IMF Survey: Financial Crisis Takes Harsh Toll on Europe

IMF News, October 21, 2008

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A confluence of multiple adverse shocks has depressed economic activity in Europe.
Gradual recovery is expected late next year, according to the IMF's regional outlook titled "Europe: Dealing with Shocks."
Restoring financial stability is identified as the main policy priority and requires a comprehensive and coherent global approach.

In advanced Europe:
- Real GDP growth is projected to drop to 1.3 percent in 2008 and 0.2 percent in 2009 (down from 2.8 percent in 2007).
- Growth is expected to start recovering in the second half of 2009.
Growth is weakening in the emerging economies as well.

The turmoil in financial markets has reached crisis proportions in recent weeks.
Several large financial institutions in the United States and Europe failed and had to be nationalized.
Borrowing costs and credit default spreads in Europe have reached historically high levels, severely impairing the functioning of credit markets.
Financial stock prices have fallen substantially, reflecting a spike in risk aversion by investors.
Corporate bond yields are at their highest levels in 10 years.
Growth of credit to businesses and households—and especially mortgage credit—has slowed significantly.
Emerging economies, previously thought immune, are now under serious pressure; a slowdown in Europe may worsen loan quality, especially where housing prices are falling.

Restoring financial stability is the principal policy objective and requires coordinated, global action.
European policymakers should pursue coordinated crisis-management measures; recent steps include:
- A coordinated interest rate cut in October and expanded liquidity provision by several central banks.
- Extended deposit insurance, bank recapitalization programs, and debt guarantees agreed by European leaders.
Longer-term reforms recommended:
- Step up joint financial oversight.
- Introduce mechanisms to strengthen market discipline.
- Improve cross-border crisis resolution frameworks.
Quoted guidance: Alessandro Leipold, Acting Director of the IMF's European Department, urged European leaders to follow up with "bold steps on their recent commitment to concerted and coordinated action, to resolve this crisis swiftly."

Past commodity price increases boosted headline inflation and depressed consumption earlier in the year.
IMF analysis indicates:
- Deteriorating economic conditions, improved labor market flexibility, and stronger monetary policy credibility have limited second-round effects in advanced European economies.
- Energy price increases since 2003 have not had a significant impact on core inflation in advanced European economies.
- Some emerging economies remain vulnerable to spillovers of commodity price pressures, especially where food and fuel are a large share of consumption.
More recently, commodity prices have moderated and headline inflation is receding, creating room for macroeconomic policies to support growth.
In advanced economies, headline inflation is projected to drop to levels below central bank objectives over the policy horizon, allowing a move to a more accommodative policy stance.
In select emerging economies with existing overheating or large external vulnerabilities, a continuing tight policy stance may be justified.
Leipold: "With upside risks to inflation rapidly dissipating, the recent concerted easing of monetary policy was appropriate and there is scope for further easing going forward. Meanwhile, the provisions of the Stability and Growth Pact—which incorporate greater flexibility than is often thought—will allow fiscal policy to cushion the downturn."

IMF Survey: Financial Crisis Takes Harsh Toll on Europe (October 21, 2008).