April 24, 2012 10:12 pm
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The high cost of disorderly deleveraging
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By John Plender
Markets in Europe have understandably been preoccupied with politics, but Monday’s weak eurozone purchasing managers’ indices suggest that more attention ought now to be paid to the dysfunctional relationship between eurozone banks and the real economy.
That point is reinforced by the latest Global Financial Stability Report from the International Monetary Fund, which ominously forecasts that the process of deleveraging in the European banking system is set to continue and broaden.
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The report’s authors, though, are not entirely downbeat, pointing out that these simulated shocks to eurozone credit are well within the range of past episodes of deleveraging such as Japan in the 1990s or the US at the start of the financial crisis. It should also be said in passing that if the deleveraging process can be managed in an orderly way, any reduction in big bank balance sheets is good both from a systemic stability and competition policy point of view.
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That said, the aggregate figures say nothing about the extent of the pain in southern Europe, where any solution to the sovereign debt problem is inconceivable without economic growth. And this credit contraction coincides with a return to fiscal austerity across the eurozone; also with the end of the European Central Bank’s longer term refinancing operations and the imminent conclusion of the asset purchasing programmes of the Bank of England and the Federal Reserve. Indeed, the queasiness of markets probably reflects a tightening of global liquidity as all this stimulus ebbs away.
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The risk is of a vicious circle whereby eurozone economic conditions deteriorate, so depressing bank earnings and weakening asset quality, which in turn requires increased provisions. That erodes bank capital, creating more pressure for yet more deleveraging. A further risk is that deleveraging becomes disorderly if synchronised sales of bank assets cause a downward spiral in prices, which leads not only to capital shrinkage but funding shortages as interbank lending is cut back.
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The biggest victims will be the emerging market economies of eastern Europe, as eurozone banks seek to repatriate funds. The effects of the new parochialism will be felt further afield. Small and medium-sized enterprises, already penalised by the Basel capital regime, will also be badly hit. Where their credit lines have not been withdrawn, lending conditions have been tightened since early last year and borrowing costs could rise further.
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The SMEs are being doubly squeezed as big corporations seek to manage working capital more efficiently. GlaxoSmithKline last year increased the average number of days payable on outstanding trade credit in the UK from 50 to 61 days. That is going on all across the corporate sector of the developed world, helping knock the stuffing out of myriad potential employment creators.
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In the light of the weak policy response to this SME squeeze, it is easy to feel nostalgia for German-style banking, in which a more regionally based, politicised system operates on a non-profit-maximising basis and sees Mittelstand companies safely through the downturn. Yet the flaws in that model have been exposed by the crisis. Witness the state bailouts. Their undercapitalisation and over-dependence on wholesale funding has now made them doubly vulnerable.
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Compared with the US, and to a lesser extent the UK, the eurozone corporate sector remains overdependent on banks for funding. Even after the deleveraging predicted by the IMF, eurozone banks will still be relatively undercapitalised.
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If the eurozone economy is not now to be stricken by hypothermia, someone will have to offset the contractionary effect of bank deleveraging. As far as fiscal policy is concerned, the governments of northern Europe certainly will not, even if some of them can, while those of southern Europe cannot.
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So the mantle will fall once again on the central bankers. Yet the suspicion must be unconventional measures will have a dwindling impact. And of course they do little to address the underlying solvency problem. Plus ça change.
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The writer is an FT columnist
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That point is reinforced by the latest Global Financial Stability Report from the International Monetary Fund, which ominously forecasts that the process of deleveraging in the European banking system is set to continue and broaden.
In the last quarter of 2011 alone, the 58 banks in the IMF’s sample reduced assets by almost $580bn. On current policies, the fund’s economists expect a $2.6tn decline in bank assets between end-September 2011 and the end of 2013, equivalent to a seven per cent decline in total balance sheet size. About a quarter of that fall in assets reflects a potential reduction in lending as opposed to asset sales.
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On a weaker policy scenario in which cyclical pressures are doing more to hold back the economy, which is where the PMI managers come in, the forecast is for assets to be cut by $3.8tn. This would amount to a 1.4 per cent knock to eurozone real gross domestic product..
The report’s authors, though, are not entirely downbeat, pointing out that these simulated shocks to eurozone credit are well within the range of past episodes of deleveraging such as Japan in the 1990s or the US at the start of the financial crisis. It should also be said in passing that if the deleveraging process can be managed in an orderly way, any reduction in big bank balance sheets is good both from a systemic stability and competition policy point of view.
.
That said, the aggregate figures say nothing about the extent of the pain in southern Europe, where any solution to the sovereign debt problem is inconceivable without economic growth. And this credit contraction coincides with a return to fiscal austerity across the eurozone; also with the end of the European Central Bank’s longer term refinancing operations and the imminent conclusion of the asset purchasing programmes of the Bank of England and the Federal Reserve. Indeed, the queasiness of markets probably reflects a tightening of global liquidity as all this stimulus ebbs away.
.
The risk is of a vicious circle whereby eurozone economic conditions deteriorate, so depressing bank earnings and weakening asset quality, which in turn requires increased provisions. That erodes bank capital, creating more pressure for yet more deleveraging. A further risk is that deleveraging becomes disorderly if synchronised sales of bank assets cause a downward spiral in prices, which leads not only to capital shrinkage but funding shortages as interbank lending is cut back.
.
The biggest victims will be the emerging market economies of eastern Europe, as eurozone banks seek to repatriate funds. The effects of the new parochialism will be felt further afield. Small and medium-sized enterprises, already penalised by the Basel capital regime, will also be badly hit. Where their credit lines have not been withdrawn, lending conditions have been tightened since early last year and borrowing costs could rise further.
.
The SMEs are being doubly squeezed as big corporations seek to manage working capital more efficiently. GlaxoSmithKline last year increased the average number of days payable on outstanding trade credit in the UK from 50 to 61 days. That is going on all across the corporate sector of the developed world, helping knock the stuffing out of myriad potential employment creators.
.
In the light of the weak policy response to this SME squeeze, it is easy to feel nostalgia for German-style banking, in which a more regionally based, politicised system operates on a non-profit-maximising basis and sees Mittelstand companies safely through the downturn. Yet the flaws in that model have been exposed by the crisis. Witness the state bailouts. Their undercapitalisation and over-dependence on wholesale funding has now made them doubly vulnerable.
.
Compared with the US, and to a lesser extent the UK, the eurozone corporate sector remains overdependent on banks for funding. Even after the deleveraging predicted by the IMF, eurozone banks will still be relatively undercapitalised.
.
If the eurozone economy is not now to be stricken by hypothermia, someone will have to offset the contractionary effect of bank deleveraging. As far as fiscal policy is concerned, the governments of northern Europe certainly will not, even if some of them can, while those of southern Europe cannot.
.
.
So the mantle will fall once again on the central bankers. Yet the suspicion must be unconventional measures will have a dwindling impact. And of course they do little to address the underlying solvency problem. Plus ça change.
.
The writer is an FT columnist
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Copyright The Financial Times Limited 2012
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