We are a long way from recession

Jun 24, 2008

THE CREDIT crisis continues to dominate the headlines but the question on the lips of many business people across Buckinghamshire and Bedfordshire is: what impact is the credit crisis having on the local economy and what will this mean for my business?

This question can be examined firstly in terms of the financial market effect and secondly in terms of the impact on the ‘real’ economy. In terms of financial markets, it is clear that yield spreads in the credit market are still wide. Although they have showed some improvement since the worst of the crisis in August 2007, and a record gap last December, they have narrowed since then. But the truth is that they are unlikely to return to pre-August 2007 levels, as those represented a time of chronic under-pricing of the ‘riskiness’ of these financial instruments.

Generally, global equity markets, including the UK, have shown some recovery since the 2008 low in March though are generally below their pre-August 2007 peaks levels. But financial markets remain fragile and susceptible to adverse news.

Similarly, volatility in credit markets is still marked and this could persist through 2008 and into 2009. The reason is that, at the time of writing, not all of the bad news about potential losses and positions in more complex securities has been released and so credit markets will remain open to further shocks as new information emerges. Effectively, there is little or no market in derivatives instruments, like Collateralised Debt Obligations (CDOs) or Collateralised Loan obligations (CLOs).

As a result of a continuation of market dislocation in credit instruments, surveys by central banks in the US, UK and Eurozone all show that banks are tightening credit standards or planning to, which will raise borrowing costs and lower the supply of credit. In the UK, the planned tightening of credit standards is relatively mild for credit cards but more severe for mortgage and corporate loans.

Most agree that the credit crisis is probably coming through most strongly in the residential mortgage area, where many mortgages have been withdrawn. Specialist mortgage lenders can no longer get access to cheap credit in wholesale markets and then sell on the risk from loans created through securitisations. As yet, however, there seems to be little direct impact on economic growth, as volume retail sales growth, for instance, was up by 4.2% in the year to April.

So what does all of this mean for the ‘real’ economy? The fear is that the credit crisis will impact because of the importance of the financial sector in generating economic growth and as higher borrowing costs are passed on to households and companies. That would lead them to borrow and spend less and so weaken overall economic growth.

If that is the logic, then there some signs that this is happening, with the economy slowing to a 0.4% quarterly pace of growth in Q1 2008 from a 0.6% pace in Q4 2007, but this is a long way from recession. Further, some of this slowdown must be related to the effects of earlier increases in interest rates than specifically to the credit crisis.

Evidence suggests that consumer confidence has fallen back sharply since August, but still not to levels associated with recession or falling output. Economic growth in the UK was 0.4% in Q1 2008, up 2.5% on the same period of the year before. Growth was up more modestly in the US, which is at the epicentre of the crisis, at 0.9% annualised in Q1 but was up by 0.8% in the eurozone in Q1, 2.2% higher than in the same period of 2007.

Although we have a slowing trend for UK economic growth in Q1 2008, surveys of company activity and data for actual output suggest that activity will be sideways in the next three months – they do not suggest that a recession type contraction is on the way.

The Bank of England cut interest rates by 0.25% in December, February and April, citing signs of weaker growth and high interbank rates. But they have held rates at 5% since then, increasingly worried about the inflation risk from high oil prices, rising food prices, and an enhanced ability by companies to pass on increases in their costs to their customers.

In summary, it is not clear what the final outcome of the credit crisis will be on the real economy outside of the US. So far, evidence suggests that the impact for the UK is quite mild. The South East remains a successful area for business and Milton Keynes’s close links, both geographically and economically, with London, stand it in good stead. One example is the rate of claimant count unemployment, which stood in May at 1.5% for the South East and 2.7% for London, compared with 2.3% for Milton Keynes. This is against the national unemployment rate average of 2.5%. Hence, the South East area effectively has full employment.

In the last few years, the emerging markets have been providing the majority of the impetus to global growth and this may mitigate the wider impact of a credit induced economic slowdown in the major economies. Although the effect of the credit crisis on the emerging market economies directly or indirectly so far has been insignificant, it is possible to see how it could impact more severely. Therefore, until the full extent of the credit crisis is known and absorbed, it will remain a downside threat to economic growth. But it is doubtful whether this will be enough to lead the Bank of England to cut interest rates in the UK as it is very worried about inflation.

Trevor Williams is chief economist for Lloyds TSB Corporate Markets and is a member of the Institute for Economic Affairs Shadow Monetary Policy Committee.

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