## Box 1. Euro Area Spillovers to LICs (_cr11185)

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### I. Background
- The Euro Area (EA) produces about a fifth of global output.
- EA exports and imports together add to almost 30 percent of GDP.
- EA banking exposures to other countries exceed those of all other economies.
- The euro is the second most important reserve currency after the U.S. dollar; its share of reserves has been growing steadily since inception.
- EA program countries (Greece, Ireland, Portugal) jointly represent just 6 percent of EA GDP.
- Their share in the foreign exposure of core EA banks is 2.6 percentage points.
- For core EA banks that hold such assets, exposure is 32 percent of total shareholders’ equity.
- Key program approval dates:
  - Greece program board approval: 9 May 2010
  - Ireland program board approval: 16 December 2010
  - Portugal program approval: 20 May 2011

### II. Views from outside on Euro Area spillovers
- External authorities’ concerns and channels:
  - Primary concern: financial spillovers, escalating sharply if sovereign debt difficulties spread beyond the periphery to Spain and the core EA.
  - Critical channels: financial confidence effects and direct banking channels.
  - Trade and FDI channels: significant for geographically close countries with strong trade ties to the EA.
  - Regulation channel: EU financial regulatory reforms could have major spillovers on neighbors if discretionary regulatory powers change.
- Policy responses regarded as important:
  - Delink sovereign and banking sector problems (stress tests, recapitalizations where needed).
  - Move toward more centralized fiscal policy within the EA.
- Other assessments:
  - Spillovers from EA fiscal consolidation through demand compression regarded as relatively minor; net impact could be positive with credibility gains.
  - Spillovers from ECB policy normalization seen as contained if they do not undermine the periphery.

### III. Mapping euro area spillovers — growth and financial channels
- Growth spillovers
  - S-5 (EA, U.S., U.K., Japan, China) showed highly correlated growth; synchronous contraction in 2008.
  - Spillovers from the EA to other S-4 are meaningful but generally smaller than from the U.S.
  - EA diagnosed as a net importer of global spillovers due to its trade openness versus the U.S.
  - G-20 macroeconometric model: spillovers tend to be greater for economies geographically closer to the EA; among G-20 countries highest impact in Russia, followed by the U.K.
  - Inward and outward output spillover estimates: average peak impulse responses to a 1 percent output shock in another S-4 economy (chart-based results referenced).
  - Non-EA European and North African economies with large trade shares with the EA could face substantial impacts from EA growth shocks.

- Financial sector spillovers
  - Principal components analysis finds:
    - Global common risk component increased sharply in Spring 2010 as peripheral pressures intensified.
    - About one-fifth of the common component of risk across selected global financial markets is driven by volatility in EA financial markets—modestly less than the one-quarter recorded for the U.S.
    - Direct spillovers from Greece, Ireland, Portugal, Spain sovereigns to the rest of the world appear modest once common risk is stripped out; strongest direct effect is on the bond market of EA financial corporations.
    - Spillovers from core EA financial institutions are much larger: after adjusting for common risk, cross-correlations of EA financial sector spreads with EA non-financial corporations and with financial corporations outside the EA are sizable and significant.
  - Shadow banking in the EA seen as less relevant than in the U.S. given EA reliance on traditional relationship banking.

### IV. Policy issues and implications
- If stress is contained to periphery program countries, direct spillovers likely manageable; if stress spreads to the core EA, potential global impact is much larger.
- Multiple analytical approaches (financial price correlations, bank deleveraging analysis, macroeconomic models) support greater global impact when core EA is affected.
- Policy implications emphasized:
  - Shore up banking sector resilience (stress tests, recapitalizations).
  - Reduce sovereign–bank linkages.
  - Coordinate EA policy measures to prevent periphery-to-core transmission.

### Market CDS correlations and conditional probabilities
- Method: use correlations of market CDS spreads to estimate implied conditional probability of distress in non-EA banks/sovereigns given distress in EA program country sovereigns or in a large core EA bank.
- Key findings:
  - Distress in a major core EA bank would raise probability of distress in many non-EA banks to high levels (40 percent or more).
  - Conditional probabilities highest in banks geographically close to the EA and with closest banking links.
  - Spillover to the U.K. would be greatest among the S-4.
  - For most non-EA banks, conditional probability given core EA bank distress is as high or higher than peak implied unconditional probability after Lehman.
  - Conditional probabilities given EA program country sovereign distress are sizable but much lower than those given core EA bank distress.

### Global bank interconnectedness and BIS-based deleveraging scenarios
- Model basis: BIS bank foreign claims; banks deleverage when facing large mark-to-market trading-book losses.
- Two shocks analyzed:
  - Scenario 1: further 30 percent decline (from current levels) in EA program country sovereign and bank bond prices.
  - Scenario 2: further 30 percent decline (from current levels) in bond prices of EA program country sovereigns and of all EA banks.
- Results:
  - Scenario 1 (confined to program countries): some deleveraging, mostly in the EA.
  - Scenario 2 (entire EA affected): much larger impact, especially rest of Europe and parts of North Africa.
  - Results based on direct exposures; indirect exposures (including guarantees via CDS) may exacerbate deleveraging.
  - BIS data indicate total exposure of U.S. banks to EA program countries may be several times as large as direct exposure.
  - Actual spillovers could be more severe if other deleveraging amplifiers (non-bank wholesale funding compression, financial accelerator effects) occur.

### Macroeconomic modeling: “Tremor” and “Earthquake” scenarios (GPM)
- Two illustrative simulations (deviations from pre-crisis baseline, in percentage points):
  - Tremor Scenario (Annual, 2011 / 2012):
    - U.S.: -0.2 / -0.2
    - Euro Area: -0.4 / -0.2
    - Japan: 0.0 / -0.1
    - Emerging Asia: -0.1 / -0.1
    - Latin America: -0.1 / -0.1
    - Remaining GPM countries: -0.2 / -0.2
    - World 1/: -0.2 / -0.1
  - Earthquake Scenario (Annual, 2011 / 2012):
    - U.S.: -0.7 / -0.7
    - Euro Area: -1.4 / -1.3
    - Japan: -0.1 / -0.4
    - Emerging Asia: -0.3 / -0.4
    - Latin America: -0.2 / -0.3
    - Remaining GPM countries: -0.6 / -0.8
    - World 1/: -0.4 / -0.5
  - Note: 1/ GPM world represents 87.5 percent of world GDP by PPP (2007-2010 average).
- Aggregate impacts:
  - Under earthquake scenario, EA growth falls by 2½ percentage points relative to baseline; global growth falls by about 1 percent over 2011−12.

### Authorities’ views and policy implications (market and policy channels)
- Authorities’ assessment:
  - Problems confined to periphery would have modest spillovers.
  - Smaller and better-known exposures to program country assets than 2008 subprime reduce scope for panic.
  - Core area involvement would have severe repercussions.
  - Containing peripheral risk critical: strong national action, effective EA crisis management, completing governance reforms.

### Spillovers from monetary and fiscal policies
- ECB exceptional liquidity provision:
  - Helped contain deleveraging by EA banks and corresponding spillovers.
  - Counterfactual withdrawal of exceptional liquidity and higher funding costs could significantly impact neighboring European countries (e.g., the U.K.).
  - ECB counterparts agreed exceptional liquidity provision helped contain negative spillovers and stated it would not be withdrawn under stressed conditions.
  - Ongoing exceptional liquidity provision can dilute incentives for weak banks to restructure timely.
- Monetary tightening scenarios:
  - Accelerated monetary tightening in the EA estimated to generate moderate output losses: cumulative additional output loss of less than 1 percent over 2011-16 (implicit assumption: EA program countries absorb higher interest rates without intensification of stress).
  - Spillovers to rest of world modest, mainly via reduced EA export demand mitigated by currency depreciation elsewhere.
- Fiscal consolidation:
  - Modeling covers projected EA fiscal consolidation through 2015.
  - If consolidation reduces EA risk premia (partly reversing 150 bps increase since late 2009), net cumulative spillovers to other countries over medium term could turn positive.
  - Authorities argued expenditure-based consolidation may reassure markets and be growth-friendly.

### Structural policy spillovers
- Basel III capital requirements:
  - Higher minimum core capital requirement by 2018; many banks likely implement earlier.
  - Stronger capital requirements have major financial stability benefits but may cause short-term contractionary effects if credit supply is rapidly reduced.
  - Direct output losses outside EA, assuming deleveraging is the adjustment channel, should be modest and within BIS Macroeconomic Assessment Group range.
  - ECB agreed higher capital requirements would generate modest spillovers.
  - Authorities supported swift and robust Basel III implementation without exceptions, with ambitious capital levels and SIFI top-ups, allowing macro-prudential flexibility.
- Labor and product market reforms:
  - Reforms enhancing EA growth potential would have positive but modest spillovers; stronger to Asia and rest of world than to U.S. and Japan.
  - GIMF simulations based on EU 2020-style reforms yield positive labor supply consequences and internal growth gains via budget savings and crowding-in.
- Trade liberalization:
  - A roughly 50 percent reduction in trade-weighted average EA tariff rates would raise total global exports to the EA by more than 1 percent.

### Conclusions and recommended priorities
- Prospect of large spillovers—especially if periphery stress spreads to the core—underscores urgent need for actions to contain and overcome the crisis.
- Decisive further actions called for:
  - Achieve fiscal sustainability.
  - Strengthen economic governance.
  - Introduce greater fiscal risk sharing.
  - Address remaining banking sector weaknesses.
- Planned fiscal consolidation in the EA could benefit the rest of the world if it restores credibility; gradual monetary normalization spillovers manageable if unwinding is timed with banking-sector improvements and reduced sovereign bond volatility.

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### Box 1 — Euro Area spillovers to low-income countries (LICs)
- Direct channels to LICs: trade, remittances, FDI, aid; indirect via global commodity prices.
- EA receives about 20 percent of LIC exports.
- About 30 percent of exports from LICs in Sub-Saharan Africa (SSA) go to the EA.
- About 20 percent of exports from LICs in Asia and CIS go to the EA.
- Fuel and crude material make up roughly 60 percent of LIC exports to Europe in 2008.
- Over 30 percent of SSA’s remittance inflows originate from the EA.
- EA FDI dominates flows to CIS and SSA; EA is largest donor across LICs; EA aid makes up more than 40 percent of total aid to LAC and SSA.

### Empirical evidence on LIC spillovers
- Growth regressions: trading partner growth significantly impacts LIC growth.
- Bilateral FDI analysis: EA growth drives FDI flows to LICs, though effect weaker than recipient economy size.
- Aid flows are procyclical with donors’ business cycles and influenced by donors’ fiscal situations after large shocks.

### Quantitative evidence and common risk contribution
- GVAR model: EA-to-US spillovers about 10 percent; EA-to-UK about a quarter (spillover coefficients interpreted as elasticity measures).
- Principal component analysis: over the sample Aug 2007-Feb 2011, risk commonalities explain about one-third of total volatility; EA contributes to over one-fifth of changes in risk commonalities—second only to the US.
- Volatility spillover patterns:
  - After removing common risk, significant volatility spillovers from EA sovereign bond markets are mainly to EA financial corporations’ bond market.
  - If stress spreads from periphery sovereigns to core EA financial institutions, spillover potential becomes much larger and affects EA non-financial corporations and foreign banks.

### Market-based conditional distress (CoPoD) methodology
- Spillovers measured by averages of estimated Conditional Probabilities of Distress (CoPoD) in non-EA sovereigns and banks given distress in EA sovereigns and banks.
- Distress defined as a hypothetical credit event that triggers CDS contracts.
- CoPoDs estimated using linear and non-linear dependence between individual Probabilities of Distress (PoDs) derived from market quotes.

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### ECB liquidity provision — bank-deleveraging simulation (selected quantitative results)
- Cumulative Euro Area output loss from accelerated monetary tightening: 0.9 percent over 2011−2016.
- ECB exceptional liquidity provision assumed to have lowered funding costs of periphery banks and subsidiaries by 500 basis points in main scenario.
- Simulated overall reductions in foreign claims (Bill US$) — main scenario:
  - Advanced countries: 216
  - Euro area (excluding Luxembourg): 79
  - United Kingdom: 83
  - United States: 34
  - Japan: 6
  - Emerging Markets: 9
  - Central and Eastern Europe: 7
  - Latin America: 2
- Alternative scenario totals (reduced liquidity more severe): 351 (alternative), 416 (750 bps), 36 (250 bps).
- Main scenario deleveraging by country (percent of foreign claims):
  - Irish banks: 36.5 percent
  - Portuguese banks: about 15 percent
  - Greek banks: about 5 percent
- Under a 750 bps funding shock, foreign asset reductions:
  - Irish banks: 68 percent
  - Portuguese banks: 28 percent
  - Greek banks: 18 percent
  - Spanish banks: 1 percent
- Geographic pattern: most spillovers occur within EA and between EA and other advanced economies; UK significantly affected. Spillovers to emerging markets small on average, except some CEE countries.
- Policy caveat: ongoing exceptional liquidity provision can delay restructuring of weak banks.

### Euro Area fiscal consolidation — model simulation results (2011−2016)
- Consolidation path (April 2011 WEO projections):
  - 2011 consolidation on order of 1.7 percent of GDP (0.9 percent is the cyclically-adjusted component).
  - Subsequent years until 2016: adjustments averaging 0.5 percent of GDP.
  - Implied cumulative structural consolidation: 2.4 percent of GDP by end-2016.
- Alternative scenario: sovereign risk premia fall cumulatively by 50 basis points in the EA and by 20 basis points in rest of world by 2016.
- Output effects (2011−2016):
  - Baseline (no risk premia reduction): EA cumulative output losses range from 2.2 to 2.4 percent.
  - Alternative (with risk premia reductions): EA cumulative output losses range from 0.9 to 0.8 percent.
- Spillovers to rest of world:
  - Without risk premia reductions: cumulative output drop over 2011-16 in rest of world on order of 0.5 percent.
  - If risk premia fall, spillovers are largely positive.

### Fiscal consolidation spillovers (additional ranges)
- Estimated cumulative output gains if fiscal consolidation lowers global risk aversion and risk premia: on order of 0.2 percent.
- Region-specific output changes range from -0.3 to 0.5 percent.
- GIMF model shows somewhat larger spillovers than G-20 model due to trade link strengths and trade in intermediate goods.

### Spillovers from higher bank capital requirements — deleveraging and macro impacts
- Bank deleveraging scenarios for a uniform 2 percentage point increase in minimum capital to asset ratios (to reach 6 percent):
  - Banks realize 80 percent of required increase by equity, 20 percent by deleveraging.
  - Deleveraging proportionally across asset classes; assumed no reduction in funding costs from reduced leverage.
- Main deleveraging findings:
  - French, German, Swiss, Swedish banks: reductions equivalent to 6−8 percent of assets.
  - Host-country deleveraging exceeds 5 percent of GDP for Belgium, Cyprus, Iceland, Ireland, New Zealand, and some small countries and emerging markets (three Baltic countries, Hong Kong SAR).
  - Spillovers mostly within EA; EA banks drive most deleveraging.
  - In absolute terms, US and UK see second largest deleveraging but small relative to GDP.
  - Partial transmission to local affiliates (30 percent pass-through) significantly reduces cross-country spillovers.
  - Liquidity funding shocks with 20 percent haircuts marginally increase spillovers; higher haircuts could have large non-linear effects.
- Selected reductions in foreign liabilities to GDP (scenario 1 / scenario 2 / scenario 3):
  - Luxembourg: 47.41% / 48.19% / 37.37%
  - Ireland: 8.30% / 8.48% / 7.46%
  - Belgium: 6.36% / 6.44% / 4.54%
  - Iceland: 5.58% / 5.68% / 5.09%
  - Cyprus: 5.55% / 5.63% / 4.81%
  - Netherlands: 2.98% / 3.03% / 2.82%
  - United Kingdom: 3.91% / 3.98% / 2.51%
  - United States: 0.76% / 0.77% / 0.47%

### Peak output losses from capital adequacy requirement increases
- Estimated peak output loss in the EA from a one percentage point increase in capital adequacy requirements: 0.30 to 0.32 percent.
- A 0.12 percent increase in the interest rate spread (MAG (2010) estimate) approximately linear in the capital adequacy requirement increase.
- In other advanced economies, estimated peak output losses range from 0.01 to 0.09 percent.
- In emerging economies, estimated peak output losses range from 0.02 to 0.14 percent.

### Structural reforms — GIMF results and calibrations
- Combined labor and product market reforms estimated to raise EA steady-state real GDP by almost 6 percent.
- Labor reform components and calibrations:
  - Increase ALMP spending per unemployed worker to average of high-performing European countries.
  - Cut average replacement rate (ARR) to average of selected advanced economies.
  - Increase standard retirement age by two years; move to actuarial neutrality for ages 60-65.
  - ALMP implemented in 2011; other reforms phased from 2012 and perceived credible by 2012.
- Product market reforms:
  - Multifactor productivity gains in tradable and nontradable sectors calibrated to OECD estimates; implemented in 2012; gains realized over 10 years.
- Spillover channels and magnitudes:
  - Reforms raise EA productivity and employment → higher incomes → increased imports → positive spillovers.
  - Spillovers modest to US and Japan; more substantial to emerging Asia and rest of world block.
  - Reduced goods markups account for around two thirds of gains.
- Comparative note: earlier work found EA long-run output rise of about 12 percent from raising competition to U.S. levels; rest-of-world impact then under 1 percent.

### Trade liberalization — 50 percent reduction in EA tariffs
- Partial-equilibrium simulation: 50 percent reduction in trade-weighted average EA tariff rates.
- Main findings:
  - Global exports to the EA increase by more than 1 percent.
  - Largest export volume increases to the EA for countries facing highest current EA tariffs: China, Pakistan, Brazil, Vietnam, New Zealand, Australia.
  - Majority of countries increase exports to the EA; some countries experience export declines due to preference erosion.
  - Adverse distributional effects: 16 countries not eligible for EBA preferences could export less to the EA after unilateral MFN tariff cuts due to preference erosion.
  - Caveats: many EU trading partners already receive preferences; compliance costs and rules of origin constrain preference use for many LICs.

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*International Monetary Fund — Euro Area Policies 2011 Spillover Report (Box 1 and related sections) — _cr11185*

### Box 1. Euro Area Spillovers to LICs ....................................................................................

### Box 1. Euro Area Spillovers to LICs

### I. Background
- The Euro Area (EA) produces about a fifth of global output.
- EA exports and imports together add to almost 30 percent of GDP.
- The EA financial sector is one of the world’s largest; EA banking exposures to other countries exceed those of all other economies.
- The euro is the second most important reserve currency after the U.S. dollar, and its share of reserves has been growing steadily since inception.
- Market perceptions of events in EA program countries (Greece, Ireland, and Portugal) illustrate potential for large spillovers:
  - The three program countries jointly represent just 6 percent of EA GDP.
  - Their share in the foreign exposure of core EA banks is 2.6 percentage points.
  - For core EA banks that hold such assets, exposure is 32 percent of total shareholders’ equity.
- Sovereign CDS spreads and bond yields for the EA program countries rose to historically high levels during the recent stress period; correlations of these spreads with other EA economies remained very high.
- Key program approval dates referenced:
  - Greece program board approval: 9 May 2010
  - Ireland program board approval: 16 December 2010
  - Portugal program approval: 20 May 2011

### II. Views from outside on Euro Area spillovers
- External authorities emphasized financial spillovers as the primary concern, with spillovers escalating sharply if sovereign debt difficulties in the EA intensified and spread beyond the periphery to Spain and the core EA.
- Channels of concern:
  - Financial confidence effects and direct banking channels were seen as especially critical.
  - Trade and FDI channels could be significant, particularly for geographically close countries with strong trade ties to the EA.
- Policy responses that authorities regarded as important to limit spillovers:
  - Measures to delink sovereign and banking sector problems, including stress tests and recapitalizations where needed.
  - More centralized fiscal policy within the EA.
- Other spillovers discussed:
  - Macroeconomic policies: Counterparts saw the prospect of adverse spillovers from EA fiscal consolidation plans—through demand compression—as relatively minor; some noted the net impact could be positive if credibility gains and confidence effects were significant. Spillovers from ECB policy normalization were seen as contained to the extent they did not undermine the periphery.
  - Trade and FDI: Given the EA’s role as the world’s single largest trading entity, trade and FDI links were seen as strong, particularly for neighboring countries and those in EA supply chains.
  - Regulation: Proposed EU financial regulatory reforms could have major spillovers on neighbors, especially if discretionary regulatory powers were affected.

### III. Mapping euro area spillovers
- Growth spillovers
  - The S-5 (EA, U.S., U.K., Japan, China) exhibited highly correlated growth (except China to a lesser extent); the financial crisis produced a synchronous sharp contraction in 2008.
  - Estimated spillovers from the EA to the other S-4 (abstracting from financial contagion) are meaningful but generally smaller than spillovers emanating from the U.S.
  - EA diagnosed as a net importer of global spillovers, attributed to its relative trade openness versus the U.S.
  - A G-20 macroeconometric model indicates spillovers tend to be greater for economies geographically closer to the EA; among G-20 countries the highest impact is found in Russia (reflecting strong trade linkages with the EA), followed by the U.K. (strong trade and financial linkages).
  - Inward and outward output spillover estimates: the analysis depicts average peak impulse responses of output in each S-5 economy to a 1 percent output shock in another S-4 economy (chart-based results referenced in text).
  - The relation between estimated impact of EA output shocks and a country’s share of trade with the EA highlights the importance of trade channels; non-EA European and North African economies—often with even larger trade shares with the EA—could therefore face substantial impacts from EA growth shocks.

- Financial sector spillovers
  - A principal components analysis of global risk factor movements across asset classes finds:
    - The global common risk component increased sharply in Spring 2010 as pressures in peripheral European countries intensified (though not as severely as in late 2008).
    - About one-fifth of the common component of risk across selected global financial markets (interbank rates, bonds, equities) can be shown as being driven by volatility in EA financial markets—only modestly less than the one-quarter recorded for the U.S.
    - Direct spillovers from sovereign bond markets in Greece, Ireland, Portugal, and Spain to the rest of the world appear modest once common risk is stripped out; raw cross-market correlations are widespread, but conditional correlations (with common risk removed) indicate the strongest direct effect from these peripheral sovereign markets is on the bond market of EA financial corporations.
    - In contrast, spillovers from core EA financial institutions appear much larger: after adjusting for common risk, cross-correlations of EA financial sector spreads with spreads of EA non-financial corporations and with financial corporations outside the EA (e.g., Japanese and U.S. banks) are sizable and significant—reflecting direct links among financial institutions and transmission via bank funding markets.
  - Authorities and staff concurred that financial spillovers from core EA banks to the rest of the world could be substantial.
  - Shadow banking in the EA was seen as less relevant than in the U.S., given EA reliance on traditional relationship banking and a relatively large share of the banking sector in overall financing.

### IV. Policy issues
- Spillovers from intensification of EA financial market stress
  - Direct spillovers from further stress in EA program countries would likely remain manageable if contained to those periphery countries.
  - If stress spreads to the core EA, the potential to affect the rest of the world is much larger.
  - Multiple analytical approaches (financial price correlations, bank deleveraging analysis, macroeconomic models) support this conclusion.
  - Comparative distress analysis (April 2011 average) referenced:
    - Current unconditional probability of distress in non-EA banks is compared to expected probability given distress in a) GIP sovereign and b) a core EA bank (chart-based results referenced in text).
  - Policy implications highlighted by the analysis and counterpart views include:
    - Further measures to shore up banking sector resilience (stress tests, recapitalizations) to limit direct banking channels of spillover.
    - Steps to reduce sovereign–bank linkages.
    - Continued attention to coordinated EA policy measures to prevent transmission of periphery stress to the core.

*International Monetary Fund, Euro Area Policies 2011 Spillover Report — Box 1. Euro Area Spillovers to LICs*

### 13.      Financial markets signal that spillovers of further stress in the EA would be large if

### 13.      Financial markets signal that spillovers of further stress in the EA would be large if

### Market CDS correlations and conditional probabilities
- Analysis uses correlations of market CDS spreads to estimate implied conditional probability of distress in a variety of non-EA banks and sovereigns if distress (defined as a (hypothetical) credit event that triggers CDS contracts) were to occur in an EA program country sovereign or bank, or in a large core EA bank.
- A geographically diverse group of countries—and representative banks from those countries—was chosen due to modeling framework and data availability constraints.
- Key finding:
  - If there is distress in a major bank from a core EA economy, the probability of distress in many non-EA banks would rise to high levels (40 percent or more).
  - Conditional probabilities are generally highest in banks based in countries geographically close to the EA and whose banking systems are most closely linked to that of the EA.
  - Among the S-4, the spillover to the U.K. would be greatest, reflecting its very strong banking links with the EA.
  - For most non-EA banks, the estimated conditional probability of distress given distress in a core EA bank is as high or higher than the peak implied unconditional probability of distress in the period after the Lehman bankruptcy.
  - Estimated conditional probabilities of distress in non-EA banks given distress in an EA program country sovereign are sizable but much lower than those conditional on distress in a major core EA bank.

### Global bank interconnectedness and deleveraging scenarios (BIS-based model)
- Model uses BIS bank foreign claims data and assumes banks deleverage when faced with large mark-to-market losses on trading books.
- Two shocks analyzed:
  - (i) Scenario 1: a further decline (from current levels) in EA program country sovereign and bank bond prices of 30 percent.
  - (ii) Scenario 2: a further 30 percent decline (from current levels) in bond prices of EA program country sovereigns and of all EA banks.
- Results:
  - Scenario 1 (confined to program countries) would cause some deleveraging, mostly in the EA itself.
  - Scenario 2 (more severe, affecting entire EA) would have a much larger impact, especially in the rest of Europe and parts of North Africa.
  - Results are based on direct exposures; indirect exposures, including guarantees via CDS contracts, may exacerbate deleveraging.
  - BIS data indicate total exposure of U.S. banks to EA program countries may be several times as large as just the direct exposure.
  - Actual spillovers could be more severe if other factors intensify deleveraging (e.g., compression in non-bank wholesale funding and financial accelerator effects through non-bank private sector balance sheets), which are not captured by the model.

### Macroeconomic modeling: “Tremor” and “Earthquake” scenarios (Global Projections Model, January 2011 WEO update)
- Two illustrative simulations:
  - “Tremor” scenario: milder shock largely confined to EA program countries.
  - “Earthquake” scenario: larger shock that spreads to entire EA and assumes policy response that falls short.
- Key quantitative results (Deviation from pre-crisis baseline, in percentage points):
  - Tremor Scenario (Annual, 2011 / 2012):
    - U.S.: -0.2 / -0.2
    - Euro Area: -0.4 / -0.2
    - Japan: 0.0 / -0.1
    - Emerging Asia: -0.1 / -0.1
    - Latin America: -0.1 / -0.1
    - Remaining GPM countries: -0.2 / -0.2
    - World 1/: -0.2 / -0.1
  - Earthquake Scenario (Annual, 2011 / 2012):
    - U.S.: -0.7 / -0.7
    - Euro Area: -1.4 / -1.3
    - Japan: - 0.1 / - 0.4
    - Emerging Asia: -0.3 / -0.4
    - Latin America: -0.2 / -0.3
    - Remaining GPM countries: -0.6 / -0.8
    - World 1/: -0.4 / -0.5
  - Note: 1/ GPM world represents 87.5 percent of world GDP by PPP (2007-2010 average).
- Aggregate impacts:
  - Under the earthquake scenario, EA growth falls by 2½ percentage points relative to the baseline, while global growth falls by about 1 percent over 2011−12.

### Authorities’ views and policy implications
- Authorities’ assessment:
  - Problems confined to the periphery would have modest spillover effects.
  - Smaller size and greater market knowledge of exposures to EA program country assets than subprime assets in 2008 implied less scope for panic than during the Lehman episode.
  - Market exposure to program country assets has been reduced over the past year, limiting potential spillovers.
  - Core area involvement would have severe repercussions.
  - Containing peripheral risk is critical; key ingredients include strong national policy action, effective EA crisis management, and completing governance reforms.

### Spillovers from monetary and fiscal policies
- ECB exceptional liquidity provision:
  - Has helped contain deleveraging by EA banks and corresponding spillover effects.
  - Counterfactual scenarios indicate withdrawal of exceptional liquidity provision and associated higher funding costs could have significant impact on neighboring European countries, such as the U.K.
  - ECB counterparts agreed exceptional liquidity provision helped contain negative spillovers and stated it would not be withdrawn under stressed conditions.
  - Ongoing exceptional liquidity provision can dilute incentives of weak banks to pursue timely restructuring.
- Monetary tightening scenarios:
  - Baseline assumes monetary tightening in the EA proceeds at pace expected by Euribor futures market; alternative assumes somewhat more frontloaded rate hikes.
  - Macroeconomic model estimates: accelerated monetary tightening in the EA generates moderate output losses, on the order of a cumulative additional output loss of less than 1 percent over 2011-16 (implicit assumption: EA program countries absorb higher interest rates without intensification of stress).
  - Spillovers to rest of world are modest, primarily via reduced EA export demand mitigated by currency depreciation elsewhere.
  - Authorities stressed ECB’s mandate to secure price stability in the euro area overall and saw limited spillovers from faster monetary tightening.
- Fiscal consolidation:
  - Modeling covers projected fiscal consolidation by EA members through 2015, abstracting from monetary policy accommodation.
  - Negative demand effects to other countries estimated to be relatively small since consolidation magnitude for EA as a whole is moderate.
  - If consolidation is accompanied by decline in EA countries’ risk premia—only partly reversing the 150 bps increase since late 2009—net cumulative spillovers to other countries over the medium term could turn positive.
  - Authorities argued impact within EA itself would likely be even more modest than staff estimates due to perceived permanence of fiscal plans and monetary policy responses; expenditure-based consolidation may reassure markets and be growth-friendly.

### Structural policy spillovers
- Basel III capital requirements:
  - Under Basel III, banks are expected to be subject to higher minimum core capital requirement by 2018; many banks likely to implement new requirements well in advance.
  - Stronger capital requirements expected to have major financial stability benefits, but may have short-term contractionary effects if adjustment involves rapid reduction in credit supply.
  - Different analytical approaches suggest direct output losses outside the EA—assuming deleveraging is the means by which EA banks meet higher capital requirements—should be modest and within range reported by BIS Macroeconomic Assessment Group.
  - In countries where EA banks’ subsidiaries account for sizable share of banking activity, impact tempered by subsidiaries’ reliance on domestic funding.
  - ECB agreed higher capital requirements would generate modest spillovers.
  - Authorities supported swift and robust implementation of Basel III without exceptions, with ambitious capital levels and significant top-ups for SIFIs, while allowing flexibility for macro-prudential tools.
- Labor and product market reforms:
  - Reforms enhancing EA growth potential would have positive but modest spillovers to the rest of the world.
  - Simulations (GIMF) based on EU 2020-style reforms (including active labor market policies and pension reform with higher retirement age) yield positive labor supply consequences and internal growth gains via budget savings and crowding-in.
  - Product market reforms assumed to raise multifactor productivity in tradable and nontradable sectors, producing small positive growth spillovers—stronger to Asia and rest of world than to the relatively closed U.S. and Japanese economies.
- Trade liberalization:
  - Based on current offers in Doha round, assuming roughly a 50 percent reduction in trade-weighted average tariff rates applied by EA countries on imports, exports from most countries to the EA would increase.
  - Preliminary results suggest unilateral reduction in EA tariffs would raise total global exports to the area by more than 1 percent.

### Conclusions and recommended priorities
- Prospect of large spillovers—particularly if stress in EA program countries spreads to the core—underscores urgent need for actions to contain and overcome ongoing crisis.
- Measures over past year (national action in pressured countries, establishing EFSF, continuation of ECB unconventional policies) may have helped contain spillovers for now, but EA financial markets remain under stress, requiring additional strong measures.
- Decisive further actions called for:
  - Achieve fiscal sustainability.
  - Strengthen economic governance.
  - Introduce greater fiscal risk sharing.
  - Address remaining banking sector weaknesses.
  - These actions, as outlined in the 2011 Article IV Staff Report and EFFE report, are instrumental in ending the crisis and mitigating adverse spillovers.
- Further observations:
  - Planned fiscal consolidation in the EA could benefit the rest of the world if it restores credibility; direct demand effects likely modest and confidence effects that reduce spreads could more than offset demand losses.
  - Spillovers from gradual monetary policy normalization appear manageable under appropriate conditions; unwinding ECB extraordinary measures must be timed with banking-sector improvements and reduced sovereign bond volatility to limit spillovers.

*EURO AREA POLICIES  2011  SPILLOVER REPORT — INTERNATIONAL MONETARY FUND*

### 26.      Execution  of  the  structural  reform  agenda  will  carry  positive  spillovers.  External

### Execution of the structural reform agenda will carry positive spillovers

### Key findings on structural reform spillovers
- External effects from any temporary deleveraging that banks are forced to undergo in response to tougher capital requirements would be modest, and should be offset by positive externalities from a healthier banking system.
- Reforms to labor and product markets (as laid out in the EU 2020 agenda) and in trade (per the EU’s offers under the Doha round) are positive for the Euro Area (EA) and for its trading partners.

### Box 1 — Euro Area spillovers to low-income countries (LICs)
- Direct channels of EA influence on LICs include trade, remittances, FDI and aid flows; the EA also has indirect spillovers on LICs via global commodity prices.
- The EA receives about 20 percent of LIC exports.
- About 30 percent of exports from LICs in Sub-Saharan Africa (SSA) go to the EA.
- About 20 percent of exports from LICs in Asia and CIS countries go to the EA.
- Commodity exports play an important role in LIC bilateral trade links with Europe where fuel and crude material make up roughly 60 percent of LIC exports to Europe in 2008.
- Over 30 percent of SSA’s remittance inflows originate from the EA.
- EA FDI dominates flows to CIS and SSA countries (EA FDI particularly important for LICs in Sub-Sahara Africa).
- The EA is the largest donor across LICs; EA aid makes up more than 40 percent of total aid to LAC and SSA.

### Empirical evidence on LIC spillovers
- Growth regressions indicate trading partner growth has a significant impact on LIC growth.
- Bilateral FDI analysis suggests EA growth is a driver of FDI flows to LICs, though the effect is much weaker than the size of the recipient economy.
- Evidence indicates aid flows are procyclical with respect to donors’ business cycles and can be influenced by donors’ fiscal situations, particularly when donors face a large negative shock.

### Financial-market and macro-model assessments of EA spillovers (selected quantitative results)
- GVAR model results: output spillovers from the EA to other systemically important economies are meaningful; spillovers to the US are about 10 percent, and to the UK about a quarter (spillover coefficients interpreted as elasticity measures).
- Macroeconometric (G-20) model simulations: five scenarios (supply, demand, monetary policy, term premium, equity risk premium) calibrated to raise EA output by 1 percentage point; average peak impulse responses similar to GVAR results with strongest spillovers to the UK and moderate spillovers elsewhere.
- Average peak impulse response ratios: about a quarter for Russia and the UK (reflecting strong trade, commodity price, and financial linkages).

### Contribution to common risk in global financial markets
- Principal component analysis of asset risk premiums finds the common risk component increased sharply in Spring 2010 as sovereign pressures in peripheral European countries intensified (though not as severe as at the time of the Lehman bankruptcy).
- Over the sample August 2007-February 2011, risk commonalities are found to explain about one-third of the total volatility for the portfolio considered.
- The EA is estimated to contribute to over one-fifth of the changes in risk commonalities—second only to the US.

### Volatility spillover patterns (sovereign and financial sector)
- “Raw” cross-market correlations show widespread observed co-movements across assets and borders.
- After stripping out the common risk component, significant volatility spillovers from EA sovereign bond markets are likely limited primarily to the bond market of EA financial corporations, signaling a surge in EA banks’ perceived riskiness.
- Once stress spreads from periphery sovereigns to core EA financial institutions, spillover potential is much larger: specific volatility spillovers from the EA financial sector (with the common factor stripped out) can significantly increase perceived riskiness of EA non-financial corporations, Japanese and U.S. banks.
- The analysis suggests shocks to EA financial corporate bond spreads tend to be negatively correlated with EMBI+ bond spreads once global risk commonalities are removed (potentially reflecting investors’ hedging strategies or opposite fluctuations in benchmark 10-year government bond yields).

### Market-based conditional distress (CoPoD) assessment — methodology overview
- Spillovers are measured by averages of estimated Conditional Probabilities of Distress (CoPoD) in non-EA sovereigns and banks given distress in EA sovereigns and banks.
- Distress is defined as a hypothetical credit event that triggers CDS contracts.
- CoPoDs are estimated using linear and non-linear dependence between individual probabilities of distress (PoDs) derived from market quotes, following multivariate density optimizing and Conditional Probability of Default methodologies.

*International Monetary Fund — EURO AREA POLICIES 2011 Spillover Report — Selected Issues*

### 0.2  to 0.4

### 0.2  to 0.4

### Overview
- Analysis based on averages of pairwise Conditional Probabilities of Distress (CoPoDs) from January 2010 to April 2011, derived from five-year sovereign and bank CDS spreads in U.S. dollar.
- CDS-to-PoD transformation assumes a constant recovery rate of 40 percent and uses the transformation function described in O'Kane and Turnbull (April, 2003).
- Key finding: EA (Euro Area) spillovers can be substantial — largest in neighboring Europe, smallest in Asia. Distress in EA program country sovereigns could knock on to banks, including core EA banks, producing global systemic effects.

### Sovereign-to-Sovereign spillovers
- Peripheral EA program country sovereign credit events have larger spillovers to neighboring sovereigns (notably Eastern Europe) than elsewhere.
- Meaningful spillovers also occur to some other advanced and emerging markets such as Brazil.
- Conditional Probability of Distress of each Non-Euro Area sovereign given Euro Area Program Country Sovereigns Fall in Distress: averages indicate higher likelihoods in countries with close market confidence links to peripheral EA program countries.

### Sovereign-to-Banks spillovers
- Sovereign credit events in EA program countries would mainly affect banks in those countries.
- Larger effects on banks in countries with close links to the EA such as Hungary and Turkey.
- China and Japan are affected less, reflecting lower exposure.
- Conditional Probability of Distress of Global Banks Given Euro Area Program Country Sovereigns Fall in Distress: elevated conditional PoDs for banks closely linked to EA; Japanese and Chinese banks among least affected.

### Bank-to-Bank spillovers
- Estimated spillovers from EA program country banks are large for other banks in the region; smaller for banks elsewhere.
- Strongest distress spillovers are within Europe, including Hungary, Turkey, Russia and the UK.
- Brazil is indirectly affected, reflecting the large presence of Spanish banks.
- Asian and US banking systems experience relatively less significant spillovers due to: lower direct exposures; stronger local economic conditions (Asia); or investment banking returns that remained robust over 2010 (US).
- Conditional probability of default for the U.S. hovers near the low end of the 0.2–0.4 range, while Brazil is at the upper end.
- Core EA bank distress would be a systemic event impacting banks globally: spillovers from core EA banks are very large for Hungary, Turkey, the UK, Brazil and Russia.
- Under core EA bank distress, the conditional probability of default for the U.S. increases to the upper end of the 0.2–0.4 range.

### Resilience of Japanese and Chinese banks
- Japanese and Chinese banks remain the least affected by spillovers from the EA due to:
  - Lower direct exposure and limited holdings of bonds issued by European sovereigns and banks.
  - Strong liquidity positions based on substantial local deposit bases, insulating them from funding withdrawal pressures.
- The most significant impact of EA bank distress on Asian banks may be via global risk aversion, trade and growth prospects rather than direct exposures.

### Cross-Border Deleveraging: Scenarios and assumptions
- Simulations based on BIS foreign claims and the bank deleveraging model in Tressel (2010).
- Behavioral assumption: banks maintain a target minimum capital-to-asset ratio and contract balance sheets when facing sudden losses.
- Two scenarios considered:
  - Scenario 1 (GIP sovereign & banks): claims held in trading books suffer a 30 percent loss; 20 percent of claims are in trading books; same loss applied to trading books.
  - Scenario 2 (GIP sovereign and banks + other EA banks): same loss assumptions (30 percent loss; 20 percent trading book share); shock affects additional EA banks beyond GIP.
- Events assumed to occur over a short time span during which banks cannot raise equity.
- Trading-book losses arise from a sudden and sharp increase in bond yields affecting claims on governments and banks.
- Exposures indicate spillovers mainly channeled by German and French banks due to size and high leverage; German and French banks have large exposures in percent of their equity to Greece, Ireland, and Portugal.

### Deleveraging simulation findings
- Losses of major international banks remain manageable if crisis is contained to Greece, Ireland and Portugal (GIP).
- Under Scenario 2, trading book losses become large and exceed 10 percent of equity of French and German banks.
- Deleveraging in absolute terms would be largest within the EA itself.
- The US and the UK would be the most affected after the EA in absolute terms, followed by Central and Eastern European countries.
- Most deleveraging would be caused by EA banks.
- Advanced economies and emerging markets in Europe are particularly vulnerable to deleveraging; most susceptible countries (Scenario 2) include Poland, Czech Republic, Hungary, Nordic and Baltic countries.
- Other emerging markets are relatively resilient to such shocks.

### Indirect exposures (BIS consolidated banking statistics, Q4 2010)
- Indirect gross exposures can significantly enlarge the mapping of potential spillovers relative to direct exposures.
- Examples of direct and indirect gross exposures to GIP (amounts shown in the source table; values are "Direct gross exposures" and "Indirect gross exposures" to Greece, Ireland, Portugal; debt issued by banks and sovereign only):
  - France — Direct gross exposures: 17.1 12.1 14.3; Indirect gross exposures: 8.3 12.6 4.5 2.4
  - Germany — Direct gross exposures: 24.9 31.7 23.5; Indirect gross exposures: 5.9 40.4 13.8
  - US — Direct gross exposures: 31 3.8 3.6; Indirect gross exposures: 34.1 54 41.2
  - UK — Direct gross exposures: 6.0 22.8 6.8; Indirect gross exposures: 5.0 59.2 4.7
  - Japan — Direct gross exposures: 0.9 3.1 1.4; Indirect gross exposures: 0.1 1.3 0.6
- Interpretation provided: total exposure for some countries (e.g., U.S., U.K.) may be several times as large when indirect exposures are included; for France and Germany indirects are generally several times smaller than direct exposures.

### Global Projection Model (GPM) analysis: tremor and earthquake scenarios
- GPM: a six-region non-linear rational expectations model (US, EA, Japan, Emerging Asia, Latin America, remaining countries); captures idiosyncratic and instantaneous global shocks and real-financial linkages.
- Two GPM scenarios constructed:
  - "Tremor" (baseline): shocks to EA financial conditions (bank lending) and domestic demand equal to about half of those experienced in the Lehman crisis.
  - "Earthquake" (downside): magnitude of shocks doubled from the tremor scenario (bank lending affected in a manner similar to Lehman; domestic demand doubled).
- GPM results:
  - Tremor scenario: milder shock induces GDP reduction in program countries, with only modest spillover elsewhere. Core EA real economy little affected.
  - Earthquake scenario: if strains spread to core EA and policy response is insufficient, substantial financial market losses and a decline in capital ratios in all EA countries occur; worldwide growth impact substantially higher.
- GPM quantitative results (Deviation from pre-crisis baseline, in percentage points):
  - "Tremor" Scenario
    - U.S.: 2011 -0.2; 2012 -0.2
    - Euro Area: 2011 -0.4; 2012 -0.2
    - Japan: 2011 0.0; 2012 -0.1
    - Emerging Asia: 2011 -0.1; 2012 -0.1
    - Latin America: 2011 -0.1; 2012 -0.1
    - Remaining GPM countries: 2011 -0.2; 2012 -0.2
    - World: 2011 -0.2; 2012 -0.1
  - "Earthquake" Scenario
    - U.S.: 2011 -0.7; 2012 -0.7
    - Euro Area: 2011 -1.4; 2012 -1.3
    - Japan: 2011 -0.1; 2012 -0.4
    - Emerging Asia: 2011 -0.3; 2012 -0.4
    - Latin America: 2011 -0.2; 2012 -0.3
    - Remaining GPM countries: 2011 -0.6; 2012 -0.8
    - World: 2011 -0.4; 2012 -0.5
- Note: GPM world represents 87.5 percent of world GDP by PPP (2007-2010 average).

### Monetary policy and liquidity operations spillovers
- Two ECB-related scenarios analyzed:
  - (i) faster-than-anticipated monetary policy tightening (short-term nominal interest rate returns to its neutral level six quarters sooner than markets expect).
  - (ii) withdrawal of the ECB’s exceptional liquidity provision to banks.
- Findings:
  - Faster-than-anticipated monetary tightening would generate a modest output loss in the EA.
  - Early withdrawal of exceptional liquidity could have significant repercussions, especially for the UK and some CEE countries.

*Source: Staff calculations and analyses as presented in the supplied IMF text.*

### 0.9 percent is estimated over the period

### _cr11185 - 0.9 percent is estimated over the period

### Monetary tightening in the Euro Area and global spillovers
- Cumulative Euro Area output loss of 0.9 percent is estimated over the period 2011−2016.  
- This output loss is generated by the interest rate and exchange rate channels of monetary policy, amplified by an international financial accelerator mechanism.
- Accelerated monetary tightening in the EA is estimated to generate moderate spillovers:
  - Other advanced economies: estimated cumulative output losses range from 0.0 to 0.3 percent over 2011−2016.
  - Emerging economies: estimated cumulative output losses range from 0.0 to 0.2 percent over 2011−2016.
- Spillovers primarily reflect reduced export demand from the EA, mitigated by real effective currency depreciations in the rest of the world.

### ECB liquidity provision — simulation setup and assumptions
- Purpose: estimate cross-border spillovers of the ECB full allotment liquidity provision to the periphery EA’s banks via a bank-deleveraging model.
- Behavioral assumption: banks maintain a target minimum leverage ratio by contracting their balance sheet (deleverage) or recapitalizing when experiencing losses or an increase in the required minimum capital to asset ratio.
- Key historical policy context:
  - The ECB started providing unlimited liquidity at a fixed rate in October 2008 via full allotment tenders.
  - In December 2010, the ECB prolonged the 3-month LTRO as fixed rate full allotment tenders at least until July 2011.
- Main scenario assumptions:
  - Exceptional liquidity provision is assumed to have lowered funding costs of periphery banks and subsidiaries by 500 basis points.
  - Overall funding needs approximated by the sum of (i) the liquidity provision by the ECB to these banks; and (ii) total interbank liabilities.
  - Subsidiaries of periphery banks deleverage in the same proportion as their parent in response to withdrawal of ECB exceptional liquidity provision.
- Alternative and robustness scenarios:
  - Country-differentiated funding shock: funding costs increase by 700 bps in Greece and Ireland, 400 bps in Portugal, and 250 bps in Spain.
  - Sensitivity scenarios: funding costs rise by 250 bps and by 750 bps.
- Rationale for 500 bps:
  - The 500 bps is within the range of the decrease in euribor in late 2008 and the increase in long-term rates in 2010; used as a counterfactual for returning to competitive auctions.

### Simulated impacts and estimated deleveraging
- Overall reductions in foreign claims (Bill US$) — selected main scenario numbers:
  - Advanced countries: 216
  - Euro area (excluding Luxembourg): 79
  - United Kingdom: 83
  - United States: 34
  - Japan: 6
  - Emerging Markets: 9
  - Central and Eastern Europe: 7
  - Latin America: 2
- Scenario comparisons (Reduction in Foreign Claims, Bil US$):
  - Alternative scenario totals: 351
  - Scenario (250 bps): 36
  - Scenario (750 bps): 416
- Bank equity losses and deleveraging:
  - Should exceptional liquidity provision be ended, the funding shock would be substantial for Greek, Portuguese and Irish banks, resulting in losses exceeding 20 percent of bank capital in some cases.
  - Main scenario deleveraging by country (in percent of foreign claims):
    - Irish banks: 36.5 percent
    - Portuguese banks: about 15 percent
    - Greek banks: about 5 percent
  - Under a 750 bps funding shock, foreign asset reductions would be:
    - Irish banks: 68 percent
    - Portuguese banks: 28 percent
    - Greek banks: 18 percent
    - Spanish banks: 1 percent
- Geographic pattern of spillovers:
  - Most spillovers occur within the EA and between the EA and other advanced economies.
  - The UK would be significantly affected due to its role as a financial center and interconnectedness with other European countries.
  - Spillovers to emerging markets are small on average, except for a small number of CEE countries.
- Policy caveat noted in simulations:
  - Ongoing exceptional liquidity provision can have drawbacks, notably delayed restructuring of weak banks.

### Euro Area fiscal consolidation — model simulation results
- Models used:
  - IMF’s Global Integrated Monetary and Fiscal Model (GIMF) — 6-region version.
  - Refined version of the structural macroeconometric model of the Group of Twenty (G-20 model).
- Consolidation path (based on April 2011 World Economic Outlook projections):
  - Consolidation in 2011 on the order of 1.7 percent of GDP (of which 0.9 percent is the cyclically-adjusted component).
  - Subsequent years until 2016: adjustments averaging 0.5 percent of GDP.
  - Implied cumulative fiscal consolidation in structural terms: 2.4 percent of GDP by end-2016.
- Baseline scenario: consolidation does not affect interest rates over the first five years in all regions; change in structural balance is permanent in the year implemented; future changes are not anticipated.
- Alternative scenario: consolidation reduces sovereign risk premia:
  - Sovereign risk premia in the Euro Area assumed to fall gradually by a cumulative 50 basis points by 2016.
  - Rest of the world sovereign risk premia assumed to fall by a cumulative 20 basis points by 2016.
- Output effects (2011−2016):
  - Baseline (no risk premia reduction): Euro Area cumulative output losses range from 2.2 to 2.4 percent.
  - Alternative (with sovereign risk premia reductions): Euro Area cumulative output losses range from 0.9 to 0.8 percent.
  - The generalized fall in risk premia partly offsets Euro Area output losses arising from planned fiscal adjustment (at least until end-2015).
- Spillovers to the rest of the world:
  - Without risk premia reductions: cumulative output drop over 2011-16 in the rest of the world on the order of 0.5 percent.
  - If risk premia fall, spillovers are largely positive.

*Source: Staff calculations.*

### 0.1 to 1.1 percent. By contrast,

### _cr11185 - 0.1 to 1.1 percent. By contrast,

### Fiscal consolidation spillovers (Euro Area)
- Estimated cumulative output gains under a scenario where fiscal consolidation lowers global risk aversion and brings down risk premia worldwide: on the order of 0.2 percent.
- Region-specific output changes range from -0.3 to 0.5 percent.
- Differences across countries reflect trade linkages: greater trade openness and a higher share of trade with the Euro Area imply larger spillovers.
- The GIMF model simulations show somewhat larger spillover effects than the G-20 model, largely due to the strength of trade links and the distinction between trade in final versus intermediate goods.
- Figure caption: "Cumulative Effect of Euro Area Fiscal Consolidation on Output: 2011-2016 — GIMF and G20 Models." (Source: Staff calculations.)

### Spillovers from higher bank capital requirements in the Euro Area — overview
- Analysis integrates cross-border spillovers using: (1) a global model of bank balance sheets (bank deleveraging framework) and (2) a global macroeconometric model (macroeconomic spillovers).
- Focus is on direct potential spillovers only, abstracting from the potentially large positive impact of higher capital requirements on underlying bank stability.
- Simulations are calibrated using BIS consolidated banking statistics; simulations are based on 2010Q2 data.

### Bank deleveraging — scenarios and key assumptions
- Common shock: international banks experience a uniform 2 percentage point increase in their minimum capital to asset ratios (to reach a capital to asset ratio of 6 percent), resulting in a symmetric shock to all asset classes.
- Common funding composition assumption: banks realize 80 percent of the required increase in capital (given total assets) by increasing equity, and 20 percent by deleveraging.
- Deleveraging is proportionally distributed across all asset classes; the risk composition of bank portfolios is assumed constant.
- Assumed, for the model: the reduction in leverage does not lower funding costs.
- Three scenarios:
  - Baseline scenario: full pass-through of the deleveraging to local affiliates of international banks (100 percent).
  - Scenario 2: baseline plus moderate liquidity funding shocks with 20 percent haircuts associated with fire sales.
  - Scenario 3: partial transmission — only a 30 percent pass-through of the deleveraging to local affiliates.

### Bank deleveraging — main quantitative findings
- Reduction in total assets is significant for French, German, Swiss and Swedish banks: reductions equivalent to 6−8 percent of assets.
- Austrian, Canadian, U.S., Italian and Japanese banks do not deleverage significantly following the increase in required capital.
- From a host country perspective, deleveraging exceeds 5 percent of GDP for: Belgium, Cyprus, Iceland, Ireland, and New Zealand; and for a few emerging markets (the three Baltic countries, Hong Kong SAR) and several small countries.
- Spillovers occur mostly within the Euro Area; EA banks drive most of the deleveraging and thus affect other EA countries.
- In absolute terms, the US and the UK would experience the second largest deleveraging, but the spillover remains small in percent of their GDP.
- Partial transmission to local affiliates (scenario 3) significantly reduces cross-country spillovers: the reduction in foreign claims of international banks exceeds or is about 5 percent of GDP in only a few countries under partial pass-through.
- Liquidity funding shocks (scenario 2) with 20 percent haircuts only marginally increase spillovers; higher haircuts would have much larger, highly non-linear effects.

### Selected reductions in foreign liabilities to GDP (Table highlights)
- Luxembourg (reduction by euro area banks): 47.41% (scenario 1), 48.19% (scenario 2), 37.37% (scenario 3).
- Ireland (reduction by euro area banks): 8.30% (scenario 1), 8.48% (scenario 2), 7.46% (scenario 3).
- Belgium (reduction by euro area banks): 6.36% (scenario 1), 6.44% (scenario 2), 4.54% (scenario 3).
- Iceland (reduction by euro area banks): 5.58% (scenario 1), 5.68% (scenario 2), 5.09% (scenario 3).
- Cyprus (reduction by euro area banks): 5.55% (scenario 1), 5.63% (scenario 2), 4.81% (scenario 3).
- Netherlands (reduction by euro area banks): 2.98% (scenario 1), 3.03% (scenario 2), 2.82% (scenario 3).
- United Kingdom (reduction by euro area banks): 3.91% (scenario 1), 3.98% (scenario 2), 2.51% (scenario 3).
- United States (reduction by euro area banks): 0.76% (scenario 1), 0.77% (scenario 2), 0.47% (scenario 3).
- Notes: Table distinguishes reductions in foreign liabilities to GDP by euro area banks and by non-euro area banks; comprehensive country-level figures are reported in the source table.

### Macroeconomic spillovers — modeling approach and transmission
- Analysis uses an extended and refined version of the macroeconometric model of the world economy disaggregated into its fifteen largest national economies (documented in Vitek (2009)).
- Scenarios abstract from monetary policy stabilization and assume transmission exclusively via a permanent increase in the spread between commercial bank lending and deposit rates.
- A capital requirement shock is treated analogously to a permanent monetary policy shock and is transmitted via the interest and exchange rate channels.

### Macroeconomic spillovers — quantitative result
- Estimated peak output loss in the Euro Area from a one percentage point increase in capital adequacy requirements: 0.30 to 0.32 percent, depending on the speed of implementation.

*Source: Staff calculations; Prepared by Thierry Tressel and Francis Vitek.*

### 0.12 percent increase in the interest rate

### 0.12 percent increase in the interest rate

### Peak output losses from capital adequacy requirement increases
- A 0.12 percent increase in the interest rate spread following MAG (2010) is approximately linearly increasing in the capital adequacy requirement increase.
- In other advanced economies, estimated peak output losses range from 0.01 to 0.09 percent.
- In emerging economies, estimated peak output losses range from 0.02 to 0.14 percent.
- These output losses primarily reflect reduced export demand from the EA, mitigated by real effective currency depreciations in the rest of the world.

### Spillovers from structural reforms (Euro Area) — methodology and aggregate results
- Analysis based on IMF’s dynamic general equilibrium model, the Global Integrated Monetary and Fiscal Model (GIMF).
- Structural reforms covered: labor and product market reforms.
- The combined reforms are estimated to raise the steady state level of EA real GDP by almost 6 percent.
- Spillovers vary by region: modest to the United States and Japan; more substantial to emerging Asia and the “rest of world” block.

### Labor market reform scenarios and implementation
- Reform components (based on OECD work):
  - Increase in active labor market policies (ALMP).
  - Reduction of the average replacement rate (ARR).
  - Increase in the standard retirement age by two years.
  - Move to actuarial neutrality for worker ages 60-65 (implicit tax on continued employment reduced to zero).
- Calibration details:
  - ALMP spending per unemployed worker increased to the average level of Denmark, Austria, Netherlands, Norway, Sweden, and Switzerland relative to GDP per capita.
  - ARR cut to the average prevailing in Australia, Canada, Japan, New-Zealand, United Kingdom, and United States.
  - ALMP implemented in 2011; other reforms implemented gradually starting in 2012 and perceived fully credible by 2012.
- Fiscal impacts (IMF staff estimates):
  - Pension outlay savings and ARR reforms reduce government transfers.
  - ALMP requires an increase in government consumption expenditure.
  - Higher employment raises labor tax revenues endogenously in GIMF.
  - Overall fiscal impact of ARR, ALMP, and pension reform are roughly neutral in the first few years; fiscal gains realized gradually from reduced transfers and higher labor income tax revenue.
- Timing and dynamics:
  - ALMP has the largest direct impact on real GDP in the first few years due to increased government consumption and quick household labor supply response.
  - Gains from pension reforms realized over several years as labor supply effects are gradual.
  - ARR implementation delayed to mitigate negative income effects in the first few years.

### Product market reforms — calibration and timing
- Product market reforms result in multifactor productivity growth gains in tradable and nontradable sectors calibrated to match OECD estimates.
- Reforms include moving to best regulatory practices in upstream sectors (average of the three most competitive OECD countries).
- Reforms implemented in 2012; productivity growth gains realized over a 10-year period.
- OECD reforms scaled depending on prior implementation extent.

### Spillovers of EA reforms onto the rest of the world — channels and magnitudes
- Mechanisms:
  - Higher EA productivity and employment increase household incomes and demand for goods, spilling into imports and increasing exports of other regions.
  - In the medium term, rises in EA and world interest rates offset trade channel boosts, limiting spillovers.
  - In the long run, supply responses and fading crowding-out effects make spillovers more significant.
  - International spillovers also arise from appreciation of the rest of the world’s terms of trade due to EA’s increased output and exports, and from EA shifting spending toward investment (higher foreign content).
  - Reduced goods markups (improved product market competition) account for around two thirds of the gains.
- Regional impacts:
  - Spillovers modest in the US and Japan.
  - More substantial in emerging Asia.
  - Quite significant in the “rest of the world” block—neighboring countries (non-EA EU countries, Turkey, Russia) account for about 40 percent of the rest of the world block (in 2007 GDP in US dollar).
- Comparative findings:
  - Earlier work referenced found an EA long-run output rise of about 12 percent from raising product and labor market competition to U.S. levels; calibrated impact on rest of world was just under 1 percent.
  - The spillover coefficient is larger for cuts in goods markups than for wage markups because of stronger output—and hence terms of trade—effects.

### Spillovers from a 50 percent reduction in Euro Area tariffs — model and results
- Approach:
  - Partial-equilibrium model of international trade with many exporting countries; exporters respond to net-of-tariff prices and import demand depends on tariff-inclusive prices.
  - Simulated a 50 percent reduction in trade-weighted average tariff rates applied by EA countries; tariffs elsewhere held fixed.
  - Analysis covers exports and real GDP in 155 exporting countries.
- Main findings:
  - A 50 percent reduction in EA tariffs would raise global exports to the EA by more than 1 percent.
  - Aggregate export volume to the EA increases most for countries currently facing the highest tariff rates in the EA, including China, Pakistan, Brazil, Vietnam, New Zealand, and Australia.
  - Majority of countries experience an increase in export volume to the EA; export volume to the rest of the world may decline (tariffs there unchanged), but aggregate export volume increases for most.
  - Countries with relatively large export shares to the EA experience the largest growth increase.
- Adverse distributional effects:
  - Some countries would export less to the EA after unilateral MFN tariff reductions because of preference erosion for EBA beneficiaries (Everything But Arms) and for countries with preferential trade agreements.
  - The EBA initiative allows exports from 49 developing economies to enter the EU duty free and quota free; only 43 of these countries are included in the model due to data limitations.
  - Export volume declines to the EA for 16 countries not eligible for EBA preferences because they have preferential agreements with EU countries or face tariff rates below MFN rates.
  - Caveats: many EU trading partners already receive preferences, reducing effective preference margins for many LICs; compliance costs with EU rules of origin discourage claiming preferences; many LICs may benefit from sharper Doha cuts for agricultural products and textiles.
- Magnitudes:
  - Preliminary estimates: aggregate exports to the EA increase by more than 1 percent following a 50 percent reduction in average EA tariff rates.

*Prepared by IMF staff based on content in the supplied document.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11185.pdf_