The International Monetary Fund (IMF) today said that the severe economic downturn in Europe could end during the second half of 2010, followed by a gradual recovery, but that further policy actions, especially in the financial sector, will be essential to induce this recovery. In its Spring 2009 Regional Economic Outlook (REO) for Europe, the IMF notes economic activity is likely to contract most in emerging economies in the region this year, although activity may rebound slightly more in 2010 compared to the advanced economies of Europe.

For Europe’s advanced countries, the IMF forecasts a 4 percent contraction in 2009. The advance countries are still expected to record negative growth in 2010, though at a more moderate rate of 0.4 percent. For Europe’s emerging economies, the IMF projects a 4.9 percent decline in 2009, with a return to growth of 0.7 percent in 2010. Inflation is expected to fall to very low levels in many countries, but outright deflation is likely to be avoided, according to the IMF. The risks around this overall economic scenario, however, still remain tilted to the downside, it warns. With low inflation, consumers could regain confidence earlier, but continued weak global demand could lengthen and deepen the recession.

“The measures taken to counteract the deep recession in Europe have provided a good foundation for a gradual recovery, but further actions by policy makers, particularly in the financial sector, are needed to restore market trust and confidence, and accelerate the recovery,” said Marek Belka, Director of the IMF’s European Department. These actions include continued provision of liquidity and engagement in credit easing where necessary; credible loss recognition in the financial system; recapitalization of viable institutions by the private sector, but with public support if needed; and ring-fencing of impaired assets where they constitute a significant part of balance sheets, and preferably through a private sector managed bad-bank construction with government support and funding.

Macroeconomic policies are also needed to cushion the downturn. Fiscal policy needs to continue to support demand, combining rapid and extensive implementation of fiscal stimulus packages with a commitment to future fiscal consolidation. Monetary policy should be used to anchor inflation expectations solidly in positive territory, preempting deflationary risks.

“What is mostly needed is a robust approach to coordination, in particular on financial and regional macroeconomic stability,” Belka said. “Europe is the most economically integrated market economy in the world, and yet the policies to address the crisis have been undertaken at the national level. Without a well-coordinated effort in these areas, neither fiscal nor monetary policy efforts will work as effectively as they must to make sure that Europe is as vibrant and prosperous after the crisis as it was before. Europe is facing the economic storm of a lifetime and it urgently needs to weatherproof its institutions,” added Belka, who also called for improving the EU’s financial stability framework, going beyond the recommendations suggested earlier in 2009 in the report by the High-Level Group of Financial Supervision in the EU, chaired by Jacques de Larosière.