Emerging markets susceptible to shocks from Europe, says IMF

Risks to global financial stability have increased and financial markets have been volatile as European policymakers grapple with the ongoing crisis, the IMF said in its latest assessment of the global financial sector.

Faltering market confidence has led to capital flight from countries on the ‘periphery’ to the core of the euro area. This has meant higher borrowing costs and a growing wedge between the economic and financial ‘haves’ and ‘have-nots’.

European policymakers have taken a number of important steps in recent months to help reverse the fragmentation of euro area financial markets and strengthen the European Monetary Union, the IMF said in its latest Global Financial Stability Report launched at the start of the IMF World Bank Annual Meetings in Tokyo.

The most recent action, in September, was the announcement by the European Central Bank to buy government bonds on a conditional basis.

These actions have helped markets stabilise in recent months. However, policymakers need to take additional measures to restore confidence. If they do not, the result will be an acceleration in deleveraging, which raises the risk of a credit crunch as banks make fewer loans, and an ensuing economic recession, the IMF said.

“Further policy efforts are needed to gain lasting stability,” said José Viñals, Financial Counsellor and head of the IMF’s Monetary and Capital Markets Department, which produced the report.

Euro area: restore confidence and reverse fragmentation

The IMF said delays in resolving the crisis have likely increased the amount of asset deleveraging by banks, which may further constrain the supply of bank credit and reinforce financial and economic fragmentation in the euro area.

Unless additional, decisive policy measures are taken urgently, the latest report says that mounting pressure on banks in Europe could result in asset shrinkage by as much as $2.8 trillion to $4.5 trillion through the end of 2013, with the largest burden of credit supply contraction falling on the euro area periphery.

The report was released in Tokyo in the run-up to the IMF’s Annual Meetings, the day after the 188-member institution issued its outlooks on global growth and government debts and deficits, which show growth has declined in the last six months, and countries’ efforts to control the debt overhang is taking longer to yield results.

“Commitment to a clear roadmap on a banking union and fiscal integration are needed to restore confidence, reverse the capital flight, and reintegrate the euro area,” said Viñals.

Countries need to do their part by implementing policies that promote growth and complete the clean-up of the banking sector, said Viñals.

Policy actions needed

To restore confidence, policymakers in the euro area need to swiftly complete the work they’ve begun, including:

• Implementation of structural reforms to reduce external imbalances and promote growth; and
• Reduction of government debts and deficits in a way that supports growth;
• Clean-up of the banking sector, including recapitalising or restructuring viable banks and resolving nonviable ones.

Policymakers need to complement these efforts with actions at the euro area level, according to the IMF. The European Central Bank should continue to ensure sufficient funding is provided to banks through their liquidity framework. More fundamentally, concrete progress toward a banking union in the euro area will help break the pernicious link between sovereigns and domestic banks.

Over the longer term, a successful banking union will require sufficient pooling of resources to provide a credible fiscal backstop to the bank resolution authority, and a joint deposit insurance fund.

Beyond the euro area

The risks to financial stability are not confined to the euro area. Both Japan and the United States face significant fiscal challenges, which, if un-addressed, can have negative financial stability implications, according to the IMF.  Both countries require medium-term deficit reduction plans that protect growth and reassure financial markets.

The key lesson of the last few years is that imbalances need to be addressed well before markets start signaling credit concerns. If there is no credible medium-term plan, markets will force an adjustment over a compressed period, with adverse effects on growth and financial stability,

Thus far, emerging economies have adeptly navigated through global shocks, but need to guard against potential shockwaves from the euro area crisis, while managing slowing growth in their own economies.

Many central and eastern European economies are vulnerable as a result of their high direct exposure to banks in the euro area and some similarities with weaknesses in the periphery. At the same time, several economies in Asia and Latin America are also prone to risks associated with being in the later stages in a credit cycle. If spillovers were to intensify, rising domestic vulnerabilities and a reduction in policy space could pose increased challenges, the IMF said.