One issue alone is likely to dominate the G20 summit in Los Cabos: Europe.
Mounting debt, sluggish economies and mass bank bailouts: Europe’s woes are all too real, imperilling not just the single currency – and perhaps the EU’s very future – but also threatening to stall the global economy or jam it into reverse.
But another problem – one just as ominous and malign – should strike fear into the hearts of global leaders as they gather on the Mexican Pacific coast this week: deleveraging. It may be a clumsy word, but its impact, particularly on the emerging world, may prove to be simply and chillingly destructive.
It is not a new phenomenon: deleveraging has been a concern since the onset of the financial crisis in 2008, when European and North American banks brutally cut lending in and around their home markets. Credit supply shrank drastically, bringing developed-world economies to a juddering halt.
Now that process is happening again, only this time the fall guy is not likely to be Germany or the United States but key emerging markets – the fast-growing economies of Asia, Africa, Latin America and emerging Europe, which, until recently, were driving the global recovery process.
Developed-world lenders are systematically withdrawing funding to emerging markets, either by naturally shrinking their asset bases by reducing loan rollover rates, or by selling equity stakes in local subsidiaries.
Lending lines to emerging markets fell to $5.5 trillion by the end of 2011 from $5.9 trillion, according to Viktor Shvets, an analyst at Credit Suisse in Hong Kong. He blames the “growing home bias” of western lenders for restricting global banking flows. Shvets expects a further $1 trillion in funding to be withdrawn from emerging markets.
EUROZONE RETREAT
At the heart of the problem, again, lies Europe. Deleveraging is happening across the old world – Britain, Japan and America – but nowhere is the process more acute than in the embattled eurozone, where a deepening economic contraction, rising bad loans, and – thanks to bank regulations introduced last year – the need to boost tier-1 capital to 9% by the end of this month, are all combining to shrink balance sheets across the continent.
Eurozone banks, under rising political pressure to shore up capital at home in markets that are barely growing, are slashing lending to emerging markets that were, until recently at least, in rude health.
This process will worsen if Europe’s economic condition deteriorates from ailing to chronic. “Deleveraging is likely to increase if the eurozone crisis isn’t sorted out,” says Edward Strawderman, associate director, financial markets, Europe and central Asia, at the International Finance Corporation (IFC).
“The strength of the balance sheets of parent banks is now being questioned, and there is a risk of a more rapid and destabilizing withdrawal of funding if these banks decide to focus on core markets.”
Often this deleveraging is hard to see. Western banks retrench quietly, calling in loans or quietly withdrawing debt facilities or cross-border credit lines. Statistics are often hard to come by, except in the broadest brush strokes, provided by institutions such as the Bank of International Settlements, which reckons that $6 trillion in cross-border funding lines were eliminated between March 2008 and December 2011.
RBC Capital Markets reckons that to hit its collective tier-1 target by the end of this month, eurozone banks alone will have to cut their total emerging market exposure by around $630 billion.
In its April Global Financial Stability Report the International Monetary Fund predicted eurozone banks would shrink their balance sheets by $2 trillion over the next 18 months. José Viñals, its director of monetary and capital markets, warned that the region hit hardest by this deleveraging would be emerging Europe, adding that other emerging markets would also be badly affected.
EQUITY STAKES
More damning evidence is presented by the direct sale of equity stakes in emerging-market assets by western lenders. Franco-Belgian group Dexia dumped assets in Turkey; Société Générale of France exited investments in Kazakhstan and Russia; Holland’s ING did the same in Taiwan and China; Germany’s WestLB is looking to do the same in Brazil.
RBC emerging market analyst Nick Chamie estimates that, in the 12 months to end-May 2012, eurozone banks alone sold $12 billion in equity stakes held in Asian, central and eastern European (CEE) and Latin American subsidiaries, to shore up capital at home. A further $10 billion will be added to that pile, Chamie reckons, over the next year, if Spanish lenders BBVA and Santander, as expected, sell assets in Latin America.
Few regions of the emerging world have escaped the damaging effects of western bank deleveraging. Asian Development Bank (ADB) assistant chief economist Joseph Zveglich notes: “Money is being pulled out of Asia by western European banks as they consolidate [at home], and this is a process that will continue over at least the next year or two.”
Gunter Deuber, head of CEE research at Raiffeisen Bank International (RBI) in Vienna, says cross-border exposure is decreasing in Russia, Poland, Hungary and the Czech Republic, adding: “In Hungary, there is a big process of deleveraging ongoing by western European banks."
IFC’s Strawderman notes the impact of deleveraging in Europe “will be felt in CEE, in Africa, and in Latin America. Beyond [Europe], French banks are very active in Africa and Spanish banks in Latin America, so those markets are also affected.”
Some markets, particularly those most dependent on external financing and short-term loan rollovers, are notably affected by sharp withdrawals of liquidity. Credit Suisse’s Shvets highlights India, Turkey, Poland, the Czech Republic and Hungary as being most acutely affected by any significant pullback in liquidity.
Devam Modi, a banking analyst at Equirus Capital in Mumbai, says India is being battered by this withdrawal of capital. “Deleveraging, in the form of falling liquidity, is hurting all emerging markets, including India,” he says. “This is hitting capital expenditure [plans] and also restricting economic growth.”
FILLING THE VACUUM
Deleveraging has two notably knock-on effects, each compelling in its own way. The first is the vacuum created as western banks retreat from emerging markets.
In a few cases, new lenders are plugging the funding void. When ING sold its 51% stake in its Chinese life insurance joint venture, Pacific Antai, in 2011, it found a willing buyer in Beijing lender China Construction Bank.
Russia’s Sberbank has been prominent in snapping up bargain assets around CEE and central Asia. Its E505 million acquisition of Volksbank International, the CEE subsidiary of Austria’s Oesterreichische Volksbanken, was augmented this year by the $3.6 billion purchase of Turkey’s DenizBank, from Dexia.
Yet this remains the exception rather than the rule. Most emerging markets struggle to find viable new foreign banking partners. Divorce can be painful, nowhere more so than in emerging Europe, where the likes of the Czech Republic are almost wholly reliant on funding from eurozone lenders, just as Balkan economies, from Serbia to Bulgaria, remain painfully dependent on funding by Greek lenders.
SLOWING DOWN
The second issue is perhaps more troubling: slowing growth rates across the emerging world, as lower rates of direct banking funding, trade finance and workers’ remittances flow in from Europe.
In recent weeks, China has cut interest rates for the first time in three years, on fears that falling electricity output and tepid date on imports and new property starts heralded a protracted period of much lower, slower growth. Brazil, likewise, saw its economy slow markedly in the first quarter of the year, while India, perhaps the most troubled of the big emerging economies, saw its growth rate slip sharply.
Europe’s woes are a leading contributor to the uncertainty in emerging market economies, but experts believe that this sudden slowdown is exacerbated by aggressive financial deleveraging by western banks.
In its twice-yearly economic report issued last week, the World Bank warned that tensions in the eurozone posed the “most serious potential risk for developing countries” across Europe, Latin America and Asia. The bank noted that gross capital flows to developing nations from the developed world shrank 44% in May year-on-year.
Not all emerging economies are going begging: Credit Suisse’s Shvets highlights China and Russia – two countries with reasonably well-protected banking industries and economies – as largely insulated against western bank deleveraging, along with Indonesia, the Philippines, South Korea, Taiwan and Malaysia.
Confidence in a country’s ability among emerging markets to absorb the fallout from western bank deleveraging and the eurozone crisis also varies from region to region. Gerard Lyons, chief economist at Standard Chartered, says that in Asia there is a broad belief that regional institutions will replace European banks as they retrench, while in Latin America, any funding gaps will be quickly replaced by US or Chinese lenders.
He says deleveraging has generated specific problems in Asia, with governments and institutions struggling to secure trade and infrastructure finance on a regular basis, thanks to the withdrawal of French lenders in particular.
Europe’s broader economic issues are in turn harming growth in emerging economies around the world – a situation that is further ameliorated as liquidity is withdrawn to its ‘home’ markets in Europe and the rest of the developed world.
“I would argue that deleveraging itself is a reflection of Europe’s problems,” says Lyons. “Europe’s downward spiral is feeding its fiscal and debt problems, which is feeding problems in the banking system, which is causing deleveraging, which is hurting emerging markets” – a vicious economic cycle that appears to be self-sustaining.
Many would like to see policymakers and regulators finally hammer out a set of banking laws acceptable to everyone, everywhere: a one-size-fits-all approach to regulation that solves the European problem and gets global growth back on track.
“We’ve already forgotten about the pain of the crisis,” says the ADB’s Zveglich. “I’d like to see progress made on reforming the global financial and banking system. It needs to get back on the table, and it needs to take into account the fact that money crosses borders, and that this creates vulnerabilities.”
Adds RBI’s Deuber: “We haven’t seen much reform on the banking side in recent years, and we need to push forward with that. What pops up when I speak to policymakers in emerging markets is how disappointed they are by policymakers in Europe.
“The banking and economic crisis in Europe is not being tackled – eurozone leaders have to work harder, with Germany taking a much stronger and more proactive role,” he adds. “There’s no point in talking about new Basel regulations taking effect two, four, six, eight years from now if you have big [eurozone] problems in one or two months’ time.”
So there will be plenty to discuss in Los Cabos this week. Europe will be top of the list of material concerns, but deleveraging by western banks, and the impact this is having on economic growth in the emerging world, should run it a close second.