Bloomberg News

IMF Says Europe Needs Stronger Monetary Union to Stem Contagion

July 18, 2012

Europe’s leaders need to move toward a more complete monetary union if “substantial” spillover effects for the global economy are to be avoided, the International Monetary Fund said.

The immediate priority is making progress toward a banking union for the euro area, the IMF said in a staff report on euro- area economic policies today. While acknowledging that leaders have taken important steps already, the report argued that an even stronger and more collective effort is required to staunch financial contagion from the crisis.

“A strong commitment toward a robust and complete monetary union would help restore faith in the viability” of the economic and monetary union, the IMF said. “This should encompass a credible path to a banking union and greater fiscal integration, with better governance and more risk sharing.”

Leaders have struggled to contain a crisis of confidence in Europe’s fiscal health since Greece became the first of five countries so far to ask for aid from international lenders including the IMF in 2010. Last month, a fresh push for enhanced joint budgetary control and closer financial-sector integration was overshadowed by the appeal of Spain, the region’s fourth- largest economy, for funds to recapitalize its ailing banks.

‘Acute Stress’

“The adverse links between sovereigns, banks and the real economy are stronger than ever,” the IMF said. “Despite major policy actions, financial markets in parts of the region remain under acute stress, raising questions about the viability of the monetary union itself.”

As the crisis has deepened, the growth outlook has waned, according to the report. While maintaining its forecast on July 16 for a 0.3 percent contraction of the euro-area economy in 2012, the IMF revised down the growth outlook for 2013 to 0.7 percent from 0.9 percent. In today’s report it cited subdued domestic demand, imminent budget cuts, and deteriorating global performance as drags on growth.

“With many of these headwinds significantly stronger in the periphery, growth is expected to be much lower there than in the core,” the IMF said. “Germany and France are expected to post weak but positive growth in 2012.”

Analysts are cutting European profit forecasts at the fastest rate since 2009 as the region heads for a recession and growth in China slows for a sixth quarter.

‘Sizable Risk’

Given the dim economic prospects, the inflation rate is likely to fall “well below” the ECB’s target of 2 percent next year and remain under that level during 2014, the IMF said.

“There is a sizable risk that inflation could even turn negative in the medium run,” the IMF said, assessing the risk of deflation as 25 percent by early 2014.

“This risk of deflation is relatively low in the faster- growing economies, but significant in the periphery, where administrative price and tax increases are masking more severe downward price pressures from still substantial output gaps,” the IMF said.

The IMF’s deflation warning contrasts with European Central Bank President Mario Draghi’s remark on July 12 that there is “no sign” of deflation in any euro country. The ECB on July 5 cut its benchmark interest rate to a record low of 0.75 percent and its deposit rate, which has steered market rates since the financial turmoil started, to zero.

‘Selective Measures’

The ECB could provide a stronger bulwark against renewed crisis pressures by cutting its main interest rate further, implementing a program of large-scale asset purchases and undertaking further multi-year loans to banks, the IMF said.

A more accommodative monetary policy is needed from the ECB, and that would “likely include unconventional measures,” IMF European Department Deputy Director Mahmood Pradhan said.

“There is some further room to reduce interest rates, but it is likely that they will need more measures, and this would include some traditional measures such as quantitative easing, or more selective measures,” such as the ECB’s securities markets program, Pradhan said. “That may need to be scaled up.”

U.S. Federal Reserve Chairman Ben. S Bernanke yesterday outlined options to ease policy further in case the flagging economic recovery fails to lower unemployment, including further purchases of Treasuries and mortgage-backed securities.

Against a backdrop of fiscal consolidation, the fund said the “overarching challenge” in Europe is to plan budget cuts without unduly harming economic growth.

“A further intensification of the crisis would have substantial impact on neighboring European countries and the rest of the world,” according to the report. “A determined move toward a more complete union is needed now to demonstrate policy makers’ unequivocal commitment to sustain” the economic and monetary union.

To contact the reporters on this story: Jeff Black in Frankfurt at jblack25@bloomberg.net; Jana Randow in Frankfurt at jrandow@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net


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