Eurozone Crisis at Point of Maximum Danger, Great Depression II?

Economics / Euro-Zone
May 19, 2010 - 08:10 AM

By: Mike_Whitney

Debt woes in Greece have sent bond yields soaring and increased the prospect of sovereign default. A restructuring of Greek debt will deal a blow to lenders in Germany and France that are insufficiently capitalized to manage the losses. Finance ministers, EU heads-of-state and the European Central Bank (ECB) have responded forcefully to try to avert another banking meltdown that could plunge the world back into recession.

They have created a nearly-$1 trillion European Stabilization Fund (ESF) to calm markets and ward-off speculators. But the contagion has already spread beyond Greece to Spain, Portugal and Italy where leaders have started to aggressively cut public spending and initiate austerity programs. Belt-tightening in the Eurozone will decrease aggregate demand and threaten the fragile recovery. We are at a critical inflection point.

From American Banker:

"Bank stocks plunged last week under the theory that banking companies will take large losses in Europe. The theory is correct. Banks will get hurt," Richard Bove of Rochdale Securities LLC wrote in a research note.
Bove wrote in a separate report last week that "big American banks have a bigger stake in this drama than thought." He estimates that JPMorgan Chase has $1.4 trillion of exposure across all of Europe alone, while Citigroup Inc. has $468.4 billion.

Analysts said large U.S. banks have opaque ties to the region through their overseas counterparts. U.S. money-center banks trade derivatives, orchestrate currency swaps and handle other transactions with large European banks. U.S. banks may not hold a lot sovereign debt in Europe, but those European institutions do. If Greece defaults, that could create a crisis of confidence in the European banking market that would spread to large U.S. banks.

"Obviously, the European banks have exposure to Greece. The U.S. banks have loans out to those banks," said Keith Davis an analyst with Farr Miller & Washington. "There are a number of different ways they can have exposure — it's not hard to imagine how a wildfire can spread." (Europe's debt Crisis, US Banks Exposure", Paul Davis and Matt Monks, American Banker)

China and the United States have begun to hunker down and pursue deflationary policies. China has already been blindsided by a steep 14.5% rise in the renminbi over the euro in the past 4 months which is beginning to hurt exports. But China's leaders are also trying to unwind a real estate bubble that was created by loose monetary policies and the massive $600 billion fiscal stimulus package. Rather than drain liquidity by raising interest rates, (which would strengthen the renminbi) China is tightening lending standards to put more pressure on speculators. It's a circular strategy to deal with a serious problem. This is from The People's Daily online:

"On April 16, the State Council rolled out a series of measures to curb the domestic housing market amid concerns over asset bubbles. These measures include a 30 percent down payment for first time buyers for houses larger than 90 square meters, 50 percent down payment and lifting mortgage interest rate for second home buyers. The government has also imposed a temporary ban on mortgage applications for third or above home buys and cross-city purchases. Shanghai will be the third region after Beijing and Shenzhen to have rules governing property buys, said Sun." the people's daily online, Shanghai property curbs soon.

By tapping on the brakes, China will likely limit the fallout from the burst credit bubble, but will also slow investment which is the main driver of growth. That leaves the experts divided about what the future holds in store; many now believe that China is headed for a "hard landing". Here's an excerpt from hedge fund manager Hugh Hendry with a particularly grim forecast:

"The composition of China's growth has undergone a potentially treacherous change: in the absence of expanding foreign demand for its exports, it has instead come to rely on a massive surge in domestic bank lending to fuel its growth rate. Indeed, when measured relative to the size of its economy, the 27pc point jump in bank loans to GDP is unprecedented; at no point in history has a nation ever attempted such an incredible increase in state-directed bank lending.

“What a turnaround: from an export juggernaut to a credit addict. Who would have thought it necessary back in 2001, the year everything all started to work out for China?....China has become the world's biggest creditor, after amassing nearly $2.3 trillion of foreign exchange claims on us. However, the specter of a creditor nation running persistent trade surpluses has ominous historical portents. It has happened only twice before, with the US economy in the Twenties and with the Japanese economy in the Eighties.â€