Since the last Global Financial Stability Report (GFSR), risks to stability have increased, despite various policy steps to contain the euro area debt crisis and banking problems. European policymakers have outlined significant policy measures to address the medium-term issues contributing to the crisis, and some of these have helped to improve market sentiment, but sovereign financing remains challenging and downside risks remain. If funding challenges result in a round of deleveraging by banks, this could ignite an adverse feedback loop to euro area economies. The United States and other advanced economies are susceptible to spillovers from a potential intensification of the euro area crisis, and some have homegrown challenges to the removal of financial tail risks, including overcoming political obstacles to achieving an appropriate pace of fiscal consolidation. Developments in the euro area also threaten emerging Europe and may spill over to other emerging markets. Further policy actions are needed to restore market confidence. This effort will require building larger backstops for sovereign financing, assuring adequate bank funding and capital, and maintaining a sufficient flow of credit to the economy, possibly by establishing a “gatekeeper” charged with preventing disorderly bank deleveraging.
The euro area debt crisis has intensified further, requiring urgent action to prevent highly destabilizing outcomes.
Sovereign bond yields in the periphery rose sharply, especially at short to medium maturities, inverting yield curves in the last quarter of 2011 and signaling increased concerns about financing and default risks. As outlined in the September GFSR, policy packages have been insufficient to contain adverse feedback loops, thus trapping some sovereigns in a ―bad equilibrium‖ as long-term foreign investors shed exposures. Domestic institutions were unable to fill the gap, and the European Central Bank (ECB) became a critical support for peripheral sovereign debt through its Securities Markets Program (SMP). As the crisis intensified, it spilled from the periphery into the core with yields rising and spreads widening, including on the sovereign debt of Austria and France. As of end-2011, more than two-thirds of euro area sovereign debt had credit default swap (CDS) spreads of over 200 basis points (Figure 1). Since September, ratings downgrades and negative outlooks across a wide range of euro area sovereigns have also contributed to the rise in yields. Although there has recently been some improvement in market conditions, fundamental challenges remain. … more
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Source: International Monetary Fund