And you thought Europe was safe from the subprime mortgage disaster?

Is Europe really safe from the sub-prime mortgage disaster?

The Europeans have by and large been oblivious to the subprime meltdown that is currently unfolding in the US. The European newspapers have not covered it much. There was a bit more interest in the subject recently, but only to the extent that people needed an explanation of why stock markets have fallen. The general feeling has been that this is some eccentric US problem that has not much to do with us.

Unfortunately, this view is both complacent and wrong. There are a whole number of channels through which the sub-prime mortgage disaster is affecting the euro area. Of course, if the sub-prime disaster led to an economic slowdown in the US, this would affect the world economy at large, despite the implausibly fashionable decoupling theories. But there are also more direct financial transmission channels of the subprime mortgage crisis. Here are five:

1. The first is one we already know. Global equity markets are seriously sensitive to credit risk. Further defaults in US subprime, carrying over to other parts of the mortgage market, will affect the valuation of US – and by extention – world equity markets. We have seen the first such spillovers two weeks ago, and again on this Tuesday.

2. Many European savers are invested in global savings vehicles, such as investment funds, which are heavily invested in US mortgage backed securities. European hedge funds are holding collateralized debt obligations (CDOs) that include mortgage components, including some subprime tranches. Most retail investors probably don't know the details. We don't have any precise estimates about the extent of this exposure (and we will publish it once we have them), but the anecdotal evidence we hear from the investment industry is that this exposure is non-trivial.

3. Some local euro area mortgage markets have their own version of subprime. In Spain, for example, it is easier for poor immigrants from Latin America to buy property than to rent it. These immigrants have no asset wealth, no income guarantees, and no credit history. Yet, Spain's increasingly competitive mortgage industry has been queuing up to give everybody a loan who asks for one. This is just how the subprime industry in the US worked. Now, the Spanish economy, more than any other in Europe, is heavily dependent on construction for its economic growth. Spain's productivity growth is the lowest in the EU, while about 18% of economic output is related to housing and construction – about half is normal for most EU countries. This means that if the US subprime crisis spills over into Spain, it will affect credits spread throughout, at a time when short-term market interest rates are already over 4%. This has all the hallmarks of a financial/economic crisis – an event which the Spanish government is not prepared for. You have a similar situation in Ireland, where there is already heightened concerned. Ireland is small, but Spain's is a large euro area economy. Don't believe for a minute that the rest of the euro area economy will weather this without problems.

4. The subprime disaster leads to a revaluation of credit spreads worldwide, in the prime markets, in CDO's, and in mortgaged backed-securities. It will thus affect European companies' ability to raise cheap finance. We have already seen a spillover to the European Itraxx Crossover Index, which includes a number of junk-rated European bonds.

5. Some of the European banks are involved, either directly or indirectly, in the US subprime market.

The Europeans are not quite used to talk about Itraxx, or ABX indices, but we would expect that this will be changing at some point. The mechanism that is currently unfolding is one that the European public, including some bankers and central bankers, do not understand very well. If this goes badly, it will have the potential to shake the currently light-headed mood of unbridled optimism in the European economy, one that is wholly oblivious to events outside. The subprime crisis, plus the other knock-on effects, is one such event that could derail this Goldilocks scenario.

What did Trichet say exactly?

The Irish Times quoted Jean-Claude Trichet as saying that inflationary expectations were “excellently anchored”. We at Eurointelligence don't normally like to go much into central bank linguistics, and in fact we would wholeheartedly support his statement. But we find this statement nevertheless surprising, not because it is untrue, but because Trichet chose to say it at this particular time. To justify another interest rate increase, the ECB needs to maintain the rhetoric that there are some inflationary pressures out there, or rather that the risks are still on the upside, which is what they have been saying all along. The ECB's staff forecast already suggests that there is no visible inflationary pressure on the mid-term horizon. The German wage round is proving not as threatening as some might have feared. Furthermore, there are signs of a weaker US economy. It may well be that Trichet is starting to believe his own's staff's forecasts. We still believe – but only just – that euro area interest rates are going up once more to 4%, though any further dovish comments from Trichet could make us change our mind. We would be very surprised if the ECB's governing council was unanimously in favour of another rise.

Why does the Bundesbank want to sell gold?

Gold sales used be to the stuff of disputes between the Bundesbank and the German government. When the government asked the Bundesbank to sell gold in the late nineties, the bankers successfully resisted what they regarded to be an assault on the financial solidity of the state. This time, it was the Bundesbank that made discreet inquires with the German government, whether they can sell gold. If they did, the receipts would accrue to the government under German law. This, however, is not what the Bundesbank has in mind. Axel Weber, president of the Bundesbank, wants to shift the Bundesbank's reserves into more liquid securities. The Bundesbank's has €84.7bn in official reserves, of which €53.1bn are held in gold. Weber does not care about the returns (though higher returns would be a side effect since gold yields nothing). Weber cares about the active use of reserves in the conduct of monetary policy.

FT Deutschland quoted Weber as saying: “Foreign currency reserves serve the purpose to counteract disorderly movements in the financial markets.” (see also our press review form Thursday on this issue.) This is a remarkable statement, since it suggests that the Bundesbank may be preparing the ground for large scale currency intervention at some point in the future. The Bundesbank appears to be building up a war chest to defend itself against the eventuality of a sharp depreciation in the dollar. We suspect that the latest economic and financial news from the US has made a few European central bankers a touch more nervous. It would be interesting to know whether other national central banks in the euro area, especially the gold-heavy Banque de France, are also moving in that direction. One to watch.

Some interesting new research finding about Europe's productivity gap with the US

If you thought that the EU has caught up with the US, as some of the headline GDP growth figures suggest, here are some findings that would put this optimism into perspective. A hugely ambitious EU project, run by the University of Groningen's Growth and Development Centre under Bart van Ark, has this week produced a downbeat assessment of Europe's productivity performance in comparison with the US. While the study only covers the period until 2004, it is unlikely that the euro area will have undergone big structural shifts since then. The full report and the data can be found here.

They suggest that the EU's gap with the US is large and persistent. While productivity growth in manufacturing is approximately the same in Europe and the US, most of the differences is due to services, such as retail and wholesale, and general business services. While there is a gap between the EU and the US, there are also some significant differences within the EU. The UK, having been a laggard into terms of productivity growth performance in the past, is now one of the better performers, as is the Netherlands, in both cases due to strong productivity growth in the services sector. Germany and France occupy the middle ground, while Spain and Italy are the two worst performers, dragging the euro area average way down.

Europe's performance is particularly disappointing in terms of total factor productivity, where only the Nordic countries and the Netherlands score well. The study concludes that the EU must make better use of its productive capacities, and focus more on the service sector.

We are only just scratching the surface of the many deep results from this study.

With this in mind, we turn to the following subject that has raised some eyebrows this week, but which can be dealt with in full relatively briefly:

Has Germany's potential output doubled from 1% to 2% within one year, as the Kiel-based Institute for World Economics has claimed?

Of course, not. Don't be silly.

Email:

mundschenk(at)eurointelligence.com

munchau@eurointelligence.com

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