Europe’s next crisis?

By Preston Keat

There is a new optimism in the Eurozone, but it may be masking some serious risks.

In a moment of crisis this spring, representatives of the 16 Eurozone governments came together to take dramatic action. Greece faced imminent financial collapse. Spain, Portugal, and Italy looked to be next in line. The Eurozone committed substantial sums of money, markets stabilized, and disaster was averted. Yet, Europe can no longer ignore the reality that the days of slow but steady Eurozone "convergence" are finished — possibly forever.

Gone are the days when traders could ignore big differences in Greek and German economic policies as they invest in the two countries’ sovereign debt. Prospective Eurozone members from Eastern Europe were once treated with little differentiation, despite wide variation in the credibility and transparency of their policymaking. The rule was for lower costs of capital for current members and Eurozone hopefuls alike, regulatory and legal integration, and diminishing attention to differences in national-level economic policymaking.

In the new Europe, the consensus favors belt-tightening. Governments must spend less money, collect more revenue, and guard against inflation. If governments fall of the wagon, it is feared, Europe’s single currency will again be in serious trouble.

The good news here is that markets are now paying attention to what each government is actually doing to balance its books and reform its labor markets. Questions of good governance now matter as much for France and Germany as for Hungary and Turkey. National-level politics is back. Policymakers across Europe face new scrutiny.

The bad news is that are still some large underappreciated risks in play.

The European banking system is integrated across borders, but banking regulations are still written and enforced by individual governments. This poses two problems. First, an individual government may not have the money to bail out a suddenly drowning bank. Second, there are no clear rules to help multiple governments and international financial institutions agree quickly on whether, when, and how to save a particular bank.

In June, finance ministers of the Eurozone countries created a special purpose vehicle to ensure they have the money and the means to rescue an ailing government. But what about an ailing bank? If Europe were to face a banking crisis, sovereign lending facilities could be accessed indirectly, but that could trigger a run on the lending facilities themselves.

Where might a European banking crisis begin? In Eastern Europe, the banking sector is dominated by large Western European firms. If one country falls short of economic performance expectations, investors could lose faith in other governments in the neighborhood, encouraging banks to tighten lending rules to reduce their risk exposure throughout the region and making matters worse in a series of countries-and then for the banks, as well.

Ironically, the recent stress tests of European banks, which Dan Alamariu wrote about recently in this space, have inadvertently raised the stakes with baseline expectations for economic performance that at-risk countries like Romania, Bulgaria, and Latvia may not be able to meet. For 2011, the stress test results assumed GDP growth for these countries at 3.6 percent, 3.9 percent and 4 percent respectively. In the worst case, they’re all projected to grow by more than 2 percent. If these countries fail to meet these targets, they will throw the stress test results into question, raising new doubts about the underlying strength of several large European banks.

Another problem with the stress tests is that they didn’t account for risks related to fluctuations in foreign exchange rates. They assumed stable exchange rates in the Eastern European countries where Western banks face their biggest risks. In Eastern Europe, many (in some countries, most) mortgages and corporate loans are denominated in foreign currencies (usually Euros or Swiss francs). When local currencies lose value, it becomes more expensive to service debt costs. That’s already happening. The recent rise in the value of the Swiss franc has raised the risk of a surge in non-performing loans in Hungary.

And if these local currencies remain weaker for several months, Western European banks, and the Eurozone itself, may face the kind of stress test they dread the most.

Preston Keat is Director of Research at Eurasia Group.