FYI | Feb 17 2009
By Greg Peel
In the late 1980s Japan was a serious contender to knock the US off its perch as the world’s largest economy. Then disaster struck. Japan has at least managed to retain second spot ever since, but on release of its fourth quarter 2008 GDP figures, which showed an annualised fall of 12.7% – the worst result since 1974 – it is now apparent second spot may soon be up for grabs.
On 2007 nominal GDP numbers it was touch and go between Germany and China as to who would take the bronze, but Germany just pipped China by a nose. On the 2008 numbers, however, China has snatched the bronze with US$4.2trn to Germany’s US$3.8trn (as at the end of 2008 and thus not accounting for exchange rate movements since). The US was still high on the podium, with US$14.3trn, but Japan’s silver came only with a small margin at US$4.8trn. With Japan contracting at around 13% and China still growing at 6-7%, it may not be long before China takes first runner up.
2008 did, however, see the European Union, as a bloc, outperform the US economy with US$18.9trn. The EU was the larger economy in 2006, but lost that mantle in 2007. The top ten list of countries by GDP includes all of Germany, France, the UK (which is in the EU but not the euro currency bloc), Italy and Spain. The gaps are filled by Russia and Brazil. The EU was able to knock off the US once again, as the US economy was the first to recede in the face of the global financial crisis. The US is hoping to halt its slide with zero interest rates, enormous fiscal stimulus, and enormous banking sector support. With the incumbent Japanese government not long for this world, Japan is on a slippery slope to hell. And with a restrictive trading bloc structure as an impediment (no doubt the GFC was not quite foreseen when the EU was created), Europe is facing its own kind of hell.
Which might be called The Eastern Bloc.
The original intention of the European Union was to unite the economic powerhouses of Germany, France, the UK et al as a single trading bloc able to compete with the US on a united front. Membership was initially extended to other Western economies and as the decade progressed, various Eastern economies from behind the former iron curtain stuck their hands up as well. After reasonable scrutiny they were welcomed as exciting “emerging markets”.
Thus, the Western states of Austria, Belgium, Cyprus, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Spain, Sweden and the UK share EU membership with the Eastern states of Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia. Growth in these Eastern frontiers has been almost exclusively financed by European banks, which have also extended significant credit beyond the EU bounds to the likes of Russia, the Ukraine and others.
While various Western members of the EU now fall into the “basket case” category of economic status – Ireland being a standard bearer, for example – there is still little comparison to the economic nightmares from behind the former iron curtain.
Ambrose Evans-Pritchard – the London Daily Telegraph’s resident doomsayer – notes that Austrian Banks have lent 230 billion euros to the former Soviet bloc, which equates to 70% of Austria’s GDP. The Austrian government has just put together a 150 billion euro rescue package, as the local media points out a failure of only 10% of the loans to the East would result in the collapse of the Austrian financial sector. The European Bank for Reconstruction and Development is predicting bad loans will reach a level closer to 20%. Failure would have ramifications beyond Austrian borders. Italy’s Unicredit owns Bank Austria, for example.
Austria appealed to rest of the EU to lend support to its rescue package. Germany said “Not our problem”. But as Evans-Pritchard suggests, “We’ll see about that”.
Morgan Stanley points out that Eastern Europe has borrowed US$1.7 trillion abroad on mostly short-term maturities. There is a US$400bn rollover required in 2009, but global credit markets are shut. Russia must still cover the US$500bn in debts run up by its famed (and now defunct) oligarchs. But with oil at US$33/bbl, this will be a struggle. Russia has spent vast amounts of foreign reserves just trying to prop up the ruble, which has still fallen 36%.
Morgan Stanley suggests this is the largest run on a currency in history.
Sixty percent of all Polish mortgages are denominated in Swiss francs. (Switzerland, of course, is not a member of the EU). The value of the zloty has halved against that of the franc. Imagine if 60% of Australian mortgage repayments had doubled. Australia’s GDP was the fifteenth largest in the world in 2008 – Poland’s (population 38 million) was twenty-second. There are similar stories to be heard in Hungary, the Balkans, the Baltics and the Ukraine. Evans-Pritchard suggests this is a European version of the US “subprime crisis”, except that this time no US banks are involved.
Virtually all Eastern bloc debt is owed to Western Europe, with the stand-out lenders being Austria, Sweden, Greece, Italy and Belgium. Moving further a-field, Europeans hold an astonishing 74% of the US$4.9trn of loans to all global emerging markets. European banks are five times more exposed than US or Japanese banks and 50% more leveraged. Spain has huge exposures in Latin America, where the likes of Mexico and Brazil have now embraced the global slump, while the UK and Switzerland have major exposures to Asia.
“Whether it takes months, or just weeks,” suggests Evans-Pritchard, “the world is going to discover that Europe’s financial system is sunk, and that there is no EU Federal Reserve yet ready to act as a lender of last resort or to flood the markets with emergency stimulus”.
As noted in “Just Who Will Fund The US Bail-Out” (FYI; 10/02/09), the European Central Bank decided not to cut its cash rate this month from 2%, despite the rest of the world continuing to cut madly or already being at zero. The decision was not based on any indication Europe’s economic slump has plateaued, but on a small matter of not being able to cut any further without issuing bonds.
The US Federal Reserve is able to inject enough funds to maintain a zero cash rate and step in to support the US banking system because the Treasury issues bonds on the other side of the equation and the world buys those bonds, thus lending the US the money. The EU has a central bank – the ECB – but no EU bond.
Instead, each member continues to issue its own bonds. In order for the ECB to rescue the European banking system, it would have to issue EU bonds for the first time. Apart from then having to find someone to buy them (and the way this story is playing out, who would?), it would effectively mean taxpayers in the relatively strong economies of Germany and France, for example, would be bailing out the taxpayers of the basket case economies (which include the likes of Italy). Such a move would most likely lead to the collapse of the EU altogether.
The stronger Western economies have already begun to circle the wagons. Some governments are pressuring their banks to withdraw from Eastern Europe and leave their subsidiaries stranded. Athens has ordered Greek banks to pull out of the Balkans.
The International Monetary Fund (which is mostly funded by the US) is the only remaining safety net between survival and disaster for the Eastern bloc. The IMF has already bailed out EU members Hungary and Latvia, as well as Iceland, Ukraine, Belarus and Pakistan, with Turkey next in line. Eastern Europe needs to roll over US$400bn this year and the IMF has already used up much of its US$200bn of reserves. It may yet have to dust off arcane powers and actually print “world” currency. (What would that do to the price of gold?)
Deutsche Bank expects the German economy – the biggest in the EU – will contract by close to 9% before the end of the year. Is Germany going to run around rescuing the credit bubble economies of Ireland, Spain, Greece and Portugal, the heavily indebted Italy, or the overextended Austria? A 9% economic contraction is by itself, suggests Evans-Pritchard, “the sort of level that sparks popular revolt”.
Can the European Union survive? Can Europe survive?