IMF Survey: Europe: Riding Out the Turbulence

November 12, 2007

  • Subprime fallout should be manageable, but growth set to ease in most countries
  • Downside risks rise, especially where foreign borrowing funds imbalances
  • Financial turbulence underscores need to strengthen financial systems

Strong fundamentals should allow Europe's economies to weather the current financial turmoil, sparked by subprime mortgage lending in the United States, relatively well.

Europe: Riding Out the Turbulence

Auto parts in Mulhouse, France: euro area expected to grow faster than United States this year and next, IMF says (photo: Olivier Morin/AFP)


In the advanced economies, the IMF's latest Regional Economic Outlook (REO) for Europe says, average GDP growth is expected to slow to 2.2 percent in 2008, down from 2.7 percent in 2007. In the emerging economies, growth should remain robust at 5.7 percent in 2008, down from 6.3 percent in 2007 (see table). But continued problems in the credit markets constitute a key downside risk to this outlook, the REO, published on November 12, cautioned.

Subprime fallout

A still resilient global economy, combined with generally sound macroeconomic policies and increasing trade and financial integration in Europe, has yielded a vibrant regional economy (see chart). After years of sluggish growth, the advanced economies in Europe are expected to outpace the United States this year and next, and the top-performing European emerging economies are posting growth rates second only to developing Asia.

But continued problems in the credit markets constitute a key downside risk to the outlook for Europe, especially for its advanced economies. While the broader financial system has continued to function well, money and credit markets remain tight. There is little doubt that protracted financial turbulence would have downsides for the real economy, especially as higher-than-expected oil prices increases and euro appreciation are providing some headwind.

Despite relatively high external vulnerabilities, the financial turbulence has so far had little effect on Europe's emerging markets because of limited reliance on interbank markets and complex financial products. But risks have also risen for this part of the region, especially for those countries that have been funding large current account imbalances with foreign bank borrowing. In this regard, the financial turbulence may herald a healthy correction to past exuberance, bringing risk spreads closer to fundamentals, improving credit discipline, and helping to reduce external imbalances.

Uncharted waters

The problems in the credit markets have complicated policymakers' task of maintaining growth without overheating, especially in advanced economies. While their response has been broadly effective so far, central banks will have to continue to stand ready to provide liquidity to deal with systemic risks.

In the euro area and several other advanced economies, monetary policy has been appropriately kept on hold in view of the downside risks associated with the financial turmoil. Looking further ahead, the baseline forecast assumes that these risks will gradually dissipate, in which case a further tightening may be required. Tighter interest rates would of course need to be reconsidered if the slowdown became protracted.

In the emerging economies, inflationary pressures and external vulnerabilities could warrant further interest rate increases. In countries where monetary policy tools are either ineffective or unavailable, the tightening will need to be achieved through fiscal restraint. Strong banking supervision will be critical throughout emerging Europe.

Supervisory gaps

The subprime lending crisis has underscored the need for financial sector reform. The losses sustained by a number of European financial institutions revealed that private and public prudential frameworks have not kept up with developments in financial innovation. Europe's financial supervisors will need to do a better job going forward, not least in ensuring that new financial products do not exploit gaps in prudential frameworks.

That said, financial innovation is important to Europe's overall competitiveness and needs to be encouraged. The challenge will thus be to make prudential arrangements, financial safety nets, and crisis resolution mechanisms more effective without stifling innovation.

Eye on fiscal policy

Looking beyond the current turmoil, Europe faces major challenges if it is to sustain reasonably robust growth. To deal with expenditure pressures from population aging, fiscal consolidation—based on expenditure reduction—needs to return to a more ambitious track.

For several advanced economies, an added reason for reducing expenditures is that deficits remain too high to deal comfortably with eventual downturns. In Europe's emerging economies, more fiscal consolidation is desirable to mitigate convergence-related demand pressures and insure against risks posed by the rapidly rising indebtedness of the private sector. Fiscal consolidation should be complemented by structural reforms that can help deliver on the promise of income convergence, including measures to advance economic and financial integration.

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