By José Viñals

(Versions in  عربي, 中文, EspañolFrançaisРусский日本語)

Since September of last year, risks to global financial stability have deepened, notably in the euro area.

However, over the past few weeks, markets have been encouraged by measures to provide liquidity to banks and sovereigns in the euro area. This recent improvement should not be taken for granted, as some sovereign debt markets remain under stress, and as bank funding markets are on life support from the European Central Bank (ECB).

Main sources of risk

Many of the root causes of the euro area crisis still need to be addressed before the system is stabilized and returns to health. Until this is done, global financial stability is likely to remain well within the “danger zone,” where a misstep or failure to address underlying tensions could precipitate a global crisis with grave economic and financial consequences.

Despite the recent improvements, sovereign financing stress has increased for many countries—with almost two-thirds of outstanding euro area bonds at spreads in excess of 150 basis points—and financing prospects are challenging. Markets remain very volatile and long-term foreign investors have sharply reduced their exposure to a number of euro area debt markets, including some in the core. Keeping these investors involved is essential to stabilizing markets.

Moreover, deleveraging by European banks may ignite an adverse feedback loop to euro area economies and beyond, even if acute pressures have been mitigated by recent extraordinary ECB measures. Like cholesterol, deleveraging can be good and bad. European banks have had excessive levels of leverage and had expanded into a number of non-core areas. So, increasing bank capital levels, shedding bad loans, and withdrawing from non-core businesses should be encouraged. But there is also the danger that deleveraging could be too fast, overly concentrated in some areas, and could cut off credit at the expense of the economy.

 All these risks could spill over well beyond the euro area. Emerging European economies would be most affected, reflecting the substantial presence of euro area banks in these countries. Nor is the United States immune to spillover risks, given the close trans-Atlantic financial and trade connections. A large shock from the euro area could be magnified by existing weaknesses, notably in the still-fragile U.S. housing sector.

Policy Priorities

Policymakers need to press ahead and bolster plans to restore financial stability in the euro area and beyond. Urgent policy action is needed:

 First, in the euro area, the “firewall” needs to be sufficiently large and convincingly built to avoid abnormally high funding costs for sovereigns and banks. To do this, it will be important to strengthen, and advance work on, the European Stability Mechanism (ESM) as soon as possible. Action by the ECB to provide the necessary liquidity support to stabilize bank funding and sovereign debt markets will also be essential. At the international level, the IMF aims to raise up to $500 billion in additional lending resources to create a global firewall. This would further help not only restore confidence in the euro area, but also address potential spillovers.

Second, a macroprudential gatekeeper is needed to assure bank deleveraging plans are consistent with sustaining the flow of credit to support economic activity and to avoid a downward spiral in asset prices. The potentially harmful effects of deleveraging should be addressed at both the national and international levels. Within the European Union, such a role should be coordinated among European banking authorities.

Third, a credible increase in bank capital buffers remains necessary to restore market confidence. Banks should increase their capital levels, not just capital ratios, in line with the recent European Banking Authority (EBA) recommendations. For those solvent and otherwise viable banks that cannot raise sufficient private capital, public funds should be made available, based on strict conditionality. To complement this support and limit the additional burden on some sovereigns, a pan-euro-area facility should have the capacity to take direct stakes in banks.

 Fourth, adjustment remains essential, but the short-term impact on growth should be taken into account. The solvency of sovereigns must be assured. Governments have to implement credible medium-term fiscal consolidation strategies within a solid euro area framework. Over the longer term, initiatives to strengthen fiscal and financial union will be crucial to restoring market confidence. Elsewhere, the United States and Japan need to address their fiscal challenges, and the United States must solve the problems of the housing market and mortgage debt overhang.

 Fifth, policymakers in emerging markets should stand ready to counter funding and credit strains, and to deploy countercyclical policies where headroom is available. Emerging markets in many cases have built ample cushions of reserves that could be used to counter external liquidity shocks

The global financial system remains fragile. It is urgent to restore confidence in the euro area and beyond. Otherwise we run the risk of a deepening of the crisis, with far-reaching global economic and social consequences.

Fortunately, it is not too late to put in place the right policies that take us out of the danger zone. But for this, we need good politics and the collective determination to reach now a cooperative solution both within Europe and at the global level.