Friday, 21 November 2008
Vicious Circle in the Markets
Markets are spooked by three Ds: deleveraging, deflation and depression, feeding into one another in a potentially vicious manner. With banks facing strain again, governments must rapidly complete existing recapitalization plans and probably take further steps to prevent excessive belt-tightening.
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Vicious Circle in the Markets
Breakingviews.com
20 November 2008
Markets are spooked by three Ds: deleveraging, deflation and depression, feeding into one another in a potentially vicious manner. With banks facing strain again, governments must rapidly complete existing recapitalization plans and probably take further steps to prevent excessive belt-tightening.
The most recent downward lurch in the markets has been driven by news of deflation in the United States and fears that the main industrialized economies could face a depression more severe than initially expected. Worries have also resurfaced about the banks. Citigroup’s shares dived 23 percent on Wednesday, while spreads on bank credit-default swaps - which measure the market’s view of the likelihood of going bust - have started to rise again.
An important component in this story is deleveraging. Unfortunately, so much debt was built up in the good times that the deleveraging story has a long way to go. From 1983 to 2007, the ratio of private credit to gross domestic product in the Group of 7 plus China rose from 92 percent to 155 percent, according to a Nomura Securities calculation.
There are two main feedback loops between deleveraging and a depression. First, as banks cut lending, the prices of assets that have been financed by borrowing fall. The fall in asset prices then hits banks’ balance sheets - both because the banks own many of these assets themselves, and because some of their loans have gone sour.
As banks’ balance sheets get hit, they then cut their lending further. This deleveraging is not just affecting the speculative borrowing. As loans to companies are called and credit is withheld, the recessionary contraction mounts.
Second, as the downturn gets more severe, banks will be hit by more losses. This next wave of recession-induced losses could reach €475 billion, or $600 billion, for European banks alone over the next four years, according to Nomura. U.S. banks could lose even more, since house prices there have not stopped falling and the overall level of consumer debt is higher.
Again, as banks stare into this recessionary abyss, they are becoming more cautious in their lending, adding a further twist to the deflationary ratchet.
The governments’ plans last month to inject capital into the banks did help stem the panic in the banking industry.
But they have not done much to stop the cycle of deleveraging. Part of the problem is that both banks and markets have come to the view that the extra capital is there just to fill holes in balance sheets - rather than to keep the lending spigot open.
Another problem is that in many cases, the governments’ plans are just plans. Much of the money has not yet been deployed.
In the United States, for example, the Treasury secretary, Henry Paulson Jr., has pretty much put a pause on new capital injections after his first series of bailouts. Meanwhile, in continental Europe, the recapitalizations have so far been slow and patchy.
Governments should get moving and pump the required capital into the banks now. They should then examine whether even more is needed to stop deleveraging from devouring the real economy. The answer is probably yes. - Edward Hadas and Hugo Dixon
SOVEREIGN FUND À LA FRANÇAISE
Only two things are clear about President Nicolas Sarkozy’s projected sovereign fund à la française. One, he really wanted it. Two, he doesn’t know what people mean by “sovereign fund” - a portfolio of investments in foreign markets funded from current account surpluses. France has deficits and no money to spare.
What Sarkozy has in mind is a fund to “defend and promote vital economic interests,” as he said in January. In other words, a tool for interventionist policies that would help French companies fend off unwanted foreign bidders.
The fund, which has started up, is as pointless and ill advised as it was in January. In time, it should be able to invest up to €20 billion in French companies. That’s less than 2.5 percent of the market capitalization of the Paris bourse. At the very least, the fund lacks size.
Sarkozy also says the fund could invest in companies that need financing for “innovative projects” or have to “stabilize their capital base for the future.” In plain French, this is a return to the good old days of top-to-bottom meddling.
The fund may play a marginal role, as a deterrent, against some hostile deals. As such, it is sending investors the clear message that they should keep out. Exactly what France needs, with its stock market down 47 percent this year. - Pierre Briançon
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