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Citigroup Faces a Crucial Test

Stocks in this article: C JPM BAC GS MS

NEW YORK ( TheStreet) - When Citigroup (C) closed 2011 with a big earnings miss, many investors and analysts gave the bank a pass and focused on its growing emerging market operations in Latin American, Eastern Europe and Asia.

While a similar dynamic of investment banking weakness and emerging market excitement is likely to be key to Citigroup's second quarter earnings due on Monday, it's time for investors to scrutinize whether the bank's multi-year runoff of U.S. businesses and its focus on global lending is as promising as some expect.

As emerging market economies cool on an escalating European debt crisis and a developed markets slowdown, Citigroup's strategy to expand lending and businesses in countries with higher-than-trend gross domesting product (GDP) growth outlooks may face its biggest post-crisis test starting this quarter. At once, the strategy is appealing amid a 2012 outlook for sub 2% developed market GDP growth and a Eurozone recession, according to the International Monetary Fund; however, it doesn't come without risk.

"The big story for Citigroup is the emerging market piece of its earnings," says Jim Sinegal, a director of bank equity research at Morningstar.

While Citigroup has stomached large earnings drains as it shrinks its CitiHoldings portfolio of non-core assets from over $800 billion to just over $200 billion, the bank has been reinvesting sale proceeds in its U.S. and emerging market lending operations and its global corporate banking unit. The result is that while Citigroup's balance sheet is far smaller than pre-crisis levels, its growth prospects versus peers JPMorgan and Bank of America (BAC) may be particularly strong.

But the second quarter could test of whether emerging market growth expectations match reality.

"If Citigroup can manage to grow without having major credit problems, I think people will look pretty favorably on that," says Sinegal, who notes that this quarter may mark the biggest recent test of the banks' credit quality outside of the U.S. - where its prospects are bright. Citigroup's test comes at a time when investors and economists are yet to fully gauge the spillover effects of developed market weakness on emerging market growth.

"We are now looking all over the world for the next bust," adds Sinegal. He's concerned about whether mortgage and credit card lending quality will hold steady in Latin American, Eastern European and Asia where Citigroup is particularly active, and which may show signs of weakening in the second quarter.

"Credit quality should continue to improve, but at a moderating pace," writes Sandler O'Neill analyst Jeffrey Harte, who calculates that non-performing loans and charge-offs will fall by 5% and 4% respectively, on a quarter-over-quarter basis, even as loan loss reserve releases fall to $848 million from above $1 billion in the first quarter. Harte expects reserve ratios should hold steady at 4.3% of total loans.

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