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In short, the Global Financial Stability Report [GSFR] notes, downside economic risks have indeed been reduced. Unfortunately, it states, financial stability risks remain. A particularly important aspect of those risks is of further deleveraging by the banks. This is necessary, given their bloated balance sheets. But it is economically dangerous.
In what the GSFR calls its “current policies scenario”, 58 large banks based in the European Union could shrink their balance sheet by as much as €2 trillion ($2.6 trillion) by the end of 2013, or almost 7 per cent of total assets. The effect on eurozone credit supply is only 1.7 per cent of credit outstanding, but this decline will be concentrated in what the report calls “high-spread” countries, making their return to private sector led growth even harder to achieve. Other likely victims are emerging economies of central and eastern Europe. Even under what it calls a “complete policies scenario”, which would include strengthened crisis management, dynamic bank restructuring and a “road map for a more financially and fiscally integrated monetary union” the fall in banks assets might be $2.2 trillion.
To contain the dangers of disorderly deleveraging, capital will have to be inserted into banks, including by the new support funds. But even this would not break the pernicious link between banks and fragile sovereigns. As much as 12.4 per cent of the consolidated assets of Italy’s “depository institutions” – an amount equal to 32 per cent of forecast 2012 gross domestic product – consists of claims on the Italian government. In Spain, corresponding numbers are 7.7 per cent of assets and 26.5 per cent of GDP. The combination of vulnerable sovereigns with exposed banks remains dangerous. Indeed, the ECB’s generous funding has strengthened that link. This medicine has perilous side effects. But it had to be used, given the desire of so many foreigners to reduce their exposure. Almost half of Italy’s public debt is held abroad. If that is dumped, it is bound to end up in Italian hands.
The financial crisis has exposed the weaknesses in any currency union among otherwise sovereign countries, particularly the difficulty of adjustment and the lack of a proper central bank. It has also exposed the weaknesses of the actual design of the eurozone. Last but not least, it has exposed weaknesses in policies and institutions of Member States, particularly in financial regulation, in their banks, in management of public finances and in labour markets. Unfortunately, the scale of the crisis has made it necessary to remedy what can be remedied, under huge pressure. At every stage, the eurozone has done more than one might have expected, yet it has not been enough.
The immediate priorities are clear, however: to give the countries in difficulty the time and the opportunity to adjust their economies and so achieve stability once more. My reading of the IMF analyses is that these countries are making painful progress. But far more must be done. Above all, growth must restart if the burden of public and private debt and the close links between such debts and the banks are to be managed. The challenge remains huge. Try even harder, for everybody’s sake.
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