Journal Issue

Euro Area Policies

International Monetary Fund
Published Date:
July 2011
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I. Background

1. The Euro Area (EA) plays a major role in the global economy and therefore has potentially large spillover effects on the rest of the world. The EA produces about a fifth of global output, second only to the US. With its exports and imports together adding to almost 30 percent of GDP, the area accounts for a larger share of world trade than any other economy. Its financial sector is also one of the world’s largest, with banking exposures to other countries exceeding those of all other economies, although its debt and equity markets—as measured by turnover—are dwarfed by those in the US. The euro is also the second most important reserve currency after the U.S. dollar, and its share of reserves has been growing steadily since its inception.

Share of Global Goods Trade


Source: DOTS and IMF staff calculations

Share in World GDP


Source: WEO

Equity Market: Value of Share Turnover

(Year to Sept. 2010)

Source: WFE

Electronic Order Book Trades - Euro area is presented ex-Nordic Exchange

Relative Governement Debt Market Turnover

(2009 Estimate of Average Daily Cash Transactions)

Sources: NY Fed, JSDA, National Debt Agencies and IMF staff calculations.

Currency Composition of Allocated World Foreign Exchange Reserves

Sources: COFER database and staff calculations.

BIS Banks: Total Foreign Claims (Billions, US$) 1/

1/ Total foreign claims are defined as the sum of cross-border claims by financial institutions headquartered in each economy and their foreign affiliates’ local claims (claims extended by foreign affiliates in the host country).

Sources: BIS and staff calculations.

2. Market perceptions of events in the EA program countries (Greece, Ireland, and Portugal) illustrate the possibility of large spillovers from the area in times of stress.

  • While these countries are small in economic terms, the financial exposure of core EA country banks to them is large. Jointly they represent just 6 percent of EA GDP and a very small share in the foreign exposure of core EA banks overall (2.6 percentage points). However, at 32 percent of total shareholders’equity for those core EA banks that hold such assets in the case of program countries, the exposure is quite sizable in absolute terms, opening the door to significant spillovers also outside the euro area.
  • This potential for major spillovers can be seen in market reaction to developments in the EA over the past year (see charts). CDS spreads and bond yields for the EA program countries have risen to historically high levels, and their correlation with financial market spreads for other EA economies remains very high. In the run up to the approval of the Greece program, correlations of EA program country CDS spreads and bond yields with global asset prices rose sharply, highlighting the contagion potential. Marked pickups in correlations were also evident around the time the Ireland and Portugal programs were being finalized. While the increased correlations between EA and non-EA asset prices could partly reflect reactions to common risk factors (see Section III.B), they underscore the risk that an intensification of stress in the EA could have sizable effects on global markets.

Sovereign CDS spreads

Note: Other Euro Area countries include Austria, Belgium, France, Germany, Italy, Netherlands and Spain.

Source: Datastream, staff calculations.

Correlation with Average GIP CDS Spreads

(60-day rolling correlation of daily percentage changes)

Note: GIP include Greece, Ireland and Portugal; Core EA include Germany, France and Italy; G-20 EM include Korea, Indonesia, Mexico, South Africa, Turkey, Russia and Brazil; S4 include U.S., The U.K., China and Japan. Sources: Datastream, Bloomberg and staff calculations.

3. Against the backdrop of the EA’s large global role and ongoing challenges in the EA program countries, the rest of this paper undertakes an in-depth analysis of EA spillovers. To motivate the analysis and to identify key areas where spillovers could be important, the next section sets out views from authorities outside the EA on their perceptions of the main spillovers from the area. Section III maps economic spillovers to assess their size and how they are transmitted across regions (e.g., through trade and financial linkages, and indirectly through broader confidence effects). Section IV assesses potential spillovers to the rest of the world from policies in progress or envisioned in the area, with special focus on the estimated global impact of (i) an intensification of financial market stress in the EA; (ii) prospective EA monetary and fiscal policies; and (iii) EA structural reform in the areas of financial regulation, labor and product markets, and trade. Conclusions are presented in the last section.

II. Views From Outside on Euro Area Spillovers

4. Most partner authorities focused on financial spillovers from the EA, with spillovers seen as escalating sharply if the sovereign debt difficulties in the EA were to intensify. Authorities generally saw the spillover potential from further stress in Greece, Ireland, and Portugal as relatively contained, but were concerned that if stress were to spread to Spain and, especially, the core EA, spillovers could be substantial. Potential spillovers through financial confidence effects and direct banking channels were seen as especially critical, but some authorities also considered that effects through trade and FDI channels could be significant, particularly for countries that are geographically close, and with strong trade ties, to the EA (see below). Counterparts noted that while EA authorities had made progress in the wake of the Greece program in addressing problems in the periphery (at both the individual country and central levels), further measures to delink sovereign and banking sector problems, including through stress tests and follow-up to recapitalize banks as needed, as well as more centralized fiscal policy would help limit adverse spillovers to the rest of the world.

5. Other spillovers discussed included the impact of EA macroeconomic policies, trade and FDI links, and regulatory changes on partner countries.

  • Macroeconomic policies. Problems with EA debt sustainability were seen as increasing global tail risks, as discussed above. On a more positive note, counterparts saw the prospect of adverse spillovers from EA fiscal consolidation plans—through the demand compression effect—as relatively minor, and some observed that the net impact could even be positive if credibility gains and associated confidence effects are significant. Spillovers from ECB policies were, similarly, seen as contained to the extent that any phasing out of the ECB’s unconventional support policies did not undermine the periphery. Spillovers from ECB rates hikes ahead of other advanced economy central banks would also likely be contained to the extent that robust EA growth at the core was in place.
  • Trade and FDI. Reflecting the EA’s role as the world’s single largest trading entity, trade and FDI links were seen as strong, particularly for neighboring countries. For close neighbors, their role in the EA supply chain accentuates these trade linkages, making them far stronger than financial spillovers. Counterparts were confident that implementation of the EA’s Doha commitments would have a favorable impact.
  • Regulation. Some counterparts argued that proposed EU financial regulatory reforms could have major spillovers on neighbors, especially should their discretionary regulatory powers be affected as a result of new EU regulations.

III. Mapping Euro Area Spillovers

A. Growth Spillovers

6. Economic growth in the S-5 has, apart from China, been highly correlated (text chart). Growth in the U.S., U.K., and EA economies was particularly highly synchronized over the past decade. The financial crisis subjected the S-5 countries to a synchronous, sharp contraction in 2008, and all have since embarked on the recovery process. The co-movement of growth in China with the EA and the rest of the S-5 has been weaker as China’s economic performance outpaced that of the rest of the S-5 countries, including during the recent crisis.

Real GDP growth rates, YoY

Source: WEO, IMF

7. A closer look at these growth links suggests that Euro Area output shocks have had generally moderate spillovers. Estimated spillovers from the EA to the other S-4, which abstract from financial contagion and may therefore understate true spillovers, are nevertheless of meaningful size, though smaller than those emanating from the U.S. (text chart and Chapter 1 of Selected Issues Paper). Echoing this, Euro Area authorities diagnosed the EA as a net importer of global spillovers. This was attributed mostly to the EA’s relative trade openness, compared with the U.S., which exposes it to incoming trade shocks. The continuing dominance of U.S. debt and equity markets, backed by the still strong global role of the U.S. dollar, was also seen as playing an important role. As an illustration, the authorities noted that their analysis of the transmission of positive investment shocks indicated that such shocks in the EA had smaller spillover effects on the rest of the world than the other way around.

Inward and Outward Output Spillovers

Note: Depicts the average peak impulse responses of output in each S-5 economy to shocks in each of the other S-4 economies which raise output there by one percent.

Source: Staff calculations

8. Moving beyond the S-5, countries geographically closer to the EA—generally those with stronger trade links—are affected more by the area’s economic fluctuations. Results from a G-20 macroeconometric model of business cycle transmission through international trade and financial channels indicate that spillovers tend to be greater for economies closer to the EA (Chapter 1 of Selected Issues Paper). Among G-20 countries, the highest impact can be found in Russia, reflecting its strong trade linkages with the EA, followed by the U.K., reflecting its strong trade and financial linkages (text chart).

Trade Links with the Euro Area

(Share of Exports to the EA in total exports)

Source: Staff calculations.

Banking Links with the Euro Area

(Share of Euro Area bank-owned assets in total banking system assets)

Note: Data only covers selected emerging markets.

Source: Bankscope and staff calculations.

Average Peak Impulse Responses of Output to Shocks in the Euro Area

(Relative to Euro Area)

Source: Staff calculations.

Note: Depicts percent change in output in a given country associated with one percent increase in output in the Euro Area, in response to a mixture of real and financial shocks in the Euro Area.

9. A implication of this analysis is that EA growth shocks are likely to have the largest spillover effects on non-EA European and North African economies. Though direct empirical results from the macroeconometric analysis are not available for these countries, their generally strong financial and trading links with the EA suggest that the impact of EA growth shocks on their economies could be substantial. Indeed, the strong relation between the estimated impact of EA output shocks on G-20 economies and their share of trade with the EA (text chart) points to the importance of trade channels in transmitting growth shocks. With the EA accounting for an even larger share of trade in many non-EA European and North African countries, the impact of EA shocks on these economies could be especially significant.

Average Peak Impulse Response versus Trade Weight

Source: Staff calculations.

B. Financial Sector Spillovers

10. Analysis of global risk factor movements across different asset classes suggests strong spillovers from the EA (Chapter 2 of Selected Issues Paper). The analysis, which is based on a principal components approach, assesses the extent of spillovers from individual EA asset markets across borders and across various financial markets (mainly bonds and equities), after abstracting from “risk commonalities” (that is, after adjusting for comovement due to common shocks). The key findings are:

  • The global common risk component increased sharply in Spring 2010 as pressures in peripheral European countries intensified, although the rise was not as severe as during the Lehman episode in late 2008.
  • About one-fifth of the common component of risk across global financial markets—in a selection of interbank interest rates, bonds, and equities—can be shown as being driven by volatility in EA financial markets, only modestly less than the one-quarter recorded for the U.S.
  • Direct spillovers from the sovereign bond markets in Greece, Ireland, Portugal, as well as Spain—the peripheral EA countries that global market participants focused on most during the initial crisis period—to the rest of the world appear to be modest. While “raw” cross-market correlations (blue bars in the text chart) suggest that “observed” volatility co-movements across assets and across borders tend to be widespread, cross-correlations of spreads with the common risk component stripped out (red bars) reveals that, among the financial markets in the sample, volatility spillovers from these EA sovereign bond markets are likely to be felt strongly only in the bond market of EA financial corporations.
  • In contrast, spillovers from core EA financial institutions appears much larger. Even after adjusting for common risk, cross-correlations of EA financial sector spreads with spreads of EA non-financial corporations as well as with financial corporations outside the EA, such as Japanese and U.S. banks, are sizable and significant. The latter may reflect direct links among financial institutions as well as transmission of spillovers via bank funding markets.

Measuring risk commonalities: alternative proxies

(basis points, LHS; index, RHS)

Contribution of individual regions to risk commonalities

(percentage, average over August 2007 - February 2011)

Source: Staff calculations

Conditional correlations vs peripheral EA sovereign bond spreads

Source: Staff calculations.

Conditional correlations vs EA financial corporate bond spreads

Source: Staff calculations.

11. The authorities agreed with staff’s views that financial spillovers from core EA banks to the rest of the world could be substantial. Both the authorities and staff also agreed that shadow banking in the EA was less relevant than in the U.S., given the EA’s reliance on traditional relationship banking and the relatively large share of the banking sector in overall financing in the EA.

IV. Policy Issues

A. Spillovers from Intensification of EA Financial Market Stress

12. Direct spillovers from further stress in the EA program countries would likely remain manageable, but the potential to affect the rest of the world is much larger if stress spreads to the core EA. Several methods of analyzing financial and other spillovers from the periphery and the core support this conclusion, including analysis based on correlations of financial market prices, bank deleveraging analysis, and macroeconomic models.

13. Financial markets signal that spillovers of further stress in the EA would be large if the core is affected (Chapter 3 of Selected Issues Paper). The analysis uses correlations of market CDS spreads to estimate the implied conditional probability of distress in a variety of non-EA banks and sovereigns if distress—defined as a (hypothetical) credit event that triggers CDS contracts—were to occur in a EA program country sovereign or bank, or in a large core EA bank. The modeling framework and data availability constrained the number of sovereigns and banks that could be analyzed, so a geographically diverse group of countries—and representative banks from those countries—was chosen. The results indicate that if there is distress in a major bank from a core EA economy, the probability of distress in many of the non-EA banks would rise to high levels (40 percent or more), and would generally be highest in banks based in countries that are geographically close to the EA and whose banking systems are most closely linked to that of the EA. Among the S-4, the spillover to the U.K. would be greatest, reflecting its very strong banking links with the EA. For most non-EA banks, the estimated conditional probability of distress given distress in a core EA bank is as high or higher than the peak implied unconditional probability of distress in the period after the Lehman bankruptcy. By contrast, the estimated probabilities of distress in non-EA banks conditional on distress emerging in an EA program country sovereign, while still sizable, are much lower than those conditional on distress in a major core EA bank.

Current implied probability of distress compared to expected probability of distress in non-EA banks…

… given distress a) in GIP sovereign, b) in core EA bank

Source: Staff calculations.

14. Analysis of global bank interconnectedness also suggests that further EA stress would have negative spillovers that are sharply exacerbated if core Europe is affected (text charts and Chapter 4 of Selected Issues Paper). The model, which uses BIS bank foreign claims data, is based on the assumption that banks deleverage when faced with large mark-to-market losses on their trading books. The shocks that are analyzed comprise: (i) a further decline (from current levels) in EA program country sovereign and bank bond prices of 30 percent (Scenario 1); and (ii) a further 30 percent decline (from current levels) in bond prices of EA program country sovereigns and of all EA banks (Scenario 2). Results suggest that the first shock, which is confined to the program countries, would cause some deleveraging, though mostly in the EA itself. Under the more severe scenario, the impact would be much larger, especially in the rest of Europe and parts of North Africa. These results are based on direct exposures; indirect exposures, including through guarantees via CDS contracts, may exacerbate deleveraging in a shock scenario. Recent data from the BIS indicate that the total exposure of U.S. banks to EA program countries, for example, may be several times as large as just the direct exposure. Moreover, actual spillovers could easily be more severe than estimated by this exercise if other factors also intensify deleveraging, such as a compression in non-bank wholesale funding of banks and financial accelerator effects through impacts on non-bank private sector balance sheets, which are not captured by the model but would be expected to be at play under such a scenario.

Impact of stress in EA program countries: Reduction in foreign liabilities,

(In percent of GDP) - Scenario 1

Source: Staff calculations.

Impact of stress in entire EA: Reduction in foreign liabilities,

(In percent of GDP) - Scenario 2

Source: Staff calculations.

15. The importance of spillovers from shocks to the core EA are further underscored by results from a broader macroeconomic modeling approach (Chapter 5 of Selected Issues Paper). Two sets of illustrative simulations were run under the Fund’s Global Projections Model (GPM; as presented in the January 2011 WEO update). These comprised, first, a “tremor” scenario of a milder shock which may be interpreted as a shock that is largely confined to the EA program countries, and, second, an “earthquake” scenario of a larger shock that spreads to the entire EA. Under the first scenario, spillovers are moderate (see text table). By contrast, the second scenario, which assumes a large shock and a policy response that falls short, leads to large financial losses in the periphery which, in turn, result in banking problems throughout the EA. Consequently, EA growth falls by 2½ percentage points relative to the baseline, while global growth falls by about 1 percent over 2011-12.

Effect of Euro Area Turbulence on GDP Growth(Deviation from pre-crisis baseline, in percentage points)
“Tremor” Scenario“Earthquake” Scenario
Difference from Pre-crisis BaselineDifference from Pre-crisis Baseline
Euro Area-0.4-0.2-1.4-1.3
Emerging Asia-0.1-0.1-0.3-0.4
Latin America-0.1-0.1-0.2-0.3
Remaining GPM countries-0.2-0.2-0.6-0.8
World 1/-0.2-0.1-0.4-0.5
Source: WEO Update (January 2011).

GPM world represents 87.5 percent of world GDP by PPP (2007-2010 average).

Source: WEO Update (January 2011).

GPM world represents 87.5 percent of world GDP by PPP (2007-2010 average).

16. The authorities shared staff’s views on these dual spillover findings. They stressed that problems confined to the periphery would have modest spillover effects. The smaller size, and greater market knowledge, of exposures to EA program country assets than, say, subprime assets at the outset of the 2008 crisis, implied less scope for panic than during the Lehman episode. Also, market exposure to program country assets has been reduced over the past year, which would also limit potential spillover effects. They acknowledged, however, that core area involvement would have severe repercussions. They agreed, therefore, that containing peripheral risk was critical and cited strong national policy action, effective EA crisis management, and completing governance reforms as key ingredients of such a strategy.

B. Spillovers from Monetary and Fiscal Policies

17. ECB exceptional liquidity provision has helped contain deleveraging by EA banks and corresponding spillover effects. Counterfactual scenarios used to assess the impact of higher funding costs likely associated with the withdrawal of exceptional liquidity provision indicate that the impact on some neighboring European countries, such as the U.K. could be significant (text chart and Chapter 6 of Selected Issues Paper). ECB counterparts agreed that exceptional liquidity provision had helped contain negative spillovers and stressed that it would not be withdrawn under stressed conditions. They recognized, however, that ongoing exceptional liquidity provision can also have drawbacks, notably that it could dilute incentives of weak banks to pursue timely restructuring.

Impact of the withdrawal of ECB exceptional liquidity provision: Reduction in Foreign Liabilities

(In percent of GDP)

Source: Staff calculations.

18. A slightly faster pace of monetary tightening in the EA than markets presently expect would have generally limited spillovers (Chapter 6 of Selected Issues Paper). The baseline scenario assumes that monetary tightening in the EA proceeds at the pace expected by the Euribor futures market, while an alternative scenario assumes somewhat more frontloaded rate hikes (see chart). Macroeconomic model estimates suggest that accelerated monetary tightening in the EA will generate moderate output losses, on the order of a cumulative additional output loss of less than 1 percent over 2011-16, built on the implicit assumption that ongoing adjustments in the EA program countries allow them to absorb the somewhat higher interest rates without an intensification of economic stress. This in turn is estimated to have modest spillovers to the rest of the world, primarily reflecting reduced EA export demand, mitigated by currency depreciation in the rest of the world. The authorities also saw limited spillovers from faster monetary tightening and stressed that the ECB’s mandate was to secure price stability in the euro area overall.

Short Term Nominal Interest Rate

Source: Staff calculations.

Cumulative Output Losses: 2011 – 2016

Source: Staff calculations.

19. Projected EA fiscal consolidation should have modest global demand spillovers, and these could be more than offset by credibility gains. The modeling exercise covers projected fiscal consolidation by EA members through 2015. To highlight the impact of fiscal policy and its spillovers, the simulations abstract from monetary policy accommodation in the EA as well as the rest of the world, thereby overstating somewhat the true contractionary effect on output that would actually take place. Even so, the negative demand effects to other countries are estimated to be relatively small since the magnitude of the consolidation for the area as a whole is moderate (Chapter 7 of Selected Issues Paper). Moreover, if the consolidation is accompanied by a decline in EA countries’ risk premia—only partly reversing the 150 bps increase since late 2009—net cumulative spillovers to other countries over the medium term could even turn positive (see text charts). The authorities agreed with staff that spillovers from planned fiscal consolidation would be modest, but argued that the impact within the EA itself would likely be even more modest than estimated by staff, as the fiscal multiplier would likely be contained given the perceived permanence of the fiscal consolidation plans and since monetary policy would take into account fiscal consolidation to the extent it influenced price pressures. They observed that since consolidation efforts are mainly expenditure based, they are more likely to reassure financial markets about the long-term sustainability of the fiscal position and therefore yield a lasting and growth-friendly correction of fiscal imbalances.

Cumulative Effect of Euro Area Fiscal Consolidation on Output: 2011-2016

GIMF and G20 Models

Source: Staff calculations.

C. Structural Policy Spillovers

20. Turning to structural reforms, any deleveraging associated with higher bank capital requirements is expected to have only modest spillovers (Chapter 8 of Selected Issues Paper). Under Basel III, banks are expected to be subject to higher minimum core capital requirement by 2018, and many banks are likely to implement the new requirements well in advance of the deadline. Stronger capital requirements are expected to carry major financial stability benefits and address current excessive leverage, but may also have short-term contractionary effects as banks adjust, in particular if the adjustment takes the form of a rapid reduction in credit supply. Different analytical approaches suggest that direct output losses outside the EA—assuming that deleveraging will form the means through which EA banks meet higher capital requirements—should be modest (and well within the range of estimates reported by the BIS Macroeconomic Assessment Group), even if the adjustment is undertaken well in advance of the agreed deadline. In countries where EA banks’ subsidiaries account for a sizable share of banking activity, the impact would tempered by subsidiaries’ reliance on domestic funding (rather than funding from parents). The ECB agreed that higher capital requirements would generate modest spillovers. On a related issue, the authorities agreed in principle that EU bank regulations could have spillover effects. They understood concerns in some neighboring countries over the preservation of supervisory independence in non-EA members of the EU, but considered that enhanced supervisory effort and supervisory and regulatory coordination (including through supervisory colleges and the newly installed EU-level financial authorities) would help address these concerns. They also took note of staff support for implementing Basel III swiftly and without exceptions, setting capital requirements at an ambitiously high level—including significant top-ups for SIFIs—and allowing sufficient flexibility for introducing macro-prudential tools (described in the 2011 Article IV Staff Report and the European Financial Stability Framework Exercise Report, EFFE). In addition, the authorities called on major regulatory authorities in the rest of the world to also implement robust requirements to limit regulatory arbitrage and spillovers.

Impact of Basel III: Reduction in Foreign Liabilities, in Percent of GDP

Source: Staff calculations.

21. Labor and product market reforms that enhance EA growth potential would have positive, albeit modest, spillovers to the rest of the world (Chapter 9 of Selected Issues Paper). The analysis of the impact of reforms was based on work undertaken for the G-20 mutual assessment process, with simulations performed using the Fund’s Global Integrated Monetary and Fiscal Model (GIMF). Structural reforms covered both labor and product market measures, along the lines of the reforms set out under the EU 2020 agenda. These include more active labor market policies, reforms to make pension systems sustainable (including a higher retirement age), which would have positive labor supply consequences and generate stronger internal growth due to budget savings and crowding-in effects. Product market reforms were assumed to result in multifactor productivity growth gains in both tradable and nontradable sectors. This in turn would lead to positive but small growth spillovers elsewhere, with spillovers to Asia and the rest of the world stronger than in the relatively closed U.S. and Japanese economies (text chart). The authorities agreed that while structural reforms were critical and could significantly improve the EA’s growth prospects, the spillover effects to partner countries would likely be generally moderate.

Real GDP impact from Euro Area structural reforms,

(percent deviation from steady state baseline)

Source: Staff calculations

22. Further trade liberalization would also have positive spillovers (Chapter 10 of Selceted Issues Paper). Based on current offers in the ongoing Doha round of negotiations—under which it is assumed there is a roughly 50 percent reduction in trade-weighted average tariff rates applied by EA countries on imports—exports from most countries to the EA would increase. In aggregate, preliminary results suggest that the unilateral reduction in EA tariffs would raise total global exports to the area by more than 1 percent.

Impact of a Reduction in Protection in the European Union

(Percent change in export volume to the Euro Area)

Source: Staff calculations.

V. Conclusions

23. The prospect of large spillovers—particularly if recent stress in EA program countries were to spread to the core—underscores the urgent need for actions to contain, and eventually overcome, the ongoing crisis. Measures taken over the past year—including national action in the countries facing market pressures, establishing the EFSF, and the continuation of the ECB’s unconventional policies—may have helped contain spillovers from the EA program countries to the rest of the EA and to countries outside the EA for now, but EA financial markets remain under stress, underscoring the urgent need for additional strong measures. Decisive further actions to achieve fiscal sustainability, strengthen economic governance, introduce greater fiscal risk sharing, and address remaining banking sector weaknesses—as outlined in the 2011 Article IV Staff Report and the accompanying EFFE report—will, therefore, be instrumental in ending the crisis and mitigating adverse spillovers to the rest of the world.

24. The planned fiscal consolidation in the EA could benefit the rest of the world, assuming it helps restore credibility. The direct effect of the consolidation on global demand and growth in trading partner countries will likely be modest. To the extent the EA’s fiscal adjustment credibly addresses sustainability concerns, it should help reduce spreads in the periphery and, through confidence effects, in the area more broadly and elsewhere. This latter effect, depending on its magnitude, could more than offset the direct demand impact.

25. Spillovers from gradual monetary policy normalization appear manageable under appropriate conditions. Exit from current interest rates at a slightly faster pace than markets are presently discounting is estimated to have modest spillover effects, especially if the ongoing adjustment in EA program countries allows them to absorb the somewhat higher interest rates without an intensification of economic stress. Given the importance of the ECB’s extraordinary crisis measures in limiting bank deleveraging, unwinding of extraordinary measures will need to be timed with progress in improving banking sector health and reducing volatility in sovereign bond markets in order to limit spillovers.

26. Execution of the structural reform agenda will carry positive spillovers. External effects from any temporary deleveraging that banks are forced to undergo in response to tougher capital requirements (as part of the steps to enhance stability) would be modest, and should be offset by positive externalities from a healthier banking system. Reforms to labor and product markets (as laid out in the EU 2020 agenda) and in trade (per the EU’s offers under the Doha round) are good not only for the EA itself, but also for its trading partners.

Box 1.Euro Area Spillovers to LICs

Low-income countries (LICs) are affected by developments in the Euro Area (EA) through several channels. Direct channels include trade, remittances, FDI and aid flows. At the same time, the EA also has indirect spillover effects on LICs, especially through global commodity prices.

  • The EA receives about 20 percent of LIC exports. About 30 percent of exports from LICs in Sub-Saharan Africa and 20 percent of exports from Asia and CIS countries go to the EA. Commodity exports, in particular, play an important role in LIC bilateral trade links with Europe where fuel and crude material make up roughly 60 percent of LIC exports to Europe in 2008.

Total LIC Exports


Sources: DOTS, World Bank and staff calculations

Remittances by Source and Region

  • Remittances and FDI from the EA are particularly important for LICs in Sub-Sahara Africa. Over 30 percent of SSA’s remittance inflows originate from EA. In other regions, the U.S.’s remittance role is generally larger. In addition, EA FDI dominates flows to CIS and SSA countries.
  • The EA is the largest donor across LICs, particularly for LAC and SSA where EA aid makes up more than 40 percent of total aid to these regions.

FDI Flows from Advanced Countries

(average, 2005-2007)

Sources: OECD and staff calculations

Aid to LICs


Sources: OECD and staff calculations

Empirical evidence suggest that developments in EA could have significant spillovers on LICs. Estimates from growth regressions suggest that trading partner growth has a significant impact on LIC growth. An empirical study using bilateral FDI data between EA and LICs suggests that EA growth is one driver of FDI flows to LICs, although the effect is much weaker than the size of the recipient economy. In addition, there is evidence that aid flows are procyclical with respect to the donors’ business cycle and could be influenced by donors’ fiscal situation, particularly when donors face a large negative shock.1

1/See Dabla-Norris and others (2010), FDI Flows to Low-Income Countries: Global Drivers and Growth implications, IMF WP 10/132; and Dabla-Norris and others (2010), Business Cycle Fluctuations, Large Shocks and Development Aid: New Evidence, IMF WP 10/240.

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