Abstract

Growth in Europe is expected to slow significantly in 2008–09, reflecting spillovers from weaker global growth, rising commodity prices, and the strains in financial markets. Meanwhile, inflation has picked up, driven by a surge in food and energy prices. The challenges for policymakers in advanced economies are to restore confidence in the financial system and support real activity while maintaining inflation credibility and safeguarding long-term fiscal sustainability. In emerging Europe, policies need to focus on reducing vulnerabilities and strengthening the resilience of the financial system.

Growth in Europe is expected to slow significantly in 2008–09, reflecting spillovers from weaker global growth, rising commodity prices, and the strains in financial markets. Meanwhile, inflation has picked up, driven by a surge in food and energy prices. The challenges for policymakers in advanced economies are to restore confidence in the financial system and support real activity while maintaining inflation credibility and safeguarding long-term fiscal sustainability. In emerging Europe, policies need to focus on reducing vulnerabilities and strengthening the resilience of the financial system.

Advanced Economies

Headwinds to Growth

Growth momentum in advanced economies decelerated toward the end of 2007 as concerns about the health of the U.S. subprime mortgage market prompted a reappraisal of risks across a broad range of financial markets. Growth in the United States slowed sharply, reflecting the continuing housing sector correction and financial market dislocations.1 In Europe, growth deceleration in the fourth quarter was relatively mild; however, business confidence and indicators of economic activity suggest continuing weakness in early 2008 (Figures 1 and 2).2

Figure 1.
Figure 1.

Europe and the United States: Real GDP Growth, 2001–09

(Percent)

Source: IMF, World Economic Outlook.
Figure 2.
Figure 2.

Key Short-Term Indicators

At the same time, headline inflation picked up, boosted by a surge in global commodity prices (Figure 3). Energy prices rose by 70 percent in the year ending February 2008, while food prices increased by nearly 40 percent. This rise in food and energy prices was driven by a combination of strong demand growth from emerging economies and the biofuel industry and tight supply constraints (including adverse weather and disruptions in oil production). The higher commodity prices are depressing consumers’ purchasing power and pushing up production costs.

Figure 3.
Figure 3.

Euro Area: Contribution of Food and Energy to Headline Inflation, January 2006–December 2007

(Percent)

Sources: Eurostat; and IMF staff calculations.

Growth in the advanced European economies is expected to decline by 1¼ percentage points to 1.5 percent in 2008—well below potential growth—and to weaken further in 2009 (Figure 1 and Table 1). The projection reflects the current IMF staff assessment of the economic impact of the financial turbulence (from higher funding costs and tightening credit conditions), the likely spillovers to Europe from weaker U.S. and global growth, and the effects of higher commodity prices. Inflation is expected to remain elevated in the near term but should come down gradually later in the year as commodity price growth moderates and economic activity eases.

Table 1.

European Countries: Real GDP Growth and CPI Inflation, 2006–09

(Percent)

article image
Source: IMF, World Economic Outlook.

Average weighted by PPP GDP.

Montenegro is excluded from the aggregate calculations.

Repricing of Risks Led to Higher Lending Rates…

The financial turmoil in advanced economies has intensified in recent months (see Chapter 2). What started as a liquidity squeeze, sparked by strains in a small section of the U.S. household lending market, quickly developed into a generalized repricing of credit risks, affecting a wide range of financial markets. The drying up of the asset-backed securities market and liquidity strains in the interbank market raised the cost of bank financing relative to policy rates. With banks passing on the rise in their funding costs to borrowers, lending rates have increased (Figure 4). The cost of bond and equity financing has also gone up. All major European central banks have acted aggressively to mitigate the rise in the cost of wholesale funds by increasing liquidity provision in the interbank market. Some central banks have also introduced new intervention instruments and broadened the range of securities that can be used as collateral. Despite these efforts, liquidity remains seriously impaired as concerns about credit risks have intensified—the spreads between short-term interbank and policy rates are well above historical averages (Figure 5).

Figure 4.
Figure 4.

Euro Area: Cost of Financing, 2005–08

(Percent)

Source: European Central Bank.
Figure 5.
Figure 5.

Spreads of Three-Month Interbank Rates over Expected Policy Rates, 2007–08

(Basis points)

Source: Bloomberg L.P.

… and Prompted a Tightening of Credit Standards

Credit growth remained relatively strong through the end of 2007, although there are signs that lending is starting to cool off. Mortgage credit growth is slowing in many countries; however, in a number of cases the slowdown was already in train before the onset of the crisis. Business lending growth has also moderated in the United Kingdom. Corporate lending in the euro area has continued apace so far, although that could be due, at least in part, to a switch from market to bank financing. Only a few sectors, such as leveraged buyouts, are experiencing a notable drop in access to credit.

Surveys of lending conditions in Europe suggest that lenders are tightening credit standards and nonprice lending terms, particularly for loans to enterprises (Figure 6). The main factor explaining this tightening of standards is the deterioration of the macroeconomic outlook. Additional factors for some lenders are the need to rebuild capital and halt the expansion of balance sheets resulting from reduced securitization of loans, activation of credit lines, and assumptions of off-balance-sheet liabilities.

Figure 6.
Figure 6.

Changes in Credit Standards for Loans to Enterprises and Households, 2005–08 1/

Sources: Haver Analytics; and European Central Bank.1/ Net percentage of banks reporting tightening of credit standards. Household loans refer to mortgage loans only.

A particular concern is that the expected tightening of bank credit is not likely to be offset by increased availability of bond and equity financing. In past episodes of financial market turbulence, different parts of the financial system were able to compensate partially for the difficulties experienced in one segment. This may not be possible at present because the crisis has affected both banks and capital markets, the twin engines of the financial system.

IMF staff analysis suggests that the turbulence in financial markets is likely to reduce real growth in Europe by about ¾ percentage point in both 2008 and 2009 relative to a baseline without financial shocks (see Chapter 2). This reduction reflects the combined impact of rising lending rates, reduced access to funds, and the likely declines in asset prices. Since the crisis is still unfolding, estimates of its impact are subject to significant uncertainty.

Spillovers from Weaker Global Growth Could Be Large

The deflation of the house price bubble and the dislocations in financial markets have brought the U.S. economy to the brink of recession (IMF, 2008a). The United States is a major trading partner for many European countries (e.g., Ireland and the United Kingdom) and accounts for about 15 percent of export demand for the euro area. Historically, the spillovers from a slowdown in the United States to Europe have been substantial, with financial linkages an even more important channel of transmission than trade (Bayoumi and Swiston, 2007). The IMF staff estimates that a 1 percentage point decline in U.S. growth reduces growth in Europe by about ½ percentage point (Box 1).

The recent appreciation of the real effective exchange rate of the euro may strengthen the negative trade effects for the euro area (Figure 7).

Figure 7.
Figure 7.

Measures of the Euro Exchange Rate, 1999–2008

Source: IMF, Global Data Sources.

Spillovers from Weaker U.S. Growth

Changes in U.S. growth have a clear impact on growth in both advanced and emerging European economies. A vector autoregression (VAR) analysis based on quarterly data from 2001 to 2007 suggests that a 1 percentage point temporary slowdown in U.S. growth directly reduces growth in advanced and emerging Europe by about ½ percentage point within two quarters. Furthermore, indirect spillovers from weaker growth in advanced economies in Europe could weaken growth in the emerging economies by a further ¼ percentage point. Previous IMF staff work suggests that the spillovers may be even greater in the event of a U.S. recession (IMF, 2007).

box1fig1
box1fig1

Response of European Countries to a 1 Percentage Point Decline in the U.S. Growth Rate 1/

(Percent)

Source: IMF staff estimations.1/ The impulse responses are derived from a VAR of U.S. growth, advanced EU growth, and emerging Europe growth with two lags. ± 2 standard errors shown by dotted lines.2/ The advanced EU group in this analysis includes the United Kingdom and the euro area countries, excluding Ireland and Slovenia. The emerging Europe group comprises Bulgaria, Croatia, the Czech Republic, Hungary, Poland, and the Slovak Republic. The countries in each group are aggregated using purchasing-power-parity-adjusted GDP weights.
Note: The main author of this box is Srobona Mitra.

IMF staff estimates suggest that the euro is on the strong side of its medium-term equilibrium value. Specifically, the euro is overvalued, as is the U.S. dollar, vis-à-vis the currencies of countries with current account surpluses, such as the oil producers and some Asian economies.

Uncertainties around the Outlook Are Unusually High

The risks around the current growth projection are substantial. The turbulence in financial markets is still unfolding, and assessments of its potential impact on growth are fraught with uncertainty. If growth and employment in Europe decline sharply, structural rigidities in the advanced economies’ labor and product markets could make for a prolonged slowdown. First, the slowdown in the United States may be deeper and more protracted than currently projected, causing greater spillovers to the rest of the world. Such developments would depress further growth in Europe. Second, as events unfold, banks’ losses could turn out to be larger than currently assessed. In this case, the credit squeeze could become more severe, with corresponding consequences for activity. Third, a significant further appreciation of the euro may affect competitiveness, especially if it is driven mainly by a decline in the relative risk premium on euro assets. Other risks to growth include further gains in commodity prices, a rise in protectionist pressures, and the possibility of disorderly developments related to global imbalances.

Risks may be magnified in countries going through an adjustment of house prices. Many European countries, including Ireland, Spain, and the United Kingdom, have experienced house price booms over the past decade. In recent months, house prices have started to decline in Ireland and the United Kingdom, while in other countries growth rates have come down substantially. It is difficult to predict the magnitude of the correction, but simple indicators of sustainability, such as the ratios of prices to rents and of prices to income, remain significantly above their historical averages. Commercial real estate prices are also declining in the United Kingdom. Although some asset price corrections are already built into the outlook, a more abrupt or sizable adjustment would depress economic activity further and could trigger financial decelerator effects.

On the positive side, households in many advanced European countries have lower debt-to-income ratios than their U.S. counterparts, making them less sensitive to changes in credit conditions. A number of studies suggest that the effects of changes in house prices on consumption are relatively small in Europe, because equity withdrawal is less prevalent than in the United States. In addition, there is very limited or no domestic subprime lending in most countries, which should limit the extent of homegrown credit problems. Even in the few countries that do have a subprime mortgage market—such as the United Kingdom—the share of subprime loans in total loans is much smaller than in the United States. Finally, the historically high rate of employment should support domestic demand in the near term.

Upside risks to the inflation outlook include further increases in oil and agricultural prices and the possibility of an acceleration of wage growth, given the high capacity utilization and tight labor conditions throughout Europe. Downside risks are a deepening of the financial turmoil, further euro appreciation, and a reversal of commodity prices.

Policy Challenges

The immediate task facing policymakers in Europe’s advanced economies is to minimize the impact of the financial market turmoil on the real economy, while maintaining hard-won inflation credibility and long-term fiscal sustainability. Parallel efforts to restore confidence in the financial system and improve the financial regulation and supervision framework should help safeguard financial stability. Meeting these challenges will also help emerging economies, which are vulnerable to further disruptions of the global financial system.

Monetary policymakers face a delicate balancing act

The combination of rising inflationary pressures, increasing downside risks to growth, and high volatility in financial markets creates a particularly challenging environment for monetary policy authorities. Inflation is set to move higher in the near term, although it should come down later as slower demand growth tempers pressures on capacity and commodity price growth moderates. However, with labor markets still tight, wage and price pressures (“second-round effects”) may intensify. Because the appropriate monetary policy response in the current circumstances depends on the likelihood of such effects materializing, policymakers are closely monitoring the outcome of ongoing private and public sector wage negotiations in several European countries.3 If real wages adjust flexibly and inflation expectations remain anchored, monetary policy authorities can accommodate the commodity price rise, thereby minimizing the impact on growth.

The challenge for individual central banks is to find the right policy balance for their economies. The European Central Bank (ECB) has appropriately kept interest rates on hold through the end of March. However, policymakers should stand ready to respond flexibly to changes in the economic environment. While current inflation is uncomfortably high, prospects point to its falling back below 2 percent during 2009 in the context of an increasingly negative outlook for activity. Accordingly, the ECB can afford some easing of the policy stance. The Bank of England has reduced its policy rate by a cumulative ½ percentage point since last summer. There may be room for some further monetary policy easing as downside risks to growth have increased, and inflation may undershoot the target at the two-year policy horizon. At the other end of the spectrum, the decision of the Swedish central bank to increase its policy rate by ¼ percentage point in February was justified by strong demand pressures, high capacity utilization, and rising costs. Future policy moves by individual central banks will depend on shifts in the balance of risks to inflation.

Fiscal policy: allow automatic stabilizers to operate

Under the baseline forecast, policymakers should allow automatic stabilizers to cushion the downturn. Most advanced European economies have larger automatic stabilizers and more extensive social safety nets than the United States. A number of countries have reined in their fiscal deficits during the recent economic upswing, freeing space for stabilizers to operate fully in the downturn (Table 2). However, in economies that are close to the boundaries set by their fiscal rules (France, Italy, and Portugal), stabilizers should be allowed to operate only as long as adjustment toward medium-term objectives continues. It will be important not to jeopardize the process of improving public balance sheets in preparation for the coming rise in population aging-related expenditure.

Table 2.

European Countries: External and Fiscal Balances, Government Debt, 2006–08

(Percent)

article image
Source: IMF, World Economic Outlook.

Weighted average. Government balance weighted by PPP GDP; external account balance, by U.S. dollar–weighted GDP.

Montenegro is excluded from the aggregate calculations.

If downside risks materialize and growth contracts to near-recession levels, discretionary fiscal stimuli would be warranted in countries where medium-term objectives are well in hand. Normally, monetary policy should be the first line of defense in case of a global slowdown. However, if financial dislocations weaken the normal monetary transmission mechanism, a timely, temporary, and well-targeted fiscal stimulus could be effective in supporting the economy. An example of a specific measure is a one-off tax rebate to low-income households. Most fiscal rules (including the Stability and Growth Pact, or SGP) allow for temporary deviations from targets in cases of a sharp economic downturn. The stimulus should be unwound once the economy has stabilized: if fiscal sustainability becomes a concern, long-term interest rates may rise, reducing the effectiveness of the stimulus.

Confidence in the financial system needs to be restored

Financial sector policies in the short term should aim to improve transparency and restore confidence in financial markets. As long as uncertainty about asset valuations and concerns about the health of financial institutions persist, banks will remain overly cautious in their lending behavior, and the effectiveness of a monetary stimulus of the economy will be limited.4 Policymakers also need to put in place reforms to safeguard the stability of the financial system (see Box 2 for specific policy recommendations).

Emerging Economies

Growth to Decrease from High Levels; Inflation Remains a Concern

Growth in the emerging economies substantially outpaced growth in the rest of Europe in 2007, continuing the process of convergence (Table 1 and Figure 8). Activity was supported by strong domestic demand, including buoyant residential investment. Fiscal stimulus added to demand pressures in a number of countries, including the Baltics, Romania, and Serbia. Concerns that some economies may be overheating intensified as current account deficits continued to widen, inflation picked up sharply, and, in some cases, wage growth significantly outpaced productivity.

Figure 8.
Figure 8.

Growth in Emerging Europe, 2001–09

(Percent)

Source: IMF, World Economic Outlook.

The rapid rise in headline inflation was driven mostly by food and energy prices, but core inflation pressures also intensified. Food price increases have had a particularly large effect on headline inflation in emerging Europe—especially in southeastern Europe, the Baltics, and Ukraine—owing to the large share of food in the consumption baskets, local supply shocks, and convergence pressures (see Box 3).

Economic activity moderated in a few countries in the early part of 2007 for idiosyncratic reasons. Hungary’s tightening of public finances to achieve fiscal sustainability depressed private consumption and investment. Activity also weakened in Turkey, reflecting a sharp, drought-related drop in agricultural production, the lagged effect of earlier monetary tightening, and the renewed strength of the lira. Growth in Latvia and Estonia slowed and house prices started to decline as foreign banks lowered the rates of credit expansion.

Emerging Europe will be affected by the turbulence in financial markets and the slowdown in advanced economies. Growth momentum from continuing integration into the European economy and the benefits from past structural reforms should strengthen the resilience of the region. However, the economies’ greater openness to trade and financial flows leaves them vulnerable to spillovers from global developments. Based on the latest available data for imports, retail sales, and credit growth, some softening of activity is becoming apparent in several economies, including the Baltics and Slovenia. Confidence indicators have also turned down since last summer (Figure 9).

Figure 9.
Figure 9.

Emerging Europe: Confidence Indicators, January 2006–February 2008

(Percentage balance)

Sources: Haver Analtytics; European Commision; and IMF staff calculations.1/ Average of individual indexes for Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, the Slovak Republic, Slovenia, Poland, and Romania.

Financial Turbulence: Policy Lessons

Against the backdrop of growing concerns about counterparty credit risks, a range of financial policies may be required to rebuild counterparty confidence—which is an immediate priority to reduce systemic threats and spillovers—and set the stage for more medium-term reforms, aimed at reinforcing the financial soundness of institutions.

In the short term, continued efforts will be needed in the following areas:

  • Providing liquidity. Central banks should continue to provide liquidity in the interbank market to mitigate the rise in the cost of wholesale funds.

  • Improving transparency. Lack of reliable information about exposures and risks leads to possible misperceptions and heightened risk aversion. While loss recognition on the side of financial institutions remains essential (Chapter 2), supervisory authorities should seek to fill information gaps about the vulnerabilities of national financial institutions and markets, highlighting plans to restore financial soundness.

  • Raising bank capital. To strengthen confidence and prevent capital reductions from constraining lending, banks with weak capital positions should be strongly encouraged to raise capital. In some instances, supervisors may need to direct banks to suspend dividend payments and share buybacks in order to preserve capital ratios.

Over the medium term, more fundamental changes are needed to ensure institutions manage risks well:

  • Enhancing supervisory oversight of risk management. Regulators should provide incentives for financial institutions to review and improve their internal risk management.

  • Building capital buffers. Banks must maintain sufficient capital to absorb shocks from the reduction in mark-to-market valuations or losses on asset sales. This would reassure counterparties that access to funding can be sustained, including during periods of severe turbulence. Indeed, whenever the supervisors identify deficiencies, the second pillar of the Basel II capital accord should be used to ensure that banks hold additional capital beyond the minimum requirement identified by risk weights or by internal models under the first pillar.

  • Monitoring balance sheet leverage. Bank supervisors need to consider balance sheet leverage more carefully when assessing capital adequacy. In line with the Basel II framework, market and liquidity risks accompanying balance sheet growth need to be properly considered for capital adequacy purposes. Particular vigilance is needed toward banks that are characterized by an asset base that (1) is mostly subject to mark-to-market valuations, (2) is highly dependent on markets for funding, or (3) has a high degree of leverage.

  • Managing liquidity risks. Banks need to improve their management of liquidity risk. This may include improving the assessment of backup contingency lines and conducting regular, well-calibrated stress test exercises. Supervisors also need to be more proactive in identifying cases of underinsurance against liquidity risks.

  • Strengthening regulation of off-balance-sheet entities. Incentives to set up off-balance-sheet entities should be reduced, while stricter rules are needed on their use by banks. Disclosure should be improved so that investors can assess the sponsor’s risk to the entity. Supervisors may also need to strengthen guidelines regarding the circumstances under which risk transfers to off-balance-sheet entities warrant capital relief.

Addressing underlying vulnerabilities in the financial system architecture should also become an essential part of broader public policy actions aimed at reducing future risks:

  • Improving crisis resolution frameworks. When the failure of an institution poses a systemic threat, public assistance may need to be considered, but the institution’s shareholders must bear the full brunt, and clear mechanisms must be implemented to ensure that operations will continue on a commercial basis, with an unambiguous plan for exit by the public sector. Resolution should avoid adding to pressures of distressed debt sales, as this may force banks to become undercapitalized, leading to costly strains on insured depository institutions.

  • Reinforcing cross-border supervisory cooperation. Rapidly increasing cross-border integration in advanced Europe, as well as stronger reliance of emerging European economies on concentrated foreign funding, underscores the need for greater cross-border supervisory cooperation in the European Union (see also Boxes 4 and 5 in Chapter 2). The expansion abroad of local banks also raises new challenges. The ongoing implementation of the Basel II capital accord has called for more effective cross-border coordination among bank supervisors.

Note: The main author of this box is Silvia Sgherri. This box draws from the policy recommendations contained in Chapter 1 of the IMF’s Global Financial Stability Report (IMF, 2008a) and from recent IMF Financial Sector Assessments (FSAPs) conducted in emerging Europe.

The baseline outlook is for a relatively soft landing, with projected growth rates for most of the region remaining close to IMF staff estimates of potential growth. More specifically, growth is expected to slow from 6.9 percent in 2007 to 5.5 percent in 2008, and soften somewhat further in 2009 (Figure 1 and Table 1). Headline inflation is expected to come down in the second half of 2008 as food and commodity prices moderate. The projection assumes that domestic demand will continue to provide impetus to growth as external demand weakens and that the disruption of financial flows to the region will be contained. However, the downside risks are substantial, especially for countries with large external imbalances. The highest potential risk is a significant retrenchment in foreign investors’ exposure to the region.

The impact of the turmoil in financial markets so far has been greater in emerging Europe than in other emerging markets, reflecting the region’s high dependence on external financing. With foreign banks—which dominate the banking system in most of the region—starting to pass on the increase in their cost of funds, lending rates are rising, although real lending rates still remain low. The cost of market financing has also gone up (Figure 10), and access to market funds has become more difficult. External debt spreads have widened substantially, and equity markets have sold off. Bond issuance by the private sector has contracted sharply since mid-2007 (Figure 11). As a result, credit growth rates have started to fall—from very high levels—in several countries, including the Baltics and Croatia. In Turkey, funding to domestic banks from securitized loans has contracted, and there are concerns that syndicated loans may also be slowing and that liquidity in the currency swap markets, which domestic banks use to transform foreign currency funding into local currency, may be drying up.

Figure 10.
Figure 10.

Emerging Europe: Sovereign and Corporate Bond Spreads, January 2007–March 2008 1/

(Basis points)

Source: Bloomberg L.P.Note: EMBI+ is the JPM organ Emerging Markets Bond Index Plus.1/ JP Morgan EMEA EMBI + spreads over treasury bonds.
Figure 11.
Figure 11.

Emerging Markets: Private Sector External Bond Issuance, 2006–08

(Billions of U.S. dollars)

Sources: Dealogic; and IMF staff calculations.

Understanding Food Price Inflation in Emerging Europe

Headline inflation in Europe has increased sharply since the summer of 2007, driven mostly by a rise in global commodity prices. World food prices rose by 40 percent (in U.S. dollars) since May 2007 as demand for biofuel production surged, while poor wheat harvests in Europe, North America, and Australia restricted supply. The steady rise in oil prices also fueled the inflation pressures.

The impact of food price increases on headline inflation has been larger in Europe’s emerging economies than in the advanced economies (first figure). What are the factors that can explain this difference?

  • Food prices have a much larger weight in the consumption baskets of emerging market economies due to these countries’ lower average income levels (second figure). In 2007, the share of food in the consumer price index averaged 14 percent in the advanced European economies, 22 percent in the new EU members, and above 40 percent in Albania, Belarus, and Ukraine.

  • Because the price levels of most agricultural commodities in emerging economies are lower than in the advanced economies, a similar absolute price increase across Europe would lead to a greater increase in percentage terms in emerging Europe.

  • The upward trajectory of food prices in emerging Europe was exacerbated by local supply shocks (poor weather conditions). In Bulgaria, agricultural value added plummeted by 30 percent in 2007, in Romania it fell by 17 percent, and in Hungary and Turkey by 13 and 6 percent, respectively. These effects are expected to be transitory.

  • Growing trade integration and the gradual convergence of wages also contributed to the faster pace of food price inflation in the emerging economies. In recent years, trade in food products increased rapidly, especially for the new EU member countries (third figure), putting pressure on local prices. Rising wages and transportation costs added to this pressure. Finally, income convergence is increasing local demand, especially for higher-value-added food items. These trends are likely to continue until full integration has been achieved.

box3fig1

Europe: Contribution of Food to Headline Inflation (Headline inflation = 100), December 2005–December 2007

(Percent)

Sources: Eurostat; and IMF staff calculations.1/ Excluding Cyprus and Malta.
box3fig2

Share of Food Expenditures and Per Capita Income in European Countries, 2007

Sources: Eurostat; and IMF staff calculations.

In terms of policy response, containing the second-round effects of the sharp increase in inflation will be essential. Monetary policy may need to be tightened to prevent a wage-price spiral in countries with floating exchange rates. Good communication with the public may help—policymakers should make it clear that most factors driving the increase in inflation are temporary and that inflation is expected to return to target in the medium term. Price controls should be avoided since they would introduce distortions and inefficiencies into the market. Instead, there may be a case for providing targeted temporary subsidies to the most vulnerable social groups. Competition in the retail and distribution sectors should be encouraged to reduce markups and ease price pressures.

box3fig3

New EU Member Countries: Measures of Agricultural Trade Integration, 2002–06 1/

(Exports plus imports of food)

Sources: Eurostat; and IMF staff calculations.1/ Excluding Cyprus and Malta.2/ EU-27 = Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovenia, Slovak Republic, Spain, Sweden, and United Kingdom.
Note: The main authors of this box are Geoffrey Oestreicher and Alex Pivovarsky.

Uncertainty around the Outlook Is Substantial; Risks Are Skewed to the Downside

First, there is significant uncertainty about the duration and depth of the global downturn and the magnitude of spillovers to emerging Europe. IMF staff analysis (Box 1) suggests that emerging European economies may be more vulnerable to a global slowdown than the advanced economies in Europe. The direct trade effect from a sharp downturn abroad is likely to be significant because countries in the region are highly open, with exports accounting for 30 to 80 percent of GDP. Most exports are going to other European economies. The share of exports going to oil-producing countries and the dynamic emerging economies in Asia—which are likely to be less affected by the current downturn—is very small. A sharper-than-expected global slowdown would also increase the severity of financial contagion.

Second, the extent of moderation of food price inflation in 2008 is difficult to predict. While the effect of domestic supply shocks is likely to wear off, convergence factors and heightened global demand for biofuel products could continue to exert upward pressure. Also, oil prices may rise further amid tight supply. The impact of rising energy prices would be especially large in Ukraine and Moldova, where gas prices still need to converge to world levels.

Third, the heavy dependence on foreign capital leaves the region exposed to an abrupt retrenchment of capital inflows. Emerging Europe relies more heavily than other emerging economies on foreign inflows intermediated by the banking system. In the Baltics, Romania, Serbia, and Ukraine, more than 25 percent of domestic lending is financed by borrowing abroad, and the share has been rising (see Box 5 in Chapter 2). Rapid credit growth, fueled by capital inflows, has boosted economic activity in recent years. A sharp decline would dampen both consumption and investment.

The extent to which foreign banks will curtail lending in response to the financial turmoil in mature markets is highly uncertain. It is likely to depend on the health of parent banks, their access to funding, and the size and concentration of their exposures to emerging markets. The foreign banks with the greatest involvement in emerging Europe have little (known) direct exposure to U.S. subprime mortgages; however, the heavy reliance of some of them on interbank loans for financing increases the risks of indirect contagion. Scandinavian banks are attempting to gradually reduce credit growth to the region to avoid triggering sharp asset price declines that would weaken their balance sheets.

If downside risks materialize, countries with greater imbalances will be more susceptible to shifts in confidence. Economies with large current account deficits or high external debt ratios would be especially vulnerable if foreign financing dried up (Figure 12). A number of countries experienced stock market and house price booms in recent years, raising concerns about potential asset price bubbles (Figure 13). Since mid-2007, stock prices have fallen sharply and house prices are starting to come down in some countries. Large, abrupt asset price adjustments would weaken banks’ balance sheets and consumer confidence, and might trigger financial decelerator effects (see Chapter 3 for a detailed discussion of vulnerabilities).

Figure 12.
Figure 12.

Emerging Europe: Bond Spreads and Current Account Deficits

Sources: Bloomberg L.P.; IMF, World Economic Outlook; and IMF staff calculations.1/ Basis points. Emerging Markets Bond Index (EMBI) euro difference in spreads between January 1, 2008, and March 17, 2008.
Figure 13.
Figure 13.

Central and Eastern Europe: Credit Growth and House Prices, 2002–06

(Percent)

Sources: Égert and Mihaljek (2007); and IMF staff estimates.Note: The speed of credit growth is defined as the annual percentage point increase in the private credit-to-GDP ratio, averaged over 2002–06.

Policy Focus: Reducing Imbalances and Ensuring a Soft Landing

In those emerging economies still experiencing overheating pressures, policies should remain focused on dampening domestic demand, reducing domestic and external imbalances, and preventing second-round effects from the sharp increase in inflation:

  • In countries with flexible exchange rate regimes, monetary policy needs to bring down the rate of inflation. With wages rising faster than productivity in some countries and little slack in the labor markets, preventing the temporary wave of inflation from feeding into wage growth will be important to avoid a further loss of competitiveness. The central banks in Poland, the Czech Republic, Romania, and Serbia appropriately raised their policy rates in early 2008 to ensure that the temporary rise in commodities inflation does not trigger a wage-price spiral. Further policy tightening may be needed in several countries, especially Russia, to achieve a reduction in inflation. In some economies, an appreciation of the exchange rate has helped contain inflation pressures. Fiscal tightening should complement monetary policy in cooling off economic activity.

  • In countries with fixed or heavily managed exchange rates, fiscal restraint remains the key tool for controlling overheating.

  • Restraining the growth of public sector wages will help moderate private sector wage demands (especially in Bulgaria, Estonia, Latvia, and Romania).

However, with the cycle already turning in a number of countries, concerns about overheating are giving way to worries about the imbalances that have built up during the cyclical upswing. The risks of a hard landing have increased, and countries with greater imbalances may be especially vulnerable. Policymakers need to be ready to adapt policies flexibly to the changing circumstances:

  • Under the baseline forecast, overheating pressures will dissipate, as demand falls in line with potential output. In this scenario, policies will need to focus less on demand management. However, reducing vulnerabilities and implementing reforms that raise potential output should remain top policy priorities.

  • In the case of a greater-than-expected slowdown, automatic fiscal stabilizers should be allowed to play fully. There would be relatively little room for discretionary fiscal policy, especially in the new member states that are either close to the deficit limit of 3 percent of GDP under the SGP or have sizable current account deficits and external debt levels. For countries with floating exchange rates, monetary easing could also be an option once inflation pressures dissipate.5

Continued emphasis on strengthening the resilience of the financial system and implementing structural reforms would help reduce vulnerabilities and mitigate the risks of a sharp growth slowdown. As demonstrated by the Russian crisis in 1998, investors do differentiate among countries on the basis of fundamentals, even in times of a generalized increase in risk aversion. To minimize the possibility of disruptions in the functioning of the domestic financial systems, policymakers should step up oversight (including nonbank financial sector supervision), bring regulations in line with best practices, and strengthen cross-border supervisory cooperation. The introduction and enforcement of prudential measures, such as limits on loan-to-value ratios and higher reserve requirements for foreign borrowing, would create buffers that could improve adjustment to shocks. Tightening the disclosure requirements for risk management and internal control would encourage better risk control and enhance transparency. At the same time, structural reforms that help reduce vulnerabilities and raise potential output—such as increasing labor market flexibility, fostering competition, strengthening the quality of institutions, enforcing the rule of law, and improving the business climate—should continue.

Note: The main author of this chapter is Dora Iakova.

1

See the IMF’s World Economic Outlook (2008a) and the Global Financial Stability Report (2008b) for a detailed discussion of global developments and the outlook for the United States.

2

In what follows, the group of emerging European economies comprises Albania; Belarus; Bosnia and Herzegovina; Bulgaria; Croatia; the Czech Republic; Estonia; Hungary; Latvia; Lithuania; Macedonia, FYR; Malta; Moldova; Montenegro; Poland; Romania; Russia; Serbia; the Slovak Republic; Slovenia; Turkey; and Ukraine. All other European economies are included in the group of advanced economies.

3

To ensure that the rise in inflation remains temporary, real wage growth needs to slow temporarily relative to productivity. Resisting the adjustment of real wages would exert further upward pressure on prices and lead companies to scale back employment. The agreements that have been completed so far suggest that wage pressures are likely to be contained.

4

So far, there have been no failures of major financial institutions in Europe because capital has been injected promptly. The U.K. authorities had to nationalize a medium-sized mortgage lender that relied heavily on wholesale funding and mortgage securitization. Germany salvaged two small banks that were heavily exposed to products related to the U.S. subprime market. A few large European financial institutions have received capital injections from shareholders or other sources, strengthening their capital positions. Nonetheless, uncertainty about the magnitude of potential losses in the financial system and concerns about counterparty risk remain (Chapter 2).

5

The scope for easing policies would depend on the triggers and the severity of the slowdown. In the event of an abrupt loss of investor confidence, policymakers might have little choice but to tighten policies until confidence is regained.

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    Europe and the United States: Real GDP Growth, 2001–09

    (Percent)

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    Key Short-Term Indicators

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    Euro Area: Contribution of Food and Energy to Headline Inflation, January 2006–December 2007

    (Percent)

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    Euro Area: Cost of Financing, 2005–08

    (Percent)

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    Spreads of Three-Month Interbank Rates over Expected Policy Rates, 2007–08

    (Basis points)

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    Changes in Credit Standards for Loans to Enterprises and Households, 2005–08 1/

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    Measures of the Euro Exchange Rate, 1999–2008

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    Response of European Countries to a 1 Percentage Point Decline in the U.S. Growth Rate 1/

    (Percent)

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    Growth in Emerging Europe, 2001–09

    (Percent)

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    Emerging Europe: Confidence Indicators, January 2006–February 2008

    (Percentage balance)

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    Emerging Europe: Sovereign and Corporate Bond Spreads, January 2007–March 2008 1/

    (Basis points)

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    Emerging Markets: Private Sector External Bond Issuance, 2006–08

    (Billions of U.S. dollars)

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    Europe: Contribution of Food to Headline Inflation (Headline inflation = 100), December 2005–December 2007

    (Percent)

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    Share of Food Expenditures and Per Capita Income in European Countries, 2007

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    New EU Member Countries: Measures of Agricultural Trade Integration, 2002–06 1/

    (Exports plus imports of food)

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    Emerging Europe: Bond Spreads and Current Account Deficits

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    Central and Eastern Europe: Credit Growth and House Prices, 2002–06

    (Percent)

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