European Central Bank in Frankfurt, Germany. European leaders committed to ensure financial stability of euro area (photo: Thomas Lohnes/Newscom)
INTERVIEW ON EUROPE
In an interview with IMF Survey magazine, Director of the IMF’s European Department Reza Moghadam discusses the pressing challenges facing the euro area and the Fund’s broader role in the region.
IMF Survey online: How do you view the steps European leaders have taken to address the challenges in the eurozone?
Moghadam: We should keep in perspective just how much Europe has done in a short period, particularly given the need for coordination among a large number of countries to reach agreements at the EU and euro area levels.
European policymakers have taken unprecedented action in response to the crisis and have committed to do “whatever is necessary to ensure the financial stability of the euro area.” Toward this end they have created and strengthened their firewall through the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), which just came into force, provided sizable financing to smooth adjustment for countries under pressure, strengthened fiscal discipline through the Fiscal Compact and other measures, and announced their intention to take steps toward a banking union.
For its part, the European Central Bank (ECB) has provided substantial liquidity to banks, stepped in to address market strains through Securities Markets Program (SMP) purchases, and most recently, announced its policies for Outright Monetary Transactions (OMT), which could be a game-changer.
Individual countries also have made meaningful progress to unwind fiscal and external imbalances that developed over years.
All that said, while market conditions have improved in the wake of the OMT announcement, borrowing costs are still high in some areas, further adjustment remains necessary, and the damaging link between banks and sovereigns has not yet been severed.
The elements of a solution are there, but further implementation is needed at both the country and euro area levels, against a backdrop of weak growth and challenges in sustaining political support across the euro area.
IMF Survey: How are IMF-supported programs in the eurozone helping to meet these challenges?
Moghadam: Each country’s challenges are different, and accordingly, so are the programs, but all are seeking to outline a path back to economic health while providing financing to cushion the adjustment.
Drawing on advice from the IMF’s financial experts, Ireland moved quickly after the launch of its program to draw a line under banking sector problems at the heart of its difficulties. It also has significantly unwound the competitiveness loss from the boom, seen modest growth, begun work to reduce large deficits from the downturn and banking cleanup costs, and started to address over time the debt distress of some households and small and medium-sized enterprises. Much lower borrowing spreads and new bond issuance, albeit limited, signal the progress made, but further support, in line with euro area leaders’ statements on improving the sustainability of the well-performing program, could help lock in these gains.
***** European policymakers have taken unprecedented action in response to the crisis and have committed to do “whatever is necessary to ensure the financial stability of the euro area.”
Like Ireland, Portugal has demonstrated strong performance under its program so far and recently undertook a successful bond exchange which helped smooth its maturity profile. Improvements on long-standing competitiveness challenges have been realized and the primary fiscal balance is on an improving path, although more is needed on both fronts, and economic weakness complicates the fiscal task. Perhaps most important in Portugal has been the broad political backing for the program, although recent demonstrations highlight that this cannot be taken for granted.
The array of fiscal, competitiveness, and banking issues Greece faces as well as a high initial debt level have made Greece a challenging case. There has been progress, with a substantial improvement over the past few years in Greece’s primary fiscal balance, labor costs, and the current account balance. But the situation remains difficult, especially with debt still very high and the need for further improvements in competitiveness as well as fiscal adjustment. Our Greece team will continue to work hard to help the Greek authorities chart a course toward stability and renewed confidence.
IMF Survey: How does the IMF assess the prospects for Spain’s economy?
Moghadam: Spain unquestionably faces serious challenges in the wake of credit and housing booms, but the Spanish government is already taking action in the key areas—assessing banking sector needs and moving ahead on its plan to address weaknesses, having already put a backstop in place; identifying further fiscal measures to strengthen the primary balance and reduce the overall deficit; and undertaking reforms, including to the labor market, to help boost competitiveness and bring down unacceptably high unemployment.
In short, Spain has a blueprint for the required actions, including in the financial sector where a recent Financial Sector Assessment Program (FSAP) by the Fund has provided useful guidance.
Some calibration of the pace of fiscal adjustment may be appropriate, but the direction to be taken on financial sector, fiscal, and growth-enhancing structural policies is clear. The key now is implementation, and the government’s determination is encouraging even if there is a long road ahead.
IMF Survey: Do you think the appropriate balance has been struck between austerity and growth in the programs being supported by the IMF in the eurozone?
Moghadam: These countries are facing a very difficult time. All recognize that fiscal adjustment is needed—it is a question of getting the pace of consolidation right. The circumstances facing each country are different so striking the right balance is critical.
We are engaged in a continuous dialogue with the countries themselves as well as with our partners, calibrating our analysis and advice based on conditions on the ground. Again, it has to be a country-by-country approach that depends on factors such as the pace of growth, market pressures, debt levels, as well as the broader package of monetary and structural measures. We are pragmatic.
IMF Survey: What are the IMF’s recommendations on the design and timing of a banking union?
Moghadam: Allowing free financial flows across EU borders but keeping responsibility for banks at the national level made it harder to spot and address trouble brewing, and has intensified the effects of the crisis. Governments have taken on costs related to banking sector cleanups while rising government debt ratios and funding costs have spilt over into higher bank funding costs.
***** Creating a banking union is the logical conclusion to the idea that deeply interconnected banking systems require a much more integrated prudential approach.
Creating a banking union is the logical conclusion to the idea that deeply interconnected banking systems require a much more integrated prudential approach. Moving responsibility for potential financial support, and associated bank supervision, to a pan-euro area entity could break the vicious loop of rising sovereign and bank borrowing costs, going a long way toward ending the crisis.
For that reason the IMF has been forceful in advocating creation of a banking union as part of a more stable long-term architecture for the monetary union.
We think a banking union should have a strong single supervisory mechanism, such as the ECB, working in cooperation with national supervisors. It should also have an effective single resolution mechanism with powers to close or restructure banks and intervene well ahead of insolvency, and it should be supported with common backstops and a pan-euro area deposit insurance scheme.
These elements are essential to break the harmful sovereign-bank linkages. A single framework for banking stability has the potential to bring a uniformly high standard of supervision and enforcement.
It also would help reverse financial fragmentation so that monetary policy transmission is more effective and the ECB policy actions feed through to all corners of the euro area. The banking union should have broad coverage of European banks, but might focus first on banks that could pose systemic risk or that might need recapitalization in the near term.
IMF Survey: Do you think the European Central Bank’s new framework for intervening in the sovereign bond markets has managed to reset expectations in a lasting manner?
Moghadam: Announcement of the ECB’s framework for Outright Monetary Transactions (OMT) has undoubtedly had a substantial positive effect on market conditions, bringing spreads down for countries that had been under pressure.
OMT has been well received because it has the potential to reverse financial fragmentation and remove doubts about the monetary union by allowing ECB intervention in the secondary bond markets of countries that have market access and are demonstrating strong policy commitment and implementation.
Its strong emphasis on policy implementation gives countries a powerful incentive to move on confidence-enhancing actions. That OMT purchases would not have seniority compared to private investors is key to helping countries sustain market access. Down the line, elaborating how OMT might cement a return to markets for countries that are implementing their economic programs, such as Ireland and Portugal, would be very helpful.
As noted by the ECB, use of OMT could involve the IMF and we stand ready to cooperate within our frameworks.
IMF Survey: Turning to the other half of the continent, Eastern and Central Europe have weathered the eurozone problems relatively well, but will that continue?
Moghadam: Initially, Central and Eastern Europe were little affected by eurozone problems. Growth in 2010 and 2011 was around 4¾ percent, as the region rebounded from the deep 2009 crisis. The rebound owed much to a strong adjustment effort and relatively flexible economies: the dangerously high current account deficits of the past no longer exist and good progress has been made in reallocating resources across sectors—construction has shrunk and manufacturing has gained ground.
Markets have taken note. In the past, risk premia for the region used to be much higher than for Western Europe, but that is no longer the case with some risk premia—Estonia and Poland come to mind—now lower than those of France.
In the second half of 2011 and 2012, the crisis started to spill over. Beleaguered eurozone banks resumed withdrawing funds from Central and Eastern Europe. Exports were hit hard when the eurozone slipped into recession. We expect weaker but still positive growth this year and next of around 3 percent.
There are important intra-regional differences though: Poland, Turkey, Russia and the Baltic countries are holding up relatively well, while growth in most countries in Southeastern Europe is very low or negative.
***** Central and Eastern Europe could face formidable challenges if the eurozone crisis is not resolved.
Central and Eastern Europe could face formidable challenges if the eurozone crisis is not resolved. Western Europe is the main export market and the home of the banking groups whose subsidiaries are central to many local financial systems. Moreover, the 2008–09 crisis and the preceding boom have left Central and Eastern Europe with a number of vulnerabilities that are not yet fully worked off, including sizable non-performing loans on banks’ books, increased public debt, and pervasive foreign-currency lending. So there is considerable downside risk to our projections.
What can be done? For Central and Eastern Europe it is paramount to push ahead with reducing these vulnerabilities. In addition, monitoring of financial sectors in close cooperation with the authorities in the countries where the cross-border banking groups are headquartered is key. The IMF promotes such efforts in its bilateral work with member countries throughout Europe, as well as multilaterally in the context of the “Vienna Initiative.”
These actions will help, but Central and Eastern European countries are also looking to eurozone policymakers to contain and resolve the crisis there given important spillovers.
IMF Survey: How do you see the IMF’s future role in Europe?
Moghadam: While euro area challenges have captured many recent headlines, the IMF’s role in Europe has been and will be much broader.
We will continue to conduct surveillance of economic policies for all member countries, provide program support for those undertaking adjustment efforts, and offer technical assistance where needed to help build government capacity.
Most importantly, in each of these areas, the Fund will bring its expertise, cross-country experience, and independent perspective to assist countries in designing sound economic policies and deliver stability and growth.
