By Ralph Atkins in Frankfurt, June 30 2009 11:03

Eurozone annual inflation has turned negative for the first time, complicating the job of the European Central Bank as draws a line under emergency measures to tackle continental Europe’s recession.

Consumer prices in the 16-country eurozone were 0.1 per cent lower in June than the same month a year before, according to Eurostat, the European Union’s statistical office.

It was the first time eurozone annual inflation had fallen below zero since comparable records began in 1991. Inflationary pressures in continental Europe are now lower than at anytime since at least the early 1950s, according to calculations by some economists.

The fall in prices reflected sharply lower energy costs but also the effects of the worst post-war economic downturn. The US had already reported year-on-year falls in consumer prices.

News that inflation had turned negative – and was massively undershooting the ECB’s target of an annual rate “below but close” to 2 per cent – came as the ECB prepares for Thursday’s interest rate setting meeting in Luxembourg.

Since last October, the ECB has slashed its main policy rate by 325 basis points to 1 per cent, and pledged to meet in full banks’ demands for liquidity – which resulted in it last week pumping €442bn in one-year loans in the banking system.

But the ECB’s governing council is not expected to cut official borrowing costs further at this week’s meeting and analysts expect the main policy rate to remain at 1 per cent for many months – possibly well into next year or even beyond.

The ECB believes the impact of its measures have still to feed through into the economy. But it faces a difficult balancing act. Even though the inflation outlook justified further action, the central bank feared “that more aggressive easing now could risk financial stability and or a too sharp acceleration of inflation over the longer-term,” said Nick Kounis, European Economist at Fortis Bank.

Jean-Claude Trichet, ECB president, is likely to stress on Thursday that negative inflation will be only a temporary with a return to positive annual rates expected later this year. But ECB forecasts show inflation remaining well below 2 per cent in 2010 and the worry for ECB policymakers is that months of below-zero inflation rates will stoke fears of full-blown deflation – generalised and persistent falls in prices that wreak significant economic damage.

Meanwhile, credit figures released by the ECB just ahead of the inflation news highlighted how the liquidity it has pumped into the banking system have not yet stopped credit flows to the economy from being thrown into reverse. Businesses repaid a net €5bn in loans in May, slowing the annual rate of growth in such loans to just 4.4 per cent. Even more dramatically, the annual rate of growth of borrowing by households turned negative, with loans down 0.2 per cent on the year.

The ECB has been stepping up its appeals recently for banks to pass on the extra liquidity they have been lent, but it could be some months before any extra lending to businesses and households shows up in official data.

I’m concerned about Europe. Actually, I’m concerned about the whole world — there are no safe havens from the global economic storm. But the situation in Europe worries me even more than the situation in America.

Just to be clear, I’m not about to rehash the standard American complaint that Europe’s taxes are too high and its benefits too generous. Big welfare states aren’t the cause of Europe’s current crisis. In fact, as I’ll explain shortly, they’re actually a mitigating factor.

The clear and present danger to Europe right now comes from a different direction — the continent’s failure to respond effectively to the financial crisis.

Europe has fallen short in terms of both fiscal and monetary policy: it’s facing at least as severe a slump as the United States, yet it’s doing far less to combat the downturn.

On the fiscal side, the comparison with the United States is striking. Many economists, myself included, have argued that the Obama administration’s stimulus plan is too small, given the depth of the crisis. But America’s actions dwarf anything the Europeans are doing.

The difference in monetary policy is equally striking. The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates (it actually raised rates last July), and it has shied away from any strong measures to unfreeze credit markets.

The only thing working in Europe’s favor is the very thing for which it takes the most criticism — the size and generosity of its welfare states, which are cushioning the impact of the economic slump.

This is no small matter. Guaranteed health insurance and generous unemployment benefits ensure that, at least so far, there isn’t as much sheer human suffering in Europe as there is in America. And these programs will also help sustain spending in the slump.

But such “automatic stabilizers” are no substitute for positive action.

Why is Europe falling short? Poor leadership is part of the story. European banking officials, who completely missed the depth of the crisis, still seem weirdly complacent. And to hear anything in America comparable to the know-nothing diatribes of Germany’s finance minister you have to listen to, well, Republicans.

But there’s a deeper problem: Europe’s economic and monetary integration has run too far ahead of its political institutions. The economies of Europe’s many nations are almost as tightly linked as the economies of America’s many states — and most of Europe shares a common currency. But unlike America, Europe doesn’t have the kind of continentwide institutions needed to deal with a continentwide crisis.

This is a major reason for the lack of fiscal action: there’s no government in a position to take responsibility for the European economy as a whole. What Europe has, instead, are national governments, each of which is reluctant to run up large debts to finance a stimulus that will convey many if not most of its benefits to voters in other countries.

You might expect monetary policy to be more forceful. After all, while there isn’t a European government, there is a European Central Bank. But the E.C.B. isn’t like the Fed, which can afford to be adventurous because it’s backed by a unitary national government — a government that has already moved to share the risks of the Fed’s boldness, and will surely cover the Fed’s losses if its efforts to unfreeze financial markets go bad. The E.C.B., which must answer to 16 often-quarreling governments, can’t count on the same level of support.

Europe, in other words, is turning out to be structurally weak in a time of crisis.

The biggest question is what will happen to those European economies that boomed in the easy-money environment of a few years ago, Spain in particular.

For much of the past decade Spain was Europe’s Florida, its economy buoyed by a huge speculative housing boom. As in Florida, boom has now turned to bust. Now Spain needs to find new sources of income and employment to replace the lost jobs in construction.

In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come.

Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe.

But Europe can still prove the skeptics wrong, if its politicians start showing more leadership. Will they?

By Stefan Wagstyl, February 25 2009

This should have been a year of celebration in central and eastern Europe. It is 20 years since the Berlin Wall fell, the 10th anniversary of Nato’s eastward expansion and five years after the European Union began its enlargement into the region: from the Baltic to the Black Sea, the countries that escaped from Soviet rule have much to commemorate.

But the global economic crisis has spoilt the party. Instead of building on the achievements of the past two decades, the region’s leaders are feeling the economic foundations shaking under their feet.

All of Europe is heading towards its worst economic crisis since the 1930s. But compared with the wealthy west, central and east European nations are in a weaker position to respond. The dangers are so great that European Union leaders meeting in Berlin last Sunday agreed to back a doubling of International Monetary Fund resources to $500bn (£348bn, €391bn) to support the CEE countries in what Angela Merkel, German chancellor, called an “extraordinary international crisis”.

At risk is not only the economic development of vulnerable countries but even their political stability. Nobody expects a repeat of 1930s evils. But mounting anger over recession, unemployment and debt could fuel populism with unpredictable consequences. As in western Europe, there could be social and ethnic tensions. Reformist governments, multinational companies and banks could all become the targets of public protest when livelihoods are threatened. “The economic crisis will impact … eastern Europe more than western Europe because the political and economic systems in eastern Europe are more vulnerable,” says Carl Bildt, Sweden’s foreign minister.

The EU itself, the region’s political and economic lodestone, is running into trouble amid signs of western leaders responding to the crisis by putting national interests before Union-wide solidarity, notably over state aid for finance and industry. Having worked hard to bring their countries into the globalised European mainstream, some central and east European leaders feel betrayed. Pavol Demes, a former Slovak foreign minister and head of the CEE office of the German Marshall Fund, a US think-tank, says: “People are questioning liberal democracy, the markets and the EU. They see countries like France going for national solutions when international solutions are needed. They feel excluded.”

He and others applaud the Czech Republic, holder of the EU’s rotating presidency, for challenging Nicolas Sarkozy, the French president, over suggestions that aid to France’s carmakers might be tied to preserving French jobs rather than those the marques provide in central Europe. Mirek Topolanek, Czech prime minister, spoke for many in the CEE region when he said the response of eurozone countries “has deformed the joint project of the euro more than any other imaginable event”.

For all the anti-government demonstrations in Bulgaria and Lithuania, violent protests in Latvia and a surge in anti-Roma rhetoric in Hungary, however, CEE is not a region about to collapse into disorder. Despite the worries about EU solidarity, the 27-nation bloc’s new members remain committed to enhancing their integration. Poland, for example, is accelerating plans to join the eurozone. “What we need is more Europe, not less Europe,” says Eugeniusz Smolar, head of Warsaw’s Centre for International Relations.

Whatever happens, different countries are likely to go through the crisis with widely differing results. At one extreme are nations under particularly severe financial pressures, headed by Hungary, Latvia and Ukraine, which have secured IMF rescue packages. At the other stand Poland, the Czech Republic and Slovakia, a base of relative economic stability in the central European heartland. Manfred Wimmer, chief financial officer of Erste Group, the Austrian bank with big CEE operations, warns: “What’s been lost in this crisis very often has been the ability of people to differentiate.”

Still, there is a sense of gathering gloom even in countries that have so far escaped the worst. In Croatia, record numbers of skiers have holiday­ed abroad this winter, property prices on the Adriatic coast remain high and the nightspots of Zagreb, the capital, are busy. But all is not well, says Davor Butkovic, a commentator at the daily Jutarnji List. Speaking in Zagreb’s fashionable Bulldog bar, he says: “We don’t have an economic crisis yet but there’s a feeling that something bad is coming. At Jutarnji List there is a 30 per cent drop in advertising this year.”

After nearly a decade of rapid growth, still at nearly 5 per cent last year, gross domestic  product in the region – including central and south-east Europe and Ukraine but excluding Russia – is set to fall in 2009 for the first time since the post-communist chaos of the early 1990s. Migrants are returning home from the faltering economies of western Europe and Russia. Foreign direct investment is being postponed, as with Fiat’s €1bn ($1.3bn, £890m) plan to modernise Serbia’s Zastava car plant.

Worse, some of the international banks that fuelled the recent economic growth are struggling to fund local subsidiaries, raising fears of collapses in credit. According to the Bank for International Settlements, the central banks’ grouping, at the end of September eastern Europe’s loans from foreign banks (local and foreign currency) were $1,656bn – three times more than in 2005 and mostly borrowed from west European banks.

This month’s market turmoil has highlighted the dangers. The European Bank for Reconstruction and Development, the region’s multilateral bank, estimates the banking sector needs $200bn in refinancing this year and $100bn-$150bn to recapitalise in order to cope with bad loans. The question is how much of the loan books turn sour as economies slow and currencies fall. Foreign exchange loans, ranging to 90 per cent of lending in Latvia, are a particular concern because of the extra burden on borrowers who make repayments out of local currency earnings.

If banks cover only 70 per cent of their subsidiaries’ needs, governments and multilateral institutions might face demands for about $100bn – a big sum but not overwhelming given the scale of west European and US bank bail-outs. Robert Zoellick, the World Bank president who has estimated a lower figure of $40bn-$45bn, is urging EU governments to support the IMF, the World Bank and the EBRD in raising funds, saying the issue is crucial to Europe’s future. He told a German newspaper this week: “I would consider it an immense tragedy if Europe were to break into two parts again.”

Not everybody is queuing at the IMF, however. Slovakia and Slovenia are safely inside the eurozone. Poland and the Czech Republic insist they need no support and say recent market upheavals are partly due to panicked investors mistakenly viewing the region as an undifferentiated disaster zone.

The social and political impact of the crisis will also vary. Latvia’s government collapsed last week over IMF-mandated austerity. In Ukraine, the economic turmoil has become the latest battleground between President Viktor Yushchenko and Yulia Tymoshenko, his prime minister. In Bulgaria the crisis has boosted support for Gerb, a populist anti-corruption grouping that hopes to win power in elections this summer. Elsewhere, however, the crisis has strengthened governments. Donald Tusk, Poland’s liberal prime minister, is more popular today than when he took power in 2007.

But these are short-term developments. A prolonged crisis could undermine support for market-oriented policies and generate conflict and confusion. Krisztian Szabados, head of the Political Capital Institute, a Budapest research group, worries about increased far-right activity, particularly in countries with significant gypsy minorities. “The right wing is on the rise,” he says, pointing to Jobbik, a far-right Hungarian party that won 8.5 per cent of the vote in a local election last month.

A bigger test for the likes of Jobbik will come in this summer’s European parliament elections. The issue for CEE leaders may not be the size of the extremist vote. After all, few rightwing parties in the region have done as well over time as France’s National Front. But managing shows of extremism will be hard. Public institutions are weaker than in the west and officials are sometimes unable or unwilling to impose their authority. Mr Szabados cites the example of the recession-hit Hungarian city of Miskolc where a police chief, removed for blaming gypsies for a crime wave, was reinstated after demonstrations in his support.

Ivan Krastev, head of the Centre for Liberal Studies in Bulgaria, worries about a collapse in middle-class morale if people lose their jobs and are engulfed by their mortgages: “These people identified with the west and now feel betrayed. ‘We did our best,’ they say. ‘We followed the best practices and now we are told these were the worst practices.’ And no other models are available.”

He draws parallels with the 1998 Russian financial crisis, where middle-class people who lost their savings turned their backs on liberal democracy and came to support the authoritarian Vladimir Putin. “There could be a loss of faith in the west, as there was in Russia,” Mr Krastev says.

But this seems too apocalyptic a view for most of the CEE region. With the benefits of EU membership in full flow, from farm aid to political security, elites will fight hard against populist efforts to change course. Democratic and market-oriented institutions are far stronger than in 1990s Russia.

Also, even in recession, the region’s economies are this year forecast to perform better than those of western Europe. CEE’s advantage of low-cost, high-quality labour remains in place. As Erik Berglof, the EBRD’s chief economist, says: “Despite the crisis, the long-term integration of central and eastern Europe with western Europe will go on. The development model is the right one.”

AUSTRIAN BANKS:

Exposed Vienna tries to put a brave face on its neighbours’ misfortunes

The fall of communism in eastern Europe marked the beginning of a long bonanza for Austria, writes Eric Frey. From the late 1990s it recorded growth rates well above the eurozone average thanks to its massive engagement in the economies of its by then booming neighbours. As recently as January this year, the European Commission predicted that the country would be less affected by the global economic downturn than Germany or Italy.

Yet Austria’s luck may have finally run out. Of particular concern is the huge exposure of the three major banks, Bank Austria, Erste Bank and Raiffeisen, to central and eastern European economies now in the grip of a deepening financial crisis. Shares of Erste Bank and Raiffeisen International, once the heavyweights on the Vienna stock exchange, have tumbled over the past two weeks, losing about 90 per cent from its 1997 peaks before recovering slightly.

Austrian banks have lent a total of $300bn (€210bn, £235bn) to clients in the region, equivalent to 68 per cent of Austrian gross domestic product, according to the Bank for International Settlements (BIS). If Bank Austria, which is owned by Italy’s Unicredit, were included, the figure would rise to about 100 per cent, by far the highest of any west European country.

An economic collapse in the east would wipe out the capital of Austria’s banks and force the government to launch a hugely expensive bail-out. It would also hurt hundreds of industrial groups, retailers and other service companies that either invested in eastern Europe or rely on sales in the region.

Market jitters about the crisis in eastern Europe have driven up the spreads on Austrian state debt over German bunds since the beginning of the year. Last week they widened sharply amid talk that Austria might lose its triple-A credit rating.

These reactions may be overdone, according to some analysts. “Even a wave of defaults in the east similar to the Asian crisis would not affect Austria’s ability to service its debt,” says Dirk Schumacher, an economist at Goldman Sachs in Frankfurt.

Most Austrian bankers and economists argue that the country’s links with eastern Europe remain an asset for the economy, at least in the long run. Ewald Nowotny, the governor of the Austrian National Bank, points to the relatively solid economies of the Czech Republic and Slovakia, two of Austria’s main economic partners. “Austria is most exposed in those countries that are still expected to grow,” he says.

The two main trouble-spots are Ukraine, where Raiffeisen has a large exposure, and Romania, where Erste Bank has been the market leader since it acquired Banca Comerciala Romana in 2005. Both countries are suffering from high private debt burdens and are projected to see a surge in default rates.

But Andreas Treichl, Erste Bank’s chief executive, says: “Ninety-eight per cent of our clients make their interest payments on time. I don’t see that it is dangerous for Austrian banks to be in central and eastern Europe. We made huge investments in the region, but we invested in the real economy.” So far neither Erste Bank nor Raiffeisen have accepted capital injections offered by the government because they have not yet agreed on terms.

Yet there is plenty of anxiety in government and financial circles. The banks have lobbied the European Commission for a special aid programme for institutions exposed in central and eastern Europe, while Josef Pröll, Austria’s finance minister, this month toured the region in an attempt to mobilise support for a co-ordinated approach.

By Stefan Wagstyl in London, Alan Beattie in Washington, and Aline van Duyn in New York

Fears of banking upheavals in eastern Europe and the potential fallout on western Europe yesterday triggered widespread turmoil in global financial markets.

Sharp declines in east European equities and currencies prompted drops in west European bourses and the euro as investors fled for the safety of bonds, the US dollar and gold.

The turmoil was prompted by a report from Moody’s, the credit rating agency, which warned that west European banks with east European subsidiaries risked rating downgrades because of the growing vulnerability of eastern Europe’s banking systems. Standard & Poor’s, a rival agency, later issued a similar caution.

This raised fears that the European economy as a whole could suffer from the deepening difficulties of those east European states that are struggling to raise credit for their debt-financed economies and of those western European banks that have long been the region’s main source of funds.

“This is reminiscent of the Asian crisis of 1998,” said Michael Wang, an emerging market strategist at Morgan Stanley, the investment bank.

“We are seeing what used to happen in emerging markets, where during the years of global expansion countries borrowed heavily and built up large external imbalances, only to face downward pressure on currencies and growth once the cycle turned and foreign capital inflows dried up.”

The euro fell 1.5 per cent to a two-month low of $1.2599 against the US dollar. The Swedish krona fared even worse, falling 2.7 per cent to SKr8.7815 against the dollar. The Polish zloty slumped to a five-year low of 4.93 zlotys against the euro, prompting Donald Tusk, the prime minister, to say the government may sell euros if the zloty fell to 5 against the euro – the first time Warsaw has published an exchange rate floor. The Hungarian forint fell to a record low of Ft309.60 and the Czech koruna, the Romanian leu and the Russian rouble were all down.

Polish and Czech shares dropped to their lowest level in five years, while other equity markets in the region came under pressure.

In Moscow, trading was temporarily suspended amid sharp price drops, provoked partly by the government cutting its 2009 economic forecast from a contraction of 0.2 per cent to one of 2.2 per cent.

The turmoil in eastern Europe spread west, with much attention focused on banks with east European operations.

Italy’s Unicredit closed 7.3 per cent lower. In Austria, Raiffeisen International plunged 13.5 per cent and Erste fell 18 per cent.

Global investor sentiment was dented by a US report showing manufacturing activity in the New York region sliding to a record low in February.

The S&P 500 had fallen 4.2 per cent by late afternoon trading to 792.53, the first time it has fallen below the 800 level since November, while the FTSE Eurofirst 300 index shed 2.5 per cent.

Government bonds rallied, with the yield on the 10-year US Treasury sliding 20 basis points to 2.69 per cent and the 10-year German Bund yield falling 5bp to 2.99 per cent.

Gold hit a seven-month high above $970 an ounce.

Additional reporting by Adrian Cox, Miles Johnson, Dave Shellock and Peter Garnham in London, Jan Cienski in Warsaw and Thomas Escritt in Bucharest