European banks hold about $1.8 trillion in U.S. dollar-denominated assets, which, as deleveraging continues in the Old Continent, will tighten lending conditions in the U.S. and become a drag on economic growth, Goldman Sachs’ chief economist, Jan Hatzius, wrote in a note.
The sovereign debt crisis that has flailed Europe has taken a particular beating on the Eurozone’s financial sector. Banks like Credit Agricole, BNP Paribas, Dexia, and even Deutsche Bank have seen their stock prices drop as tightening funding conditions and exposure to peripheral debt fed shareholder anxiety.
Banks have been forced into a deleveraging cycle as regulators revamp scrutiny in order to root-out insolvency. In order to reach core tier 1 capital ratios of 9% by June 2012, Euro-area banks could shed up to €3 trillion ($3.9 trillion) in assets, according to Barclays; these banks would also reduce lending and take on less risk.
Here’s where the direct effect on the U.S. economy becomes visible. Noting that non-US banks hold almost $10 trillion in dollar-denominated assets ($1.8 trillion held by Eurozone banks) Goldman’s Hatzius cites Hyun Song Shin of Princeton who wrote “it is as if an offshore banking sector of comparable size to the US commercial banking sector is intermediating US dollar claims and obligations.” As this offshore banking sector shrinks in the face of the Eurozone crisis, credit conditions in the U.S. will tighten and economic growth will slow down, explained Hatzius.
Breaking down the numbers, the $1.8 trillion held by Eurozone banks constitutes 3.3% of total U.S. debt outstanding (which hit $53.3 trillion in the first quarter of 2011). If these banks were to shrink their claims on U.S. counterparties at a similar rate as in the peak 2008-9 period, they would shed assets at a pace of about 25%.
This means U.S. credit growth would fall by about 0.8 percentage points. Hatzius estimates that in isolation this would shave off 0.33% of real GDP growth in the short-run and about 0.47% in the long-run, as lending standards tighten in the U.S. But the impact could be even greater, Hatzius explained:
Overall, our discussion suggests that a reduction in the lending of foreign banks to US counterparties could have a meaningful impact on US growth. While the numbers are not huge, it is important to note that the overall effect could be significantly larger if there are spillovers from the behavior of foreign banks to the behavior of domestic US banks.
If asset sales by Euro area banks depress prices and thereby hurt the balance sheets of domestic US banks, additional changes in credit supply would probably follow. Moreover, at least the analysis based on the loan officers' survey only offers a snapshot of the hit implied by the tightening seen to date [with foreign banks goin from a 22.7% easing in lending standards in Q2 to an 18.2% tightening in Q4]; additional tightening of lending standards in the future would imply a larger impact.
Foreign banks’ U.S. branches have already tightened lending standards substantially, and U.S. banks, while still easing, are doing so at a declining pace. The situation could be compounded by U.S. banks pulling back on their own exposure to Eurozone assets. Jefferies, under fire by investors after the demise of MF Global, cut its PIIGS exposure by half. Morgan Stanley, JPMorgan Chase, and Goldman Sachs have all seen their stock prices take a hit in part given concerns over their European sovereign debt exposure.
Hatzius’ research team estimates the European sovereign debt crisis will shave 1 percentage point from real GDP over the next year, “with banking spillovers accounting for about half of this impact.”