Cablegate: Frankfurt Financial Experts Express Pessimism On

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OO RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV
DE RUEHFT #2299/01 2060810
ZNR UUUUU ZZH
O 240810Z JUL 08
FM AMCONSUL FRANKFURT
TO RUEHC/SECSTATE WASHDC IMMEDIATE 7418
INFO RUEATRS/DEPT OF TREASURY WASHDC IMMEDIATE
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UNCLAS SECTION 01 OF 02 FRANKFURT 002299

DEPARTMENT FOR EUR/AGS
TREASURY FOR LUKAS KOHLER/OFFICE FOR EUROPE AND EURASIA

SIPDIS

E.O. 12958: N/A
TAGS: EFIN ECON EU GM

SUBJECT: Frankfurt Financial Experts Express Pessimism on
Macro-Outlook to OCC

Ref: Frankfurt 1581, Frankfurt 1001, Berlin 0112

ENTIRE TEXT IS SENSITIVE BUT UNCLASSIFIED. NOT FOR INTERNET
DISTRIBUTION

1. Summary: With commodity prices soaring, the euro at an all time
high, and financial turmoil in the U.S. in the headlines, worries of
a recession and further shocks to the financial system remain high
in Germany and Europe. Frankfurt-based financial and macroeconomic
experts agree that growth will decline in 2008 and 2009 and
profitability will be low in the financial sector. Despite the
turmoil, they see little reason to fear a wider banking crisis or an
economic shock that would stoke a deep recession. End Summary.

Macroeconomic Growth Prospects Low
----------------------------------

2. In a July 21-22 visit to Frankfurt, Arthur McMahon, Director for
Economic Outlook and Bank Conditions at the Office of the
Comptroller of the Currency (OCC), and Geralynn Batista, an OCC
economist, spoke with senior economists and financial sector experts
at the European Central Bank (ECB), Deutsche Bank and Citibank on
current risks to the European banking sector and macroeconomic
trends. All sides agreed that current macroeconomic growth
prospects in the euro zone were likely to trend downwards due to the
rise in euro zone interest rates, the strong euro and rising
commodity prices. Several interlocutors argued that the current
prospects debunked the myth of "decoupling", whereby Europe's
decreasing dependence on the U.S. market would supposedly help it
avoid a downturn.

3. A Citibank economist predicted euro zone growth for 2008 of 1.8%
and 0.9% for 2009 and 1.8% and 0.6% in Germany, figures below those
of the ECB which he felt were too optimistic but would eventually be
revised down. He predicted a sharper drop in exports, a source of
current German economic strength, which would set in as demand fell
off in the U.S. and elsewhere. He also drew a corollary between
rate rises by the Bundesbank (Germany's central bank) in 1973, 1981
and 1992, which each time led to a recession, and the current rate
rise by the ECB. Nevertheless he argued that the ECB would rather
"take the hit upfront" than set off a larger crisis in the long term
by not fighting inflation.

4. A macroeconomic analyst at the ECB highlighted the problem of
rising food and oil prices, which negatively affects euro zone
consumption and investment. He saw food prices stable in the near
term, but doubted oil prices would drop significantly as the
increased demand in the developing world would not go away. Senior
economists at Deutsche Bank, however, pointed out that all previous
attempts to predict oil prices had failed, but there were signs of
decreasing demand in the developing world. All sides felt that
despite some wage increases, Europe had avoided a wage-price spiral
that would set off inflation.

Credit Crunch Unlikely, but Earnings Low
----------------------------------------

5. On the European banking system, experts saw no sign of an
impending credit crunch or big surprises from the banks. An ECB
financial stability expert said that of the twenty largest, and
therefore systemically relevant, European banks only five or six had
so far had serious write-downs due to the financial turmoil. He
expressed surprise that leverage ratios were not decreasing in
European banks, but speculated that banks were most likely moving to
higher quality assets. The flight to quality would inevitably mean
diminished returns in the near term.

6. All sides pointed out that the 14% rise in corporate lending
since the beginning of the financial turmoil in August 2007 should
allay any fears of a drying up of credit. The Citibank economist,
however, ascribed this trend to a lag effect and said the volume
would go down in the coming quarter. Many credit lines negotiated
before August 2007 are still open to corporations and actively drawn
on. However, as these lines expire, new ones will be negotiated
with less favorable rates leading to a decrease in volume. With
equity prices also low, corporations will have few attractive
sources of raising capital.

7. The Deutsche Bank economist expressed some pessimism on earnings
in the financial sector in the coming months. With so much debt
already on the firms' balance sheet, a negative credit cycle of
decreased lending was inevitable. Earnings capacity is also
diminished by lower demand for services, such as equity issuances.
Firms like Deutsche Bank, which is still doing well on its business
in the Asia-Pacific region, can count on good earnings, but others
will need to search for new business models. He worried about a

FRANKFURT 00002299 002 OF 002

regulatory backlash, saying that a rise in capital ratios would have
a negative impact on balance sheets.

8. Comment: While the mood on the economic outlook among economists
and financial sector experts has turned decidedly sour, few expect
great shocks ahead. But experts have called several false dawns
over the course of the last year in hopes that the worse was behind
only to be surprised by further turmoil. Key indicators such as
European export figures, euro zone inflation rates and bank
quarterly reports will be closely watched in the coming quarters to
judge the health of the European economy. End Comment.

9. This cable was coordinated with Embassy Berlin and cleared with
Arthur McMahon and Geralynn Batista at the OCC.
POWELL

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