European deleveraging hits emerging markets

Morgan Stanley analysts suggest European banks will look to shrink their balance sheets by between €1.5 trillion and €2.5 trillion during the next 18 to 24 months. It remains to be seen which borrowers will be worst affected. Strong political pressure will be brought to bear on banks to support their national economies.

Borrowers in the faster growing emerging markets might suffer most, as European banks that lack local deposit bases give up the fight to establish relevance to customers with loans funded in wholesale markets.

Jonathan Anderson, economist at UBS, says: "Total claims by foreign banks against developing countries are roughly $5.5 trillion. This represents more than 20% of emerging GDP and is around one-fourth the size of the total stock of local credit extended in the EM world.

"The vast bulk of this sum is provided by European banks. Looking at the 85-plus emerging economies that fall into our regular reporting coverage, European institutions reported outstanding claims of around $4.4 trillion as of end-June, compared with only $900 billion for US banks and $500 billion for Japan."

Early last month, Stuart Gulliver, chief executive of HSBC, sparked intense debate concerning the potential impact of European bank deleveraging in Asia. Delivering the bank’s interim management statement on November 9, Gulliver said: "Bank credit as a percentage of GDP in Asia is back up to levels of leverage we saw pre the Asian crisis." Gulliver pointed out that with most of this lending made up by European banks, "there is vulnerability there". He warned that, similar to the 2008 crisis, European banks might withdraw within their national borders.

"A big fear of a Lehman Brothers’ rerun immediately leads to a squeeze in bank lending in emerging markets," says Frederic Neumann, managing director and co-head of Asian economic research for HSBC in Hong Kong. "If all European funding was taken from China, the economy would feel a pinch, there is no doubt about this.

"It is important that lending from European banks gets replaced immediately." If it is not, some Asian companies would be forced to default. "This could have a ripple effect in China, not only in European debt but in Chinese debt," says Neumann.

However, it is unlikely that the travails of European banks will spark a severe credit crunch in countries with decent credit fundamentals, good growth prospects and attractive demographic profiles. There is probably more at stake for European banks giving up the prospect of doing business with emerging market borrowers. The potential earnings from such business in Asia might attract other, stronger lenders, including US banks and those notionally European-headquartered lenders – notably HSBC and Standard Chartered – with deep roots and local deposit bases in the region. Stronger economies might also be able to fund themselves.

China’s reserves of $3.5 trillion would be more than enough of a backstop to deal with a withdrawal of European credit from the economy. The People’s Bank of China, sources say, sold dollars in September but the CNH (offshore Chinese renminbi) exchange fell against the dollar. Chinese corporates that had borrowed in dollars were required to make abrupt repayments of loans from European banks. "This suggests that, at the margin, the dollar is being stretched in Hong Kong’s financial market," says Neumann. "More importantly, this acts as a sign that some corporates might be vulnerable to a withdrawal of European investment."

Anderson at UBS points out that by far the biggest role played by European lenders in Asia is the provision of trade finance. He says: "There is not a single economy in Asia or Latin America that saw domestic credit or real activity fall anywhere near as hard as external trade did during the 2008/09 crisis, precisely because the latter category is the only place where global banks really fit into the picture. And we have little doubt that another sudden-stop collapse of global finance would be as painful today for external trade as it was back then."

Huw van Steenis, bank analyst at Morgan Stanley, points out: "We see growing risks to global trade finance – French banks looking to reduce dollar dependency represent 25% of outstanding trade finance. In an orderly scenario, we think this will be passed to local banks or selected global banks [such as HSBC, Standard Chartered, JPMorgan and Citi]. If the deleveraging were to become disorderly, we could see a repeat of what happened in 2008/09 when European banks reduced their exposures by 20%."

However, other banks could pick up the slack on short-term trade finance, which is a low risk-weighted activity.

The retreat of stressed European banks might provide opportunities to stronger competitors. "Big players in Asia, such as Standard Chartered and HSBC, are under less pressure to deleverage," says James Longsdon, co-head of Fitch’s EMEA bank ratings business. "They have a stronger footing in Asian markets, as this is where their key markets are."

The most vulnerable emerging market region is much closer to the storm engulfing European banks, many of which are becoming dependent for short-term funding on the ECB.

Morgan Stanley analysts state that, in Central and Eastern Europe, "European banks represent three-quarters of the banking system. Twelve of the 16 largest European banks in CEE, representing a around 78% of these banking assets, either had a capital shortfall in the recent 9% EBA stress test or are Tarp recipients."

Anderson at UBS points out that gross external debt, most of it provided by Western European banks, is a far larger share of emerging European GDP than the economies of Asia and Latin America. The only good news is that net new debt from Western European lenders ground to a halt three years ago. The region is recovering from the severe contraction that accompanied this sudden stop.