An analysis published by the Royal Institute of International Affairs (Chatham House) suggests Europe is the key risk to world economic recovery. The time left for averting a second round of industrial cutbacks and financial volatility is fast running out, it says.

In the United Kingdom, the deputy governor of the Bank of England has acknowledged that second-quarter GDP figures -- due for publication later this week -- are likely to show a downturn rather than a recovery. GDP dropped a massive 2.4 percent in the first quarter of 2009. He warned that signs of some stabilization in the U.K. housing market could prove to be short-lived. Meanwhile, the government has disclosed a likely shortfall in tax revenues this year of more than 20 billion pounds.

German Chancellor Angela Merkel has threatened to jawbone banks into lending more freely to German businesses, complaining that the billions of state aid to banks has still left companies with "massive problems" in obtaining finance for investments of more than 10 million euros. The president of the German Federation of Industry has warned, "Even completely healthy companies could get into difficulties that would threaten their survival."

Fearing for their reputations, German commercial banks -- and those owned by the Lander (federal states) -- have shied away from taking up the bailout funds on offer from the government's financial market stabilization fund to boost their equity reserves. Likewise, a government-sponsored "bad bank" -- designed to take toxic assets (mainly parcels of securitized U.S. mortgages) off their hands -- have so far had no takers with banks rejecting the onerous conditions attached.

Like Merkel, her Finance Minister Peer Steinbrueck has rejected mandatory state aid. But the Sueddeutsche Zeitung newspaper reported this week that contingency plans are being drawn up that would force banks -- as in the United Kingdom and the United States -- to take government money in exchange for partial nationalization.

Steinbrueck, who poured scorn on the huge public spending packages and economic stimulus programs in place in the United Kingdom and the United States, has threatened German banks with unspecified "unprecedented measures" if they refuse to play ball and lend. But financial analysts point out that bank nationalization is no panacea, with state-owned banks in Britain and the United States opting to use government money to build up their reserves rather than provide business credit.

So far, other measures proposed by Steinbrueck have been thwarted. A proposal to relax the Basel ll rules on banks' equity capital and a suggestion that the Bundesbank (Germany's central bank) should bypass reluctant banks and lend directly to business have been rejected by Germany's European partners.

The Chatham House paper, meanwhile, warns that conditions in most of the eurozone and emerging Europe continue to deteriorate, creating the risk of further feedback effects. It foresees a policy vacuum in Europe for the next couple of months at least while the parties making up Germany's center-right/center-left coalition government campaign against each other in a general election due Sep. 27.

Der Spiegel news magazine says German financial policy advisers are warning that German banks are highly vulnerable with their continued toxic assets forcing them to tighten their lending, with Germany at risk of a renewed credit crunch that could tip a number of companies into bankruptcy just as politicians are stumping the country for votes.

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