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20 October 2010

IMF: Difficult policy choices await Europe as recovery gets under way


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The IMF is predicting growth of 2¼ percent for Europe in 2010. While the recovery remains sluggish and uneven, it represents a turnaround for Europe, which was gripped by fears over sovereign solvency in May 2010 that threatened monetary union.


Defying testing times
Six months ago, concerns about economic prospects in Europe ran high as strains in Greek sovereign bond markets started to spread to other countries and sectors. Amid tumbling equity markets and a sharply depreciating euro, doomsayers predicted a breakup of the euro area and a relapse of the global economy into recession.
The recovery has withstood the turmoil in financial markets thanks in large measure to a forceful policy response, including the establishment of the European Stabilization Mechanism to backstop EU governments with financing problems, the report points out. Europe’s economy is projected to expand by 2¼ percent this year and next (see table). However, the recovery is bound to remain modest and dependent on the pull of the global economy.
Policymakers face difficult choices as they tackle vulnerabilities while nursing a fledgling economic recovery. Fiscal policy needs to strike a delicate balance between supporting demand through deficits on the one hand, and addressing unsustainable debt dynamics and eroding market acceptance on the other.
Financial sector reform faces the dual task of reviving credit growth and strengthening a still vulnerable system (see chart). Implementing structural reforms to facilitate the necessary adjustment in the real economy will require strong political will during a time of high unemployment and uncertain economic prospects. A strengthened governance framework would help build much needed confidence.
Moderate recovery in advanced Europe
Advanced Europe emerged from recession in the second half of 2009 and is projected to grow at 1.7 and 1.6 percent this year and next. According to the report, these moderate growth rates reflect not only well known structural rigidities that limit potential growth, but also the temporary nature of the factors that were driving the recovery early on. Going forward, restocking, decisions to move ahead with frozen investment plans, and the rebound of exports are likely to make more limited contributions to growth. Moreover, the fiscal policy stance is set to become more restrictive.
Sustaining the recovery will require astute policies on a number of fronts. To fully restore confidence in the financial system, the report recommends that vulnerable banks be resolved, restructured, or recapitalized without delay, using the recent EU-wide stress tests as a road map. This would allow the European Central Bank (ECB) to exit from extraordinary liquidity measures before they become entrenched. And banks would be better positioned to step up still feeble lending, crucially to smaller firms that lack access to capital markets.
Growth-friendly fiscal consolidation
Getting fiscal consolidation right is perhaps the trickiest task. The report emphasizes that expenditure-based fiscal consolidation, especially when it tackles entitlement reforms, tends to be more growth friendly than tax hikes or cuts to public investment. Embedding fiscal consolidation into credible medium-term plans backed by concrete measures also helps.
The phasing of fiscal consolidation needs to be tailored to country-specific circumstances, the report says. Countries already under market pressure have no choice but to frontload fiscal adjustment. Countries with fiscal space can proceed less aggressively, including by delaying consolidation if the recovery proved weaker than expected. For the euro area, the overall projected fiscal stance is neutral in 2010 and turns mildly contractionary in 2011. The composition of the planned fiscal adjustment is broadly reassuring, but many countries should enhance the credibility of their plans, the report says.
Finding solutions to governance gaps
Policymakers should move swiftly to fill the gaps in the EU’s governance framework exposed by the crisis to build confidence and support the recovery. Progress is furthest along in the financial sector with the decision to establish European Supervisory Authorities and a European Risk Management Board in 2011. At the moment, policy makers are debating how to enhance fiscal governance. Broader structural reforms have so far been less of a priority, although they could contribute to redressing intra-euro area external imbalances and unlock growth potential, the report says.


© International Monetary Fund


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