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Economics Weekly - Financial and economic crisis getting worse; Weekly economic data preview - Weak economic data justify more policy action

Economics Weekly 8 December 2008


Financial and economic crisis getting worse


A few months ago, the financial markets were in turmoil, but since the collapse of Lehman Brothers in mid September the situation has actually turned much worse. As the Bank of England said in the statement accompanying its decision to cut the Bank rate by 1% to 2% on 4 December, ‘Despite the actions taken to raise bank capital, ease funding and improve liquidity, conditions in money and credit markets remain extremely difficult. The Committee noted that it was unlikely that a normal volume of lending would be restored without further measures.’ Equity markets have fallen more sharply, currency market volatility has increased, government bond yields have fallen on a flight to safety and corporate bond spreads have widened significantly further.


The crisis is worsening despite the sharp increases in government spending and lower interest rates...

The economic situation has also worsened everywhere in the last few months, with recession likely in almost all of the advanced countries in 2009, and certainly in all of the major ones, with a weaker outcome for the rest of the world in consequence. And although the emerging economies as a block are likely to avoid recession in 2009, that is down to continued growth in the large economies of China and India. As a result of weaker growth and falling inflation, central banks have been cutting interest rates aggressively in most economies, so pushing down interbank rates, see chart a. But lending spreads have remained wide, see chart b, and credit markets are worse now than at any time since the crisis first broke over a year ago, see chart c. The question is why have all the stimulus measures have not worked so far, even though official interest rates began to be cut about a year or so ago and are at record lows in many cases and government spending has been increased massively. Unfortunately, the answer appears to lie in the nature of the proximate causes of the current downturn. It is a combination of high price inflation, which is now beaten and is no longer the problem, but also excessive leverage (or excessive borrowing) in some developed economies. This was caused by abundant liquidity and too low interest rates along with other contributory factors but leverage is now reversing after large losses on investments made. This is having devastating consequences for the world economy and appears to be intensifying rather than easing even after the broad range of measures taken by governments and central banks to tackle it.

In the last decade, private sector balance sheets in a range of developed countries have expanded aggressively, including the US, UK, Spain and Australia especially but also many other developed economies. This translated into huge leveraged positions for firms that traded the related complex derivative products that lie at the heart of the present financial crisis. This is illustrated by the gap between the value of the underlying stock of global equities and bonds and the derivatives that have been written off the back of them, though the recent crash means that the underlying assets are now down by about 50%, but so at least are the derivatives.


...the reason is that the size of the derivatives market is out of proportion...

Chart d shows that the total global value of equities was $60.1 trillion at end-2007, and global domestic debt securities were put at $42.8 trillion. Hence, the total global amount of equity and debt thus stood then at roughly $103.5 trillion, see chart d. Compare this to the global value of the over the counter (OTC) derivatives market, see chart e. The notional value of contracts written stood at around $800 trillion at end June 2008, though the gross market value at the end of this period was 'only' $23 trillion, see chart f. Just focusing on equity linked, interest rate, and FX derived products and credit default swaps still yields a figure of $15.9 trillion. These are not the net figures - we do not know for sure what those are in these types of markets - but they are a guide to the extent of the pace of growth of exposure and leverage over the last few years in these new markets. In chart g, the extent of the rise is also shown – almost from a standing start in 2001, these have risen sharply in percentage terms. any solution to the current crisis involves restarting the asset backed securities market

This widening mismatch between derivatives and the real economy has led to disastrous consequences. The engineering of ever more complex products to trade in the global financial system in place of the underlying assets has turned even good risks into bad because of the massive leverage that has occurred with those derivatives and the lack of transparency around their structures. The credit crisis effectively started when rising defaults on US sub prime mortgages led to a global fall in the value of all asset backed securities (ABS), and that in turn hit collateralised debt obligations (CDO) that are also bundles of ABS. Confidence is unlikely to return to credit markets until these securities are traded and suspicion is allayed about the solvency of holders of any large quantity of them. So what is to be done? The Paulson plan was initially designed to start a trade in ABS, and in particular mortgage-backed securities, so that they could be properly valued and ultimately traded (i.e. taken off balance sheets for some), so reduce suspicion and return confidence to the credit markets. This plan has now been abandoned as too complex to work and was badly thought through but still needs to be resurrected in a form that will work. A proper trade in mortgage backed CDOs seems required so that confidence about ABS improves. However, that seems unlikely until the new administration takes power in the US on 20 January next year. Until then, and barring a surprise move, this crisis in credit markets seems likely to rumble on, unnecessarily worsening economic prospects in the interim.

Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview W/c 8 December 2008

Weak economic data justify more policy action

The Bank of Canada and the Swiss National Bank are both expected to cut rates by 50bp to 1.75% and to 0.5%, respectively. In addition, financial markets will be digesting last week's rate cuts and alert to scheduled speeches and comments by policy makers, including President Trichet's testimony to the European Parliament today, that will give official views on the health of their economies and their likely policy reaction to it. Given that economic news is almost universally bad and that CPI inflation is falling sharply we are of no doubt that there will be more monetary easing, including interest rate cuts to come, with a real possibility of US, UK and Eurozone rates falling to and staying at the zero to 1% level in 2009. Data releases for November/December will bring more very depressing news. This week, in the UK, official house prices, BRC retail sales and manufacturing growth figures are likely to show little positive effect neither from recent interest rate cuts nor from the UK government's £20bn fiscal stimulus. But arguably, without these policy responses, the situation may well have been even worse. Advance retail sales and the preliminary University of Michigan confidence survey for December will highlight weakness in the US consumer sector, while significant falls in German industrial orders reported last week, point to a considerable downside risk for December's key German ZEW economic sentiment survey.


UK data releases will give an indication of inflation, consumer spending & industrial activity, as well as housing market trends. Producer prices released this morning, showed factory gate prices continued to fall sharply in November. The DCLG official house price figure is likely to fall further, confirming weak reports by the Halifax and Nationwide (though not the same levels) as mortgage approvals are running close to record lows and actual mortgage lending is stalling. Likewise, BRC like-for-like retail sales in November will continue their downward trend, despite the fact that official retail sales show that on a rolling 3-month basis sales are flat, not declining. We forecast a 0.6% contraction in industrial output in October, suggesting that for UK manufacturers the benefit of competitive advantage from the weak pound is outweighed by higher intermediate goods import costs and by sharply falling demand in major export markets. Hence, news of further sharp drops in raw materials producer prices will bring little comfort to UK manufacturers that are struggling to maintain sales. Economic weakness across the board will be highlighted in the NIESR's rolling 3-month GDP estimate for November. The UK trade deficit in October may have stabilised at -£7.5bn.


The end of the week is heavy on US data. Following Friday's announcement that the US economy lost 533,000 jobs in November the key questions are: will weekly initial jobless claims stay above 500,000, will the contraction in retail sales in November be greater than the 2.8% fall in October and will the University of Michigan confidence survey for December deteriorate below last month's figure of 55.3? All this is probable and will add to the tension ahead of next week's Fed meeting, at which we expect the fed funds rate to be cut from 1% to 0.5%. As in the UK, further declines in US producer prices are expected, but again this will offer only minor offset against US firms' challenge in maintaining sales. The US trade deficit may have declined to -$53.5bn in October from -$56.5bn in September, as oil prices and other commodity prices plunge and the recession deepens.


Depressing eurozone economic data and a sharp fall in CPI inflation to 2.1% in November from 3.2% in October, triggered a 0.75 percentage point cut in eurozone official rates to 2.5% last Thursday - a deeper cut than the 0.5 percentage points that markets had been expecting. This reduction was unprecedented since the ECB's inception in 1999 and is testimony to the worsening outlook for 2009. The German ZEW business survey of economic sentiment improved last month, but the recent spate of weak economic reports, including a second month of sharply lower German factory orders and very weak PMI manufacturing and service surveys point to a weaker ZEW economic sentiment outcome this month.

Nichola James, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.



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