The European Commission released its revised — and bleak — economic forecast for the European Union. Europe is facing myriad troubles, including government denial of systemic economic problems, banking troubles and potential deflation. Unlike previous recessions in the twentieth century, Europe will have to rely on its own efforts to emerge from the current economic crisis. Editor's Note: This is the second part in a series on the global recession and signs indicating how and when the economic recovery will — or will not — begin.
The European Commission forecast published on May 4 painted a somber picture of the Continent's economy, with a European Union-wide gross domestic product (GDP) contraction of 4 percent, more than double the forecast made in January. The Commission also forecast the swelling of member states' budget deficits to 6 percent of GDP (1.6 percentage points greater than January's forecast and greater than the 2.3 percent deficit in 2008), which is well above the eurozone limit of 3 percent, and a rise in unemployment to 9.4 percent in 2009 (from 7 percent in 2008). The Commission expects the recession to continue into 2010, with GDP contracting by 0.1 percent and a potential rise in unemployment to 11 percent for the 27-country bloc. EU Commissioner for Monetary Affairs Joaquin Almunia said he hoped the May numbers represented "the last downward revision of our forecasts." The current recession sweeping Europe was triggered initially by the U.S. subprime crisis, which caused a global liquidity crunch, but has since moved on to a Continent-wide economic calamity that has wholly European origins. The financial crisis that befell the U.S., and by extension threw the global financial system into turmoil, only revealed the underlying fundamental problems in Europe, problems that were going to arise at some point — one way or another — for the Continent. The revised, more somber, forecast by the European Commission comes as no surprise to STRATFOR. Since June 2008, STRATFOR had cautioned that European banks were in serious trouble stemming from several factors. In particular, we pointed to the exposure of the overheated economies in Central Europe and the housing crisis in certain member states. Furthermore, one of the long-standing problems for the European financial sector — the lack of unified banking regulation due to member states' concerns regarding sovereignty issues — left the EU seriously exposed in mid-2008 to a financial crisis with few, if any, levers on the EU level available to fight the crisis. Going forward, we expect Europe to face a downturn more severe than what the United States is facing, particularly the EU's export-dependent economies that derive close to or more than 50 percent of their GDP from exports. These countries include Austria, Belgium, Switzerland, Czech Republic, Germany, Denmark, Hungary, Ireland, the Netherlands, Sweden, Slovenia and Slovakia. Overall, the European Union depends on exports for more than 40 percent of its GDP, a figure much higher than the United States, which is comparatively isolated from global trade, and relies much more on domestic consumption (over 70 percent of GDP) for economic growth. Europe, and in particular Germany, will have to wait for global demand to pick up before it can expect to recover.
2009 Recession in Context of Past Recessions
The current European recession is set to be the most severe economic contraction since the end of World War II. Of the major economies in Europe — Germany, the United Kingdom, France, Italy and Spain — all are set to contract by more than double their previous post-World War II recessions. Germany's 5.4 percent contraction of GDP would be the biggest decline since the depths of the Great Depression in 1932, when the economy shrank by roughly 7.5 percent — excluding the immediate post-World War II devastation from 1945 to 1946. The contractions that occurred in 1974-1975, 1980-1982 and 1992-1993 provide comparisons for the current recession. A spike in oil prices prompted by geopolitical events outside of Europe's control caused the first two contractions. The Organization of the Petroleum Exporting Countries (OPEC) oil embargo in the 1970s caused the 1974-1975 contraction, long perceived as the most notorious recession because it halted 20 years of post-World War II economic growth. Rising oil prices induced by the 1979 Islamic Revolution in Iran caused the second recession from 1980 to 1982. In Europe, both the 1970s and 1980s recessions were exemplified by high inflation due to the increase in commodity prices (particularly in Spain and Italy). Unemployment was severe in the United Kingdom, but relatively tame in France, Germany and Italy, at least compared to current numbers. The 1970s recession ended the labor migration into Europe and exacerbated the conflict over the position of migrants in European societies that continues to rage. The recession in the 1990s was caused by a combination of factors, including a spike in oil prices instigated by the Iraqi invasion of Kuwait in 1990. The United Kingdom had already been in a recession since 1990 due to its exposure to the U.S. markets and financial sector, which went through a number of difficult periods in the late 1980s with the savings-and-loan crisis and the 1987 Black Monday stock market crash. The post-reunification hangover further exacerbated the recession in Germany, with its 5 percent GDP growth in both 1990 and 1991 slowing down to 2.2 percent in 1992 and -0.8 percent in 1993. (click to enlarge) The key variables of previous European recessions were exogenous factors, meaning Europe simply had to wait out the recession in order to recover. This is not to say the recessions did not exact a human toll through increases in unemployment, high inflation of prices, and social unrest, or that they were without tectonic political shifts. An example of the latter was the election of Francois Mitterand to the French Presidency in 1981 on an ambitious socialist economic platform. The contemporary recession, however, is unique in that it has revealed a set of severe structural economic problems in Europe, particularly the lack of unified banking regulation and the looming housing crisis, which will take some time for Europe to resolve. The fact that Europe has yet to really even admit the problems, much less undertake steps to resolve them, only exacerbates the negative outlook going forward. Therefore, the recession may end by 2011, with economic growth picking up in some economies in 2010, but it will take Europe longer this time around to get out of the doldrums, particularly because it cannot depend on rest of the world to pull it out of the recession. It will be up to Europe.
Origins of the 2009 Recession
The U.S. subprime housing crisis triggered much of the European recession, but it acted more as a catalyst than the fundamental cause. In Europe, the effects of the subprime crisis have caused about $380 billion in asset write-downs, with European banking heavyweights UBS, Royal Bank of Scotland, HSBC and Credit Suisse among the worst affected. The initial losses were significant, but not unmanageable. The subprime crisis, however, exposed fundamental vulnerabilities in Europe's economies and its financial systems, vulnerabilities that ran much deeper than mere bank exposure to the U.S. subprime crisis. Among the key weaknesses exposed were Europe's overindulgence in credit expansion, exposure of Western European banks to Central Europe's shaky economies, and a potentially large housing crisis in a number of European countries. Credit expansion in Europe is a general term that STRATFOR uses to describe two independent phenomena: low interest rates brought on by eurozone membership and effects of carry-trade on non-eurozone economies. Low interest rates came to countries like Italy, Spain and Ireland after the introduction of the euro, powered by the robust German economy. Spain went from averaging an interest rate above 10 percent between 1980-1995 to under 5 percent between 1995-2009. This low interest rate fueled consumption, particularly in the housing sector that was the basis of much growth in Spain and Ireland. As lending contracts and demand for housing withdraws due to the current economic crisis, however, the construction sector that fueled much of the growth (and employed large segments of the labor pool) is in serious jeopardy. This phenomenon is most severe in Spain and Ireland, but could have similarly negative effects in other European countries experiencing a housing crisis. Conversely, various forms of carry-trade brought the euro's (as well as Swiss franc- and Yen-based) low interest rate to consumers in non-eurozone economies. Borrowers in Central Europe were offered mortgages and other consumer loans in the form of Swiss franc or euro loans. This worked well when domestic currencies were strong due to a flow of foreign investments buoyed by global credit indulgence of post 2001 growth, but as the global economic crisis set in and investors fled what they perceived as risky emerging markets, currencies across Central Europe began to depreciate. This caused loans issued in foreign currencies to appreciate in relative value, and put a large number of outstanding loans in dangerous territory. The European Bank for Reconstruction and Development (EBRD) now estimates that as much as 20 percent of all loans in Central Europe could be non-performing, while the World Bank has estimated that the Balkans, the Baltic States and Central Europe may need at least 120 billion euro ($154 billion) for bank recapitalization efforts. The EU, particularly Germany, is wary of picking up the tab in order to shore up emerging markets in the event of a potential Central European collapse, and has therefore aggressively pushed for the recapitalization of the IMF to share the burden with non-European nations, such as the United States, Japan, and perhaps China. The issue of carry-trade credit overexpansion brings up another fundamental problem for Europe: the exposure of Western European banks to emerging Europe. It was largely through foreign-owned financial institutions that foreign currency-denominated loans flowed into Central Europe, the Balkans and the Baltic States. Consumers and businesses in emerging Europe took out 950 billion euros ($1.3 trillion) in loans with Austrian, Italian, Swedish, Greek, Belgian and French banks. With rising numbers of non-performing loans in emerging Europe, both due to the effects that depreciating currencies have on serviceability of loans and the general recession effects on loan performance, these banks have come under severe stress. According to premiums investors are prepared to pay to protect against the risk of default, some of the most troubled banks are in Austria (Erste Bank and Raiffeisen), Greece (EFG Eurobank, National bank of Greece, Piraeus Bank), Belgium (KBC) and Sweden (Nordea Bank and Swedbank). A banking collapse in these countries would represent a significant blow to confidence in the eurozone's financial systems. Finally, the current recession has exposed a massive housing correction, particularly in countries that experienced credit expansion due to the introduction of the euro, such as Ireland and Spain. The United Kingdom, the Netherlands, Denmark and the Baltic states also experienced a housing market boom due to general credit availability in the global growth years after 2001. Housing corrections can negatively impact the banking sector because of the links between lending and housing booms. As property development grinds to a halt and the construction industry seizes up, banks that extended loans to them could be under severe pressure. Furthermore, the effects on the construction industry are already leading to massive unemployment in Ireland, where the number is projected to increase to 13.3 percent in 2009 from 6.3 percent in 2008, and Spain, where unemployment is projected to increase to 17.3 percent in 2009 from 11.3 percent in 2008. But housing market correction is far from over, as the IMF's "housing price gaps" figures illustrate. The IMF housing price gaps are defined as the percent increase in housing prices above what can be explained by sound economic fundamentals, such as interest rates or increases in homeowner wealth. While Ireland and Spain certainly lead the pack in the severity of the correction, a number of other European economies may be looking on with dread at the effects the housing correction has had on Madrid and Dublin.
The Rocky Way Ahead
Europe's recession is now firmly entrenched, with slumping global demand leading to a drop in industrial output and exports. Industrial production has collapsed in the European Union, with an annualized rate of 27 percent decline between August 2008 and January 2009, while exports have declined 6.7 percent quarter on quarter in the fourth quarter of 2008, the largest decline since 1970. Germany, the economic powerhouse of Europe, has experienced quarter-on-quarter export decline of 7.3 percent in the fourth quarter of 2008, with a 47 percent year-on-year decline in orders for heavy machinery and factory equipment in January 2009 leading the drop in demand. The large decrease in export demand and the decimation of Europe's manufacturing sector has in part contributed to the revised Commission forecast for 2009. (click to enlarge) The severe contraction in the non-financial sector of Europe's economy is particularly troubling because Europe's corporate and banking sectors are heavily intertwined. Unlike in the United States, where firms rely more on corporate bond markets and equities for capital, European corporations are almost exclusively dependent on bank lending for financing. Spain, Italy, Sweden, Greece, the Netherlands, Denmark and Austria are all dependent on banks for more than 90 percent of funding, while the United Kingdom relies on more than 80 percent and Germany is close to 80 percent. This means that a severe recession is going to impact Europe's financial sector through an increase in traditional credit risks associated with recessions: a rise in bankruptcies and non-performing loans. Banking risk will therefore move from banks exposed to Central Europe to the rest of Western Europe, including German banks that until recently were thought to be solid. Europe's effort to address risk in the banking sector (and the crisis as a whole) has been disjointed from the very beginning. The European Central Bank (ECB) is split on the issue of direct intervention in corporate debt, with Austria and Greece supporting such a measure and Germany staunchly opposing it. Furthermore, bank lending guarantees and recapitalization efforts depend on national government plans, but there is no unified European scheme to oversee the efforts. Meanwhile, a plan on a unified financial regulatory framework was delayed due to U.K. opposition, despite the European Union's apparent unified stance on the matter at the G-20 summit. In addition to the looming banking crisis, European governments are also faced with mounting public debt and budget deficits. Budget deficits are ballooning across the Continent, with just some of the egregious examples being Ireland (12 percent deficit projected in 2009), the United Kingdom (11.5 percent deficit projected in 2009), Spain (8.6 percent deficit projected in 2009) and France (6.6 percent deficit projected in 2009). Public debt is just as dire, and in some cases quite extreme, such as Italy, which is set to go over 110 percent of GDP with its public debt in 2009 while the United Kingdom is going to go from 52 percent in 2008 to more than 80 percent of GDP in 2010. The situation is made all the more dramatic by the fact that very few of the European states began the situation with exorbitant public debts. The problem with rising budget deficits and public debt is that it is making sovereign bond issues from European countries less and less attractive. European countries are already competing with U.S. Treasury securities — traditionally a safe-haven investment during recessions due to their perceived security — on the international bond market, as well as with the similarly safe German government bond (referred to as the German Bund). Unattractive sovereign bond issues in concert with greater competition, caused by expanding global levels of public debt, is problematic. The fear that bond auctions will fail — and a few have already failed — due to lack of demand and investor interest has forced European countries to move away from the international bond market that relies on auctions, and towards syndicated loan issues, essentially negotiated deals with few lenders — meaning more expensive forms of debt financing. The increased risk is also reflected in the increase in the yield spread between the German Bund — considered the safest European sovereign debt — and other European bonds. One final note of caution is that of deflation. Numbers released on May 5 by the European Commission show that factory gate prices in the eurozone have fallen 3.1 percent from a year earlier, the biggest decline since February 1987. The trend is worrisome because it illustrates a price drop in manufactured goods and not just in energy and food. While price deflation in energy and food prices can be beneficial for consumers due to cost decreases, it can also postpone investment, causing unwanted volatility, and continuous price deflation in manufactured goods can lead to a potential deflationary cycle. It shows that manufacturers have been forced to decrease prices in order to reduce inventories (which built up significantly in third quarter of 2008), leading consumers to delay purchases as price decrease becomes an expected phenomenon. For Europe, the way forward is unclear. The biggest problem in Europe right now is that most European governments are not even admitting there are serious systemic problems with the banking sector. This may be in part because it is easier for domestic purposes to blame the crisis on the United States, but also because the European economic engine — Germany — is in the midst of a complicated election campaign that could become even more complicated were European-wide recovery placed on the government's agenda. There has been no serious coordinated effort to deal with European banks on an EU-level and no loan remediation program to deal with potential housing problems (not that the EU would have legal ability to enact such a program anyway). Finally, the problems of deflation are concerning because were it to actually develop into a deflationary cycle, the eurozone would not be able to use quantitative easing to print its way out of the problem, due to eurozone monetary rules. A few weeks of decreased prices do not necessarily mean the Continent is headed for a deflationary spiral. At the very least, however, Europe will have to sort outs its coming banking crisis before recovery can take hold, which could be as far as 2011. Until that time, the current economic crisis could see further political change and sporadic outbursts of social unrest (including against migrants and minorities) across the Continent, with particularly threatened governments in Greece, Estonia, Lithuania and Hungary. All of Europe, however, will be bracing for a tough 2009.