Risks to global financial stability have increased and financial markets have been volatile as European policymakers grapple with the ongoing crisis, the IMF said in its latest assessment of the global financial sector. The Eurozone crisis has moved from a sudden stop into a capital-flight phase despite substantial policy interventions, as cross-border private capital is being repatriated from the periphery back to the core of the currency union.

Faltering market confidence has led to capital flight from countries on the ‘periphery’ to the core of the Eurozone. This has meant higher borrowing costs and a growing wedge between the economic and financial ‘haves’ and ‘have-nots’.

European policymakers have taken a number of important steps in recent months to help reverse the fragmentation of Eurozone financial markets and strengthen the European Monetary Union, the IMF said in its latest 'Global Financial Stability Report'. The most recent action, in September, was the announcement by the European Central Bank to buy government bonds on a conditional basis.

These actions have helped markets stabilize in recent months. However, policymakers need to take additional measures to restore confidence. If they do not, the result will be an acceleration in deleveraging, which raises the risk of a credit crunch as banks make fewer loans, and an ensuing economic recession, the IMF said.

“Further policy efforts are needed to gain lasting stability,” said José Viñals, financial counsellor and head of the IMF’s Monetary and Capital Markets Department, which produced the report. Viñals was a senior official at
Banco de España, during the Spanish property bubble.

Eurozone: restore confidence and reverse fragmentation

The IMF said delays in resolving the crisis have likely increased the amount of asset deleveraging by banks, which may further constrain the supply of bank credit and reinforce financial and economic fragmentation in the Eurozone.

Unless additional, decisive policy measures are taken urgently, the latest report says that mounting pressure on banks in Europe could result in asset shrinkage by as much as $2.8 tn to $4.5 tn through the end of 2013, with the largest burden of credit supply contraction falling on the Eurozone periphery.

The report was released in Tokyo in the run-up to the IMF’s Annual Meetings, the day after the 188-member institution issued its outlooks on global growth and government debts and deficits, which show growth has declined in the last six months, and countries’ efforts to control the debt overhang is taking longer to yield results.

“Commitment to a clear roadmap on a banking union and fiscal integration are needed to restore confidence, reverse the capital flight, and reintegrate the Eurozone,” said Viñals.

Countries need to do their part by implementing policies that promote growth and complete the clean-up of the banking sector, said Viñals.

Policy actions needed
 

To restore confidence, policymakers in the Eurozone need to swiftly complete the work they’ve begun, including:

• Reduction of government debts and deficits in a way that supports growth;
• Implementation of structural reforms to reduce external imbalances and promote growth; and
• Clean-up of the banking sector, including recapitalizing or restructuring viable banks and resolving nonviable ones.

Policymakers need to complement these efforts with actions at the Eurozone level, according to the IMF. The European Central Bank should continue to ensure sufficient funding is provided to banks through their liquidity framework. More fundamentally, concrete progress toward a banking union in the Eurozone will help break the pernicious link between sovereigns and domestic banks.

Over the longer term, a successful banking union will require sufficient pooling of resources to provide a credible fiscal backstop to the bank resolution authority, and a joint deposit insurance fund.

Beyond the Eurozone

The report says the risks to financial stability are not confined to the Eurozone. Both Japan and the United States face significant fiscal challenges, which, if unaddressed, can have negative financial stability implications, according to the IMF.  Both countries require medium-term deficit reduction plans that protect growth and reassure financial markets. 

The IMF says the key lesson of the last few years is that imbalances need to be addressed well before markets start signaling credit concerns. If there is no credible medium-term plan, markets will force an adjustment over a compressed period, with adverse effects on growth and financial stability.

Thus far, emerging economies have adeptly navigated through global shocks, but need to guard against potential shockwaves from the Eurozone crisis, while managing slowing growth in their own economies. Many central and eastern European economies are vulnerable as a result of their high direct exposure to banks in the Eurozone and some similarities with weaknesses in the periphery. At the same time, the IMF says several economies in Asia and Latin America are also prone to risks associated with being in the later stages in a credit cycle. If spillovers were to intensify, rising domestic vulnerabilities and a reduction in policy space could pose increased challenges, the IMF said.