Press Release No. 10/391

Press Release: IMF Sees Continued Recovery in Europe, Risks Remaining

October 20, 2010

Europe continues to recover from its deepest recession in the postwar period with GDP projected to expand by 2.3 percent in 2010 and 2.2 percent in 2011, after a 4.6 percent contraction in 2009, the International Monetary Fund (IMF) said today.

In its latest Regional Economic Outlook (REO) for Europe, the IMF said that the recovery has been boosted by the resurgence of the world economy, with export growth especially strong in countries that export capital goods. However, the recovery is sluggish and projected growth rates are low by historical standards.

In advanced Europe, where policy actions helped contain sovereign debt troubles in early 2010, growth is projected at 1.7 percent in 2010 and 1.6 percent in 2011. Despite recent strength, however, the upswing is projected to remain weak compared with previous recoveries and also with advanced economies in other regions. In part, these growth differentials are due to the lingering impact of the crisis and the accelerating fiscal adjustment in 2011. But they also reflect well-known structural rigidities in the labor, product, and services markets that will limit the euro area’s potential growth.

The REO also noted that significant risks remain, and urged policymakers to implement appropriate policies. Fiscal consolidation, while inevitable, should be undertaken in a way that minimizes the negative impact on growth and unemployment; if growth threatens to slow appreciably more than we expect, countries with fiscal room could postpone some of the planned consolidation. Monetary policy must steer carefully between the need to normalize policies on the one hand and the necessity to mitigate sovereign market volatility and ensure bank liquidity on the other; and the recent checkup of European banks should be followed by rapid action to eliminate remaining weaknesses in balance sheets while continuing to safeguard lending capacity.

“Policymakers need to focus on strengthening bank balance sheets,” said Ajai Chopra, Acting Director of the IMF’s European Department. “Vulnerable financial institutions should be restructured, recapitalized, or resolved without delay. The results of the recent European Union-wide stress tests provide a rough guide of the banks that may need to be merged or recapitalized. Better government supervision with enhanced cross-border cooperation can help build market confidence. A number of initiatives are already in train. We need to wrap them up, get regulatory clarity, and implement.”

The IMF also welcomed the proposed improvements of the governance of the European Union (EU) and the euro area and urged member countries to accelerate its implementation.

Although the crisis in emerging Europe has been deep, banking and currency crises have largely been avoided—the result of strong domestic policy responses, rapid and large-scale financing packages of international institutions, and the continued support of Western banks. The REO forecasts that emerging Europe¹ will grow by 3.9 percent in 2010 and 3.8 percent in 2011, with the outlook depending crucially on developments in advanced Europe, where renewed turmoil could affect trade channels as well as hurting capital flows to the region and domestic credit growth.

Credible fiscal consolidation plans could help preempt sovereign debt concerns, which is particularly critical for countries where banks have substantial exposure to sovereigns. With demand for credit now recovering, public policies should reduce supply side constraints by reducing uncertainty about macroeconomic policy. Beyond the short term, the region will need to find new growth engines by shifting toward greater reliance on the tradable sector as the growth model of the boom years—driven by capital inflows, rapid credit growth, and domestic demand booms has proven unsustainable.

The boom-bust cycle provides important lessons in crisis prevention, Mr. Chopra said. “Country experiences in emerging Europe have been very diverse,” Mr. Chopra said. “Some countries, like the Baltics experienced double-digit output declines while others, for example Poland, escaped a recession altogether. The primary reason is that countries with the biggest credit booms during the good years suffered the most severe downturns during the recession. As credit boom-bust cycles can be very costly, it is important to prevent excessive credit growth during the next boom. Supervisors will need to deploy strong prudential measures—in close collaboration with supervisors of western European parent banks, while buoyant fiscal revenues during boom years should be saved to build up buffers for bad times instead of being used to finance an increase in expenditure.”