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Emerging Markets Hold Breath as E.U. Banks Shrink

From Beijing to Bucharest, emerging market policymakers are as worried as those in Brussels that the rapid contraction in western European banks' balance sheets will compound the debt crisis and further delay economic recovery.

From Beijing to Bucharest, emerging market policymakers are as worried as those in Brussels that the rapid contraction in western European banks' balance sheets will compound the debt crisis and further delay economic recovery.

In a striking indication of that concern, the International Monetary Fund said developments in the euro area pose a greater risk to the Asia-Pacific region than either a hard landing in China or a rise in commodity prices.

"An escalation of the crisis with a disorderly, large-scale, and aggressive trimming of balance sheets could have a serious impact on Asia," the IMF said in a report released on Friday.

Memories in the region are fresh of how quickly banks drew in their horns after the collapse of Lehman Brothers in September 2008. From peak to trough, the foreign claims of euro area and British lenders fell by around 37 percent and 21 percent of outstanding claims, respectively, the IMF estimates.

World trade shrank by 30 percent. Asian economies slowed to a crawl, prompting China to start transforming the yuan into an international currency to reduce its reliance on fickle dollar funding.

"If European Union bank deleveraging accelerates and even prompts banks from other regions to cut back, this will amount to a real pinch for Asia," HSBC economist Frederic Neumann in Hong Kong said in a note to clients.

"A pinch, of course, is not tantamount to a systemic collapse, but it is uncomfortable nonetheless."

ECB BALM

Figures from the Bank for International Settlements (BIS) show why Asia is nervous.

In the fourth quarter of last year, the consolidated claims of European and UK banks on Asia including Japan fell by $105 billion, or 5.9 percent, after a 2.9 percent drop in the preceding three months. Overall cross-border lending to Chinese banks fell for the first time in 10 quarters.

The result of the pullback was an acute shortage of dollars in Asia that caused interbank rates to rise and put exchange rates under pressure, Neumann said.

European banks cut their exposure as the euro crisis intensified funding strains. European Union regulators also ordered banks to make sure they had core Tier 1 capital equivalent to 9 percent of their risk-weighted assets by June 2012, either by raising fresh capital or shedding assets.

By contrast, U.S. banks, which had already beefed up their capital, reduced their lending to Asia in the fourth quarter by just 0.8 percent. They had lent $785 billion to the region at the end of 2011, less than half Europe's $1.684 trillion exposure, according to Nomura's analysis of the BIS figures.

Since then, the European Central Bank's provision of about 1 trillion euros in cheap three-year loans has eased the funding pressure on euro zone banks. Lenders were still tightening credit standards in the first quarter of 2012 but not as aggressively as in late 2011.

Thanks to the ECB's twin long-term refinancing operations (LTROs), euro zone banks were under less pressure to shed assets in Asia last quarter and may even have increased their exposure, according to Nomura's chief Asian economist Rob Subbaraman.

But he said there were still reasons to be worried.

"As Asia still has a high level of exposure to European banks, it remains vulnerable to a drastic cut of European credit lines," Subbaraman said.

Among the economies at greatest risk if foreign lenders shy away are Malaysia and Taiwan, where the claims of European and British banks came to 20 percent and 15 percent of GDP respectively at the end of 2011.

TROUBLE CLOSER TO HOME

Eastern Europe, by dint of geographic proximity and financial integration, is potentially even more vulnerable than Asia if the euro zone crisis intensifies.

Foreign banks, with Austria, Italy and France to the fore, typically own 60 percent to 90 percent of bank assets in the region, according to the European Bank for Reconstruction and Development (EBRD).

"Eastern Europe is right in the firing line. If European banks are having to deleverage, their subsidiaries and the odd branch in eastern Europe are the first place they look," said economist Gabriel Sterne at Exotix, a frontier-market investment bank in London.

The IMF's central case is that western European banks will reduce their assets by $2.4 trillion in the next 18 months. .

For the EU's eastern European members, that could translate into a drop of about 4 percent in total private credit in 2012-2013. But in a downside scenario, the Fund reckons that credit, the life blood of an economy, could contract 6 percent.

The BIS's most recent figures are somewhat reassuring.

Cross-border claims on emerging Europe, calculated according to where lending banks are located, dropped $14 billion in the fourth quarter of 2011. On the same basis, lending to Asia was down $67 billion.

Jeromin Zettelmeyer, the EBRD's deputy chief economist, said the ECB's two long term funding operations had bought time for eastern Europe, as they had for the euro zone.

Real credit growth in eastern Europe had been "pretty bad" on balance in the past few months, but deleveraging was occurring at a manageable pace, he said.

Moreover, capital flows into the region were encouraging, as was growth in local deposits. And, critically, the LTROs had removed the tail risk of a funding crisis at big Italian banks that have extensive operations in eastern Europe.

"There is certainly no uniform sudden stop taking place in the region," Zettelmeyer said.

Nevertheless, western European banks were still under pressure to shrink their balance sheets and some had taken the strategic decision to pull back to their core markets.

"We're not in crisis mode, as long as things continue like this. But we may well be in recession mode in some countries," he said. (Editing by Anna Willard)

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