Nearterm prospects for the UK economy remain grim and it will be a long route back to sustainable economic prosperity, according to an analysis by Citigroup.
The UK government announced a range of measures aimed at improving credit supply. There are seven main elements says the Citi analysis:
1. Extend debt guarantee scheme for banks. The Government’s Credit Guarantee Scheme (CGS) set up last October, aimed to guarantee up to £250bn of new bank debt, and was due to close in April. It will now be extended to December. There is no change to the fee structure for banks using the scheme.
2. New government guarantee facility for asset-backed securities, to start in April 2009 (subject to EU approval), with full or partial government guarantees attached to eligible triple-A rated asset-backed securities, including mortgages and corporate and consumer debt. So this takes the Crosby proposals – which recommended guarantees for mortgage-backed securities – and extends it across mortgages, corporate and consumer debt. This seeks to overcome BoE Governor Mervyn King’s objection that the state should not uniquely guarantee mortgage debt by extending the guarantee across other forms of loans.
3. Long-term liquidity for banks. Extend the maturity date for the Bank of England’s Discount Window Facility from 30 days to 1 year, allowing banks to swap less liquid assets for gilts or cash. The existing Special Liquidity Scheme (SLS) will, as planned, close to new loans on 31 January. In its place, the DWF will be extended to provide long-term liquidity. The DWF accepts a broad range of collateral, including G10 sovereigns, US agency debt, higher grade corporate and mortgage-backed securities, commercial paper and UK state-guaranteed bank debt. Securities may be denominated in sterling, euro, US dollars, Australian dollars, Canadian dollars, Swedish krona or Swiss francs or, in the case of Japanese government bonds only, yen.
4. Partial indemnities for banks against further losses. Banks will be able to buy insurance from the government against losses on specified assets, with banks bearing roughly the first 10% of losses and the Treasury selling insurance against about 90% of the institutions' additional losses. A figure of £200bn for assets to be covered has been floated in the press, but it is unclear if this figure comes from the UK Treasury or not. So, rather than isolate “impaired” assets into a “bad bank” these plans seek to leave the assets on banks’ balance sheets but to limit banks’ exposure to further possible losses. There are few details available. The Treasury simply say that the “Government will make a further statement on the details of the scheme by the end of February”. There are suggestions that banks will be able to pay for such indemnities with shares, hence giving governments an additional equity stake in banks.
5. A new BoE facility to purchase high quality assets. Initially, this is a scheme to allow the BoE to buy up to £50bn of private sector securities, including corporate bonds, commercial paper, syndicated loans and a limited range of asset backed securities, financed by the issue of Treasury bills and with the BoE indemnified against possible losses. In theory, such purchases could help improve market liquidity. It is unclear if these purchases would be at market price, at a discount or a premium. But, in addition, this facility offers the MPC a vehicle through which they can implement Quantitative Easing (QE) if they so choose. The BoE Act (1998) appeared to give the MPC authority to implement QE. But, the authority to use QE was not explicit. The BoE Act also did not specify the institutional arrangements through which QE could happen, and nor did it specify that the Treasury would underwrite the BoE against possible losses – and, of course, the MPC could not afford to authorise the BoE to implement QE without such protection. So this announcement confirms the MPC has the authority to implement QE, and establishes the framework by which it can happen. If QE were to happen, the scale (up to £50bn) could be expanded and the financing of the scheme (initially through treasury bills) can be changed.
6. The government is trying to dispel worries that the FSA wants banks to hold extra capital. In last October’s bank rescue package, the FSA used a 8% Tier 1 capital ratio as a guide whether banks had enough of a buffer to have a satisfactory minimum of 4% Tier 1 capital in bad times. This has led to suggestions that the FSA regard 8% Tier 1 capital as the new minimum. The FSA are attempting to say this is not the case, that 4% is still the minimum. This effort by the FSA is not particularly successful in our view, because (a) it is clear that international capital ratios will be revised, and likely that ratios will be made more contra-cyclical, requiring banks to hold above-average capital during upturns; (b) last October’s experience makes it clear that – even if banks meet stated capital adequacy rules — the government can decide at any point to order banks to get extra capital, with the risk for banks that such extra capital might be obtained at very high cost, if it can be obtained at all. The FSA do not say that banks have enough capital, and – with banks reporting major losses — it will not be surprising if banks continue to seek to protect and, if possible raise, their capital levels.
7. The government is seeking to reverse the drop in credit supply from nationalised banks. The government will swap up to £5bn of preference shares (which have a 12% coupon) in the big state-owned bank for ordinary shares, aiming to remove pressure on the bank to pay high interest payments. In addition, the government will no longer seek to shrink the loan book of Northern Rock, the mortgage bank it nationalised last year, although any plans to offer low-cost mortgages and expand NB’s loan book would need EU approval.
This is a major and wide-ranging package. Citi analysts make several points.
First, these measures are aimed at the key issue, which is to seek to improve credit supply. The rescue package of last October was aimed at preventing the major UK banks from closing. It succeeded reasonably well in that narrow aim, but was not designed to encourage banks to lend – and, unsurprisingly, credit supply has continued to shrink. These measures have a broader and more ambitious aim of encouraging banks to lend more freely and improving credit supply across the economy. As US Fed Chairman Bernanke recently argued, “credit easing” is the key priority. And, measures to improve credit supply do not need to wait until policy rates hit zero. Governments and central banks can act already.
Second, government debt funding policy does not seem to be a priority for the UK government. Some have suggested that the government should sell fewer gilts, and seek to fund itself via treasury bills or bank loans. The aim is to either lower gilt yields or boost private sector liquidity. Such measures are not really the main focus, which is on credit rather than liquidity. To be sure, corporate liquidity is deteriorating rapidly in the UK, but this has become a crisis chiefly because of a lack of credit supply. And in any case, changes to gilt funding policy would affect mainly the liquidity of institutional investors rather than the corporate sector.
Third, these measures continue the recent pattern of country-by-country rescue packages rather than internationally coordinated measures. The UK government is fond of stressing the need for international cooperation in resolving the economic and financial crisis, but that language seems aimed more at talking up the importance of the G20 summit to be held in the UK in April, rather than a guiding principle for the measures that are announced. To be sure, several of the measures announced by the UK government will need international input (e.g. EU approval over state aid, Basle capital ratios). But, the UK government has announced the outlines of its measures without waiting to get clarification over state aid rules and without seeking to get other governments to adopt similar measures. Of course, governments are talking to each other over possible rescue packages, and learning from each others “successes” and failures (e.g. in last autumn’s rescue packages, most other governments offered their banks capital on cheaper terms than the UK did). And, given the global nature of the crisis, part of the route to recovery depends on the actions of other governments and central banks and is out of the UK hands. But, the main approach for crisis resolution is proceeding on a country-by-country approach.
Fourth, it is unclear if these measures will be sufficiently large and far-reaching to significantly improve credit supply. This is partly because the scale and terms of some measures are unclear at this stage. It also reflects the huge scale of the problem. The UK has had a massive debt-fuelled boom in spending and asset prices over recent years, and this has left a legacy of overextended banks, overstretched and falling house prices, very low household savings, with high debt levels, high debt service and high debt refinancing needs among households and businesses. The boom was truly massive, leaving private debt/GDP ratios at record highs. The illusion of eternal prosperity and ever-rising asset values, which supported the previous debt bubble, has been burst and cannot be quickly recreated. Banks are losing fortunes, and a severe recession, with widespread job losses and business failures, is underway, both in the UK and externally. Moreover, the full scale of the recession remains unclear. Under these conditions, it is no surprise that well-managed banks are cautious about making new loans. Even these measures may still leave banks cautious.
Fifth, it may well be unclear in coming months if these measures are really working or not. For last October’s package, the test of success was relatively clear: would the banks close? For these measures, it may be a far more nebulous mix of credit spreads, surveys and anecdotal evidence of credit availability, asset prices and so forth. Conditions may remain unclear for a while.
Sixth, even if credit supply does improve significantly, it is too late to prevent a severe recession. Households and businesses are likely to retrench further to rebuild their balance sheets after the boom-bust cycle of recent years. To be sure, restoration of normal credit supply is probably a crucial and necessary step on the route to economic recovery, but even if credit is normal, spending in the economy will be weak for a while.
Seventh, the government has set up a framework for the MPC to introduce QE if they desire. This does not mean that QE will definitely happen, but does allow the MPC to move fairly quickly to QE if they want to. We expect to hear more on the possible role of QE from the BoE Governor in his speech Tuesday evening, and – whether or not the MPC actually introduce QE — it is likely to be on the MPC’s agenda for the February meeting. But, whether or not the classic forms of “quantitative easing” (central bank purchases of government debt, expansion of banking system reserves) are introduced, government-led “credit easing” is underway.
And, eighth, if and when the continued expansion of government into the economy does succeed in helping the economy recover, there will be a major challenge in unravelling these schemes without further destabilising the economy. If they are reversed too fast, renewed recession might be a risk: too slow, and, with ultra low policy rates as well, we will get a new credit boom, risks of sharply higher inflation and major distortions in the allocation of resources across the economy. This will be genuinely difficult, and – given that many of these measures are under the control of government not an independent central bank — may be further complicated by political pressures. Moreover, it is not clear if we have yet seen the full social and political price that will exacted from banks and companies in return for emergency assistance for this crisis, and to what extent the new economy that eventually emerges will be dictated by state control.
