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Satyajit Das: Europe's Debt Crisis Will Return

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Perhaps overly optimistic European governments and policy makers now proclaim a stabilization or lower rate of decline as an indication of the success of their policies.

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The identified weaknesses of key policies will increasingly be tested by markets.

Firstly, the weakness of the real economy will increase financial pressure on European countries. During the second quarter 2013, European economies recorded slow growth, technically ending the recession. However, the levels of economic activity excluding Germany and France remained low. The turnaround may prove fragile, given deteriorating conditions in emerging markets which have been major buyers of European exports.

Ever optimistic European governments and policy makers now proclaim a stabilization or lower rate of decline as an indication of the success of their policies. But those forecasts of recovery may prove overly rosy.

Secondly, banking sector problems will continue. European banks may have as much as Euro 1 trillion in non-performing loans. Italian banks may have as much as Euro 250 billion of these.

Increasingly, European governments are resorting to tricks to resolve problems of the banking system, including inadequate stress tests, overly optimistic growth and asset price forecasts, and accounting stratagems. For example, Spain is seeking to convert Euro 51 billion in deferred tax assets resulting from loan losses into core capital to meet minimum requirements. If successful, then these would represent around 30% of Spanish bank core capital.

Without urgent and resolute action, bad debts and weak capital positions will create zombie banks that are unable or unwilling to supply credit to the economy, restricting any recovery.

Thirdly, crucial structural reform of labor markets and entitlements will be slow, reflecting weak economic activity and also the unpopularity of many measures. In addition, the relative stability of the last 12 months has lulled governments into a false sense of security, reducing the urgency of pursuing economic restructuring.

Fourthly, political tensions, both national and within the eurozone, are likely to increase. As evident in Greece, Portugal, Spain, and Italy, weak economic conditions have increased pressure on the government, highlighting political differences and destabilizing fragile ruling coalitions. All these countries also have domestic issues that contribute to political instability; for example, the bribery scandal involving the ruling PP in Spain and the continued legal difficulties of former Italian Prime Minister Silvio Berlusconi.

Across the eurozone, Germany's repeated rejection of any steps amounting to a mutualization of debt or hidden transfer payments as well as reluctance to increase German commitments, increasingly supported by Northern European nations, will complicate crisis management. Little is expected to change under the new German government.

The new phase of the crisis will follow a familiar narrative. Weaker countries may require extensions of existing loans, additional assistance, or debt write-downs.

Credit ratings will come under pressure. Italy's current credit rating (BBB with a negative outlook) is perilously close to non-investment grade. Stronger countries will also face rating pressure from larger financial burdens of supporting peripheral countries and European and global economic weakness.

Borrowing costs of weak European countries will remain high or increase, reflecting different factors including the following: economic weakness of the borrowers, political stresses, and also the potential reduction of the US quantitative easing program. Doubts about the OMT program and decreasing flexibility to use national banks and state pension funds to purchase government debt will accelerate the pressure on rates.

In 2012, Europe's policy makers were able to calm markets. This time around, with their options increasingly constrained, it will be interesting to see their response, and whether or not it works again.
No positions in stocks mentioned.

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