The emerging markets crisis
Last night an article by Niels Jensen of Absolute Return Partners caught my eye. In it, he made a very strong case for worrying about European bank exposure to emerging markets and its potential for creating systemic risk. I would like to share some highlights from this well-written piece and add a few thoughts of my own.
I have talked quite a bit about this problem in my blog in the past. Below are a few related articles. I am generally of the view that the crisis in the U.S. and Western Europe has been addressed sufficiently to provide a slow recovery. However, I am quite concerned of collateral damage from elsewhere bringing things to a head and precipitating a systemic problem. European bank lending to over-indebted emerging markets is tops on my list of worries.
Niels Jensen puts it quite well.
In the US, bank lending is already responding to Fed’s tactics. Total commercial and consumer bank lending has grown by an annualised rate of almost 50% in the last month and a half. Quite impressive in an economy which is supposedly in recession.
So far so good. The problem is, however, that the near meltdown has unleashed an asteroid storm of problems. Take Iceland. As most investors know by now, Iceland is in very serious trouble. According to at least one estimate, European banks stand to lose about $75 billion on Iceland – not exactly pocket change. And that is on a population the size of Coventry! Earlier this week, the Central Bank of Iceland raised the policy rate from 12% to 18%. Inflation is now running at about 16% and will undoubtedly peak at much higher levels. According to Danske Bank, expect it to hit 75% before things get better. That is ugly.
The canary in the coalmine
I have an increasingly uneasy feeling that Iceland is the canary in the coalmine. Hungary is struggling. So are Pakistan, Ukraine, Belarus, Romania and Argentina. Cristina Fernández de Kirchner, the President of Argentina, took everyone by surprise last week when she announced that the country’s private pension funds (about $26 billion) would be transferred into the state pension system. The official line is that she is aiming to protect the country’s pension funds from the global turmoil. Who is she kidding?
Now, the Federal Reserve Bank has decided to provide emergency loans to Mexico, Brazil, Singapore and South Korea. Not that long ago, it was Singapore (amongst others) which provided emergency funding to the ailing U.S. banking sector. If countries such as South Korea and Singapore require help from the outside, the state of affairs in other and less developed nations could be much worse than generally perceived.
This is the problem. There are any number of countries that are in jeopardy of imploding from a slowing economy, high debt and macro imbalances. The list extends from Asia to Eastern Europe to Latin America and beyond.
“So what?” you say. Well, not so fast. In a globalized economy, the interdependence of nations is a lot more than you might think. In fact, European banks have a lot of exposure to Emerging markets, having lent ridiculous sums over the past decade. Think of this as a 1980s Latin American debt problem writ-large.
European banks at risk
Worldwide cross-border lending now stands at $37 trillion with about $4.7 trillion going towards Eastern Europe, Latin America and emerging Asia. Cross-border lending by European and UK banks to emerging market countries accounts for 21% and 24% of respective GDPs compared to 4% for U.S. banks and 5% for Japanese banks (see chart 4). Europe has about $3.5 trillion of debt outstanding to emerging market countries whereas the U.S. has only about $500 billion on the line.
The country most exposed to emerging markets is Austria with total emerging market loans accounting for no less than 85% of the country’s GDP – most of it to Eastern Europe. Austrian banks have been aggressively pursuing opportunities in Eastern Europe for years. They have in fact been so aggressive that their total lending to the region (approximately $300 billion) exceeds the amount lent by Germany to Eastern Europe. Even more worryingly, Austrian banks are the largest holders of debt on Hungary and Ukraine – two of the most fragile economies on the old Soviet bloc. As an aside, when the global banking system collapsed in May 1931 in the midst of the Great Depression, it was a run on the Austrian banks which acted as a catalyst.
Italy is possibly in an even more dire condition. According to a recent article in The Daily Telegraph3, Italy’s public debt is now the third largest in the world, behind the U.S. and Japan. And, at 107% of GDP, it is almost twice the limit set by the Maastricht Treaty (so much for treaties!). Italy is also a big lender to Eastern Europe. Unicredit alone has about $130 billion of debt outstanding to Eastern European countries. Italy’s predicament is well recognised by fixed income investors. 10-year Italian government bonds now yield 1.08% more than their German sister bonds. The market is telling us that something rather unpleasant could happen to Italy. It is even possible that Italy could be forced to pull out of the euro, unless they can turn the ship around fairly quickly.
Meanwhile, UK banks are primarily exposed to emerging Asia and Latin America. Only Poland stands out in Eastern Europe as a major recipient of loans from UK banks and Poland is perhaps not up to its neck in problems the way Hungary and Ukraine are right now, but the situation is deteriorating there as well. Sweden is mostly exposed to the Baltic countries. The three Baltic countries owe a total of $123 billion, $83 billion of which originate from Sweden. Knowing that Latvian banks in particular have been rather innovative with the structure of their mortgage products (such as Yen based loans), would you sleep well if you were the credit officer of one of the major Swedish banks?
Spain is the Latin juggernaut
Spain is another worry. Contrary to popular belief, the U.S. is not the largest lender to Latin America – Spain is. Just under $1 trillion of cross-border debt is outstanding across Latin America. Only 17% of that comes from U.S. banks. Spanish banks, on the other hand, have more than 30% of the debt on their books. Let’s hope for Spain’s sake that Ms. Kirchner is telling the truth when she claims that the nationalisation of the private pension funds was done to protect them from the evils of this world. Somehow I doubt it.
The sharp rise in the value of the U.S. dollar and the Yen is not helping emerging market economies either. We do not know exactly what proportion of the $4.7 trillion of loans to emerging market countries are denominated in U.S. dollars and Yen respectively, but we suspect that it is a significant share. As long as the world is deleveraging, you should expect both currencies to continue to appreciate in value, as most carry trades have been based on either U.S. dollars or Yen. Meanwhile, some countries are putting up a brave fight (e.g. Hungary and Romania). However, as we learned in 1992, a wounded currency is like a bleeding torso in shark infested waters. You can rest assured that speculators will finish off the job. No central bank can win that battle.
One might argue that a devaluation of the Hungarian currency or a collapse of the Pakistani economy won’t really affect your portfolio, but that misses the point. It is the risk to an already wounded banking industry you have to worry about. And, as I have pointed out above, European banks are much more exposed to emerging market countries than their U.S. competitors.
And this is a big problem because European banks are undercapitalized. You might remember an article I wrote in June referencing a Citigroup study that said that European banks had a $400 billion capital shortfall. This shortfall has not disappeared. Arguably, it is much worse despite the many government bailouts in the intervening months because the losses have been much greater than anticipated.
If European banks were to suffer large losses in the emerging markets, we could have another panic on our hands, and this time no amount of government intervention would be able to forestall the inevitable bank runs and deleveraging. I recommend you read Niels’ piece. We need to sound the alarm on European banks because these institutions are in desperate need of more capital. If we wait until crisis hits to tackle this looming threat, it may be too late.
When the Chickens Come Home to Roost – Niels Jensen