Abstract

Europe is in a deep recession. Adverse feedback between the financial and real sectors and across borders is likely to delay the recovery and create downside risks. Unprecedented policies have been undertaken to address the crisis-but are they likely to be successful and sufficiently coordinated for a tightly integrated region? To restore trust and confidence in financial markets, additional and forceful action will be essential. Maintaining fiscal support should help soften the downturn, in particular if sustainability is supported by solid medium-term strategies and fiscal frameworks. To be effective, these policies require coordination across advanced and emerging economies. The report's analytical work underpins the link between fiscal sustainability, coordination, and effectiveness, and stresses that emerging markets have been affected differently by the crisis, with the quality of policies and external vulnerabilities being key factors.

References

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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
  • Gale, W., and P. Orszag, 2004, “Budget Deficits, National Saving, and Interest Rates,Brookings Papers on Economic Activity: 2, pp. 101210.

    • Search Google Scholar
    • Export Citation
  • Galesi, Alessandro, and Silvia Sgherri, 2009, “Regional Financial Spillovers Across Europe: A Global VAR Analysis,IMF Working Paper 09/23 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Hardy, Daniel C.L. and Maria Nieto, 2008, “Cross-Border Coordination of Prudential Supervision and Deposit Guarantees,IMF Working Paper 08/283 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Hauner, David, Jiri Jonáš, and Manmohan S. Kumar, 2007, “Policy Credibility and Sovereign Credit—The Case of the New Member States,IMF Working Paper 07/1 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
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  • International Monetary Fund (IMF), 2008a, Euro Area Policies: 2008 Article IV Consultation, IMF Country Report No. 08/262 (Washington).

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    • Search Google Scholar
    • Export Citation
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    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Export Citation
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    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Export Citation
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    • Export Citation
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    • Export Citation
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    • Search Google Scholar
    • Export Citation
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    • Search Google Scholar
    • Export Citation
  • Rancière, Romain, Aaron Tornell, and Athanasios Vamvakidis, forthcoming, “Currency Mismatch, Financial Crises and Growth: Theory and Evidence,IMF Working Paper (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
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Note: The main authors of this chapter are Martin Čihák and Srobona Mitra.

37

Emerging European economies are defined to include (1) countries that joined the EU in 2004 or thereafter and had not joined the euro area by end-2008 (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and the Slovak Republic), and (2) the non-EU countries of Albania, Belarus, Bosnia and Herzegovina, Croatia, FYR Macedonia, Moldova, Montenegro, Russia, Serbia, Turkey, and Ukraine. In the subsequent econometric analyses, some countries were dropped due to lack of data.

38

In fact, the average ratio of government debt to GDP in countries that had to resort to official financial assistance has been less than half of the euro area average.

39

Bank-related capital inflows are defined as the balance of payments item “other investment, liabilities,” aggregating the subitems “loans” and “currency and deposits.” These two items capture loans comprising inflows from parent banks into emerging market subsidiaries and cross-border loans to banks and corporates, excluding portfolio and foreign direct investment inflows. The breakdown of this category into bank and nonbank flows is not available consistently across countries, but available data and anecdotal evidence suggest that the bankrelated portion is large, reflecting the central roles of the banking sector and the high degree of foreign ownership in most emerging European banking systems.

40

The European Central Bank and the European Commission provide assessments for the NMS on their progress toward meeting the criteria for convergence to euro adoption (the “convergence criteria”). The five criteria are the fiscal deficit (less than 3 percent of GDP), government debt (less than 60 percent of GDP), inflation (less than 3.2 percent for 2008), the long-term interest rate (less than 6.5 percent for 2008), and the exchange rate (participation in the Exchange Rate Mechanism (ERM) II).

41

Different authors have interpreted the halo effect differently. Hauner, Jonas, and Kumar (2007) posit that it is linked to EU membership, in particular the effect of better institutions and processes, such as fiscal rules, that have been put in place since EU accession. This would suggest that the halo effect may be lasting. Luengnaruemitchai and Schadler (2007) point out that the halo effect is essentially an unexplained residual that may turn out to be temporary.

42

The econometric analysis involves robust ordinary least squares (OLS) estimates on pooled data of 43 European countries, covering three main subgroups: euro area members, NMS, and other emerging Europe. Episode fixed effects were used to control for common factors that affected all countries. Country-specific variables were used to explain cross-country differences in performance.

43

Each convergence criterion (see footnote 40) is assigned one point. If the country meets a criterion, it gets 0; otherwise, 1. Therefore, the variable used in the regression takes values from 0 (for a country fulfilling all criteria) to 5 (for a country meeting none of the criteria).

44

The estimates use an augmented version of the methodology by Laeven and Majnoni (2003). A limitation of the estimates is the shortness of the time series as well as the fact that eastern European banks have not yet been through many business cycles. The estimates therefore need to be treated only as illustrative.

45

See De Nicolò (2000); and Maechler, Mitra, and Worrell (forthcoming) for a discussion of the z-index and its various forms. Here, z = (return on assets + equity/assets)/mean deviation of return on assets within a bank. Higher z should in general indicate greater stability or lower risk of insolvency.

46

To give an example based on the empirical model, a decrease in Latvia’s growth rate from 10.0 percent in 2007 to −4.6 percent in 2008—a decline of about 15 percentage points—would mean an increase in provisions by 1.05 percentage points—for a total of 1.26 (=0.21+1.05) percent of 2007 assets. For most countries, such an increase is beyond two standard errors of average provisions. The quantitative impact modeled in the regression is linear, and hence probably on the lower side. During a crisis, the effects could be nonlinear mainly for two reasons: first, second-round effects of reduced credit flows on output and employment would cause further distress on bank balance sheets, and, second, widespread balance sheet mismatches in foreign currency of the private sector could be exacerbated through large-scale exchange rate depreciations generating further credit risk for banks. These second-round effects have not been modeled here due to lack of data.

47

In a bivariate vector autoregression of consumption growth and income growth in the United States, Blanchard (1993) shows that shocks to consumption could be long-lasting and could delay recovery from crises.

48

The correlation between consumption and retail sales growth is, on average, higher than 50 percent (and significant) for the emerging European economies.

49

The methodology follows Bacchetta and Gerlach (1997) and Bayoumi and Melander (2008), who estimate the effect of predictable changes in credit on consumption growth. It augments these regressions with measures of consumer sentiment about unemployment expectations following Carroll and Dunn (1997). To address the shortness of the time series for emerging European markets, monthly series on retail sales and real wages are used, with the latter approximating movements in income.

50

Because there could be reverse causality from retail sales to current income growth, instrumental variables were used to substitute for current real wages. Instruments included real wage growth and retail sales growth lagged by one through three, six, and nine months. Granger causality tests show that credit growth, on average, does a much worse job at predicting future wage growth than past wage growth or retail sales growth. This finding supports the interpretation that the significance of credit growth in the regression reflects its ability to explain retails sales growth beyond its role in explaining current income growth.

51

Carroll and Dunn (1997) show that, for the United States, when uncertainty about future labor income increases, consumers postpone purchases of durable goods until their balance sheet condition improves. Another result suggests that durables consumption was more sensitive to this uncertainty measure after financial liberalization. The sensitivity could have increased over time for emerging markets too as their financial systems were gradually liberalized over the last decade.

52

Under Basel II Pillar 2, bank supervisors need to evaluate banks’ internal capital adequacy calculations and compliance, and could require higher capitalization for individual banks if their risk profiles are higher. Supervisors need to determine this risk by conducting stress tests. But countries need to have the supervisory capacity to make the necessary assessments and the adequate legal framework to take action.

  • Angeloni, Ignazio, Anil Kashyap, Benoît Mojon, and Daniele Terlizzese, 2002,Monetary Transmission in the Euro Area: Where Do We Stand?” ECB Working Paper No. 114 (Frankfurt: European Central Bank).

    • Search Google Scholar
    • Export Citation
  • Ardagna, S., F. Caselli, and T. Lane, 2004, “Fiscal Discipline and the Cost of Public Debt Service: Some Estimates for OECD Countries,ECB Working Paper No. 411 (Frankfurt: European Central Bank).

    • Search Google Scholar
    • Export Citation
  • Bacchetta, Philippe, and Stefan Gerlach, 1997, “Consumption and Credit Constraints: International Evidence,Journal of Monetary Economics, Vol. 40 (October), pp. 20738.

    • Search Google Scholar
    • Export Citation
  • Bayoumi, Tamim, and Ola Melander, 2008, “Credit Matters: Empirical Evidence on U.S. Macro-Financial Linkages,IMF Working Paper 08/169 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Bayoumi, Tamim, and Silvia Sgherri, 2009, “On Impatience and Policy Effectiveness,IMF Working Paper 09/18 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Beechey, Meredith J., Benjamin K. Johannsen, and Andrew T. Levin, 2008, “Are Long-Run Inflation Expectations Anchored More Firmly in the Euro Area than in the United States?” Finance and Economics Discussion Series No. 2008-23 (Washington: Board of Governors of the Federal Reserve System).

    • Search Google Scholar
    • Export Citation
  • Beetsma, R., M. Giuliodori, and F. Klaassen, 2006, “Trade Spillovers of Fiscal Policy in the European Union: A Panel Analysis,Economic Policy, Vol. 21 (October), pp. 63987.

    • Search Google Scholar
    • Export Citation
  • Beetsma R., and X. Debrun, 2007, “The New Stability and Growth Pact: A First Assessment,European Economic Review, Vol. 51 (February), pp. 45377.

    • Search Google Scholar
    • Export Citation
  • Blanchard, Olivier, 1993, “Consumption and the Recession of 1990–1991,American Economic Review, Papers and Proceedings, Vol. 83 (May), pp 27074.

    • Search Google Scholar
    • Export Citation
  • Blanchard, Olivier, and R. Perotti, 2002, “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output,Quarterly Journal of Economics, Vol. 117 (November), pp. 132968.

    • Search Google Scholar
    • Export Citation
  • Campbell, J.Y., and N.G. Mankiw, 1989, “Consumption, Income and Interest Rates: Reinterpreting the Time Series Evidence,” in NBER Macroeconomics Annual 1989, ed. by O. Blanchard and S. Fischer (Cambridge, Massachusetts: MIT Press), pp. 185216.

    • Search Google Scholar
    • Export Citation
  • Carroll, Christopher, and Wendy Dunn, 1997, “Unemployment Expectations, Jumping (S, s) Triggers, and Household Balance Sheets,” in NBER Macroeconomics Annual 1997, ed. by B. Bernanke and J. Rotemberg (Cambridge, Massachusetts: MIT Press), pp. 165217.

    • Search Google Scholar
    • Export Citation
  • Christiansen, L., 2008, “Fiscal Multipliers—A Review of the Literature,” Appendix II to IMF Staff Position Note 08/01 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Čihák, Martin, and Wim Fonteyne, 2009, “Five Years After: European Union Membership and Macro-Financial Stability in the New Member States,IMF Working Paper 09/68 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Claessens S., M. A. Kose, and M. E. Terrones, 2008, “What Happens During Recessions, Crunches, and Busts?IMF Working Paper 08/274 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Debrun, Xavier, and Bikas Joshi, 2008, “Credibility Effects of Numerical Fiscal Rules: An Empirical Investigation,” in Hungary: Selected Issues, IMF Country Report No. 08/314, by X. Debrun, B. Joshi, and S. Mitra (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Debrun, X., L. Moulin, A. Turrini, J. Ayuso-i-Casals, and M.S. Kumar, 2008, “Tied to the Mast? National Fiscal Rules in the European Union,Economic Policy: A European Forum, Vol. 23 (April), pp. 297362.

    • Search Google Scholar
    • Export Citation
  • De Nicolò, Gianni, 2000, “Size, Charter Value and Risk in Banking: An International Perspective,International Finance Discussion Paper No. 689 (Washington: Board of Governors of the Federal Reserve System).

    • Search Google Scholar
    • Export Citation
  • Engen, E., and G. Hubbard, 2004, “Federal Government Debt and Interest Rates,” in NBER Macroeconomics Annual 2004, ed. by M. Gertler and K. Rogoff (Cambridge, Massachusetts: MIT Press), pp. 83138.

    • Search Google Scholar
    • Export Citation
  • European Commission, 2006, Public Finances in EMU-2006 (Luxembourg: European Commission).

  • European Commission, 2007, Public Finances in EMU-2007 (Luxembourg: European Commission).

  • European Commission, 2008, Public Finances in EMU-2008 (Luxembourg: European Commission).

  • Fitch Ratings, 2009, “European Government Borrowing,January 26.

  • Freedman C., M. Kumhof, D. Laxton, and J. Lee, 2009, “The Case for Global Fiscal Stimulus,” IMF Staff Position Note 09/03 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Freedman, C., M. Kumhof, D. Laxton, D. Muir, and S. Mursula, forthcoming, “Fiscal Multipliers Galore,IMF Working Paper (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Gale, W., and P. Orszag, 2004, “Budget Deficits, National Saving, and Interest Rates,Brookings Papers on Economic Activity: 2, pp. 101210.

    • Search Google Scholar
    • Export Citation
  • Galesi, Alessandro, and Silvia Sgherri, 2009, “Regional Financial Spillovers Across Europe: A Global VAR Analysis,IMF Working Paper 09/23 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Hardy, Daniel C.L. and Maria Nieto, 2008, “Cross-Border Coordination of Prudential Supervision and Deposit Guarantees,IMF Working Paper 08/283 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Hauner, David, Jiri Jonáš, and Manmohan S. Kumar, 2007, “Policy Credibility and Sovereign Credit—The Case of the New Member States,IMF Working Paper 07/1 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund (IMF), 2007, Regional Economic Outlook: Europe (Washington, November).

  • International Monetary Fund (IMF), 2008a, Euro Area Policies: 2008 Article IV Consultation, IMF Country Report No. 08/262 (Washington).

  • International Monetary Fund (IMF), 2008b, “Fiscal Policy as a Countercyclical Tool,” Chapter 5 of World Economic Outlook, (Washington, October).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund (IMF), 2008c, Regional Economic Outlook: Europe (Washington, April).

  • International Monetary Fund (IMF), 2008d, Regional Economic Outlook: Europe (Washington, October).

  • International Monetary Fund (IMF), 2008e, “Stress in Bank Funding Markets and Implications for Monetary Policy,” in Global Financial Stability Report (Washington, October).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund (IMF), 2009a, Global Financial Stability Report (Washington, April).

  • International Monetary Fund (IMF), 2009b, “The State of Public Finances: Outlook and Medium-Term Policies After the 2008 Crisis.Available via the Internet: www.imf.org/external/np/pp/eng/2009/030609.pdf.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund (IMF), 2009c, “Companion Paper—The State of Public Finances—Outlook and Medium-Term Policies After the 2008 Crisis.Available via the Internet: www.imf.org/external/np/pp/eng/2009/030609a.pdf.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund (IMF), 2009d, World Economic Outlook (Washington, April).

  • International Monetary Fund, and World Bank, 2001, Guidelines for Public Debt Management (Washington).

  • Jappelli, T., and M. Pagano, 1989, “Consumption and Capital Market Imperfections: An International Comparison,American Economic Review, Vol. 79 (December), pp. 10881105.

    • Search Google Scholar
    • Export Citation
  • Krugman, Paul, 2008, “European Macro Algebra,New York Times, December 14.

  • Kumhof, M., and D. Laxton, 2007, “A Party without a Hangover? On the Effects of U.S. Government Deficits,IMF Working Paper 07/202 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Laeven, Luc, and Giovanni Majnoni, 2003, “Loan Loss Provisioning and Economic Slowdowns: Too Much, Too Late?Journal of Financial Intermediation, Vol. 12 (April), pp. 17897.

    • Search Google Scholar
    • Export Citation
  • Laeven, Luc, and F. Valencia, 2008, “Systemic Banking Crises: A New Database,IMF Working Paper 08/224 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Lombardi, Marco J., and Silvia Sgherri, forthcoming, “Risk Repricing and Spillovers Across Assets,IMF Working Paper (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Luengnaruemitchai, Pipat, and Susan Schadler, 2007, “Do Economists’ and Financial Markets’ Perspectives on the New Members of the EU Differ?IMF Working Paper 07/65 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Maechler, Andrea, Srobona Mitra, and DeLisle Worrell, forthcoming, “Decomposing Financial Risks and Vulnerabilities in Emerging Europe,IMF Staff Papers, and IMF Working Paper 07/248 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Mecagni, Mauro, Ruben Atoyan, David Hofman, Dimitri Tzanninis, 2007, “The Duration of Capital Account Crises—An Empirical Anyalysis,IMF Working Paper 07/258 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Perotti, Roberto, 2002, “Estimating the Effects of Fiscal Policy in OECD Countries,ECB Working Paper No. 168 (Frankfurt: European Central Bank).

    • Search Google Scholar
    • Export Citation
  • Rancière, Romain, Aaron Tornell, and Frank Westermann, 2008, “Systemic Crises and Growth,Quarterly Journal of Economics, Vol. 123, No. 1, pp. 359406.

    • Search Google Scholar
    • Export Citation
  • Rancière, Romain, Aaron Tornell, and Athanasios Vamvakidis, forthcoming, “Currency Mismatch, Financial Crises and Growth: Theory and Evidence,IMF Working Paper (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Rudebusch, Glen, and Tao Wu, 2003, “A Macro-Finance Model of the Term Structure, Monetary Policy, and the Economy,FRBSF Working Paper No. 2003-17 (San Francisco: Federal Reserve Bank of San Francisco).

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  • Sgherri, Silvia, and Edda Zoli, forthcoming, “Rising Sovereign Spreads in the Euro Area: Are Markets Concerned About Fiscal Sustainability?IMF Working Paper (Washington: International Monetary Fund).

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  • Sørensen, Christoffer Kok, and Thomas Werner, 2006, “Bank Interest Rate Pass-Through in the Euro Area: A Cross-Country Comparison,ECB Working Paper No. 580 (Frankfurt: European Central Bank).

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  • Vamvakidis, Athanasios, forthcoming, “Convergence in Emerging Europe: Sustainability and Vulnerabilities,” Eastern European Economics.

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