Rising economic woes test Europe's leaders

From the lush emerald hills of Ireland to the gritty steel plants of Ukraine, Europe faces multiplying economic headaches.

Perhaps a longtime European Union member such as Greece or Spain will default on its sovereign debt. Or one or more of the heavily indebted ex-communist states in Eastern Europe will capsize and require a costly rescue.

Either way, an economic crisis that Europeans once regarded as fundamentally American in origin and consequence is testing the continent's resilience. So far, the results are not reassuring. Germany, Europe's economic engine, ardently resists talk of a bailout for either old or new Europeans, fearing it will inevitably get stuck with the tab. A top EU official, meanwhile, unsuccessfully seeks to calm fears that some countries will be left to fail, by insisting there is a rescue plan but that its details are secret.

"Europe doesn't have the institutional capacity to deal with the situation — either Ireland within the eurozone or Hungary outside it," says Marc Chandler, senior vice president for currency strategy at Brown Bros. Harriman.

The U.S. Treasury has drawn fire for its handling of the increasingly costly bailouts of banks, insurers and automakers in this country. But imagine what the economy would look like if there were no Treasury to do the bailing — no marble building adjoining the White House; no bronze statue of Albert Gallatin, the longest-serving Treasury chief, out front; nothing.

That's why Europe is flailing amid a worsening recession, talk of sovereign defaults and quaking banks. A decade after the launch of a single currency, the euro, the European Union has a central bank but no federal financial policy organ. Where the U.S. has Gallatin's descendent, Treasury Secretary Timothy Geithner, Europe has 27 national finance ministers.

Worries for USA

The consequences of Europe's incomplete union ultimately could boomerang on American banks and companies. Simon Johnson, former chief economist for the International Monetary Fund, calls Europe's financial woes "a dagger pointed at the heart of major U.S. banks." Links among major global banks mean that massive losses by European institutions, which loaned massive amounts to Eastern borrowers, could ripple onto already weakened U.S. behemoths, Johnson says.

"They're all interconnected. … If the Europeans have a problem in the banking system, it will come through to American banks," he says.

As eurozone economies contract, European customers are buying fewer American products. Intel's fourth-quarter sales in Europe fell 27% from the fourth quarter in 2007, to $1.6 billion. Overall, U.S. exports to Germany in December of $3.8 billion were down 5.6% from the same month in 2007. And trade flows have only shrunk since then.

In recent years, the European Union expanded to include former Warsaw Pact states such as Poland, Hungary and the Czech Republic, and laid plans for those new members to adopt the euro. Lenders from Western Europe and borrowers in the ex-communist East both assumed the road to the euro would be smooth. Eastern countries embarked on borrowing sprees in a rush to match the living standards of their Western cousins. Soon, the Baltic nations and countries such as Hungary and Romania were running chronically large current-account deficits.

Year by year, banks in Germany, Austria and Switzerland loaned billions of dollars to Eastern European households and businesses, which were drawn to euro-denominated loans by low interest rates. Today, those banks have $1.7 trillion in loans outstanding to borrowers in the East with $400 billion in short-term debt due to be paid off or refinanced this year, says Stephen Jen, managing director at Morgan Stanley in London. That $400 billion amounts to roughly one-third of the region's annual economic output. And that's where the real problems begin.

As investors rediscovered risks of all kinds amid the global financial crisis, currencies in the ex-communist states paid the price. Since last July, the Hungarian forint, for example, has lost 28% of its value against the euro. A 1,500-euro monthly mortgage payment that used to require 342,240 forints now costs 474,750.

Corporate borrowers, meanwhile, are being hit twice. Along with the exchange rate impact, their sales have been hammered by the intensifying slowdown in the West, which accounts for at least half their export revenue. The drop-off leaves Eastern companies with insufficient cash to service their debts, Jen says. As global demand for steel has collapsed, Ukraine, for example, has seen about one-quarter of its export sales vanish.

About three-quarters of Eastern Europe's foreign cash comes as bank loans, according to Morgan Stanley. The global crisis now is pinching the flow of foreign capital that countries in Central and Eastern Europe depend upon.

Today's difficulties were foreseen by some. An IMF team last summer warned Romania that by shifting to more short-term loans, the country was "increasing debt rollover risks." Now, Romania is in talks with the IMF about a possible multibillion dollar financial bailout.

Capital flows into eight Central and East European nations peaked at $388.2 billion in 2007 and are expected to sink to just $6.7 billion this year, according to the Institute of International Finance, an association of banks and other financial institutions. Excluding Russia and Ukraine, which are both forecast to see net outflows of capital to repay foreign lenders, the falloff is less dramatic, though still worrisome. Flows into Poland, the Czech Republic, Hungary, Romania, Bulgaria and Turkey totaled $180.9 billion in 2007 and will be $59.5 billion this year, the IIF said.

"Eastern Europe is going to collapse in the next phase of the crisis," says Tim Lee, an economist at Pi Economics in Stamford, Conn.

Lee, who has been warning of gathering problems in the region for years, says the financial contagion ultimately will infect countries that have remained relatively unaffected so far, such as Turkey and Poland.

Analysts from Danske Bank, Denmark's largest financial institution, warned clients recently of the "very clear risk of an Asian crisis-style meltdown," a reference to the 1997 episode that spread from Thailand to topple all the region's vaunted "tiger" economies.

Officials from the region, however, insist the danger has been exaggerated. On March 4, six central bank chiefs from Central and East Europe (CEE) pushed back at market speculation about an inevitable regional crisis. Such arguments were "simplified and misleading, and could have negative implications for banks operating in these countries," their statement said.

"Such self-fulfilling speculation totally disregards fundamental economic developments in the CEE countries and creates misperceptions that could inevitably be detrimental to both the CEE region and Europe as a whole," the bankers said.

Eastern Europe's wounded

Not all countries east of Germany are failing. Eurozone members Slovenia and Slovakia seem safe, as do euro aspirants Poland and the Czech Republic. Most vulnerable are Hungary; the Baltic trio of Latvia, Estonia and Lithuania; Bulgaria; Romania; and Ukraine. The IMF already has extended multibillion-dollar financial lifelines to Hungary, Latvia and Ukraine, with more wounded countries waiting in the wings.

Hungarian Prime Minister Ferenc Gyurcsány proposed a $240 billion EU bailout fund for the Eastern European countries, but was rebuffed at a March 1 summit. A few days earlier, the World Bank cobbled together a roughly $33 billion package to support bank lending, which IMF Managing Director Dominique Strauss-Kahn hailed as helping "mitigate the effects of the financial crisis on credit flows in the region."

But private sector analysts were dismissive. "It's a first step. But you have to multiply it by 20," said Daniel Gros, director of the Centre for European Policy Studies in Brussels.

Tuesday, the European Union endorsed doubling the IMF's financial war chest to $500 billion to cope with likely rescue needs.

Western banks' $1.7 trillion exposure to the East, measured against the EU's $13 trillion economic output, doesn't appear unmanageable. But because the EU lacks a central treasury, each country's banks, for the moment, are on their own. Austrian banks — notably, the giant Raiffeisen Bank, with operations in 17 Eastern countries — have exposure to the East that is equal to 68% of Austrian gross domestic product.

If losses mushroom on those debts, the Austrian government would be unable to rescue its banks alone. Vienna would have to turn to the EU, where the key player is Germany. And facing national elections this fall, German Chancellor Angela Merkel has resisted telling German voters they must pay to rescue their more profligate neighbors.

"The German decision now is totally suicidal. Their banks are heavily overleveraged. So if they helped Eastern European countries, they would help themselves," says Anders Aslund, an economist with the Peterson Institute for International Economics in Washington.

But if Germany has been slow to rescue the newest Europeans, it might also be because Europe's problems aren't confined to the East. Several smaller EU economies are behaving in ways that suggest to spooked markets they might one day default on their government debts. Investors have lumped the cash-poor candidates under the waggish moniker PIIGS — for Portugal, Ireland, Italy, Greece and Spain. All face the need to borrow growing amounts to cover yawning gaps in their public finances.

In Ireland, the aftermath of an outlandish housing bubble has driven the economy into recession and exposed widespread bad loans by the country's major banks. The plunging economy, in turn, has wrecked public finances. The moribund property market is depriving the government of a critical source of tax revenue, while fast-rising unemployment sends social spending soaring.

The result is a massive budget deficit of nearly 10% of gross domestic product, which will require sizeable borrowing by the Irish government. Markets have responded by driving up the cost of credit-default swaps, a form of insurance against Ireland defaulting on its bonds, to more than 355 basis points, vs. just 31 basis points before the Lehman Bros. bankruptcy in mid-September. Likewise, Ireland now must offer investors 2.7 percentage points higher yield on its bonds than rock-solid German government debt.

On Friday, the ratings agency Fitch, joining Moody's and Standard & Poor's, said Ireland was in danger of losing its AAA credit rating unless it repaired its tattered finances.

If Ireland or another PIIG nation does default, the consequences — in an already fragile global environment — could be serious for both global market psychology and the euro. Most analysts expect that Germany would ultimately help fund a bailout, most likely through the auspices of the IMF or one of the European multilateral institutions. Joaquin Alumina, the EU's monetary affairs commissioner, said earlier this month the bloc had an unspecified "solution" for eurozone countries at risk of default. "By definition, this type of thing should not be explained in public," he said.

For investors, that vague promise raised more questions than it answered. But the uncertainty about how the costs of a bailout, for old or new Europe, would be allocated has investors taking a hard look at Europe's political and financial structures. Europe's monetary union "is being stress-tested for the first time in its history, and this is a severe test," says Morgan Stanley's Jen. "We don't know what the outcome is. And nothing can be ruled out."