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IMF warns Europe's banking system poses threat to global financial stability

The eurozone's creaking banking system poses a serious threat to global financial stability, according to the International Monetary Fund, which warned European leaders to accelerate plans to support weak banks and create a banking union.

In a report that forecasts a "Goldilocks" outcome of stable growth, IMF financial counsellor José Viñals said the end of low interest rates in the US, coupled with a failure by the Obama administration to monitor risky lending, a sharp slowdown in China and disruption to emerging markets could all upset expectations of a smooth recovery.

"Can the US make a smooth exit from unconventional policies? I call this the 'Goldilocks exit' - not too hot, not too cold, just right.

"This is our base line, most likely outcome. After a turbulent start, the normalisation of monetary policy has begun. But a bumpy exit is possible."

He said the eurozone's incomplete repair of bank and corporate balance sheets continued to place a drag on the recovery, while the widening gap between Germany and the poorest of the 18 member states was restricting the flow of funds around the currency zone and hampering the growth of smaller businesses. "Thus, further efforts must be made to strengthen bank balance sheets, through the European comprehensive bank assessment and follow-up, and to tackle the corporate debt overhang," he said.

The IMF, which published the global financial stability report on Wednesday, acts as lender of last resort to bankrupt countries and is one of many economic organisations to worry about the effects on global growth of the US attempting to behave as if the recovery is complete when many countries are still struggling to cope with the aftershocks.

Since last May's signal from the US Federal Reserve that interest rates would soon begin to rise, policymakers have been wary of the knock-on effects of a return to more normal rates in the US. The hint by former Fed boss Ben Bernanke caused a flight of investor capital from Turkey, Brazil and South Africa back to the US in the expectation of better returns.

Willem Buiter, chief economist at US bank Citi, told an audience at the IMF's spring conference that the US central bank was irresponsible to predict higher interest rates without putting in place insurance plans for countries that will be hit by the increased costs.

Buiter said greater co-operation was needed to insulate weaker countries from the ripple effects of policy changes in the US.

A refusal by the European Central Bank and its boss Mario Draghi to make borrowing cheaper for local banks was also a concern, he said.

"We talk about the US exiting loose monetary policy and low interest rates, but the eurozone has not yet even entered. Europe is too confident that everything will be OK when its banks are still in need of massive support," he said.

"The markets are strong, but investors are still sniffing the glue provided by Draghi and his declaration to do whatever it takes to rescue the euro."

Buiter said the banking union needed a 1tn fund to underwrite European banks and not the 55bn proposed by Brussels.

Alistair Darling, the Labour MP and former chancellor of the exchequer, said the banking union was desperately under-capitalised.

"In my experience 55bn only rescues one bank," he said.

"We kid ourselves into believing that it is all over and a banking crisis could never happen again. This is very dangerous. "

Viñals also explained that a repeat of the sub-prime loans disaster that sparked the financial crisis was also possible, though less in the housing market and more in the sale of corporate bonds. He said the value of low quality bonds, issued by companies with a high risk of going bust, was more than double the level over the last three years as the amount recorded before the crash.

While commending US regulators for being "on top of this", he said a panic could increase the costs of financing company debts and trigger a flurry of defaults and a second crisis.

Charles Evans, president of the Federal Reserve Bank of Chicago, argued that the US economy was still fragile and in need of huge support from the central bank.

Signalling that many members of the Fed board support chair Janet Yellen's doveish stance, he said: "US unemployment is higher now than it was at its peak in the last recession. US workers are not in as strong a position to withstand shocks and face many obstacles to higher productivity and wages from technological and structural changes."

Viñals said emerging markets from Turkey to Indonesia could struggle in the face of rising interest rates, weakening corporate earnings, and depreciating exchange rates.

"Indeed, in this scenario, emerging market corporates owing almost 35% of outstanding debt could find it hard to service their obligations.

While the situation varies widely across countries, those economies under recent pressure also share some vulnerabilities in their corporate sectors," he said.

To solve issues that reveal the inter-connectedness of national economies, he said: "We need greater global policy cooperation as we are all in this together. This extends to monetary policy, financial regulation and supervision, and ensuring orderly market conditions."

[Source: By Phillip Inman in Washington, The Guardian, London, 09Apr14]

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