Interplay between economy and financial crisis intensifies
Tue, Jan 20 2009, 06:06 GMT
by Trevor Williams
As everyone is already well aware, economic data in the UK and elsewhere in the world have taken a turn for the worse in recent weeks. UK industrial production, business surveys, and the volume of UK exports and imports all disappointed. Despite the sharp fall in sterling over the last year, the UK’s volume of goods exports in the three months to November fell by 3.2%, while the volume of imports was down by 6.8%. It is clear from these figures that the recession is not yet easing up, and indeed appears to be worsening. And financial markets remain clogged up as the economic downturn deepens, worsening credit risk for lenders.
Financial markets still in the doldrums...
Chart a shows that although there has been a fall in the VIX volatility index, a measure of equity market risk, it remains higher than at any time since just after the failure of Lehman Brothers on 15 September 2008. Moreover, one measure of credit market risk, the European Itraxx crossover index, although no longer rising and off its peak, is still close to its all time high. Recent figures from the latest Bank of England Credit Conditions Survey (CCS) highlight the unsurprising expectation amongst lenders of further increases in defaults as the economy enters recession, see chart b. This is leading to a toughening of credit conditions for borrowers, see chart c, as lenders reduce credit. The Q4 Bank of England CCS revealed that lenders expect a sharp rise in the default rates on their loans from mortgage borrowers, on unsecured products and on corporate advances.
...leading to a worrying interplay as economic conditions worsen
This outlook in turn might be leading some companies to cut costs even more to try and ensure that they survive the economic downturn. Of course, as companies reduce activity this will slow economic growth further increasing defaults at the macro level, leading to tighter credit conditions hence impacting companies and creating a negative feedback loop. Such a cycle is likely to worsen the economic downturn unless there is sufficient liquidity in the monetary system to help prevent it from happening. This is especially important since the sharp rise in commodity prices and in price inflation last year drove down real earnings for households and real profits for companies. The implication is a squeeze on cash flows and a worsening of economic growth, as consumer and corporate spending is cut back, something that is happening already. This can be thought of as separate from the effects that directly emanate from the problems in financial markets caused by the bursting of the bubble in securities markets. In reality, of course, the two are hard to disentangle and their impact on the real economy is almost indistinguishable.
What do the latest trends suggest for UK credit conditions and the performance of the economy in the next three months?
As noted in charts b and c, a rising expectation of defaults from customers is leading to a tightening of credit conditions, including credit availability and spreads. There is beginning to be a closer correlation between the results of the Bank of England’s Credit Conditions Survey and the worsening trend of some key sectors of the UK.
We have looked at some of these linkages in the following charts. A reduction in the availability of credit for household unsecured lending (credit cards etc) did not prevent continued annual growth in loans accelerating from under 6% in June 2007 to a peak of just under 7% in June 2008. However, loan growth to this sector started to slow by the June 2008 CCS report and this slowdown has become more pronounced in the last few months as credit conditions have tightened further, and unsecured lending is heading below 5% growth at end 2008. Bearing in mind that charts b and c showed that credit conditions are expected to tighten further in the next three months, this trend is likely not only to persist but possibly accelerate. The same pattern is evident in growth for mortgage-related loans and credit intentions by lenders to the sector. Chart e shows clearly the implied relationship between a reduction in credit for mortgages and the rapid slowdown in mortgage growth. This has slowed from nearly 12% in June 2007 to under 4% growth in November last year as the mortgage market seized up.
Economic conditions are set to get worse before they get better
The decline in the availability of loans to the corporate sector is as sharp as it has been for the household sector. Corporate borrowing growth is weakening fast, see chart f, and this is perhaps one of the factors behind the sharp fall in industrial production. Chart g shows that the fall in the output of UK non-financial firms is nearly 7%, the fastest pace of decline since 1981. All of this is suggesting a bleak outcome for overall economic growth in the months ahead and implies that the worst of the economic downturn may yet be to come. Indeed, one feature of the slowdown so far is that it has been led by a sharp correction in firms’ investment spending. The worry has to be that with the rise in unemployment yet to fully come through, that the downturn in company activity this implies when it does will lead to a sharper cutting back in consumer spending in the months ahead. This suggests that the recession will persist well into 2009 or even into 2010.
