The European debt crisis threatens to spill over to the U.S. and emerging markets, requiring a bigger financial firewall, more bank recapitalization and limits on bank deleveraging, the International Monetary Fund said.
While European policy makers have taken steps to contain the crisis, it still poses risks to U.S. stability and may spread to emerging markets beyond central and Eastern Europe, the IMF said. The U.S. in particular is at risk, including the direct exposure of banks, according to the IMF.
”The global financial system remains fragile,” Jose Vinals, the director of the IMF’s monetary and capital markets department, said today in Washington. “This makes it urgent to restore confidence in the euro area and beyond. Otherwise we run the risk of a deepening of the crisis with far reaching global economic and social consequences.”
Europe should build a larger “firewall” to contain the crisis, the IMF said in an update of its Global Financial Stability Report released today. It should create a monitor to ensure that “deleveraging plans are consistent with sustaining the flow of credit to support economic activity and to avoid a downward spiral in asset prices.”
The IMF suggested that the European Banking Authority, the European Systemic Risk Board, bank supervisors and banks themselves could help coordinate monitoring and limiting deleveraging in home countries and abroad.
Capital Injections
“While some deleveraging may be unavoidable, the way it is done makes a difference — there is a ‘good’ and ‘bad’ deleveraging,” the IMF said. It also recommended direct capital injections into banks in some cases.
The report follows a speech by IMF Managing Director Christine Lagarde yesterday in Berlin, where she urged European policy makers to increase their bailout fund and share fiscal risks.
Euro-area countries have been setting up financial arrangements designed to stop the crisis from spreading to countries outside the 17-nation region, a process known as constructing a “firewall.” Those structures include the European Stability Mechanism, known as the ESM, with a planned funding of 500 billion euros ($651 billion).
Without a bigger firewall, countries such as Italy and Spain could be forced “into a solvency crisis by abnormal financing costs,” Lagarde said in Berlin.
Strengthen ESM
”The firewall needs to be sufficiently large and convincingly built to avoid abnormally high funding costs for sovereigns’ index,” Vinals said. ”To do this it will be important to strengthen in advance work on the European Stability Mechanism, the ESM, as soon as possible.”
The IMF, which sees a potential financing need of $1 trillion globally in coming years, is seeking as much as $500 billion in new lending resources to play its part, Lagarde said.
The German government yesterday floated the idea of combining Europe’s two rescue funds to create a bigger firewall. Germany may be open to boosting the combined aid limit from 500 billion euros when a permanent fund runs alongside the temporary fund starting in July, government officials in Berlin said.
Germany, Europe’s dominant economic power, gave the strongest signal yet that it would allow the roughly 250 billion euros left in the temporary rescue fund to be tapped once the permanent fund is set up. Such a step would boost Europe’s unspent crisis-fighting capacity to around 750 billion euros. In addition, 150 billion euros would be pledged by euro-area central banks to the IMF.
Provide Liquidity
The IMF said it would be “highly desirable to increase the size and flexibility” of the funds as soon as possible. Until the larger firewall is established, the European Central Bank should continue the provide liquidity, it said.
The IMF recommended further recapitalization of banks through direct government measures. Public funding should be made available to banks as a backstop, given the challenges in accessing private capital, the IMF said. Some of the bank capital could be raised along with government injections, it said.
Further, the IMF said there needs to be a euro facility to take direct stakes in banks and bank guarantee plans to reopen the private markets. Yesterday, Lagarde called for the facility within the region to have the power to take direct stakes in banks to help end a “vicious cycle” between banks and sovereigns.
The Stoxx Europe 600 Index tumbled 11 percent last year, while the MSCI All-Country World Index slid 9.4 percent and the Standard & Poor’s 500 Index fell less than 0.1 percent. Banks led losses in equities in 2011, with European lenders falling 32 percent as a group and financial shares in the S&P 500 slumping 18 percent.
Euro-Area Contraction
The IMF today predicted that euro-area’s economy would contract 0.5 percent this year.
At the end of 2011, more than two-thirds of euro-area sovereign debt had credit-default swap spreads of more than 200 basis points, the IMF said.
The crisis is already showing signs of reaching the U.S. through funding strains in the broader economy with tight conditions for obtaining bank credit and money market funds scaling back credit to the euro banks. This is already demonstrated in the widening of interbank spreads in dollar markets since mid-2011 along with the widening of euro interbank spreads, the IMF said.
U.S. Susceptible
“The U.S. economy is susceptible to a range of shocks from the euro area, reflecting the close financial and trade integration extending across the Atlantic,” the IMF said. “Potential spillovers could include direct exposures of U.S. banks to euro area banks or the sale of U.S. assets by European banks.”
While emerging markets have been “resilient” to shocks, recent indicators and the general business climate have weakened, the IMF said. As credit channels become impaired, European banks could pull back cross-border lending.
Euro-area banks provide about 30 percent of trade and project finance in the Asia region, even though their balance sheets account for only 5 percent of bank assets, the IMF said.
By Cheyenne Hopkins – businessweek.com
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