Is The Continent In Denial?

The crisis may hit Europe harder than it expects

Until a few months ago, Europe seemed an oasis of steady growth in an increasingly shaky world. Whispers of inflation picking up in the U.S., plus Asia's long sickness, highlighted the Continent's many fundamental strengths, from ongoing corporate restructuring to deficit-cutting to a cyclical recovery that was just gathering steam. The prospect of monetary union made the optimism even livelier.

Now, the picture has grown fuzzy. Although many of the reasons for confidence in the Old World's economy remain sound, Europe faces a host of unknowns. Fears of huge bank losses from Russian loans and flagging exports to Asia have caused Continental stock markets to plunge since August. Already, economists have ratcheted down growth forecasts for this year and next. Uncertainty over the fallout on Europe from the world financial crisis could put a damper on everything from consumer spending to capital investment.

POLITICAL CONCERNS. The big danger is that Europeans are underestimating how hard they will be whacked by the world financial crisis. HSBC figures that 38% of European exports go to areas vulnerable to the crisis, vs. 49.5% for the U.S. So far, the Continental consumer recovery has helped offset the hit to exports. But that could change quickly. German exports will be highly vulnerable if the mark continues to rise. The emerging-markets crisis has already depressed executive sentiment: Business confidence has dropped in recent surveys in Italy, France, and Germany.

Bank losses could further aggravate the situation. Besides UBS, which will lose $700 million from exposure to U.S. hedge fund Long-Term Capital Management, Germany's Dresdner Bank, Britain's Barclays, France's Societe Generale, and others have taken profit hits from emerging-market investments. More bad news could make lenders edgy. "The problem with all this will be if the banks get nervous and cut off credit lines," worries Mark Hoge, an analyst with Credit Suisse First Boston in London.

The longer-term concerns are political. Economists fear that center-left governments may spend more freely next year to stimulate their economies, pushing budget deficits in places such as Germany and France close to the limit of 3% of gross domestic product mandated under EMU. Another concern: that governments beholden to labor constituencies may start pushing up European wages again. Goldman, Sachs & Co. estimates that unit labor costs in the euro zone will jump by 0.8% in 1999, after rising just 0.2% this year.

So far, Europe's fundamentals are holding up reasonably well. Economic growth is projected at about 2.5% this year and next. And when the euro arrives on Jan. 1, interest rates are expected to plunge further from their current 30-year lows, while fiscal policy is easing a bit after years of austerity. Louis Schweitzer, chief executive of French auto maker Renault, still hopes for a lengthy economic expansion. The main risk? "Psychology--people being unhappy because of [plunging] financial markets," he says.

Stock investors were soothed on Oct. 5 by a half-point cut in Spanish interest rates, to 3.75%, and comments at the International Monetary Fund meeting in Washington by Bundesbank President Hans Tietmeyer suggesting that Germany might also consider a rate cut. The fact is, Europe will get a big boost from falling interest rates even if Tietmeyer does nothing. That's because under European Monetary Union, short-term rates throughout the Continent are expected to converge at Germany's low 3.3% level.

On average, Continental rates will come down by nearly half a point as Spain, Portugal, Ireland, and Italy fall into line. And some analysts predict the new European Central Bank may slash rates further when it takes over monetary policy on Jan. 1, to keep a too-strong euro from hammering exports.

Yet Europe is not immune from the deflationary forces that are plaguing the rest of the planet. Its economies may remain relatively healthy. But until the effects of the global crisis can be assessed more certainly, the market mood swings and changing forecasts are likely to continue.

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