26 August 2011

Hey Europe, What Is Going On? (Part 4)

Last time when speaking about Europe, in Part 3 of this series of articles, we explored the health of the European banking sector (which we found to be not too good to say the least). Next, to better understand the incentives for keeping Europe together and/or throwing certain countries out as well as the sensible size of the financial aid and guarantees that European countries could be assumed to provide each other, we analyse the interdependencies within Europe. We are going to do this from two perspectives: export-import relationships and banks’ cross-border exposure. 

Export-import relationships

Export-import relationships give us an indication of how much the economic fortunes of one European country depend on the economic fortunes of another European country.

First, Figure 1 below illustrates the intra and extra EU-27 exports and imports of the euro area countries and the selected other European countries. We clearly see that some countries are much more involved in the international trade than the others, and that intra EU relationships are clearly stronger than extra EU relationships. Not surprisingly, Europe appears to be the most important for those located in a strategic position (Netherlands, Belgium) as well as for the new EU members from Central and Eastern Europe (Estonia, Slovakia, Slovenia). What concerns the four largest eurozone economies (Germany, France, Italy and Spain) then Germany benefits the most from One Europe; in fact it’s the only one of the four that had intra EU-27 net export positive in 2010. Also notably, from the countries that have already admitted to be in financial difficulties (Greece, Ireland and Portugal), only Ireland seems to be the one that is important for the eurozone because of its large positive net exports; Greece and Portugal on the other hand degrade the trade balance of the area as a whole. Furthermore, Greece is even not much engaged into the intra EU-27 trade (see that there is not much difference between intra EU-27 and extra EU-27 numbers, and that the exports and imports relative to the size of economy are rather low).

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Figures 2-a, 2-b and 2-c provide more insight into the intra EU trade. When we look at these numbers, we see that Germany is undoubtedly the hearth of the European economy: 12.2% of the intra euro area exports went to Germany in 2010. For the five European countries (Austria, Belgium, Netherlands, Slovakia and Slovenia) exports to Germany, and for six countries (the aforementioned plus Luxembourg) imports from Germany exceeded 10% of their GDP-s in 2010. In addition, Germany is an important export destination for Luxembourg and Denmark, and a significant import source country for Estonia, Sweden and Denmark. Yet several countries have negative trade balance with Germany, most notably (relative to the size of their economies) Austria, Estonia and Luxembourg. Only Netherlands (and in lesser extent Belgium) manage to export to Germany considerably more than they import from there. Also France and United Kingdom play quite a role in intra EU trade which is natural given the size of these economies.

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It is worth pointing out that 5.5% of the intra euro area exports went to Belgium in 2010, which is more than the same figures for Italy and Spain (5.4% and 4.2% respectively). Similarly, exports of the other eurozone countries to Netherlands were impressive: 4.7% of the total (again, more than the same number for Spain). Imports from Belgium and Netherlands were corresponding: 5.8% and 8.4% of the total intra euro area imports respectively (Netherlands even surpassed France). This actually further signifies the role of Germany and France as both Belgium and Netherlands are net exporters to these countries. So for illustration guess what would happen if for example the French largest bank BNP Paribas (the assets of which are approximately in the same size as the country’s economy) would completely lose the trust of financial markets? First it would be a hard hit to French economy, but not only. The economies of Belgium and Netherlands would be brought to their knees too (especially given that the bank has large assets in these countries), and Ireland, given its dependency on exports to Belgium, would be in even more serious trouble. Note that so far we haven’t even considered the impacts of France losing its AAA rating with high enough probability in that example.

We further see that if there were no risks for contagion, chain reactions and domino effects in Europe, the Europe’s largest countries (Germany, France, UK, Spain and Italy) as well as Finland and Sweden would be pretty well off: their economies are not dependent on exports into one single another European country. In other words, they have diversified their risks (at least what concerns developments in Europe). The bad news is that problems are very easy indeed to spread from one country to another as illustrated by the above simple example. The probability of a systemic contagion is not less importantly aggravated by the integration of financial systems (e.g. Sweden can easily get hit by the financial troubles in Denmark which would come via Nordea Bank), one bank depending on another, public finances being threatened by the need to bail out banks (and this maybe just because of the market overreaction) and also fellow countries.

What concerns other countries and their import-export relationships then it is worth to point out the following:  
* Estonia’s economic fortune is clearly dependent on the fortunes of Sweden and Finland (especially from Sweden).
* Slovakia’s and Slovenia’s economy are closely linked to Austria, France, Germany and Italy, thus on one hand having a direct link with one of the so-called PIIGS countries, while on the other being diversified within Europe (which however is not that safe, especially considering the importance of intra EU exports for these two countries).
* As for the almost notorious trio Greece-Ireland-Portugal, then there is not much to add to the above. The good news to Cyprus is that at least in terms of exports, it’s not very much dependant on Greece. Yes, intra EU exports are important for Ireland, and Ireland’s most important export partners are UK and Belgium. Portugal is obviously related to Spain; since Portugal’s trade balance with Spain is negative, Spain gets a hit from the austerity measures in Portugal; the direct impact however will not be too large relative to the size of Spain’s economy.

Banks’ cross-border exposure

Claims that European banks have in the other European countries illustrate the interconnectedness of financial sectors. The connections are of course two-sided: Austrian banks have claims to counterparties in Germany and German banks have claims to counterparties in Austria, Belgian banks have claims to counterparties in France and French banks have claims to counterparties in Belgium, and so one. That’s why we are talking about the interdependencies. This can be well seen from the Figure 3-a.

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For example, as of 31 March 2011 German banks had claims to Italy in the amount of EUR 116.1bn and Italian banks had claims to Germany in the amount of EUR 191.5bn. Yet it’s not that we can simply net the exposures and say that all in all, German banks owe to Italy EUR 74.5bn. No, if the customers of German banks in Italy would default for example, German banks would have to write off their claims in Italy yet German counterparties still have to repay to Italian banks. At the same time, this type of analysis of net claims still provides interesting insights. So take a look to the Figure 3-b where the respective calculations are provided.

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What we see is that within euro area, French and Netherlands banks act as large net creditors (see the column “Eurozone total” in the Table above), and that most of their credit goes to Belgium, Italy and Spain. Respectively, Belgium, Italy and Spain are the largest net debtors. When we add Sweden, Switzerland and United Kingdom to the analysis, the picture is somewhat different. Notably, Spanish banks appear as net creditors (mainly as a result of the Banco Santander’s large operations in UK) and Germany is added to the significant creditors as well (again, as a result of large claims in the United Kingdom). Respectively, customers in the UK owe large amounts to German and Spanish banking sectors; in fact, UK’s overall net position appears to be even surprisingly negative. Understandably, Greece, Ireland and Portugal are in the minus side too.

How much are the euro area countries actually ready to pay to bail out their fellow members? The “Eurozone total” numbers in Figure 3-a above provide a proxy as far as saving their own banks from the direct losses is concerned. The rest is rather because of political reasons and fears. We see that Greece has quite reached its limit already with the first bailout package. Except France whose banks still have notable net exposure to Greece, the others do not have much motivation to continue bailout operations of this particular PIIGS country. Ireland and also Portugal still have playing room. Clearly, Italy, Spain and Belgium are the keys from the perspective of banking sector.

One more aspect can be added to our understanding of the interdependencies of European banking sectors (and hence also European economies) when we consider banks’ cross-border exposure relative to the home country’s GDP. This is done in Figure 4 below. Remarkably, as already implied above, the otherwise safe Swedish economy appears to be vulnerable to the developments in Denmark as its banking sector’s exposures to this country form more than 35% of Swedish GDP. Similar is true about the relations between Sweden and Finland.

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To summarise: do we want to admit it or not, this analysis of the interdependencies within Europe reveals that there are no fundamental economic and financial motivations for keeping Greece in the euro area. It also reveals that Portugal is in with one leg and out with another. Furthermore, keeping eurozone together is a real challenge for which however there are good reasons. So muddling through continues. The story of Nordic countries and Estonia is somewhat different, but still related.

Up next in this series: Europe and the rest of the World

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