The Global Effects of Deleveraging
Who will win and who will lose?
BY Duncan Webster | July 12, 2012
The world’s focus was on Europe in 2011 as crisis after crisis hit the headlines. Almost halfway into 2012, the worst is far from over. Given their sheer size, European banks represent the biggest threat to the world economy. In Europe, bank assets are three times greater than GDP.1 The ratio in the U.S. is 1 to 1.2
Euro area banks are very risky since the value of their “risky” assets – consumer credit, loans to non-financial corporations, external assets and holdings of certain securities – exceeds their deposits.3 To reduce risk, the banks need to deleverage so that “risky” assets represent a much smaller proportion of deposits. This deleveraging can be achieved by a combination of reducing risky assets and increasing deposits.
Under normal conditions, deposits increase over time, making the bank deleveraging process easier and the contraction in risky assets less severe. But these are not normal conditions.
We see three possible outcomes for European banks: a run on the banks (the worst case scenario), U.S. style deleveraging, or European style deleveraging.
In the bank run scenario, customers withdraw their deposits if they think their banks will become insolvent. As the value of deposits decreases, the “risky” assets must fall dramatically in order to catch up with the reduction in deposits. Under such conditions, banks face greater odds of bankruptcy, resulting in a full blown Euro area banking crisis.
We believe a bank run is unlikely because fear of insolvency is not widespread in Europe. While customers are withdrawing funds from Ireland and Greece, deposits in other European countries are rising. Overall, Euro zone deposits increased by 4.9% between January 2011 and January 2012.4
In the U.S. style deleveraging scenario, European banks would cut domestic lending activity, putting the economic expansion at risk. This is what happened in America. But so far, this has not been the case in Europe. Euro zone domestic credit increased 4.2% between January 2011 and January 2012.5
The most likely scenario is a made-in-Europe deleveraging. The first phase started in 2008 and involved capital repatriation from abroad. This phase still isn’t over and will likely continue for the next few years. The second phase involves reducing exposure to other European countries’ sovereign bonds. Between December 2010 and September 2011, European banks liquidated $84 billion (U.S.) in sovereign bonds from Greece, Portugal, Italy, Ireland, and Spain.6
More deleveraging is required. Estimates prepared by CIBC Global Asset Management Inc. point to another €2 to €3 trillion over the next two to three years. How this deleveraging will be done will shape the global outlook.
The European Central Bank (ECB) has deployed significant efforts to alleviate tensions in the banking system. Faith in the European common currency largely depends on whether the Euro area banking crisis is resolved or not.
There are several investment implications of European bank deleveraging:
Emerging Asia and Latin America will be positively impacted. We expect assets from these economies will outperform the rest of the world. Bank diversification out of “low growth” countries to “high growth” countries will continue benefiting these regions. In addition, emerging market currencies will continue to appreciate against the Euro and the U.S. dollar.
“Safe” sovereign bond markets will hugely benefit from the European bank deleveraging.7 That’s because Euro area banks, in order to restore their balance sheets, will continue to increase exposure to these “safe” markets. Investors will need to keep track of what markets qualify as “safe” at any given time.
Trading in the Euro is highly volatile, so there are active currency management opportunities available.
Market exposure to Portugal, Italy, Greece, and Spain, needs to be actively managed.
In the rest of Europe, there are opportunities to exploit regional differences, but investors should still be cautious.
1. As at December 31, 2011. Source: Bank for International Settlements.
2. As at December 31, 2011. Source: Bank for International Settlements.
3. Source: CIBC Global Asset Management Inc.
4. Source: European Central Bank.
5. Source: European Central Bank.
6. Source: Bank for International Settlements
7. Sovereign bonds in Germany, United States, United Kingdom, Canada and Australia.
Duncan Webster is Chief Investment Officer and Head CIBC Global Asset Management Inc.