IMF: Euro-Zone Crisis Could Spread
LONDON—The fiscal crises in Greece, Ireland and Portugal could yet spread to other parts of the euro zone and parts of eastern Europe, the International Monetary Fund said Thursday.
In its twice-yearly report on the European economy, the IMF said that while financial integration had contributed to the buildup of government debts in the three crisis countries, further integration would be necessary to help the euro zone tackle its problems.
The IMF has provided loans to Greece and Ireland alongside the euro zone, and is poised to contribute to Portugal's bailout package. But it said there is a risk that the crisis will spread beyond those countries.
"Strong policy responses have successfully contained the sovereign debt and financial sector troubles in the euro area periphery so far, but contagion to the core euro area, and then onward to emerging Europe, remains a tangible downside risk," the IMF said.
In particular, weak banking systems remain a threat to the financial health of euro-zone governments, and that further weakens the banks since their government bond portfolios decline in value.
"Negative feedback loops between concerns about the stability of government and bank balance sheets are proving difficult to break," the fund said. "And concerns about ... financial-sector balance sheets extend beyond the euro area periphery."
The IMF said bonds maturing in 2011 will be the equivalent of 10% of the combined economic output of Greece, Portugal and Spain, while Belgium, Ireland, and the U.K. will also have significantly higher "rollover needs."
"More generally, crisis-related funding pressures in high-deficit countries have forced governments to assume additional risks by shifting to shorter maturities and to rely more heavily on private syndication."
The partial integration of financial systems after the launch of the euro had contributed to the scale and duration of the fiscal crisis, while bond investors had also played their part by ignoring mounting problems.
"Risk premiums remained low, so current account imbalances became wider and more persistent," the fund said. "Markets showed little concern until mid-2007, ignoring solvency risk and covering large financing needs at low interest rates, which boosted self-feeding bubbles. By failing to demand higher risk premiums, markets failed to rein in this unhealthy development until it was too late for a soft landing."
The failure to charge appropriately high interest rates when lending to governments was partly due to the fact that investors "found it difficult to imagine that the euro area countries wouldn't come to the rescue of members in trouble—particularly given the interconnectedness of their banking systems."
However, the IMF said the euro zone shouldn't back away from financial integration, but instead make it more complete, since that would help prevent future banking crises, and reduce the drain on government funds. A needed reduction in the number of euro-zone banks is proceeding too slowly, delaying further integration, the fund said. "Consolidation is now occurring slowly, if at all, and often within borders."
"In many cases, restructuring has led to refocusing on the domestic market and sales of foreign operations, thus reducing financial integration."
The IMF expects budget deficits in Greece, Ireland and Portugal to be broadly in line with government targets. It forecast that the Greek government's deficit will fall to 6.2% of gross domestic product in 2012 from 7.4% this year, that Ireland's deficit will fall to 8.9% from 10.8% and Portugal's to 5.5% from 5.6%.
Over the medium term, a return to economic growth in those countries will be the key to addressing the euro zone's debt problems. "The most critical factor in the longer term is restoring GDP growth in the crisis-affected countries, with stronger roles for the tradable sector and exports, and less reliance on the nontradable sector, capital flows, and domestic demand."
To that end, the European Central Bank shouldn't raise its key interest rate too quickly, since "monetary policy in the euro area can afford to remain relatively accommodative."
"The ECB may need to extend further in time its regime of full-allotment refinancing for some of its liquidity operations, while refining its collateral framework to discourage systemic bidding, minimize distortions to market-based bank financing, and avoid moral hazard associated with unlimited liquidity provisions," the IMF said.
Write to Paul Hannon at paul.hannon@dowjones.com
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