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The impact of European debt crisis on the US economy

An European sovereign debt crisis could at least affect the US economy in the following two respects.

First, the devaluation of the Euro triggered by the debt crisis will make American exports more expensive. So far this year, Euro  has depreciated against US dollar by nearly 15% (from 1.44 to 1.23).  This will hurt the US’ exports.  During the last couple of years, government spending and exports have been the only two growth engines of the American economy.  With tepid consumer demand and very weak labor market, consume- spending recovery is less likely to be quick and robust.  The recovery now requires a very strong corporate spending to fill the holes left by the American consumers. One way to spur corporate spending is to sell overseas.  Since Europe is the largest export market for the US, a sharp rising dollar is going to kill one of the two recovery engines of the US economy.

But the bigger worry remains in the banking sector.  The financial markets across the Atlantic are highly integrated with each other. If the Greek debt crisis spills over into other bigger economies such as Spain and Italy, it will  shake the European core: Germany and France, to which the US banking sector has very exposure.  The following article from WSJ offers an in-depth analysis of what a potential debt contagion in Europe could impact on the US big banks.

Federal Reserve officials took pains this past week to dispel any notion that their support of Europe’s $1 trillion bailout meant U.S. taxpayer funds would be used to prop up the profligate Greeks. But in explaining the need for it to help ease financial strain, the Fed underscored that big U.S. banks remain vulnerable to Europe’s financial contagion.

During a closed-door meeting on Capitol Hill, Fed Chairman Ben Bernanke told lawmakers a European crisis would threaten U.S. banks, Sen. Richard Shelby said after the meeting. In a speech Thursday, Fed Vice Chairman Donald Kohn noted that lending systems “remain somewhat vulnerable.”

Yet big U.S. banks reported minimal exposures to Greece or Portugal, the most at-risk countries. So where does the danger lie?

The biggest threat is that the European rescue operation proves insufficient and problems spread from smaller euro-zone countries to bigger economies like France or Germany. That may threaten the viability of the euro, potentially paralyzing credit markets globally, just as happened following the collapse of Lehman Brothers.

If so, this could spell big trouble for five of the biggest U.S. banks—J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley. Exposures to France and Germany, along with second-tier euro countries, is equal to about 81% of the banks’ combined Tier 1 common capital, a buffer to absorb losses, according to first-quarter and year-end securities filings.

While the risk of widespread contagion is still a worst-case scenario, fears that Europe’s debt crisis is far from over and that austerity measures may slow economic growth roiled stock markets on Friday and pushed the euro to 19-month lows.

Which countries should investors in U.S. banks worry about? Take Ireland, Spain and Italy. Exposures of the big-five to these three are equal to about 25% of the banks’ combined Tier 1 common capital. In particular, U.S. banks have to worry about banks in these countries being hit. Exposure to banks in Spain and Ireland, for example, exceeds risks to government or private entities.

An even bigger risk is if any European crisis blows back on the bulwarks of the euro: France and Germany. It isn’t impossible for that to happen. French and German banks have Greek exposure of more than €110 billion ($138 billion). Analysts have predicted that any restructuring of Greek debt could force France and Germany to recapitalize some of their own banks.

The big U.S. banks had exposures to the debt of governments, banks and other entities within those two countries equal to about 61% of their combined Tier 1 common capital. Exposure of the big-five banks to French and German counterparts totals about $100 billion. And while German government bonds likely would be a haven, the U.S. banks’ exposure to German banks is greater than their government exposure.

Clearly, holdings of European bank and government debt wouldn’t be worthless, but the financial crisis showed how quickly bank fears can feed on themselves. And the need for the Fed to help backstop Europe raises the question of whether, nearly two years after the crisis, U.S. banks really have enough capital, and liquidity, to weather big global shocks.

Investors in U.S. banks should be on alert: what happens in Europe may not stay there.


Update 1 (Nov. 7, 2011)

WSJ had an article with a  nice graph depicting the ties between Europe and the US:

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