By James G. Neuger and Simon Kennedy
March 2 (Bloomberg) -- What doesn’t kill the euro region may make it stronger.
As the sharpest contraction since World War II batters the 16-nation economy, Europe’s leaders are belatedly -- and reluctantly -- starting to fix design flaws, including a patchwork of financial regulations and lack of fiscal coordination, that hamper the decade-old monetary union.
“A crisis is a terrible thing to waste,” says Barry Eichengreen, a professor at the University of California at Berkeley and author of a 2006 book on Europe’s economic history. “Crisis can be a catalyst for reform, and in Europe’s case we see the possibility of that happening.”
Germany, the bedrock of the euro, has embraced the idea of aiding neighboring countries in financial straits. The European Central Bank may cut its key interest rate to a record-low 1.5 percent on March 5, a level its inflation-wary officials rejected as unthinkable just weeks ago. Tighter continent-wide banking rules are increasingly likely.
Efforts to fortify the foundations of the single currency are gaining momentum. A panel of European Union advisers recommended on Feb. 25 the creation of new agencies with power to tie together national regulators of banks, insurers and securities firms. Multilateral institutions including the World Bank on Feb. 27 offered billions of euros of loans in an effort to keep collapsing economies in the east from dragging Europe into a worse recession. Still, European Union leaders yesterday rejected providing more direct government aid to eastern nations outside the euro zone.
Soaring Deficits
The euro economy shrank 1.5 percent in the fourth quarter, and the European Commission predicts a 1.9 percent slide this year. That’s sending government budget deficits soaring past the euro zone’s limit of 3 percent of gross domestic product. The aggregate shortfall is heading for 4 percent in 2009 and 4.4 percent in 2010, the Brussels-based commission says. In Ireland, next year’s gap may reach 13 percent.
From the start, Europe has lacked a U.S.-style revenue- sharing system to smooth economic ups and downs among regions. Financial regulation hasn’t kept pace with globalization, leaving Europe’s national supervisors overwhelmed by crises, like the collapse of Belgian-Dutch bank Fortis, that traverse national boundaries.
“There is at the moment great tension in the euro area,” billionaire investor George Soros said Jan. 28 at the World Economic Forum in Davos, Switzerland. “In a crisis condition, it will be resolved and the euro will emerge as a stronger, more constitutionally complete currency.”
Vested Interests
There are still obstacles to a more centrally managed union: the same vested interests and popular skepticism that made the euro a part-federal, part-national creation. The economic calamity can strengthen nationalist voices, as when French President Nicolas Sarkozy complained in a Feb. 5 television interview that his country’s carmakers shouldn’t create jobs in the Czech Republic.
When German and French leaders hatched the euro project in the early 1990s, they envisioned a club of a half-dozen continental neighbors. Instead, 11 countries passed the economic tests to join in 1999. Five more have since entered, including Slovakia this year.
The nations on the fringes generated Europe’s fastest growth in the euro’s first decade. Now they are trouble spots. As housing booms go bust, wider bond spreads and record costs for debt-default insurance in Ireland, Spain, Portugal and Greece raise the specter of national bankruptcies.
Ireland’s Collapse
Ireland, the euro region’s second-fastest-growing economy in 2007, is now its fastest-shrinking, forcing the Irish government to pay around 2.5 percentage points more on 10-year bonds than Germany, compared with a quarter point a year ago. Credit-default swaps on Irish bonds tracked by CMA Datavision peaked at 399 basis points on Feb. 17, a sign of dwindling faith in the government’s ability to pay its bills.
Such setbacks feed speculation that the leaders of weaker economies might be motivated to drop out of the monetary union so they would be free to run higher budget deficits and manage their debt by devaluing their currencies.
Hayman Advisors LP, the firm that earned $500 million betting on the U.S. subprime mortgage-market collapse, sees another possibility: Monetary union falls apart as Germany balks at following through with bailouts of faltering euro members such as Austria, Italy and Spain. Richard Howard, a managing director for global markets at Dallas-based Hayman, says defaults in the weaker economies might compel Germany to renounce the euro.
Breakup Odds
The possibility of disintegration dominated discussions on a recent trip by UBS AG economists to Asia. In a research note, they said one question came up in virtually every meeting with investors: “Will the euro break up?” Irish bookmaker Paddy Power Plc is offering 14-1 odds on the currency crumbling by the end of 2010.
Don’t take that bet, says Aurelio Maccario, chief euro- area economist at UniCredit Group in Milan. He says pulling out of the euro would make it even costlier for a renegade country to pay off its debts, while hurting its trade and almost surely leading to a run on its banking system.
“The euro is a one-way door,” says Maccario, who predicts it will rise to $1.35 this year as investors tune into that view. The currency fell to a one-week low of $1.2562 today, and traded at $1.2587 as of 12:02 p.m. in Tokyo from $1.2669 late in New York on Feb. 27.
New Climate
This week’s expected ECB decision to cut rates illustrates how quickly the climate has changed. As recently as December, council member Axel Weber cautioned against such a reduction, and colleague Yves Mersch said the scope for cuts was “very limited.”
Other old prejudices are also falling by the wayside. Sarkozy and Italian Prime Minister Silvio Berlusconi, two of the ECB’s biggest critics, have held their tongues since the economy buckled.
When Sarkozy ran for office in 2007, he demanded a “real conversation” about the ECB’s handling of the euro and the economy. Once the financial crisis struck in October, he praised the bank’s “vigorous” response.
Branching Out
Led by Frenchman Jean-Claude Trichet, the ECB is branching out beyond setting interest rates and is seeking a greater role in cross-border bank regulation. With 45 multinational financial firms accounting for about 70 percent of the EU’s total bank assets, new institutions are needed to coordinate oversight, a panel led by former Bank of France Governor Jacques de Larosiere concluded Feb. 25.
Regulatory overlap hastened the demise of Fortis, which has dual headquarters in Belgium and the Netherlands. As the Dutch government bought most of Fortis’s Dutch operations, shareholders vetoed a sale of most of the Belgian side to BNP Paribas SA.
“We won’t fix the banking system without a more federal framework for banking regulation,” says Nicolas Veron, resident scholar at Bruegel, a Brussels-based research organization.
More-centralized regulators may also extend their reach to include rules on hedge funds, supervision of credit-rating companies and sanctions on tax havens under principles worked out Feb. 22 by the heads of Europe’s major economies.
That accord marks a turnabout from the hands-off approach of the early days, says Rudolf Edlinger, who, as Austria’s finance minister, supervised technical preparations for the euro’s 1999 introduction.
‘Got Funny Looks’
Edlinger recalls suggesting “a supervisory system for hedge funds and similar products. I got funny looks, as if I came out of a bygone world.”
Equally significant is new thinking in Germany, which designed the euro in the image of the inflation-resistant deutsche mark -- and forced the rest of Europe to play by its rules to gain access to the lower interest rates and stable trading terms the single currency brought.
When Finance Minister Peer Steinbrueck said Feb. 16 that “the other states would have to rescue those running into difficulty,” he tore up decades of German economic orthodoxy.
He didn’t do so out of charity. With 42 percent of German exports bound for the euro region and 64 percent for the 27 nations in the EU, a crisis in Vienna, Lisbon or Warsaw means lost jobs in Berlin. A 7.3 percent plunge in exports was responsible for the 2.1 percent drop in German economic output in the fourth quarter.
Germany Suffers
German unemployment rose for a fourth month in February, reaching 7.9 percent. Heidelberger Druckmaschinen AG, the world’s largest printing-press maker, and ThyssenKrupp Steel AG, Germany’s biggest steelmaker, are firing staff, while companies including car-parts maker Leoni AG are putting workers on shorter shifts.
As the advanced economies crash, western investors who plowed into eastern Europe after the fall of the Berlin Wall in 1989 are pulling money out. Poland, the largest eastern European economy, and its neighbors are crying out for a lifeline.
Already, the EU has chipped in 6.5 billion euros ($8.3 billion) to prop up Hungary and 3.1 billion euros for Latvia, both euro outsiders. The World Bank, the European Bank for Reconstruction and Development and the European Investment Bank on Feb. 27 announced loans of up to 24.5 billion euros for eastern European banks.
Eastern Europe wants more: Viewing the euro as a safe haven, its leaders are pressing to be put on the fast track to join. Otherwise, they say, the east’s woes will quickly engulf the west.
Plunging Currencies
Companies in the euro region export as much to Poland, the Czech Republic and Hungary as they do to the U.S., making them vulnerable to plunges in the east’s currencies. Poland’s zloty has tumbled 29 percent in the past six months; Hungary’s forint has declined 21 percent and the Czech koruna is down 12 percent.
European Union leaders yesterday rejected pleas from eastern Europe for still more aid, bowing to German concerns over budget deficits. EU leaders vetoed a call by Hungary for loans of 180 billion euros for ex-communist economies in eastern Europe, and told automakers such as General Motors Corp.’s European arm to look to national governments for help.
One thing is forbidden: The ECB itself is barred from extending credit to governments. Even so, the euro region’s richest economies have leeway to grant loans to countries within the bloc, such as Ireland. And the EU “as a whole” can aid a member state in “economic difficulty,” says ECB board member Lorenzo Bini Smaghi.
Options include issuing joint government bonds or routing aid through the EU commission. German Chancellor Angela Merkel recommended Feb. 26 that governments coordinate national bond sales.
“Europe is never going to be a federation like the U.S., but it can mimic the U.S. in economic governance,” Eichengreen says. “Policy makers will find a way to make the currency area work because the alternative of seeing the project disintegrate is unacceptable.”
To contact the reporters on this story: James G. Neuger in Brussels at jneuger@bloomberg.netSimon Kennedy in Paris at skennedy4@bloomberg.net
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