Europe is going through a deep recession, driven by a collapse in confidence and global demand, and by adverse feedback effects between its financial system and the real economy. Unprecedented policy actions have brought about a measure of stability and cushioned the downturn. However, establishing a solid economic recovery will require additional and effectively coordinated policy interventions. The crisis provides an opportunity to strengthen economic and financial integration in Europe, including by strongly supporting emerging economies, that should not be missed.
On the heels of the global financial crisis, active fiscal policy is back on the agenda of the advanced European economies. Indeed, a fiscal expansion could be particularly effective in the near-term economic environment: the recent tightening of credit constraints could make spending more sensitive to current income and, thus, taxes and subsidies. Given the increased integration of European economies, policy coordination is nonetheless key to magnifying the effects of national fiscal expansions. While it is important for countries to support their economies in the face of this unprecedented slowdown, a clear and credible commitment to long-run fiscal discipline is now more essential than ever: any loss of market confidence may raise long-term real interest rates and debtservice costs, partly offsetting the stimulus effects of measures taken to deal with the crisis and further adding to financing pressures. Hence, it is particularly crucial that any short-term fiscal action be cast within a credible medium-term fiscal framework and envisage a fiscal correction as the crisis abates.
A short period of apparent resilience to the global financial turmoil has given way to a deep crisis in several European emerging markets, though with substantial differentiation across the region. The crisis has put an increased premium on sound macroeconomic and macroprudential policies: countries with lower inflation, smaller current account deficits, and lower dependence on bank-related capital inflows in recent years have so far fared better. While the external environment and structural reform efforts will matter, the banking sector, which has played a central role in the run-up to the crisis, holds a key to the speed of recovery from the crisis. In the short term, bank recapitalizations seem unavoidable to prevent recessions from becoming protracted. In the medium term, recovery efforts need to be supported by a strengthening of financial stability arrangements, including for cross-border activities, and the introduction of more forward-looking provisioning policies.
Andrea M. Maechler, Ms. Srobona Mitra, and Delisle Worrell
This paper assesses how various types of financial risk such as credit risk, market risk, and liquidity risk affect banking stability in emerging Europe. It also examines how the quality of supervisory standards may have mitigated the vulnerabilities arising from these risk factors. Using panel data, the paper finds that (1) credit quality is of general concern especially in circumstances where credit growth is accelerating; (2) although higher provisioning could adversely affect profits and returns volatility, good supervisory policies on provisioning mitigate such adverse effects; and (3) highly liquid banks are not necessarily more stable because they might be pursuing activities with more volatile returns, but a well-functioning payments system helps to lower the adverse impact on stability. The paper also corroborates earlier evidence of the positive (negative) effect of financial depth (foreign ownership) on stability.
Mr. Guillermo Calvo, Mr. Eduardo Borensztein, Mr. Paul R Masson, and Mr. Manmohan S. Kumar
The two papers draw from the brief yet radical reform experiences of five countries-Bulgaria, former Czechoslovakia, Hungary, Poland, and Romania. The first paper describes the financial sector reforms untertaken by these countries since the 1980s, as well as the problems encountered. It also discusses the roles privatization, stabilization policies, and prudential supervision can play in the financial sector development of these countries. The second paper analyzes the different exchange arrangements as they apply to previously centrally planned economies; examines the general arguments for convertability in these countries; and considers the desirable degree of exchange rate flexibility.