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Nomura: Koo - Whither the Patchy US Recovery?

Nomura: Koo - Whither the Patchy US Recovery?

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Published by Edward Harrison
Richard Koo's take on recovery chances in the U.S. in April 2010. Summation: The Fed will be on Easy Street for some time to come but monetary policy has limits. Fiscal cutbacks loom though and that spells trouble.
Richard Koo's take on recovery chances in the U.S. in April 2010. Summation: The Fed will be on Easy Street for some time to come but monetary policy has limits. Fiscal cutbacks loom though and that spells trouble.

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Published by: Edward Harrison on Apr 26, 2010
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20 April 20101 Nomura Research
Richard Koo: a personal view of the macroeconomy
Whither the patchy US recovery?
Last week, US share prices rose on continued expectations of an economic recovery. OnFriday, however, the Goldman Sachs news and fresh doubts about the strength of the economysent the stock market lower.On the policy front, Fed chairman Ben Bernanke testified before the US Congress. He notedthat while the economy was experiencing a gradual rebound, numerous problems remained,including the real estate market and the credit crunch.The Fed also released its
Beige Book 
survey of regional economic conditions last week. Whilethe general tone of the report pointed to a modest recovery, many districts were characterizedby a mixture of strong and weak data. In some districts, even the report’s authors seemedunable to determine whether the economy was advancing or retreating. In my view, thissuggests that the US recovery is still patchy at best.
* Bernanke far more cautious on economy than market participants
Turning first to Mr. Bernanke’s testimony, the Fed chairman adopted a cautious tone comparedwith the market’s strong expectations for recovery. He began by saying that the 5.6% GDPgrowth reported in 2009 Q4 (q-q annualized) was a sign that the inventory adjustment thatfollowed the Lehman crisis had finally ended and that production was once again expanding.However, the flip side of this view is that the recovery in production may be only a temporaryphenomenon that will end once manufacturers complete their inventory buildup. In other words,the economy could stall again unless private final demand picks up. The Fed chairmanspecifically pointed out this possibility in his testimony.Mr. Bernanke also argued that the economy has been supported by demand from a very largefiscal stimulus, but that private demand will become more important as the stimulus winds downbetween now and end-2010. In a sense, this was a warning that we should not expect theexisting demand structure—which is reliant on government spending—to persist.A look at the seven-page manuscript for Mr. Bernanke’s speech shows only the first page and ahalf devoted to positive economic news, while most of the remaining 5 1/2 pages deal withpotential risks and appropriate responses. I think Mr. Bernanke is being careful not to take toooptimistic a view of the current situation.While noting that the jobs situation is finally improving, for example, the Fed chairmanexpressed serious concerns about the fact that, as of March, a record 44% of the unemployedhad been without jobs for more than six months.Historically, people unemployed for more than six months experience a significant deteriorationof vocational skills and face severe difficulties in finding their next job.
* Bernanke has begun to talk about decline in private loan demand
Mr. Bernanke also argued that a key cause of the continued drop in US bank lending to bothindividuals and businesses is falling loan demand, which he attributed to the weak economy andto the fact that many borrowers are in such a poor financial position that they are no longer ableto borrow.I was hoping to see a more direct acknowledgement that soft loan demand was attributable toimpaired private-sector balance sheets. Nonetheless, the Fed’s latest
Senior Loan Officer Opinion Survey 
, referred to by the chairman in his testimony, highlights a continued decline incorporate loan demand. Although the scale of the decline has eased compared to before,survey respondents still indicated that demand for commercial and industrial loans hadweakened over the past three months (Exhibit 1).
Nomura Securities Co Ltd, Tokyo
Economic Research – Flash Report
20 April 2010
(issued in Japanese on 19 Apr 2010)
R. Koo
Chief economistNomura Research Institute, TokyoNomura research sites:www.nomura.com/researchBloomberg: NMR
Please read the importantdisclosures and disclaimerson pages 10–11.
20 April 2010Nomura Research 2
Exhibit 1. US corporate loan demand falls sharply
-50-40-30-20-100102030990001020304050607080910(CY)(D.I.)Small firmsHousing bubble collapseIT bubblecollapse
Business increasing demand for fundscompared to 3 months agoBusiness decreasing demand for funds compared to 3 months ago0Large and middle-market firms
Note: D.I. are calculated from the answers to the question, "Apart from normal seasonal variation, how hasdemand for C&I loans changed over the past three months?"D.I. = ("Substantially stronger" + "Moderately stronger" × 0.5) - ("Moderately weaker" × 0.5 + "Substantiallyweaker")Source: Nomura Research Institute, based on FRB,
Senior Loan Officer Opinion Survey on Bank Lending Practices
Mr. Bernanke’s acknowledgement that loan demand is falling is equivalent to saying that the USeconomy cannot be fixed with monetary policy alone. If an inadequate
of funds ishindering recovery, the authorities can remove the bottleneck by supplying liquidity to or injecting capital into the banks. But there is little that monetary authorities can do when private-sector demand for loans is shrinking despite zero interest rates.This implies that fiscal policy is the only way to support the economy for now. When the Fedchairman said that large budget deficits would be unavoidable in the short term, I believe hecould have inferred that large budget deficits
should not be avoided 
* Fed understands risks of too-rapid bad loan disposals
Mr. Bernanke also emphasized that the Fed is making serious efforts to address credit supplyproblems—ie, the credit crunch.The Fed chairman understands that an exclusive focus by bank examiners on uncovering badloans could leave banks reluctant to lend, thereby sparking a “bank inspector recession” anddelaying the recovery. To prevent this scenario, Mr. Bernanke says he has instructed Fed bankinspectors to ensure that banks are lending to creditworthy borrowers.In ordinary times, the Fed would seek to have banks write off their non-performing loans asquickly as possible. This is the correct approach when there are only a handful of distressedlenders. But during a systemic crisis, when many banks face the same problems, forcinglenders to rush ahead with bad loan disposals (ie, sales) can trigger a further decline in assetprices, creating more bad loans and sending the economy into a tailspin.I think the Fed’s shift in focus from conventional nonperforming loan disposals to credit crunchprevention is an attempt to avoid this scenario.
* Legacy of “Takenaka shock” still haunts Japanese banks
Former Japanese financial services minister Heizo Takenaka, who served in the Koizumiadministration, did not understand this point. At a time when the majority of Japanese banksfaced the same problems, he forced lenders to rush ahead with bad loan disposals, triggering asteep fall in asset prices (and particularly in stock prices) that aggravated the credit crunch and
20 April 20103 Nomura Research
dealt a heavy blow to the economy. This sequence of events was dubbed the “Takenakashock.”These events substantially delayed the recovery for an economy already in the midst of asevere balance sheet recession.For the past two years, Japan’s Financial Services Agency has focused its efforts on averting acredit crunch rather than trying to flush out bad loans. Nonetheless, banks that lived through theTakenaka shock remain reluctant to lend, fearing that a change of administrators at the FSAcould once again lead the regulator to crack down on problem loans.
* Fed retraining bank examiners in bad loan management
Perhaps based on an awareness of Japan’s failures in this area, the US has not only madepublic a list of items bank examiners are to focus on, but is also retraining its examiners in a bidto keep them on the right track. Roughly 1,000 inspectors have already completed theretraining.Among other things, the retraining program teaches examiners how to modify loans to troubledborrowers and how to manage distressed commercial real estate loans. In that sense, it is a far cry from traditional training, which emphasized the quick discovery and disposal of nonperforming loans.With this program, the Fed seeks to make it clear to bank inspectors and banks alike that itspriorities as an inspection authority have changed. I think a similar program for Japaneseinspectors under financial services minister Shizuka Kamei might potentially ease the currentdistrust of banking authorities in Japan.
* From borrower’s perspective, credit crunch is worsening
Amid a severe nationwide credit crunch, the Fed is now actively listening to borrowers andtrying to build a close cooperative relationship with the National Federation of IndependentBusiness (NFIB), a leading small business organization.This is a major, unprecedented change. Traditionally, the Fed paid little attention to the views of borrowers, and as a result there were no data series like the index of banks’ willingness to lendas seen by the borrowers found in the Bank of Japan’s
survey.Without input from borrowers, the Fed tended to administer policy based solely on the views of lenders—ie, the financial sector.

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