The Grim Outlook for Europe

By MARCUS WALKER in Berlin and JOELLEN PERRY in Frankfurt Europe's economy faces a deeper recession and a slower recovery than the U.S. or other world regions. As a result, the European Union is becoming the region that is most hurting prospects for an early end to the global economic slump. The EU's economy is set to contract 4% this year and an additional 0.3% next year, according to new forecasts published Wednesday by the International Monetary Fund. That's even worse than the outlook for the U.S. economy, which the IMF says will shrink 2.8% this year and stagnate in 2010. Mounting expected losses have exposed European banks' weakness, and policy makers are struggling to come up with an aggressive response to the crisis. The worsening outlook for the 27-nation EU is a blow for many of the region's governments, who have argued that the U.S. is the center of the global economic storm and that Europe's problems are smaller. Because of that, plus fear of rising inflation and public debt, authorities in the euro zone have been slower than those in the U.S. or leading Asian economies to cut interest rates or adopt ambitious fiscal-stimulus measures. Mounting distressed assets in the European banking sector also threaten to derail an economic recovery. EU banks' projected credit losses have already overtaken those of U.S. banks, according to the IMF. Although Europe's banks have bigger balance sheets than U.S. lenders, so that their losses are smaller as a proportion of total assets, they will need more fresh money than the U.S. to repair their capital buffers, the IMF said. Europe's poor prospects are likely to rebound on the U.S., Asia and other regions, given that the EU's $18.4 trillion economy makes up 30% of the world economy. In a sign of such spillover, Peoria, Ill.-based equipment maker Caterpillar Inc. said its first-quarter sales to Europe fell 46% from a year ago, significantly more than its sales declines in the U.S., Asia or Latin America, as it announced a first-quarter loss on Tuesday. European firms' hopes are pinned on other economies with stronger stimulus policies. At Munich-based engineering firm HAWE Hydraulik SE, owner Karl Haeusgen is hoping that signs of life in the U.S. and China will lead to new export orders. In recent months, his orders have fallen as much as half from a year ago. HAWE is holding on to its workers at idle German factories only because the government is helping to pay their salaries -- a policy many European countries use to damp unemployment figures. "That we have a downturn is not surprising, but the intensity is unexpected and abnormal," says Mr. Haeusgen. The German economy, Europe's biggest, shrank at an annualized rate of 13.2% in the first quarter amid plunging exports, the German government said Wednesday. That's even worse than the 8.4% annualized contraction in the last quarter of 2008. Leading German economics institutes said Wednesday that the country's economy is set to contract 6% this year. That would be the worst recorded performance since 1931. On Wednesday, the U.K. created a new 50% tax bracket for annual income over £150,000 ($220,000), in a dramatic step to plug the country's gaping budget deficit that reverses two decades of income-tax cuts for the highest earners. Britain's jump in national debt this year is set to be the biggest since World War II, as its economy contracts at the fastest pace since that era. In France, labor protests became more violent this week as workers stormed and ransacked a government building near Paris, after they failed in court to prevent their tire factory, owned by German auto-parts company Continental AG, from being shut down. German Trade Union Federation head Michael Sommer warned his country's industrialists this week that such social unrest could spread to Germany if mass layoffs multiply. Some business surveys and economic data suggest the pace of Europe's contraction might be easing. But signs of a recovery in coming months appear weaker than in other regions, such as Asia and the U.S., where economists say more aggressive government efforts to revive activity through fiscal-stimulus packages and central-bank activism are starting to show some effect. "At some deep level the European banks and policy makers don't get it: that they helped cause the crisis, that their slow response is part of the reason that the economy is bad, and that more is on the way," says Simon Johnson, a professor at MIT Sloan School of Management and former IMF chief economist. Tentative signs of relief in Asia include Chinese factory output and auto sales, which improved in March. China's central bank said on Wednesday that the country's four trillion yuan ($586 billion) stimulus package should help the economy achieve the government's target of around 8% growth this year. The IMF, however, predicted Wednesday that China's economy will grow only 6.5% this year. Policy makers are partly to blame for the severity of the euro zone's slowdown, say analysts. "When you think of the broader monetary and fiscal policy mix, it's clearly been more aggressive in the U.S.," says David Mackie, economist at J.P. Morgan in London. The European Central Bank has cut its key interest rate to 1.25% from 4.25% in October, and is expected to trim the rate to 1% in May. But the ECB's rates are still higher than those in the U.S. and U.K. Governments in Europe have also been slower to use fiscal policy to support demand. Fiscal stimulus measures in 2008-2010 are equivalent to 4.8% of gross domestic product in the U.S. and 4.4% in China, according to the IMF -- but only 3.4% in Germany, 1.5% in the U.K., and 1.3% in France. Europe's economy faces a greater risk of further deterioration than other regions, economists say, because of the deep economic, financial and political crisis in the Continent's formerly communist East, as well as from worsening asset quality at European banks. An IMF report published Tuesday said that write-downs at Western European banks outside the U.K. will total $1.109 trillion for 2007-2010, topping the U.S. total of $1.049 trillion. Banks in the euro zone have so far written down only 17% of their losses, compared with roughly 50% at U.S. banks, the IMF said. U.K. banks have written down about a third of their $310 billion in expected losses, the report said. More than half of mainland European banks' projected losses are homemade, the IMF said, reflecting rising bad loans to European firms and households rather than toxic U.S. securities. The weakening of Europe's banking sector is potentially more damaging for the wider economy than woes at U.S. banks, because Europe's financial system relies more on bank lending and less on securities markets. On Tuesday, credit-rating agency Standard & Poor's predicted that debt defaults among risky European companies would catch up with and overtake defaults among low-rated U.S. companies. Restrictive lending by banks trying to repair their capital ratios already is holding back European businesses. Fixing the banking system is particularly tricky in the EU, where 16 countries share a common currency and a central bank, but where banking regulation mostly remains the preserve of national governments. Crisis-hit countries in Europe's East could also pose a threat to Western European banks, though overall, the euro zone's exposure to the hardest-hit economies in Eastern Europe remains small relative to its $12.2 trillion economy, according to London-based consultancy Capital Economics. And not all Eastern European countries are melting down: The Czech and Polish economies will slow substantially this year, but they aren't seeing the same kind of bust, fueled by capital flight, that has forced neighbors including Hungary and Ukraine to seek emergency aid from the IMF. Still, some Western European countries are particularly exposed to the crisis in the East: Austria-based banks, for example, have some $278 billion in exposure to Europe's post-Communist transition countries, equivalent to over 70% of Austria's gross domestic product. The IMF expects Continental European banks' losses on emerging-market assets to reach $172 billion by 2010, more than four times the emerging-market losses it expects for U.K., U.S. or Asian banks. Write to Marcus Walker at marcus.walker@wsj.com and Joellen Perry at joellen.perry@wsj.com