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By Jason Stipp | 06-04-2010 12:33 PM

Sri-Kumar: Banks Will Be the Carriers of European Contagion

TCW chief global strategist Komal Sri-Kumar says the impact of Europe's woes will be felt in the U.S. via global bank exposures and could result in less private-sector lending.

Jason Stipp: Also that has been causing shockwaves in the market to fluctuate mostly on the downside is the news coming out of Europe. Now, I think that for a lot of investors, they're wondering, what is the contagion effect here? Why is the situation in Europe causing such problems in my portfolio? Europe, we weren't considering it to be a major growth driver, and we are having trouble there, but why is it having such an effect on us and how much does that contribute to your thesis on a double-dip?

Komal S. Sri-Kumar: Jason, it's often said that Europe, even though it's a big part of world GDP, for instance, the eurozone's GDP and that of the United States are roughly equal today. They are both the same at about US$13 trillion. But they say, even though that is the case, Europe is not a big growth region and therefore, we shouldn't be worried if European growth slows. In my opinion, that's a wrong diagnosis of the problem, and why is that the case?

It is a wrong diagnosis because it's not just a case of slow growth, but European banks are major lenders to some of the troubled Southern European countries. It is like saying that Lehman Brothers is a tiny part of the U.S. economy, so a Lehman Brothers collapse is not going to have much of an impact in terms of what happens to U.S. economic growth, and, of course, we know what happened after September 2008.

Therefore, the issue here is what exactly is the transmission mechanism? And while the immediate slowdown in U.S. economic growth as a result of the slowdown in the eurozone or the European Union growth is minimal, the impact is much greater, the contagion is going to work through the financial market, it is going to work in terms of the losses which the major European banks have almost definitely going to take over the next 12 to 18 months, because Greece, Spain, Portugal are not going to be able to pay their debts as scheduled.

So these banks are going to have so-called haircuts or losses imposed on them, and when that happens, there are going to be U.S. financial institutions, which have exposures to these entities, and then the contagion spreads and these banking institutions do not lend to the private sector. A phenomenon that we have seen in the United States in the last 18 months is going to be spread over both the United States and Europe and you continue with economic stagnation.

To me, Jason, that is the more important transmission mechanism to watch rather than just the slowdown in European growth and how much that contributes in terms of the slowdown in U.S. economic growth.

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