LONDON (Reuters) - If European banks are forced to cut back lending to rebuild shot balance sheets, the ensuing credit shock could hit developing countries worldwide as much as those at the center of the euro zone storm.
With Europe’s banks accounting for almost two thirds of the foreign lending to global emerging markets, the fear is their retrenchment could drain those economies set to provide about 70 percent of world growth next year.
This latest so-called “negative feedback loop” from the euro zone sovereign debt crisis is yet another potentially damaging blow to a global economy already experiencing shocks to both business sentiment and planning as well as bank funding strains.
An echo of the global reverberations caused by the Lehman Brothers bust through the winter of 2008/09, this transmission mechanism may have weakened slightly over the past two years due to more regulatory safeguards but still underlines the viral impact of banking shocks in an interconnected global system.
It also illustrates why many emerging economies have as much interest in the resolution of the euro crisis as leaders of the Group of Seven rich nations or even the Europeans themselves.
Regional exposure of European banks to their emerging neighborhood in central and eastern European is clear.
“The region could be in for a much bigger shock this time around because its economies are so tightly linked to the euro zone,” Piroska Nagy, adviser to the chief economist of the European Bank for Reconstruction and Development, told Reuters.
A lending crunch could hurt much further afield too.
“The possibility that European banks might reduce their exposure to Asia as part of their recapitalization effort is something that has to be taken seriously,” Deutsche Bank’s Michael Spencer told clients, warning of risks to the likes of Vietnam, South Korea, Indonesia and India.
In a report last week, Morgan Stanley reckoned that European banks may be forced to shrink their balance sheets by up to 2 trillion euros by the end of 2012, resulting in a drop in overall lending to emerging markets of over 500 billion euros.
“Investors have not properly calibrated the intensity of the negative feedback loop between developed markets and emerging markets via the ever important funding channel,” said the bank.
This is one of the reasons why the much-debated “decoupling” of faster-growing, more fiscally sound emerging economies away from the slow-grinding, debt-burdened rich world struggles to play out in the short term at least.
Emerging equities .MSCIEF -- for a variety of reasons to do with sagging Western demand and early-year monetary tightening -- have underperformed developed stock markets .MIWD00000PUS this year by seven percentage points.
The breakneck globalization of the past two decades that benefited so many developing economies was at least in part due to the opening of credit pipes from the giant global banks.
If those global banks, the lion’s share of whom were European, are now under the cosh from domestic politicians and regulators to both strengthen their capital ratios and focus on their home economies and businesses, that could spell retreat.
“We are not doing business which is not to the benefit of Germany or Poland,” the Commerzbank’s Chief Financial Officer Eric Strutz told analysts on Friday. “We have to focus on supporting the German economy.”
Given the sort of minimum capital ratios now being required of European banks -- the European Banking Authority demands a 9 percent minimum by the middle of 2012 -- Morgan Stanley expects cutbacks in assets or loans to be inevitable.
“The core bank function of lending to corporates and consumers is uneconomic at the current cost of wholesale funding, which makes deleveraging absolutely necessary,” the report said, adding as much as 1 trillion of the 1.7 trillion euros in bank debt maturing through 2014 would be allowed to roll off or not be refinanced.
Of $35 trillion of Western European bank assets outstanding, some $3.8 trillion, or 2.7 trillion euros, are in emerging markets -- a rise of well over 300 percent in a decade and surpassing the mid-2008 peaks hit before the credit crisis.
These statistics from the Bank for International Settlements also show European bank lending to emerging markets at ten times their U.S. peers and now equal to the amount they lend to the United States as a whole. A decade ago European bank lending to the United States was twice that to emerging markets.
If there were to be a repeat of the 20 percent drop in European bank lending to emerging markets that took place in the 15 months after the credit crisis snowballed in early 2008, Morgan Stanley said that could see a lending shock of more than 500 billion euros.
That compares to total external financing needs of emerging market on a 12-month rolling basis of some 1.5 trillion euros.
Yet, “emerging markets” is a large and diverse group of countries and some are more vulnerable than others.
Even though 12-month external financing needs in emerging Asia are -- at almost 500 billion euros -- are close to the combined 549 billion euro needed in central and eastern Europe, Middle East and Africa (CEEMEA), the former markets are cushioned by national surpluses and hefty hard cash reserves.
The CEEMEA region, however, is right the firing line -- especially big deficit countries such as Turkey and Poland.
With average loan-to-deposit ratios at banks across the region in excess 100 percent and foreign bank ownership high, there is a vulnerability to wholesale funding stress as well as parent bank sales of so-called “non-core” assets.
This is a particular risk for eastern Europe and Africa -- where European banks account for 91 percent and 85 percent of foreign lending respectively. And, as the credit crisis has proven, domestic banking instability quickly becomes sovereign.
There are some who say the anxiety may be overstated.
Acknowledging the threat of shrinking credit lines, ING’s global emerging markets strategist David Spegal points out that domestic banking assets in emerging markets were stronger than first seems. Even excluding a relatively closed Chinese sector, European bank holdings of emerging bank assets -- when domestic bank assets are taken into account -- is just 19 percent.
Spegal also said a series of new regulations and monitoring regimes since 2008 would likely limit the risk of widespread or sudden exits by parent banks from local emerging markets.
Yet, many policymakers are already braced for fallout.
“The fear is that it would be easier for Western banks just to cut their exposure in eastern Europe,” said the EBRD’s Nagy. “The point is to make sure there is genuine recapitalization -- with EBA supervision required -- and not massive deleveraging.”
Additional reporting by Sebastian Tong. Graphic by Scott Barber, editing by Mike Peacock