Analysis: Money's retreat home threatens globalization

LONDON (Reuters) - The European banking shock and its aftermath have sent finance and investment running for home, a process that could hurt world growth, globalization and developing economies for years to come.

"There has been massive deleveraging with some home bias, not just in our region but in general. We see a clear and present danger," said Piroska Nagy, director for country strategy at the European Bank for Reconstruction and Development, which monitors private sector financing across the former communist countries of central and eastern Europe.

Policymakers explained the surge in globalization and world growth through the 1990s and 2000s and the parallel rise in accounting imbalances between major economies partly by banks and investors lifting their sights beyond their home countries.

Most famously, former Federal Reserve chief Alan Greenspan regularly trumpeted the steep decline in home country investing to defend bloated U.S. current account deficits that had chilled many economists in the years leading up to the credit crisis.

This decline in home bias was catalyzed by the erosion of cross-border capital controls worldwide but also by events like the collapse of the Berlin Wall in eastern Europe, the launch of the euro across western Europe and the advance of the internet.

For at least some of these reasons, European banks were in the vanguard of cross border finance -- most obviously within the new single currency area but also in the emerging economies of central and eastern Europe as well as Asia and Latin America.

Last year European banks had 10 times the amount of loans outstanding in emerging markets than U.S. banks and lend as much to developing countries as they do to the United States.

But, reeling from years of property, credit and sovereign debt slumps, a deepening euro crisis and stiff new international rules on bank balance sheets designed to prevent future taxpayer rescues, European banks are rapidly retrenching.

TEMPORARY EBB?

Global lending by banks fell by a whopping $799 billion in the fourth quarter of last year, or 2.5 percent, the biggest fall since the drop seen after the collapse of U.S. investment bank Lehman Brothers three years ago, Bank for International Settlements data showed earlier this month.

The drop was led by deleveraging euro zone banks, who cut loans by $584 billion, or 4.7 percent and the lion's share of the pullback was from French, German and Spanish banks who all cut lending by about 5 percent.

The process intensified within the euro zone itself in the first quarter of this year and European Central Bank data shows euro zone banks' cross-border holdings of the bloc's government and corporate bonds fell to their lowest in a decade.

The IMF forecast in April that European banks could further shrink collective balance sheets by as much $2.6 trillion by the end of 2013 - almost 7 percent of total assets - and about a quarter of this could come by a reduction of lending on top of the sale of securities and overseas assets.

The question for many economists is whether this retreat in global finance is merely a temporary ebb that knocks the froth off the worst credit excess, a peculiarity related to the existential euro crisis or a longer-term decline in international finance that could stall globalization.

Philip Lane, a professor at Trinity College Dublin who specializes in globalization, said the initial post credit crisis debate was like distinguishing between "good cholesterol and bad cholesterol", separating productive cross-border flows from more dangerous sorts of lending to offshore bank vehicles and conduits that supercharged and destabilized the credit boom.

But he said it was now important the authorities addressed the return to more domestic financing, and initiatives such as a European banking union could be critical to that.

"The incredible boom in cross-border finance in 2002-07 period was just not sustainable and we had that sudden stop in 2008-09. But in the reconstruction of these flows, international institutions need to support them or a return to more national financing is possible," Lane said.

EMERGING MARKETS IN FIRING LINE

Together with the International Monetary Fund, the EBRD has, since 2008, been trying to slow the retreat of euro banks from the emerging European economies to the east, where euro zone banks have lent heavily and also have many subsidiaries.

"If we do not have this home-host country coordination, host countries are starting to have their own bias, they are starting to ring fence," EBRD's Nagy said. "There is a very strong desire for the host countries to lock in capital and liquidity."

The hope among the IMF and others is that the 20 percent drop in euro bank lending to emerging markets in the year after the Lehman collapse would not be as severe this time around as less-affected regional and domestic banks in Asia or Latin America step into the breach.

But they also acknowledge that, unlike the 2008-2009 shock, much of the retreat looks structural this time around due to regulation and could have a longer-lasting impact.

Lars Thunell, head of the World Bank's International Finance Corporation, which helps finance private sector development in emerging economies, says the European bank pullback from trade financing in particular was still a big worry and new bank rules such as Basel III were a key problem.

"There is a credit crunch or something very close to that going on. Basel III is aggravating the problem by asking for even more capital, disproportionately increasing the capital ratios for trade finance," he said, adding that trade finance should be classified as a low risk activity.

"Total bank deleveraging was $500 billion in the first quarter of this year. These are big numbers. We are trying desperately to get Asian bank syndication, to get them involved. It's proving difficult."

Yet some question whether the passing of high watermark in global finance was necessarily all bad and questioned whether the Greenspan faith in more efficient allocation of world resources as a result of more global finance was misplaced.

BIS Economic Advisor Steve Cecchetti told the central bank forum's annual meeting at the weekend that financial globalization was only great up to a point.

"For most people, the term globalization means cross-border trade in real goods and services -something that we would all agree has brought the greatest benefits to a large number of people."

"But this real side of globalization relies on financial intermediaries to fund the trading of all this stuff across borders. And the recent crisis showed how problems both on and off the intermediaries' balance sheets can have very large, very real and very bad implications. Many of us have started to ask if finance has a dark side."

(Additional reporting by Carolyn Cohn, Andrew Callus, Steve Slater, Kirsten Donovan; Graphics by Scott Barber/Vincent Flasseur; editing by Philippa Fletcher)