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IMF Says European Economic Recovery to be Fragile and Calls for Policy Action to Secure a Solid Rebound

The current European economic recession is showing signs of bottoming out, but the recovery is likely to be slow and fragile, the International Monetary Fund (IMF) said today in its October 2009 Regional Economic Outlook (REO) for Europe. Helped by rebounding confidence and a tentative pick up in global trade, the contraction in Europe appears to have ended at mid-2009 and is expected to give way to a moderate recovery in 2010 and more solid growth returning only afterwards, the report said.

“The long recession shows signs of finally bottoming out. But the recovery will likely be slow and fragile because the pickup in demand from Asia can hardly substitute for the pre-crisis appetite for imports of U.S. consumers. Europe cannot count on exports alone to drive the recovery. In addition, credit remains scarce, unemployment is rising, and the crisis has reduced Europe’s growth potential,” said Marek Belka, Director of the IMF’s European Department. In advanced economies this should result in an average decline of -4.0 percent in 2009 and growth of 0.5 percent in 2010. In emerging Europe activity is expected to contract by -6.6 percent this year, but growth should return to most countries in 2010, with GDP increasing by an average 1.7 percent.

The report calls on policymakers to focus their attention on securing the recovery. In the near term, they should adopt a more resolute approach to assessing the balance sheet risks faced by banks, and take action to recapitalize or restructure viable institutions and resolve others. “The economic recovery might be weaker than hoped for unless the financial sector problems are dealt with promptly and effectively,” Belka said.

Macroeconomic policies also need to sustain the upswing while preparing for an exit. The fragility of the recovery will require fiscal policy to continue with planned stimuli and letting automatic stabilizers work, but sustainability concerns demand a strong consolidation effort once the recovery has firmed up. And monetary policy will need to remain supportive but, once financial conditions normalize and the recovery is firm, attention needs to be given to exiting the unprecedented market interventions forced by the crisis. Clear communication of this exit strategy will be essential, the report says. “There is little rest for the weary. The fragility of the upswing will require policymakers’ steady hand to maintain support for activity while preparing to exit from the policies put into place during the crisis. Getting its timing and the pace right will require careful judgment,” Belka stated.

“But, overall, moving fast to repair the damage the crisis has caused to potential growth is what ultimately matters most. Only lifting the long-run growth potential of Europe will put the crisis behind us for good,” he added. To achieve this, policymakers in advanced countries should pursue opportunities to reform labor and product markets, while those in emerging economies should focus on developing a new business model that rebalances the sources of growth and financing.

Brief Summary of the Analytic Chapters in the 2009 October REO

Chapter 2 of the 2009 October REO, entitled “The Crisis and Potential Output,” looks at the impact of the crisis on Europe’s potential growth and concludes that financial sector difficulties, weak investment, and long spells of unemployment are likely to hold back potential growth over the next few years. The magnitude of their impact is, however, uncertain. Over the long term, potential growth should return to its historic trend in most of Europe’s advanced economies, except where unsustainable financial sector profits might have exaggerated growth. In emerging Europe, resuming convergence will depend on restoring sustainable capital inflows by ensuring a business-friendly environment, strengthening policy frameworks to reduce uncertainty, and implementing sound macroeconomic policies.

Chapter 3 of the REO, entitled “Implications of the Fall in Potential Output for Macroeconomic Policies,” concludes that the decline in potential output and the surrounding uncertainty complicates both fiscal and monetary policy decisions in an already difficult environment and can lead to policy mistakes. To keep inflation expectations anchored, monetary policymakers will need to clearly communicate their views on potential output on which policy rate decisions are based, while emphasizing their commitment to adjust as new information arrives. Given the large fiscal costs of the crisis, fiscal policy should err on the side of caution and consolidate as soon as the recovery takes momentum.

Chapter 4 of the REO, entitled “Policies in Emerging Economies to Cope with Heightened Risk during Recovery,” says that emerging Europe is likely to face higher risk premiums and a more volatile environment in the aftermath of the financial crisis, as investors pay increased attention to domestic policies in individual countries. Adopting policies that lower uncertainty about the state of the financial system and reduce fiscal discretion would go a long way in addressing concerns and will yield a “double dividend” in improving prospects for long-term growth.