ECB Sees Fiscal Crises in Central and Eastern Europe and

UNCLAS SECTION 01 OF 02 FRANKFURT 000687 DEPARTMENT FOR EUR/AGS SIPDIS E.O. 12958: N/A TAGS: EFIN ECON EU GM SUBJECT: ECB Sees Fiscal Crises in Central and Eastern Europe and Euro Zone as Manageable ENTIRE TEXT IS SENSITIVE BUT UNCLASSIFIED. NOT FOR INTERNET DISTRIBUTION ¶1. Summary. In a conversation with a Treasury delegation, ECB officials indicated they could deal with worsening financial turmoil in Central and Eastern Europe, seeing little chance that crises there would destabilize the euro zone. They saw a debt default from a euro zone member such as Greece or Italy as equally unlikely, as these fiscally troubled countries were still able to service their debts. In Central and Eastern Europe, they pointed out the large differences in economic health between countries, stating that only those that had pursued bad fiscal policy were now facing real danger. In a separate conversation, a private economist said that a debt default from a euro zone member was likely and would necessitate an EU loan that would require more fiscally prudent members such as Germany and France to offer assistance. End Summary. ¶2. On March 5, Treasury Deputy Assistant Secretary Eric Meyer, Treasury Attache for Europe Matthew Haarsager, Treasury Economist Lukas Kohler and Congen Econ Off discussed the ECB's view on economic stability in Eastern and Central Europe and the euro zone with the ECB's Director General for International and European Relations Frank Moss, Deputy Director for General Economics Philippe Moutot, and Head of EU Countries Division Klaus Masuch. The delegation had separate meetings with Deutsche Bank Chief Economist Norbert Walter and Goldman Sachs Economist Dirk Schumacher. Eastern and Central Europe Crises Manageable -------------- ¶3. The ECB officials emphasized that one should not look at Central and Eastern Europe as a single entity, as only certain countries like Latvia and Hungary were experiencing severe crises due to years of bad fiscal policy. Others, such as Poland and the Czech Republic, had kept government debt low and had only small current account deficits. Moss pointed out these differences were reflected in markets as seen in varying credit default spreads on government bonds(a measure of the likelihood of default) and share prices of local banks. Masuch added that in Western Europe, only Austrian banks were heavily exposed and that other European governments would step in if Austria experienced a rash of bank failures, which he felt was unlikely. ¶3. The officials also stressed that one needs to differentiate within Central and Eastern Europe between euro zone members, EU members, candidate members and non-candidate countries, as the EU's framework to help was different in each case. For all countries, the ECB continued to offer currency swaps to ensure euro liquidity. Moutot pointed out that some Eastern and Central European economies had smartly avoided a heavy "euro-ization" of borrowing. The Baltic states had unwisely fixed their currencies to the euro and then borrowed heavily in euros, assuming eventual adoption of the currency. If the currency pegs are abandoned, the euro debt will be difficult to pay back. The officials argued against accelerated adoption of the euro in the Baltics, saying that such a move would not be possible given the current treaty and would only reward bad decisions. Euro Zone Should Hold Up -------------- ¶4. Turning to the euro zone, the officials doubted that any of the more troubled economies (Greece, Italy, Spain and Portugal) would be unable to service their debts and argued that the current crisis offered the opportunity to enact long-overdue structural reforms and cut fiscal deficits. The ECB had lowered the minimum accepted credit rating for government bonds taken as collateral, allowing it to continue to accept Greek bonds, but the officials admitted any further downgrading of Greek bonds would create a "tricky" situation. They pointed out that the ECB's offer of unlimited liquidity to the financial sector had worked well so far in preventing any large bank failure in Europe, unlike in the United States. ¶5. Moutot also commented on the recent De Larosiere report on recommended changes in the EU financial supervisory structure, saying that it was still not clear how many aspects of the plan would work in practice. The proposed Systemic Risk Council (ESRC) chaired by the ECB president would elevate the level of coordination, but he pointed out that a great deal of coordination was already in place in the form of the Financial Stability and Supervision Directorate and the Committee of European Banking Supervisors. Moutot agreed with the report's recommendation that Basel II needed to be revised to reduce "pro-cyclicality" (the idea that certain regulations could heighten financial risk) but said that the problem needed to be studied more at the working level as no one understood it well enough at the moment. On a positive note, he said that even fiscally responsible euro zone members now had FRANKFURT 00000687 002 OF 002 developed a deeper appreciation for a coordinated, regional approach. The View from the Private Sector -------------- ¶6. Separately, Deutsche Bank's Norbert Walter doubted that any euro zone member would need a bailout, saying Greece was still getting better terms on its debt than many private companies. Goldman's Dirk Schumacher expressed a different opinion, seeing a default in Greece, Italy, Spain or Portugal as likely and pointing out that the maturity on Greek debt was getting shorter and the premium higher. He predicted that in the event of a euro zone member default, the EU would offer a loan put together by other member nations. In practice, the loan would be funded primarily by Germany and France, the only members with current fiscal capability. Germany and France would demand something in return, namely tax harmonization. Germany, whose economy is heavily dependent on exports, would have the unenviable choice between funding a loan or facing a severe blow to its own economy as its overseas investments and trade sink further. Funding an EU loan would be politically unpopular in an election year, and the blame would be shared in the Grand Coalition by the SPD and CDU. ¶7. Comment: Although ECB officials remain confident that the fiscal crises in parts of the euro zone and in Central and Eastern Europe are manageable, further deterioration in the global economy would put greater strain on these teetering economies. While the weak economies will suffer the most, all of the relatively small economies in Central and Eastern Europe are heavily dependent on the euro zone for trade and investment. Failure by a fiscally troubled euro zone member to service its debt would be an even greater and unprecedented shock to the system that would require a political agreement among EU member countries to solve. End Comment. ¶8. This cable was coordinated with Embassy Berlin. POWELL