Press Release No. 08/89

Press Release: IMF Regional Economic Outlook for Europe Sees Slower Growth; Explores Challenges Policymakers Face in Seeking to Limit the Impact of Financial Turbulence

April 21, 2008

Europe is facing slower growth as a result of protracted financial turbulence, high inflation and spillovers from an expected mild recession in the United States. The IMF's Regional Outlook (REO) for Europe released today projects economic growth in advanced European economies to slow significantly over the next two years to 1.5 percent in 2008 and 1.4 percent in 2009, from 2.8 percent in 2007. In Emerging Europe, growth is also expected to moderate, to 5.5 percent in 2008 and 5.2 percent in 2009, down from 6.9 percent in 2007.

The risks to the growth outlook are broadly balanced, but with a tilt to the downside in 2009. In the near term, domestic demand could be stronger than projected, as labor markets are still strong and the short-term indicators still reasonably sustained. On the downside, global growth could weaken more than expected, global imbalances could unwind suddenly, accompanied by upward pressure on the euro exchange rate, and the credit squeeze could become a credit crunch.

"Europe has so far been relatively resilient to the U.S. slowdown and the global financial turbulence, but the historical record suggests these will increasingly take their toll," said Mr. Michael Deppler, Director of the IMF's European Department. He noted that "When U.S. growth declines, Europe follows. The extent of the pass through and its timing has varied, but it is there and, indeed, seems to have if anything somewhat increased historically. In our projections, the financial and confidence linkages are a more important channel of transmission than trade, consistent with their prominence in the context of the current financial turmoil. The sharp rise in inflation, which has already dampened consumer confidence and spending in Europe, is a further source of weakness."

According to the report, policymakers in advanced economies need to restore confidence in the financial system and minimize the impact of the financial crisis on the real economy. They should give priority to rebuilding counterparty confidence and reinforcing the soundness of financial institutions. Central banks will have to strike the right balance between supporting the real economy and preventing second-round effects from the recent rise in inflation. If, as anticipated, inflation expectations remain well anchored and indicators confirm the projected slowdown, room for policy easing will increasingly emerge. Meanwhile, countries that have made sufficient progress toward fiscal sustainability should let automatic stabilizers operate fully. In emerging economies, many of which have large external vulnerabilities and are expected to continue to grow rapidly, the policy focus should remain on managing demand pressures and reducing imbalances.

Analytic chapters: The Financial Turmoil and Convergence in Emerging Europe

In addition to the economic outlook, the REO presents an analysis of the impact of the current global financial turmoil on Europe's financial systems. The financial turbulence has spread quickly across asset classes and throughout Europe. Despite the depth and width of the turmoil, financial systems in Europe have held up relatively well so far. The soundness of major systemic players has been maintained, as shareholders and outside investors have injected fresh capital where needed. But the test is not over yet, as loss recognition still needs to catch up and additional risks remain on the horizon.

In Chapter 3, the report looks in more detail at the prospects and vulnerabilities of emerging Europe. The trend toward convergence with advanced economies is based on strong fundamentals, in particular productivity gains, and will therefore continue, albeit at a slower pace. Fast growth has been associated with rising external imbalances in several economies, including large current account deficits and high levels of external debt, raising risks of a hard landing. Macroeconomic policies and structural reforms will need to do more to ensure a smooth convergence path in emerging Europe.