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European Economy, the Central Banks & EU Banking Fragility

by internationalbanker

By Phillip Mann – phillip.mann@internationalbanker.com

The European economy has gone through one of the most difficult periods in its recent history. There have been several countries seeking membership into its ranks, issues in integrating fiscal and monetary policies and issues in coordinating and building consensus for economic policies within the region. What has made it more difficult is the banking system’s exposure to explicit and hidden risks. As the European economy recovers slowly, very slowly in some economies, the focus will be on how to tackle impediments to growth – such as how to manage excessive debt, how the European Central Bank (ECB) and the Bank of England (BOE) react to any spikes in inflation, manage the growth of the European Union collectively, and manage the fragility of the banking system for exposure to further risks, both domestic and abroad. It appears that the ECB, BOE and the European Banking institutions will need to tackle difficult situations over the next 3 to 5 years. 

A recent study conducted by the ECB highlighted that when regional economies emerge from financial crisis, the growth rate, inevitably, will vary across each of the countries. It appears that this trend of stagnant and inconsistent growth will be the norm within the EU over the next 3 to 5 years. Countries which have emerged relatively robust during the crisis, and some such as Germany supporting other minor countries, will emerge more strongly over the medium term. Other countries such as Greece, Spain and Portugal are likely to grow but at a relatively lower rate than that of Germany and will be dependent on direct assistance and other indirect means such as debt restructuring.  In the case of France and Italy economic growth over the next 3 to 5 years would lag behind that of Germany, particular given the structural reforms that are necessary to increase the growth rates above its current trajectory. Given the current situation of high debt levels, low interest rates are necessary in the medium term to ensure regional economic and financial stability. As such, it could be possible that the ECB and the BOE push for low interest rates, near 0%, and maintain this level over the next 3 to 5 years. One of the biggest questions that the ECB will face over the next 5 years is whether it will engage in any quantitative easing, and in essence follow the Federal Reserve of the US, the BOE, and the bank of Japan. This could be likely given the possibility of deflation within the Eurozone. There will be other consequences such as a weaker currency if the ECB delivers on the QE. The current inflation for the Eurozone has been relatively low, below 1% for several months – and well below the target of 2%. Generally, economists agree that a moderate inflation rate of 2% – 3% is required for sustainable growth during times of stability. Some expect that with intervention, the inflation within the Eurozone will average between 1 to 2% in the next 3 to 5 years. There has also been some reversal of the negative capital outflow from the Eurozone which occurred during the crisis several years ago. Now, there are capital inflows into this Eurozone, signalling some confidence that opportunities could present for private and public sectors to assist in the recovery.

As the EU emerges from the crisis, there will be a real need for borrowing from local banks within the Union. It is imperative that during this period, a bank’s lending regimes and due diligence are robust and ethical – to ensure that undue risks do not accumulate on the balance sheets, and unnoticed. Fitch Ratings has highlighted that some European Banks are exposed to more emerging markets. Brazil, India, Indonesia, Turkey, South Africa, Argentina, Russia and Chile are the 8 countries referred to as the “Fragile 8”. This list had grown from the Fragile 5 to 8 when Argentina, Russia and Chile joined the group. While Fitch Ratings expect that these risks alone are likely manageable and have small impact on the overall systemic risks within the region, the agency does raise concern that these risks could create contagion with other, more prominent, highly connected large banks within the EU. The risks highlighted may be underestimated given that large banks such as Banco Santander, while having the most exposure to the Fragile 8, has strong interconnected financial ties with other emerging markets not on the list, such as Hong Kong. The fear is that this connectedness inevitably links the bank (and hence the region) to other emerging markets within the South East Asian region. While other European banks have some material risks with the Fragile 8, it is expected that the exposure will increase further when the Fragile 8 will inevitably be expanded to include other emerging markets. These structural ties puts further at risk the fragile growth of the European banking system and the economy.  

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