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Tuesday, August 21, 2007

Credit Tightening or Liquidity Crunch?

The situation in the financial markets following last Friday's Federal Reserve decision to lower the discount rate can hardly be considered to have returned to normal. Yields on short term US treasury bills continue to decline as investors continue to bet that the Federal Reserve may cut the benchmark federal funds rate even before next month's policy meeting. As a result the three-month T-bill yield, which fell 126 basis points at one point on Monday to have its biggest one-day drop since the stock market crash of 1987, slipped again to 2.960 percent in Asian trading this morning, after recovering to around 3.270 percent in late trading in New York.One indication of the difficulties the Fed have been having containing the situation can be seen in the fact that the fed funds rate is continually slipping below Fed's target rate, and at one point last week the rate actually fell as low as zero percent in overnight trading (which means of course that someone or other could make a tidy penny lending out to someone else in - say - New Zealand while New York quietly sleeps, which is one of the things I guess Bernanke would wish to avoid, and why there is so much talk out there at the moment about "helicopter Ben" and the "Bernanke put", getting this under control and keeping the balance right doesn't seem to be at all an easy matter).

Meantime the German banking sector also seems to be struggling to regain some kind of normality, while the Bank of Japan continues to inject liquidity into the Japanese banking system. This morning (9:20 a.m. Tokyo time) they supplied an additional 800 billion yen ($7 billion) to the banking system, and this is the 17th time the BoJ has supplied a sum of that amount or more this year and the fourth since Aug. 9, when the ECB added 94.8 billion euros in an attempt to lower short-term lending rates and avoid a crisis of confidence in credit markets.

Obviously this entire situation is leading to all sorts of speculation about the future direction of interest rate policy in all the major economies. It is now considered to be extremely unlikely that the Bank of Japan will proceed with a quarter point raise later this month, and it is very doubtful in my view that the ECB will raise in September. It is pretty much a foregone conclusion that the next move by the Federal Reserve will be down, and the only outstanding question really is when.

Obviously we need to wait and see how the financial markets respond to the latest move from the Fed, but my feeling is that the so called "credit tightening" (or liquidity crunch) isn't over yet (and not by a long stretch), and that even were the "liquidity crunch" to come to an end soon the consequences for the real economy are going to be important, since credit - both corporate and private, and possibly even sovereign - will more than likely be harder to come by. What this "harder to come by" really means is that you will have to pay more for it, especially if your credit valuation is not of the highest (as was the case with the US sub-prime home purchasers).

But it is important to be clear here that what we have at this point is a liquidity crunch and not a generalized credit crunch, although evidently the danger is that the former spreads to the latter, which, of course, it may well do if the impact of the liquidity crunch on the real economy is seen as being sufficiently important as to warrant a good deal more caution in lending. It's as simple as that I think.

Basically liquidity crunches occur from time to time when asset prices decrease quickly, since banks typically demand more money and become more reluctant to lend out the money they already have. In order to maintain adequate liquidity (and guarantee its target refi rate) the ECB, for example, normally carries out a liquidity "top up" operation once a week. But what this means is that any sudden shifts in demand for and supply of funds which take place during the week in-between the "top-ups" can lead to liquidity squeezes. When banks sense there is not enough liquidity in the system then they start to hoard it and as a consequence liquidity can dry up very quickly. In such situations the ECB (or the Federal Reserve, or the Bank of Japan) may provide liquidity at a higher frequency than normal until demand and supply stabilise again and overnight rates once more return to their normal levels. This is the process we have seen at work over the last week or so.

Now this kind of liquidity crunch should not be confused with a more general credit crunch where credit conditions are tightened across the board vis-à-vis companies and consumers. At this point in the story there are no real signs that this is happening. In the eurozone, for example, M3 growth and broad credit growth are still at very high levels and lending standards are still generally favourable. The problem is that if the current financial crisis intensifies, and in particular, if there are perceived to be ongoing consequences for the real economy which derive from the liquidity crunch, then there is a genuine risk that we may see a broader tightening of credit.

In order to address this risk we need to think about why this liquidity crunch has happened now, and indeed about what it is that has been the immediate cause provoking it.

On the first count, the broad background has to be that the current cycle of economic expansion - which after all started back in 2001/2002 - is quite possibly nearing its peak. Volatility has been steadily creeping into the markets since the spring of 2006 - in Hungary, in Iceland, in Turkey - and often such events are early warning signals of bigger trouble coming further down the road, especially if the volatility increases. The US economy has been visibly slowing since the start of the year, the credit scare will not make it any easier to restart the critical housing sector, and consumer confidence is evidently down on all the worries and fears being expressed. Indeed this concern is already indicated in the Fed statement about downside risk to the economy, which is evidently a departure from the earlier inflation vigilance tone. GDP in Japan also slowed natably in Q2, as it did in some key Eurozone economies (most notably Italy and Germany).

This gradual "waning" of the present cycle has evidently been reflected in the financial markets and since the spring volatility in financial markets has been steadily and notably increasing in anticipation of the arrival of a bigger problem. That "bigger problem" it would seem is now with us.

Turning then to the immediate (or in the terminology of the Greek historian Thucydides the "efficient") cause of the crisis, it is important to allow ourselves to think about significance of the fact - as few commentators seem to have really done - that the whole issue has started with sub-prime lending in the United States. This detail would seem to be important for three principal reasons. In the first place these mortgages were made to people in what you might consider to be a "high risk" group for lending, and obviously the risk was too high. This appreciation may well now lead the banks and other financial institutions to examine all the other "high risk" assets they have in their portfolios and to begin the process of systematically discarding them. This I do think will happen.

Secondly, it is not insignificant that the high risk group which set things in motion was associated with the property sector and this little detail will surely have implications (see below) which reach right across the real economy given the important role which construction and housing have been playing in the current cycle.

Thirdly it is important to notice that the sub-prime defaults problem surfaced in the United States, and that the Federal Reserve started the interest rate tightening cycle at least a year before most of the central banks in the other major economies did (with the significant exception of the Bank of England). So this means that the sub-prime population in those other economies (who of course have also been receiving money) have yet to start experiencing significant "distress" in the way their US counterparts have. But they will do. It is just that we are most probably still at 6 to 9 months distance from that stage elsewhere, and this is just another of the reasons why I think the problem will be a drawn-out affair, and any real economy slowdown may also have some duration attached to it.

Coming back to any possible general credit crunch, as I say, were this to occur it would undoubtedly make itself felt at all levels, since the banking sector has clearly had a big shock, and any credit tightening will clearly involve individuals, companies and even governments (and again it is interesting to note that the Fitch rating agency has already replied to some of the criticism by downgrading Latvian government debt). Just how it may affect them is what we are now waiting to see. But it is important to bear in mind that such impacts on new and rollover credit would occur regardless of the extent to which central banks lower their base rates, since what will have happened is that the lending environment will have deteriorated, and this deterioration is likely to influence conditions in new lending (or rollover credit) for years rather than months into the future.

Obviously existing mortgage holders on variable rate mortgages can get some fresh air from any loosening in the base rates, but it is the demand for new mortgages, and activity in the construction sector, and not locally but globally, that we need to be thinking about here. Clearly construction growth can slow, as lenders become more choosy about who - and under what conditions - they lend to. This becomes important for the real economy when we come to consider the importance which construction activity shares have had in economic growth in some major economies - the US, the UK, Spain, Australia etc - since the turn of the century, and the impact which the so-called wealth effect has had on the rate of growth of private consumption in this self same economies. So clearly, in some developed economies, economic growth is now likely to be rather weaker, and for some time to come.

But any looming "credit crunch" is also likely to affect the so called "risk appetite" (that is the willingness to invest in riskier areas or activities) and the place where this is most likely to be felt is in the emerging market area. Those emerging markets which are considered to be most vulnerable will undoubtedly have the hardest time of it, and this brings us directly to Eastern Europe I think and to economies like those in the Baltics (Latvia, Estonia and Lithuania), to Hungary, and then maybe (if there were to be contagion) to the larger economies like Poland and Romania. Alarm driven reports about the dangers of a hard landing in the Baltics have been floating around for some months now (I say alarm driven not because the danger isn't real, but because most of the reports are quite superficial, and don't really appreciate the magnitude of the problem). Whatsmore, as the Bank for International Settlements pointed out in the June edition of its quarterly review , in 2006 Eastern European economies accounted for a staggering 60% of new emerging market credit:

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.

To quote the Economist's Buttonwood, "WHEN investors get twitchy, developing countries are usually the first to pay the price.", and those who are most exposed get to pay a higher price than those who are less so, I might add.

Well investors are definitely twitchy right now, and, as Danske Bank Senior Analyst Lars Christensen commented last Wednesday (pdf link), one piece of evidence that the markets are getting nervous about this whole problem set is the fact that signs of pressures on the Latvian currency (the lat, which is currently pegged to the euro) are now re-emerging after some months of calm. The Hungarian Forint has also been coming under mounting pressure during the last couple of weeks.

At the end of the day though, and when we come to look at the actual mechanics of risk, I cannot do other than agree with the Economist when it describes the Baltics (and even Hungary for that matter) as being "financial pipsqueaks". The big issues are obviously going to come - if, that is they do come - in Poland and Romania, due to their size.

Whilst Hungary may in some ways be considered to be something of a special case, the general problem of the Eastern European EU10 can be simply summed up: they are experiencing rapid catch up growth which they are unable to live up to on the supply side due to severe labour shortages being produced by the impact of both strong migration westwards across Europe (driven by the large wage differentials), and the sudden drop in fertility following the fall of the Berlin Wall back in 1989. The "missing children" who never arrived following the drop are now the "missing young people" who would be steadily arriving as young labour market entrants and facilitiating the much needed growth process. These problems, it should be noted, are now long term and structural, so there is no easy fix. As a result wages all over Eastern Europe (see here for Romania), and even in Russia (and here), are now starting to rise dramatically.

Claus Vistesen and I have been trying to get to grips with all of this (once we became aware of the Latvian situation) both theoretically (on the Demography Matters blog, where you can find a whole slew of recent posts) and practically in terms of back-of-the-envelope calculations about how soon the crunch will come, and where.

In principle I would say Poland should have two or three years to run before getting to where Latvia is now (although the Polish government are, it should be noted busily out looking for labour in India right now), but, of course, and this is the whole point about what is happening now, and about why this downturn may be a little different from earlier ones, the financial markets may not let them get to two or three years from now as is. Once the financial markets wake up to the fact that Poland can ultimately get through to where Latvia is now, then there may well be fireworks8something similar can also happen to Romania, and both the IMF and the EU Commission have been pretty critical of the way the government is running up the fiscal deficit there). Poland, it seems, is going to have elections in the autumn so there will plenty of opportunity coming up for the markets to fret about the issue, should they get into the mood for fretting about things.

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