Sovereign debt problems could spread and lead to a second credit crunch
The fund, which is funding around a third of the cost for the rescues of Greece, Ireland and Portugal, states: "Contagion to the core euro area, and then onwards to emerging Europe, remains a tangible downside risk."
In its latest Regional Outlook for Europe, the fund states: "Financial linkages between countries with sovereign debt troubles and the rest of Europe could potentially pose more risk to the outlook. Banks in the core countries of advanced Europe carry substantial exposure to the euro area periphery on their books, and a shock to confidence could spread quickly throughout Europe". As with the original credit crunch in 2007, that could trigger a further collapse in already fragile business and consumer confidence, itself adding to banks' bad debts and creating a "negative feedback loop". This time, though, the loop would be even harder to break as few European countries have much "fiscal headroom" to launch new stimulus packages or fund further sovereign bailouts or bank recapitalisations.
The European financial system remains highly vulnerable to systemic risk if the Greek and other government bonds owned by financial institutions, including the major banks, are devalued in any restructuring of sovereign debt, voluntary or otherwise. The intimate linkages between Europe's major banking groups – including the UK's – means that a crisis in Greece could soon prove a systemic risk to the entire continent, raising fears of a "second credit crunch".
The fund concludes: "Financial spillovers from sovereign debt problems remain a tangible risk. For this reason, it is urgent to implement agreed enhancements to the framework for crisis management in the euro area."
Looking forward to the EU-wide "stress tests" to be run by the European Commission in June, the IMF urges the European and national authorities to "deal with weak banks in a swift and effective manner" to "dispel lingering uncertainties about the overall health of the banking sector and the potential fiscal cost of propping them up". The stress tests "will only make a real difference if backed by a programme of recapitalisation, restructuring and resolution". At its Spring Meetings in Washington earlier this year, the IMF said that one third of Europe's banks were operating with inadequate capital.
Apart from Greece's own banks, those European banks with the highest exposure to Greek bonds are: BNP Paribas, Dexia, Commerzbank, SocGen, ING and RBS. The European Central Bank holds about 20 per cent of Greece's debt.
There is broad support for the UK Government's strategy to cut the budget deficit, but they add: "Despite some support from the depreciated pound and a rapid unfreezing of past investment decisions, stronger headwinds from a 'front-loaded' fiscal strategy and higher household debt levels will restrain growth somewhat". The IMF sees the British economy expanding by 1.7 per cent this year and 2.3 per cent in 2012.
The next stage in Europe's long-running debt crisis is a vote in the Finnish parliament today on the Portuguese rescue, without which it cannot go ahead. If, as is expected, the proposals survive that, then European finance ministers will meet next week to launch the Portuguese deal formally and, perhaps, to make fresh announcements on change to the Irish deal or further assistance to Greece. For Athens, markets would now be surprised if the country did not eventually organise a "voluntary restructuring", probably involving an extension of the maturities of its bonds. Some expect a "haircut" in bond values of 70 per cent.
Nonetheless, such a move would crystallise fears as well as losses, and could again spark a wave of panic in the debt and currency markets. Most observers agree that if Spain manages to escape infection the euro itself, for the time being, should be safe.
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