European bank money is heading home as the sovereign debt crisis reaches a crescendo, insulating the euro exchange rate but threatening a credit shock to challenge policymakers worldwide.
To the extent this is being caused by a deleveraging of euro zone banks facing both dollar funding strains and regulatory pressure to build capital, the repatriation helps explain why the single currency has not been hit by European dollar shortages as it was after Lehman Brothers' bust in 2008.
Data on the euro zone's balance of payments released Monday offered support to anecdotal evidence that a repatriation of European money is underway via bank asset sales.
The European Central Bank numbers showed net portfolio investment flows into the euro zone -- essentially movements of stock and bond holdings -- rose for the second month in a row in September, clocking 20.7 billion euros ($28 billion) during the month after an inflow of 31.9 billion euros in August.
What is remarkable is how robust the inward investment numbers continue to look despite the bloc's rising financial stress, fears for the single currency and a looming austerity-driven recession.
Cumulative net portfolio inflows to the euro's 17 member countries in the 12 months to September were a whopping 335 billion euros -- more than 300 billion euros higher than the previous 12 months. And only two of the first nine months of 2011 -- January and July -- showed net outflows.
What makes the net inflow all the more significant is that it comes against ample evidence that overseas investors have been exiting euro zone securities.
U.S. mutual fund data tracked by EPFR, for example, shows 10 straight weeks of outflows from European bond funds to mid-November. Bank of America Merrill Lynch's monthly funds survey also shows managers with heavy underweight positions in euro equity while overweight U.S. and emerging market stocks.
What at first appears a puzzling new-found enthusiasm for euro financial assets is more likely to be the product of pressure on the region's banks.
Economists at Morgan Stanley reckon the counter-intuitive inflows are at least partly related to a big retreat by euro zone banks from the United States and developing economies.
As euro zone banks and other euro zone entities lose access to funding markets abroad, they are forced, at least partly, to sell foreign assets, the bank told clients ahead of Monday's ECB release, which reinforced their observations.
Balance of payments data show that euro zone residents sold foreign portfolio assets heavily in the summer with the selling intensifying in August, it said. This creates the rather counterintuitive result that stress in funding markets abroad induce repatriation flows that support rather than hurt the euro.
DELEVER AND REPATRIATE
Both Morgan Stanley and Deutsche Bank cite early month data on French balance of payments. Morgan Stanley point out that French banks lost some $60 billion of funding in September, up from a loss of $40 billion in August.
French balance of payments data was hugely revealing about the source of EUR strength, said Alan Ruskin, strategist at Deutsche Bank in New York.
A three-month average of French portfolio flows, show repatriation of money exceeding the peaks of late 2008, he said.
French or German banks cutting assets in the troubled euro zone periphery and buying home assets like German or French government bonds has already been well documented, but this would not have any foreign exchange impact given that it is all within the euro zone.
Repatriation arguments would tend to suggest that outflows from the periphery and the core will not be enough to sink the euro until such time as we also see repatriation flows dry up, Deutsche's Ruskin said. One broad conclusion is that the euro is probably the worst instrument to express negative euro area views, with periphery bonds and equity purer gauges of stress.
LOSING DOLLAR FUNDING
The driving force for this repatriation is the twin pressures on euro zone banks from forced capital rebuilding by regulators and soaring short-term dollar funding costs, evident in euro/dollar cross currency basis swaps.
In essence, if short-term dollar credit lines to euro zone banks are cut or become too expensive to roll over then they will sell the longer-term assets or loans created by that funding. Often these have been the best performing assets.
The cut in these funding lines is best illustrated by the extent to which U.S. money market funds have stopped lending to European banks.
Ratings firm Fitch estimates that top 10 U.S. money funds have reduced lending to European banks by almost $20 billion over the past six weeks alone, cutting European bank exposure by almost three percentage points to a record low of 34.9 percent of their overall portfolio of some $642 billion.
Overall, economists reckon Europe's banks could ditch up to 3 trillion euros of so-called risk-weighted assets or loans over the next year or so and political pressures will mean the bulk of these sales will be outside home markets and even the euro zone itself.
Euro zone banks hold more than $6 trillion in assets outside the bloc, including $1.8 trillion in the United States and $1 trillion in Eastern Europe, according to Nomura analysts. Morgan Stanley reckons 500 billion of emerging market assets could be sold over that time, mostly in central and eastern Europe, if the pattern of the 2008 shock were repeated.
But in flagging concern about the impact on eastern European economies such as the Czech Republic and Hungary, where western European bank lending is some 90 percent of national output, Credit Agricole's emerging markets strategist Sebastian Barbe said this retrenchment could be worse in than in 2008.
This time round the crisis is very much focused on western Europe itself as opposed to the U.S. sub-prime mortgage crisis three years ago and the impact on European bank behavior as a result could be worse, Barbe said.