ECONOMIC COMMENT:WE WANT to get away from them. But "developments in the euro area remain the key risk to global financial stability.
Recent important policy steps have brought some much-needed relief to financial markets, as sovereign spreads have eased, bank funding markets have reopened, and equity prices have rebounded. However, new setbacks could still occur. The path ahead has significant . . . risks, and policies need to be further strengthened to secure and entrench financial stability.” Thus did the International Monetary Fund’s Global Financial Stability Report assess progress towards what it called, optimistically, a “quest for lasting stability”. Many would settle for something far less ambitious: a few years of stability would be an unexpected delight.
The IMF’s latest World Economic Outlook, also released last week, offered sensible recommendations: “It is . . . critical to break the adverse feedback loops between subpar growth, deteriorating fiscal positions, increasing recapitalisation needs, and deleveraging . . . The European Central Bank should implement additional monetary easing to ensure that inflation develops in line with its target over the medium term and guard against deflation risks, thereby also facilitating much-needed adjustments in competitiveness. Moreover, . . . banking authorities should work together . . . to monitor and limit deleveraging of their banks at home and abroad.”
Let us summarise. First, it is still easy to identify risks, not least the state of the banks, particularly given their close relationship with fragile sovereigns. Second, growth is too slow and ECB monetary policy too tight. Finally, inflation needs to rise in the more competitive countries, to facilitate adjustment among member countries.
If the IMF is called to offer assistance to member countries out of the additional resources it has acquired, its conditionality for the eurozone needs to match these arguments. It is not enough to beat up weak countries. The policy regime itself needs to change.
Yet, perhaps the most important point to have emerged is that the crisis is subject to growing political risks. The fall of the Dutch government and the victory of François Hollande in the first round of the French presidential election demonstrate this point. The street might overwhelm the establishment. The fear of just this might cause yet another self-fulfilling prophecy of crisis. Even France could be dragged in. Then the game might be up.
Encouragingly, confronted with the risk of a financial meltdown in late 2011, the eurozone did act. The ECB’s longer-term refinancing operation reduced funding strains and contained the risk of bank failures. New governments in countries under pressure are implementing substantial reforms. Ireland and Portugal have made progress in their adjustment programmes. Greece has negotiated debt restructuring. Progress has been made towards surveillance of internal imbalances, not limited to fiscal imbalances. The eurozone’s “firewall” against contagion has been strengthened.
In short, the GFSR 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 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 $2.2tn.
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.
