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OO RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV RUEHSR
DE RUEHFT #0687/01 0711014
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O 121014Z MAR 09
FM AMCONSUL FRANKFURT
TO RUEHC/SECSTATE WASHDC IMMEDIATE 9896
INFO RUEATRS/DEPT OF TREASURY WASHDC IMMEDIATE
RUCNMEM/EU MEMBER STATES  IMMEDIATE
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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