Europe action against financial crisis and its implications

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By Xin Lian
Updated: 2008-10-14 11:33

The whole world is gripped by the financial pandemic originating from the United States. Europe appears especially fragile with its leading financial institutions in deep trouble. Hard as European governments have tried, the situation keeps deteriorating, casting doubts on the European Union’s competence to handle the crisis, its economic outlook, and the future of its integration.

1. A looming meltdown European banks have a tradition of prudence. However, impressed by the development model of their American counterparts, many European banks have become more leveraged in recent years. According to the Center for European Policy Studies, the leverage of the top 10 banks based in Euro zone averages at 33:1. They invested in mortgage loans and derivatives, hoping to boost returns.

The subprime crisis in the US has dealt a heavy blow to European banks. On Bloomberg’s estimate, as of the end of last August, the crisis had forced the European banking sector to write down USD 227.3 billion, accounting for about half of the losses reported worldwide. Big tickets such as UBS and RBS have suffered the worst. To make things more complicated, the decade-long housing bubble has burst in the UK, Spain, Ireland, France and other major economies, resulting in poor profitability and rising bad debts in the banking sector. To meet the requirement for capital adequacy ratio and liquidity, in particular to deleverage their operation, local banks were in desperate need of financing. However, with the stalling international money market and credit market, European banks found it unaffordable or impractical to obtain new credit. They had no choice but to sell proprietary assets at big discounts, reminiscent of the vicious cycle in America.

According to the Wall Street Journal, Europe’s 30 biggest financial institutions hold over USD 1 trillion in liabilities which will mature within 15 months. The pressure of refinancing is huge. This is corroding investor confidence in their solvency and liquidity. Driven by the fear that the authorities may recapitalize these banks, diluting their shares, investors are fleeing from the financial sector, sending the European stock markets to new lows.

2. Doomed individual actions To stabilize the market, European governments have introduced various measures. One option is to recapitalize the distressed banks. For example, Dexia received a joint injection of EUR 6.4 billion from France, Belgium and Luxembourg. United Kingdom-based Northern Rock was nationalized. Another initiative is to extend guarantees for domestic depositors. Ireland, the UK, Germany, France, Austria, Sweden, Denmark, and Iceland have done so to restore confidence. On Oct. 7th, the financial ministerial meeting of the EU decided to increase bank deposit guarantees to EUR 50,000 and to keep them in place for not less than 1 year. Moreover, ECB, Bank of England and other central banks have joined the Fed to replenish liquidity in the banking sector. However, as I observed in a note on Oct. 2nd, Europe’s monetary and political landscapes make it difficult for EU to take concerted effort to address this continent-wide crisis.

First, ECB’s major mandate is to stabilize prices instead of serving as a lender of last resort. Therefore, apart from supplying liquidity for the whole banking sector, it is unable to bail out individually insolvent banks.

Secondly, as the central banks in Euro zone do not issue banknotes, the only source of relief has been the fiscal authorities. To be justifiable before domestic taxpayers, these bailout efforts are limited within respective borders. This beggar-my-neighbor politics has victimized the most fragile economies. Cut out of aid from the EU, Iceland is on the verge of bankruptcy and has to seek a USD-5.4-billion lifeline loan from Russia.

Thirdly, some bank holding groups are too globalized to be bailed out by a single country. Their overseas affiliates are usually incorporated as independent legal entities with separate balance sheets, but their operation and cash flow remain controlled by the head office. Once these affiliates are taken over by respective governments of host countries, they are unable to continue operation. Thus the governments have to sell these affiliates after temporary take-over. However, in the battered market, it is difficult to find interested bidders. For example, when Fortis fell victim to the crisis, Benelux governments nationalized parts of Fortis in their respective countries. But later they realized this plan wouldn’t work out. So Luxembourg and Belgium arranged for an equity swap with BNP Paribas. Furthermore, it’s a sensitive, entangled issue to distribute among countries the losses from bank failures.

At a summit on Oct. 4th, Germany and the UK turned down a French proposal to set up a mutual bailout fund for the European banks. As the joint statement reveals, France, Germany, the UK, and Italy have agreed to ensure the stability of the banking sector and the financial system. But how to counter the crisis will remain at the discretion of individual countries. Without a union-wide initiative for concerted action, the country-level efforts could be meaningless.

Fortunately, banks of the new EU member states are much less integrated into the global system. Their losses have been relatively moderate so far.

3. Implications A) A slowing European engine The financial outlook in the Euro zone has been upset by the financial turmoil. Data shows that fundamentals are deteriorating fast. The jobless rate is up to 7.5%. Growth in Germany and other major economies is freezing for a whole quarter, or even a whole year. As the world economy gets deleveraged, the future of the Euro zone is being frustrated. . The IMF has tuned its growth projections for the area from 1.7% to 1.4% this year, and 1.2% to 0.9% for the next.

B) Derailed political and economic integration EU has rolled out rules to ensure fair competition between enterprises from its member states and enforce budgetary principles. For example, member states should abide by regulation on state aid and fair competition when providing aid for the private sector. The weight of budgetary deficits and outstanding public debt shall not exceed 3% and 60% respectively, relative to GDP. However, pressed by the crisis, member states have bent these rules, asking for greater discretion. This will undermine the foundation of the common market. A fragmented EU could lead to depreciation of the euro.

C) A changing geopolitical landscape Russia is also a victim of the subprime crisis, with loss-ridden banks, capital flight (exacerbated after the conflict with Georgia), a plunging stock market, and stagnant growth. But it owns foreign exchange reserves of USD 563 billion, the world’s third largest. While America and Europe are licking their wounds, Russia is positioned to play a bigger role in regional and international affairs. After Iceland was deserted by the EU, Russia seized the opportunity to show its economic muscle and influence over the world economy, by offering USD 5.4 billion in emergency loans. Many political and economic analysts say that the geographic significance of this deal is “obvious”, as Iceland is a NATO country and Russia’s relations with the west are far from constructive.