Abstract
The euro area (EA) plays a major role in the global economy. Market perceptions of events in the EA program countries illustrate the possibility of large spillovers from the area in times of stress. The prospect of large spillovers underscores the urgent need for actions to contain, and eventually overcome, the ongoing crisis. The planned fiscal consolidation in the EA could benefit the rest of the world. Spillovers from gradual monetary policy normalization appear manageable. Execution of the structural reform agenda will carry positive spillovers.
I. Background
1. The Euro Area (EA) plays a major role in the global economy and therefore has potentially large spillover effects on the rest of the world. The EA produces about a fifth of global output, second only to the US. With its exports and imports together adding to almost 30 percent of GDP, the area accounts for a larger share of world trade than any other economy. Its financial sector is also one of the world’s largest, with banking exposures to other countries exceeding those of all other economies, although its debt and equity markets—as measured by turnover—are dwarfed by those in the US. The euro is also the second most important reserve currency after the U.S. dollar, and its share of reserves has been growing steadily since its inception.
Share of Global Goods Trade
(2009)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: DOTS and IMF staff calculationsShare in World GDP
(2010)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: WEOEquity Market: Value of Share Turnover
(Year to Sept. 2010)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: WFEElectronic Order Book Trades - Euro area is presented ex-Nordic ExchangeRelative Governement Debt Market Turnover
(2009 Estimate of Average Daily Cash Transactions)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Sources: NY Fed, JSDA, National Debt Agencies and IMF staff calculations.Currency Composition of Allocated World Foreign Exchange Reserves
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Sources: COFER database and staff calculations.BIS Banks: Total Foreign Claims (Billions, US$) 1/
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
1/ Total foreign claims are defined as the sum of cross-border claims by financial institutions headquartered in each economy and their foreign affiliates’ local claims (claims extended by foreign affiliates in the host country).Sources: BIS and staff calculations.2. Market perceptions of events in the EA program countries (Greece, Ireland, and Portugal) illustrate the possibility of large spillovers from the area in times of stress.
While these countries are small in economic terms, the financial exposure of core EA country banks to them is large. Jointly they represent just 6 percent of EA GDP and a very small share in the foreign exposure of core EA banks overall (2.6 percentage points). However, at 32 percent of total shareholders’equity for those core EA banks that hold such assets in the case of program countries, the exposure is quite sizable in absolute terms, opening the door to significant spillovers also outside the euro area.
This potential for major spillovers can be seen in market reaction to developments in the EA over the past year (see charts). CDS spreads and bond yields for the EA program countries have risen to historically high levels, and their correlation with financial market spreads for other EA economies remains very high. In the run up to the approval of the Greece program, correlations of EA program country CDS spreads and bond yields with global asset prices rose sharply, highlighting the contagion potential. Marked pickups in correlations were also evident around the time the Ireland and Portugal programs were being finalized. While the increased correlations between EA and non-EA asset prices could partly reflect reactions to common risk factors (see Section III.B), they underscore the risk that an intensification of stress in the EA could have sizable effects on global markets.
Sovereign CDS spreads
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Note: Other Euro Area countries include Austria, Belgium, France, Germany, Italy, Netherlands and Spain.Source: Datastream, staff calculations.Correlation with Average GIP CDS Spreads
(60-day rolling correlation of daily percentage changes)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Note: GIP include Greece, Ireland and Portugal; Core EA include Germany, France and Italy; G-20 EM include Korea, Indonesia, Mexico, South Africa, Turkey, Russia and Brazil; S4 include U.S., The U.K., China and Japan. Sources: Datastream, Bloomberg and staff calculations.3. Against the backdrop of the EA’s large global role and ongoing challenges in the EA program countries, the rest of this paper undertakes an in-depth analysis of EA spillovers. To motivate the analysis and to identify key areas where spillovers could be important, the next section sets out views from authorities outside the EA on their perceptions of the main spillovers from the area. Section III maps economic spillovers to assess their size and how they are transmitted across regions (e.g., through trade and financial linkages, and indirectly through broader confidence effects). Section IV assesses potential spillovers to the rest of the world from policies in progress or envisioned in the area, with special focus on the estimated global impact of (i) an intensification of financial market stress in the EA; (ii) prospective EA monetary and fiscal policies; and (iii) EA structural reform in the areas of financial regulation, labor and product markets, and trade. Conclusions are presented in the last section.
II. Views From Outside on Euro Area Spillovers
4. Most partner authorities focused on financial spillovers from the EA, with spillovers seen as escalating sharply if the sovereign debt difficulties in the EA were to intensify. Authorities generally saw the spillover potential from further stress in Greece, Ireland, and Portugal as relatively contained, but were concerned that if stress were to spread to Spain and, especially, the core EA, spillovers could be substantial. Potential spillovers through financial confidence effects and direct banking channels were seen as especially critical, but some authorities also considered that effects through trade and FDI channels could be significant, particularly for countries that are geographically close, and with strong trade ties, to the EA (see below). Counterparts noted that while EA authorities had made progress in the wake of the Greece program in addressing problems in the periphery (at both the individual country and central levels), further measures to delink sovereign and banking sector problems, including through stress tests and follow-up to recapitalize banks as needed, as well as more centralized fiscal policy would help limit adverse spillovers to the rest of the world.
5. Other spillovers discussed included the impact of EA macroeconomic policies, trade and FDI links, and regulatory changes on partner countries.
Macroeconomic policies. Problems with EA debt sustainability were seen as increasing global tail risks, as discussed above. On a more positive note, counterparts saw the prospect of adverse spillovers from EA fiscal consolidation plans—through the demand compression effect—as relatively minor, and some observed that the net impact could even be positive if credibility gains and associated confidence effects are significant. Spillovers from ECB policies were, similarly, seen as contained to the extent that any phasing out of the ECB’s unconventional support policies did not undermine the periphery. Spillovers from ECB rates hikes ahead of other advanced economy central banks would also likely be contained to the extent that robust EA growth at the core was in place.
Trade and FDI. Reflecting the EA’s role as the world’s single largest trading entity, trade and FDI links were seen as strong, particularly for neighboring countries. For close neighbors, their role in the EA supply chain accentuates these trade linkages, making them far stronger than financial spillovers. Counterparts were confident that implementation of the EA’s Doha commitments would have a favorable impact.
Regulation. Some counterparts argued that proposed EU financial regulatory reforms could have major spillovers on neighbors, especially should their discretionary regulatory powers be affected as a result of new EU regulations.
III. Mapping Euro Area Spillovers
A. Growth Spillovers
6. Economic growth in the S-5 has, apart from China, been highly correlated (text chart). Growth in the U.S., U.K., and EA economies was particularly highly synchronized over the past decade. The financial crisis subjected the S-5 countries to a synchronous, sharp contraction in 2008, and all have since embarked on the recovery process. The co-movement of growth in China with the EA and the rest of the S-5 has been weaker as China’s economic performance outpaced that of the rest of the S-5 countries, including during the recent crisis.
Real GDP growth rates, YoY
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: WEO, IMF7. A closer look at these growth links suggests that Euro Area output shocks have had generally moderate spillovers. Estimated spillovers from the EA to the other S-4, which abstract from financial contagion and may therefore understate true spillovers, are nevertheless of meaningful size, though smaller than those emanating from the U.S. (text chart and Chapter 1 of Selected Issues Paper). Echoing this, Euro Area authorities diagnosed the EA as a net importer of global spillovers. This was attributed mostly to the EA’s relative trade openness, compared with the U.S., which exposes it to incoming trade shocks. The continuing dominance of U.S. debt and equity markets, backed by the still strong global role of the U.S. dollar, was also seen as playing an important role. As an illustration, the authorities noted that their analysis of the transmission of positive investment shocks indicated that such shocks in the EA had smaller spillover effects on the rest of the world than the other way around.
Inward and Outward Output Spillovers
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Note: Depicts the average peak impulse responses of output in each S-5 economy to shocks in each of the other S-4 economies which raise output there by one percent.Source: Staff calculations8. Moving beyond the S-5, countries geographically closer to the EA—generally those with stronger trade links—are affected more by the area’s economic fluctuations. Results from a G-20 macroeconometric model of business cycle transmission through international trade and financial channels indicate that spillovers tend to be greater for economies closer to the EA (Chapter 1 of Selected Issues Paper). Among G-20 countries, the highest impact can be found in Russia, reflecting its strong trade linkages with the EA, followed by the U.K., reflecting its strong trade and financial linkages (text chart).
Trade Links with the Euro Area
(Share of Exports to the EA in total exports)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.Banking Links with the Euro Area
(Share of Euro Area bank-owned assets in total banking system assets)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Note: Data only covers selected emerging markets.Source: Bankscope and staff calculations.Average Peak Impulse Responses of Output to Shocks in the Euro Area
(Relative to Euro Area)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.Note: Depicts percent change in output in a given country associated with one percent increase in output in the Euro Area, in response to a mixture of real and financial shocks in the Euro Area.9. A implication of this analysis is that EA growth shocks are likely to have the largest spillover effects on non-EA European and North African economies. Though direct empirical results from the macroeconometric analysis are not available for these countries, their generally strong financial and trading links with the EA suggest that the impact of EA growth shocks on their economies could be substantial. Indeed, the strong relation between the estimated impact of EA output shocks on G-20 economies and their share of trade with the EA (text chart) points to the importance of trade channels in transmitting growth shocks. With the EA accounting for an even larger share of trade in many non-EA European and North African countries, the impact of EA shocks on these economies could be especially significant.
Average Peak Impulse Response versus Trade Weight
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.B. Financial Sector Spillovers
10. Analysis of global risk factor movements across different asset classes suggests strong spillovers from the EA (Chapter 2 of Selected Issues Paper). The analysis, which is based on a principal components approach, assesses the extent of spillovers from individual EA asset markets across borders and across various financial markets (mainly bonds and equities), after abstracting from “risk commonalities” (that is, after adjusting for comovement due to common shocks). The key findings are:
The global common risk component increased sharply in Spring 2010 as pressures in peripheral European countries intensified, although the rise was not as severe as during the Lehman episode in late 2008.
About one-fifth of the common component of risk across global financial markets—in a selection of interbank interest rates, bonds, and equities—can be shown as being driven by volatility in EA financial markets, only modestly less than the one-quarter recorded for the U.S.
Direct spillovers from the sovereign bond markets in Greece, Ireland, Portugal, as well as Spain—the peripheral EA countries that global market participants focused on most during the initial crisis period—to the rest of the world appear to be modest. While “raw” cross-market correlations (blue bars in the text chart) suggest that “observed” volatility co-movements across assets and across borders tend to be widespread, cross-correlations of spreads with the common risk component stripped out (red bars) reveals that, among the financial markets in the sample, volatility spillovers from these EA sovereign bond markets are likely to be felt strongly only in the bond market of EA financial corporations.
In contrast, spillovers from core EA financial institutions appears much larger. Even after adjusting for common risk, cross-correlations of EA financial sector spreads with spreads of EA non-financial corporations as well as with financial corporations outside the EA, such as Japanese and U.S. banks, are sizable and significant. The latter may reflect direct links among financial institutions as well as transmission of spillovers via bank funding markets.
Measuring risk commonalities: alternative proxies
(basis points, LHS; index, RHS)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Contribution of individual regions to risk commonalities
(percentage, average over August 2007 - February 2011)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculationsConditional correlations vs peripheral EA sovereign bond spreads
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.Conditional correlations vs EA financial corporate bond spreads
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.11. The authorities agreed with staff’s views that financial spillovers from core EA banks to the rest of the world could be substantial. Both the authorities and staff also agreed that shadow banking in the EA was less relevant than in the U.S., given the EA’s reliance on traditional relationship banking and the relatively large share of the banking sector in overall financing in the EA.
IV. Policy Issues
A. Spillovers from Intensification of EA Financial Market Stress
12. Direct spillovers from further stress in the EA program countries would likely remain manageable, but the potential to affect the rest of the world is much larger if stress spreads to the core EA. Several methods of analyzing financial and other spillovers from the periphery and the core support this conclusion, including analysis based on correlations of financial market prices, bank deleveraging analysis, and macroeconomic models.
13. Financial markets signal that spillovers of further stress in the EA would be large if the core is affected (Chapter 3 of Selected Issues Paper). The analysis uses correlations of market CDS spreads to estimate the implied conditional probability of distress in a variety of non-EA banks and sovereigns if distress—defined as a (hypothetical) credit event that triggers CDS contracts—were to occur in a EA program country sovereign or bank, or in a large core EA bank. The modeling framework and data availability constrained the number of sovereigns and banks that could be analyzed, so a geographically diverse group of countries—and representative banks from those countries—was chosen. The results indicate that if there is distress in a major bank from a core EA economy, the probability of distress in many of the non-EA banks would rise to high levels (40 percent or more), and would generally be highest in banks based in countries that are geographically close to the EA and whose banking systems are most closely linked to that of the EA. Among the S-4, the spillover to the U.K. would be greatest, reflecting its very strong banking links with the EA. For most non-EA banks, the estimated conditional probability of distress given distress in a core EA bank is as high or higher than the peak implied unconditional probability of distress in the period after the Lehman bankruptcy. By contrast, the estimated probabilities of distress in non-EA banks conditional on distress emerging in an EA program country sovereign, while still sizable, are much lower than those conditional on distress in a major core EA bank.
Current implied probability of distress compared to expected probability of distress in non-EA banks…
… given distress a) in GIP sovereign, b) in core EA bank
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.14. Analysis of global bank interconnectedness also suggests that further EA stress would have negative spillovers that are sharply exacerbated if core Europe is affected (text charts and Chapter 4 of Selected Issues Paper). The model, which uses BIS bank foreign claims data, is based on the assumption that banks deleverage when faced with large mark-to-market losses on their trading books. The shocks that are analyzed comprise: (i) a further decline (from current levels) in EA program country sovereign and bank bond prices of 30 percent (Scenario 1); and (ii) a further 30 percent decline (from current levels) in bond prices of EA program country sovereigns and of all EA banks (Scenario 2). Results suggest that the first shock, which is confined to the program countries, would cause some deleveraging, though mostly in the EA itself. Under the more severe scenario, the impact would be much larger, especially in the rest of Europe and parts of North Africa. These results are based on direct exposures; indirect exposures, including through guarantees via CDS contracts, may exacerbate deleveraging in a shock scenario. Recent data from the BIS indicate that the total exposure of U.S. banks to EA program countries, for example, may be several times as large as just the direct exposure. Moreover, actual spillovers could easily be more severe than estimated by this exercise if other factors also intensify deleveraging, such as a compression in non-bank wholesale funding of banks and financial accelerator effects through impacts on non-bank private sector balance sheets, which are not captured by the model but would be expected to be at play under such a scenario.
Impact of stress in EA program countries: Reduction in foreign liabilities,
(In percent of GDP) - Scenario 1
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.Impact of stress in entire EA: Reduction in foreign liabilities,
(In percent of GDP) - Scenario 2
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.15. The importance of spillovers from shocks to the core EA are further underscored by results from a broader macroeconomic modeling approach (Chapter 5 of Selected Issues Paper). Two sets of illustrative simulations were run under the Fund’s Global Projections Model (GPM; as presented in the January 2011 WEO update). These comprised, first, a “tremor” scenario of a milder shock which may be interpreted as a shock that is largely confined to the EA program countries, and, second, an “earthquake” scenario of a larger shock that spreads to the entire EA. Under the first scenario, spillovers are moderate (see text table). By contrast, the second scenario, which assumes a large shock and a policy response that falls short, leads to large financial losses in the periphery which, in turn, result in banking problems throughout the EA. Consequently, EA growth falls by 2½ percentage points relative to the baseline, while global growth falls by about 1 percent over 2011-12.
Effect of Euro Area Turbulence on GDP Growth
(Deviation from pre-crisis baseline, in percentage points)
GPM world represents 87.5 percent of world GDP by PPP (2007-2010 average).
Effect of Euro Area Turbulence on GDP Growth
(Deviation from pre-crisis baseline, in percentage points)
| “Tremor” Scenario | “Earthquake” Scenario | |||
|---|---|---|---|---|
| Difference from Pre-crisis Baseline | Difference from Pre-crisis Baseline | |||
| 2011 | 2012 | 2011 | 2012 | |
| Country/Region | Annual | Annual | Annual | Annual |
| U.S. | -0.2 | -0.2 | -0.7 | -0.7 |
| Euro Area | -0.4 | -0.2 | -1.4 | -1.3 |
| Japan | 0.0 | -0.1 | -0.1 | -0.4 |
| Emerging Asia | -0.1 | -0.1 | -0.3 | -0.4 |
| Latin America | -0.1 | -0.1 | -0.2 | -0.3 |
| Remaining GPM countries | -0.2 | -0.2 | -0.6 | -0.8 |
| World 1/ | -0.2 | -0.1 | -0.4 | -0.5 |
GPM world represents 87.5 percent of world GDP by PPP (2007-2010 average).
Effect of Euro Area Turbulence on GDP Growth
(Deviation from pre-crisis baseline, in percentage points)
| “Tremor” Scenario | “Earthquake” Scenario | |||
|---|---|---|---|---|
| Difference from Pre-crisis Baseline | Difference from Pre-crisis Baseline | |||
| 2011 | 2012 | 2011 | 2012 | |
| Country/Region | Annual | Annual | Annual | Annual |
| U.S. | -0.2 | -0.2 | -0.7 | -0.7 |
| Euro Area | -0.4 | -0.2 | -1.4 | -1.3 |
| Japan | 0.0 | -0.1 | -0.1 | -0.4 |
| Emerging Asia | -0.1 | -0.1 | -0.3 | -0.4 |
| Latin America | -0.1 | -0.1 | -0.2 | -0.3 |
| Remaining GPM countries | -0.2 | -0.2 | -0.6 | -0.8 |
| World 1/ | -0.2 | -0.1 | -0.4 | -0.5 |
GPM world represents 87.5 percent of world GDP by PPP (2007-2010 average).
16. The authorities shared staff’s views on these dual spillover findings. They stressed that problems confined to the periphery would have modest spillover effects. The smaller size, and greater market knowledge, of exposures to EA program country assets than, say, subprime assets at the outset of the 2008 crisis, implied less scope for panic than during the Lehman episode. Also, market exposure to program country assets has been reduced over the past year, which would also limit potential spillover effects. They acknowledged, however, that core area involvement would have severe repercussions. They agreed, therefore, that containing peripheral risk was critical and cited strong national policy action, effective EA crisis management, and completing governance reforms as key ingredients of such a strategy.
B. Spillovers from Monetary and Fiscal Policies
17. ECB exceptional liquidity provision has helped contain deleveraging by EA banks and corresponding spillover effects. Counterfactual scenarios used to assess the impact of higher funding costs likely associated with the withdrawal of exceptional liquidity provision indicate that the impact on some neighboring European countries, such as the U.K. could be significant (text chart and Chapter 6 of Selected Issues Paper). ECB counterparts agreed that exceptional liquidity provision had helped contain negative spillovers and stressed that it would not be withdrawn under stressed conditions. They recognized, however, that ongoing exceptional liquidity provision can also have drawbacks, notably that it could dilute incentives of weak banks to pursue timely restructuring.
Impact of the withdrawal of ECB exceptional liquidity provision: Reduction in Foreign Liabilities
(In percent of GDP)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.18. A slightly faster pace of monetary tightening in the EA than markets presently expect would have generally limited spillovers (Chapter 6 of Selected Issues Paper). The baseline scenario assumes that monetary tightening in the EA proceeds at the pace expected by the Euribor futures market, while an alternative scenario assumes somewhat more frontloaded rate hikes (see chart). Macroeconomic model estimates suggest that accelerated monetary tightening in the EA will generate moderate output losses, on the order of a cumulative additional output loss of less than 1 percent over 2011-16, built on the implicit assumption that ongoing adjustments in the EA program countries allow them to absorb the somewhat higher interest rates without an intensification of economic stress. This in turn is estimated to have modest spillovers to the rest of the world, primarily reflecting reduced EA export demand, mitigated by currency depreciation in the rest of the world. The authorities also saw limited spillovers from faster monetary tightening and stressed that the ECB’s mandate was to secure price stability in the euro area overall.
Short Term Nominal Interest Rate
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.Cumulative Output Losses: 2011 – 2016
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.19. Projected EA fiscal consolidation should have modest global demand spillovers, and these could be more than offset by credibility gains. The modeling exercise covers projected fiscal consolidation by EA members through 2015. To highlight the impact of fiscal policy and its spillovers, the simulations abstract from monetary policy accommodation in the EA as well as the rest of the world, thereby overstating somewhat the true contractionary effect on output that would actually take place. Even so, the negative demand effects to other countries are estimated to be relatively small since the magnitude of the consolidation for the area as a whole is moderate (Chapter 7 of Selected Issues Paper). Moreover, if the consolidation is accompanied by a decline in EA countries’ risk premia—only partly reversing the 150 bps increase since late 2009—net cumulative spillovers to other countries over the medium term could even turn positive (see text charts). The authorities agreed with staff that spillovers from planned fiscal consolidation would be modest, but argued that the impact within the EA itself would likely be even more modest than estimated by staff, as the fiscal multiplier would likely be contained given the perceived permanence of the fiscal consolidation plans and since monetary policy would take into account fiscal consolidation to the extent it influenced price pressures. They observed that since consolidation efforts are mainly expenditure based, they are more likely to reassure financial markets about the long-term sustainability of the fiscal position and therefore yield a lasting and growth-friendly correction of fiscal imbalances.
Cumulative Effect of Euro Area Fiscal Consolidation on Output: 2011-2016
GIMF and G20 Models
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.C. Structural Policy Spillovers
20. Turning to structural reforms, any deleveraging associated with higher bank capital requirements is expected to have only modest spillovers (Chapter 8 of Selected Issues Paper). Under Basel III, banks are expected to be subject to higher minimum core capital requirement by 2018, and many banks are likely to implement the new requirements well in advance of the deadline. Stronger capital requirements are expected to carry major financial stability benefits and address current excessive leverage, but may also have short-term contractionary effects as banks adjust, in particular if the adjustment takes the form of a rapid reduction in credit supply. Different analytical approaches suggest that direct output losses outside the EA—assuming that deleveraging will form the means through which EA banks meet higher capital requirements—should be modest (and well within the range of estimates reported by the BIS Macroeconomic Assessment Group), even if the adjustment is undertaken well in advance of the agreed deadline. In countries where EA banks’ subsidiaries account for a sizable share of banking activity, the impact would tempered by subsidiaries’ reliance on domestic funding (rather than funding from parents). The ECB agreed that higher capital requirements would generate modest spillovers. On a related issue, the authorities agreed in principle that EU bank regulations could have spillover effects. They understood concerns in some neighboring countries over the preservation of supervisory independence in non-EA members of the EU, but considered that enhanced supervisory effort and supervisory and regulatory coordination (including through supervisory colleges and the newly installed EU-level financial authorities) would help address these concerns. They also took note of staff support for implementing Basel III swiftly and without exceptions, setting capital requirements at an ambitiously high level—including significant top-ups for SIFIs—and allowing sufficient flexibility for introducing macro-prudential tools (described in the 2011 Article IV Staff Report and the European Financial Stability Framework Exercise Report, EFFE). In addition, the authorities called on major regulatory authorities in the rest of the world to also implement robust requirements to limit regulatory arbitrage and spillovers.
Impact of Basel III: Reduction in Foreign Liabilities, in Percent of GDP
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.21. Labor and product market reforms that enhance EA growth potential would have positive, albeit modest, spillovers to the rest of the world (Chapter 9 of Selected Issues Paper). The analysis of the impact of reforms was based on work undertaken for the G-20 mutual assessment process, with simulations performed using the Fund’s Global Integrated Monetary and Fiscal Model (GIMF). Structural reforms covered both labor and product market measures, along the lines of the reforms set out under the EU 2020 agenda. These include more active labor market policies, reforms to make pension systems sustainable (including a higher retirement age), which would have positive labor supply consequences and generate stronger internal growth due to budget savings and crowding-in effects. Product market reforms were assumed to result in multifactor productivity growth gains in both tradable and nontradable sectors. This in turn would lead to positive but small growth spillovers elsewhere, with spillovers to Asia and the rest of the world stronger than in the relatively closed U.S. and Japanese economies (text chart). The authorities agreed that while structural reforms were critical and could significantly improve the EA’s growth prospects, the spillover effects to partner countries would likely be generally moderate.
Real GDP impact from Euro Area structural reforms,
(percent deviation from steady state baseline)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations22. Further trade liberalization would also have positive spillovers (Chapter 10 of Selceted Issues Paper). Based on current offers in the ongoing Doha round of negotiations—under which it is assumed there is a roughly 50 percent reduction in trade-weighted average tariff rates applied by EA countries on imports—exports from most countries to the EA would increase. In aggregate, preliminary results suggest that the unilateral reduction in EA tariffs would raise total global exports to the area by more than 1 percent.
Impact of a Reduction in Protection in the European Union
(Percent change in export volume to the Euro Area)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Source: Staff calculations.V. Conclusions
23. The prospect of large spillovers—particularly if recent stress in EA program countries were to spread to the core—underscores the urgent need for actions to contain, and eventually overcome, the ongoing crisis. Measures taken over the past year—including national action in the countries facing market pressures, establishing the EFSF, and the continuation of the ECB’s unconventional policies—may have helped contain spillovers from the EA program countries to the rest of the EA and to countries outside the EA for now, but EA financial markets remain under stress, underscoring the urgent need for additional strong measures. Decisive further actions to achieve fiscal sustainability, strengthen economic governance, introduce greater fiscal risk sharing, and address remaining banking sector weaknesses—as outlined in the 2011 Article IV Staff Report and the accompanying EFFE report—will, therefore, be instrumental in ending the crisis and mitigating adverse spillovers to the rest of the world.
24. The planned fiscal consolidation in the EA could benefit the rest of the world, assuming it helps restore credibility. The direct effect of the consolidation on global demand and growth in trading partner countries will likely be modest. To the extent the EA’s fiscal adjustment credibly addresses sustainability concerns, it should help reduce spreads in the periphery and, through confidence effects, in the area more broadly and elsewhere. This latter effect, depending on its magnitude, could more than offset the direct demand impact.
25. Spillovers from gradual monetary policy normalization appear manageable under appropriate conditions. Exit from current interest rates at a slightly faster pace than markets are presently discounting is estimated to have modest spillover effects, especially if the ongoing adjustment in EA program countries allows them to absorb the somewhat higher interest rates without an intensification of economic stress. Given the importance of the ECB’s extraordinary crisis measures in limiting bank deleveraging, unwinding of extraordinary measures will need to be timed with progress in improving banking sector health and reducing volatility in sovereign bond markets in order to limit spillovers.
26. Execution of the structural reform agenda will carry positive spillovers. External effects from any temporary deleveraging that banks are forced to undergo in response to tougher capital requirements (as part of the steps to enhance stability) would be modest, and should be offset by positive externalities from a healthier banking system. Reforms to labor and product markets (as laid out in the EU 2020 agenda) and in trade (per the EU’s offers under the Doha round) are good not only for the EA itself, but also for its trading partners.
Euro Area Spillovers to LICs
Low-income countries (LICs) are affected by developments in the Euro Area (EA) through several channels. Direct channels include trade, remittances, FDI and aid flows. At the same time, the EA also has indirect spillover effects on LICs, especially through global commodity prices.
The EA receives about 20 percent of LIC exports. About 30 percent of exports from LICs in Sub-Saharan Africa and 20 percent of exports from Asia and CIS countries go to the EA. Commodity exports, in particular, play an important role in LIC bilateral trade links with Europe where fuel and crude material make up roughly 60 percent of LIC exports to Europe in 2008.
Total LIC Exports
(2007)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Sources: DOTS, World Bank and staff calculationsRemittances by Source and Region
(2007)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Remittances and FDI from the EA are particularly important for LICs in Sub-Sahara Africa. Over 30 percent of SSA’s remittance inflows originate from EA. In other regions, the U.S.’s remittance role is generally larger. In addition, EA FDI dominates flows to CIS and SSA countries.
The EA is the largest donor across LICs, particularly for LAC and SSA where EA aid makes up more than 40 percent of total aid to these regions.
FDI Flows from Advanced Countries
(average, 2005-2007)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Sources: OECD and staff calculationsAid to LICs
(2007)
Citation: IMF Staff Country Reports 2011, 185; 10.5089/9781462339549.002.A001
Sources: OECD and staff calculationsEmpirical evidence suggest that developments in EA could have significant spillovers on LICs. Estimates from growth regressions suggest that trading partner growth has a significant impact on LIC growth. An empirical study using bilateral FDI data between EA and LICs suggests that EA growth is one driver of FDI flows to LICs, although the effect is much weaker than the size of the recipient economy. In addition, there is evidence that aid flows are procyclical with respect to the donors’ business cycle and could be influenced by donors’ fiscal situation, particularly when donors face a large negative shock.1
1/ See Dabla-Norris and others (2010), FDI Flows to Low-Income Countries: Global Drivers and Growth implications, IMF WP 10/132; and Dabla-Norris and others (2010), Business Cycle Fluctuations, Large Shocks and Development Aid: New Evidence, IMF WP 10/240.Prepared by Sergejs Saksanov and Francis Vitek.
Smith, L.V. and A. Galesi (2010), GVAR Toolbox 1.0, http://www-cfap.ibs.cam.ac.uk/research/gvartoolbox/index.html.
Japan’s spillovers to other countries might appear stronger than expected. This is likely due to the fact that the estimates are based on long time series, which cover periods in the 1980s and 1990s when Japan’s role was larger.
Based on Vitek (2010).
Prepared by Silvia Sgherri.
The importance of risk commonalities varies over time, being greater at time of generalized stress in financial markets. On average, over the sample August 2007-February 2011, risk commonalities are found to explain about one-third of the total volatility for the portfolio considered.
This could either be due to investors’ hedging strategies in the asset markets considered or to (opposite) fluctuations in the respective benchmark 10-year government bond yields.
Prepared by Sally Chen, Mali Chivakul, Siret Dinc, Ola Melander, Mohamed Norat, and Malika Pant.
While the note investigates spillovers from the EA as a whole, the effects of developments in the core and periphery EA are studied separately. Core EA, for the purposes of this analysis, comprises of Austria, Belgium, France, Germany, and the Netherlands, and EA program countries are Greece, Ireland, and Portugal. Both sovereigns and banks are studied for all G-20 countries except India, Indonesia, Mexico and South Africa (due to insufficient data for the sovereign for India and banks for others), and for Hungary (taken because of the availability of bank CDS data as representative of new EU member states in terms of their links—and hence as potential spillover recipients—with the Euro Area). Only one major bank from each country is used due to technical limits of the model. The EA banks are as follows: Austria - Erste, Belgium - Dexia, France - BNP Paribas, Germany - Deutsche, Greece - Alpha Bank, Ireland - Allied Irish, Netherlands - ING, Portugal - BCP, Other countries’ banks are as follows: Brazil - Itau Unibanco, China - Bank of China, Hungary - OTP Bank, India - State Bank of India, Japan - Nomura, Korea - Shinhan, Russia - Sberbank, Turkey - Akbank, UK -Barclays, US - Citigroup.
A credit event could be a failure to pay on schedule, default, or, more broadly, a restructuring where bondholders are forced to bear losses.
The CoPoDs are estimated as in Segoviano (2006), “Consistent Information Multivariate Density Optimizing Methodology,” Financial Markets Group, London School of Economics, Discussion Paper 557; Segoviano (2006), “The Conditional Probability of Default Methodology,” Financial Markets Group, London School of Economics, Discussion Paper 557; and Segoviano and Goodhart (2009), “Banking Stability Measures,” IMF Working Paper, WP/09/04.
Transformation of CDS spreads to PoDs is done through a Matlab program which assumes a constant recovery rate of 40 percent. The transformation function is based on work on credit default swap such as O’Kane, D. and S. Turnbull. “Valuation of Credit Default Swaps.”Lehman Brothers, Fixed Income Quantitative Credit Research. April, 2003.
Prepared by Thierry Tressel.
Tressel, T, 2010, “Financial Contagion through Bank Deleveraging: Stylized Facts and Simulations Applied to the Financial Crisis”, IMF Working Paper 10/236.
The simulations are based on Q3 of 2010 data (ultimate risk basis), including for sectoral bilateral exposures. However, when the sectoral data were not available (for example for French banks), the simulations were based on Q2 of 2010 data disclosed in the December 2010 BIS Quarterly Review. For German banks, Q3 of 2010 data on immediate risk basis were used; this method may overestimate German exposure to Ireland.
Prepared by the GPM team, Research Department. The two scenarios and their results were published in WEO Update January 2011. http://www.imf.org/external/pubs/ft/weo/2011/update/01/index.htm
In GPM:
Emerging Asia includes China, Hong Kong, India, Indonesia, South Korea, Malaysia, Philippines, Singapore, Taiwan and Thailand;
Latin America includes Brazil, Chile, Mexico, Columbia, Peru;
The remaining GPM countries include Argentina, Australia, Bulgaria, Canada, Denmark, Estonia, Israel, New Zealand, Norway, Russia, South Africa, Sweden, Switzerland, Turkey, UK and Venezuela.
Prepared by Francis Vitek and Thierry Tressel.
Vitek, F. (2010), Monetary policy analysis and forecasting in the Group of Twenty: A panel unobserved components approach, IMF Working Paper, 152.
Tressel, T, 2010, “Financial Contagion through Bank Deleveraging: Stylized Facts and Simulations Applied to the Financial Crisis”, IMF Working Paper 10/236.
Measures adopted by the ECB included fixed rate tenders with full allotment in all liquidity-providing operations; additional refinancing operations with one-month and three-month maturities, as well as the provision of funding at longer maturities of six months and one year, and a broadening of the collateral program.
Refinancing by the ECB is backed by the provision of collateral, including sovereign debt securities and bank bonds. The ECB is also directly exposed to sovereigns of the periphery through the Securities Market Programme.
Hence, the analysis differentiate banking systems according to their dependence on ECB refinancing and interbank financing. Interbank liabilities of the banking systems of the four countries are approximated by the total consolidated claims on domestic banks by banks of other nationalities (source: BIS Consolidated Banking Statistics, Q3 of 2010, and BIS Quarterly Review Dec 2010).
More negative numbers mean larger deleveraging.
Prepared by Silvia Sgherri, Francis Vitek, Derek Anderson, and Stephen Snudden.
A comprehensive overview of the theoretical structure of GIMF is provided in Michael Kumhof, Douglas Laxton, Dirk Muir, and Susanna Mursula (2010), “The Global Integrated Monetary and Fiscal Model (GIMF) -Theoretical Structure,” International Monetary Fund Working Paper, 10/34. The structural macroeconometric model of the Group of Twenty is documented in Vitek, F. (2010), “Monetary policy analysis and forecasting in the Group of Twenty: A panel unobserved components approach,” International Monetary Fund Working Paper, 10/152.
Prepared by Thierry Tressel and Francis Vitek.
Basel Committee on Banking Supervision, “Results of the Comprehensive Quantitative Impact Study”, December 2010.
See Tressel, T. (2010), Financial contagion through bank deleveraging: Stylized facts and simulations applied to the financial crisis, IMF Working Paper, WP/10/236.
The simulations are based on 2010Q2 data.
The pass-through to subsidiaries may be partial because they are significantly financed by local deposits.
Vitek, F. (2009), Monetary policy analysis and forecasting in the world economy: A panel unobserved components approach, International Monetary Fund Working Paper, 09/238.
Macroeconomic Assessment Group (2010), Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements, Financial Stability Board and Basel Committee on Banking Supervision Final Report.
Prepared by Mali Chivakul and Stephen Snudden.
See Kumhof and others (2010), “The Global Integrated Monetary and Fiscal Model (GIMF)-Theoretical Structure,” IMF Working Paper, 10/34.
The model contains 5 blocks: the US, the EA, Japan, emerging Asia and the rest of the world. Emerging Asia block comprises China, Hong Kong S.A.R., India, Indonesia, the Republic of Korea, Malaysia, Philippines, Singapore, and Thailand. The rest of the world block comprises the remaining 167 countries in the world.
The reform scenarios and country-by-country parameters are taken from Bouis and Duval (2011), “Raising Potential Growth After the Crisis: A Quantitative Assessment of the Potential Gains from Various Structural Reforms in the OECD Area and Beyond,” OECD Economics Department, Working Papers No. 835. The impact analyses, however, are simulated through GIMF.
Bourlès and others (2010), “The Impact on Growth of Easing Regulations in Upstream Sectors”, CESifo Dice Report, Journal of International Comparisons, Vol. 8, No. 3.
See Bayoumi and others (2004), “Benefits and Spillovers of Greater Competition in Europe: A Macroeconomic Assessment,” NBER Working Paper 10416.
Prepared by Stephen Tokarick.
This is the average reduction in EU tariffs used by Laborde, D., W. Martin, and D. van der Mensbrugghe, (2010), “Implications of the 2008 Doha Draft Agricultural and Non-agricultural Market Access Modalities for Developing Countries,” Washington: World Bank, to assess the likely impact of the December 2008 draft modalities being considered in the Doha Round.
The 11 EU member countries that do not use the euro were excluded from this analysis due to likely conflicting effects on exports and GDP. On the negative side, these 11 EU countries would suffer from relative preference erosion under the proposed EU-wide tariff reductions. However they could benefit indirectly from their own reduced tariff rates.
Countries eligible under the EBA are: Afghanistan, Angola, Bangladesh, Benin, Bhutan, Burkina Faso, Burundi, Cambodia, Cape Verde, Central African Republic, Chad, Comoros, Democratic Republic of the Congo, Djibouti, East Timor, Equatorial Guinea, Eritrea, Ethiopia, Gambia, Guinea, Guinea-Bissau, Haiti, Kiribati, Laos, Lesotho, Liberia, Madagascar, Malawi, Maldives, Mali, Mauritania, Mozambique, Nepal, Niger, Rwanda, Samoa, São Tomé and Principe, Senegal, Sierra Leone, Solomon Islands, Somalia, Sudan, Tanzania, Tuvalu, Togo, Uganda, Vanuatu, Yemen, and Zambia. Only 43 of these countries are included in the model, due to data limitations.
