Is The Continent In Denial?

The global crisis could hit Europe hard

Until a few months ago, Europe was widely perceived as 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, promising more competitive markets and perhaps even hoped-for political reforms. Investors flooded into European stocks.

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 their growth forecasts for this year and next. And since no one can yet quantify the fallout on Europe from the world financial crisis, uncertainty could put a damper on everything from consumer spending to capital investment.

The wild volatility of stocks reflects the schizophrenic mood. On Oct. 2, UBS, Europe's biggest bank, confirmed that it would lose $700 million from exposure to U.S. hedge fund Long-Term Capital Management. The news pushed UBS shares down 37.7%, bringing the bank's market value down by a staggering 61% from its $104 billion peak in July. But by the following Tuesday, investors were again looking at the $2.3 billion profit UBS is expected to turn this year. At the end of Oct. 6, the bank's shares had rebounded 22% from their Friday low. "People started to say it was crazy for UBS to have fallen so far," says Bank Julius Baer analyst Hans Kaufmann.

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. And the emerging-markets crisis could depress capital spending if sentiment gets more negative. Business confidence has dropped in recent surveys in Italy, France, and Germany.

Bank losses could further aggravate the situation. Besides UBS, Germany's Dresdner Bank, Britain's Barclays, and France's Societe Generale, among 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.

BAD OLD WAYS. The longer-term concerns are political. Average European unemployment remains a punishing 11%, and voters have replaced conservative governments with job-promising, center-left coalitions in every major nation expect Spain. There are already signs of a shift toward the old spendthrift ways. For instance, Europe is expected to have about $120 billion in excess currency reserves after European Monetary Union, or EMU, begins. Italian Prime Minister Romano Prodi proposes spending the money on new infrastructure projects to create jobs. France's Socialist government quickly backed the plan.

Prodi's style of thinking is proliferating in Europe. Even with the economy still growing, Germany's newly elected Social Democrats are calling for central banks to cut rates to promote job growth. Economists fear center-left governments may also 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 the center-left governments, beholden to their 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 and last.

So far, Europe's fundamentals are holding up fairly well. Economic growth is predicted to be 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 carmaker Renault, still hopes for a long expansion. The main risk? "Psychology--people being unhappy because of [plunging] financial markets," he says.

Stock investors were soothed on Oct. 6 by a half-point cut in Spanish interest rates, to 3.75%, as well as by 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.

EURO-PHORIA. 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.

Confidence in the single currency has soared. One reason is that the euro zone has been untouched by currency turmoil abroad, easing GermaN fears that the new currency would be unstable. Bond yields in Italy, Portugal, and Spain, which soared during the Mexican peso crisis, have followed the German rate this time. The German mark, a proxy for the euro, has risen 11% in recent weeks against the dollar as investors have searched for a safe haven. That sets the stage for a strong euro, at least at first.

European consumers also remain unperturbed by the crisis abroad. HSBC Group Inc. estimates that consumer spending in the euro zone will rise by 2.4% this year and 3.4% in 1999 as inflation stays low and real disposable income rises sharply.

Yet Europe is not immune from the deflation 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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