Commodity Price Shocks and Financial Turbulence: Implications for Europe Luc Everaert

European DepartmentEU Policies/Regional Studies

1

Commodity Price Shocks and Commodity Price Shocks and Financial Turbulence: Implications Financial Turbulence: Implications

for Europefor Europe

Luc Everaert

September 25, 2008

39th CMTEA Conference


2

OutlineOutline

• Commodity prices: lower growth and high inflation Commodity prices: lower growth and high inflation – Growth and real wages need to slowGrowth and real wages need to slow– Core inflation need not increaseCore inflation need not increase– Inflation risks depend on labor market flexibility and policy Inflation risks depend on labor market flexibility and policy

credibilitycredibility• Financial turbulence: drag on growth with downside risksFinancial turbulence: drag on growth with downside risks

– Significant impact through various channels, but no systemic Significant impact through various channels, but no systemic breakdown, owing to policy interventionbreakdown, owing to policy intervention

– Impact differs across countries, depending on levels of debt, Impact differs across countries, depending on levels of debt, external imbalances, quality of policy frameworks and policies, external imbalances, quality of policy frameworks and policies, degree of financial integration and type of financial systemdegree of financial integration and type of financial system

– Real effects manageable, but credit crunch poses downside risk Real effects manageable, but credit crunch poses downside risk • Economic Outlook and Policy ImplicationsEconomic Outlook and Policy Implications


3

Commodity Price IncreasesCommodity Price Increases

• Developments and outlookDevelopments and outlook• Impact on supply and demandImpact on supply and demand• Impact on inflationImpact on inflation• Potential for wage-price spirals:Potential for wage-price spirals:

– Advanced economies: Advanced economies: • Real wages are adjusting to oil price shock;Real wages are adjusting to oil price shock;• But food prices are a concern;But food prices are a concern;• Policy credibility will be key to keep/bring inflation expectations to Policy credibility will be key to keep/bring inflation expectations to

targettarget

– Emerging economies:Emerging economies:• Higher inflation risks as shock and pass-through to core are Higher inflation risks as shock and pass-through to core are

stronger, overheating already present, and track record for credible stronger, overheating already present, and track record for credible policies shorterpolicies shorter

– Policies need to address wage resistance Policies need to address wage resistance


4

Following their recent sharp increase, commodity prices are likely to stabilize at an elevated level

Oil, Food, Metal Prices (Index 2005=100)

0

50

100

150

200

250

2000Q1

2000Q4

2001Q3

2002Q2

2003Q1

2003Q4

2004Q3

2005Q2

2006Q1

2006Q4

2007Q3

2008Q2

2009Q1

2009Q4

2010Q3

Crude Oil (simple average of three spot prices; Dated Brent, West Texas Intermediate, and the Dubai Fateh)

Food Price Index (Cereal, Vegetable Oils, Meat, Seafood, Sugar, Bananas, and Oranges)

Metals (Copper, Aluminum, Iron Ore, Tin, Nickel, Zinc, Lead, and Uranium)

Projections


5

Energy intensity

determines

supply effects

of oil price

increases

GERMANY

POLAND

RUSSIA

FINLANDSWEDEN

NETHERLANDS

BELGIUM

DENMARK

UKRAINE

FRANCE

IRELAND

CZECH REPUBLIC

AUSTRIA

LUX.

BELARUSUNITED

KINGDOM

BULGARIA

ALBANIA

GREECE

TURKEY

SWITZ.

ICELAND

HERZEGOVINA

SLOVENIA

NORWAY

MOLDOVASLOVAKIA

LITHUANIA

LATVIA

ESTONIA

ROMANIAHUNGARY

SPAIN

MACED.

PORTUGAL

MALTA

ITALYBOSNIA AND SERBIA

CROATIA

MONTENEGRO

RUSSIA

GREECE

Energy intensity of production (TPES/GDP)

>0.39

0.20-0.29

0.15-0.19

<0.15

data unavailable

KOSOVO

1/ Source: International Energy Agency.

GERMANY

POLAND

RUSSIA

FINLANDSWEDEN

NETHERLANDS

BELGIUM

DENMARK

UKRAINE

FRANCE

IRELAND

CZECH REPUBLIC

AUSTRIA

LUX.

BELARUSUNITED

KINGDOM

BULGARIA

ALBANIA

GREECE

TURKEY

SWITZ.

ICELAND

HERZEGOVINA

SLOVENIA

NORWAY

MOLDOVASLOVAKIA

LITHUANIA

LATVIA

ESTONIA

ROMANIAHUNGARY

SPAIN

MACED.

PORTUGAL

MALTA


CROATIA

MONTENEGRO

RUSSIA

GREECE

Energy intensity of production (TPES/GDP)

>0.39

0.20-0.29

0.15-0.19

<0.15

data unavailable

KOSOVO

1/ Source: International Energy Agency.


6

Terms of trade shocks determine impact on demand; the Baltic countries and southeastern Europe are likely to suffer most

GERMANY

POLAND

RUSSIA

FINLANDSWEDEN

NETHERLANDS

BELGIUM

DENMARK

UKRAINE

FRANCE

IRELAND

CZECH REPUBLIC

AUSTRIA

LUX.

BELARUSUNITED

KINGDOM

BULGARIA

ALBANIA

GREECE

TURKEY

SWITZ.

ICELAND

HERZEGOVINA

SLOVENIA

NORWAY

MOLDOVASLOVAKIA

LITHUANIA

LATVIA

ESTONIA

ROMANIAHUNGARY

SPAIN

MACED.

PORTUGAL

MALTA


CROATIA

MONTENEGRO

RUSSIA

GREECE

Impact of food and oil prices on trade balances 1/

deficit of > 5 percent

deficit of < 5 percent

surplus of < 5 percent

surplus of > 5 percent

data unavailable

KOSOVO

1/ Average food and fuel trade balance in 2006-07, in percent of GDP.

GERMANY

POLAND

RUSSIA

FINLANDSWEDEN

NETHERLANDS

BELGIUM

DENMARK

UKRAINE

FRANCE

IRELAND

CZECH REPUBLIC

AUSTRIA

LUX.

BELARUSUNITED

KINGDOM

BULGARIA

ALBANIA

GREECE

TURKEY

SWITZ.

ICELAND

HERZEGOVINA

SLOVENIA

NORWAY

MOLDOVASLOVAKIA

LITHUANIA

LATVIA

ESTONIA

ROMANIAHUNGARY

SPAIN

MACED.

PORTUGAL

MALTA


CROATIA

MONTENEGRO

RUSSIA

GREECE

Impact of food and oil prices on trade balances 1/

deficit of > 5 percent

deficit of < 5 percent

surplus of < 5 percent

surplus of > 5 percent

data unavailable

KOSOVO

1/ Average food and fuel trade balance in 2006-07, in percent of GDP.


7

GERMANY

POLAND

RUSSIA

FINLANDSWEDEN

NETHERLANDS

BELGIUM

DENMARK

UKRAINE

FRANCE

IRELAND

CZECH REPUBLIC

AUSTRIA

LUX.

BELARUSUNITED

KINGDOM

BULGARIA

ALBANIA

GREECE

TURKEY

SWITZ.

ICELAND

HERZEGOVINA

SLOVENIA

NORWAY

MOLDOVASLOVAKIA

LITHUANIA

LATVIA

ESTONIA

ROMANIAHUNGARY

SPAIN

MACED.

PORTUGAL

MALTA


CROATIA

MONTENEGRO

RUSSIA

GREECE

Contribution of food price increases to inflation (percentage points)

> 5 percent

2-4.99 percent

1-1.99 percent< 1 percent

data unavailable

KOSOVO

1/ Cumulative in the year to 2008Q2.

GERMANY

POLAND

RUSSIA

FINLANDSWEDEN

NETHERLANDS

BELGIUM

DENMARK

UKRAINE

FRANCE

IRELAND

CZECH REPUBLIC

AUSTRIA

LUX.

BELARUSUNITED

KINGDOM

BULGARIA

ALBANIA

GREECE

TURKEY

SWITZ.

ICELAND

HERZEGOVINA

SLOVENIA

NORWAY

MOLDOVASLOVAKIA

LITHUANIA

LATVIA

ESTONIA

ROMANIAHUNGARY

SPAIN

MACED.

PORTUGAL

MALTA


CROATIA

MONTENEGRO

RUSSIA

GREECE

Contribution of food price increases to inflation (percentage points)

> 5 percent

2-4.99 percent

1-1.99 percent< 1 percent

data unavailable

KOSOVO


Food price increases have a sizeable impact, with Eastern Europe more affected


8

GERMANY

POLAND

RUSSIA

FINLANDSWEDEN

NETHERLANDS

BELGIUM

DENMARK

UKRAINE

FRANCE

IRELAND

CZECH REPUBLIC

AUSTRIA

LUX.

BELARUSUNITED

KINGDOM

BULGARIA

ALBANIA

GREECE

TURKEY

SWITZ.

ICELAND

HERZEGOVINA

SLOVENIA

NORWAY

MOLDOVASLOVAKIA

LITHUANIA

LATVIA

ESTONIA

ROMANIAHUNGARY

SPAIN

MACED.

PORTUGAL

MALTA


CROATIA

MONTENEGRO

RUSSIA

GREECE

Contribution of oil price increases to inflation (percentage points)

> 5 percent

2-4.99 percent

1-1.99 percent

< 1 percent

data unavailable

KOSOVO


GERMANY

POLAND

RUSSIA

FINLANDSWEDEN

NETHERLANDS

BELGIUM

DENMARK

UKRAINE

FRANCE

IRELAND

CZECH REPUBLIC

AUSTRIA

LUX.

BELARUSUNITED

KINGDOM

BULGARIA

ALBANIA

GREECE

TURKEY

SWITZ.

ICELAND

HERZEGOVINA

SLOVENIA

NORWAY

MOLDOVASLOVAKIA

LITHUANIA

LATVIA

ESTONIA

ROMANIAHUNGARY

SPAIN

MACED.

PORTUGAL

MALTA


CROATIA

MONTENEGRO

RUSSIA

GREECE

Contribution of oil price increases to inflation (percentage points)

> 5 percent

2-4.99 percent

1-1.99 percent

< 1 percent

data unavailable

KOSOVO


The impact of oil prices is smaller, without clear regional bias


9

Advanced economies: oil prices are unlikely to cause second-round effects as wages are not moving up with energy prices

Pre 1986:2 Post 1986:2 Pre 1986:2 Post 1986:2 Pre 1986:2 Post 1986:2

Austria 0.32 0.91 ... 0.03 ... ...Belgium 0.86 1.06 ... ... ...Denmark 0.84 0.98 ... 0.1 0.08Finland 0.93 0.92 0.17 0.05 0.24 ...France 0.58 0.95 0.15 0.08 0.13 ...Germany 0.84 0.73 ... 0.05 ... ...Sweden 0.68 0.41 0.06 ... ...United Kingdom 0.35 0.81 0.24 0.09 0.16 0.01

Note: Impulse responses to a 10 percentage points shock to oil prices inflation. Results are reported only for responses that are significant at the 90% level.

Headline inflation Core inflationEnergy inflation

Inflation response to an oil price shock (Peak response within the first 6 months)


10

But food price increases have recently had a tendency to show up in core inflation

Food inflation Headline inflation Core inflation

Pre 1996:5 Post 1996:5 Pre 1996:5 Post 1996:5 Pre 1996:5 Post 1996:5

Austria - 1.58 - 0.19 - 0.16Belgium 0.50 0.57 - -Finland - 0.99 - -France - 0.86 - 0.40 - 0.19Germany - 1.28 - 0.44 - 0.50Greece - 2.10 0.48 0.62 -Italy - 0.52 - 0.12 - 0.08Sweden 0.28 0.58 - 0.26 - 0.46United Kingdom 0.22 0.96 - 0.24 - 0.27

Note: Impulse responses to a 10 percentage points increase shock to world food price inflation. Results reported only for responses that are significant at the 90% level.

Inflation response to a world food price shock (Peak response within the first 6 months)


11

Policy credibility is key to keeping inflation expectations in line with targets

Inflation Expectations in the Euro Area and the United Kingdom

Sources: Bloomberg; ECB; Haver Analytics; and IMF staffcalculations and forecasts.

1

2

3

4

5

6

2001 2002 2003 2004 2005 2006 2007 2008

0

10

20

30

40

Euro area 10-year break-even inflationrate (daily, left scale)

UK 10-year forward RPI inflationexpectations, derived from gilts (dailydata, left scale)Euro area consumer inflationexpectations (monthly, right scale) 1/


12

Emerging economies face more significant inflation pressures

Response of Core Inflation to Shocks to Domestic Food and EnergyPrice Inflation 1/ 2/(Percentage points)

Domestic food price Domestic energy price inflation shock 3/ inflation shock 3/

Bulgaria 0.6 -Czech rep. 1.4 -Estonia 1.3 -Latvia 1.2 -Lithuania 2.4 1.2Macedonia 1.2 0.5Romania 3.0 -Serbia 0.7Slovenia 2.5 -Turkey 2.7Ukraine 1.0

1/ Results are reported only when significant at 95 percent level. 2/ 10 percentage points increase in domestic food and energy price inflation. 3/ Maximum response within 12 months.


13

As core inflation and inflation expectations have drifted upward

Core inflation (12-month percent change) 1/(Year-on-year, percent)

Sources: 1/ Baltics: Estonia, Latvia, and Lithuania; other NMS: the Czech Republic, Hungary, Poland, Slovak Republic, Bulgaria, Romania, and Slovenia; SEE: Albania, Bosnia and Herzegovina, Croatia, Macedonia, Montenegro, and Serbia.

0

2

4

6

8

10

12

14

16

Jan

-04

Apr

-04

Jul-

04

Oct

-04

Jan

-05

Apr

-05

Jul-

05

Oct

-05

Jan

-06

Apr

-06

Jul-

06

Oct

-06

Jan

-07

Apr

-07

Jul-

07

Oct

-07

Jan

-08

0

2

4

6

8

10

12

14

16Baltics

Other NMS

CIS

SEE

Sources: National authorities; and Consensus Economics.

Inflation Expectations 12-month Ahead(Percent)

0

2

4

6

8

10

12

14

16

18

Jan

-05

Apr

-05

Jul-

05

Oct

-05

Jan

-06

Apr

-06

Jul-

06

Oct

-06

Jan

-07

Apr

-07

Jul-

07

Oct

-07

Jan

-08

Apr

-08

Jul-

08

0

2

4

6

8

10

12

14

16

18

Turkey

Russia

Poland

Czech Rep.

Ukraine


14

Wage resistance and policy attempts to sustain output are likely to aggravate the downturn

Wage Resistence and Policy Drift (Percentage points deviation from baseline)

Source: GEM simulations. Notes: Solid - energy sector supply shock; dotted - supply shock with temporary wage resistence; and dashed - temporary wage resistanceand a policy drift.

-2

-1

0

1

2

1 5 10 15

-2

-1

0

1

2Real GDP

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

1 5 10 15

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3CPI Inflation (y-o-y)

-1.0

-0.5

0.0

0.5

1.0

1 5 10 15

-1.0

-0.5

0.0

0.5

1.0Real Wage

-0.5

0.0

0.5

1 5 10 15

-0.5

0.0

0.5Nominal Interest Rate


15

Financial Turbulence: Channels of ImpactFinancial Turbulence: Channels of Impact

• Global risk repricing • Lower equity values • Tighter lending standards


16

Risk has been re-priced Risk has been re-priced

Estimating Shifts in the Global Price of Risk, 2007–08 1/ (Basis points, 50 and 90 percent confidence intervals)

-600

-400

-200

0

200

400

600

800Ja

n-0

7F

eb-0

7M

ar-

07

Apr

-07

Ma

y-07

Ma

y-07

Jun

-07

Jul-

07

Aug

-07

Sep

-07

Oct

-07

No

v-07

De

c-07

Jan

-08

Feb

-08

Ma

r-0

8A

pr-0

8M

ay-

08Ju

n-0

8Ju

l-0

8A

ug-0

8

-600

-400

-200

0

200

400

600

800

July 17, 2007–extent of Bear Stearns damage revealed

August 9, 2007– BNP Paribas' funds suspension

September 8, 2007– preannounced shift in Fed's policy

March 10, 2008 –liquidity problems at Bear Stearns

September 2008 –GSE bailout Lehman trouble


17

Equity prices have declined Equity prices have declined

60.0

70.0

80.0

90.0

100.0

110.0

120.0

130.0

1/1/

2007

3/1/

2007

5/1/

2007

7/1/

2007

9/1/

2007

11/1

/200

7

1/1/

2008

3/1/

2008

5/1/

2008

7/1/

2008

9/1/

2008

FranceGermanyItalyEuroStoxxFTSES&P500Switzerland 40

60

80

100

120

140

160

180

1/1/

2007

3/1/

2007

5/1/

2007

7/1/

2007

9/1/

2007

11/1

/200

7

1/1/

2008

3/1/

2008

5/1/

2008

7/1/

2008

9/1/

2008

Czech Republic

Hungary

Poland

Bulgaria

Romania

40

60

80

100

120

140

160

180

1/1/

2007

3/1/

2007

5/1/

2007

7/1/

2007

9/1/

2007

11/1

/200

7

1/1/

2008

3/1/

2008

5/1/

2008

7/1/

2008

9/1/

2008

Estonia

Latvia

Lithuania

Croatia40

90

140

190

240

290

1/1/

2007

3/1/

2007

5/1/

2007

7/1/

2007

9/1/

2007

11/1/

2007

1/1/

2008

3/1/

2008

5/1/

2008

7/1/

2008

9/1/

2008

SerbiaRussiaTurkey Ukraine


18

Lending standards have tightened, and lending to household has slowedLending standards have tightened, and lending to household has slowedbut corporate lending continues in the euro area but corporate lending continues in the euro area

Changes in lending standards2005Q1-2008Q2 1/

-30

-20

-10

0

10

20

30

40

50

60

2005

Q1

2005

Q2

2005

Q3

2005

Q4

2006

Q1

2006

Q2

2006

Q3

2006

Q4

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

Households

Enterprises

Source: European Central Bank

Loans to enterprises and households (2000Jan-2008June, year-over-year percent change)

0

2

4

6

8

10

12

14

16

EnterprisesHouseholds


19

Money markets remain stressedMoney markets remain stressed

-20

0

20

40

60

80

100

120

140

160

Jul-

07

Au

g-0

7

Se

p-0

7

Oct

-07

No

v-0

7

De

c-0

7

Jan

-08

Fe

b-0

8

Ma

r-0

8

Ap

r-0

8

Ma

y-0

8

Jun

-08

Jul-

08

Au

g-0

8

Se

p-0

8

-20

0

20

40

60

80

100

120

140

160

U.S. dollarPound sterling

Euro

Source: Bloomberg L.P.

Figure 4. Spreads of Three-Month Interbank Rates over Expected Policy Rates, 2007–08(Basis points)


20

A direct confidence channel?Headlines in FT of September 22, 2008

Negative tone• Fears emerge over $700 billion Fears emerge over $700 billion

rescuerescue• Oil price jumps $25 dollar in a dayOil price jumps $25 dollar in a day• Regulators step up curbs on Regulators step up curbs on

shortingshorting• Lehman bondholders face losses Lehman bondholders face losses

of $110 billionof $110 billion• Money market funds suffer large Money market funds suffer large

outflowsoutflows• Freddie and Fannie bank losses Freddie and Fannie bank losses

growgrow• Fed acts to protect Goldman, Fed acts to protect Goldman,

Morgan StanleyMorgan Stanley• Pressure builds on Wamu to reach Pressure builds on Wamu to reach

dealdeal• Heavy losses for regional banks Heavy losses for regional banks

amid growing skepticismamid growing skepticism• Libor rates show that banks are Libor rates show that banks are

still protecting their cashstill protecting their cash

Positive tone• Fed action proves positive for Fed action proves positive for

ABSABS


21

Financial Turbulence: Factors Affecting Impact Financial Turbulence: Factors Affecting Impact Across CountriesAcross Countries

• Advanced economies: public debt and quality of Advanced economies: public debt and quality of policies policies

• Emerging economies: external imbalances, Emerging economies: external imbalances, credibility of policy frameworks and quality of credibility of policy frameworks and quality of policiespolicies

• Financial integration with the U.S.Financial integration with the U.S.• Mortgage market features Mortgage market features • Procyclicality of corporate leverage Procyclicality of corporate leverage


22

Advanced economies: spreads depend on levels of debt and the quality of macroeconomic policies

Public Debt (percent of GDP)

0

20

40

60

80

100

120

Spain Portugal France Belgium Italy

Sovereign Spreads in Euro Area(10-year , over Germany)

0

10

20

30

40

50

60

70

80

1/1/

2007

2/1/

2007

3/1/

2007

4/1/

2007

5/1/

2007

6/1/

2007

7/1/

2007

8/1/

2007

9/1/

2007

10/1

/200

7

11/1

/200

7

12/1

/200

7

1/1/

2008

2/1/

2008

3/1/

2008

4/1/

2008

5/1/

2008

6/1/

2008

7/1/

2008

8/1/

2008

9/1/

2008

Italy

Spain

Belgium

France

Portugal


23

Emerging economies: investors differentiate based on external imbalances, credibility of policy frameworks, and quality of policies

EMBI Global Bond Spreadsbasis points

0

100

200

300

400

500

600

700

Bulgaria Hungary Poland Russia Serbia Turkey Ukraine EMBI Global

24-Jul-07 23-Jun-08 5-Sep-08


24

Financial integration determines size of spillovers from U.S.

Response to One Standard Error Decline in US Equity Prices

Real equity prices

-16

-14

-12

-10

-8

-6

-4

-2

0

0 2 4 6 8 10 12 14 16 18 20 22 24

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

Central-Eastern EuropeBaltic CountriesSouth-Eastern European CountriesEuro AreaOther Advanced European EconomiesUnited States


25

Mortgage market features define magnitude of house price fluctuations

Source: Haver Analytics Source: Haver Analytics

Residential Real Estate Prices (2004Q1=100)

100

110

120

130

140

150

160

2004

- Q1

2004

- Q3

2005

- Q1

2005

- Q3

2006

- Q1

2006

- Q3

2007

- Q1

2007

- Q3

2008

- Q1

France

Spain

Ireland

United Kingdom

Residential Real Estate Prices (2004Q1=100)

100

150

200

250

300

350

400

450

2004

- Q1

2004

- Q3

2005

- Q1

2005

- Q3

2006

- Q1

2006

- Q3

2007

- Q1

2007

- Q3

2008

- Q1

Estonia

Latvia

Lithuania


26

Procyclical leverage boosts the volatility of investment

Procyclicality of Leverage and Macroeconomic Volatility

PL

SI

HR

LT

HU

LV

EE

SK

CZ

RU

BGTR

ES

PTIE

GR

FICH SE

NO

NL ITDE

FR

DK

BE

AT

UKUS

0

1

2

3

4

-1.0 -0.5 0.0 0.5

0

1

2

3

4

Correlation between changes in leverage and changes in real GDP

Vo

latil

ity o

f in

vest

me

nt

(in

co

ntr

ibu

tion

to

gro

wth

)


27

Financial Turbulence: Real Effects Financial Turbulence: Real Effects • Significant reduction in growth: Significant reduction in growth:

– relatively more important for advanced economiesrelatively more important for advanced economies– and stronger in cases where a negative feedback loop with and stronger in cases where a negative feedback loop with housing prices exist;housing prices exist;

• Further downside potential:Further downside potential:

– if bank capital is impaired and/or deleveraging is needed;if bank capital is impaired and/or deleveraging is needed;– if a mutually reinforcing deterioration of financial and economic if a mutually reinforcing deterioration of financial and economic conditions developsconditions develops


28

Higher borrowing cost and falling asset prices take a toll on growthHigher borrowing cost and falling asset prices take a toll on growth

Other Advanced New United European EU Member United

Euro Area 1/ Kingdom Economies 2/ States 3/ States

100-basis-point increase in corporate spreads for two years in all advanced economies

2008 -0.3 -0.3 -0.1 -0.1 -0.22009 -0.4 -0.4 -0.2 -0.2 -0.3

15 percent decline in equity prices for one year in advanced and emerging economies

2008 -0.2 -0.2 -0.2 -0.4 -0.42009 -0.1 0.0 0.0 -0.1 0.0

House prices decline in United States, United Kingdom, Spain, and Ireland

2008 -0.1 -0.5 -0.1 -0.2 -0.52009 -0.3 -0.8 -0.2 -0.2 -1.1

Source: IMF staff estimates. 1/ Excluding Cyprus and Malta. 2/ Denmark, Norway, Sweden, and Switzerland. 3/ Bulgaria, Estonia, the Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, and the Slovak Republic.

Output Response to Financial Shocks: Simulation Results(Real GDP percent deviations compared with a no-shock scenario)


29

Markets are concerned about the viability of financial institutions Markets are concerned about the viability of financial institutions

0

100

200

300

400

500

600

700

800

900

1000

Jan-

07M

ar-0

7A

pr-0

7M

ay-0

7Ju

n-07

Jul-0

7A

ug-0

7S

ep-0

7O

ct-0

7N

ov-0

7D

ec-0

7Ja

n-08

Feb

-08

Mar

-08

Apr

-08

May

-08

Jun-

08Ju

l-08

Aug

-08

Sep

-08

0

100

200

300

400

500

600

700

800

900

1000U.S., 90th percentile

EU, 90th percentile

EU, 50th percentile

U.S., 50th percentile

Implied Credit Default Swap Spreads, 2007–08(Basis points)

Source: Moody's KMV; and IMF staff calculations. 1/ EICDS = expected-default-frequency-implied (EDF-implied) credit default swap spread. 2/ Median of sample at each point in time. 3/ 10 percent worst banks at each point in time.

European Banks: Market Evaluation of Assets in Distress

0

10

20

30

40

50

60

70

80

90

100

0.00 0.05 0.10 0.15 0.20 0.25 0.30

March 31, 2008

December 31, 2007

January 31, 2007

September 9, 2008

Default probability

Cum

ula

tive

ass

ets

(p

erce

nt)


30

Deleveraging to repair balance sheets could cut growth further Deleveraging to repair balance sheets could cut growth further

>Bank capital is being impaired by losses on subprime assets and rising delinquencies associated with economic slowdown

Example: euro area. Bank losses on subprime assets of U$50 billion are equivalent to 2 percent of bank capital; at constant leverage leading to a credit contraction of 2 percent, with an estimated negative impact on GDP 0.2 percent. However, banks have raised capital to offset the losses, though not fully.

>Markets are pressuring banks to delever; i.e. increase the capital to non-weighted assets ratio

This ratio is less than 3 percent in continental Europe (more than 5 percent in U.S.). Projections suggests an increase to 3 and ¾ percent, leading to a sharp and protracted slowdown in credit growth


31

Economic Outlook and Policy ImplicationsEconomic Outlook and Policy Implications

• Slower growth with gradual recovery and varying inflationSlower growth with gradual recovery and varying inflation– Growth below potential, with sharp slowdown in some emerging Growth below potential, with sharp slowdown in some emerging

economieseconomies– Advanced economies stagnating before gradual recoveryAdvanced economies stagnating before gradual recovery– Inflation likely to recede in advanced economies but remain high Inflation likely to recede in advanced economies but remain high

in most emerging economiesin most emerging economies• Risks tilted unfavorablyRisks tilted unfavorably

– Output: downside from financial turmoil Output: downside from financial turmoil – Inflation: upside from wage-price spiral (especially in emerging Inflation: upside from wage-price spiral (especially in emerging

economies)economies)• Policy response: monetary, fiscal, and financial sector policesPolicy response: monetary, fiscal, and financial sector polices

– Adjusted to country specific circumstances, balancing output and Adjusted to country specific circumstances, balancing output and inflation risksinflation risks

– Contingency plans needed for financial turmoil related risksContingency plans needed for financial turmoil related risks


32

Growth likely to be well below potential

Europe and the United States: Real GDP Growth, 2001–09 (Percent )

0

2

4

6

8

10

12

2001 2002 2003 2004 2005 2006 2007 2008 2009

0

2

4

6

8

10

12

Emerging European economies

Advanced European economies

United States

Projections

Source: IMF, World Economic Outlook .

Growth in Emerging Europe, 2004–2009 (percent)

Source: IMF, World Economic Outlook.

1/ The Czech Republic, Hungary, Poland, and the Slovak Republic.

2/ Estonia, Latvia, and Lithuania.

3/ Albania; Bosnia and Herzegovina; Bulgaria; Croatia; Macedonia,

FYR; Moldova; Romania; Serbia; and Turkey.

Growth in Emerging Europe, 2004–2009 (percent)

Source: IMF, World Economic Outlook. 1/ The Czech Republic, Hungary, Poland, and the Slovak Republic. 2/ Estonia, Latvia, and Lithuania. 3/ Albania; Bosnia and Herzegovina; Bulgaria; Croatia; Macedonia, FYR; Moldova; Romania; Serbia; and Turkey.

0

2

4

6

8

10

12

2004 2005 2006 2007 2008 2009

0

2

4

6

8

10

12

Central-eastern Europe 1/Baltics 2/Southeastern Europe 3/

Projections


33

Advanced economies: stagnation followed by a gradual recoveryGDP (quarterly level seas. adj.; 2005Q1=100)

100

102

104

106

108

110

112

114

United Kingdom

United States

Euro Area

France

Germany

Italy

Spain

Projections


34

Inflation is likely to recede in advanced economies, but remain high in emerging economies

Advanced Economies: Inflation, 2004-2009(Annual Average, Percent)

Source: IMF, World Economic Outlook.

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

2004 2005 2006 2007 2008 2009

Euro areaUnited KingdomSwedenSwitzerland

Emerging Economies: Inflation, 2004–09(Annual Average, Percent)

Source: IMF, World Economic Outlook. 1/ The Czech Republic, Hungary, Poland, and the Slovak Republic. 2/ Estonia, Latvia, and Lithuania. 3/ Albania; Bosnia and Herzegovina; Bulgaria; Croatia; Macedonia, FYR; Moldova; Romania; Serbia; and Turkey.

0

2

4

6

8

10

12

14

2004 2005 2006 2007 2008 2009

0

2

4

6

8

10

12

14Central-eastern Europe 1/Baltics 2/Southeastern Europe 3/

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

2004 2005 2006 2007 2008 2009

Euro areaUnited KingdomSwedenSwitzerland


35

Risks are unfavorably tilted

Gap Models

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

Jan

-99

Jul-

99

Jan

-00

Jul-

00

Jan

-01

Jul-

01

Jan

-02

Jul-

02

Jan

-03

Jul-

03

Jan

-04

Jul-

04

Jan

-05

Jul-

05

Jan

-06

Jul-

06

Jan

-07

Jul-

07

Jan

-08

Jul-

08

Jan

-09

Jul-

09

Jan

-10

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

Headline inflationAverageMedianAv. +1 STDAv. -1 STD

While a majority of models predicts euro area inflation to fall to target, the average of all forecasts is still slightly higher

Advanced European Economies: Growth and Risk Balance (75 and 85 percent confidence intervals)

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2002 2003 2004 2005 2006 2007 2008 2009-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Though growth forecast is balanced, financial risk imparts a tilt to the downside


36

What should policymakers do?

• Advanced economies:Advanced economies:– Monetary policy: on hold to deal with inflation risks, but easing Monetary policy: on hold to deal with inflation risks, but easing

soon as disinflationary forces take hold;soon as disinflationary forces take hold;– Fiscal: automatic stabilizers but within limits afforded by fiscal Fiscal: automatic stabilizers but within limits afforded by fiscal

rules and need for sustainabilityrules and need for sustainability– Financial sector: provide liquidity as needed, have contingency Financial sector: provide liquidity as needed, have contingency

plans operational to address financial system instabilityplans operational to address financial system instability• Emerging economies:Emerging economies:

– Monetary policy: tighten, except where inflation falling and Monetary policy: tighten, except where inflation falling and inflation expectations are within targetinflation expectations are within target

– Fiscal policy: tighten to address structural deficits and let Fiscal policy: tighten to address structural deficits and let automatic stabilizers operate; contingency plans for hard landingautomatic stabilizers operate; contingency plans for hard landing

– Financial sector: ensure crisis resolution frameworks are Financial sector: ensure crisis resolution frameworks are operational, including cross-border dimensionoperational, including cross-border dimension


37

Thank you!


38

IMF advice on turmoilIMF advice on turmoil • Policy recommendations through bilateral and multilateral venues to deal with Policy recommendations through bilateral and multilateral venues to deal with

turmoil and prevent recurrence:turmoil and prevent recurrence:– Restore confidence in markets: Restore confidence in markets:

• provide liquidity provide liquidity • improve transparencyimprove transparency• raise bank capitalraise bank capital

– Reinforce soundness of financial institutions:Reinforce soundness of financial institutions:• increased supervisory oversight of liquidity managementincreased supervisory oversight of liquidity management• build capital buffersbuild capital buffers• monitor leveragemonitor leverage• manage liquidity riskmanage liquidity risk• regulate off-balance sheet entitiesregulate off-balance sheet entities

– Improve financial system architecture:Improve financial system architecture:• crisis resolution frameworks (e.g. UK) crisis resolution frameworks (e.g. UK) • cross-border supervisory cooperationcross-border supervisory cooperation


39

Effect on bank capital and leverage will be crucialEffect on bank capital and leverage will be crucial

First round effects of exposure:First round effects of exposure:

Estimated Losses on Mortgage-Related Subprime Bank Exposures 1/(Billions of U.S. dollars)

United Europe States

Expected losses 123 144U.S. subprime loans 16 29Asset-backed securities 27 12Collateralized debt obligations 53 90Conduits and SIVs 2/ 27 13

Reported losses 80 95

Remaining losses expected 43 49

Sources: Goldman Sachs; UBS; and IMF staff estimates.1/ Calculations as of March 2008.2/ SIV = structured investment vehicle.


40

CaveatsCaveats

• Losses may be higher:Losses may be higher:– US recognized losses are now at US$160 billion, and estimated US recognized losses are now at US$160 billion, and estimated

losses US$220-260 billion (compared to US$95 and US$144 losses US$220-260 billion (compared to US$95 and US$144 billion, respectively at end March 2008).billion, respectively at end March 2008).

– European banks may post further write-downs (e.g., UBS likely European banks may post further write-downs (e.g., UBS likely Q2 $4.8 billion)Q2 $4.8 billion)

– Monoline insurers are under pressure: reduction in rating would Monoline insurers are under pressure: reduction in rating would require banks to make further write offs;require banks to make further write offs;

– Banks may be hit by other shocks related to economic slowdown Banks may be hit by other shocks related to economic slowdown and other financial institutions are not covered by the analysisand other financial institutions are not covered by the analysis

• Real impact may be lower:Real impact may be lower:– Bank recapitalization may continue: e.g. US banks have raised Bank recapitalization may continue: e.g. US banks have raised

US$125 billion and Citi just announced it would seek another US$125 billion and Citi just announced it would seek another US$40 billionUS$40 billion


41

Financial Conditions: Role of CreditFinancial Conditions: Role of CreditShare of Output Variation Explained by Credit and Asset Price Shocks

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Be

lgiu

m

Ire

lan

d

Bu

lga

ria

De

nm

ark

Sp

ain

Sw

itze

rla

nd

Po

rtu

ga

l

Cro

atia

Slo

vak

Re

pu

blic

Po

lan

d

Ge

rma

ny

Hu

ng

ary

Cze

ch R

ep

ub

lic

Slo

ven

ia

Ita

ly

No

rwa

y

Tu

rke

y

Gre

ece

Un

ited

Sta

tes

Un

ited

Kin

gd

om

Sw

ed

en

Ne

the

rla

nd

s

Fra

nce

Fin

lan

d

Ru

ssia

Au

stri

a

Lith

ua

nia

Est

on

ia

La

tvia

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

equity pricescredit

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Commodity Price Shocks and Financial Turbulence: Implications for Europe Luc Everaert