Europe has a leading role in international finance, with the EU ranking as the top investor in such countries as India and China.Major stock exchanges of Europe include those in Amsterdam, the Netherlands; Frankfurt, Germany; London; Paris; and Zurich, Switzerland. The London Bullion Market Association is the center of the world’s gold market, and Amsterdam is the center of the world’s diamond market. Frankfurt, the site of the European Central Bank, has become a major center for the European bond market.

 

Some of the world’s largest banks, which receive much foreign investment because they offer security and high rates of return, have their headquarters in France, Germany, Switzerland, and the United Kingdom. The spread of the euro has made such large banks even more important, as more and more international investors have acquired funds in euros.

 

Government plays a vital role in the economies of European countries, as it provides such public services as education, highway systems, and military protection. European central governments hence employ large numbers of people, and thereby regulate much of their countries’ economies.

 

 

The recession was even deeper than in the United States. The stabilisation of the financial sector and of the real economy were achieved through an armoury of measures including historically low interest rates, quantitative easing to increase liquidity in financial markets, targeted support to non-performing banks and large fiscal stimulus programmes, including subsidies for the purchase of new cars (similar to the United States’ cash for clunkers programme). Some European countries also introduced measures to mitigate the effect of the recession on the labour market by subsidising reductions in working hours per employee.

 

This led to labour hoarding, which helped to contain the increase in unemployment during 2009 but could lead to rising unemployment in 2010. Similar to that in the United States, the recovery in Europe has so far mainly been driven by fiscal programmes, which supported infrastructure investment and private consumption. Consumers also benefited from the lowering of the inflation rate to close to zero. Exports were another driving force and started to increase again in some European countries despite the relatively strong euro exchange rate. In the euro area, GDP declined in 2009 by 4% and

is expected to increase by only about 1% in 2010 and by less than 2% in 2011.

 

In some European countries such as Spain, Greece, Ireland and the three Baltic countries Lithuania, Estonia and Latvia, the recession has been most severe. In Lithuania, Estonia and Latvia, which are not members of the euro area, GDP declined on average by 16%, and is likely to continue falling in 2010. Positive growth is expected only by 2011. In Greece, the risk premium has significantly increased owing to fears of sovereign insolvency; the government has been forced to take harsh austerity measures to prevent insolvency.

 

Among the hardest hit during the global crisis, Europe is coming out of recession at a slower pace than other regions. Within both advanced and emerging Europe, country experiences and recovery prospects vary considerably. A substantial macroeconomic stimulus has supported the recovery in core advanced European economies, although private demand has yet to take a fi rm hold. At the same time, large current account and fiscal imbalances threaten the recovery in some smaller European countries, with potentially damaging effects on the rest of the region.
Having entered the crisis with substantial imbalances, Europe suff ered greatly. Among the worst performers were advanced and emerging European economies that had experienced large current account defi cits and domestic imbalances. External financing constraints forced a sharp decline in output in some emerging European economies, particularly those with large current account defi cits and heavy dependence on foreign fi nancing (for example, Baltics, Bulgaria, Romania). The reversal of construction and credit booms, accompanied by banking sector problems, led to an output collapse in some euro area countries. Substantial output losses, costly crisis-related measures, and one-time factors led to very large fi scal defi cits in a number of countries (for example, Greece, Ireland, Lithuania, Portugal, Spain, United Kingdom). And although current account imbalances have adjusted in many emerging European countries, they remain substantial (and diffi cult to unwind) in a number of euro area countries that cannot use currency depreciation as a mechanism to improve competitiveness.

 

There are several powerful forces holding back the recovery in Europe. Sizable fi scal and current account imbalances are constraining recovery in several euro area countries, with potentially negative spillover eff ects to the rest of Europe. Indeed, concerns about sovereign solvency and liquidity in Greece (and possible contagion eff ects on other vulnerable euro area countries) have threatened the normalization in fi nancial market conditions. Separately, unresolved problems in the banking sector, which plays a key role in fi nancial intermediation in Europe, have hampered the return to normality. In addition, remaining external fi nancing constraints, vulnerable household and corporate balance sheets, and fi nancial sector deleveraging have limited the speed of the recovery in the hardest-hit economies in emerging Europe.

 

Nevertheless, the ongoing recovery in Europe has been supported by several factors. First, the turn in the inventory cycle boosted activity in the euro area during the second half of 2009. Second, the normalization of global trade has contributed signifi cantly to growth in the euro area and in emerging Europe.

 

Third , forceful policies have also fostered recovery, including supportive macroeconomic and financial sector measures for many European economies and coordinated assistance from multilateral institutions for the hardest-hit economies in the region.

 

Against this backdrop, Europe’s growth performance is expected to be modest. In particular, advanced Europe’s GDP is projected to grow at 1 percent in 2010, edging up to 1¾ percent in 2011. Emerging Europe’s growth in real activity is expected to be 3 percent in 2010, picking up to 3½ percent in 2011. ese aggregate projections, however, do not capture the pronounced diff erences in outlook across the region In advanced Europe, recovery is projected to be gradual and uneven among euro area countries.

 

Specifically, euro-area-wide GDP is expected to grow at 1 percent in 2010 and 1½ percent in 2011. The recovery is expected to be moderate in Germany and France, where export growth is limited by external demand, investment is held back by excess capacity and credit constraints, and consumption is tempered by higher unemployment.

 

Coming out even more slowly from the recession will be smaller euro area economies, where growth is constrained by large fiscal or current account imbalances (Greece, Ireland, Portugal, Spain). Outside the euro area, the prospects for recovery in advanced Europe are similarly diverse. In the United Kingdom, the recovery is projected to continue at a moderate pace, with previous sterling depreciation bolstering net exports even as domestic demand likely remains subdued.

 

• In emerging Europe, growth prospects also vary widely. Economies that weathered the global crisis relatively well (Poland) and others where domestic confidence has already recovered from the initial external shock (Turkey) are projected to rebound more strongly, helped by the return of capital flows and the normalization of global trade. At the same time, economies that faced the crisis with unsustainable domestic booms that had fueled excessively large current account deficits (Bulgaria, Latvia, Lithuania) and those with vulnerable private or public sector balance sheets (Hungary, Romania, Baltics) are expected to recover more slowly, partly as a result of limited room for policy maneuvers.
The uncertainty around the outlook in Europe has increased since the October 2009 WEO, with two downside risks becoming more pronounced. In the near term, the main risk is that, if unchecked, market concerns about sovereign liquidity and solvency in Greece could turn into a full-blown sovereign debt crisis, leading to some contagion (see Chapter 1 of the April 2010 GFSR). This reinforces the importance of eff orts by the Greek authorities to reestablish the credibility of their fi scal policy. The financial support package agreed upon by euro area countries, the European Commission, and the European Central Bank to be provided if necessary is a welcome and important step to ensure that jitters about Greece do not lead to fi nancial instability or create signifi cant adverse eff ects on balance sheets and banking systems in Europe. A second downside risk lies in the need to adjust fi scal and current account imbalances in peripheral economies.

 

Although resolving these imbalances is expected to dampen growth, delays in taking decisive policy action could lead to a protracted process punctuated with occasional crises. Regarding fi scal policy, the priority is to make credible commitments to debt sustainability while proceeding with planned stimulus measures in 2010 where this is feasible. In some cases, large defi cits need to be reversed promptly to address concerns about debt sustainability (Greece, Ireland, Portugal, Spain). However, in core euro area economies where fiscal sustainability is not in question (Germany), the current plans to execute stimulus measures in full remain appropriate. Outside the euro area, several economies have already undertaken early consolidation (Hungary, Iceland, Latvia, Turkey).

 

Across most European economies, however, the key fiscal challenge will be to commit, prepare, and communicate credible plans for fi scal consolidation. These should involve moving to suffi ciently high primary surpluses in order to place public debt on a stabilizing and, eventually, declining path.
Monetary policy should remain highly accommodative in most cases. Recovery prospects are still sluggish, and so infl ation pressures remain subdued. Indeed, in advanced Europe, core infl ation is projected to remain low and stable (about 1 percent in the euro area), as infl ation expectations are well anchored. Hence, in the euro area, it is appropriate to keep interest rates exceptionally low and to withdraw quantitative measures and unwind collateral requirement changes very gradually. This will help support the recovery in core economies while facilitating fi scal and realeconomy adjustments in peripheral economies. In emerging Europe, infl ation prospects are generally contained but more diff erentiated, owing to the variation in exchange rate regimes and output-recovery prospects across these economies. In most of these countries (with flexible exchange rate regimes and independent monetary policy), central banks could also afford to keep interest rates relatively low in the near term in order to support activity.

 

Another key policy challenge relates to Europe’s financial sector. To the extent that they remain unresolved, banking sector issues will likely hamper the credit supply (see Chapter 1 of the April 2010 GFSR). These include the need for continued deleveraging to rebuild liquidity and capital buffers, the uncertainty about future bank restructuring, and the need to absorb additional writedowns.

 

Moreover, growing sovereign risk poses another challenge for fi nancial systems in Europe. These issues call for completion of the restructuring and recapitalization of vulnerable financial institutions, stabilizing funding, and reevaluating bank models. In many ways, the most important task ahead is to strengthen EU policy frameworks to promote better adjustment mechanisms in good times and bad. The global crisis and its ripple eff ects have exposed weaknesses in existing policy arrangements on various fronts that need to be corrected to ensure Europe’s future fi nancial stability and growth.
• A reformed fiscal framework should incorporate a better mechanism for preventing and resolving fiscal imbalances. It could move in the direction of common fiscal rules and should include close monitoring of fiscal policies and public balance sheets.

 

• A stronger structural policy framework would help economies raise productivity, improve competitiveness, and reduce imbalances. Major amendments to the EU 2020 Agenda will be necessary to ensure its credible and effective delivery. A workable strategy rather than a focus on rigid targets should be at its core, which will require moving beyond the open method of coordination.

 

• Finally, given the cross-border nature of many European financial institutions and the potential for large spillovers across countries within the region, there is a strong case for an improved financial framework. The proposed new supervisory and regulatory structure should be put in place as planned and complemented with further work on an integrated crisis-prevention, -management, and -resolution mechanism .