Spotlight G20: Emerging markets and Europe

C.P. Chandrasekhar (also available in Portuguese)

For some time now the focus of the discussion on the European crisis has been on Greece. Its wider dimensions, though recognised, were not emphasized. Among those dimensions was the real possibility of a banking crisis in Europe, since a haircut on bank loans to governments as part of the attempt at crisis resolution is unavoidable. Even if the banks are able to prevent that, an actual default failing resolution would hit them.

In the event of a European banking crisis, it cannot remain a regional problem given global financial integration. It would also affect emerging markets, whose growth is seen as crucial to bolstering the “multi-speed” global economy.

One of the consequences of financial globalization has been the increased presence of global banks in developing countries and an increase in their role as lenders in these countries. As of the end of the second quarter of 2011, banks in countries reporting to the Bank of International Settlements (BIS) had foreign claims of $27.3 trillion outstanding. Though a dominant share ($20.1 trillion) of these accumulated claims was in the developed countries, the developing country share ($5.1 trillion) was by no means meagre. What is particularly noteworthy is that the international banks involved are predominantly European. Around 70 per cent of the foreign claims of the global banking system are on account of European banks. Greater financial integration in Europe is one obvious reason. Of the $20.1 trillion claims on the developed countries, $12.3 trillion is in European developed countries, as compared with just $5.6 trillion in the US.

But another reason is that European banks faced with increased competition at home have been seeking out developing countries to expand business and sustain profitability. Close to 19 per cent of the exposure of banks abroad is in developing countries, and this is true of European banks as well. Given the greater role of European banks in total international funding and the importance of a few developing “emerging markets” as recipients of capital, this is of significance. The concentration of emerging market exposure of banks in one region increases the vulnerability of both these banks and their clients.

In the current context, the vulnerability of the developing countries, as demonstrated by the experience during the 2008-09 crisis, comes especially from one source. Having to cover losses at home, recapitalise themselves and improve the risk profile of their lending, European banks are likely to look to retrenching assets in their global operations. Emerging markets are bound to be affected by such moves.

The impact is likely to be greater because of a disconcerting feature of foreign bank claims in emerging markets. They seem to have been driven to a substantial degree by short-term supply side developments in the developed countries. Those developments have also significantly increased foreign claims in the Asia-Pacific, which is seen as buffering the global economy. Claims on developing countries in the region rose by $547 billion during the 2000-2006 period, when there occurred a supply side driven surge in capital flows across the globe. Even during the crisis period stretching from 2007 to the middle of 2009 foreign bank claims in the region increased by $290 billion. And when the post-crisis liquidity infusion made available cheap capital in large quantities to the banking system, the Asia-Pacific developing countries were the locations for an expansion of foreign bank claims to the tune of $596 billion in just two years. A capital surge of this kind, that provided additional grounds for the “decoupling” perspective, makes the region even more vulnerable to a capital outflow or a mere cutback in lending by foreign entities.

This vulnerability needs to be assessed in the context of the collateral damage that a banking crisis in Europe can result in. It would worsen the recession in Europe, which is an important destination for exports from emerging markets. The recession in Europe would in turn precipitate the double dip that can damage Asia’s foreign exchange earnings and growth even more. And finally, the European banking crisis could trigger a global crisis, not just in banking but in the financial sector generally, given the multiple institutions and instruments through which financial markets are interlinked today. If that occurs, what matters is the aggregate exposure of emerging markets to global capital: and that is indeed substantial. In sum, we have at hand a problem that should and does worry not just the G7, but the G20 and more.

Comments are closed.