By Colin Barr
July 21, 2010

The sovereign debt scare that rattled Europe this spring must serve as a “wake-up call” for reform, the IMF said Wednesday.

The International Monetary Fund said Europe must act boldly to restore confidence after a brush with insolvency in Greece fed questions about the region’s future.

The IMF said it expects the euro area’s economy to expand just 1% this year and 1.25% next, amid fears that surging public debt will keep growth in check.

Noting the prospect of continued financial instability, the IMF urged banking watchdogs to provide more information about the health of the region’s banks. It also stressed the need for national policy cooperation and said an overhaul of European institutions is overdue.

“The euro area has faced a severe market test in recent months,” the IMF said in its annual report on Europe. “The current turmoil resulted from unsustainable policies in some member countries, delayed repair of the financial system, and a lack of progress in fixing the deficiencies in economic governance laid bare by the global economic crisis.”

The group’s comments come as European policymakers prepare for Friday’s planned release of the results of a stress test of the region’s banks. Investors have been worried that faltering state finances in southern European nations such as Greece, Portugal and Spain could leave banks in stronger nations with massive losses, necessitating another round of costly bank bailouts.

The IMF said it believes Europe would be best served by a policy of the more information, the better.

“To reduce aggregate uncertainty and induce a greater willingness to tackle troubled banks, staff called for a more detailed disclosure of inputs and outcomes, possibly at the institution-level, together with announcements of remedial actions by weak institutions to mitigate capital shortfalls,” the IMF said. “The staff also called for broadening the transparent use of stress tests beyond the largest institutions.”

But it acknowledged that bank regulators aren’t exactly lining up behind the concept. As was the case here before the results were released last May, there is much angst over the possibility that a miscommunicated stress test result could actually trigger a bank run rather than foreclosing that possibility.

“With sovereign risk predominant, staff agreed that communication would need to be handled carefully,” the IMF said. “Supervisors felt that disclosure of individual bank results could prove too market-sensitive and some national authorities noted legal impediments to publication.”

The IMF also pushed back against the deficit hawks now prevailing in European budget debates, warning that premature fiscal tightening could crimp growth.

“Restoring growth is not just important for its own sake―it is also essential to lay to rest worries about public debt,” the IMF said.

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