European Credit Crunch Starting As Crisis Spreads To Private Sector

Beyond the sovereign debt crisis, Europe faces the prospects of a credit crunch that could take hold and amplify the negative effects of rising borrowing costs on the private sector.  With bond yields for core European nations on the rise, pressure has begun to mount on corporate debt funding markets, exacerbated by tightening lending standards and eurozone bank deleveraging, according to a report by Barclays� global macro research team.

The European situation continues to deteriorate and has now spread even to Germany, the eurozone�s economic engine, as evidenced by a failed bond auction last week.  As sovereign debt markets deteriorates, the risk of a credit crunch looms, raising the stakes for policymakers and the private sector alike.

�Pressure on bank funding and balance sheets increase the risk of a credit crunch,� noted the OECD in a gloomy note released Monday.  Analysts at Barclays concur, and provide further detail.  �We [have arrived] at a risky situation for the euro area economy, with clear knock-on effects to corporate funding costs both in terms of higher sovereign yields and in terms of widening corporate credit spreads on top,� explained the analysts.

Rising sovereign bond yields, particularly in core eurozone economies like Germany and France, already puts pressure on corporate bond yields, given the �risk premium� investors pay in the private sector.

A bigger problem European corporates are facing is bank deleveraging, though.  According to Barclays, bank deleveraging could total �500 billion to �3 trillion, or up to 10% of eurozone bank assets.  Regulators have turned up the heat on European banks to strengthen their balance sheets and improve their core tier 1 capital ratios, having set a deadline of June 2012 to reach 9%.

Banks, therefore, are relying on deleveraging, as opposed to earnings growth.  Deleveraging causes economic dislocations, with overall eurozone balance sheets shrinking about 10% or nearly one third of eurozone GDP.

Euro area banks have been cutting down on risky assets.  French banks like BNP Paribas have been very vocal about their plans to cut exposure to PIIGS, and even U.S. banks like Goldman Sachs and Morgan Stanley have been warned by credit rating agencies that their investment banking operations could be very exposed.  After the fall of MF Global, investors have zeroed in on financial institutions� exposure to Europe, punishing them severely, as Jefferies� stock price shows.

Bank lending standards have tightened, Barclays suggests, and debt funding costs have risen sharply, both for financials and non-financials.  �Historically, such a tightening of lending standards has presaged economic weakness and a consequent rise in high yield corporate credit default rates, typically with a 12-month lag,� wrote the analysts.

Supply of European investment grade corporate credit will wane in 2012, according to Barclays, as firms remain cautious on funding requirements.  European non-financials are forecast to reduce their debt-to-EBITDA ratio to �a cycle low 1.1x by the end of the year, consistent with the �244bn of net investment-grade redemption forecast by our credit strategists this year.�

Thus, Barclays suggests remaining underweight European construction, utilities, and travel & leisure.  On the flip side, they expect three sectors to outperform: industrial goods, telecoms, and chemicals.