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Europe challenges world economic recovery

Report from today’s Journal:

Europe’s economy faces a deeper recession and a slower recovery than the U.S. or other parts of the world, making it the region that is most hurting prospects for an early end to the global economic slump.

The EU’s economy is set to contract 4% this year, even worse than the 2.8% drop projected for the U.S., according to new forecasts published Wednesday by the International Monetary Fund.

(click to enlarge; source: IMF)

Those figures came as the U.K. released a budget that includes its biggest jump in the national debt since World War II. Germany, Europe’s biggest economy, shrank by 3.3% in the first quarter — a steep slide from a 2.1% contraction in the last quarter of 2008. Leading German economics institutes said Wednesday that the country’s economy is set to contract 6% this year, which would be its worst recorded performance since 1931.

European banks’ losses from the global financial crisis are now projected to overtake U.S. banks’ losses, according to IMF figures, which could hurt the banks’ ability to lend liberally to help the bloc out of its crisis. More than half of the losses on continental Europe are homemade, the IMF said, reflecting bad loans to European firms and households rather than toxic U.S. securities.

The worsening outlook for the 27-nation EU is a blow for many of the region’s governments, who have argued that the U.S. is the center of the global economic storm and that Europe’s problems are smaller. Because of that, plus fear of rising inflation and public debt, authorities in much of Europe have been slower than those in the U.S. or leading Asian economies to cut interest rates or adopt ambitious fiscal-stimulus measures.

“At some deep level the European banks and policy makers don’t get it: that they helped cause the crisis, that their slow response is part of the reason that the economy is bad, and that more is on the way,” says Simon Johnson, a former IMF chief economist.

Europe’s poor prospects are likely to rebound on the U.S., Asia and other regions, given that the EU’s $18.4 trillion economy makes up 30% of the world economy.

In a sign of such spillover, Peoria, Ill.-based equipment maker Caterpillar Inc. said its first-quarter sales to Europe fell 46% from a year ago, significantly more than its sales declines in the U.S., Asia or Latin America, as it announced a first-quarter loss on Tuesday.

Even European firms’ hopes are pinned on other regions where countries are spending more on stimulus plans. At Munich-based engineering firm HAWE Hydraulik SE, owner Karl Haeusgen is hoping that signs of life in the U.S. and China will lead to new export orders. In recent months, his orders have fallen as much as half from a year ago.

HAWE is holding on to its workers at idle German factories only because the government is helping to pay their salaries — a policy many European countries use to damp unemployment figures. “That we have a downturn is not surprising, but the intensity is unexpected and abnormal,” says Mr. Haeusgen.

In France, labor protests became more violent this week as workers stormed and ransacked a government building near Paris, after they failed in court to prevent their tire factory, owned by German auto-parts company Continental AG, from being shut down. German Trade Union Federation head Michael Sommer warned his country’s industrialists this week that such social unrest could spread to Germany if mass layoffs multiply.

On Tuesday, credit-rating agency Standard & Poor’s predicted that debt defaults among high-risk European companies would overtake defaults among low-rated U.S. companies.

Some business surveys and economic data suggest the pace of Europe’s contraction might be easing. But signs of a recovery in coming months appear weaker than in other regions, such as Asia and the U.S., where economists say more aggressive government efforts are starting to show some effect.

Tentative signs of relief in Asia include Chinese factory output and auto sales, which improved in March. Japan is also seeing some glimmers of hope, as exports in March nearly halved from a year earlier but rose from February, the first monthly gain since May last year.

Policy makers are partly to blame for the severity of the euro zone’s slowdown, say some analysts. “When you think of the broader monetary and fiscal policy mix, it’s clearly been more aggressive in the U.S.,” says David Mackie, economist at J.P. Morgan in London.

The European Central Bank cut its key interest rate to 1.25% from 4.25% in October, and is expected to trim the rate to 1% in May. That’s still well above comparable rates in the U.S. and U.K.

Governments in Europe also have been slower to use fiscal policy to support demand.

Fiscal stimulus measures over a three-year period of 2008-2010 are equivalent to 4.8% of last year’s gross domestic product in the U.S. and 4.4% in China, according to the IMF — but only 3.4% in Germany, 1.5% in the U.K., and 1.3% in France.

The weakening of Europe’s banking sector is potentially more damaging for the wider economy than woes at U.S. banks, because Europe’s financial system relies more on bank lending and less on securities markets. Although Europe’s banks have bigger balance sheets than U.S. lenders, so that their losses are smaller as a proportion of total assets, they will need more fresh money than the U.S. to repair their capital buffers, the IMF said.

An IMF report published Tuesday said that write-downs at Western European banks outside the U.K. will total $1.109 trillion for 2007-2010, topping the U.S. total of $1.049 trillion. Banks in the euro zone have so far written down only 17% of their losses, compared with roughly 50% at U.S. banks, the IMF said. U.K. banks have written down about a third of their $310 billion in expected losses, the report said.

Restrictive lending by banks trying to repair their capital ratios is holding back European businesses. At French racing-bicycle maker Look Cycle International SA, sales are suffering because the bicycle stores and distributors it deals with in markets including France and Italy can’t get enough financing, says Look Chief Executive Thierry Fournier. “Dealers and distributors have problems with their banks, so everybody is more cautious about placing orders or holding stocks,” he says.

Fixing the banking system is particularly tricky in the EU, where 16 of the 27 countries share the euro currency and a central bank, but where banking regulation mostly remains the preserve of the national governments.

“In Continental Europe, there is basically no prospect of any coordinated policy action to identify the weaknesses in the banking system,” says Nicolas Veron, a research fellow at Brussels think tank Bruegel.

Europe’s economy also faces a greater risk of further deterioration than other regions because of the deep economic and financial crisis in the formerly communist East. Austria-based banks, for example, have some $278 billion in exposure to those countries, equivalent to over 70% of Austria’s gross domestic product.

The IMF expects Continental European banks’ losses on emerging-market assets to reach $172 billion by 2010, more than four times the emerging-market losses it expects for U.K., U.S. or Asian banks.

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