Biggest risk to the world economy lies currently in Europe, not in China

Banking black clouds in Portugal, Italy and most-importantly Germany leave Europe on the ropes, and maybe just one serious blow away from knockout

PUBLISHED : Tuesday, 04 October, 2016, 9:21am
UPDATED : Tuesday, 04 October, 2016, 10:56pm

Economists such as Harvard University’s Ken Rogoff may believe that the greatest risk to the global economy comes from an economic slowdown in China – but in reality perhaps the most clear and present danger for the world economy emanates from Europe where there is renewed focus on a perceived fragility in the European banking system.

In fairness to Rogoff, a former chief economist at the International Monetary Fund (IMF), he has been remarkably consistent on this issue.

As far back as May 2014 he wrote that a hard economic landing for the Chinese economy probably “ranked as the number one risk to the global economy today”.

In truth too, last month the Basel-based Bank for International Settlements, often referred to as the central banks’ central bank, highlighted how debt was building within the Chinese economy noting how China had accrued a credit-to-gross-domestic-product ratio of 30.1 per cent, the highest for any nation since collection of such data began in 1995.

But at the beginning of October 2016, it is problems in Europe that perhaps demand the attention of investors and policymakers alike.

Though not their base scenario, on Friday French bank Societe Generale pondered whether the rating agency DBRS might cut Portugal to sub-investment grade in its review due on 21 October, a development that could leave Portuguese banks ineligible for access to European Central Bank (ECB) liquidity and reliant on Emergency Liquidity Assistance funding via Portugal’s own central bank.

As for Italy, although its own banks are burdened by some 360 billion euros of non-performing loans, Italian Prime Minister Matteo Renzi feels that pales into insignificance compared to issues some European banks face over their derivative exposure.

“If this non-performing loan problem is worth one, the question of derivatives at other banks, at big banks, is worth one hundred. This is the ratio: one to one hundred,” Renzi said in July.

Renzi returned to the subject on 19 September urging Jens Weidmann, the head of Germany’s central bank, to concentrate on fixing problems in German banks after Weidmann had urged Italy to cut its public debt.

Deutsche Bank, Germany’s biggest bank and which is currently trying to close out the sale of its US$4 billion minority stake in China’s Huaxia Bank, might be a case in point.

In “its 2015 Annual Report: Passion to Perform, Deutsche reports that the total notional amount of its derivatives book as of 31 December 2015 was just over 41.9 trillion [euros], equivalent to about 46 trillion [US dollars], over twice US [gross domestic product],” wrote Kevin Dowd, professor of finance and economics at Britain’s Durham University in August.

But that is a “scare figure,” as Dowd attests, noting that “Deutsche reports the net market value of its derivatives book” at 18.3 billion euros although Dowd thinks that number itself is “likely to be an under-estimate.”

Nevertheless such are the challenges facing Deutsche that Dowd thinks the German bank is like “a boxer on the ropes: one more blow could knock him out.”

I did not know if I should laugh or cry that the bank that made speculation a business model is now saying it is a victim of speculators
Sigmar Gabriel, Germany’s Vice Chancellor and Economy Minister

To stretch that pugilistic analogy, it remains to be seen if the US Department of Justice’s intention to levy a multi-billion dollar fine on Deutsche to settle a probe related to mortgage-backed securities proves to be a glancing blow or a more damaging uppercut.

In the meantime even Germany’s Vice Chancellor, and Economy Minister, Sigmar Gabriel seems short of sympathy for Deutsche. “I did not know if I should laugh or cry that the bank that made speculation a business model is now saying it is a victim of speculators,” said Gabriel on Sunday.

Either way, given that the IMF wrote in June that Deutsche Bank “appears to be the most important net contributor to systemic risks “among globally important banks, the German bank’s fate is a matter of great import.

At a policy level, the European Central Bank’s (ECB) adoption of very low and indeed negative interest rates is seen by some in Germany as having weakened the prospects of euro zone banks.

Yet “if a bank represents a systemic threat to the euro zone, it can’t be because of low interest rates. It has to do with other reasons,” said ECB President Mario Draghi on 28 September, in a comment that excused the central bank from responsibility for, while not denying the existence of, any such “systemic threat to the euro zone.”

With Germany directly involved, the fault lines in Europe’s banking system cannot be casually dismissed.

Surely the greatest risk currently to the global economy is Europe’s faltering banking system not the possibility of a hard landing in China’s economy. Perhaps Professor Rogoff needs to reconsider.