Europe to feel full force of eastern blast

--3/4 of banks loans to emerging market is from European --Austria and Netherland are two most exposed, > 60% of GDP By Peter Garnham Published: February 18 2009 17:44 Last updated: February 18 2009 17:44 The euro has tumbled to its lowest level so far this year against the dollar – and is down 22 per cent from its July peak at $1.2544 – on heightened concerns over eurozone banks’ exposure to a sharp slowdown in emerging economies in eastern Europe. But while investor concern is currently focused on Hungary, Poland and the Czech Republic, the euro also stands more exposed than any other currency to a slowdown in emerging markets across the globe. While 90 per cent of loans to central and eastern Europe come from banks in the eurozone, almost three quarters of bank loans to emerging economies globally also come from the region, according to the latest statistics from the Bank for International Settlements. “This sharp discrepancy in exposure confirms the market’s view that an accident in emerging markets will damage European banks far more than it will US or Japanese banks,” says Paul Meggyesi at JPMorgan. Of the $4,593bn of foreign banks’ loans to developing countries worldwide, eurozone banks have lent $3,369bn, or 73.4 per cent. This compares with 10.3 per cent from the US and 4.8 per cent from Japan. The exposure of eurozone banks to emerging market loans amounts to 18.8 per cent of gross domestic product, compared with 3.4 per cent for the US and 5 per cent for Japan. Within the eurozone, Austria stands as the most exposed, with loans to emerging economies, mostly in eastern Europe, accounting for 79.6 per cent of GDP. The Netherlands, which has more diversified exposure across regions, is next in line with loans accounting for 66.4 per cent of GDP. Spain is the largest single lender to emerging market economies in Latin America, providing a third of all loans to the region. Mr Meggyesi says while the lending data do not provide a comprehensive summary of the financial linkages between developed and developing currencies, they should nonetheless prove useful as the focus of financial concerns switches unpredictably from one emerging market country to another. “Given that banks are at the epicentre of the crisis, the size and location of bank loan exposure to emerging market economies is by far and away the most important component of these linkages and therefore the factor most likely to influence how the exchange rates of major currencies respond to any further deterioration in emerging market conditions.” Steve Barrow at Standard Bank says the data should alert investors straight away to the fact that global economic problems, especially in the developing world, could weigh especially heavily on eurozone banks, and on the euro. He says given the large international exposures of eurozone banks it is conceivable that the euro is at risk if devaluations and possible defaults in emerging regions rock the market. In 1994, when Mexico devalued its currency, US banks were hit hard and the dollar crumbled. “We could argue that things are very different today. That all banks are in a mess and hence the ability of the currency market to distinguish between the winners and losers is very hard,” says Mr Barrow. “But we think the market will be able to distinguish between the banking problems in the US and UK, which are more domestic and hence can more easily be addressed by government and central bank action, and the strains in the eurozone, which are more sensitive to emerging market developments.” Those strains are beginning to show, with the cost of insuring government debt through credit default swaps rising across Europe. Indeed, analysts say investor sentiment towards Europe is now at its worst level since the height of the financial crisis in October last year. Not only is the cost of insuring government debt soaring for eastern European countries and those weaker countries on the periphery of the eurozone, such as Greece and Ireland, but it is now rising for countries at the core of the eurozone, such as France and Germany. Simon Derrick at Bank of New York Mellon says this is perhaps the real measure of the darkening mood towards Europe. The five-year CDS on French sovereign debt now stands at 81 basis points compared with 48bp on October 28 last year at the height of the first phase of the financial crisis. Similarly, the equivalent cost for Germany stands at 76.5bp now compared with 32bp 3½ months ago. Mr Derrick says that if investor sentiment has deteriorated to levels last seen during the crisis of September and October last year, then it also makes sense to look how the currency markets behaved back then. “The sharp deterioration in sentiment in eastern Europe that emerged from around October 6 of last year and which hit its peak on October 28 saw the euro collapse by around 10 per cent,” he added.