Europe: The Risk from a U.S. Downdraft

The euro zone grows increasingly concerned that it may not be immune to the fallout from slowing U.S. growth and the subprime mess

Only a few months ago Europeans were reassuring themselves that their economic zone would be largely insulated from the U.S. credit market melodrama and resulting slowdown, thanks to thriving exports to Asia, particularly China. Well, it's time for a reality check.

European Central Bank President Jean-Claude Trichet is now fretting that the combination of a strengthening euro and rising oil prices will take some of the wind out of Europe's sails. And economists across the Continent are scrambling to revise their growth forecasts—downward. "Globally we're past the peak," says Rolf Schneider, head of economic research at Dresdner Bank (AZ), which on Nov. 23 pared back its 2008 estimate for euro zone growth to 1.8% from 2.1%.

It turns out that proponents of the "decoupling" thesis—that the U.S. and European economies no longer move in tandem—were only half right. No question, America's gravitational pull has waned some. The share of European exports bound for the U.S. has slipped to 13% of the total, from 16% in 1999, according to Swiss bank UBS (UBS). Over the same period, shipments bound for emerging markets have risen to 26% of exports from 21%.

No Relief From Trichet

But never mind what the trade data say. Perceptions of U.S. economic strength have a mighty influence on global sentiment. The Standard & Poor's European 350, an index of leading European stocks, has charted the same wild roller-coaster ride as the Dow Jones industrial average. And while European banks have suffered less than their U.S. counterparts from the subprime meltdown, uncertainty about the size of losses has undermined trust among banks and curtailed their lending to each other—and ultimately to business. "Sooner or later what happens in the U.S. has a pronounced effect on Europe," says Ulf Schneider, chief executive of Fresenius (FREG.DE), a German company that is the world's largest supplier of dialysis equipment and services.

Growth in the 13-nation euro zone has been robust by regional standards over the last couple of years, pushing down unemployment and helping countries such as Germany tame their budget deficits (, 10/30/07). Most economists now expect growth to dip slightly below 2% next year, a number that could be notched down further if the U.S. slides into recession. Don't expect much relief from Trichet, either: With high oil prices stoking inflation, which reached an annualized 3% in Germany in November, Europe's central bank will be reluctant to cut interest rates.

All of this adds up to a big disappointment for European government leaders who have spent a decade trying to create a self-sustaining economic region and immunize themselves against any U.S. contagion. The population of the European Union has nearly doubled since 2004 with the admission of 12 new members, a move that has injected some new vitality into the bloc. Also, European manufacturers have boosted competitiveness—and helped cushion against the impact of currency fluctuations—by shifting more of their operations to the U.S. and Asia. Take BMW (BMWG.DE). To get around the plunging dollar, the German automaker aims to expand capacity at its plant in Spartanburg, S.C., by more than 71%, to 240,000 cars, by 2010. "We have addressed natural hedging aggressively," says BMW CEO Norbert Reithofer.

Ricochet Effect

European corporations also have been working hard to curb their dependence on the U.S. market. Rome-based Bulgari (BULG.MI) now sells 40% of its jewelry and watches to increasingly affluent customers in Asia, while the U.S. accounts for just 14% of sales. German machinery makers enjoyed double-digit increases in exports to China, Russia, and within the European Union from January to August, even as sales to the U.S. rose just 1.4%. But some analysts warn of a ricochet effect: If U.S. consumers buy fewer Chinese-made goods, then Chinese factory owners will buy fewer German machines. "Those indirect linkages are quite powerful," says Jacques Cailloux, chief euro area economist for the Royal Bank of Scotland (RBS).

European companies with an exposure to the U.S. housing market already are starting to feel some pain. "As new homes are not getting built and people are not moving, we have clearly felt an impact," says Patricia Russo, CEO of Paris-based telecom equipment giant Alcatel-Lucent (ALU), which draws a third of its $26 billion a year in sales from North America and takes a hit when fewer people sign up for broadband Internet connections.

Better placed to weather the downturn may be German software maker SAP (SAP), which recently added Wal-Mart Stores (WMT) and Apple (AAPL) to its roster of corporate clients. "So far we haven't seen a negative impact from the slower U.S. economy," says SAP CEO Henning Kagermann. "However, we will watch the situation carefully."

With Gail Edmondson in Frankfurt and Carol Matlack in Paris

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