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  Riskier than Most Realized: How the Crisis Is Hitting Europe

Riskier than Most Realized How the Crisis Is Hitting Europe

By Jack Ewing

Part 2: Europe's Advantages and Disadvantages

Pain is deepest in Europe's poorest countries. Their huge growth was fueled by lending to companies and consumers by the likes of Italy's UniCredit Group, Germany's Commerzbank, and Belgium's KBC Group. As a result, some nations have run up massive current-account deficits. In Bulgaria, the shortfall equals more than 20 percent of gross domestic product. Adding to the risk: During the boom, banks issued low-rate mortgages and other loans in euros and Swiss francs. When the Hungarian forint, Romanian leu, and other weaker scrips began plunging last summer, the cost of repaying those loans skyrocketed. More than half of the private debt in Hungary, Romania, and Bulgaria is in foreign currency, according to Morgan Stanley. Today, customers in Eastern European countries owe foreign banks the equivalent of one-third of their combined GDP, according to the Bank for International Settlements.

The debt problem has been compounded by slumping exports and consumer spending. In Romania, the second-poorest EU member after neighboring Bulgaria, steelmaker Arcelor Mittal imposed a two-month shutdown, idling 1,200 workers at its plant in Hunedoara, a city nestled in the Transylvanian mountains where iron has been forged since Roman times. Dacia Group, a unit of France's Renault that produces the low-cost Logan sedan in Pitesti, 75 miles west of Bucharest, slashed production and cut investment by $130 million.

Europe's political leaders and central bankers face unique constraints as they try to jump-start growth. Stimulus plans, such as a German initiative to give a $3,200 rebate to people who trade in old cars for new ones, have a limited effect that doesn't stretch far beyond the border. A country such as Romania really needs Chinese factories to start buying German machinery again-which could boost demand for Romanian steel. But all the stimulus programs in the euro zone don't amount to even 1 percent of GDP, and they're focused on infrastructure, offering little relief to industries such as tourism, which employs millions of Europeans. "There are a lot less tourists, even those who are well off," says Catherine Castanier, manager of La Coupe d'Or, a café nestled among the luxury boutiques on Paris' swank rue Saint-Honoré.

National governments, meanwhile, face tough choices in shoring up their banks. After the fall of communism, Vienna financial houses such as Erste Group and Raiffeisen International grabbed state-owned institutions in Eastern Europe, and today Austria's banks hold assets in the region equal to at least two-thirds of their home country's total economic output. In backing its banks, Vienna is effectively propping up their subsidiaries in the former Warsaw Pact countries.

Europe lacks institutions with a clear mandate to tackle such issues regionally. For instance, the ECB would have a hard time boosting lending via purchases of commercial paper and asset-backed securities, as the U.S. Fed has done, argues Mewael F. Tesfaselassie, an economist at Germany's Kiel Institute for the World Economy. Washington stands behind the Fed, but it's not clear who would pick up the tab if the ECB faced huge capital losses. The ECB has already broadened the securities it accepts as collateral for short-term loans, but that provides less relief to credit markets than outright purchase.

Economic tensions are beginning to spill into the streets. In January, Greek farmers demanding government aid blockaded border crossings with their tractors, holding up international truck traffic for more than a week. And on Jan. 13, 10,000 protesters gathered on Doma Square in the gothic Old Town of Riga, Latvia, demanding bolder government action to ease the pain of the financial crisis. The protest turned violent, and demonstrators battled with police, looted stores, and broke windows of several bank branches in the shadow of the Finance Ministry. "There's a huge amount of stress and tension," says Filip Klavins, a Latvian-American lawyer working in Riga.

Low Consumer Debt

As the situation deteriorates, some pundits even say a weaker member of the euro zone -- perhaps Greece or Ireland -- could pull out of the union rather than face the pain of lower wages and higher unemployment. But few mainstream economists really believe the monetary union will come apart. On the contrary, non-euro members such as Iceland and Denmark may try to join to protect themselves from sharp declines in their currencies. "Imagine what it would have been like with George Soros betting against the deutsche mark, lira, and franc," says Michael Burda, a professor of economics at Humboldt University in Berlin. "It's a blessing the euro and the ECB are there."

Still, the crisis is forcing European leaders to rethink how they manage their economies. The European Union probably needs a single securities and bank regulator rather than the tangle of national bodies it currently has. There's talk of establishing a Europe-wide deposit insurance fund to prevent nervous Hungarians or Lithuanians from withdrawing their money from local banks and sending it to Germany. The European Commission could issue its own bonds backed by all members to help the likes of Spain, where borrowing costs have soared after a downgrade of the country's debt.

The Continent has some competitive advantages over the U.S. and could still emerge from the crisis more quickly. Thanks to decades of investment in nuclear, solar, and wind power as well as a history of energy conservation, Europe is less vulnerable to oil shocks than the U.S. Consumer debt is relatively low in most countries, helping to offset other risks to the banking system. And conservative lending practices mean that, outside of Britain and Ireland, European banks could recover their ability to lend more quickly than devastated U.S. institutions. Deutsche Bank Chief Executive Josef Ackermann argues that, by refusing state aid, he will have more freedom to operate internationally than weakened rivals subject to government intervention. "We can determine our own fate," Ackermann told reporters on Feb. 5.

Like the destiny of its companies, Europe's fate may depend on events outside its own borders. Germany and Eastern Europe won't recover until there is a revival in orders for cars and machinery from Russia, the Middle East, the U.S., and China. Britain and Ireland, with their huge banking sectors, must await a stabilization in worldwide financial markets. Just as the crisis began elsewhere, it may have to end elsewhere before Europe returns to health.

With Carol Matlack and Tiffany Stecker in Paris, Kerry Capell and Mark Scott in London, Jason Bush in Riga, and Bogdan Turek in Warsaw. Ewing is BusinessWeek's European regional editor.