EUROZONE : A CREDIT DEMAND CRUNCH / THE WALL STREET JOURNAL OP EDITORIAL ( RECOMMENDED READING )

OPINION EUROPE

AUGUST 18, 2009

A Credit Demand Crunch

By GILLES MOEC

The surprise return of modest second-quarter growth in Germany and France last week has only highlighted concerns that another credit crunch may smother the fledgling euro-zone recovery. Getting banks to lend again has become a major issue for policy makers. Euro-zone governments and to a lesser extent the European Central Bank fear that tighter credit standards, a legacy of the financial turmoil, could pull down the economy. The latest figures, from June, reinforce the worry: Corporate borrowers paid back €35 billion more to the banks than they borrowed.

Still, credit supply is only part of the story. The overlooked problem is the indebtedness of corporate Europe. While June's negative credit flows represent just 0.4% of euro zone gross domestic product, outstanding corporate debt surpassed 100% of GDP in early 2009. This is twice as much as in the U.S. and up from 62% of GDP a decade ago. The banks' current tightening of credit standards is simply precipitating and amplifying a corporate deleveraging process that had to occur anyway.

Disentangling the effects of supply and demand on credit flows is always tricky. Slower business triggers a fall in investment, thus dampening credit demand. At the same time, it also raises the probability of borrower defaults and makes banks reluctant to lend. Still, this time, since the current credit contraction started after a seizing-up of the interbank market—which was unrelated to any real economic development—it's easy to see why some policy makers consider this predominantly as a supply side problem. But contrary to complaints by industry associations, surveys do not confirm this intuition.

The quarterly ECB Bank Lending Surveys show that, since the summer of 2007, banks increasingly cite their own balance-sheet constraints as a reason for tightening credit standards. Yet these surveys also strongly suggest that the main force behind the tightening was a sharp downward revision of the banks' assessment of the economic situation and its impact on borrowers. Besides, at the time the banks started tightening credit standards, they were also reporting a steep decline in credit demand. This corresponds with corporate Europe's own assessments. According to the July European Commission industry survey, only 6% of respondents mentioned financial constraints as a factor hampering production. In contrast, more than 50% cited low demand. This supports the view that much of the credit decline was the result of businesses voluntarily cutting back requests for bank loans.

It was a development long in the offing. Despite higher operating profits on the back of wage moderation, corporate Europe's savings actually have been falling since 2005. This was largely due to higher debt servicing costs after the ECB started tightening monetary policy in December 2005. Still, non-financial corporations stepped up their capital expenditures again in 2007 and 2008, topping the previous peak in 2000. Lacking cash flow, this meant taking on more debt. At the onset of the financial crisis, the euro-zone corporate sector was in a vicious debt cycle.

Corporate debt started first to accelerate with monetary union in 1999 as interest rates converged toward the German benchmark. The appetite for debt was not equally distributed across the euro zone, though. The impact was extremely strong in countries such as Spain, where financing costs used to be particularly high. Spain, which represents just 12% of euro-zone GDP, accounts for 31% of the overall increase in corporate debt in the monetary union between 1999 and 2008.

Germany Inc. did not join the leveraging spree that swept across the rest of the euro zone. Consequently, corporate net interest payments actually declined there over the last 10 years as the corporate savings rate rose to 18% in 2008—significantly above those of the other big euro-zone countries. Despite its high savings rate, Germany won't be able to play a leading role in the recovery—its export-dependent economy is particularly exposed to the collapse in global demand. Once the world economy rebounds, however, Germany will be in a strong position again.

The mostly debt-financed investments in the rest of the euro zone left corporations with an abundant capital base just as they were hit by the recession. It will probably take some time into the next recovery to exhaust that overhang and trigger a meaningful rebound of capital expenditure. Accordingly, a prolonged decline in long-term credit would not be, in itself, a cause for alarm. The contraction in short-term credit flows, which currently exceeds that of long-term loans, could be, for the time being, a reflection of the sharp fall in inventories. Conversely, as inventories gradually normalize and firms need to step up expenditures to respond to the first signs of a rebound in global demand, businesses, in an environment of dwindling operating profits, will probably have to seek more short-term credit again. This is the channel through which supply-side credit restrictions could harm the recovery. However, the latest bank-lending survey last month, which points to a stabilization of credit standards, was encouraging.

Beyond the possible need for bridge-financing, corporate deleveraging still has some way to go, which will likely dampen the recovery. Businesses will probably avoid taking on new debt by stepping up internal funding of capital expenditure. This will likely mean pressure on wages and hiring, thus stifling consumer demand. At the same time, household savings will probably rise in anticipation of higher unemployment.

There will be a strong temptation for governments to offset rising private savings by increasing their own borrowing. This, however, would conflict with the need to bring down public deficits after the shock of the recession. A better way out would be for euro-zone businesses to move away from debt financing to more equity funding of capital expenditure as in the U.S.

Europe's banks may be reluctant to step up lending now, but in doing so, they share a common assessment of risk with businesses.

—Mr. Moec is senior European economist with Deutsche Bank.

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved