1. Outlook: Beyond the Crisis

International Monetary Fund. European Dept.
Published Date:
September 2009
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Fragile Recovery

The Contraction Appears to Be Ending…

The crisis has hit Europe particularly hard, perhaps harder than other regions of the world (see IMF, 2009e), though considerable diversity prevails across the region. All countries have been affected by the financial crisis and the collapse in global trade, with the impact commensurate with the extent of exposure to toxic assets, reliance on securitization, and dependence on world markets. In addition, several countries are suffering from the bursting of homegrown real estate and construction bubbles (Ireland, Spain, the United Kingdom, and the Baltics, for example). And a number of countries have been left vulnerable because of concerns about fiscal sustainability like Greece and Italy or because of concerns about large current account deficits like Hungary and the Balkans.1

There are signs that the recession, which is now one of the deepest and longest on record, is bottoming out. In the advanced economies, very weak investment and falling exports were the main drivers of a contraction that gathered speed at a frightening pace in the second half of 2008 and climaxed in early 2009, with the first quarter showing an annualized drop of GDP of about 10 percent for the European Union (EU) and the euro area (Figure 1). Consumption held up relatively better in many countries, mirroring still-robust real wage growth, the absence of a large-scale labor market adjustment helped by collective bargaining agreements and government-supported work-time reductions, the operation of generous social safety nets, and some fiscal measures supporting specific purchases such as car-scrapping subsidies.2 Ireland and Spain are notable exceptions to this pattern and have seen their unemployment rates rise rapidly amid construction busts (Figure 2). The pace of the fall in GDP slowed markedly during the first half of 2009, however, as the near-panic subsided, confidence ended its free fall, and policy stimulus gained traction. Hence, during the second quarter of 2009, GDP in the EU and euro area contracted by only about 1 and ½ percent (annualized), respectively, while France and Germany registered modest growth.

Figure 1.Euro Area: Contribution to Growth, 2006–09

(Quarter-on-quarter annualized percentage points)

Source: Eurostat.

Figure 2.Selected European Countries and the United States: Unemployment, January 1999–August 2009


Sources: Eurostat; Haver Analytics; and IMF staff calculations.

1/ Excluding Ireland and Spain.

2/ Bulgaria, Croatia, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Turkey, and Ukraine.

Most emerging European economies and new EU member states followed a similar path, but with more heterogeneity. For many of these economies, domestic demand in the rest of Europe and global trade greatly affect their business cycle, a connection that, particularly in Central Europe, is amplified by tight supply chain links to Western neighbors (for example, in the car industry). For other countries, such as the Baltics, that face sharp external financial difficulties, the speed of the downturn is easing more slowly. Russia’s recession is particularly pronounced because of the combination of the reversal in capital flows and low energy prices. Poland, in contrast, the largest of the new EU member states, has so far weathered the global storm remarkably, without registering a contraction. This success has been due to resilient consumption and a relatively low dependence on exports. In addition, the absence of internal or external imbalances allowed room for countercyclical policies.

Financial and capital markets show signs of returning confidence and risk appetite. The yield curve has been steepening, and equity markets have steadied (Figure 3). Compared to the situation before the collapse of Lehman Brothers, when investors fled risky assets and accumulated sovereign bonds, European markets have regained some of the lost ground, and longer-term bond yields in the euro area are approaching precrisis levels. Shorter-run interest rates have come down further across advanced economies and—with delay and at a slower pace—in some emerging economies.

Figure 3.Euro Area: Yield Curves and Equity Markets

Sources: European Central Bank; Datastream; Bloomberg L.P.; and IMF staff calculations.

Nonetheless, problems in the banking sector linger, and credit growth continues to weaken while cross-border flows remain subdued. Banks have been measurably tightening credit standards, citing a weak economic outlook, funding difficulties, and a continued need to reduce the leverage of their balance sheets. Indeed, the pace of credit extension to households and firms is declining in the euro area and elsewhere (Figure 4), and small- and medium-sized enterprises especially are complaining about credit constraints. Recent surveys of bank lending, however, indicate that the pace of standard tightening might be decreasing, at least in EU countries, and it is noteworthy that GDP growth declined even faster than credit aggregates in the euro area, which sends mixed signals about the extent to which supply constraints are affecting credit at this point (Figure 5).

Figure 4.Selected European Countries: Growth of Real Credit to Private Sector, January 2006–May 2009 1/


Sources: Haver Analytics; and IMF, International Financial Statistics.

1/ Unweighted averages of annual growth rates.

Figure 5.Euro Area: Real Bank Credit and GDP Growth, 2000:Q1–2009:Q2


Sources: Eurostat; European Central Bank; Haver Analytics; and IMF staff calculations.

Meanwhile, in emerging Europe, increased official financing and regional coordination between private and public agents have averted a collapse in capital flows to emerging economies; market participants, though, remain concerned about the level of private debt, the availability of external financing, and the instability of the exchange rate (IMF, 2009c). Hence, while capital flows into the region have rebounded slightly from their crisis lows, they remain limited, and there are indications, that interest rates spreads will remain elevated for many European emerging markets for some time (Chapter 4).

… And Inflation Bottoming Out

Against the background of the deep recession associated with a sharp decline in commodity prices, headline inflation has fallen considerably in most advanced economies. In the euro area, it reached into negative territory in mid-2009, and although the most recent readings suggest that inflation may be past its trough, much will depend on any further fluctuations in energy prices (Figure 6). Measures of core inflation, which exclude energy prices, have been declining at a slower pace or moving sideways, which may be among the reasons why inflation expectations are well anchored at positive levels.3 Price developments in emerging European economies, while following the same general pattern, continue to show somewhat more diversity mostly because of nominal fluctuations in the exchange rate. This phenomenon also sets apart the United Kingdom, where the depreciation of the pound has contributed to positive headline inflation since the beginning of the crisis.

Figure 6.Selected European Countries: Headline and Core Inflation, January 2006–July 2009


Sources: Eurostat; Haver Analytics; national authorities; and IMF staff calculations.

Notes: Peggers: Bulgaria, Estonia, Latvia, and Lithuania; New Member State floaters: the Czech Republic, Hungary, Poland, Romania, and the Slovak Republic; Others: Russia, Turkey, and Ukraine.

1/ Harmonized index of consumer price inflation (excluding energy, food, alcohol, and tobacco) excluding Russia and Ukraine, for which national definition was used.

Growth May Be Around the Corner…

Strong policy action across many advanced and emerging economies has eliminated the fears of a major depression and helped stabilize demand. High-frequency indicators have also been increasingly pointing upward (Figure 7), equity values are well off their lows, and there are signs that declines in housing prices are abating. Still, with credit declining, unemployment set to rise, and household balance sheets to be repaired in a number of countries in Europe, upward momentum is likely to remain weak for some time. Indeed, the positive signs of the second quarter in the euro area mask some underlying vulnerabilities: consumption held up, but to a large extent because of temporary public schemes; net exports contributed, but mostly because of declining imports; and capital spending and inventories constituted a drag. History also suggests that recoveries from a deep financial crisis are sluggish (see IMF, 2008, and Chapter 2 of this REO).

Figure 7.Selected European Countries: Key Short-Term Indicators

Source: Datastream.

Source: J.P. Morgan.

Sources: Eurostat, European Commission Business and Consumer Surveys; Haver Analytics; and IMF staff calculations.

1/ Seasonally adjusted; deviations from an index value of 50.

2/ Percentage balance; difference from the value three months earlier.

Sources: Haver Analytics; and IMF staff calculations.

1/ Averaged percentage balance; difference from the value three months earlier.

2/ Difference from an index value of 100.

Source: Datastream.

Source: Datastream.

The baseline forecast thus calls for real activity to remain fairly stable during the rest of 2009, giving way to a moderate recovery in 2010 and a gradual return to more solid growth only afterward (Table 1). In advanced economies, GDP growth should therefore average 0.5 in 2010 and grow at a rate of 1.1 percent by end-2010. Most countries in emerging Europe should see growth resume in 2010, with the subregion’s GDP rising by an average of 1.7 percent. There is a stark difference, however, between the weaker outlook for countries that need to restructure their economy as they adjust to sharply reduced capital inflows and the more promising prospect for those with an already competitive export sector.

Table 1.European Countries: Real GDP Growth and CPI Inflation, 2006–10(Percent)
Real GDP GrowthCPI Inflation
Europe 1/2/
Advanced European economies 1/
Emerging European economies 1/1/
European Union 1/
Euro area2.92.70.7-
Slovak Republic8.510.46.4-
Other EU advanced economies
United Kingdom2.92.60.7-
New EU countries 1/
Czech Republic6.86.12.7-
Non-EU advanced economies
Other emerging economies
Bosnia and Herzegovina6.96.85.5-
Macedonia, FYR4.05.94.9-
Source: IMF, World Economic Outlook.

The baseline predicts headline inflation to remain subdued, as output gaps are expected to continue to be large while commodity prices are projected to rise moderately. The latter will be the dominant factor nudging euro area inflation back to positive levels during the remainder of 2009 to an average of about 0.8 percent during 2010. Countries such as Germany and Ireland that were hit particularly hard by the crisis will experience inflation well below this average. For emerging economies, the picture is more diverse, reflecting, in addition, differences in exchange rate regimes, inflation targets, and policy performance. In the Baltics and Romania, downward pressures are likely to persist for some time, whereas in other New Member States and a number of Balkan countries inflation should be past its trough. In some countries (Ukraine and Russia, for example), inflation will remain relatively high, despite a projected decline.

…But a Robust Recovery Is Unlikely

While the recession is likely to be over, the recovery may not be smooth. On the positive side, confidence has rebounded sharply, in some cases even reaching precrisis levels (Sweden, for example), and equity markets have been buoyant. At the microlevel, the ongoing inventory adjustment could proceed more quickly than many firms anticipate, which could prompt stronger orders than what is currently on the books. Yet, these factors may provide only temporary support for the recovery.

The nature of the global recovery entails substantial risks for Europe. Ideally, as global rebalancing takes place, countries hitherto strongly relying on exports would shift to domestic demand. If that shift were to occur, with emerging Asia in the lead, the upswing could help Europe’s more export-oriented economies regain their footing earlier and more solidly than expected. In case of a short-lived rebalancing, however, global trade would fail to deliver the uplift assumed in the baseline forecast (IMF, 2009e). As the crisis has amply demonstrated, Europe is tightly linked to Asia through trade, and Europe’s high degree of internal integration would spread the repercussions of such a reversal in net exports throughout the region, including among emerging countries.

Links between the real and the financial sector could turn more negative than envisaged. As credit quality declines further because more households struggle with falling income and more firms enter bankruptcy, banks will be less willing or able to support the recovery. Corporate insolvencies are indeed worrisome: for instance, compared to 2008, bankruptcies are up by about 10 percent in Germany, 50 percent in the United Kingdom, and 300 percent in Spain, though from a very low base in the last case (Figure 8). As a consequence, firms seeking new investment financing during the upswing could face constraints. That the European Central Bank (ECB) and the Bank of England have recently turned to moral suasion, asking banks to restart their lending and pass on interest rate cuts to borrowers, underlines this risk. Emerging economies remain vulnerable to significant credit contractions, with the added threat of negative intra-European feedback loops between parent banks and their affiliates abroad.

Figure 8.Selected European Countries: Bankruptcies, 2005–09

(Index, 2007Q1 = 100)

Sources: Haver Analytics; National Institute of Statistics; and IMF staff calculations.

1/ Excluding Nordrhein-Westphalen. Data for 2009:Q2 estimated based on April and May 2009 figures.

2/ Provisional data since 2006:Q1.

3/ Data for England and Wales.

Another risk lies in the fragility of European employment dynamics. While employment has held up well so far, it is likely to deteriorate, particularly in advanced economies. With the growth outlook modest, sales and revenues far below precrisis levels, and the burden of excess capacities heavy, firms are likely to adjust their payrolls downward and postpone rehiring until later in the upswing. Indeed, the stylized facts suggest that employment in euro area countries is significantly more persistent than in the United States or in many of Europe’s emerging economies (Figure 9). On average, employment tends to hold up better during downturns but takes much longer to pick up during upturns. As a consequence, the recovery is likely to be jobless, and initially further job losses are probable (Box 1)—a situation that opens up the possibility of a downward spiral of deteriorating consumer sentiment, consumption, and investment.

Figure 9.Selected Countries: Employment Over the Business Cycle

(Employment rate, change in percent)
(Employment rate, change in percent)

Sources: OECD, Eonomic Outlook; Haver Analytics; and IMF staff calculations. Notes: All data are logarithmic change times 100. Time-axis shows quarters around the peak of the business cycle.

1/ Excludes Greece, Luxembourg, Netherlands, Slovak Republic, and Slovenia.

2/ Bulgaria, Estonia, Latvia, Poland, Romania, and Turkey.

3/ Excludes Luxembourg, Slovak Republic, and Slovenia.

4/ Bulgaria, Estonia, Hungary, Latvia, Poland, Romania, and Turkey.

Box 1.Employment and Productivity Dynamics Around Recessions: Germany, Spain, and the United Kingdom

While the global financial crisis and recession have hit all of Europe’s economies, the impact has varied considerably across countries. Output and employment, for instance, have moved quite differently in Germany, Spain, and the United Kingdom, three of the larger European economies. Institutions, policies, and additional idiosyncratic shocks are possible explanations for this heterogeneity. How these factors play out will affect the type of recovery ahead.

To separate the roles of policies, institutions, and shocks in the reaction to the crisis, it is useful to compare the output and labor dynamics during the current cycle with the stylized historical behavior suggested by previous cycles. To that end, the time path of the change in per capita output can be broken down into changes in the employment rate, labor productivity, and labor force participation.1 By definition, these series are interrelated: if employment moves in line with output, but with little change in the labor force, labor productivity would hold steady; in contrast, if employment changed little as output dropped, labor hoarding would take place, leading to an adjustment in hours worked per employee.

The fact that Germany, Spain, and the United Kingdom have all seen a significantly larger fall in output per capita than they have in the past illustrates the singularity of the current recession in Europe.2 The contrast between previous cycles and the current recession is most striking in Germany (see first figure), with its massive drop in output in the current downturn. But perhaps equally striking is the degree to which the dynamics of employment and productivity vary among countries.

As in past downturns, Spain had the steepest reduction in the employment rate, followed by the United Kingdom and Germany. However, current employment losses in Spain (see second figure)—where the global crisis has coincided with the end of an extraordinary but unsustainable housing and construction boom—have been substantially higher than in previous cycles. For the United Kingdom, while employment losses are also higher than is typical at this point in the cycle, they are moderate compared to Spain. In contrast, Germany has seen fewer employment losses than in previous recessions.

Germany: Labor Market Dynamics Around Recessions

Sources: OECD, Economic Outlook; and IMF staff calculations.

Note: All data are logarithmic change times 100. Time-axis shows quarters around the peak of the business cycle.

The stark differences in employment responses are mirrored in pronounced differences in productivity dynamics. With little or no labor hoarding, Spanish productivity tends to grow more steadily and at positive rates during recessions, including the current one. In the United Kingdom (see third figure), productivity usually falls during a recession, but the decline has been somewhat steeper this time around.3 The very sharp drop in productivity in the current recession in Germany deviates substantially from its historical pattern of smooth productivity declines.

Institutional labor market flexibility—employment protection in particular—is often seen as highly relevant in explaining variations in labor adjustments to shocks.4 Higher levels of employment protection tend to reduce both inflows and outflows into employment and can slow down labor reallocation after major shocks. In addition to the legislated rules, such as dismissal protection for regular employees or restrictions on temporary work agencies, their interpretation and implementation also play a role (OECD, 2004). In Germany, for instance, labor court decisions and collective bargaining agreements have tended to reinforce the legal restrictions.5 And indeed, based on the OECD’s summary indicator of employment protection, countries with less employment protection have generally greater job destruction during a downturn but greater job creation during the recovery than countries with more protection (although other adjustment costs and their possible asymmetry will also influence the cyclical pattern of job destruction and creation). At nearly 2 percent during a typical recession, the peak year-over-year decline in the employment rate for countries with lower employment protection is well outside the interquartile range for countries with higher protection. And, so far, job destruction in the current recession seems to follow the same pattern (IMF, 2009e, Box 1.3).6

Spain: Labor Market Dynamics Around Recessions

Sources: OECD, Economic Outlook; and IMF staff calculations.

Note: All data are logarithmic change times 100. Time-axis shows quarters around the peak of the business cycle.

However, the case of Spain—which has large employment losses despite high employment protection—illustrates that labor market flexibility is a multifaceted concept. One factor at play is the dual nature of the Spanish labor market, which is characterized by a very high share of employees with fixed-term contracts. At currently about 25 percent (down from about 30 percent one year ago) overall and about 40 percent in the construction sector, the share of fixed-term workers is much higher than the EU average (table). As a result, employment adjusts relatively faster in Spain, as firms let fixed-term contracts expire or fire workers on such contracts, given lower and more predictable firing costs.7 In the current recession, shocks such as the strong decline in construction activity and the steep increase in bankruptcies (see Figure 8) have amplified that trend. Given the high level of protection for permanent employees and very limited wage flexibility overall (reflecting, among other things, the role of labor unions, collective wage bargaining outcomes, and wage indexation), many small and medium-sized enterprises face bankruptcy, given the size of the adverse shock. Still, so far, fixed-term workers have been bearing the brunt of the overall employment adjustment.

During the current cycle, the slower employment adjustment and stronger drop in productivity in Germany compared with the United Kingdom support the idea that labor market flexibility matters but that other factors are also at play. On the policy front, the United Kingdom has recently introduced measures to support employment, and Germany’s active labor market policies in the form of subsidies to support reductions in working hours while avoiding dismissals are particularly relevant. In addition, Germany’s production structure, which is geared toward high skill intensive capital goods, provides a strong incentive for firms to retain their employees; and a prolonged phase of wage moderation (supported by collective wage agreements that sometimes trade wage concessions for employment guarantees) has made such behavior less costly.

United Kingdom: Labor Market Dynamics Around Recessions

Sources: OECD, Economic Outlook; and IMF staff calculations.

Note: All data are logarithmic change times 100. Time-axis shows quarters around the peak of the business cycle.

Selected Indicators of Labor Market Flexibility, 2008
Strictness of employment protection (index) 1/Fixed term employees (percent of total) 2/
OverallRegular employmentTemporary employmentCollective dismissals
United Kingdom1.
Sources: OECD, Employment Outlook; Eurostat; and IMF staff calculations.

These findings have a number of implications for employment during the recovery:

  • For Germany, job creation is likely to be low by historical standards as substantial labor hoarding will have to be unwound. Worse, job reductions are probably unavoidable unless global demand picks up more rapidly than envisioned.

  • A jobless recovery could also be in the cards for the United Kingdom. While lack of labor market flexibility is not an issue in the sense that employment protection is low, the financial crisis has hit the banking sector particularly hard in the United Kingdom, which typically is associated with a slow recovery (see IMF, 2009e, Chapter 4), and some labor hoarding will need to be worked off.

  • In Spain, although labor hoarding is less of a problem, it is unclear whether the expiration of fixed-term contracts will be sufficient to absorb the impact of a major housing and construction bust in the near term.

Note: The authors of this box are Ravi Balakrishnan and Helge Berger.1 Formally, Δ log (Y/P) = Δ log (Y/E) + Δ log (E/LF) + Δ log (LF/P), where Y is real GDP, P is population, E is employment, LF is the labor force, and Δ log indicates the change in the logarithm (see IMF 2009e, Box 1.3).2 The historical data are at a quarterly frequency and include recessions going back to the 1970s. The historical patterns are identified using the median response over past cycles. In the figures below, results are presented along a centered time axis, with T=0 indicating a peak in real GDP growth.3 The median historical pattern for the United Kingdom masks a trend toward a more pronounced employment and a smaller productivity response to recessions since the 1980s. However, by some measures the employment adjustment during the current recession looks small compared with other recent downturns. See Felices (2003) and Bank of England (2009) for a more detailed discussion.4 Other factors include the coverage of collective bargaining agreements. See Nickell, Nunziata, and Ochel (2005) for a recent analysis of the role of institutions for labor market performance in Europe.5Grund (2006) and Berger (1998), among others, discuss labor court behavior in Germany.6 The indicator weighs more than 18 dimensions of legislated and actual employment protection, including notification requirements, severance pay, difficulties of dismissal, minimum wage requirements for temporary workers, and any additional costs attached to collective dismissals.7 Fixed-term contracts also have limited possibilities for labor court recourse. See Ayuso i Casals (2004) for a more detailed discussion of the dual labor market in Spain. The European Union’s average fixed-term employment share is 14 percent.

Strong Policy Response

Although policy frameworks in Europe typically take a medium-term approach, policymakers have adapted and moved steadily to address many of the policy and coordination challenges raised by the crisis. As a result, economic policy has contributed significantly to reducing the impact of the crisis, truncating tail risks, and paving the way for the recovery.

Progress in Repairing the Financial System

The first phase of financial sector interventions was characterized by a flurry of measures aimed at eliminating systemic risk that, owing to the urgency of the crisis and the lack of established European processes for dealing with it, often had an impromptu character (see IMF, 2009d). While early on central banks provided significant liquidity support, measures to address underlying solvency issues—such as guarantees of bank liabilities, the provision of funds for recapitalization, the restructuring of unviable institutions, and the establishment of ways to deal with impaired assets, took longer to coordinate and implement; a process still underway.

More unified financial sector stress testing for the entire region is now being undertaken. A joint supervisory exercise, coordinated by the Committee of European Banking Supervisors (CEBS) and supported by the ECB, looked into the robustness of 22 major European banking groups, the majority of which are operating across borders, including in emerging Europe. And an initiative involving Central, Eastern, and Southern European central banks coordinated by the IMF is stress testing banks in this region to provide an up-to-date assessment of their potential resilience to shocks and to identify capital needs. While not immediately linked to action, these exercises provide critical information that can help supervisors gauge what needs to be done to clean the remaining financial sector risks from the system.

Meanwhile, a focused effort is underway to fill some of the policy gaps at the European level and to clarify the framework for postcrisis financial stability and the regulatory environment essential for allowing the financial system to resume its intermediation role:

  • Turning crisis into opportunity, policymakers in the EU have agreed to attempt an ambitious overhaul of the EU’s financial stability arrangements.4 While many details of the reforms are still under discussion, the European System of Financial Supervisors (ESFS) will bring together national supervisors with independent European Supervisory Authorities (ESAs) to coordinate rulebooks and supervision of cross-border institutions. The European Systemic Risk Board (ESRB) is to bridge the gap between macro- and microprudential oversight and could support monetary policy by initiating the use of macroprudential regulation to mitigate unwanted trends in asset prices, while taking into account the diversity of European markets (see Box 2).

  • In addition, numerous regulatory initiatives are in the pipeline. Among other things, the EU has introduced a set of proposals to standardize regulation of the financial industry, including a legal framework for credit-rating agencies and hedge funds, a directive updating capital requirements for banks, and regulation of cross-border payments, some of which (such as the treatment of non-EU entities in hedge fund regulation) are being intensively debated both within the EU and internationally. There is also a discussion about the usefulness of forbearance in accounting, where some have argued for greater leeway in the evaluation of crisis-impaired assets, while others point to the advantages of transparency in financial accounting.5

Box 2.Asset Price Swings, Monetary Policy, and Prudential Policy: A European View

As turmoil in the global financial markets has demonstrated, financial systems are inherently subject to cycles: growth in lending, leverage, and asset prices often magnify underlying economic dynamics and lead, at times, to a buildup of financial imbalances followed by sharp corrections. Financial cycles can, in turn, have an impact on the economy, both by affecting the capital adequacy of lenders and their ability to extend loans and by altering asset prices and collateral values and thereby impinging on the creditworthiness of borrowers. Indeed, by reinforcing the role of financial assets as collateral, the financial sector has the potential to amplify fluctuations in the business cycle and increase the impact of monetary policy shocks and movements of asset prices on real activity.1 Moreover, cross-border ownership of financial assets exposes financial institutions to macroeconomic, financial, and asset price fluctuations in other countries where they hold positions. Within Europe, although macrofinancial links appear particularly complex and are increasingly integrated across borders, country-specific characteristics, preconditions, and developments in housing and corporate finance systems account for a wide dispersion of responses to swings in asset prices and financial conditions in different economies.2 What can European policymakers do to lessen the undesirable macroeconomic volatility associated with the dynamics of asset prices in the face of highly integrated and converging, but still heterogeneous national financial systems?

Monetary Policy and Fluctuations in Asset Prices

Many now consider that monetary policy should bear some responsibility for avoiding excessive volatility in asset prices. Recent empirical studies posit that monetary policy should be relatively more aggressive in economies whose financial markets are more developed, allowing agents to borrow more easily against financial wealth and build up higher stocks of private debt.3 In a risk-management framework, such an approach would also need to accommodate the uncertainty about what factors are driving asset prices—in particular, whether they reflect speculative forces or changes in fundamentals—and their impact on the economy. It would also be important to apply such an approach symmetrically: while easing monetary policy may be justified when asset prices fall rapidly, “leaning against the wind” by tightening during asset price booms may also prove useful in limiting the risk of a buildup of financial imbalances. Paying attention to developments in asset prices need not require a change in the formal mandates of major central banks, but could be achieved by interpreting existing mandates more flexibly: for instance, central banks could extend the horizon for inflation and output targets and pay greater attention to financial indicators and their interaction with those targets.

Curbing the Buildup of Financial Imbalances

Monetary policy, however, cannot do the job alone.4 Within a currency area, the effectiveness of a single monetary authority in curbing the risk of a buildup of financial imbalances is necessarily limited because its response can focus only on area-wide aggregates and not on financial developments in each national market. Fiscal space permitting, countercyclical national fiscal policies that reduce the intensity of boom-and-bust cycles could be important in this regard. But prudential policies should play a critical role in guarding against a national or regional buildup of financial risk. At the same time, though, the objective of a single financial market and its prerequisite of establishing a level playing field argue against variations in financial regulation within the European Union (EU).

How can the tensions between these different objectives be resolved? The key is giving prudential policies (regulation and supervision) a greater macroeconomic focus and increasing their effectiveness but to do so in ways that minimize distortions and are consistent with the objective of a single financial market. In the present set-up, national supervisors have struggled to keep pace with increasingly complex cross-border links within the EU. Many supervisors, each with its own practices and rules, can be involved in the supervision of a single cross-border financial conglomerate or in the supervision of a national financial market with an extensive foreign presence. This criss-crossing of responsibilities creates a coordination problem in two dimensions: the effective supervision of cross-border groups and effective prudential action to avoid a national or regional buildup of risk. Given the growth of cross-border activity and the increasing number of cross-border mergers of financial institutions, these coordination challenges have become all but insurmountable within a system consisting of a large number of independent national supervisors.

Reforms of Cross-Border Arrangements for Financial Stability

Against this background, in June 2009 the EU adopted an ambitious reform program of its cross-border arrangements for financial stability, comprising the establishment of two new structures: the European Systemic Risk Board (ESRB) and the European System of Financial Supervisors (ESFS). While the ESRB will be tasked with identifying systemic risks and recommending ways to address them, the ESFS will seek to harmonize prudential rules and supervisory practices and oversee the national supervisors. On the basis of its assessments, the ESRB will be able to issue risk warnings and specific recommendations to the ESFS and other policymakers. This set-up could potentially deliver the right combination of a centralized monitoring and assessment of risks and a targeted and effective implementation of measures, by leveraging the advantages of close contact with financial firms, extensive experience, and detailed information that the national supervisors possess. To realize this potential, the ESRB will need to monitor developments in individual member states or groups of member states, respond to concerns of authorities in individual countries, and recommend tailored responses using the most appropriate policy tools. The ESFS will need to ensure an effective follow-up to ESRB advice, close cooperation so that national supervisors act together as an integrated system, and high-quality supervision of all parts of the financial system. To do so, it will need effective powers over national supervisors, as well as adequate tools for overseeing the work of the colleges of national supervisors that will organize the supervision of cross-border groups.

Dealing with Boom-and-Bust Cycles

How should this system deal with boom-and-bust cycles? An important part of the answer should be to correct the procyclical bias in bank capital requirements that conventional risk management and regulatory tools tend to exhibit.5 In a system where loan loss provisions are tied to loan delinquency, cyclical variations in loan delinquencies affect both the capital and the capital needs of financial institutions. This feedback loop reinforces the magnitude of boom-bust cycles, and risks credit squeezes that turn downswings into financial and economic crises.6 To mitigate these cyclical effects, some European supervisors (for example, in Spain) have advocated (and implemented) the use of countercyclical provisioning methodologies (sometimes referred to as “dynamic” or “statistical”), which require banks to provision more than evidenced by losses in good times, when the identified need for provisioning is smaller, and draw against these reserves in bad times, when the need for provisions is larger.7 A harmonized system of countercyclical capital requirements could be an important element in resolving the EU’s financial stability conundrum. To counter potentially divergent national and regional developments within the EU, such a system should tie capital requirements to the riskiness and cyclicality of the exposures, applying equally to any EU institution that holds these exposures. Concretely, concerns about developments in asset prices in one or more specific countries should lead to increased capital requirements for all EU banks that hold related exposures, regardless of where these banks are headquartered. This approach would serve both the objective of financial integration, by allowing a single rule book and a “level playing field,” and that of financial stability, by greatly reducing the scope for circumvention and regulatory arbitrage.

Note: The main authors of this box are Wim Fonteyne and Silvia Sgherri.1 The observation that credit-fueled booms in asset prices were particularly likely to end in financial crises is hardly new (Charles Kindleberger, 1978). The role of balance sheet effects and collateral in credit cycles was first singled out by Bernanke and Gertler (1989) and later developed by Kiyotaki and Moore (1997) and Bernanke, Gertler, and Gilchrist (1999). A well-known exposition of the procyclical feature of financial systems is Minsky’s financial instability hypothesis (Minsky, 1992).2 For an in-depth cross-country study on differences in financing conditions in European economies and their crucial role in accounting for a dispersion of responses to a “credit squeeze” across Europe, see IMF (2008).3 See, for instance, the recent contribution by Christiano and others (2009) for a DSGE model of the euro area embedding a financial accelerator mechanism and the studies by Calza, Monacelli, and Stracca (2007) and Iacoviello and Neri (2008) for estimated models allowing for housing financing.4 For a more detailed discussion, see IMF (2009e, Chapter 3).5 There is a growing literature on the potential procyclicality of the new risk-sensitive bank capital regulation—known as Basel II—mirroring the concern that the increase in capital requirements during downturns might severely contract the supply of credit. On this point, see, among others, Jokipii and Milne (2006), Taylor and Goodhart (2006), Saurina and Trucharte (2007), and Repullo and Suarez (2008). For recent policy discussions, see also Caruana and Narain (2008) and Goodhart and Persaud (2008).6 Borio, Furfine, and Lowe (2001) review the factors contributing to swings in credit conditions that may amplify macroeconomic cycles. They stress the role played by the inappropriate response of financial market participants to shifts in the level of risk—especially in its systematic component—as an important source of this amplification. Incorrect responses appear to be due not only to a misassessment of risk over time but also to distortive incentives likely to make financial market participants react in a socially suboptimal way.7 Model simulations of a decrease in procyclicality of banks’ lending—following, for example, the introduction of a countercyclical element into prudential regulation of banks’ capital—suggest substantial reductions in the volatility of investment in financially integrated economies with high stocks of private debt (see, for instance, Gruss and Sgherri, 2009).

Macroeconomic Policies Have Been Supportive

In response to disinflationary pressures, monetary policy has made full use of its conventional instruments. Since the beginning of the crisis, the ECB has lowered its policy rate by 3.25 percentage points to 1 percent, adjusted its refinancing operations to fixed-rate tenders with full allotment, and, in a widely observed move in June 2009, offered extended refinancing operations with a one-year maturity. The liquidity operation in June was remarkable not only because of its size but also because it strongly conveyed the message that interest rates would stay low for a lengthy period. Sweden’s Riksbank, too, has explicitly communicated its expectation that policy rates would remain low as long as necessary to steer the economy out of the crisis. And despite the fact that monetary policy had to tread more carefully in emerging Europe, collectively Europe’s central banks have contributed significantly to mitigating the risks of an economic meltdown.

Monetary policymakers have also expanded their arsenal where needed to bolster the effectiveness of their stance. Policy rate changes have continued to affect markets, but weaker and slower transmission compared to the precrisis period prompted a search for means to enhance policy effectiveness (Cihák, Harjes, and Stavrev, 2009). While the Bank of England, similar to the Federal Reserve, has moved to support sovereign as well as corporate bond markets directly, the ECB so far has focused its open-market interventions on covered bonds and on a relatively limited scale (Meier, 2009). It has, however, broadened its already very wide collateral list for more traditional refinancing operations to support security markets, including mortgage-backed securities. While these approaches differ, owing, in part, to the differences in financial systems, the resulting increase in central bank balance sheets has been broadly similar, and the levels reached are equally remarkable (Figure 10). The associated buildup of risk in the aggregated public sector balance sheet—which comes in addition to the contingent liabilities from government interventions in the financial sector—has raised new questions for fiscal management.

Figure 10.Selected Countries: Central Banks’ Total Assets, January 2007–August 2009

(Percent of GDP)

Sources: National central banks; Haver Analytics; and IMF staff caclulations.

Fiscal policy played an important role in supporting the economy and forestalling a downward spiral in demand. The euro area-wide discretionary stimulus amounts to about 1 percent per year in 2009 and 2010. The brunt of the fiscal reaction, however, is provided by automatic stabilizers.6 In addition, governments have made extensive use of the public balance sheet, committing to guarantee, recapitalize, and resolve financial institutions. Together, these measures add up to an expected accumulated deficit of almost 16 percent of GDP over the 2008–10 period (Table 2). With an estimated overall level of financial sector guarantees of about 25 percent of GDP for the advanced economies, however, there is also a nonnegligible increase in contingent liabilities in the fiscal balance sheets. The implied challenge for fiscal sustainability is quite substantial, not least because the increase in actual and contingent public debt comes at a time when medium-term growth potential is severely weakened (see Chapter 3). In emerging Europe, deficits have started to increase more recently, but that increase is mostly an echo of the somewhat delayed impact of the crisis and less an attempt to stabilize the economy with the discretionary stimulus. Still, at about 10 percent, the expected accumulated deficit in Europe’s emerging economies is sizable.

Table 2.European Countries: External and Fiscal Balances, 2006–10(Percent)
Current Account Balance to GDPGeneral Government Balance to GDP
Europe 1/0.70.2-0.4-0.10.2-0.10.1-1.3-6.5-6.3
Advanced European economies 1/0.80.6-0.1-0.10.3-0.9-0.4-1.8-6.6-7.2
Emerging European economies 1/2/0.2-2.0-1.8-0.2-
European Union 1/-0.3-0.5-1.1-0.8-0.5-1.5-0.9-2.3-6.9-7.5
Euro area0.40.3-0.7-0.7-0.3-1.2-0.6-1.8-6.2-6.6
Slovak Republic-7.0-5.3-6.5-8.0-7.8-3.5-1.9-2.5-5.3-4.4
Other EU advanced economies
United Kingdom-3.3-2.7-1.7-2.0-1.9-2.6-2.6-5.1-11.6-13.2
New EU countries 1/-6.2-8.0-7.8-2.9-3.2-3.2-1.8-2.8-5.9-6.0
Czech Republic-2.6-3.1-3.1-2.1-2.2-2.6-0.6-1.4-6.0-7.0
Non-EU advanced economies
Other emerging economies
Bosnia and Herzegovina-8.4-12.7-14.7-8.8-9.12.2-0.1-4.0-4.7-4.0
Macedonia, FYR-0.9-7.2-13.1-10.6-9.7-0.50.6-1.0-2.8-2.8
Source: IMF, World Economic Outlook.

Beyond the aggregate, the fiscal reaction across Europe has been quite diverse even among advanced economies. One source of diversity has been the size of financial sector interventions, where countries like the United Kingdom and Ireland have up to now provided significantly more up-front financing than, for instance, France or Italy. Another has been the fiscal room for maneuver. In general, among the larger EU economies, those having lower debt levels going into the crisis—and thus more fiscal space—also show a larger increase in their fiscal deficit (Figure 11).

Figure 11.Selected EU Countries: Debt Level and Cumulative Fiscal Deficit 1/

(Percent of GDP)

Sources: IMF, World Economic Outlook; and IMF staff estimates.

1/ Data as of August 10, 2009.

And Multilateral Help Continues to Facilitate Adjustment

Emerging Europe has not decoupled from the rest of Europe, with the trade and financial links that brought growth and prosperity also importing the downswing through falling export demand and capital inflows. Countries that relied on unprecedented capital inflows, as reflected in large external current account deficits, and experienced very fast credit growth before the crisis are facing the need for significant adjustment.

To help close some external financing gaps created by the crisis and ease the burden of adjustment, the IMF, working with the EU and other multilateral institutions, has continued to play a major role in providing multilateral help. Since April 2009, assistance has been stepped up along three dimensions:

  • First, with the addition of Romania and Bosnia and Herzegovina, the number of countries in Europe covered by standby arrangements has been increased to eight (Table 3).

  • Second, the extension of the Flexible Credit Line to Poland has bolstered confidence with positive spillover effects throughout the region.

  • Third, financial assistance has been augmented and rephased to take account of downward revisions in growth and somewhat better-than-envisaged developments in foreign exchange reserves.

Table 3.IMF Support for European Countries Affected by the Global Crisis (As of September 4, 2009)
CountryIMF Loan Size, Approval DateKey Objectives and Policy ActionsAdditional Information 1/
Hungary$15.7 billion, November 2008Address the main pressure points in public finances and the banking sector:
  • Substantial fiscal adjustment, to provide confidence that the government's financing need can be met in the short- and medium-run.

  • Up-front bank capital enhancement, to ensure that banks are sufficiently strong to weather the imminent economic downturn, both in Hungary and in the region.

  • Large external financing assistance, to minimize the risk of a run on Hungary's debt and currency markets.

In addition to financial assistance from the IMF, the program is also supported by $8.4 billion from the European Union, and $1.3 billion from the World Bank.

The second review of the program was completed in June 2009.

Available via the Internet:
Ukraine$16.9 billion, November 2008
  • Help the economy adjust to the new economic environment by allowing the exchange rate to float, aiming to achieve a balanced budget in 2009, phasing in increases in energy tariffs, and pursuing an incomes policy that protects the population while slowing price increases.

  • Restore confidence and financial stability (recapitalizing viable banks and dealing promptly with banks with difficulties).

  • Protect vulnerable groups in society (an increase in targeted social spending to shield vulnerable groups).

Since the program's adoption, the global economic environment has deteriorated markedly, hitting Ukraine harder than expected. This has required a recalibration of economic policies. The second review of the program was completed in July 2009.

Available via the Internet:
Iceland$2.1 billion, November 2008
  • Prevent further sharp króna depreciation by maintaining an appropriately tight monetary policy and temporary restrictions on capital outflows.

  • Develop a comprehensive and collaborative strategy for bank restructuring by (1) putting in place an efficient organizational structure to facilitate the restructuring process, (2) proceeding promptly with the valuation of banks' assets, (3) maximizing asset recovery in the old banks, (4) ensuring the fair and equitable treatment of depositors and creditors of the intervened banks, and (5) strengthening supervisory practices and the insolvency framework.

The first review of the program, initially scheduled for the first quarter of 2009, was delayed, to allow the authorities to fully articulate their policy plans. The government of Iceland and IMF staff reached agreement in early-August on policies to underpin the first review. The agreement is being reviewed by IMF management and will need to be presented to the IMF's Executive Board for its consideration and approval. A Board meeting could be held in September 2009.

Available via the Internet:
Latvia$2.35 billion, December 2008
  • Take immediate measures to stem the loss of bank deposits and international reserves.

  • Take steps to restore confidence in the banking system in the medium-term and to support private debt restructuring.

  • Fiscal measures to limit the substantial widening in the budget deficit and prepare for early fulfillment of the Maastricht criteria.

  • Implement incomes policies and structural reforms that will rebuild competitiveness under the fixed exchange rate regime.

The first review of the program was completed in August 2009.

Available via the Internet:
Belarus$2.5 billion, January 2009; augmented to $3.5 billion in June 2009
  • Facilitate an orderly adjustment to external shocks and address pressing vulnerabilities.

  • Adopt a new exchange rate regime—a step devaluation of the rubel against the dollar of 20 percent and a simultaneous switch to a currency basket with a trading band of ±5 percent—to improve external competitiveness.

  • Support policies to strengthen monetary framework, balanced budget, and impose strict public sector wage restraint.

The first review and an augmentation of the program was completed in June 2009.

Available via the Internet:
Serbia$0.5 billion, January 2009; augmented to $4.0 billion in May 2009
  • Tighten the fiscal stance in 2009-10, with the 2009 general government deficit limited to 1% percent of GDP, followed by further fiscal consolidation in 2010. This involves strict incomes policies for containing public sector wage and pension growth and a streamlining of nonpriority recurrent spending, which helps create fiscal space to expand infrastructure investment.

  • Strengthen the inflation-targeting framework while maintaining a managed floating exchange rate regime.

Since the program was designed, Serbia's external and financial environment has deteriorated substantially. In response, the authorities have (1) raised fiscal deficit targets for 2009-10, while taking additional fiscal measures; (2) received commitments from main foreign parent banks that they would roll over their commitments to Serbia, and keep their subsidiaries capitalized; and (3) requested additional financial support from international financial institutions and the EU. The first review was completed in May 2009. Available via the Internet:
Romania$17.1 billion, May 2009Cushion the effects of the sharp drop in private capital inflows while implementing policy measures to address the external and fiscal imbalances and to strengthen the financial sector:
  • Strengthen fiscal policy to reduce the government's financing needs and improve long-term fiscal sustainability.

  • Maintain adequate capitalization of banks and liquidity in domestic financial markets.

  • Bring inflation within the central bank's target.

Allocations for social programs will be increased, as well as protection for the most vulnerable pensioners and public sector employees at the lower end of the wage scale.

IMF support is coordinated with that of the EU and the World Bank.

Available via the Internet:
Poland$20.6 billion Flexible Credit Line, May 2009The Flexible Credit Line (FCL) is an instrument established for Fund member countries with very strong fundamentals, policies, and track records of their implementation. Access to the FCL is not conditional on further performance criteria.The arrangement for Poland was the second commitment, after Mexico, under the IMF's FCL, created in the context of a major overhaul of the Fund's lending framework.

Available via the Internet:
Bosnia and Herzegovina$1.57 billion, July 2009Safeguarding the currency board arrangement by a determined implementation of the fiscal, income, and financial sector policies.Available via the Internet:

While there is heterogeneity across countries, adjustment efforts are broadly paying off, with some countries making good progress in normalizing access to private sources of financing. Strengthening the banking sectors was and continues to be a priority in most cases. Continued engagement by cross-border banks and coordination of efforts with European institutions, the ECB, and banking supervisors from relevant home and host countries remain essential for successful adjustment. With a few exceptions linked to the preferences of the authorities, the provision of multilateral financing has allowed fiscal deficits to increase and social spending to be largely protected. Full operation of automatic stabilizers, however, was not always possible because of concerns about constraints on flow financing and sustainability. As the global recovery takes hold, financing constraints are likely to ease, and attention will need to turn to structural reforms to strengthen competitiveness.

Further Policy Action Required

While the worst of the recession may be past, the recovery is far from solid, and policymakers cannot afford to drop their guard. To prevent a lengthy spell of below-potential growth, the financial system needs to be restored to health as soon as possible. Most of all, this effort requires an identification of capital needs and commensurate recapitalization or resolution and a further clarification of the postcrisis environment in which financial institutions are expected to operate. For emerging Europe, dealing with debt overhangs and currency mismatches constitutes an additional dimension. Macroeconomic support needs to be sustained within a credible framework of well-timed and well-communicated disengagement from extraordinary interventions, while for several emerging economies adjustment efforts need to continue, facilitated by multilateral assistance. Further structural reforms to raise potential growth are essential.

More Needs to Be Done for the Financial Sector…

Underlying the shorter-run risks threatening the European recovery are the continuing troubles of the banking sector. While decisive policy actions have largely dissipated fears of a systemic breakdown and many banks have added to their capital from private and public sources, the banking sector is still facing substantial unrecognized losses stemming from toxic assets and, increasingly, from bad loans tied to the recession (IMF, 2009c). Continuing doubts about the banks’ ability to absorb these losses perpetuates problems in market-based funding for banks. And important financing tools such as asset- and mortgage-backed securities and covered bonds remain impaired. If unaddressed, the need to repair balance sheets and problems on the financing side will constitute a formidable obstacle to the recovery as financing will remain scarce.

Effectively purging this residual uncertainty from the system—uncertainty that affects both advanced and emerging economies—requires a more resolute and proactive approach to assessing the financial positions of banks to be followed up with actions to recapitalize and restructure viable institutions and resolve others. Further progress in removing problem assets from bank balance sheets will also be highly beneficial. While aggregate stress testing is useful and can help identify cross-border risks, including those between emerging and advanced Europe, it will not be sufficient to restore confidence on its own and is no substitute for additional action on a bank-by-bank basis as needed. With respect to cross-border banks, such action should be coordinated in the context of agreements to safeguard adequate cross-border funding, subject to preserving the stability of financial institutions in both home and host countries (IMF, 2009c).

In several emerging economies in Europe, vulnerabilities associated with foreign currency–denominated debt overhangs in corporations (as in the Baltics, Hungary, Bulgaria, and Romania) and households (as in the Baltics, Romania, Hungary, and Poland) need to be addressed (see Box 3). While much household foreign currency debt is longer term, most has to be serviced out of domestic currency earnings, threatening households’ ability to pay in the face of pressures on real activity and exchange rates. Moreover, the lack of mechanisms for individual debt workouts and weak bankruptcy procedures in some countries could also add to bank losses as firms that could gainfully continue as going concerns are broken up and households choose default over debt consolidation or restructuring.7 This situation could also spell trouble for parent banks in advanced countries as ripple effects move across the tightly integrated region, again underscoring the importance of cross-border coordination.

Box 3.Currency Mismatches in Emerging Europe

Currency mismatches constrain policy responses and will influence the speed of recovery in many economies in emerging Europe. The patterns of foreign currency saving and borrowing are far from uniform across sectors and countries in the region. The analysis presented here shows that the resulting currency mismatches (that is, the difference between foreign currency borrowing and foreign currency assets as a share of total assets and liabilities) can be attributed mostly to cross-country differences in interest rates, exchange rate volatility, foreign funding of banks, institutional quality, and other country-specific variables. Policies to mitigate the impact of the crisis and jump-start recovery will therefore depend on country-specific circumstances.


Some economies in emerging Europe have a history of de facto financial “dollarization.”1 Overall, the use of foreign currency in emerging Europe as a region has not been as high as, for instance, in Latin America. But some countries in the region are relying heavily on foreign currency, in particular for deposits, and the use of foreign currency in lending has increased somewhat in recent years. In line with the historical experience, use of foreign currency tends to be very persistent once established. Following a number of crisis episodes where de facto dollarization played an important role, most notably in Asia and Latin America, the view of the phenomenon as a mostly benign or even positive development has given way to the view that it can be a major source of financial fragility (see, for example, Armas, Ize, and Levy-Yeyati, 2006).

There is a striking cross-country variation of currency mismatches in emerging Europe (first figure). For the corporate sector, the share of foreign currency deposits in most countries is between 20 and 50 percent of total deposits, while the fraction of foreign currency lending varies widely, from 10 percent to 90 percent of total loans. About one-third of the countries have negligible levels of foreign currency lending to households but have substantial differences with regard to the importance of foreign currency deposits. There is an intermediate group of countries where the share of foreign currency deposits has modestly outweighed foreign currency borrowing. The composition of credit to households in the Baltic countries, Hungary, Romania, and Ukraine is highly biased toward foreign currency.

Emerging Europe: Corporate and Household Currency Mismatches, December 2008

Source: IMF, Balance Sheet Approach.

Notes: The data are referring to foreign currency denominated loans and deposits; including loans and deposits that are indexed to foreign currency would increase the ratios in some of the countries. The Czech Republic, included here among emerging Europe, was reclassified as an advanced economy in the Spring 2009 World Economic Outlook.

Recent trends in foreign currency borrowing have varied greatly (second figure). The Baltic countries have had the largest increase in foreign currency borrowing, with an equal distribution between households and the corporate sector. Another set of countries—Albania, Bulgaria, Hungary, Romania, and Ukraine—has had most of the credit growth denominated in foreign currency, and it has gone increasingly to the household sectors. Most of the increase has been in the form of long-term foreign exchange loans, as more than 80 percent of total household credit is long term (and more than half is mortgage credit). Such credit growth in the remaining countries has been substantially less, with moderate or negligible household borrowing in foreign currency.

Emerging Europe: Trends in Foreign Currency Borrowing, 2005 and 2008

Source: IMF, Balance Sheet Approach.

Notes: The data are referring to foreign currency denominated loans and deposits; including loans and deposits that are indexed to foreign currency would increase the ratios in some of the countries. The Czech Republic, included here among emerging Europe, was reclassified as an advanced economy in the Spring 2009 World Economic Outlook.

1/ Croatia; Czech Republic; Macedonia, FYR; Serbia; and Turkey.

2/ Belarus, Moldova, and Poland.

3/ Albania, Bulgaria, Hungary, Romania, and Ukraine

4/ Estonia, Latvia, and Lithuania.

Recent trends in currency mismatches seem affected partly by demand-side factors. Although there has clearly been an increase in banks’ borrowing from nonresidents, which has been passed onto clients, the period from mid-2007 to mid-2008 was marked by widening interest rate spreads and lower exchange rate volatility (third figure) and a modest shift toward denomination of savings in domestic currency. Among the possible explanations for some of the currency mismatches could be a positive income effect: as long as the local currency is stable (or appreciating), borrowing in foreign currency has generally been less expensive than in local currency, and savings in local currency have ensured higher returns. Demand-side factors, however, seem insufficient to explain the wide (and persistent) variety in currency mismatches among countries.

Emerging Europe: Trends in Key Factors, 2005–08

Source: IMF staff calculations.

Determinants of Currency Mismatches

To better understand how currency mismatches develop, it is useful to consider the motivation of savers, borrowers, and intermediaries. For savers, foreign currency deposits promise safety, especially in the context of (potentially) high inflation. For borrowers, foreign currency loans offer a lower cash flow burden conditional on their exchange rate expectations. For intermediaries, there is a need to balance return, credit risk, and funding risk. Along these lines, the literature of foreign currency savings and borrowing (Rosenberg and Tirpák, 2008; and Scheiber and Stix, 2008, for example) points to several possible factors explaining the currency mismatches, including:

  • Interest rate differentials. The relatively lower interest rate on foreign currency is typically considered a driver of credit growth in foreign currency in emerging economies. At the same time, interest rate differentials could make domestic savings more attractive. Both effects, however, depend on the presumed persistence of high domestic interest rates and the expectation of a stable or appreciating domestic currency (or the hope for a government bailout in the case of a large depreciation). For instance, fears of exchange rate depreciation would drive depositors toward foreign currency alternatives.

  • Exchange rate volatility. Consequently, some argue that credible pegged exchange rates increase foreign currency borrowing (Backé and Wójcik, 2007). Others (Ize and Levy Yeyati, 2003) stress that, more broadly, macroeconomic uncertainty (or its absence) determines the degree of de facto dollarization of an economy.

  • Funding of banks in foreign currency. Banks in many emerging countries have had large inflows of foreign currency funding (often from their foreign parents), which they have passed onto their clients, possibly adding to interest rate differentials.

  • Institutional quality. High levels of institutional quality (in the form of general trust in the legal system, for example, or, more specifically, in the reliability of the banking system) could foster the use of domestic currency deposits and, at the same time, motivate foreign currency borrowing. Foreign currency borrowing could also increase as part of the European Union integration process (Rosenberg and Tirpák, 2008).

  • Other country-specific variables. A number of other country-specific variables—such as country size, income, openness to trade, various regulatory policies, or the availability of banking services—could also influence the use of foreign currency by the private sector.

Empirical analysis confirms that these factors are among the main determinants of currency mismatches in emerging Europe—and the role of institutional quality is particularly intriguing. On the supply side, as institutional quality improves, so does the availability of foreign currency loans. The availability of such credit also increases as banks borrow from nonresidents and channel those funds into household and corporate foreign currency loans. From the demand side, improvements in institutional quality seem to increase depositors’ willingness to keep savings in local currency and borrowing in foreign currency. In addition, higher interest rate spreads tend to increase currency mismatches as savings in local currency are more profitable relative to foreign currency deposits and make foreign currency loans less expensive. Moreover, as exchange rate volatility falls, currency mismatches increase, probably as currency risks seem smaller.

It could be that institutional quality acts as a catalyst for the other factors driving currency mismatches. Better institutions might have, in particular for new EU member states, improved access to funding that has been channeled into foreign currency loans, and especially long-term loans.2 Higher institutional quality might also promote a shift to domestic currency savings if the interest rate spread increases. The impact of both these factors might be magnified by low exchange rate volatility. The correlation between institutional quality and currency mismatches and the resulting income effect (lower interest on borrowing and higher returns on savings), in particular for households, seem partly to explain the substantial variation across countries (fourth figure).

However, even in countries with better institutional quality, depreciation could cause a sharp increase in bankruptcies and defaults. Problems with foreign currency loans and deposit outflows could potentially trigger a downward spiral for the economy as a whole. That scenario has often been the justification for heavy interventions in the foreign exchange markets, even in the large group of countries in which the currency mismatches are negative (savings mainly in foreign currency or borrowing in local currency) or the imbalances negligible.

Emerging Europe: Income Effects and Institutional Quality

Sources: World Bank: The Worldwide Governance Indicators, composite score for 2008; and IMF staff calculations.

Notes: The income effect captures the impact of interest rate differentials on interest income on loans and deposits. A more positive (or less negative) income effect means that foreign currency deposits and loans appear relatively more attractive. Other things being constant, this occurs with low foreign currency lending rates, high local currency lending rates, high foreign currency deposit rates, and low local currency deposit rates.

1/ Income effect= TL*LCLR – (FCL* FCLR + LCL*LCLR) – TD*LCDR + (FCD*FCDR + LCD*LCDR); T is total, D is deposit, L is lending, R is interest rate, FC is foreign currency, and LC is local currency.

Policy Implications

Given that currency mismatches reflect (mis)management of currency risk in corporations (including banks) and households, losses resulting from adverse exchange rate shocks should be absorbed by the shareholders and households that entered into these exposures. The policy challenge is how to ensure that this loss absorption does not threaten the stability of the financial system and the economy as a whole. In particular, if many borrowers failed at the same time because of an exchange rate movement, the shock could be transmitted through banks to the broader economy. Other concerns relate to the risk of sudden stops (especially when currency mismatches are driven by capital inflows), the risk that savers are vulnerable to wealth effects, and the risk that macroeconomic volatility will lead to massive deposit outflows. Finally, high levels of dollarization (especially of loans) make monetary policy more difficult, as aggregates become more volatile and reactions to policy instruments less predictable.

The policy options include the following (for a fuller discussion, see, in particular, Armas, Ize, and Levy-Yeyati, 2006):

  • Improving resolution regimes, including for banks. Key to reducing the cost of the crisis or recession are sufficiently effective procedures for loan workouts and insolvencies. Revising the whole resolution framework may be challenging, particularly in the aftermath of a major financial crisis or a deep recession. What may be feasible in the short term, however, is strengthening or introducing special resolution regimes for financial institutions (for example, Cihák and Nier, 2009).

  • Facilitating debt workout mechanisms. If insolvencies are widespread and threaten to swamp the judicial system, consideration could be given to regulatory measures that facilitate creditor coordination or (Pareto improving) debt write-downs and, in extreme cases, to government-supported out-of-court mechanisms (Djankov, 2008).

  • Limiting future currency risks. Prudential measures, such as tighter limits on (unhedged) foreign currency exposures and higher risk-weights, could be used to discourage new dollar lending. This measure should be complemented by stronger disclosure requirements for banks vis-à-vis their clients regarding foreign exchange risks and by more rigorous stress testing for foreign exchange risk (including credit risk induced by exchange rates) by banks. Dollarization can also be discouraged by tax or reserve requirement differentials and by promoting inflation-indexed products. In the medium term, the best way of limiting the use of foreign currency may be through achieving and maintaining domestic macroeconomic stability.

Note: The main author of this box is Johan Mathisen.1 The literature tends to use the term dollarization to describe denomination or indexation of loans and deposits (and other contracts) in currencies other than the domestic legal tender. In the region, the euro is the most commonly used foreign currency, although Swiss franc–denominated loans are also popular in some countries (Hungary and Poland, for example).2 See Scheiber and Stix (2008) for an in-depth discussion of the importance of institutional factors.

To clarify the operational environment for financial institutions and allow them to develop a sustainable business model, regulatory and supervisory reforms need to be implemented urgently and coordinated internationally (IMF, 2009c). Among other things, effective coordination of financial supervision under the new framework in Europe will require adequate resources for the new institutions, unrestricted information flow across borders and between the ESAs and the ESRB, and well-functioning decision-making mechanisms. And there is further need for improvement. With the ESRB having only the power of voice, it will be important to ensure that its warnings are not ignored during good times, when macroprudential regulation would be most useful. Moreover, a solution needs to be found to the “too big to save” or “too big to fail” problems without stymieing progress toward establishing a single financial market. Thus fundamental progress on a comprehensive cross-border crisis management framework will be vital and should include tools for early intervention and cost-sharing rules, as well as loss-allocation rules for private stakeholders and a private first line of funding to limit moral hazard and fiscal exposure.8

Monetary Policy Will Have to Plot a Careful Course…

As long as the timing and strength of the recovery are uncertain and inflation remains subdued, monetary policymakers will need to support the economy and keep all options open. Should further support for the fragile recovery be required, some central banks (including the ECB and a number of emerging market central banks) still have additional room for maneuver. In addition, even more forceful signals that interest rates will be kept at very low levels for some time and further extension of nonstandard measures may be called for.9

When the recovery takes hold, monetary policymakers will have to turn their attention to exiting from an unprecedented array of interventions, an exit necessary to prevent permanent market dislocations and entrenchment of central banks as market substitutes. Moral hazard also looms large as banks have little incentive to act cautiously when liquidity is available cheaply in practically unlimited quantities or will be tempted to “game” the various types of market interventions. Finally, though a remote prospect at this point, the vast amount of liquidity created by the expanding central bank balance sheets could be the harbinger of future inflationary pressures.

At the technical level, engineering a smooth exit once conditions are right will be feasible but needs to be handled with care. For instance, some of the unconventional measures implemented by the ECB will unwind automatically when economic conditions improve, while others have built-in sunset clauses or parameters that can be adjusted, such as the price of the extended refinancing operations or the eligibility and haircuts associated with certain collateral. Withdrawing from open-market purchasing programs could be potentially more disruptive, especially in the case of the larger interventions as conducted by the Bank of England. One solution would be to hold these papers to maturity or sell them only very gradually, a method that would work slowly; another would be reverse-repurchase agreements, which might run into the capacity constraints of available counterparties. The Bank of England and ECB, for example, also have the options of issuing central bank paper and offering additional interest-paying deposit facilities to drain excess liquidity. The most successful strategy, however, could be a pragmatic combination of these approaches.

…Clearly Communicating the Exit

As central banks prepare to let unconventional measures run out and consider raising interest rates again, they will benefit from transparent communication about their underlying views. An important aspect is the uncertainty about the drop in potential output caused by the crisis, which might drive a wedge between the inflationary pressures anticipated by policymakers and the public’s expectations and could complicate monetary policy (see Chapter 3). For instance, if the public were less pessimistic about the time path of potential output than the central bank, an increase in interest rates intended to safeguard price stability could trigger deflationary expectations. To avoid this type of problem and anchor inflation expectations, central banks should transparently and explicitly explain their views on the development of potential output and confirm their willingness to reverse course should relevant new information arrive. This approach will help limit the risk that the exit will sap confidence at the wrong moment.

Fiscal Policy Has to Be Sustainable As It Bolsters the Upswing

Fiscal policy needs to balance carefully its macroeconomic and financial sector responsibilities with the need to exit from the current accumulation of debt. While the fragility of the recovery requires fiscal policy to maintain its support for aggregate demand—which will mean following through with planned stimuli and letting automatic stabilizers work for now—the concerns about fiscal sustainability created by the crisis need to be addressed sooner rather than later. The problem is particularly urgent in Europe, because the fiscal fallout from the crisis comes on top of the fiscal costs of an aging population (European Commission, 2009a). Stressing these concerns, the current Swedish EU presidency has made fiscal consolidation one of its priorities for the second half of 2009.

Several strategies can help make this balancing act work:

  • Policymakers should shift focus from the level to the composition of the fiscal stimulus. Public investment projects, while taking longer to implement, typically hold greater promise for longer-term benefits than tax cuts or transfer increases. This factor argues for completing projects in the pipeline and concentrating any additional effort, if necessary, in this area.

  • Coordination of fiscal policy measures across Europe, both in terms of the aggregate effect and with respect to tax policy, will make support for the economy more effective and minimize exit distortions. Any additional expansionary measures should be implemented simultaneously and with an eye to cross-country differences in the remaining fiscal space; countries with less fiscal space should embark on fiscal consolidation with greater urgency.

  • Perhaps the most crucial element in the fiscal strategy will be to anchor the short-term support for the economy firmly in a credible consolidation strategy. For all countries, that strategy could mean implementing stronger fiscal rules for supporting fiscal sustainability over the medium term.10 For EU members, strengthening the preventive arm of the Stability and Growth Pact (SGP) by linking it more closely to medium-term objectives would be helpful, as would a more transparent procedure for setting these targets and a more public commitment to fulfilling them. In addition to halting a deteriorating fiscal position, such a consolidation strategy would also establish the principle that any additional fiscal stimulus would require credible offsetting measures later on.

In this regard, the management of contingent liabilities also deserves attention. Among possible measures, governments should complete a thorough and transparent assessment of the impact of financial sector measures on the aggregate sovereign balance sheet to inform fiscal analysis and the budget process and to bolster public confidence in fiscal sustainability (see Box 4).

Box 4.Managing Fiscal Risks Stemming from Public Interventions to Support Financial Systems

While they have been instrumental in stabilizing financial systems, public interventions have contributed to an expansion of sovereign balance sheets and a substantial increase in exposure of governments to risk.1 Guarantees have exposed governments to large losses in the event that the financial sector’s situation deteriorates further. Liquidity provisions by central banks have altered the size and structure of their balance sheet in terms of liquidity, maturities, currencies, and asset price volatility and have thereby exposed them, and eventually the governments themselves, to significant risks. Lending operations entail counterparty/default risks and, if they create mismatches in duration and currency composition, to interest and exchange rate risk. In the case of capital injections, risks relate to the uncertainty surrounding the value of the government’s residual claims on the institutions at the time of the capital injection, which may be smaller than what the government paid, and to possible future changes in the value of these claims. Last, asset purchases have exposed public sectors to valuation risks.

Some features of these interventions have rendered the assessment of their fiscal impact and related risks difficult. As some operations have been conducted by non-government public institutions, such as central banks, public financial and nonfinancial institutions, many off-balance sheet operations are not directly reflected on the government accounts but, sooner or later, may end up on the government’s books. In addition, the design of support operations has often been carried out in ways that avoid affecting governments’ “headline” fiscal deficits, either by extending guarantees or maintaining residual claims on financial institutions. Estimating the value of some of the assets taken onto the public sector’s balance sheet is often very difficult. Although the terms of individual operations have often been reported transparently, the ensuing risks have rarely been made public in a systematic and integrated way.

In this context, the following principles should guide the management of these fiscal risks:

  • Governments should conduct exhaustive assessments of the impact of measures on the sovereign balance sheet and of resulting fiscal risks. The balance sheet assessment should be conducted using an integrated framework (IMF, 2001), take a whole-of-government perspective, and focus particularly on the estimation of the fair value of assets and liabilities. Risk assessments require elaboration of alternative scenarios that encompass short- and long-term costs, stress test for various macroeconomic shocks, demonstrate the consequences of different assumptions about prices and asset recovery rates, and make a range of assumptions about the materialization of contingent liabilities.

  • Information about the risks associated with public interventions should be published. Transparency and accountability will be key to maintaining confidence in fiscal solvency. A useful venue would be a comprehensive statement of fiscal risks, to be submitted to the legislature as part of the annual budget, the statement would report on the valuation of acquired assets and explicit guarantees, including any difference between the purchase and the market value and estimates of potential losses.

  • Fiscal risks should be mitigated. In particular, risks and liabilities related to guarantees should be gradually transferred to the private sector, including by eliminating any subsidy component (that is, by increasing fees) and shifting to partial coverage or gradually reducing the coverage.

  • Fiscal risks should be systematically incorporated into fiscal analysis and the budget process. In the determination of fiscal targets, allowance needs to be made for the possibility that some risks will materialize (budgets, for example, should include reserve provisions for guarantees commensurate with expected losses). A close integration of fiscal risk management and the budget process calls for analyzing the fiscal sustainability implications of the medium- or long-term nature of many contingent liabilities. In addition, quasi-fiscal activities should be transferred to the government budget.

Note: The main author of this box is Edouard Martin.1 See Everaert, Fouad, Martin, and Velloso (2009) and Cheasty and Das (2009) for a more detailed discussion.

Strengthening Potential Growth Is a Must

Recessions associated with deep financial turmoil tend to depress potential output significantly (IMF, 2009e, Chapter 4). Indeed, in addition to the likely need to scrap excess capacity, gross capital formation has been weak or negative since late 2007 (Figure 1), threatening to dent productive capacity. This effect is bound to be particularly strong in emerging Europe, as the reduction in capital inflows and higher and more volatile risk premiums are dampening investment (see Chapter 4). In addition, the persistence of the expected decline in employment could lead to an increase in structural unemployment if, for instance, a longer duration of individual unemployment spells eroded labor skills or if wage negotiations ignored the unemployed.11 Finally, some economies that showed exceptionally rapid precrisis growth—for instance, because of a larger role of the financial sector as an engine of growth (as in the United Kingdom), real estate and construction booms (as in Ireland, Spain, and the Baltics), or a very strong global demand for exports (as in Germany)—might be facing less favorable growth conditions now. As a consequence, most observers expect potential growth to slow considerably over the medium term in advanced and emerging Europe (see Chapter 2).

While some of these factors may correct themselves over the longer term, others tie into Europe’s long-standing structural rigidities. There are indications, for instance, that the persistence in employment dynamics is related to more permanent labor market features, such as the presence of active labor market policies, collective bargaining systems, and legislative or labor-court based employment protection rules. These factors are likely to impede the longer-term growth potential in Europe. Strong employment protection also interacts with restrictions to market entry and other product and service market regulation to limit employment and growth in the longer run compared to the United States, for example.12 While some of the advances in productivity and growth in the United States and the United Kingdom over continental Europe might have reflected temporary gains in the financial services industry, there nonetheless seems to be room for improvement in Europe. For instance, according to the EU’s Klems database, Germany and France posted negative total factor productivity contributions to growth in the financial and business services sector during the 1995–2005 period (see Chapter 2).

Against this background, moving quickly to repair the damage caused by the crisis to potential output is crucial. The higher the medium-term growth potential, the more dynamic and robust the recovery can be, which should make the tasks of stabilizing the European banking sector, exiting from nonstandard monetary policies, and securing fiscal sustainability considerably easier. Some of the initial policy responses to the crisis, however, have made this policy gap particularly challenging to close. For instance, there is a risk that the ring-fencing of national banks will limit gains from financial market integration. Protecting certain national industries—such as cars, tourism, or construction—could hinder necessary structural adjustment. And allowing temporary social and labor market measures to become permanent might foster structural unemployment in the future by discouraging mobility or efforts to seek reemployment.

To support potential growth in the longer run, European policymakers will have to safeguard the achievements of the Lisbon Agenda and create an environment that fosters structural change. Before the crisis, the Lisbon Agenda had brought tangible successes in the areas of job creation and labor market participation using a variety of measures, including more flexible labor contracts, policies to keep workers active in the labor market, a reduction in tax-based disincentives, and the provision of better labor matching services. Rejuvenating these efforts will be critical now to bolstering longer-term growth. In addition, there is a strong case for a simultaneous effort to increase labor market flexibility and deregulate service and product markets further. An added benefit of these reforms is that they will accelerate some of the structural changes necessitated by the crisis. For example, in emerging European economies struggling to adjust to stalled capital inflows, sufficiently flexible employment protection rules should help smooth the reallocation of labor to export-oriented sectors, while further improvements in the business environment could raise their attractiveness for foreign investment. In Germany, looking for additional reform opportunities in the services sector could help grow domestic demand. While some of these measures can cause near-term costs, the combination of enhanced structural flexibility and higher potential growth will be a key element in Europe’s answer to the crisis beyond the short run.

Note: The main author of this chapter is Helge Berger.

See IMF (2009d—Chapters 1 and 3) for a more detailed discussion of how homegrown risks added to the global shock and led to a cross-country differentiation of the crisis impact in Europe.

In Germany, for example, bargaining agreements stabilize nominal wages and can include limited employment guarantees. Short-run public subsidies for short-time or work-share programs also simultaneously stabilize employment and labor income.

Consensus inflation expectations for the euro area have remained close to the aim of the European Central Bank (ECB) of keeping inflation rates below, but close to, 2 percent over the medium term throughout the crisis, and break-even expectations have recovered from their end-2008 lows to levels close to 2 percent recently (IMF, 2009a).

For a detailed discussion, see IMF (2009b).

The Financial Crisis Advisory Group (2009), reporting to international accounting boards IASB and FASB, has advised against ad hoc measures to increase the flexibility in loss accounting.

The size of automatic stabilizers varies with the size of the budget and its elasticity with regard to the business cycle. See European Commission (2009a); Horton, Kumar, and Mauro (2009); and IMF (2009d) for a more detailed discussion of the fiscal reaction to the crisis.

See IMF (2009a and 2009b) for a more detailed discussion of the need for special resolution regimes for international financial institutions.

An example would be the Bank of England’s expansion of its asset purchasing plan in August 2009.

A recent example of such an initiative is the new fiscal rule recently introduced in Germany. Anchored in the constitution, the rule sets an upper limit for the structural fiscal deficit but allows operations of countercyclical automatic stabilizers (Mody and Stehn, 2009).

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