core sector communique

IMF Says Moderate and Uneven Recovery Taking Shape Across Europe

May 11, 2010

A moderate and uneven recovery is taking shape across Europe, supported by the rebound in global trade and policy stimulus, the International Monetary Fund (IMF) says in its latest Regional Economic Outlook for Europe. Growth in the region is expected to pick up during 2010–11, but the traditional drivers of recovery are likely to be weaker than usual. In the near term, growth will continue to benefit from exports, fiscal support (including from lagged stimulus measures such as infrastructure investment), and an upswing in inventories. Improvements in investor and consumer confidence should raise domestic demand. However, with unemployment expected to increase, and with lingering difficulties in the banking sector likely to restrain credit supply, consumption and investment will remain lackluster.

Fiscal policy protected aggregate demand and private consumption from the full impact of the shock through discretionary stimulus and automatic stabilizers. Although supportive macroeconomic policies are still needed to secure a self-sustaining recovery, the costs and limits of many crisis interventions are of growing concern. Such concerns are most prominent on the fiscal side, but they exist as well for monetary and financial policies. Aiming to stabilize public debt in the short run is neither feasible nor desirable, given the risk of a relapse into recession and the magnitude of the required fiscal retrenchment. However, sustainability indicators are flashing warning signs over public debt levels in most countries, and sizable consolidation efforts are needed in the medium term. For countries with already low fiscal credibility, more immediate consolidation is a must.

For emerging Europe, the key policy challenge will be attracting and harnessing healthy capital inflows to restore economic growth. After a long period of relatively large and seemingly unstoppable inflows, the region saw capital inflows decelerate as the crisis took hold. The uneven impact of the crisis across countries reflected variations in the factors that attracted excessive foreign capital before the crisis. In general, the worst-hit countries had the largest excess in precrisis inflows related to structural factors, such as the degree of income convergence or the size and structure of their economies. Their economies often had features that tended to create the illusion of fiscal space—heavily managed exchange rates, booming credit markets, and overheated growth. As policymakers became increasingly worried about vulnerabilities associated with the surge of flows, they often resorted to prudential policies that were somewhat effective in moderating the size and composition of those flows.

These precrisis trends provide a number of important policy lessons. For countries that are already seeing a resumption of inflows, responsive macroeconomic policies will be critical to stemming an excessive surge. For countries with pegged exchange rates, the best response to inflows in excess of those driven by structural factors is to tighten fiscal policies. For countries without pegged exchange rates, the most effective response could be to let the currency appreciate. A freely floating exchange rate is also helpful in preventing excessive inflows and the accumulation of financial fragilities. Where healthy capital inflows have yet to resume, policymakers will need to reorient the sources of economic growth toward the tradables sector. While this transformation would take place in the private sector, it will require support from public policies, including through improving intersectoral labor mobility, reducing skill mismatches, and addressing country-specific infrastructure bottlenecks.

These macroeconomic policies should be accompanied by improvements in the financial stability of the region’s increasingly integrated financial system. Prudential tools such as capital requirements on foreign borrowing help to lower excessive inflows and related risks in banks. Higher risk premiums on loans to certain sectors help build buffers in the banking system and prevent overheating of certain sectors. To sustain the resilience of the financial system, these tools need supportive macroeconomic policies and effective cross-border financial supervision.