IMF fears Fed tapering could 'reignite' euro debt crisis
The tapering of stimulus by the US Federal Reserve risks reigniting the eurozone debt crisis and pushing the weakest countries into a "debt-deflation spiral", the International Monetary Fund has warned.
"The macroeconomic environment continues to deteriorate," said the Fund in its annual `Article IV' health check on the eurozone.
"Recovery remains elusive. Growth has weakened further and unemployment is still rising, and the risks of prolonged stagnation and inflation undershooting are high. Mounting social and political tensions pose an increasing threat to reform momentum."
The report warned that the onset of a new tightening cycle in the US had already led to major spill-over effects in the eurozone, pushing up bond yields across the board.
Early tapering by the Fed "could lead to additional, and unhelpfu, pro-cyclical increases in borrowing costs within the euro area. This could further complicate the conduct of monetary policy and potentially damage area-wide demand and growth. Financial market stresses could also quickly reignite," it said.
The Fund said the European Central Bank must take countervailing action to prevent "a vicious circle setting in," ideally by cutting interests, introducing a negative deposit rate, and purchasing a targeted range of private assets.
It should launch "credit-easing" policies to alleviate the deepening lending crunch in Spain, Italy, and Portugal, where borrowing costs for firms are 200 to 300 basis points higher than in Germany, with small businesses struggling to raise any money at all. The IMF said the more the Fed tightens in the US, the more the European authorities need to offset this with other forms of stimulus.
The report came as fresh data from the ECB showed that loans to the private sector contracted by €46bn in June, after falling by €33nbn in May , and €28bn in April. The annual rate of contraction has accelerated to 1.6pc
The M3 broad money supply is also fizzling out, with growth dropping to 2.3pc year-on-year. There has been almost no growth in M3 since October 2012.
The money data tends to act as an early warning indicator for the economy a year or so ahead, and therefore casts doubt on recent claims by EU leaders that the crisis is over.
"Today's figures put serious question marks over the strength of the nascent recovery," said Martin van Vliet from ING. The data is at odds with the recent rebound in industrial output and rising PMI survey indexes for manufacturing.
The IMF said the eurozone economy would shrink by 0.6pc this year, the same as in 2012. It is expected to grow by 0.9pc next year but this will not be enough to make a dent on unemployment, and could easily be thrown off course by a fresh global shock.
"There is a high risk of stagnation, especially in the periphery. Such an outcome could push the periphery toward a debt-deflation spiral," it said.
The report said that it may take years to unwind the colossal credit boom of the early EMU years. "Historically, almost all of the run-up in household debt tends to be reversed. But in the euro area, the reduction in debt-to-GDP ratios has barely started, and the boom was more pronounced."
"Furthermore, in past deleveraging episodes, the debt reversal was largely facilitated by high inflation and growth, and supported by expansionary fiscal policy. Because these factors will not contribute much to the ongoing deleveraging process in the euro area periphery, the adjustment is likely to be protracted and have to rely more on reductions in nominal debt. The contrast with history is similarly sobering when it comes to corporate debt," said the Fund, adding that the EMU periphery has the daunting task of triple deleveraging by governments, households, and firms all at the same time.
The Fund said it is crucial that the eurozone deliver on pledges from a proper banking union and resolution fund capable of "swift decisions on burden sharing".
While polite in tone, the authors appear exasperated by "incomplete or stalled delivery of policy commitments" and seemingly endless foot-dragging by EMU leaders.
"The hurdle for reaching a collective agreement is always high. Moreover, building political support for such decisions can take considerable time, especially when they involve thorny issues such as burden-sharing or ceding national control. Hence, making swift progress on completing the banking union and moving toward greater fiscal integration are proving exceedingly difficult."
In a comment clearly aimed at Germany and the key creditor powers, the IMF said "unwavering political backing for institutional reforms remains critical and is in the interest of all EMU members."