Europe Faces `Huge Threat' as Emerging Markets Slide

By Simon Kennedy

Oct. 28 (Bloomberg) -- The European economy's close ties to emerging markets are turning from a blessing to a curse.

Already skirting recession, the 15 euro nations face greater pain as economies which gave them an edge over the U.S. and Japan stumble. Neighbors to the east, that buy about a third of the region's exports, are faltering as their banks weaken and currencies slide. Meanwhile, the halving of oil prices since a July record is slowing demand from the Middle East.

European companies such as France's Schneider Electric SA and Finland's Kone Oyj are saying orders will weaken as emerging-market countries from China to Argentina succumb to the credit crunch. Citigroup Inc.'s economists now expect deeper interest-rate cuts and a recession in the euro region.

``It's a huge threat to the euro area,'' said Nick Kounis, chief European economist at Fortis in Amsterdam. ``It had been hoped these markets would hold up better and drive European growth.''

As recently as Oct. 6, European Central Bank President Jean-Claude Trichet was betting ``ongoing growth in emerging- market economies might support a gradual recovery'' next year. Yesterday, he said the bank may lower rates next week as the financial crisis damps inflation.

The 14-month credit crunch is prompting investors to sell riskier stocks, bonds and currencies, while punishing banks they view to be short of capital. Emerging-market stocks dropped to a four-year low yesterday.

Lines at IMF

Ukraine, Hungary, Belarus and Pakistan are seeking aid from the International Monetary Fund and Argentina's markets are in turmoil after its government tried to take over private pension funds. Russia has pledged more than $200 billion to stem its worst banking crisis since 1998 and China is slowing after expanding more than 10 percent for five years.

Europe's vulnerability to a downturn in emerging markets is reflected by how it benefited from their upswing. Exports to them were equivalent to about 6 percent of the continent's gross domestic product in 2006, compared with about 4.5 percent in 2000 and less than 4 percent in the U.S., says Juergen Michels, an economist at Citigroup Inc. in London.

The dozen, mostly Eastern European, nations which joined the broader European Union since 2004 account for 15.3 percent of the euro-area's foreign demand, up a third since the start of the decade, according to the ECB. The contributions of China and Russia have almost doubled. By contrast, the U.S. and U.K. portions have each dropped about 4 percentage points to 11.9 percent and 14.5 percent respectively.

`More Exposed'

``With a higher share of exports to emerging markets, the European countries benefited much more than the U.S. from booming emerging-market economies in recent years,'' said Michels. Now they are ``more exposed'' to their downturn.

The euro-area economy will contract for the first time since 1993 next year, forcing the ECB to cut its benchmark rate to at least 2 percent from 3.75 percent, he predicts. The Bank of England said in a report today that turbulence in emerging markets is posing heightened risks to Britain's financial stability.

Schneider Electric, the world's biggest maker of circuit breakers, now expects emerging markets to slow after four years. Even China ``isn't immune to external forces,'' Chief Executive Officer Jean-Pascal Tricoire said Oct. 22. Kone, a manufacturer of elevators, said the previous day that investment is slowing from Mexico to India to Qatar and that Russia is a ``question mark.''

Earnings Forecasts

Gareth Williams, an equity strategist at ING Bank NV in London, says more companies will downgrade earnings forecasts. Firms in Austria, Portugal and Spain have the most revenues from emerging markets, while Ireland, Greece and Italy have the least, he said in a report to clients yesterday.

Eastern Europe is ``rapidly becoming a key risk'' to the euro area, said Stephane Deo, chief European economist at UBS AG in London. He estimates 30 percent of euro-area exports at the start of this year went to its eastern trade partners, double the shipments to the U.S. Germany and the Netherlands are most at threat with 3.5 percent of their GDP accounted for by sales to the former communist bloc, he said.

Buoyant demand from Russia and the Middle East is ebbing as falling oil prices curb their purchasing power. Crude rose 625 percent from 2001 to a record $147.27 per barrel in July, enabling oil producers to buy equipment such as MAN AG's trucks and ``Made in Europe'' luxury goods including handbags from Gucci Group NV.

Oil Bill

The demand was strong enough for Europe to recoup two-thirds of its higher oil bill in the past five years, calculates Klaus Baader, chief European economist at Merrill Lynch & Co. While the drop in energy costs will ``be good in the short-term for domestic demand, over the medium term, reductions in demand for exports are going to weigh on the European economy,'' he said.

Already retrenching as they try to cover $221.8 billion in losses and writedowns, European banks also stand to be hurt more than most if emerging markets goes sour, said Stephen Jen, chief currency strategist at Morgan Stanley in London.

European banks lent $3.5 trillion to these economies, compared with $500 billion from the U.S. and $200 billion from Japan, according to his estimates. Those in Austria and Spain were particularly exposed, he said. Three quarters of loans to China and India originate in Europe.

``Pressures on emerging-market economies could have a particularly negative boomerang effect on European banks,'' Jen said.

To contact the reporter on this story: Simon Kennedy in Paris at Skennedy4@bloomberg.net