Euro Area: Restoring Confidence Key to Growth

Credible bank stress tests essential to restore confidence

Action needed to establish fiscal sustainability and restore growth

Wake-up call to strengthen area-wide economic governance

The turmoil has clouded the prospect of a strong regional and global recovery, with the IMF now projecting average growth of just 1 percent for 2010, rising to 1¼ percent in 2011.

Strong action by members of the European Union to establish a European Stabilization Mechanism to help countries in difficulty has helped calm markets, as has austerity plans announced by a number of countries, including Greece, Ireland, Spain, and Portugal. The European Central Bank (ECB) has also proved to be an anchor of stability throughout the crisis. Following much debate, the results of bank stress tests conducted on a large set of banks in the 27-member European Union will now be published on July 23. Successful tests should allay market concerns about the health of major European banks, and boost confidence in the euro area.

These are all positive developments. But concerted action to sort out public finances across the euro area, and a strategy for reinvigorating growth and creating jobs will be key to achieving a sustained recovery, the IMF said in its annual health check of the 16-member euro area. Restoring growth is not just important for its own sake―it is also essential to lay to rest worries about public debt.

The report, which was discussed by the IMF’s 24-member Executive Board on July 19, also stressed the importance of reforming the euro area’s economic governance.

Improving confidence in the financial system

A well-functioning financial system will be crucial to strengthening the moderate and uneven recovery that is currently under way in the euro area. But continued worries about public finances may impact the financial system adversely, the IMF warns in its report. In turn, problems in the financial system threaten the real economy. They make life especially difficult for the small and medium-sized enterprises, which depend on a sound banking system to continue to create jobs and deliver the majority of goods and services to households (see Chart 1).

To gauge the underlying health of the banking system, authorities in the euro area are subjecting major banks to “stress tests.” These tests simulate how well banks would perform under adverse economic and financial conditions. The European stress tests are overseen by national supervisors in the...