Euro area crisis has reached a critical stage. A banking union and greater fiscal integration are needed to safeguard the viability of the monetary union (photo: Lex van Lieshout/ANP/Newscom)
Economic health check
GDP growth in the euro area is expected to come in at -0.3 percent in 2012 and 0.9 percent in 2013. The pace of fiscal adjustment is particularly fast in the hard-hit periphery countries, and this is weighing on the growth outlook. Projected consolidation for 2012-13 ranges from more than 4 percentage points of GDP in Cyprus, Portugal, Greece, and Spain, to 0.5 percentage points or less in Germany, Austria, Finland and Luxembourg. The rate of unemployment is expected to continue to vary widely across the region—from 5 percent in Germany to about 24 percent in Spain this year.
“The immediate priority for the eurozone is to establish a banking union and move toward more fiscal integration. These moves would help stem the decline in confidence engulfing the region, lower borrowing costs for countries facing severe market pressure, break the downward spiral between sovereigns and banks, and reduce the risk of contagion across the euro area,” said Mahmood Pradhan, Deputy Director of the IMF’s European Department and mission chief for the euro area.
Speaking to IMF Survey—the IMF’s online magazine—Pradhan discusses recent economic developments, the outlook, and the policies needed to arrest escalating risks. He also looks at what it would take to spur the growth potential of the euro area (see box below).
Some Key Policy Measures Taken to Address the Crisis: Fiscal, Monetary, and Financial Policies and Structural Reforms
• National governments have embarked on ambitious programs to reduce fiscal deficits and government debt.
• The “Fiscal Compact” has reaffirmed commitments under the Stability and Growth Pact (SGP) and requires countries to enshrine structurally balanced budget rules in national law.
• European leaders have agreed on a “Growth Compact” to stimulate growth, investment and employment.
• The European Central Bank provides a large amount of bank liquidity under relatively accommodative conditions, including through the Long-Term Refinancing Operations (LTROs), and with interest rates at historically low levels.
• European leaders have agreed to create a single bank supervisory mechanism, which with a common backstop will help break the adverse link between sovereigns and banks.
• Once ratified, the European Stability Mechanism will become a permanent support mechanism that is able to provide financial assistance to member states, with a long-term lending capacity of €500 billion.
• The European Banking Authority’s recapitalization exercise will lead to strengthened bank balance sheets in 2012.
IMF Survey online: The IMF said recently that the euro area crisis has reached a critical stage. What do you mean exactly?
Pradhan: The critical stage is indicated by the clear signs of very high levels of stress in a number of financial markets. Risk premia have recently reached a record euro area high in some countries, especially Spain and Italy. This applies to sovereigns as well as to corporate and household borrowers.
This tells us that the adverse links between sovereigns, banks, and the real economy are stronger than ever. As a consequence, financial markets are increasingly fragmented across member countries. In other words, borrowing costs are very high for some countries, but at record lows for others, because capital within the euro area is moving away from the Southern periphery countries to safer havens in Northern Europe.
These developments are not consistent with a properly functioning economic union. They imply a breakdown in the monetary transmission mechanism. The common monetary policy is not working the way it was intended.
IMF Survey online: What short-term policies are needed to offset the impact of ongoing adjustment and support growth in the euro area? Do you think that the recent decisions by euro area leaders on a growth strategy will help?
Pradhan: Achieving growth and financial stability are the two key challenges facing policymakers in the euro area. Growth is crucial for the crisis-stricken countries to escape their debt traps. But growth requires support to underpin demand, even as fiscal consolidation takes place. Such support should come from the common monetary policy and fiscal policy in other countries.
The common monetary policy in the euro area should stay accommodative for a longer period. There is room to reduce policy rates a little bit more. The European Central Bank should, in our view, consider more unconventional measures (for instance, quantitative easing) to support financial markets in countries undergoing severe stress.
Demand can also be supported by fiscal policy. It’s true that fiscal adjustment is inevitable in many countries facing high deficit and debt levels. But in countries with less pressure, the pace of fiscal adjustment is appropriately more gradual.
In addition, the growth compact that has just been announced should help stimulate growth by enhancing infrastructure investment in the euro area.
IMF Survey online: What steps do countries that are currently under market pressure need to take in order to restore confidence?
Pradhan: The priority for countries under pressure is to continue efforts to reduce deficits to restore the health of public finances. This will help restore confidence, including among investors and allow these countries to borrow at reasonable rates.
Second, these countries need more transparency in their banking systems to identify the magnitude of stress. This should be done through independent assessments of bank recapitalization needs. To this end, the large effort underway in Spain—where external auditors will provide an assessment of the scale of the problems in the Spanish banking system—is commendable. Such assessments will help increase credibility vis-à-vis markets while supporting European efforts to gauge the scale of assistance needed to recapitalize the banking system.
Nonetheless, it is crucial that these steps are supported by collective efforts at the euro area level, including a supportive monetary policy and the European firewall—the European Stability Mechanism (ESM). We are encouraged by the fact that the recapitalization program in Spain will be supported by the common pool of financial resources from the euro area.
Finally, the euro area periphery countries also need to improve their growth prospects over time. They will inevitably need structural reforms—particularly in labor and product markets—to restore lost competitiveness.
IMF Survey online: The IMF has supported deeper financial sector integration. Are recent decisions to establish a banking union and allow the ESM to provide capital directly to banks going in the right direction?
Pradhan: Yes, I would say these are definitely the right steps on the roadmap that we have outlined in this year’s euro area Article IV consultation, though let me emphasize that the ESM still needs to be ratified by all member states and made operational as soon as possible.
The key problem in the euro area is the excessive reliance of banks and sovereigns on each other for finance. A strategy to break this link by supporting weak banks through common resources and a complete banking union would demonstrate a clear commitment by euro area policymakers to ensure the viability of the monetary union.
A complete banking union should comprise three elements: first, a common supervision at the euro area level, particularly for large systemic institutions; second, a common deposit insurance; and third, a common resolution framework with a common backstop, so that there are resources to address weak banks where they need help (see box below). So far, there has been a clear commitment on one element; a banking supervisory framework for the euro area. But there have not been firm moves on the other two elements.
Setting up a Banking Union
The euro area crisis is in part due to strong feedback loops between sovereign states and national banks: banks lend to their governments; at the same time, governments are the ultimate backstop for the banks. When governments face difficulties borrowing from capital markets at a reasonable cost, banks also face funding problems.
A banking union for the euro area would help reduce these links. It could combine three main components:
• A single supervisor to provide a unified supervisory framework, and deter financial market fragmentation.
• A bank resolution authority to address problems at weak financial institutions and facilitate orderly restructuring.
• A deposit guarantee scheme to help reassure depositors that their savings are safe and reduce the risk of sudden deposit movements across the currency area.
European leaders plan to set up a single supervisory framework by the end of this year. Plans for the other two components are yet to be made.
To make sure that debt burdens and fiscal adjustment challenges in parts of the euro area do not undermine the whole region it will be necessary to have more fiscal integration. This would require, at some point, common debt issuance with very strong governance safeguards to ensure fiscal discipline at the national level and limit risks of moral hazard, something that concerns many leaders in the euro area.
IMF Survey online: What structural reforms are needed to improve competitiveness and growth?
Pradhan: The issue of raising growth prospects is not confined to the Southern European economies, although their competitiveness problems are arguably more severe. So, when we talk about reforms to raise competitiveness and meet long-term growth challenges, we mean all economies in the euro area.
Labor market reforms are needed to reduce labor costs, increase productivity and raise labor force participation in the Southern economies. Here, improving competitiveness requires lowering costs as well as reforms to make it easier for new companies to enter the market place.
In addition, boosting investment in infrastructure and human capital would support growth and employment. By raising long-term growth, debt dynamics for these economies would be less fragile. More broadly speaking, structural reforms would also make the Southern economies more resilient. In the Northern countries, reforms in the service sector are particularly important to raise productivity.
