Sunday, July 25, 2010
The creditless recovery
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

credit.jpg

My full Sunday Times article is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

The fall in bank lending to businesses has been extraordinary. Lending growth peaked within a whisker of 20% in early 2007. Annual growth in lending to firms turned negative in June last year and in May was falling at 4.3% annually (6.1% in June according to partial data from the British Bankers’ Association).

This is a huge change, raising many questions. One of which is how to square this with the better than expected recovery. The 1.1% rise in GDP in the second quarter was roughly double what analysts expected. It is possible, of course, that the Office for National Statistics has had a rush of blood to the head and, after several quarters of producing unexpectedly weak numbers, has overcompensated.

Taking the figures at face value, however, this was a solid, across the board pick-up, with manufacturing up 1.6%, services 0.9% (including a 1.3% rise in business services and finance) and, the star of the show - and perhaps the most suspicious aspect of all - a 6.6% leap in construction output.

That will not be maintained, and neither will quarterly growth of 1.1%, but an upward surprise in the numbers was always on the cards. I mentioned recently that the monthly numbers were starting to point to growth closer to 2% than 1% this year. The forces that combined to produce a savage downturn in the autumn and winter of 2008-9, most notably de-stocking and the collapse of world trade, were always likely to result in a snapback in growth when they reversed themselves.

Can the economy build on this and enjoy sustained recovery with business lending so weak? Will the regulatory response — forcing banks to hold more capital while weaning them off emergency support — put the kibosh on any lending recovery?

The government is exercised about weak lending, particularly to small and medium-sized firms. This week it will publish a green paper. Vince Cable, the business secretary, pre-empted it last week with a warning last week that “the recovery could be aborted if we don’t get on top of this”.

The Bank of England’s monetary policy committee (MPC) caused a stir when it revealed in its minutes that “a further modest monetary stimulus” — more quantitative easing — could be needed. The Bank also touched on the chicken-and-egg question. Is lending falling because banks won’t lend or because firms won’t borrow?

Some of the lending drop is because firms are obtaining finance elsewhere. It is no bad thing businesses are weaning themselves off excessive reliance on bank borrowing. The corporate sector is running a big financial surplus and is cautious about spending at this stage of the cycle, so there are both demand and supply-side explanations for lending weakness.

As an aside, and I will return to this another day, I would be careful about adding to the existing £200 billion of quantitative easing, and not just because of the strong GDP numbers (though I would also not be raising interest rates). Whether the Bank intended it or not, people got the initial impression that quantitative easing would increase lending to cash-strapped firms. Plainly, that has not occurred.

The Bank has instead emphasised a different transmission mechanism, which is that £200 billion of asset purchases have kept bond yields low and led to improvements across a range of markets, making it easier and cheaper for the private sector to raise finance. All that remains in place.

Only if the Bank could come up with an alternative stimulus, which fed through direct to those bits of the economy that cannot access capital markets — the small and medium-sized firms — would it be worth doing. I have seen no evidence yet of this additional shot in the locker.

It is perhaps not surprising lending is so weak, given the scale of the crisis and recession. This is the phenomenon of the “creditless” recovery, identified by the International Monetary Fund and others, where it takes several quarters after the economy has turned before lending turns positive.

If the squeeze on bank lending continues indefinitely, however, it will be hard for smaller firms, drivers of employment growth and ultimately the economy, to get the finance they need for expansion.

Everybody knows banks need higher levels of capital and liquidity. In his chapter for the London School of Economics’ report The Future of Finance, Lord (Adair) Turner commendably cut through the verbiage. By all means debate “narrow” banking and Volcker rules that stop risky behaviour, he said, but in the end only two things really matter: getting banks to hold more capital and liquidity, and introducing new “macro-prudential” tools to allow the authorities to stop credit and asset price booms, partly by varying capital requirements across the cycle.

The question is when. “There is a fundamental conflict between efforts to make the banks safer and our wish to get them lending more,” Cable said last week.

This is not the only conflict. Lenders face huge refinancing pressures from the phasing out of the Bank’s emergency credit guarantee and special liquidity schemes, starting next April. Nomura reported that banks will need to refinance £390 billion next year. Banks commissioned Price Waterhouse Coopers, for a “Project Oak” exercise, to show how moving too rapidly to higher capital when special schemes are ending will cause a £1 trillion financing and refinancing headache.

Those in authority insist they are aware of this. One reason for the Bank’s hard line on ending special schemes was that some banks were making no preparations for a life without official support. The authorities will not push insistence on higher capital to the point where weak lending tips the economy back into recession.

Still, the worry is there, even amid the warm glow of an economy recovering faster than expected. Strong growth alongside very weak lending adds up to a creditless recovery. The question is how long this creditless growth can continue.