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, â€˜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.â€™ 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
...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 â€“ almost
from a standing start in 2001, these have risen sharply in percentage terms.
...so 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
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 Â£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
â€¢ 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 -Â£7.5bn.
â€¢ 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.
â€¢ 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.
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