Europe is going through a deep recession, driven by a collapse in confidence and global demand, and by adverse feedback effects between its financial system and the real economy. Unprecedented policy actions have brought about a measure of stability and cushioned the downturn. However, establishing a solid economic recovery will require additional and effectively coordinated policy interventions. The crisis provides an opportunity to strengthen economic and financial integration in Europe, including by strongly supporting emerging economies, that should not be missed.

Europe is going through a deep recession, driven by a collapse in confidence and global demand, and by adverse feedback effects between its financial system and the real economy. Unprecedented policy actions have brought about a measure of stability and cushioned the downturn. However, establishing a solid economic recovery will require additional and effectively coordinated policy interventions. The crisis provides an opportunity to strengthen economic and financial integration in Europe, including by strongly supporting emerging economies, that should not be missed.

Synchronized Recession

Activity and Inflation Have Fallen Sharply

The economic downturn has become a global, synchronized recession.1 What started as a retrenchment by consumers in response to deflating real estate markets and commodity price hikes, broadened to encompass all components of demand (Figure 1). Tighter financial conditions and greater uncertainty about the outlook triggered a sharp fall in capital spending. The intensification of the financial crisis in September 2008 caused an abrupt increase in uncertainty and led to a downward reassessment of wealth and income prospects. In turn, these developments prompted households to raise savings rates and to postpone spending on most durables, even though falling commodity prices helped boost real disposable income. This drop in demand and dearth of credit set off an unprecedented collapse in trade volumes—with euro area exports falling at an annual rate of 26 percent in the last quarter of 2008. Tight global trade links synchronized this shock, while cross-border capital flows dwindled, engulfing previously resilient emerging economies in the crisis. Comparatively stronger trade and financial integration within Europe added a crucial intraregional dimension. As a result, average growth in 2008 slowed by similar amounts in advanced and emerging economies, with some differentiation because of country-specific circumstances (Table 1).

Figure 1.
Figure 1.

Euro Area: Contribution to Growth, 2006–08

(Quarter-on-quarter annualized percentage points)

Source: Eurostat.
Table 1.

European Countries: Real GDP Growth and CPI Inflation, 2006–10


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Source: IMF, World Economic Outlook.

Average weighted by PPP GDP.

Montenegro is excluded from the aggregate calculations.

Against this background, inflation has fallen sharply. The reversal of the commodity price increases has pushed headline inflation to very low levels in advanced economies and diminished concerns about inflation in many emerging economies (Figure 2). Core inflation, though holding up at higher levels, has nonetheless been falling in several countries, indicating that the sharp weakening of activity is perhaps reducing pricing power earlier than usual. Even so, downward price pressures are less pronounced in countries that are experiencing nominal exchange rate depreciations beyond levels required to bring real effective rates in line with fundamentals.

Figure 2.
Figure 2.

Selected European Countries: Headline and Core Inflation, January 2006–February 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.

Spillovers Hold Sway in an Interconnected World …

The financial crisis originating in the United States was propagated through direct exposure to toxic assets and a reassessment of the viability of existing banking models. Wholesale liquidity evaporated, complex assets proved to be difficult to value, lack of transparency about counterparty risk undermined trust, and markets took a dim view of leverage. Hence, many banks came under severe pressure (Figure 3) and several had to be bailed out or resolved, a process that is still ongoing.

Figure 3.
Figure 3.

iTraxx Credit Default Swap Europe Financials’ Index, March 2007–April 2009

(Basis points)

Source: Bloomberg L.P.

Model-based analysis suggests that the initial financial shock was transmitted to the real economy, primarily through the equity price channel and in a more differentiated fashion through the credit channel (Galesi and Sgherri, 2009). In addition to confidence and wealth effects adversely affecting demand, the fall in equity prices—which often amounted to more than 50 percent—raised the cost of capital and dampened investment. Such a shock is estimated to have had its strongest impact on the advanced economies of Europe, but the Baltic economies would seem similarly sensitive (Figure 4). Central European economies appear more moderately susceptible, while southeastern Europe is more insulated. These model findings are consistent with the view that banks operating in emerging Europe, which relied more on traditional business models, were often not affected by direct exposure to toxic assets.

Figure 4.
Figure 4.

Generalized Impulse Response Functions: Rate of Growth of Real GDP in Response to Negative Standard Error Shock to U.S. Equity Price Growth Rate


Source: Galesi and Sgherri (2009).Note: Euro area = Austria, Belgium, Greece, Finland, France, Germany, Ireland, Italy, Netherlands, Portugal, Slovenia, and Spain; other developed European countries = Denmark, Norway, Sweden, Switzerland, and the United Kingdom; Central-eastern Europe = the Czech Republic, Hungary, Poland, and the Slovak Republic; Baltic countries = Estonia, Latvia, and Lithuania; southeastern European countries = Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Moldova, Romania, and Serbia.

However, the flight to safety associated with the intensification of the financial crisis in late 2008 rapidly put paid to the notion that emerging economies would decouple in a meaningful way. Indeed, one of the key features of the ongoing financial crisis is a jarring global repricing of risk (Figure 5). Thus far, important new crisis events have ratcheted up risk aversion. The ensuing international portfolio reallocation led to a decline in the relative price of domestic assets in emerging economies. The pressure to reduce leverage in parent banks in advanced countries and higher perceived risks drove up credit yields and led to a reduction in inflows to most emerging economies. As a result, credit growth in these economies has been declining precipitously, albeit from high levels (Figure 6). Some countries are already experiencing a credit crunch, with real credit stagnating, and domestic demand is being adversely affected everywhere.

Figure 5.
Figure 5.

Estimating Shifts in the Global Price of Risk, 2007–March 2009 1/

(Basis points)

Sources: Bloomberg L.P.; and IMF staff calculations.1/ As of March 1, 2009. See Lombardi and Sgherri (forthcoming) for analytical underpinnings.
Figure 6.
Figure 6.

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


Source: IMF, International Financial Statistics.1/ Unweighted averages of annual growth rates.

The trade channel proved equally important in propagating the crisis. During the past decade, trade links increased globally and very rapidly between Europe and Asia (Figure 7). When demand in advanced countries began to falter, Europe was not just affected through its ties with other advanced economies such as the Unites States, but also directly and indirectly through its Asian connection. With Europe relatively specialized in consumer durables and capital goods, it was hard hit by the sharp cutback in orders for such goods. This explains, for example, why Germany—an economy without significant private sector liabilities or an asset boom but specialized in capital goods production and an emphasis on export demand—is experiencing a comparatively sharp decline in activity. Demand from oil-exporting countries—another important destination for European producers—has also been weakening in response to the drop in oil revenues.

Figure 7.
Figure 7.

Europe, Asia, and United States: Value of Trade, 1995–2007

(Trillions of U.S. dollars)

Source: IMF, Direction of Trade Statistics.

Within Europe, the unfavorable feedback loop across borders through both trade and finance channels appears to be in full swing. Europe is one of the most financially and economically integrated regions in the world (Figure 8). Increased intrafirm outsourcing with firms located in emerging countries and foreign ownership of their financial systems have strengthened the interdependencies between advanced and emerging economies in Europe. Indeed, unlike in other parts of the world, these links have set in motion a process of rapid convergence, from which advanced economies have profited.2 While generally beneficial, such integration also implies that adverse shocks are transmitted more swiftly across borders.3

Figure 8.
Figure 8.

Trade and Financial Integration Within Europe

Source: IMF, Direction of Trade Statistics.
Source: Bank for International Settlements.

… with Homegrown Risks Leading to Cross-Country Differentiation

Not all countries are equally affected by the ongoing economic and financial crisis. In particular, the crisis has underscored that risky policies yield poor returns when fault lines appear in the global economy. Vulnerabilities are overlooked when global conditions are benign but ultimately lead to differentiation across countries (IMF, 2008c). The Baltic economies, Ireland, Spain, and the United Kingdom have been disproportionately affected as a result of the deflation of homegrown real estate booms. Mismatches in the financial system—be it in terms of funding models, maturities, or currencies—and high leverage have turned sour in a number of countries (e.g., Iceland, Ireland, Latvia, and the United Kingdom). Insufficiently prudent macroeconomic policies, reflected in large fiscal and/or current account deficits or high public debt have also created difficulties (e.g., Greece and Hungary). And commodity exporters are having to adjust policies rapidly to deal with large adverse terms of trade shocks (e.g., Russia and Ukraine).

Impromptu Policy Reaction

Unprecedented Policy Actions Are Under Way …

Policymakers have taken extraordinary actions in response to the deepening financial and economic crisis. In broad terms, central banks have been providing liquidity support and easing monetary policy; governments have committed large resources to guarantee, recapitalize, and resolve financial institutions, as well as support certain asset markets; and fiscal policy is being used to shore up demand. Within these contours, the response has differed across countries to take into account features of the financial system (e.g., the extent of securitization), the health of the banking systems (e.g., legacy of toxic assets), changes in size and direction of crossborder capital flows, and fiscal sustainability considerations.

What has been the effect of these policy actions so far? Their aim has been to restore confidence, stabilize the banking system, and support demand to avoid an adverse downward spiral. A key issue is the interaction of policies, with the effectiveness of monetary and fiscal policies dependent on a restoration of normal functioning to financial markets. While progress is noteworthy in several areas, policy actions have not yet yielded a decisive breakthrough:

  • Progress is most visible regarding liquidity concerns, which have been adequately dealt with in advanced economies and mitigated in most emerging economies. Stresses in money markets peaked in October 2008, as reflected in very high liquidity premiums (Figure 9). Widening of collateral, unlimited provision of liquidity at fixed rates, and currency swap lines among the major currencies, accompanied by the rapid expansion of central banks’ balance sheets, appear to have removed these premiums for advanced economies.4

  • However, financial crisis measures have not yet restored normal functioning to the financial system. Volatility remains very high, transaction volumes are small in several market segments, and insurance against counterparty risk, including sovereigns, is very costly. Moreover, tightening of lending standards persists. Guarantees extended on bank liabilities have preempted runs, while recapitalization and resolution of troubled institutions have curbed, though not fully eliminated, systemic risks. For some advanced and several emerging economies, the financial crisis has turned into a credit crunch, while for others demand and supply factors remain difficult to disentangle. In the euro area, credit to households has been falling for some time, but credit to the corporate sector has only recently stopped expanding.

Figure 9.
Figure 9.

Euro Area and United Kingdom: Liquidity Premium, 2007–April 2009

(Basis points)

Sources: Datastream; Bloomberg L.P.; and IMF staff calculations.
  • Monetary policy easing has helped financial institutions, at least through a lowering of funding costs. Most European central banks have reduced policy rates substantially since the onset of the crisis. For some emerging economies, this process was complicated by the need to stem capital outflows. Some central banks, primarily the Bank of England, have also taken measures to support nonbank sectors directly, while in other cases (e.g., Spain) fiscal resources are being deployed to restart segments of the financial markets.

  • The effectiveness of monetary policy transmission to the economy seems to have been somewhat, though not excessively, impaired. In the euro area, policy rates continue to be transmitted to market rates and the credit channel remains functional; however, this channel is adversely affected by the tightening of lending standards and pressure on banks’ capital (Box 1). So far, inflation expectations, which are key for monetary policy transmission, remain anchored close to policy objectives.

  • Fiscal policy is supporting activity through automatic stabilizers and discretionary stimulus where fiscal space is available. The general government deficit is set to increase from 1.3 percent of GDP in 2008 to 5.8 percent of GDP by 2010 (Table 2). The operation of social safety nets and increased spending on infrastructure are cushioning the downturn, while measures specifically targeted to households affected by the mortgage crisis are helping as well. Even so, overall uncertainty and a poorly functioning financial system are holding back private spending, while concerns about fiscal sustainability are raising yields, forcing some countries to curb deficits (see Chapter 2 for a detailed analysis of fiscal policy in advanced economies). Some emerging economies (e.g., Russia) have provided fiscal stimulus, but most of them have to tighten in light of financing constraints and exchange rate pressure.

Table 2.

European Countries: External and Fiscal Balances, 2006–10


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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.

… with Cross-Border Implications

In an interconnected world, policy actions have consequences beyond national borders, thus bringing policy coordination into play. Reflecting the difficulty of gauging the scope of a brewing crisis and its systemic linkages, it was no surprise that policymakers reacted in the first instance on a national scale in the current crisis. But its global and regional dimensions soon became apparent, fostering efforts at policy coordination within the European Union (EU):

  • In the area of monetary policy and liquidity provision, coordination proved to be relatively straightforward among advanced economies, but more difficult with respect to emerging economies, which have diverse exchange rate regimes and often face a different set of problems. Advanced economies in Europe coordinated monetary easing in October 2008 and established currency swap lines, leaving emerging economies on their own, except for some repurchase facilities.

  • Fiscal policy coordination took more time, but in late 2008 the EU committed itself to a stimulus of about 1½ percent of GDP under a menu approach in terms of both size and type of measures. As a result, fiscal policy differs appreciably across countries.

  • Achieving coordination of financial crisis management measures has been challenging, in part because financial systems differ substantially from one country to another and also because of the initial beliefs that Europe’s financial system would escape a meltdown and emerging Europe would remain resilient. Here, too, a menu approach was adopted while efforts were made to harmonize key parameters of policy interventions.

Has the Financial Crisis Impaired Monetary Transmission in the Euro Area?

In the face of the worst financial crisis in decades, the European Central Bank (ECB) has eased monetary policy significantly since October 2008, bringing its policy rate down (by 300 basis points) to 1.25 percent (as of end-April, 2009). The cost of credit to both businesses and households also declined, but by much less, as credit spreads initially increased and eased only recently. These developments, as well as the tightening of credit standards, raise the question of whether the effectiveness of monetary policy has been weakened during the recent financial crisis.

Main Transmission Channels

Monetary policy affects the economy through several channels. The main ones are the interest rate channel, the bank-lending channel, and the broad credit channel. In the interest rate channel, expansionary monetary policy lowers short nominal interest rates, which under sticky prices affect long nominal and real interest rates; these, in turn, affect the user cost of capital and the relative price of future versus present consumption and, hence, aggregate demand. In the bank-lending channel, the central bank can affect the supply of credit provided by financial intermediaries, and thus the cost of capital to bank-dependent borrowers, not only by changing interest rates but also by changing the quantity of base money. In the broad credit channel, given financial frictions, monetary policy affects not only interest rates, but also the financial position of borrowers and the relative cost of external and internal funds. In addition, expectations play an important role. Expectations influence significantly the effectiveness of all other channels of monetary transmission to the extent that central bank policy is anticipated by the market and priced into the yield curve.

Empirical Approach and Results

To gauge the extent to which ECB action can influence interest rates across the financial market, several bivariate vector autoregression (VAR) models are used. The VAR impulse responses show that policy rate changes have been transmitted to market rates, although the degree and the speed of pass-through varies.1 The impact on the three-month euro interbank offered rate (Euribor) is close to one-forone, and the speed of adjustment is fast, with the maximum impact transmitted within a month (first figure). The initial impact on corporate bond yields and new loans to nonfinancial corporations is similarly quick, although the full adjustment is more protracted and the impact on higher-grade bond yields is smaller than on lower-grade bond yields (0.6 to 0.7 percentage point for AA- and AAArated bonds versus 1.2 percentage points for BBB-rated bonds). The pass-through of the policy rates to loans for house purchases is somewhat smaller and the speed of adjustment slower.2


Euro Area: Pass-Through of ECB Policy Rate to Market Rates

(Response to nonfactorized one-unit innovations)

Sources: ECB; Haver Analytics; and IMF staff estimates.

The VAR residuals suggest that the pass-through from the policy rates to market rates has become somewhat less reliable since the beginning of the financial crisis (second figure). In particular, the residuals of the vast majority of the market rates have increased since the beginning of 2008, and in most cases significantly. IMF (2008e) also provides empirical support for the less efficient pass-through over the past year, pointing to the dislocation of the markets for short-term bank financing as the most likely cause.

An alternative approach to gauge the effectiveness of monetary transmission is with the help of a theorybased framework that has an aggregate supply-demand block and features the above channels.3 The effects of the bank-lending and credit channels are captured by including in the aggregate demand either a spread between loan and short rates or a spread between corporate bond yields and short rates. The model is closed with a standard monetary policy reaction function. As in Rudebusch and Wu (2003), the inflation expectations are modeled as an unobserved component, but instead of using a combination of a macro model and a yields-only finance model, they are estimated within the macro model.

Variance decomposition from the models suggest that the interest rate channel dominates monetary transmission. Specifically, it accounts for over 30 percent of inflation variation and close to 50 percent of output variation. Importantly, the results imply a major role for expectations, which account for around 40 percent of inflation variation and about 30 percent of output variation. The results suggest some role for the bank-lending and credit channels, which explain about 15 percent and 10 percent of output variation, respectively.


Euro Area: VAR Residuals of Market Rates

(Percentage points)

Source: IMF staff estimates.1/ Iboxx AAA and Iboxx BBB are indexes of yields on AAA- and BBB-rated corporate bonds, respectively.

Regarding the impact of the financial crisis, the results suggest that the effectiveness of the channels declined somewhat but was not significantly impaired (third figure). Indeed, the variability of the residuals has increased since mid-2008, but remains broadly within the ± 1 standard deviation band. Interestingly, expectations remain remarkably stable. Inflation expectations derived from the model have declined somewhat since mid-2008, but started to increase toward the end of the year—in line with market-based inflation expectations.

The above results agree with findings elsewhere in the literature. For example, Angeloni and others (2002) conclude that the interest rate channel is the most important for monetary policy transmission in the euro area. However, they also find that the bank-lending channel plays a role, although its importance varies among euro area countries. And Beechey, Johannsen, and Levin (2008) find that inflation expectations in the euro area are less variable than in other advanced countries.

To summarize, while interest rate transmission is clearly not insulated from the financial turmoil, ECB policy rate changes are still transmitted to market rates. Second, while there are also signs that the credit channel has been affected by the crisis, it remains functional. Third, owing to the ECB’s credibility, inflation expectations, which play an important role for monetary policy transmission, remain anchored.


Euro Area: Residuals from the Structural Models, 2002–November 2008

(Percentage points)

Source: IMF staff estimates.
Note: The main author of this box is Emil Stavrev.1 The sample period is January 1999–December 2008 for interbank rates and corporate bond yields, and January 2003–December 2008 for loans to nonfinancial corporations and households.2 These results are in line with findings of other studies: IMF (2008e) notes that the three-month Euribor rates have a more stable and reliable relation with the policy rate than other lender rates, and Sørensen and Werner (2006) find that bank rates on corporate loans appear to adjust most completely, followed by mortgage loan rates.3 The models are estimated with monthly seasonally adjusted data over the period from January 1995 to December 2008 for the bank-lending channel and from January 1999 to December 2008 for the credit channel, using Bayesian methods.

Despite these efforts, coordination remains insufficient in the area of financial crisis management. Measures taken by EU governments to resolve strains in the financial system have differed in scale (Figure 10) and scope. Deposit guarantees were increased nearly everywhere, but efforts to harmonize their level yielded only an agreement to raise their minimum, while most countries adopted higher levels and some extended unlimited guarantees. Even though the European Central Bank argued against guaranteeing interbank lending, a number of countries extended such guarantees either to all or to selected financial institutions. Conditions for guaranteeing debt securities by financial institutions were harmonized across the EU, but only after some countries had already provided such a guarantee with different parameters. The pricing of public capital provided to financial institutions was harmonized, but other parameters, such as the type of instrument used, the commitment to extend credit, conditions on remuneration of management, and dividend policy, continue to differ. Finally, schemes to support assets vary a great deal, ranging from the Swiss “bad” bank model to the United Kingdom’s insurance scheme for troubled assets, with Belgian and Dutch hybrids staking out the middle ground, and a Spanish scheme providing liquidity for high-quality assets.

Figure 10.
Figure 10.

Government Support, Including Guarantees, to Banks, 2008–09

(Percent of GDP; as of April 15, 2009)

Source: IMF staff calculations based on data from national authorities.Note: The volume of government support is the sum of actual and guaranteed amounts. Because the IMF is not the author of this map, the country borders do not necessarily reflect the IMF’s position.

These discrepancies in policy actions have generated some tensions across borders and reduced their effectiveness as a lack of coordination has undermined confidence. While monetary and fiscal measures to promote demand have generally positive spillover effects across borders, differences in the timing and nature of measures adopted to deal with the financial crisis initially had adverse consequences. The unilateral increases in deposit guarantees by some countries forced others to follow suit, leaving those countries with large financial systems relative to their fiscal resources, including most emerging economies, at a disadvantage. Resolution of troubled cross-border institutions failed to adhere to agreed principles, leading to a breakup along national lines. Extension of sovereign guarantees to bank debt changed the competitive landscape as sovereign spreads began to determine funding costs, which, together with two countries setting up national interbank schemes threatened a segmentation of the euro area interbank market. Attempts to revive credit as quid pro quo for recapitalization focused on national markets, with uncertain consequences for the behavior of foreign branches and subsidiaries.

The financial crisis in advanced economies has affected emerging economies mainly through a retrenchment of investors, associated with the global increase in risk aversion and the flight to safety. Even so, the country-specific components of sovereign spreads of the New Member States (NMS) of the EU showed a significant increase after the announcement of the broad financial sector support measures at the October 12, 2008 EU summit, and another spike one to two weeks later when several advanced economies put in place specific support measures (Figure 11). Hence, there is some evidence that crisis management measures in advanced economies had adverse consequences on emerging economies, perhaps because investors saw their relative stability diminished. However, for most of the NMS the impact on spreads dissipated over the next several months. The return of these spread components to levels observed before the announcements may be partly due to public commitments by parent banks to stand by their subsidiaries, the adoption by emerging economies of their own measures to support their financial system, and official support provided to countries facing difficulties, including through IMF-supported programs containing financial sector support measures.

Figure 11.
Figure 11.

New Member States: Country-Specific Components of Sovereign Spreads, September 2008–January 20091/

(Deviations from September 2008 average; basis points)

Sources: Datastream; and IMF staff calculations.1/ The spillover effects of the financial policy measures announced at the October 12, 2008 EU summit are estimated as the residuals (country-specific component) of a regression of sovereign spreads of each New Member State on the common component of the sovereign spreads of the euro area countries (see Chapter 2 for details about the common component).

Multilateral Help Is Being Extended

Facing financing difficulties, a number of countries have undertaken adjustment programs supported by financial assistance from the IMF (Belarus, Hungary, Iceland, Latvia, Romania, Serbia, and Ukraine, as of April 14, 2009) and other bilateral and multilateral sources, including the EU through its balance of payments facility for non-euro-area EU members (see Table 3 for details). Poland has requested access to the IMF’s new Financial Credit Line (FCL) to bolster international confidence.5

Table 3.

IMF Support for European Countries Affected by the Global Crisis

(As of April 14, 2009)

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More detailed information available at indicated Internet links.

While the global financial crisis was a common trigger, country-specific factors proved to be a key catalyst (see Chapter 3 for details on why crises happened where they did). Thus, the design of adjustment programs had to focus on countryspecific circumstances. To varying degrees, measures to shore up the financial system were a crucial element of all programs. Similarly, constraints on available financing and the need to establish confidence in policies made fiscal adjustment essential. In some cases it also helped curb demand to underpin competitiveness-enhancing relative price changes. Advice on monetary and exchange rate policy differed, reflecting authorities’ preferences and the need to mitigate contagion. Responding to pressure on capital flows, interest rates rose in most countries with fixed exchange rates. Countries with flexible exchange rates initially tightened monetary policy but with the intent to unwind such tightening as conditions improved (as, e.g., in Hungary and Iceland). Even so, interest rate differentials widened following the sharp reduction in policy rates in most advanced economies. Belarus devalued its currency and switched the peg to a basket of currencies to improve competitiveness and reduce its vulnerability to external shocks; Latvia, meanwhile, kept its peg in line with its preference for retaining an exchange rate anchor, while improving competitiveness through adjustments in wages and productivity instead.

Uncertain Outlook

The Road to Recovery May Be Long …

Typically, recessions associated with a financial crisis take time to recover from, and globally synchronized recessions are deeper than others (IMF, 2009d, Chapter 3). Inventories accumulated in the last half of 2008 and high-frequency indicators suggest a further sharp fall in activity in the first part of 2009 (Figure 12). Financial conditions remain tight, as reflected for example, in wide corporate bond spreads, which are indicative of a rising tide of corporate bankruptcies. The crisis has also hit emerging economies hard, with sovereigns facing a sharp increase in the cost of funding and private borrowers even more adversely affected. Confidence, which was already on a weakening trend before the intensification of the financial crisis, has been in free fall through early 2009, leading a similar decline in industrial production. And equity values, despite a rebound in late March, remain 50 percent or more below their level of 18 months ago, depressing sentiment. Unemployment, typically a lagging indicator, has begun to rise, a development that will likely persist well into 2010.

Figure 12.
Figure 12.

Key Short-Term Indicators

Source: Datastream.
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.
Source: Datastream. Source: Datastream.

The financial sector will continue to constitute a drag on both advanced and emerging economies. Having pushed risk taking and leverage to unsustainable heights, the financial system is now focusing, perhaps equally excessively, on scaling back risk and leverage.6 At the same time, economic fundamentals have been deteriorating sharply, leading to rising nonperforming loans and adding to the tightening of lending standards. Taking into account past and prospective losses for the next two years, recapitalization needs of Europe’s banking system were—subject to a considerable margin of uncertainty—estimated in April 2009 to be $1.3 trillion (IMF, 2009a). These recapitalization requirements differ considerably across countries, and their estimates will need to be refined by national authorities. Until the uncertainty surrounding loss recognition is resolved and resulting capital needs are met—which might well take another year—the financial system will be able to only partially fulfill its vital intermediation role. For advanced economies, counterparty risk and lack of transparency hamper the restoration of the normal functioning of markets, while for emerging economies access to foreign currency liquidity plays a key role as well. All economies have to contend with the expected deterioration in asset quality as a result of the recession.

As the retrenchment of cross-border capital positions continues, large external imbalances will need to be corrected. All types of capital flows, including foreign direct investment, are likely to diminish sharply, causing serious adjustment problems for countries that had been running large current account deficits. For members of a currency union (e.g., Ireland or Spain) or countries with pegged exchange rates (e.g., the Baltic economies and Bulgaria) the adjustment will be more arduous than for countries with more flexible exchange rates. However, even in these latter cases, the task ahead will be difficult as exchange rate volatility may prevent use of monetary easing to support demand, while adverse balance sheet effects—households and businesses in many emerging economies hold sizable foreign currency liabilities—will dampen spending and raise levels of nonperforming loans.

What will break the adverse feedback loop between sectors and across countries? While lower commodity prices and a deceleration in the rate of decline of equity and house prices will help, extensive policy support will be crucial. The measures undertaken so far have provided a good foundation, but further action is required, especially in the financial sector and as regards support for domestic demand into next year. These additional actions—well coordinated for increased effectiveness—should lead to a normalization of conditions in the course of 2009, laying the foundations for a recovery to take hold during 2010.

Our baseline projection assumes that these additional policy actions are undertaken and that no more systemic shocks occur, so that a floor is established under the decline in output by the second quarter of 2010. A very gradual recovery is expected to take hold thereafter, with growth momentum not returning until 2011. Commodity prices are expected to remain stable for the next two years, and modest credit growth would resume in the second half of 2010. As a result, advanced economies should see activity fall by about 4 percent in 2009 and ½ percent on average in 2010, though growth should pick up to slightly more than 1 percent by end-2010 (Table 1). Output in emerging economies is projected to fall by 5 percent in 2009 and recover by ¾ percent in 2010. While activity in advanced economies will be similar across countries, growth in emerging economies is anticipated to show a wider dispersion.

Potential growth is also projected to be appreciably lower, especially in the near term. With overcapacity being worked off in some sectors and the sharp drop in capital spending, productive capacity is expected to grow very little in 2009–10. Lengthy unemployment spells are likely to erode skills, while higher risk premiums will slow capital accumulation, dampening future trend growth. On the other hand, well-chosen investment in infrastructure and a heightened emphasis on training and education could provide a boost. For emerging economies in Europe, potential growth is also unlikely to return to precrisis trends, though it could well return to rates higher than in other emerging economies (other than East Asia), especially if structural reforms are undertaken (Box 2).

Inflation is projected to fall to very low levels in many countries, but outright deflation is likely to be avoided, helped by more rigid wages (Table 1). In the course of 2009, several advanced economies, primarily in the euro area, but possibly also Switzerland and Sweden, may experience negative 12-month inflation rates. Nonetheless, inflation expectations remain anchored in positive territory in most countries (Figure 13). Inflation performance in emerging economies will show a more mixed picture, with deflation likely in countries with pegged exchange rates undergoing adjustment, and less downward pressure on inflation in countries experiencing nominal exchange rate depreciation.

Figure 13.
Figure 13.

Selected Advanced Economies: Break-Even Inflation, 2007–April 20091/


Sources: Bloomberg L.P.; and IMF staff calculations.1/ Derived from 10-year inflation-linked government bonds.

… and Bumpy

Risks around this baseline remain tilted to the downside. With low inflation and terms of trade gains, consumers could regain confidence earlier, especially as policy actions—some of which have hardly had time to work, such as increased infrastructure spending—show signs of increasing effectiveness. On the other hand, continued weak global demand could lengthen and deepen the recession. Indeed, past recoveries in advanced economies of Europe have often been preceded or accompanied by a revival of exports (Figure 14); however, this option may not be available this time. Dynamics within Europe are also not very promising, especially as a few advanced economies and many emerging economies face the challenge of exporting their way out of excessive current account deficits. And with bank exposure to emerging Europe very large, a possible adverse feedback spiral between advanced and emerging economies through the financial system could take the downturn into uncharted territory. Moreover, large and simultaneous debt issuance by advanced economies may entail rollover difficulties and could hamper emerging economies’ ability to cover their external financing needs. And a key concern is a deficient policy response.

Figure 14.
Figure 14.

Germany, France, and Italy: Trade and GDP, 1991–2008

(Change in constant millions of euros)

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

The emerging European economies were the fastestgrowing emerging economies before the current global crisis, apart from emerging Asia; however, they have been affected the most by the crisis (first figure). This box discusses the implications of recent staff research on the region’s recovery and long-term growth prospects. The results suggest that emerging Europe will recover in the medium term, although to growth rates that will be lower, in some cases substantially, than before the crisis.1 These results are consistent with the latest World Economic Outlook projections. The results also suggest that structural reforms will strengthen the region’s growth prospects.


Emerging Economies: Real Per Capita GDP Growth, 2004–13


Source: IMF, World Economic Outlook.

Theoretical Background

Financial liberalizations, as occurred in most emerging European economies before the recent boom, can lead to excessive risk taking associated with currency mismatches, which, in turn, can lead to high growth but at the price of occasional self-fulfilling crises.2 The conceptual framework yielding this result consists of a two-sector economy, with traded and nontraded goods, and with two credit market imperfections: contract enforceability problems that generate domestic financing constraints, and systemic bailout guarantees (lenders are insured against systemic crises, but not against idiosyncratic defaults). This conceptual economy has a noncrisis equilibrium, in which the nontradable sector, which is also an input for the tradable sector, is constrained by its cash flow and a bottleneck to growth. However, there is also an unconstrained equilibrium, in which endogenous real exchange rate risk arises and firms find it optimal to take on credit risk in the form of a currency mismatch. This mismatch eases borrowing constraints, increases investment, alleviates the bottleneck in the nontradable sector, and allows the economy to grow faster. However, it also generates financial fragility, as a shift in expectations can cause a sharp real depreciation and a hard landing, particularly for the nontradable sector, which is growing much faster than the rest of the economy during the boom.

The results suggest that, if crises remain rare events and are not too costly, economies in the unconstrained equilibrium have the potential to grow faster than other economies. The first best can be attained by reducing the agency problems that generate the financing constraints—which would call for structural reforms, including in the financial sector. However, if progress in structural reforms is slow, society is faced with a trade-off between faster growth and the associated credit risk. Depending on social preferences, tolerating financial fragility might (or might not) be a second-best solution.

The model is highly stylized, but it would seem that most emerging European economies have been closer to the unconstrained equilibrium of this model. During recent years, they have experienced fast credit growth and convergence through primarily a rapid expansion of the nontradable sector, which was broadly financed by foreign currency borrowing. Structural and legal reforms have progressed, in many cases during the EU harmonization process, but contract enforcement remains more difficult than in most advanced European economies.3 And anecdotal evidence seems to suggest that markets, for right or wrong, were operating under the expectation of a systemic bailout guarantee. Assuming that this characterization is indeed correct, what does the model imply for emerging Europe?

Model Calibration for Emerging Europe

Calibrating the model for emerging Europe yields the following results:4

  • Economies in the unconstrained equilibrium do have the potential to grow faster than other economies, but only if crises do not occur often.5 An important implication is that to the extent that precrisis policies in some countries in the region were overexposing the economy to shocks, they were hurting long-term growth prospects (second figure).

  • Focusing on the unconstrained growth path, countries with good institutions, leading to better contract enforceability, seem to benefit more from taking on risk in terms of average growth rates. However, crises will also be more severe because of higher leverage.

  • A high intensity of nontradable inputs in the production of tradables is associated with faster growth.

Conclusions and Policy Implications

These results suggest that emerging Europe could resume relatively fast growth rates in the aftermath of the current crisis, although not as fast as in the precrisis period. However, this assumes that crises in the region remain rare, which will require the absence of policies leading to excessive vulnerabilities and significant progress in structural reforms.


Risky Growth Paths and the Intensity of Nontradables in the Production of Tradables

Source: IMF staff simulations.
Note: The main authors of this box are Romain Rancière and Athanasios Vamvakidis.1 Rancière, Tornell, and Vamvakidis (forthcoming).2 Many emerging economies that have experienced lending booms and financial crises have been among the fastest-growing economies (see Rancière, Tornell, and Westermann, 2008).3 For a detailed discussion and empirical evidence about emerging Europe’s recent growth performance, progress in reforms, and the vulnerabilities that led to the current crisis, see Vamvakidis (forthcoming).4 The definition of emerging Europe is consistent with the one used throughout this report. The key parameters of the model include the probability of a crisis, the degree of contract enforcement, the intensity of nontraded inputs in the production of traded goods, and the severity of financial distress costs (the fall in the cash flows of distressed firms during a crisis). The existence of a risky equilibrium requires that the probability of a crisis be low enough for risk taking to be profitable ex ante, and the severity of contract enforceability be in some intermediate range, so that, although borrowing constraints exist, the additional leverage associated with risk taking is relatively large. With risk-averse agents, the growth gains from risk taking would have to be large enough to compensate for the welfare costs of financial crises.5 These simulations include a business cycle random disturbance (drawn from a uniform distribution of +/–2 percent around the mean) and stochastic financial distress costs (drawn out of a uniform distribution of between 90 and 70 percent).

Calling for a Well-Articulated and Effectively Coordinated Policy Response

Recessions accompanied by a severe financial crisis and a persistent lack of confidence require a comprehensive policy response consisting of a coherent set of monetary, fiscal, and financial sector interventions. Moreover, with possibly severe downside risks predominating, policies need to be preemptive. The global nature of the crisis and Europe’s tight economic and financial integration put a premium on strong policy coordination. Such coordination does not imply adopting uniform policies, but taking commonalities and spillovers into account in policy design. For Europe, the crisis should be used as an opportunity to strengthen its institutions, improve its fundamentals, and make substantial progress toward its goals of economic and financial integration and regional cohesion and income convergence.

Building on ongoing progress, more forceful policy actions are required to restore market trust and confidence.7 In the financial sector, these actions—which apply to all economies of Europe—comprise the following: continued provision of liquidity and engagement in credit easing where necessary; credible loss recognition in the financial system based on stress tests that take into account the expected deterioration in asset quality from the economic downturn; recapitalization of viable institutions, ideally by the private sector but with public support if needed, and orderly resolution of other institutions; and ring-fencing of impaired assets where they constitute a significant part of balance sheets.

Macroeconomic policies need to continue to support demand to cushion the downturn and forestall a downward spiral. Monetary policy can do this by anchoring inflation expectations solidly in positive territory, thus preempting deflationary risks. Room for interest rate reductions needs to be fully and swiftly utilized, especially in advanced economies. In addition, further unconventional measures, especially to help specific, distressed segments of the financial system, are necessary. However, to avert adverse market reactions and improve their chances of success, these measures will have to be used in ways that are easily reversible; also, clear agreements will have to be reached with fiscal authorities to shield the central banks from capital losses. Volatility of capital flows and pressures on exchange rates make for a more challenging environment for monetary authorities in most emerging economies, which will need to take a cautious approach to interest rate cuts.

With the downturn now expected to last longer and more time needed to repair the financial system and restore full effectiveness of monetary policy, fiscal policy needs to continue to support demand. First and foremost, this requires rapid and decisive implementation of the announced fiscal stimulus packages and maximization of their effectiveness by good targeting, focusing on productivity-enhancing infrastructure, and committing to future fiscal consolidation (see Chapter 2). This last requirement is particularly important to underpin trust in social safety nets, which would help mitigate an excessive increase in precautionary savings by households. For the EU aggregate, a supportive fiscal stance will need to be maintained into 2010, broadly in line with current plans. The recession may yet turn out to be deeper or more protracted than envisaged. Clearly, in this case automatic fiscal stabilizers will need to continue to operate, but additional fiscal stimulus, which may be badly needed, should only be adopted when accompanied by actual measures addressing sustainability concerns. The Netherlands set an example of such an approach when it accompanied fiscal support for the economy with pension and health care reforms.

What about the regional dimension? Europe’s institutions put it in a unique position to strengthen the policy response across countries through effective coordination. The benefits and needs of such an approach are most acute in the areas of financial crisis management, fiscal policy, and the mitigation of downside risks:

  • Restoring market trust will be greatly helped if further financial crisis management measures were coordinated ex ante. For recapitalization, agreeing on the common basic methodologies for the stress tests to determine capital needs will avoid distortions, especially for banks that compete internationally. Similarly, as impaired assets are widely held, agreeing on the valuation principles in the context of ring-fencing efforts is necessary to ward off inefficient arbitrage and minimize collective costs. Dealing with crossborder banks, especially for emerging Europe, requires full home-host coordination on the principles for loss recognition and agreed burden sharing in recapitalization between home and host countries, along the approach followed by the Nordic-Baltic countries and other similar initiatives.8 In the context of resolution, adherence to the ECOFIN crisis management principles, also beyond the EU, would be beneficial.9 Removing the existing distortions through coordination (see Box 3 for the case of deposit guarantees) and devising exit strategies from government interventions will be crucial as well to prevent a dislocation of assets.

Box 3. A Case Study in Coordination: Deposit Guarantees

The global financial crisis has demonstrated an important side-effect of the close economic and financial linkages within Europe: destabilizing spillover effects can occur when response measures are not coordinated. The need for better coordination can be illustrated by the financial policy reaction to the crisis.

As the financial turmoil intensified after the Lehman Brothers bankruptcy, some EU member states unilaterally (i.e., without sufficient consultation with their EU partners) introduced crisis management measures, notably guarantees for deposits and other forms of bank debt. To prevent deposit outflows, other European governments then came under pressure to match the increases in deposit guarantees. Moreover, when state backing became more important, the resources and credit ratings of governments became a major factor in determining the soundness of banks. Thus, locally owned banks in smaller (or poorer) EU countries were put at a significant disadvantage, and, while these measures helped stabilize some banks, others suffered.

The coordination of crisis management measures has improved as time passed and as the EU institutions sought to limit competitive distortions; however, further improvements are needed. In October 2008, European finance ministers agreed that it would be desirable to harmonize deposit protection to the €50,000–100,000 range, with a €50,000 minimum. However, a number of countries remain above this range (table). These differences create incentives for potentially destabilizing outflows. Combined with the existing topping-up option, it allows banks with branches in several countries to offer better deposit guarantees in some countries than in others (or than their competitors). Improved coordination would require establishing not only a minimum, but also a clearer agreement on a maximum level of deposit guarantee coverage, defined to include both official schemes and de facto protection of creditors. A uniform coverage level might in principle be even better. However, this may not be optimal if policymakers in individual countries have different preferences regarding the profitability and stability of the banking sector (Hardy and Nieto, 2008). In addition, individual countries’ deposit guarantee schemes are still very diverse with respect to other basic parameters, such as the type of financing and the determination of premiums, and no clear consensus is in sight.

Deposit Protection Schemes in the European Union

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Sources: IMF staff, based on data from the European Commission and country authorities.
  • Demands on fiscal policy vary a great deal across the region, while room for fiscal maneuver is equally unevenly curbed due to financing constraints. Coordination in this area implies that countries with more fiscal space provide a larger share of the aggregate stimulus, that fiscal support for specific sectors and industries avoids beggar-thy-neighbor outcomes, and that some of the key measures, such as infrastructure development, be designed in a regional context. Increased provision of structural funds by the EU to emerging economies and continued participation in meeting their financing needs in the context of adjustment programs will be particularly helpful.

  • With unsettled financial markets, risk mitigation strategies can benefit from a regional dimension. Potential debt-servicing difficulties, for both advanced and emerging economies, are best addressed preemptively, involving EU institutions as well as the IMF. To deal with disruptive exchange rate movements and shore up market confidence, currency swap lines should be extended to emerging economies. For new EU member states not yet part of the euro area, adoption of strong policies and confirmation by the EU that they constitute credible road maps to swift euro adoption would improve stability and help reanchor expectations of continued convergence.

Beyond the immediate policy response, improvements in the EU’s financial stability framework will be essential to prevent future financial crises and minimize the costs associated with such crises. The current framework has proved to be suboptimal in anticipating the systemic risks of the global crisis for Europe and in resolving cross-border institutions in an orderly manner. Home-host coordination with respect to risk taking and procyclicality of bank behavior in emerging economies was also lacking. As a first step, implementing the improvements suggested in the de Larosière report10 will constitute important progress, though the ultimate response will need to go further (Box 4).

The financial crisis, the challenges in coordinating crisis management actions in the European Union, and concerns about consequent setbacks to financial integration have intensified calls for a more integrated approach to financial stability in the EU. In response, at the request of the European Commission, a highlevel expert group (de Larosière Group; the DLG) delivered a review of the EU’s supervisory arrangements in February 2009.

The group proposes to establish a European System of Financial Supervisors (ESFS), bringing together the national supervisors with three independent supranational “Authorities” (for banking, insurance, and securities markets) accountable to the EU institutions. These Authorities would oversee the work of and resolve disputes among national supervisors, who would retain responsibility for the conduct of supervision. Cross-border institutions would be supervised by colleges of home and host supervisors. To bridge the gap between macro- and microprudential oversight, the group proposes creating a European Systemic Risk Council (ESRC) linked to the European Central Bank. This council would comprise the Governors of the European System of Central Banks, the heads of the Authorities, and the European Commission. The group advocates establishment of “a truly harmonized set of core rules,” harmonized and prefunded deposit insurance schemes, and more detailed criteria for burden sharing.

The U.K. Financial Services Authority (the “Turner review”) has proposed a similar way forward, recommending the establishment of a single European regulator. This would be an independent authority to regulate all sectors of the financial system, oversee and set standards for supervision, and be significantly involved in macroprudential analysis. However, unlike the DLG Authorities, it would not have binding powers over national supervisors, instead relying on peer review.

If implemented, either approach would constitute a historic step forward, putting in place important building blocks of an EU financial stability framework that is consistent with the objective of creating an integrated financial market. The DLG proposals would likely yield better results in terms of supervising on a day-to-day basis cross-border financial institutions, reconciling the interests of home and host countries, and strengthening macroprudential oversight. However, important aspects still need to be clarified, including accountability within the ESFS, the functioning of the ESRC and the organization of operational work to support it, and provisions for data sharing. The strong linkages among banks, insurance companies, and securities markets argue for an early cross-sectoral integration of supervisory arrangements along the lines of the Turner proposals rather than considering this only as a desirable long-term option. The Turner approach would also likely bring greater progress toward harmonized regulation. However, the focus on cross-border financial stability risks will need to be complemented with efforts to ensure that home country authorities accept joint responsibility with host country authorities for domestic financial stability in host countries.

Neither set of proposals addresses the crucial question of cross-border crisis management and resolution. Yet fundamental progress in this area is essential to limit the incentive problems that tend to undermine cooperation and coordination in crisis situations (IMF, 2008a). What is needed are binding and institutionalized mechanisms to ensure adherence to the crisis management principles adopted by ECOFIN in October 2007, notably collective cost minimization and the sharing of fiscal crisis management costs. Recent experience has shown that policymakers find it difficult to adhere to these principles in the heat of the moment. This situation, in turn, makes it difficult for countries to accept the interdependencies that are inherent in an integrated financial market. The crisis has also shown the limitations of home country stability arrangements to back the cross-border operations of their banks. Because the DLG and Turner proposals do not offer solutions to these unresolved cross-border crisis management and resolution issues, they open the door for increased host country control over cross-border branches. This would essentially scrap the single passport, which has been a key driver of financial integration.

The pragmatic approach of the DLG has increased the chances of its proposals being implemented, but addressing these contentious issues will be necessary to ensure that Europe’s financial system delivers its full potential in terms of integration, efficiency, and stability. Indeed, the March 2009 European Council endorsed the DLG proposals as a basis for action and asked the European Commission to work out detailed proposals in time for the June 2009 European Council, taking into account the results of a round of public consultations. Separately, the European Commission is working out proposals on tools for early intervention and on deposit insurance, which offer prospects of some progress on crisis management and resolution. However, the scope of this progress is likely to fall well short of the comprehensive overhaul that is needed and being called for by several stakeholders to clear the road toward a single financial market.

Note: The main authors of this box are Martin čihák and Wim Fonteyne.

Accelerating and broadening structural reforms have taken on heightened importance against the background of the economic and financial crisis. Structural reforms are necessary to alleviate pressures in at least three areas: potential growth, fiscal sustainability, and external imbalances. With the crisis dampening potential growth and raising unemployment, increased emphasis on training and education will be essential to keep people attached to the labor market. In this context, measures taken to support income in the short run, such as increases in the level and duration of social benefits, will need to be reversed when conditions improve to avoid adverse consequences on long-term labor supply. Pension and health care reforms are now more necessary than ever, especially as policy actions have generally pushed public debt to a level well beyond the trajectory consistent with addressing the intertemporal aspects of the aging problem. For many emerging and some advanced economies, the immediate challenge is to facilitate the reallocation of productive resources from the nontraded to the traded goods and services sectors, a process that can be assisted by reforms to increase labor market flexibility and improvements in the business environment. Liberalization of services sectors and, for the EU, the establishment of a true internal market in services should be a boon. Meanwhile, care must be taken that government interventions in the context of the crisis do not undermine progress, or worse, introduce barriers to economic and financial integration in Europe.

Note: The main author of this chapter is Luc Everaert.


See IMF (2009d) for an in-depth discussion of the global nature of the economic downturn.


By some estimates, growth in advanced economies was higher by 0.2 to 0.4 percent a year during 2002–06 as a result of the rapid convergence by emerging economies (IMF, 2007).


Empirical analysis shows that, since 1999, risk sharing has begun to emerge across Europe, but exposure to shocks has also risen (IMF, 2008d).


No good measures of the liquidity premium are readily available for emerging economies, thus preventing an assessment for these countries.


The FCL, which comes without ex post performance criteria, is accessible to IMF member countries with very strong fundamentals, policies, and track records of their implementation.


See IMF (2009a) for a detailed description of global financial developments.


See also IMF (2009a and 2009d).


The general idea is to establish a forum for home-host coordination of policies and interventions related to financial institutions and involve participants from supervisors, central banks, national authorities, and private cross-border commercial banks, with some proposals also including multilateral financial institutions.


See Annex I of the October 2007 ECOFIN Council Conclusions—available via the Internet: www.consilium.europa.eu/ueDocs/cms_Data/docs/pressData/en/ecofin/96375.pdf.