BRUSSELS—The European Union and Organization for Economic Cooperation and Development on Tuesday urged euro-zone leaders to forge ahead with a decisive boost to the economic bloc's firewalls to prevent runs against solvent sovereigns.
Speaking at a news conference, European Commissioner for Economic and Monetary Affairs Olli Rehn said the size of the firewall must be "convincing," while OECD Secretary General Angel Gurria urged leaders to increase the lending capacity of the bloc's bailout fund to as high as €1 trillion ($1.34 billion).
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"The mother of all firewalls should be in place," said Mr. Gurria, which would send a message of support to stressed euro-zone peers so investors "won't even attempt" to speculate on sovereign markets. This could ensure the fund need never be used.
Finance ministers will gather in Copenhagen on Friday to debate the options available for reinforcing their bailout funds, after months of resistance from Germany. But on Monday, German Chancellor Angela Merkel withdrew opposition to increasing the bloc's total lending capacity, amid efforts to stem another surge in market anxiety for struggling economies such as Spain. A sizable increase to the firewall is a key precondition to unlocking additional support from outside the European Union through the International Monetary Fund.
Reinforcing "the global financial safety net" remains important to the European Union, said Mr. Rehn on the sidelines of the news conference for a new OECD report on the bloc's economy. However, finance ministers are only expected to raise the lending capacity of the European Stability Mechanism to a modest €700 billion when they meet Friday.
The EU's executive, the European Commission, had warned in a paper outlining the options available to boost the firewall that the proposal to increase the ceiling to €700 billion may not be sufficient to convince G-20 partners that the euro zone is doing all it can to stem the crisis, and would therefore jeopardize any noneuro-zone contribution to the firewall.
Market pressure to boost EU firewalls has been more muted in previous weeks, but Mr. Gurria cautioned it shouldn't take much comfort in these quiet periods, adding the risk spread for government debt remains at unsustainable levels.
In its report, the OECD recommended the ESM include provisions for private-sector involvement to encourage market discipline. It also warned that some euro-area countries may not have the means to tackle a crisis of their large domestic banking systems, adding the bloc must proceed with banking sector recapitalizations that draw, if necessary, on public funds.
The EU should also consider a more integrated system of bank supervision and resolution, according to the OECD, where bank failures would fall as much as possible on the private sector's shoulders through the use of bail-in instruments. To ensure that bank holdings are properly diversified, it said, the EU should overhaul its treatment of sovereign bonds from the current risk-free rating.
"This would further help to decouple governments from their national banking systems," said the OECD. The EU is expected to propose bank resolution legislation this year.
The OECD's outlook for economic growth in the euro area is "unusually uncertain," with large downside risks from a lack of effective policy action, which could lead to a severe recession. For instance, fiscal consolidation and potential bank deleveraging may restrict economic activity before any benefits are seen from healthier public finances. As demand keeps weakening, unemployment is likely to rise further.
If the crisis intensifies, the European Central Bank may need to widen its set of nonstandard measures to support the monetary transmission mechanism and maintain price stability. The bank could also commit to maintaining low interest rates for a long period, said the OECD report.
Countries with fiscal space—such as Finland, Germany and the Netherlands—should ease austerity temporarily, the OECD added. However, countries under financial assistance programs and those facing close market scrutiny should stick to targets. It also suggested establishing independent fiscal councils in all euro-area countries.
Structural reforms will be important in the wake of the crisis. Across the EU, leaders should work toward strengthening the internal market by breaking down national barriers, recognizing professional qualifications across all 27 member states and reforming pension systems and housing policies so workers can be more mobile within the region.
If effective policy action isn't taken, high-risk-spreads and self-fulfilling-expectations could lead to unsustainable debt dynamics that threaten a global spillover from the crisis, according to the OECD.
Write to Riva Froymovich at riva.froymovich@dowjones.com
OECD, European Commissioner for Economic and Monetary Affairs Olli Rehn, the European Union, German Chancellor Angela Merkel, BRUSSELS—The European Union, firewalls, firewall, European Stability Mechanism, economic bloc, European Commission
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