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European Outlook: Europe: Riding Out the Market Turbulence

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 2007
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Strong fundamentals should allow Europe’s economies to weather the current financial turmoil, which was sparked by subprime mortgage lending in the United States, relatively well. In the advanced economies, average growth is expected to slow to 2.2 percent of GDP in 2008, down from 2.7 percent in 2007. In the emerging economies, growth should remain robust at 5.7 percent in 2008, down from 6.3 percent in 2007 (see table). However, continued problems in the credit markets constitute a key downside risk to this outlook.

Subprime fallout

A still resilient global economy, combined with generally sound macroeconomic policies and increasing trade and financial integration in Europe, has yielded a vibrant regional economy. After years of sluggish growth, the advanced economies in Europe are expected to outpace the United States this year and next, and the top-performing European emerging economies are posting growth rates second only to developing Asia’s.

But continued problems in the credit markets constitute a key downside risk to the outlook for Europe, especially for its advanced economies. While the broader financial system has continued to function well, money and credit markets remain tight. There is little doubt that protracted financial turbulence would affect the real economy, especially in the context of higher-than-expected oil price increases and euro appreciation.

Despite relatively high external vulnerabilities, the financial turbulence has so far had little effect on Europe’s emerging markets because of limited reliance on interbank markets and complex financial products. But risks have also risen for this part of the region, especially for those countries that have been funding large current account imbalances with foreign bank borrowing. In this regard, the financial turbulence may herald a healthy correction to past exuberance, bringing risk spreads closer to fundamentals, improving credit discipline, and helping reduce external imbalances.

Slower growth ahead

Europe’s economy is expected to slow in 2008, and risks to the outlook have increased. But healthy growth is still expected, especially in Europe’s emerging economies.

(percent)
Real GDP growth
200620072008
Advanced European economies12.92.72.2
Emerging European economies1, 26.66.35.7
Euro area2.82.52.1
Advanced European economies
France32.01.92.0
Germany32.92.42.0
Italy31.91.71.3
Spain33.93.72.7
Switzerland3.22.41.6
United Kingdom42.83.12.3
Emerging European economies
Czech Republic46.45.64.6
Hungary43.92.12.7
Poland46.16.65.3
Russia6.77.06.5
Source: IMF, World Economic Outlook database.

Average weighted by purchasing power parity GDP.

Montenegro has not yet been included in the World Economic Outlook database.

Member of both the European Union (EU) and the euro area.

Member of the EU.

Source: IMF, World Economic Outlook database.

Average weighted by purchasing power parity GDP.

Montenegro has not yet been included in the World Economic Outlook database.

Member of both the European Union (EU) and the euro area.

Member of the EU.

Navigating uncharted waters

The problems in the credit markets have complicated policymakers’ task of maintaining growth without overheating, especially in advanced economies. Although their response has been broadly effective so far, central banks will have to continue to stand ready to provide liquidity.

In the euro area and several other advanced economies, monetary policy has been appropriately kept on hold in view of the downside risks. Looking further ahead, the baseline forecast assumes that these risks will gradually dissipate, in which case a further tightening may be required. Tighter interest rates would, of course, need to be reconsidered if the slowdown became protracted.

In the emerging economies, inflationary pressures and external vulnerabilities could warrant further interest rate increases. In countries where monetary policy tools are either ineffective or unavailable, the tightening will need to be achieved through fiscal restraint. Strong banking supervision will be critical throughout emerging Europe.

Closing supervisory gaps

The subprime lending crisis has underscored the need for financial sector reform. The losses sustained by a number of European financial institutions revealed that prudential frameworks have not kept up with developments in financial innovation. Europe’s financial supervisors will need to do a better job going forward, not least in ensuring that new financial products do not exploit gaps in prudential frameworks.

That said, financial innovation is important to Europe’s overall competitiveness. The challenge will thus be to make prudential arrangements, financial safety nets, and crisis resolution mechanisms more effective without stifling innovation.

Keeping an eye on fiscal policy

Looking beyond the current turmoil, Europe faces major challenges if it wants to sustain reasonably robust growth. More structural reforms will be needed to foster growth, and fiscal consolidation must be stepped up to address expenditure pressures from population aging. Reduced public spending will help Europe’s advanced economies prepare for economic downturns. In the emerging economies, it will help mitigate demand pressures arising from rapid catch-up growth and provide a counterweight to the rapidly rising indebtedness of the private sector.

Luc Everaert

IMF European Department

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