Is credit crunch 2.0 imminent?

Satyajit Das | 12 Dec 2011

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Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk.

 

The global financial crisis was never over. Financial Botox - government spending and cheap, easy money from central banks - covered the deep-seated problems. In financial markets, facts never matter until they do, but there are worrying indications.

 

Fact 1: The European debt crisis has taken a turn for the worse

An inability to diagnose and deal with the problem means the European debt problems may have reached a point of no return. With the problems having spread to Italy (which has 1.9 trillion euros in debt, more than five times Greece's 370 billion euros), the policy options and political will to deal with the issues are limited.

Greece needs to restructure its debt to reduce the amount owed - a euphemism for default. The agreed 50 per cent haircut was a trim, not the required crew cut, leaving Greece with an unsustainable residual debt burden. Inevitably, the Greek write-downs created speculation that Ireland, Portugal and perhaps even Spain and Italy would follow.

An enhanced European Financial Stability Fund (EFSF) was also the cornerstone of efforts to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the contagion. The EFSF's available capacity of 200-250 billion euros is inadequate to fund bailouts, recapitalise banks and avoid contagion. Over the next three years, Spain and Italy will need to find around 1 trillion euros to meet their financing requirements. Italy alone has to find more than 300 billion euros in 2012.

Schemes to enhance the capacity of the EFSF - borrowing for the fund or partial guarantees or seeking Chinese funding - have had lukewarm receptions. More worryingly, the EFSF's attempts to raise money to meet existing commitments have received lacklustre support and faced soaring costs.

The plan's failure to mollify markets has made contagion a reality, with the crisis engulfing Italy and Spain and reinfecting Ireland and Portugal. It even threatens stronger countries like France (at risk of losing its AAA credit rating), Belgium and Germany.

Germany and France are unwilling to increase their commitments. Germany cannot or will not exceed 211 billion euros in guarantees for the bailout already committed - about 7 per cent of its US$3.2 trillion gross domestic product (GDP).

France, also at its limit, has a GDP of about US$2 trillion and its debt to GDP is about 82 per cent. After France assumed the liabilities of the failed Franco-Belgium financier Dexia, ratings agencies have indicated France faces a downgrade.

The European Central Bank (ECB) is not allowed to print money and Germany's Bundesbank opposes debt monetisation. Unless restructuring of the euro, fiscal union and debt monetisation are available, sovereign defaults may be the only option.

 

Fact 2: Problems with banks have re-emerged

The total exposure of the global banking system to Greece, Ireland, Portugal, Spain and Italy is more than US$2 trillion. French and German banks have very large exposures.

If there are defaults, these banks will need capital. As sovereigns are increasingly themselves under pressure, their ability to support the banking system is unclear.

 

Fact 3: Money markets are seizing up

Banks and financial institutions are finding it increasingly difficult to raise funds. Costs have risen sharply.

European banks are heavily reliant on funding from local investors and central banks, including the ECB. The problems are not confined to European financial institutions. Despite limited known direct exposure to European sovereigns and their relatively strong financial positions, Australian banks' credit costs in international money markets have increased sharply.

As a result, businesses are finding finance less readily available and more expensive. Anecdotal evidence suggests businesses are having difficulty financing normal commercial transactions, recalling the credit problems of late 2008 and early 2009.

Fact 4: The broader economic environment is deteriorating

The global economic recovery is stalling. The risk of a recession or minimal growth is significant.

Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. The effects of the excessive credit expansion in China and India are showing up in bank bad debts.

Then there are pernicious feedback loops. Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures boost budget deficits, requiring greater borrowing. Lower growth feeds into greater business failures, increasing bank bad debts, which further tighten lending conditions and lift finance costs.

If markets seize up again, there might not be enough money to bail out every bank and every country that needs rescuing.

Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are at or near zero, restricting the ability to stimulate the economy by cutting interest rates. Unconventional monetary strategies - namely printing money or quantitative easing - have had limited success.

The global economy may muddle through, but a second credit crunch is now distinctly possible.

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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