Fears Intensify That Euro Crisis Could Snowball

May 16, 2010 | by Nelson D. Scwartz and Eric Dash | www.nytimes.com

After a brief respite following the announcement last week of a nearly $1 trillion bailout plan for Europe, fear in the financial markets is building again, this time over worries that the Continent’s biggest banks face strains that will hobble European economies.

In a sign of the depth of the anxiety, the euro fell Friday to its lowest level since the depth of the financial crisis, as investors abandoned the currency as well as stocks in favor of gold and other assets seen as offering more safety.

In trading early Monday morning, the euro declined again, managing at one time to reach a four-year low relative to the dollar.

The president of the European Central Bank, Jean-Claude Trichet, in an interview published Saturday, warned that Europe was facing “severe tensions” and that the markets were fragile.

For Europe’s banks, the problems are twofold. Short-term borrowing costs are rising, which could lead institutions to cut back on new loans and call in old ones, crimping economic growth.

At the same time, seemingly safe institutions in more solid economies like France and Germany hold vast amounts of bonds from their more shaky neighbors, like Spain, Portugal and Greece.

Investors fear that with many governments groaning under the weight of huge deficits, the debt of weaker nations that use the euro currency will have to be restructured, deeply lowering the value of their bonds. That would hit European financial institutions hard, and may ricochet through the global banking system.

Bourses and bank shares in Europe plunged on Friday because of these fears, with Wall Street following suit. Shares were also down in Tokyo and Australia in early trading on Monday.

“This bailout wasn’t done to help the Greeks; it was done to help the French and German banks,” said Niall Ferguson, an economic historian at Harvard. “They’ve poured some water on the fire, but the fire has not gone out.”

The European rescue plan, totaling 750 billion euros, is intended to head off the risk of default but would vastly increase borrowing. That could hamstring Europe’s nascent recovery.

Indeed, it was too much debt that caused the problem in the first place: a new report by the International Monetary Fund warns that “high levels of public indebtedness could weigh on economic growth for years.”

The world’s budget deficit as a percentage of gross domestic product now stands at 6 percent, up from just 0.3 percent before the financial crisis. If public debt is not lowered back to precrisis levels, the I.M.F. report said, growth in advanced economies could decline by half a percentage point annually.

To be sure, not all of the trends are negative. A lower euro will actually make European exports — be it German automobiles or Italian leather — more affordable and more competitive around the world. And Greece, Spain and Portugal took the first steps last week toward enacting austerity measures that would reduce their budget deficits.

Those steps were not enough to prevent a flare-up in money market funds, a crucial but little-noticed corner of the financial system in which American investors provide more than $500 billion in short-term loans to help European banks finance their daily operations.

The cash comes from conservative funds that hold the savings of big American corporations and individual American consumers.

So far, the proposed rescue package has failed to ease worries at these funds, which have cut back on loans to European banks and are demanding higher rates and quicker repayment.

“More people are making the yes or no decision to pull out of the market and keep their money closer to home,” said Lou Crandall, the chief economist of Wrightson ICAP, a money market research firm.

Initially, it was Greek and Portuguese banks that got the cold shoulder from American lenders. But over the last two weeks big banks in Spain, Ireland and Italy have struggled to secure short-term funds from the United States as the anxiety has spread.

By Friday, even banks in solid European economies like France, Germany and the Netherlands were caught in the undertow, according to market analysts and traders.

“Investors are waiting to see whether the stability package can be put into place,” said Alex Roever, a short-term fixed-income analyst for J.P. Morgan Securities.

“Until investors get a better feel, we are hung in limbo.”

Because of the pullback by American lenders, the rate banks charge one another for overnight loans, known as Libor for the London Interbank Offered Rate, has been steadily climbing. And the significance of Libor stretches far beyond Europe’s shores: that is the benchmark that helps determine the interest rate on many mortgages and credit cards held by American consumers.

Bank borrowing rates are still well below where they were at the height of the crisis. Fears that the problems in Europe could rebound in the United States, however, led the Federal Reserve to restart lines of credit to the European Central Bank and other central banks in conjunction with the European rescue package announced a week ago.

The move ensured that European institutions would be able to borrow dollars to lend to their clients, but that is more expensive than relying on private investors.

“We didn’t do so out of any special love for Europe,” Narayana R. Kocherlakota, the president of the Federal Reserve Bank of Minneapolis, told a group of small-business owners in Wisconsin on Thursday. “We’re American policy makers, and we make decisions to keep the American economy strong.” However, he said, “The liquidity problems in European markets were showing signs of creating dangerous illiquidity problems in our own country’s financial markets.”

That is not the only domino that could fall.

While the direct exposure of American banks to Greece is minimal, American financial institutions are closely intertwined with many big European banks, which in turn have large investments in the weaker European nations.

For example, Portuguese banks owe $86 billion to their counterparts in Spain, which in turn owe German institutions $238 billion and French banks $220 billion. American banks are also big owners of Spanish bank debt, holding nearly $200 billion, according to the Bank for International Settlements, a global organization serving central bankers.

Furthermore, financial policy makers find themselves running out of weapons in their arsenal.

After borrowing trillions to stimulate their economies and ease credit concerns during the last wave of fear in late 2008 and early 2009, governments cannot borrow trillions more without risking higher inflation and shoving aside other borrowers like individuals and companies. Short-term interest rates, already near zero in the United States, cannot be lowered any further. And vital steps like raising taxes or cutting spending increases could snuff out the beginnings of a recovery in northern Europe and worsen the pain in recession-battered economies like Spain, where unemployment recently passed 20 percent.

With the exception of wartime, “the public finances in the majority of advanced industrial countries are in a worse state today than at any time since the industrial revolution,” Willem Buiter, Citigroup’s top economist, wrote in a recent report.

“Restoring fiscal balance will be a drag on growth for years to come.”