US debt ceiling: Why it could cost Europe

After years of economic malaise, Europe appears to be finally turning the corner. But a US default would change all that.

Like the rest of the world, Europe is keeping a close eye on the looming budget crisis in Washington, wary of the unthinkable: a US default.

Few expect a default will happen. But if it does, nothing short of Europe’s fragile economic recovery – especially among periphery states – is at stake.

“A default would be most unwelcome for Europe,” says London-based Mark Wall, who co-heads European economics in Deutsche Bank. “Europe has reached a position to start a recovery but it’s very fragile, very uneven, and expectations point to vulnerability for few years as it gets its house in order.”

After several years of economic crisis, analysts have recently begun to see signs that Europe has turned the corner into recovery. Although economic growth in the 17-member eurozone is expected to shrink 0.4 percent in 2013, after a 0.6 percent decline in 2012, the International Monetary Fund said on Tuesday that the eurozone is expected to grow 1 percent in 2014.

Though such figures are modest, they are actually up from earlier expectations, and have translated into improving consumer sentiment and spending. According to IMF predictions, all three of Europe's top economies – France, Germany, and Britain – will see growth. France is expected to see token improvement in 2013 and 2014; Germany should grow 0.5 percent this year; and the British economy is forecast to grow 1.4 percent in 2013 and 1.9 percent in 2014.

But that would certainly change if House Republicans and the White House fail to reach an agreement by Oct. 17 on raising the debt ceiling, and the US Treasury becomes unable to raise more cash. 

The European economy is inherently exposed to effects from across the Atlantic, because is financial sector and that of the US are closely intertwined. “The US is Europe’s second biggest trading partner," says Mr. Wall, and "there is a strong degree of correlation with US financial sector."

But additionally, a US default would strike at the engine of the European recovery: European exports to the US. A weakened US dollar makes European exports more expensive, undermining the region’s competitiveness, just as years of painful adjustments are starting to pay off.

“If it comes to a default, however unlikely, for sure the recovery would be at stake. It would be such a huge shock that European risk premiums would rise again massively,” says Matteo Cominetta, a London-based European economist with HSBC.

Periphery Europe

The effects in southern Europe – Spain, Italy, Greece, and Portugal – could be worse, as its economic recovery is underway at a much slower pace than northern Europe.

The two giants of the periphery, Spain and Italy, are gaining traction, although both remain in a precarious position due to political uncertainty and unpopular governments.

Analysts say that Spain in particular is showing signs of recovering from the southern economic malaise. Its leading stock index, the IBEX 35, is up more than 50 percent in the past 14 months. Since mid-September, lenders have been demanding a higher premium to hold Italian 10-year bonds than Spanish ones.

Spain’s economy will contract 1.3 percent in 2013 and be flat in 2014. Italy’s recession will bottom out at a 1.8 percent contraction in 2013 and grow 0.7 percent in 2014, according to the IMF.

But like northern Europe, the periphery's recovery depends on strengthening exports, which is offsetting record unemployment and slumping consumer demand. A US default would certainly undermine that progress.

“The only dynamic factor in Europe is improving foreign demand,” Mr. Cominetta says. “In itself, the US is 12 percent of the eurozone export, so it’s not huge alone. But the impact of a US default would be global” and would have indirect impact on all of Europe's trade.

Additionally, a US default would raise the cost of borrowing for US banks and business, a financial shock that would immediately spread to the global financial sector, especially Europe. As a result, European rates would skyrocket, especially for periphery countries, derailing the broader recovery.

“Most of Europe is not in a position to absorb higher rates with this initial recovery,” Cominetta says.

The European Central Bank could intervene in the markets and rescue periphery countries, but even then, the consequences would be grave. It would practically erase the modest gains after years of grueling austerity and political instability.

But ultimately, however high the stakes, there is little for Europe to do beyond watch and hope.

“Other than urge Washington for a rapid conclusion to the standoff,” says Wall, "I don’t think [Europe] can do much more."