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Saturday, November 24, 2007

A Credit Crunch in Europe?

Is Europe currently facing a widespread credit crunch, or are the problems currently being experienced in the banking sector (aka "the financial turmoil of last August") only a US phenomenon? Reading many of the articles which have been appearing in the financial press recently you could be forgiven for thinking that the latter was the case, but in fact it isn't, and the problems which are emerging in the European banking system are every bit as important as those which are to be found in the United States, a detail which was highlighted by Bank of England governor Mervyn King's statement earlier this week that the Bank is now preparing to cut interest rates several times over the next year in an attempt to reduce the knock-on effects which the banking sector problems will almost certainly have on the real economy.

Or again we could take our lead from the statements which are to be found in the November Edition of the ECB Monthly Bulletin - released yesterday - to the effect that the central bank is in the process of monitoring "very closely" all current developments in the eurozone banking sector and is, in particular, ready to act on interest rates as and when necessary, drawing attention to the fact that "risks to the outlook for growth are judged to lie on the downside". Or the rather ominous "as regards the financial markets, the governing council will continue to pay great attention to developments over the period to come."

Of course many observers when they read "ready to act on interest rates" naturally genuflect towards the evident current problems in short term inflation and thing about them being moved up, but cutting through the dense undergrowth of "central- bank-speak" what such phrases really are an attempt to communicate is the idea that they take everything that is happening very seriously indeed, with the mention of "downside risk" being a pointer intended to edge expectations along in the direction of accepting any eventual rate reductions which may prove necessary.

Thus it seems a little strange, to say the least, to have to note that at one and the same time as all this growing "vigilance" is being exercised, and in the precise moment when the dollar has been hard at it "slipping and a sliding" under the very weight of these selfsame problems, the euro, in contrast, has continued to rise and rise in almost vertiginous fashion, as if tomorrow would never come. And this has been taking place despite the recent warning from Jean Claude Trichet - who seems to have expressly emerged from virtual hiding for the occasion - that "brutal (foreign exchange) moves are never welcome." So what exactly is going on?

Well, a number of reports which have been published during the last week, when placed alongside the associated comments from those responsible for overseeing of the eurozone banking sector do seem to underline just how serious the situation in the eurozone potentially is. First off we have the latest EU Commission economic forecast which draws explicit attention to the way in which the home loan credit squeeze is now beginning to work its way across the complete gambit of EU economies, pointing out in the process the likely implications of this for economic growth in the region:

An unexpectedly sharp correction in house prices resulting from the global credit squeeze poses a significant risk to growth in Europe, according to the European Commission.

Now even if I personally don't regard the European Commission as last word in economic commentary and analysis (and in particular I tend to take each and every statement which emerges from the Economy and Finance Commission headed by Joaquim Almunia - a far cry this from the days when the department was run by the ever interesting Pedro Solbes - with the proverbial pinch of salt) I do think that this time round there are good reasons for sitting up and taking note of what is being said, and in particular of the fact that the Commission itself is now signalling the growing significance of the problem. In particular, and living in Spain, I cannot but agree with Almunia when he says that since housing and construction have contributed so enormously to Spanish growth in recent years, then the international problems in the housing sector will more than likely have a particular effect here. The Spanish consumer confidence index has now hit all time record lows for the second month in succession.

Secondly we have the business confidence reports (see for example the German ZEW and IFO indexes and the Italian ISAE) one) and in particular the latest results from the KPMG/NTC business outlook survey where they found that business confidence was dropping rapidly across the entire eurozone. The survey reported that the healthy confidence which could be found in the European business outlook only a few months ago has now given way to much weaker expectations for business activity. The contrast that exists here with what is happening in the BRIC economies - Brazil, Russia, China and India - where the underlying conditions are evidently very different from those in the more developed economies, couldn't be clearer.

The confidence in the European business outlook of earlier this year has given way to much weaker expectations for business activity, revenues, profits, capital spending and employment. In contrast, corporate confidence in Brazil, Russia, India and China, the so-called Bric countries, is sky high....With Russia, India and China accounting for half the world’s economic growth for the first time in 2007, emerging markets arguably now have sufficient weight in the global economy to withstand an advanced world financial crisis.

Half the world's economic growth! This isn't "decoupling" as some people imagined it (of Europe and Japan from the United States), but it is a massive "recoupling" of the global economic train, and one which is of historic proportions, with some developing economies now assuming a role from which it seems there will be no turning back.

Clearly the ability of these developing economies to withstand a major financial crisis and economic slowdown in the developed economies is what precisely remains to be seen, and in particular it will be interesting to see who will withstand better than who. Will Russia and parts of Eastern Europe, for example, where rising inflation and rampant labour shortages following the evolution of very low male life expectancy, large scale labour out-migration and 20 years of rock bottom fertility be able to sustain the high rates of GDP growth which are currently taking place, or are some developing economies in serious danger of overheating and consequent correction. Well, we are all now going forward to a robustness test, and it will be interesting to see just who has been right and who has been wrong here.

Finally, and and returning to the main topic of this post, we have the question of the ongoing problems which beset the European banking system. Here some of the recent statements by José Manuel González-Páramo - the ECB board member responsible for open market operations - prove to be quite revealing. In a recent interview with the Financial Times González-Paramo indicated that there was "no deadline" for support for the banking sector and that the ECB Emergency help to try to calm markets would be provided for “as long as necessary.... and ...to the extent that money markets remain subject to tension, we will stay there”. He also openly admitted being taken aback by the scale of recent write-downs in the banking sector adding that “frankly speaking I did not expect them to be of this size.”

Now as the FT also notes the ECB has in fact managed been reasonably successful in bringing overnight inter-bank interest rates back into line with its main policy rates, but the three-month inter-bank rates still remain stubbornly high (and this is a reflection of the nervousness which there is in the banking sector when it comes to one bank lending to another). These higher-than-desired rates thus threaten to act as a brake on real economic activity and to drag-down growth. As we can see from the chart below, the 3 month London Interbank Rate on euro denominated loans shot up in August on the back of the growing "financial turmoil". The rate has now come down somewhat since a month or so ago, but it still resists a correction back to "normal" conditions. It is worth bearing in mind that the ECB refi rate has not been changed at all during this time. Now the 3 month euro Libor rate is useful as an indicator, since it gives us one of the best readings we can get on "sentiment" in the banking sector, and the outlook certainly has not improved dramatically at this point. (Data for the chart come from the British Banking Association).

Putting this question in a somewhat broader context, we could note that what is possibly the most widely quoted source for the state of the eurozone banking system is the quarterly bank lending survey published by the ECB. Normally a rather drab and tiring document, full of technical detail, last October's edition was eagerly anticipated and widely read. In particular for this:

The results of the October 2007 bank lending survey which refer to the third quarter of 2007 indicate a net tightening of the credit standards for loans to enterprises (from a net easing of -3% in the second quarter of 2007 to 31% in the third quarter of 2007). This follows a long period of standards remaining basically unchanged or being slightly eased. The net tightening most likely reflects the worsening of global credit market conditions. In the third quarter of 2007, banks also reported a net tightening of credit standards for housing loans to households (from a net easing of -1% in the second quarter of 2007 to 12% in the third quarter of 2007), following a slight net easing in the previous quarter. Credit standards for consumer credit and other lending to households were eased slightly, compared with basically unchanged standards in the previous quarter.

The credit market events have had a different impact on credit standards depending on the loan segment. Loans and credit lines to enterprises were more affected than loans to households. More banks expect the recent developments in credit markets to have an effect on credit standards over the next three months than was seen over the past three months. Banks generally reported that the recent turmoil in the credit markets has hampered the conditions of access to wholesale funding over the past three months, and may hamper funding over the next three months. Banks’ willingness to lend over the next three months may be affected, to some extent, by the effect of the credit market events on the costs related to the banks’ capital position.

So basically the problem is an ongoing one, affects both households and companies, and possibly companies even more than households, and perhaps this offers us an insight into the background which lies behind some of the gloom to be found in the business and consumer sentiment surveys cited above.

So, if bank lending conditions actually have tightened, how does this affect you? Well it will obviously affect you if you either want to buy or sell a house, or if you work for a company which needs to borrow money, whether to invest or maintain liquidity levels. And if this isn't your case, but you have a job or a business in the services sector, and your job or business relies on customers who either want to buy or sell a house, or who build them or sell them, or on customers who work in companies that need to borrow money, then you might just notice that you have less of them (etc, etc, etc). Surely this is not a situation for panic at this point, but it is one for concern. According to a statement issued by the ratings agency Standard and Poor's earlier today, European banks are currently well positioned to face what is likely to be an "exceptionally demanding" market environment and in general are likely to retain their stable credit ratings outlook. S&P's do note, though, that the banks face higher borrowing costs and scarcer liquidity in the months to come, giving them the expectation that interbank conditions will "remain relatively tight until at least early 2008". So the scene is definitely set, now all that remains is the wait to see just how all of this will actually affect the pound - or the euro - you have in your pocket.


The problems mentioned in this post are a long long way from disappearing. The Financial Times this morning reports that the ECB announced yesterday that it was taking fresh emergency action to pump funds into the money markets as renewed fears circulated that liquidity in European credit markets is once more starting to dry up.

On Friday night, the bank said it would inject an unspecified amount of extra liquidity next week, noting “re-emerging tensions” – and would do so until at least the end of the year. Earlier, Jean-Claude Trichet, ECB president, had pledged continuing action to keep short-term money market interest rates in line with its main policy rate.

The new promise of intervention came as three-month US interbank rates rose for the eighth day in a row to 5.04 per cent, more than half a point higher than the US Fed Funds target rate of 4.5 per cent.

Three-month money usually trades just above the Fed Funds rate which is 4.5 per cent. Europe and UK money markets are showing similar strains.

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