Photo Gallery: Financial Stress and Economic Boom


Export Optimism, Financial Fear Bank Balance Sheets Could Torpedo Recovery

Germany's economy is booming thanks to a rapid recovery of global exports. But Europe isn't out of the woods yet. Few know exactly what nasty surprises might be lurking on bank balance sheets across the Continent -- and stress tests might not be enough to reveal them.

Strict confidentiality is the order of the day when the elite of the German financial world gather. No pictures were taken of the memorable meeting which took place on Wednesday of last week. Only a laconic press release, nine lines long, informed the public of the event -- after it was all over.

The CEOs of the largest banks had accepted an invitation extended by Axel Weber, the president of Germany's central bank, the Bundesbank, and by Jochen Sanio, the head of Germany's Federal Financial Supervisory Authority (BaFin). Deutsche Bank CEO Josef Ackermann didn't attend personally, but he sent a representative -- Chief Risk Officer Hugo Bänziger.

It was a fitting choice. Tops on the agenda for the meeting were the risks currently faced by Germany's largest banks. They are to be assessed in a stress test  -- and then made public. In a subsequently released statement, the bankers in attendance declared "their fundamental willingness" to back this plan.

Still, it remains highly controversial whether such a course of action is a good idea, and the gathered bank representatives hotly debated the issue last Wednesday.

Stress tests are designed to enhance transparency and engender trust. But they can also expose new risks -- or reveal old hazards that the public has since chosen to ignore.

A high-profile stress test of German banks could thus mean even more stress for an industry that currently needs mutual trust and tranquility more than anything. It could bring a renewed sense of insecurity to the financial markets, which already act with hypersensitivity to every fresh news report.

Won't Last?

The insecurity can easily be seen in the rapid yo-yoing of the markets in recent weeks. Risk premiums for Greek and Spanish government bonds are rising, even though euro-zone countries have committed themselves to securing the financing of ailing member states. Stock markets often vacillate within hours from depression to optimism and back again. Every bit of not entirely positive news from the US or China is seen as an indication that the world economy could suffer another relapse and the surprisingly rapid recovery won't last.

Since the beginning of this year alone, the price of gold has risen by 13 percent. Gold is always in high demand when confidence in economies and currencies flags. The precious metal is seen as a safe haven in times of uncertainty.

Positive news has it rough in such times -- it's hardly even noticed and quickly forgotten. And yet there is good news. It comes from companies and from the labor market, and it tells of astonishing growth rates, full order books  and new jobs -- particularly in Germany.

Economic pundits are looking to the near future with increasing confidence. Recently the Kiel Institute for the World Economy (IfW) significantly revised upwards its growth forecast for this year. The experts in Kiel now anticipate a growth rate of 2.1 percent for 2010. Similar predictions have been made by the German economic research institute RWI in Essen. The German Chambers of Industry and Commerce (DIHK) even expect growth of 2.3 percent.

Economic advisors to Chancellor Angela Merkel's government have also been infected by the wave of optimism. In April, Berlin predicted 1.4 percent growth. That forecast has not been officially revised, but there is broad realization that it will ultimately be quite a bit higher. "Everything points to a figure of 2 percent, perhaps even slightly above that," says one government economic advisor.

Opposite Has Occurred

Even the pundits have been caught off guard by how quickly the German economy is finding its feet again. Only a few months ago, they were predicting that Germany's export-driven economy would lag behind other countries for years.

But the opposite has occurred. The global economy will grow by 4 percent this year, and global trade will even soar by 7 percent. The big winners are precisely those companies in Germany that focus on exports. "We have to be part of this -- and we will be part of this," says Economy Minister Rainer Brüderle of the business-friendly Free Democratic Party (FDP). While other countries like France and the UK are still struggling to pull out of the recession, Germany has become the motor for economic growth in Europe.

Researchers also don't appear concerned that the German government's austerity program could strangle the recovery. Next year, when the measures go into effect, they expect an effect on growth of just two-tenths of a percentage point, and perhaps lower than that.

German Chancellor Angela Merkel of the Christian Democratic Union (CDU) also feels that the concerns are unfounded. She says that the austerity program only makes up a fraction of the federal government's overall budget of some €300 billion ($375 billion).

In addition, Merkel points out that Germany's financial policy remains expansive. Her proof: Next year the German government will take on new debts to the tune of €57.5 billion. This is the figure proposed by the government's draft budget, which the cabinet intends to approve on Wednesday. The chancellor feels that there are no grounds to fear that the government is saving money at the expense of economic recovery.

Economic Blip

The current sense of optimism is driven by developments on the labor market. The German job machine is revving up again, as if the downturn of the past two years were nothing more than an economic blip and not the worst global financial crisis in decades.

When orders for core sectors of German industry plummeted by over 40 percent in the wake of the Lehman Brothers bankruptcy, there were already predictions of impending mass unemployment. Month after month, the anticipated onset of this horror scenario had to be postponed because unemployment rose only slightly -- if at all. Billions of euros spent on government-funded programs to reduce worker hours -- known as short-time, or Kurzarbeit in German -- helped as a buffer. Now the labor market is recovering with surprising strength.

In June of this year, 3.15 million Germans were out of work, more than a quarter of a million fewer than a year ago. This is the lowest figure since December 2008. The upward trend is particularly strong in eastern Germany, where there were 977,000 unemployed in June -- the lowest figure of the past 19 years.

The situation is "significantly better than expected in view of the overall economic conditions," says Germany's Federal Employment Agency. All signs indicate that the number of unemployed could drop below three million in the coming months.

Other numbers are equal cause for celebration. The number of those with gainful employment in Germany has risen to 40.28 million. The figure for the month of May was "the highest number since German reunification," Germany's Federal Statistical Office said last week.

Experts offer a range of explanations for the German job miracle: the large-scale use of short-time programs during the crisis, the rapid increase in exports and the weaker euro, which makes German goods cheaper abroad.

Extreme Unease

More than anything else, though, trade unions have practiced wage restraint for many years, which has helped enhance Germany's competitiveness. Unions and employers have agreed to differentiated and flexible working hour systems. The Hartz reforms introduced under the coalition of Social Democrats and Greens led by then-Chancellor Gerhard Schröder stripped much of the structural rigidness from the German labor market.

Over the past decade, this has resulted in one of the most robust and flexible economies in the world. Germany is the only European country with an unemployment rate that is lower today than what it was before the outbreak of the global financial crisis in the spring of 2008. Meanwhile, unemployment has doubled in the US.

Over the long run, however, the export-dependent German economy won't be able to disengage itself from trends in the global economy, which is already showing initial signs of fatigue, both in the US and China.

Some experts even fear that after a brief recovery, the global economy could fall back into a recession as economic stimulus programs run their course. They speak of the possibility of a double-dip recession.

Renewed Turbulence Guaranteed

Indeed, as long as the financial markets refuse to shed their anxiety, the foundation of the new recovery remains fragile. Renewed turbulence is virtually guaranteed. The banks still have enormous quantities of toxic assets on their books. Nobody knows when or to what extent these debts will have to be written off.

In some cases, these bad investments consist of junk bonds from the days before the crisis, including second-class US real estate loans called subprimes. In other cases, they include burdens that hardly anyone was aware of a year ago, like government bonds from Greece and other southern European countries, which were touted as a fairly sound investment at the time.

Analysts at the US investment bank Morgan Stanley say that Europe is caught in a "vicious cycle." Instead of using government funds to forcibly recapitalize all banks, as the US did, the euro countries opted for another approach. After the Lehman Brothers bankruptcy, many banks loaded up on cheap cash from the European Central Bank (ECB).

According to Morgan Stanley, they have been using this money since October 2008 to finance the purchase of government bonds worth €420 billion. During this spending spree, the banks targeted high-yielding bonds from shaky southern European countries, primarily Spain, Greece and Portugal. They then deposited these bonds with the ECB as security for more loans from the central bank.

At the outset these lucrative deals soothed nerves on the markets, but they have now turned out to be time bombs. Nobody knows exactly how these bonds are weighted on the balance sheets -- and even less can be said about what they will actually be worth in the end.

Indeed, despite euro-zone bailout packages for ailing members of the currency union, few doubt that Greece will eventually have to restructure its mounting debt. Creditors would be forced to forego some of their claims.

Breeding Mistrust

Would all banks survive such a haircut? And what happens if further euro-zone members run into trouble, plunging even more banks into difficulties?

There is an enormous sense of uncertainty, and that breeds mistrust. Banks recently parked over €300 billion with the ECB overnight for the ridiculously low interest rate of 0.25 percent. Anyone who borrows money for 1 percent, only to turn around and deposit it overnight with the ECB for just 0.25 percent -- instead of earning considerably more by loaning it to the competition -- has one problem above all: fear.

Last week the banks borrowed significantly less money in new loans than what they had to pay back to the Bundesbank, but that only briefly reduced the edginess. "There is still a great deal of tension," says Hans-Günter Redeker, head foreign exchange strategist for the major French bank BNP Paribas. He says that the balance sheets are too shadowy. "We need a sound stress test on the table, which will also be made public." This is something, at least in principle, that everyone attending last Wednesday's meeting in Frankfurt also agreed on. But there were differing opinions on what was sound and what wasn't.

There have been a number of stress tests in the past. But they weren't made public, and they did not take into account -- of all things --the greatest risk on the banks' balance sheets: the government bonds from the so-called PIIGS countries (Portugal, Italy, Ireland, Greece and Spain).

Horror Scenario

What the markets fear most of all is that these assets could plummet in value -- that these countries could declare bankruptcy and their debts would need to be refinanced. But this horror scenario is not taken into consideration in the current stress test. Otherwise critics could insinuate that the Bundesbank and the BaFin have doubts about the success of the bailout package.

Instead, the bank auditors went on the assumption that a deepening of the debt crisis could drive up the price of credit default swaps on bonds from countries like Portugal and Spain, causing their value to drop and leading to write-offs for the banks. An additional routine scenario goes on the assumption that there could be another economic downturn.

Many questions remain unanswered, however, and the representatives of the banks, the Bundesbank and the BaFin will no doubt have to meet again soon.

Translated from the German by Paul Cohen