Europe risks fresh credit crunch

THE combined eurozone economy could fall by 3% over the next two years, with a fresh “credit crunch” problem arising if decisive action isn’t taken to tackle the sovereign debt crisis, according to a new study.

The warnings form part of the latest Eurozone Economic Forecast from professional services giant, Ernst & Young. The forecast claims that the eurozone’s main bailout fund, the European Financial Stability Facility (EFSF), needs to be increased in value sevenfold, from its current level of around €440bn, in order to create what it calls “a clear and credible firebreak to prevent financial market contagion.”

The report states that the eurozone’s GDP levels could fall by 2% next year and by a further 1% in 2013 in a “disorderly default scenario”, but adds that the probability of this happening is only around the 20% mark. Another consequence of this, however, could be an 8%+ fall in bank lending within the region in the next two years.

“The latest data already shows distinct indicators of recessionary risk as bank lending in the periphery continues to fall and the supply of credit to businesses tightens across the eurozone. In the case of a disorderly default, the reduction of lending by a further 6% would severely impact fundamental drivers of the economy that will affect the long-term outlook for every country across Europe,” said Marie Diron, co-author of the report and economic adviser to Ernst & Young.

According to Ms Diron, with around €800bn worth of maturing loans in need of refinancing next year, the risk of another widespread credit crunch is real.

Sustained failure to act, she said, will exacerbate the current lack of market confidence and credit markets will “freeze further from both a supply and demand perspective; closing down income streams for banks and limiting lending to the wider market, simultaneously”.

This growing lack of credit, she added, could develop a “shadow banking segment” to exploit the lending gap — seeing investment funds, private equity houses and investment companies exploiting the opportunity and extending credit directly to large companies.

“Banks still have the competitive advantage in terms of expertise in lending activities but, without a secure supply of credit, the market remains open for the emergence of a shadow banking segment to make inroads into the more profitable lending to large corporates. Such ‘shadow banking’ activities will also sit outside much of the new regulatory and capital surcharge regime giving them a potential unfair competitive advantage in pricing certain services,” she warned.

Speaking at last weekend’s Global Economic Forum think-in at Dublin Castle, Finance Minister Michael Noonan said that European banks will probably need fresh capital well in excess of €100bn; with it coming from many sources including the EFSF.

Meanwhile, Ms Diron said that “a timely, collaborative” response is needed now more than ever.