RPT-COLUMN-Europe braces for Transatlantic capital reverse: Mike Dolan

By Mike Dolan

LONDON, May 8 (Reuters) - Europe may be better prepared to absorb a seismic shift in global investment flows than many assume, as a number of regulatory twists are set to bolster euro market depth.

U.S. President Donald Trump's unilateral redrawing of world trade rules is raising the question of whether giant U.S. capital surpluses will have to unwind if tariff hikes succeed in squeezing America's persistent trade deficits.

For macro-economists, those are two sides of the same coin.

If the administration succeeds in rebalancing the U.S. economy, defusing dollar over-valuation and regaining the country's manufacturing edge, that will have to involve some shrinkage of the roughly $26 trillion U.S. Net International Investment Position, the excess of foreign capital in U.S. assets over U.S. investments overseas.

During March and April, there was considerable concern that foreign capital flight was indeed underway as U.S. stocks, bonds and the dollar fell in tandem. The sell-off was driven by mounting anxiety about the potential for a self-inflicted U.S. recession or stagflation, fraying U.S. institutions and the dollar's role as a safe haven.

At the same time, the euro and euro stocks soared, in part due to Germany's equally dramatic new spending and borrowing plans that refired hopes for longer-term growth and an expanded pool of high-quality debt assets.

But doubts lingered about whether Europe's smaller and shallower capital markets could ever accommodate a repatriation of the deluge of savings that have poured into U.S. assets over the past decade-plus. Some $7 trillion in European savings has flocked to Wall Street equities since 2012.

Indeed, many reckon American markets attracted such vast sums as much because of their unrivalled scale and liquidity as any 'exceptional' American economic or corporate performance per se. In turn, the euro's smaller and more fragmented markets have raised doubts about whether the currency could ever challenge the dollar's wide usage.

NOT JUST 'NICE TO HAVE'

But this relative imbalance is not set in stone, especially if Europe's markets develop apace alongside a push to meet post-pandemic and Trump-linked challenges with a more "high-pressure" economy and industrial policies.

TS Lombard's Davide Oneglia argues the Trump trade shock has underlined the urgency of last year's report from former European Central Bank chief Mario Draghi on measures the EU needs to pursue to keep up with bigger economic rivals.

And, evidenced in part by Germany's fiscal bazooka this year, EU leaders are now acutely aware that Draghi's demands were not just 'nice to haves', including financial market reforms.

Oneglia highlights Draghi's conclusion that some 80% of the money required for transformation of European competitiveness will need to be financed by the private sector.

And on that score, some progress appears to be underway.

"EU policymakers finally appear to be getting serious about integrating and deepening European financial markets," he wrote this week.

BROADER, DEEPER, WIDER

Oneglia pointed to two specifics that should help expand long-term institutional investment across European markets.

First is reform of "Solvency II" regulatory rules governing the 10 trillion euro insurance industry. This could free up additional capital and allow a wider pool of public and private equity to be invested in the continent.

The second measure is a "wildly underreported" push to channel large European private savings into capital markets by developing a more expansive private pension industry across the region.

On the latter, the European Commission this year rebranded the old Capital Markets Union as the Savings and Investment Union. The private pension push accompanying this is likely to involve requirements for things like auto-enrolment in pensions and targets for national implementation as soon as this year.

In that spirit, Germany's new government has also made developing private pensions a priority.

Why this matters is that European households currently hold about a third of their savings in cash and deposits, more than twice the share U.S. households hold. And German savers are the most extreme, with more than 40% of their financial wealth in cash.

Channeling these savings into institutional investment funds will go a long way to deepening European markets.

Of course, a crush of untapped savings and returning overseas investment could flood European markets too quickly, saddling the region with an overvalued currency - the very issue America has fretted about for the past decade.

Be careful what you wish for, as the old saying goes. "Exorbitant privilege" may not be all it's cracked up to be in that scenario.

Europe has to decide how to manage those investment flows as well as what to do with the finance.

The opinions expressed here are those of the author, a columnist for Reuters