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Economic Research – Flash Report
20 April 2010
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. On Friday, however, the Goldman Sachs news and fresh doubts about the strength of the economy sent the stock market lower. On the policy front, Fed chairman Ben Bernanke testified before the US Congress. He noted that 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. While the general tone of the report pointed to a modest recovery, many districts were characterized by a mixture of strong and weak data. In some districts, even the report’s authors seemed unable to determine whether the economy was advancing or retreating. In my view, this suggests 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 compared with the market’s strong expectations for recovery. He began by saying that the 5.6% GDP growth reported in 2009 Q4 (q-q annualized) was a sign that the inventory adjustment that followed 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 temporary phenomenon 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 chairman specifically pointed out this possibility in his testimony. Mr. Bernanke also argued that the economy has been supported by demand from a very large fiscal stimulus, but that private demand will become more important as the stimulus winds down between now and end-2010. In a sense, this was a warning that we should not expect the existing 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 a half devoted to positive economic news, while most of the remaining 5 1/2 pages deal with potential risks and appropriate responses. I think Mr. Bernanke is being careful not to take too optimistic a view of the current situation. While noting that the jobs situation is finally improving, for example, the Fed chairman expressed serious concerns about the fact that, as of March, a record 44% of the unemployed had been without jobs for more than six months. Historically, people unemployed for more than six months experience a significant deterioration of 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 both individuals and businesses is falling loan demand, which he attributed to the weak economy and to the fact that many borrowers are in such a poor financial position that they are no longer able to borrow. I was hoping to see a more direct acknowledgement that soft loan demand was attributable to impaired 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 in corporate loan demand. Although the scale of the decline has eased compared to before, survey respondents still indicated that demand for commercial and industrial loans had weakened over the past three months (Exhibit 1).
20 April 2010
(issued in Japanese on 19 Apr 2010)
Chief economist Nomura Research Institute, Tokyo Nomura research sites: www.nomura.com/research Bloomberg: NMR
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20 April 2010
Exhibit 1. US corporate loan demand falls sharply
(D.I.) 30 20 10 0 -10 -20 -30 -40 -50 99 00 01 02 03 Large and middle-market f irms Business increasing demand f or f unds compared to 3 months ago 0 Business decreasing demand f or f unds compared to 3 months ago 04 05 06 07 08 09 IT bubble collapse Small f irms Housing bubble collapse
Note: D.I. are calculated from the answers to the question, "Apart from normal seasonal variation, how has demand for C&I loans changed over the past three months?" D.I. = ("Substantially stronger" + "Moderately stronger" × 0.5) - ("Moderately weaker" × 0.5 + "Substantially weaker") 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 US economy cannot be fixed with monetary policy alone. If an inadequate supply of funds is hindering 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 privatesector 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 Fed chairman said that large budget deficits would be unavoidable in the short term, I believe he could 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 supply problems—ie, the credit crunch. The Fed chairman understands that an exclusive focus by bank examiners on uncovering bad loans could leave banks reluctant to lend, thereby sparking a “bank inspector recession” and delaying the recovery. To prevent this scenario, Mr. Bernanke says he has instructed Fed bank inspectors 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 as quickly as possible. This is the correct approach when there are only a handful of distressed lenders. But during a systemic crisis, when many banks face the same problems, forcing lenders to rush ahead with bad loan disposals (ie, sales) can trigger a further decline in asset prices, 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 crunch prevention 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 Koizumi administration, did not understand this point. At a time when the majority of Japanese banks faced the same problems, he forced lenders to rush ahead with bad loan disposals, triggering a steep fall in asset prices (and particularly in stock prices) that aggravated the credit crunch and
Nomura Research 2
20 April 2010
dealt a heavy blow to the economy. This sequence of events was dubbed the “Takenaka shock.” These events substantially delayed the recovery for an economy already in the midst of a severe balance sheet recession. For the past two years, Japan’s Financial Services Agency has focused its efforts on averting a credit crunch rather than trying to flush out bad loans. Nonetheless, banks that lived through the Takenaka shock remain reluctant to lend, fearing that a change of administrators at the FSA could 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 made public a list of items bank examiners are to focus on, but is also retraining its examiners in a bid to keep them on the right track. Roughly 1,000 inspectors have already completed the retraining. Among other things, the retraining program teaches examiners how to modify loans to troubled borrowers 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 its priorities as an inspection authority have changed. I think a similar program for Japanese inspectors under financial services minister Shizuka Kamei might potentially ease the current distrust 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 and trying to build a close cooperative relationship with the National Federation of Independent Business (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 lend as seen by the borrowers found in the Bank of Japan’s Tankan survey. Without input from borrowers, the Fed tended to administer policy based solely on the views of lenders—ie, the financial sector.
20 April 2010
Exhibit 2. Small businesses continue to face severe credit crunch in US
Availability of loans Net Percent (“Easier” Minus “Harder”) Compared to Three Months Ago 2 0 -2 -4 -6 -8 -10 -12 -14 -16 -18 96 97 98 99 00 01 02 03 04 05 06 07 08 09 0 Harder than three months ago (CY) 10 Easier than three months ago
Source: NFIB Research Foundation, Small Business Economic Trends
Like the Bank of Japan, the NFIB has been asking borrowers for their views on banks’ willingness to lend for many years. Its findings are summarized in Exhibit 2. The relevant question asks businesses whether they find it easier or harder to obtain bank loans than they did three months ago. Recent numbers are deep in negative territory, indicating that banks are much more reluctant to lend than they were three months ago. This suggests that the credit crunch is not over and in fact is growing worse. * Yet lenders say they are no longer tightening credit standards The NFIB data are important because the Fed’s Senior Loan Officer Opinion Survey, which asks bank officers whether they have tightened or relaxed lending standards in the last three months, suggests that banks have not tightened their standards (Exhibit 3). Although US banks tightened credit standards substantially in the wake of Lehman’s failure, this index has recently returned to around zero, meaning that lending criteria have not changed over the past three months.
20 April 2010
Exhibit 3. US banks have finally stopped tightening credit standards
(D.I.) 60 50 40 30 20 10 0 -10 -20 99 00 01 02 Small f irms IT bubble collapse
More banks tightening credit standards compared to 3 months ago 0 More banks easing credit standards compared to 3 months ago Large and middle-market f irms Housing bubble collapse
(CY) 03 04 05 06 07 08 09 10
Note: D.I. are calculated from the answers to the question, "Over the past three months, how have your bank's credit standards for approving applications for C&I loans or credit lines changed?" D.I. = ("Tightened considerably" + "Tightened somewhat" × 0.5) - ("Eased somewhat" × 0.5 + "Eased considerably") Source: Nomura Research Institute, based on FRB, Senior Loan Officer Opinion Survey on Bank Lending Practices
The borrower- and lender-side data would therefore appear to contradict each other: borrowers are saying credit standards have become much tighter over the last three months, while banks insist they have not. Of course both may be right. If borrowers’ financial positions had deteriorated substantially, for example, credit standards—viewed from a borrower’s perspective—would appear to have tightened over the past three months even if banks had not changed their lending policies. If that is indeed the case, it would mean that problems are increasingly attributable to borrowerside issues, which the Fed is powerless to address. * Bernanke has awakened to limitations of monetary policy The fact that the Fed is now listening to borrowers as well as lenders represents major progress, in my view. Formulating the correct policy response requires an understanding of the views of agents on both sides. And recognizing the limitations of monetary policy requires an understanding of conditions at borrowers in particular. During his tenure as an academic and as Fed governor, Mr. Bernanke leaned towards the view that monetary policy was all-powerful. Only six months ago, for example, the Fed chairman was urging the government to move quickly to reduce the fiscal deficit and was arguing that further monetary accommodation would be able to offset any resulting impact on the economy. But while problems on the lender’s side can be addressed using monetary policy, problems on the borrower’s side mean that the transmission mechanisms for monetary policy are broken and that any economic weakness resulting from deficit-reduction efforts cannot be offset by easing monetary policy. The more Mr. Bernanke becomes aware of problems on the borrower’s side, the more he will come to understand the limitations of monetary policy and the need for fiscal policy. Recently, the Fed chairman has actually stopped talking about using monetary policy to offset the negative impact of fiscal consolidation efforts. When neither lenders nor borrowers are responsive to monetary accommodation, there is also little risk of inflation no matter how much liquidity the central bank supplies, and Mr. Bernanke testified that there is no short-term inflation risk.
20 April 2010
* Bad loan disposals must be carried out slowly The Fed’s efforts to retrain bank inspectors in an attempt to sustain lending is a welcome change, because it signifies that the US monetary authorities have finally recognized that the only appropriate response during a systemic crisis is to write off bad loans gradually, as Japan did. When large numbers of banks face the same problems, forcing them to mark their assets to market or to carry out quick disposals of nonperforming loans can cause the situation to spiral out of control, as happened during Japan’s Takenaka shock in 2002–04. If US authorities were to require banks to mark their commercial real estate loans to market today, lending to this sector would be extinguished, triggering a chain of bankruptcies as borrowers became unable to roll over their debt. * Wal-Mart sales strategy reflects reduced purchasing power of US consumer Rising retail sales are often cited as evidence of the US recovery. However, outstanding consumer credit in the US contracted another $11.5 billion in February, marking the twelfth decline in 13 months and demonstrating that the household sector is still undertaking balance sheet adjustments. A robust recovery in consumer spending is unlikely as long as credit continues to shrink. Retail leader Wal-Mart announced on 9 April that it would lower the prices on 10,000 of its products in response to a Q1 decline in US store sales, calling into question the oft-heard argument that retail sales are strong. The chain also said it plans to cut more prices in the future. There are two possible causes for the drop in sales at Wal-Mart. One is that incomes have risen, causing consumption to shift from the chain’s inexpensive offerings to higher-end products. The other is that the weak economy has caused a further reduction in consumers’ purchasing power. That Wal-Mart is addressing the drop in sales with further price cuts suggests that the company’s executives believe the latter scenario is the more likely. If they attributed the drop in sales to rising incomes, they would instead have announced a shift in their product mix to higher-quality, higher-priced items. * Beige Book also takes cautious outlook on economy The Fed’s Beige Book survey of regional economic conditions, released last week, began by noting that the economy had improved in all 12 districts except St. Louis. A closer look at the contents of the report, however, presents a starker picture in a number of districts. For example, a number of districts reported that banks have tightened lending standards, confirming the findings of the NFIB survey noted above. Many districts also said that it was difficult or impossible to obtain financing for commercial or residential real estate projects. A number of districts reported a decline in private-sector loan demand, and many said there were fewer creditworthy borrowers. In the housing market, many districts reported that sales of low-priced houses had increased ahead of the April deadline for receiving government subsidies. But sales of more expensive homes were weak across the country, with several districts actually reporting lower prices. There are also concerns that the market will come under renewed pressure once the government subsidies end, and it was pointed out that such concerns are making lenders more cautious. Many districts reported further deterioration in the commercial real estate market, with rents falling and vacancy rates rising. In Minnesota, for example, it was reported that commercial rents are at their lowest levels in twenty years. Many also said they expected to see a high volume of defaults going forward.
20 April 2010
* Even Beige Book authors unsure about direction of US economy At the top of this report I said that even the authors of the Beige Book survey are uncertain about the direction of the US economy. A close reading of the Fed report revealed a number of sentences that were difficult to understand. For example, the section on the San Francisco district, which has the largest economy of the 12 areas covered by the survey, contained the following comments: “Sales of retail items continued to improve but remained somewhat sluggish on net.” “Demand for services remained lackluster overall but showed further signs of improvement on balance.” It is difficult to understand what the authors intended to say with these comments, and similar examples can be found in the sections for other districts. In short, although the St. Louis district was the only area characterized by “softened” economic conditions, most other districts reported only a gradual pace of recovery, with some—like San Francisco—suggesting that the recovery was patchy. * Discontinuation of fiscal stimulus could trigger another slump The impact of the Obama administration’s $787 billion fiscal stimulus, unveiled last February, is now peaking. That reported improvements in economic conditions are still so modest naturally leads to concerns about what will happen when the stimulus winds down. The stimulus is scheduled to have its greatest impact in Q2 and Q3 this year, so I do not expect the economy to lurch backwards in the near future. Nevertheless, the economy could stall again once the stimulus ends unless private demand picks up in the next few months. The economy may rapidly improve in the coming months. However, the fact that the Fed is retraining bank inspectors in an effort to address the credit crunch suggests that central bank officials do not see the recovery as having firm underpinnings. * Conditions at eurozone lenders and borrowers quite similar The tightening credit standards and decline in private-sector loan demand observed in the US are also evident in the eurozone, where conditions are similar. Private-sector loan demand continues to decline despite historically low euro interest rates (Exhibit 4), and banks have only just stopped tightening credit standards (Exhibit 5). This means financial sectors on both sides of the Atlantic are undergoing the same process, which suggests that any recovery in the eurozone is also likely to be gradual at best. Notably, the eurozone unemployment rate has resumed rising and now stands at 10.0%, even higher than the 9.7% rate reported in the US.
20 April 2010
Exhibit 4. Corporate loan demand in eurozone falls sharply
(D.I.) 15 10 5 0 -5 -10 -15 -20 -25 03
Small and medium sized f irms
Business increasing demand f or f unds compared to 3 months ago 0 Business decreasing demand f or f unds compared to 3 months ago 04 05 06 07 08 09 Large sized f irms
Note: D.I. are calculated from the answers to the question, "Over the past three months, how has the demand for loans or credit lines to enterprises changed at your bank, apart from normal seasonal fluctuations?" D.I. = ("Increased considerably" + "Increased somewhat" × 0.5) - ("Decreased somewhat" × 0.5 + "Decreased considerably") Source: Nomura Research Institute, based on ECB, The Euro Area Bank Lending Survey
Exhibit 5. Eurozone banks have finally stopped tightening credit standards
(D.I.) 50 40 30 20 10 0 -10 -20 03 04 05 06 07 08 09 Small and medium-sized f irms (CY) 10 More banks tightening credit standards compared to 3 months ago 0 More banks easing credit standards compared to 3 months ago
Large sized f irms
Note: D.I. are calculated from the answers to the question, "Over the past three months, how have your bank's credit standards as applied to the approval of loans or credit lines to enterprises changed?" D.I. = ("Tightened considerably" + "Tightened somewhat" × 0.5) - ("Eased somewhat" × 0.5 + "Eased considerably") Source: Nomura Research Institute, based on ECB, The Euro Area Bank Lending Survey
* Economies’ fate depends on whether governments try to reduce deficits The recent problems in Greece have helped focus attention in the eurozone on the supposed need for deficit-reduction efforts. This comes at a time when the region’s fiscal stimulus already consists mostly of automatic stabilizers rather than pro-active spending. To cut government spending at this juncture would further reduce the pro-active portion of fiscal outlays and postpone the recovery.
20 April 2010
In the UK, both the Labour Party and the Conservative Party have laid out deficit-reduction plans ahead of the 6 May elections while the private sector continues to deleverage by paying down debt. The implication in my view is that even if the economies of the US, UK, and the eurozone survive fiscal cutbacks, the eventual recoveries will be modest at best. And if the spending cuts are too severe, the economies are likely to stall once again. Japan and other Asian countries that remain heavily reliant on exports to the US and Europe therefore need to closely monitor political debate on fiscal consolidation in these countries. US consumer credit continues to contract, and British households and businesses are paying down debt. Those of us in Japan, which unsuccessfully attempted to reduce its budget deficit under similar conditions in 1997 and 2001, are perhaps best positioned to warn people in the US and UK what will happen if the governments of these countries embark on fiscal consolidation efforts.
Richard Koo’s next article is scheduled for release in the week commencing 26 April.
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