European economy in a whole lot of trouble

Concerns about the health of European banks, particularly German banks, and the pace of Eurozone economic recovery have intensified.  Warnings by the European Central Bank’s (ECB) about further financial sector weakness if there is not a “V” shaped recovery reveal the extent of such concerns.  Attention is increasingly focusing on a lack of transparency and the fact that European regulators are not releasing the results of industry wide stress tests in contrast to the recently released results of US bank stress tests.  Such problems have not gone unnoticed in Germany and even the bank regulator in the country said recently that toxic assets at German bank could blow up “like a grenade”. 

It’s worth noting that the IMF’s estimates for future writedowns and capital requirements in its financial stability report suggest that European banks have much more to do than their US counterparts. See an earlier post titled “Stress testing European and UK banks”.   The IMF repeated its warnings this week as it wrapped up its consultations with European officials, whilst US Treasury Secretary Geithner is set to pressure European authorities to carry out tougher stress tests at this week’s G8 meeting.   Germany has taken some steps towards resolving its banking sector problems and this week the German cabinet agreed to support a “bad bank” plan.  Nonetheless, the task will not be easy as Germany is estimated to have over $1 billion in toxic assets, with consolidation of the regionally owned Landesbanken a major concern. 

The prospect of a “V” shaped recovery in Europe is extremely limited.  Warnings about the pace of eurozone economic recovery should be taken seriously.  However, some officials such as the ECB’s Quaden are already talking about an exit strategy, which looks very premature given the likely slower recovery in the eurozone compared to the US over the coming months.  Whilst the US economy is set to see positive growth next year, albeit below trend, Europe is facing a second year of economic contraction.   Moreover, the drop in Eurozone growth in 2009 is likely to be far steeper than the US, with the economy set to decline by close to 5%.  The bigger than forecast 21.6% annual drop in German industrial production in April and the 29% annual drop in April exports released this week provided a timely reminder of the pressure on Eurozone’s biggest economy.  Given the fact that the German economy is still highly reliant on export growth the data were particularly worrying. 

Against this background and with inflation continuing to drop, the ECB is highly unlikely to raise interest rates until the beginning of 2011 at the earliest.  The fact that ECB officials are even talking about an exit strategy seems completely at odds with the reality of the situation.  As it is the ECB’s EUR 60 billion covered bond purchase plan will have a limited impact, and the policy can hardly be labeled as aggressive.  

Even so, there is no indication that the ECB is about to embark on more aggressive credit or quantitative easing.   The latest ECB monthly report predicts that growth in the eurozone will begin to pick up by the middle of next year but admits that inflation could turn negative over coming months.   Surely this will give the ECB further room to maintain easy monetary policy.   Once again disagreements within a 16 nation ECB council will result in compromise at a time when the eurozone economy is crying out for decisive policy actions.   Growth and banking sector concerns will also be a factor that helps to prevent the euro from fully capitalising on any weakness in the dollar.

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4 Responses to “European economy in a whole lot of trouble”

  1. UP Says:

    Its also worth noting that many European Banks have large exposure to Eastern Europe, which is another ticking timebomb. They were quick to lend during the property boom in eastern europe now find themselves in a position where many billions may have to be written off. Latvia narrowly avoided a currency deval (which would have meant their debts would have multiplied overnight). This could could soon spill over to slovakia and possibly even Czech and Romania.

    • Mitul Kotecha Says:

      I think you are right to also look at the risks from Eastern Europe as we have seen lately for Latvia. However, the exposure in terms of European banks appears focused on banks in Italy and Austria. I understand that banks in Germany are less exposed. Nonetheless, contagion from Latvia is a clear risk going forward.

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