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The European Contagion

Fri, Oct 3 2008, 06:36 GMT
by HVB Group Global Markets Research

UniCredit Group

• Infection. Those who had believed the European financial system was immune to the recent escalation of the US crisis were quickly disabused of the notion. No less than four European financial institutions had to be rescued with government funds – even before the political debacle in Washington sent markets over the edge earlier this week.

• Vicious circle. The complete loss in faith in the entire financial sector is also demonstrated by the fact that – despite the central banks’ ever larger injections of billions in liquidity – money and interbank markets are virtually paralyzed (cf. chart), with some market participants hoarding cash. The danger of the financial sector and the real economy dragging each other down has increased considerably (pages 2-3).

• Bailout plan: A commitment to a multi-national, European rescue plan, possibly coupled with a surprise ECB rate cut, would be helpful. A unified approach is unlikely, but coordinated national measures could materialize. The European financial system is sounder than its US counterpart, but could also use some support.

• ECB: Rate cuts alone would be ineffective – with important wage negotiations looming, they could even be counter-productive. For that reason, the ECB left the refi rate unchanged today. Mounting concerns about a financial economic meltdown combined with subsiding inflation fears could, however, see the ECB ease sooner than projected so far. We now expect the first rate cut at the end of this year.

•  Further topics:
  

  – US: Now it's up to the House (page 4).

  – Germany: Employee deductions to rise again (page 7).

  – France: Budget facing major challenges (page 9).

  – Bank of England rate cut next week is on the table (page 11).

  – Data outlook: EMU industrial production to decline; US labor market to remain under pressure (page 12).

  – Market outlook: Volatility to continue to stay high (page 19).

Restoring faith

Over the last two weeks, we have been witnessing a complete and widespread collapse in confidence in the financial system. This crisis of confidence seems grossly out of proportion with the albeit fragile fundamentals of the financial system and of the global economy. But it is now threatening to turn into a self-fulfilling run on the system which could trigger a global financial and economic meltdown. I see two key triggers behind this confidence crisis: First, the fear that European policymakers are unprepared and unable to act in a coordinated way to rescue their financial system; Second, the fear of an adverse loop between a deteriorating growth environment and a brittle financial system. Policymakers need to escalate their response to address these two concerns. After the shocking rejection of Paulson’s plan by the House of Representatives on Monday, a modified version of the bill was approved last nigh by the Senate and might be voted on by the House by tomorrow (see research note by Roger Kubarych) European policymakers should also send a clear and loud signal that they stand ready to implement a European TARP or similar systemic intervention to guarantee greater transparency and adequate capitalization in the financial system. This should ideally be accompanied by a surprise rate cut by the ECB, or at least by the recognition that inflation concerns have been put to rest, and that the bank is getting ready to ease policy. I realize this would be an extreme departure from the path followed so far; but policymakers’ insistence that the problem would remain confined to the US smacked of a complacence which has now backfired, while the ECB’s unrelenting focus on inflation seems increasingly out of touch with reality. This global crisis needs a global response, and it needs it now – the alternative is giving up, and that is not an option.

The gravity of the situation cannot be overemphasized, and the dangers should not be underestimated. What we are witnessing is a complete loss of faith in the entire financial system, on a scale and with an intensity wholly out of proportion with even the very serious problems that the system faces. The share prices of financial institutions have plunged across the board, regardless of their financing needs, their exposure to the real estate market, their holdings of toxic assets, their mix of commercial and investment banking activities. Meanwhile, money and interbank markets remain paralyzed, with market participants hoarding cash and financial institutions unwilling to lend to each other. This paralysis in turn is exacerbating funding difficulties, and if it continues will force financial institutions to dispose of liquid assets to generate cash, triggering a wave of sell-offs and price declines in otherwise perfectly healthy assets.

There are, in my view, two triggers behind this panic:

– First, concern that decisive action in the US will not be enough to solve what is clearly a truly global problem.

– Second, fear that the global growth slowdown already underway will undermine the efforts made to stabilize the financial system.

While US lawmakers were racing against the clock to reach an agreement last weekend before the opening of Asian markets, the focus had already shifted to Europe. The nationalization of Fortis in Belgium, Bradford and Bingley in the UK and Glitnir Bank in Iceland, and the troubles faced by Hypo Real Estate highlighted market concerns that the European financial sector is at risk and under pressure. And the market clearly does not believe that European policymakers can muster the coordination which would enable a comprehensive plan like the one considered in the US. Some commentators in the last few days have noted that some European banks might be not only too big to fail, but also too big to rescue, as the size of their liabilities far outstrips the firepower of the home government. Fortis was one of the banks named, and indeed it took the joint action of three governments over the weekend to address the problem.

Meanwhile, economic data continue to disappoint across the board: growth performance in emerging markets is deteriorating faster than expected, the eurozone is probably entering a recession (albeit hopefully a mild and short-lived one), and the US outlook looks increasingly fragile. This raises an extremely serious risk of adverse loops between the financial sector and the real economy, unless confidence is restored rapidly. A further deterioration in financial conditions would almost certainly trigger a credit crunch, with varying degrees of intensity in the different economic regions. That might be enough to plunge us into a global recession, which would in turn exacerbate the problems in the financial sector.

Neither the fundamentals of the global economy nor those of the financial system, however, justify this Armageddon scenario. The global economy is still growing at a healthy pace, as emerging markets’ performance is still robust, albeit down from the previous record rates. And data in the developed economies, while disappointing, do not yet point to a deep recession. Similarly, the market’s action on financials seems extreme and out of line with fundamentals. I have always cautioned that the European financial sector would not be immune to this global crisis, but there is no doubt that the European financial sector is in a stronger shape than its US counterparts, and that many if not most of the European banks that are coming under pressure have a sound business model and are not excessively leveraged or overly exposed to toxic assets. The market appears to be betting on the complete extinction of the global financial system – which still seems like an extreme assumption.

The fact that the market reaction is not justified by fundamentals, of course, does not make it less dangerous. Unless confidence is rapidly restored, this might easily turn into a full-fledged self-fulfilling crisis, with an effective run on the global financial system resulting in a global financial and economic meltdown.

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Published on  Fri, Oct 3 2008, 06:42 GMT