euro relative to the U.S. dollar, and it is not clear that U.S.-E.U. trade flows have contracted, 16 although risks may remain. In the long term, a two-track Eurozone or break-up of the Eurozone could have substantial impacts on U.S.-European cooperation on economic issues. With respect to the U.S. financial system, the Bank for International Settlements (BIS) recently reported that direct and other potential U.S. bank exposure in September 2011 to the GIIPS countries totaled $717 billion, or 7.6% of U.S. direct and other potential exposures overseas. 17 The BIS data, however, does not reflect hedges or collateral that U.S. banks may have in place to lower their exposures, as well as the exposure non-bank financial institutions (such as money market, pension, or insurance funds) may have. For example, five of the largest U.S. banks are reported to have more than $80 billion of exposure to the GIIPS countries, but use credit default swaps to offset any potential losses by $30 billion, putting their net exposure at $50 billion. 18 A recent analysis by Fitch argues that large U.S. banks have been reducing direct exposure to stressed markets over the past year, and that net exposures are manageable, but warns that U.S. banks could be “greatly affected” if contagion were to spread. 19 Additionally, analysis by the Investment Company Institute finds that U.S. money market funds cut their exposure to the Eurozone to almost a third -- from $32.6 billion to $11.9 billion – by the end of 2011. 20 In testimony before our Committee last October, Secretary Geithner emphasized that direct exposure of U.S. institutions to the Eurozone countries and institutions under the most market pressure is small. Secretary Geithner also stressed that the U.S. financial system is better capitalized than in 2009, putting it in a better position to weather potential risks. U.S. Government Involve ment In the United States, multiple federal departments and agencies handle various facets of policymaking with respect to the Eurozone crisis. For example, the Treasury Department covers international financial policy issues for the Administration, while the State Department handles foreign policy issues. These and other agencies have taken action in response to the crisis. 14

Keith Bradsher and Liz Alderman, “Ch ina Considers Offering Aid in Europe’s Debt Crisis,” New York Times, 2/2/ 12. World Bank, World Development Indicators, 2010. 16 For monthly U.S.-E.U. trade data, see this U.S. Census website. 17 Exposure to public and private sectors. “Other potential exposures” includes derivative contracts, guarantees extended, and credit co mmit ments. Bank for International Settlements (BIS), Consolidated Banking Statistics, “Table 9E: Foreign Exposures on Selected Individual Countries, Ult imate Risk Basis,” 10/ 20/11 (Preliminary Report for June 2011). 18 Peter Eav is, “U.S. Ban ks Tally Their Exposure to Europe’s Debt Maelstro m,” New York Times, 1/ 29/ 12. 19 Joseph Scott, Christopher D. Wolfe, Tho mas Abruzzo, “U.S. Ban ks – Eu ropean Exposure,” Fitch, 11/16/11. 20 Emily Galagher and Chris Plantier, “Data Update: Money Market Funds and the Euro zone Debt Crisis,” Investment Company Institute, 1/13/12. 15

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Treasury Secretary Geithner and other Treasury officials, including Under Secretary Brainard, have been in frequent contact with their European counterparts. In January 2012, Secretary Geithner reiterated the importance of creating a “firewall” around the Eurozone as a crucial next step in preventing the crisis from spreading. While the United States wields an influential voice on the issue, it ultimately has limited ability to affect policy decisions made by and among the EU member countries and institutions. With respect to foreign policy, the United States looks to Europe for partnership in addressing a wide range of global challenges, and there are concerns about the potential effects of the debt crisis on transatlantic political and security cooperation. The State Department represents the U.S. on the Transatlantic Economic Council, a body whose mission includes deepening cooperation between the U.S. and the E.U. by promoting economic growth, increased trade, and job creation. The Transatlantic Economic Council last met on November 29, 2011, and affirmed cooperative practices between the E.U. and the U.S. 21 Additionally, on November 30, 2011, the Fed, along with the central banks of four other countries and the ECB, announced coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The stated purpose of these actions was to: “to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.” 22 This action represented a renewal of temporary reciprocal currency agreements, known as swap lines, that were first authorized in December 2007. As of February 1, 2012, $104 billion was outstanding on these swap lines, compared to a high of $583 billion during the global financial crisis in December 2008. Additionally, the Fed is currently conducting stress tests related to U.S. bank exposure to turmoil in Europe. 23 Key Upcoming Dates 24 • February 25-26, 2012: G-20 Finance Ministers meeting in Mexico City, Mexico. • February 29, 2012: ECB has second long-term refinancing operation auction. • March 2012: European leaders reassess the overall lending ceiling of the EFSF/ESM, which is to enter into force in July 2012. • March 1-2, 2012: EU leaders meet in Brussels. • March 20, 2012: In Greece, a major (€14.5 billion) government bond matures; de facto deadline for Greek government to reach a deal with European authorities, the IMF, and bondholders if default is to be avoided. • April 2012: Greek parliamentary elections are likely to be held. • April 22, 2012: French presidential elections (first round). • May 6, 2012: French presidential elections (second round). • May 19-20, 2012: G-8 summit in Chicago. • June 18-19, 2012: G-20 summit in Las Cabos, Mexico. • June 28-29, 2012: EU leaders meet in Brussels • July 2012: The ESM becomes active, and will overlap with the EFSF for a year.

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See more info rmation on the Transatlantic Econo mic Council on the State Depart ment’s webpage. See the Federal Reserve’s press release on 11/30/11. 23 See the Federal Reserve’s press release on 11/22/11. 24 Also see David Cutler, “Factbox: Co ming Events in the Euro Zone Debt Crisis,” Reuters, 1/27/12. 22

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Additional Background • CRS Report, 1/17/12: The Future of the Eurozone and U.S. Interests • CRS Report, 8/18/11: Greece's Debt Crisis: Overview, Policy Responses, and Implications • Other CRS reports on International Financial Markets and Policies • Other CRS reports on Europe and the EU • IMF, 1/24/12: World Economic Outlook Update - Global Recovery Stalls, Downside Risks Intensify • IMF, 1/24/12: Global Financial Stability Report, Market Update • Council on Foreign Relations, 12/2/11: Backgrounder – The Eurozone in Crisis Witnesses’ Biographies The Honorable Lael Brainard Under Secretary for International Affairs, U.S. Department of the Treasury Under Secretary Brainard advances the Administration's agenda of strengthening U.S. leadership in the global economy to foster growth, create economic opportunities for Americans and address transnational economic challenges, including development, climate change, food security and financial inclusion. She served as the Deputy National Economic Adviser and Deputy Assistant to the President on International Economics during the Clinton Administration, addressing challenges such as the Asian financial crisis and China's access to the World Trade Organization. She also served as the U.S. Sherpa to the G-8. Most recently, Under Secretary Brainard was Vice President and Founding Director of the Global Economy and Development Program at the Brookings Institution, where she held the Bernard L. Schwartz Chair in International Economics and directed the Brookings Initiative on Competitiveness. Previously, Under Secretary Brainard was an Associate Professor of Applied Economics at The Massachusetts Institute of Technology (MIT) Sloan School of Management. Brainard also worked at McKinsey & Co. and separately on microfinance in West Africa. Under Secretary Brainard received masters and doctoral degrees in Economics from Harvard University, where she was a National Science Foundation Fellow. She graduated with highest honors from Wesleyan University. She is also the recipient of a White House Fellowship and a Council on Foreign Relations International Affairs Fellowship. The Honorable Robert D. Hormats Under Secretary for Economic Growth, Energy, and the Environment, U.S. Department of State Under Secretary Hormats leads the State Department’s efforts to develop and implement economic growth, energy, agricultural, oceans, environmental, and science and technology policies to promote economic prosperity and address global challenges in a transparent, rules-based, and sustainable system. The bureaus and offices under his leadership work to advance the Department’s economic statecraft agenda, using America’s global leadership to strengthen our domestic economy; elevate and intensify our efforts on energy security and environmental sustainability; and foster innovation through robust science, entrepreneurship, and technology policies. He was formerly vice chairman of Goldman Sachs (International). He joined Goldman Sachs in 1982. Previously, he served as Assistant Secretary of State for Economic and Business Affairs from 1981 to 1982, Ambassador and Deputy U.S. Trade Representative from 1979 to 1981, and Senior Deputy Assistant Secretary for Economic and Business Affairs at the Department of State from 1977 to 1979. He served as a senior staff member for 6

International Economic Affairs on the National Security Council from 1969 to 1977, where he was senior economic advisor to Dr. Henry Kissinger, General Brent Scowcroft and Dr. Zbigniew Brzezinski. Under Secretary Hormats was a recipient of the French Legion of Honor in 1982 and the Arthur Fleming Award in 1974. Under Secretary Hormats has been a visiting lecturer at Princeton University and served on the Board of Visitors of the Fletcher School of Law and Diplomacy and the Dean’s Council of the John F. Kennedy School of Government at Harvard University. He is also a member of the Council on Foreign Relations. He earned a BA with a concentration in economics and political science from Tufts University in 1965and a MA in 1966 and a PhD in International Economics in 1970 from the Fletcher School of Law and Diplomacy. Mr. Steven B. Kamin Director of the Division of International Finance, Board of Governors of the Federal Reserve System As Director, Steven Kamin is responsible for overseeing the basic research, policy analysis, and reporting in the areas of foreign economic activity, U.S. external trade and capital flows, and developments in international financial markets and institutions at the Federal Reserve. Mr. Kamin has worked at the Fed since 1994. He received a Ph.D., Economics, from the Massachusetts Institute of Technology in 1987 and a B.A., Economics and History, University of California - Berkeley, in 1979.

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