22nd February 2009
The Malta Independent on Sunday
Three questions I am
frequently asked are:
Why is international economic news so gloomy that it seems more like a 1930s depression rather than merely a cyclical recession?
How come the domestic economic situation is still ticking in positive territory (at least on basis of data so far available)?
Is it merely a question of time lags and that we will probably feel the pinch in the coming months?
These questions have to be put high on the national agenda and be seriously discussed.
This recession is not merely cyclical. It is more serious than that, though hopefully it will not deteriorate into a full blown 1930s style depression given that today we have that bad experience to guide us and we have more and better economic policy tools to protect us. The difference between this and other cyclical recession is that this time round we do not have a sound banking and financial system to help us get out of the recession through expansive and cheap availability of credit. This time round the banking system itself is in the eye of the storm and it has in fact led other robust economic sectors into this recession. And, given that banking and financial services are one of the most globalised economic sectors, this recession which started with the collapse of the US housing market in the summer of 2007, has become global with astonishing speed.
Credit is the life-blood of economic systems and of international trade. If credit stops flowing throughout the system, domestically as much as internationally, economic contraction becomes inevitable as demand shrinks. Without an adequate supply of fairly priced credit, people cannot buy houses, they cannot buy cars, businesses cannot finance investments and the overall demand in the economy shrinks. For some time producers build up stocks but soon enough their liquidity stress demands that they sell their inventories by reducing prices, cut down on capacity by shutting down facilities leading to unemployment, and cut down costs wherever possible.
Even those consumers who do not lose their job will feel uncertain about the future and will unavoidably tighten their purse strings, spend less and save more even when their overall incomes are falling. So economic contraction enters into a dangerous spiral of falling demand, more unemployment and uncertainty, falling asset prices, leading to yet more reduction in demand and yet another turn in the downward spiral.
The UK economy is contracting sharply, property prices are falling like a rock and the State had to nationalise one smaller bank and take majority or significant stakes in two major banks in order to recapitalise them as they faced insolvency. Iceland has imploded. The Irish economy is horrifying with a burst property bubble and over-exposed banks nationalised to survive. In Spain unemployment is shooting up. Italy’s economy has contracted and even stronghold Germany has entered recession as demand for its exports has forced its manufacturers to cut back production. Eastern Europe is in shambles. Latvia is economy is contracting by some 10 per cent, Ukraine is on the verge of defaulting on its international payments and Russia is running down its international foreign exchange reserves at an astonishing speed as it defends the value of the rouble with market interventions. Swedish and Austrian banks are suffering on their over-exposure to Baltic and East European borrowers. Hungary has had to resort to an IMF bailout. How come in the midst of all this distressing noise our economy, while clearly slowing down, is not yet on the ropes?
The simple answer is that we have so far escaped the immediate impact of the credit crunch because we do not borrow on the international markets and have a very liquid economy with all bank loans mainly domestically focused and fully financed by domestic retail deposits without currency mismatches. The drop in domestic demand and the near freezing of the property market is being cushioned by sharply reduced interest costs. Borrowers in other countries are not benefiting from such interest rate reductions because with banks strapped for liquidity and the complete loss of appetite for risk by investors, credit margins have widened more than the reductions engineered through monetary policy cuts to the risk free rate. We are probably the only country in the world where new low quality corporate bond issues are being launched on the market with single digit coupon rates.
So while the local banking sector is experiencing a sharp reduction in profits, very much reflected in their equity prices on the Malta Stock Exchange, this results from the drop of revenue or outright losses on their foreign investments portfolios where they park their excess liquidity, rather than from deterioration in their local loan book. The same bitter experience is being shared by the private investors on their quoted investments portfolios outside top rated sovereign bonds.
So will we escape the recession? Do not confuse the credit crunch with the recession. The credit crunch has led to a recession in countries that were substantially leveraged on foreign debt, especially the US, UK, Ireland, Spain, Italy, Eastern Europe, Iceland and others. The impact has been immediate especially after the collapse of Lehman Brothers in mid-September 2008 led to the freezing of credit. We have been spared the harrowing consequences of the credit crunch because we are a liquid economy and not leveraged. We have no international credit lines that have been pulled back or not renewed.
The recession is a different matter. We will not escape that and the major impact will hit us with a time lag some time next summer. It takes time for the order book pipeline to run dry; it takes time for employers to decide to cut costs as they keep hoping that things will recover without much ado. But if the summer tourist season falls flat and if by summer the international demand for our exports shortens the order book to a level where extended shut downs, short work weeks or outright discharges have to be resorted to, we could be given a cruel wake-up call. If property prices continue to fall tempting buyers to hold off thus reducing demand further, it will become progressively more difficult for developers to continue carrying their unsold inventory, with banks breathing down their neck to meet interest costs when no revenue is coming in. We could well see things precipitate in the property market too.
So in summary the answer to the three questions: yes this recession is different and more painful but hopefully will not aggravate to a depression. We have been spared the immediate impact of the credit crunch thanks to the culture of thrift we inherited from our fathers. We will not be spared the impact of the recession, which will hit us with a time lag over the summer, and while hoping for the best we should prepare for the worst.
The Malta Independent on Sunday
Three questions I am
frequently asked are:Why is international economic news so gloomy that it seems more like a 1930s depression rather than merely a cyclical recession?
How come the domestic economic situation is still ticking in positive territory (at least on basis of data so far available)?
Is it merely a question of time lags and that we will probably feel the pinch in the coming months?
These questions have to be put high on the national agenda and be seriously discussed.
This recession is not merely cyclical. It is more serious than that, though hopefully it will not deteriorate into a full blown 1930s style depression given that today we have that bad experience to guide us and we have more and better economic policy tools to protect us. The difference between this and other cyclical recession is that this time round we do not have a sound banking and financial system to help us get out of the recession through expansive and cheap availability of credit. This time round the banking system itself is in the eye of the storm and it has in fact led other robust economic sectors into this recession. And, given that banking and financial services are one of the most globalised economic sectors, this recession which started with the collapse of the US housing market in the summer of 2007, has become global with astonishing speed.
Credit is the life-blood of economic systems and of international trade. If credit stops flowing throughout the system, domestically as much as internationally, economic contraction becomes inevitable as demand shrinks. Without an adequate supply of fairly priced credit, people cannot buy houses, they cannot buy cars, businesses cannot finance investments and the overall demand in the economy shrinks. For some time producers build up stocks but soon enough their liquidity stress demands that they sell their inventories by reducing prices, cut down on capacity by shutting down facilities leading to unemployment, and cut down costs wherever possible.
Even those consumers who do not lose their job will feel uncertain about the future and will unavoidably tighten their purse strings, spend less and save more even when their overall incomes are falling. So economic contraction enters into a dangerous spiral of falling demand, more unemployment and uncertainty, falling asset prices, leading to yet more reduction in demand and yet another turn in the downward spiral.
The UK economy is contracting sharply, property prices are falling like a rock and the State had to nationalise one smaller bank and take majority or significant stakes in two major banks in order to recapitalise them as they faced insolvency. Iceland has imploded. The Irish economy is horrifying with a burst property bubble and over-exposed banks nationalised to survive. In Spain unemployment is shooting up. Italy’s economy has contracted and even stronghold Germany has entered recession as demand for its exports has forced its manufacturers to cut back production. Eastern Europe is in shambles. Latvia is economy is contracting by some 10 per cent, Ukraine is on the verge of defaulting on its international payments and Russia is running down its international foreign exchange reserves at an astonishing speed as it defends the value of the rouble with market interventions. Swedish and Austrian banks are suffering on their over-exposure to Baltic and East European borrowers. Hungary has had to resort to an IMF bailout. How come in the midst of all this distressing noise our economy, while clearly slowing down, is not yet on the ropes?
The simple answer is that we have so far escaped the immediate impact of the credit crunch because we do not borrow on the international markets and have a very liquid economy with all bank loans mainly domestically focused and fully financed by domestic retail deposits without currency mismatches. The drop in domestic demand and the near freezing of the property market is being cushioned by sharply reduced interest costs. Borrowers in other countries are not benefiting from such interest rate reductions because with banks strapped for liquidity and the complete loss of appetite for risk by investors, credit margins have widened more than the reductions engineered through monetary policy cuts to the risk free rate. We are probably the only country in the world where new low quality corporate bond issues are being launched on the market with single digit coupon rates.
So while the local banking sector is experiencing a sharp reduction in profits, very much reflected in their equity prices on the Malta Stock Exchange, this results from the drop of revenue or outright losses on their foreign investments portfolios where they park their excess liquidity, rather than from deterioration in their local loan book. The same bitter experience is being shared by the private investors on their quoted investments portfolios outside top rated sovereign bonds.
So will we escape the recession? Do not confuse the credit crunch with the recession. The credit crunch has led to a recession in countries that were substantially leveraged on foreign debt, especially the US, UK, Ireland, Spain, Italy, Eastern Europe, Iceland and others. The impact has been immediate especially after the collapse of Lehman Brothers in mid-September 2008 led to the freezing of credit. We have been spared the harrowing consequences of the credit crunch because we are a liquid economy and not leveraged. We have no international credit lines that have been pulled back or not renewed.
The recession is a different matter. We will not escape that and the major impact will hit us with a time lag some time next summer. It takes time for the order book pipeline to run dry; it takes time for employers to decide to cut costs as they keep hoping that things will recover without much ado. But if the summer tourist season falls flat and if by summer the international demand for our exports shortens the order book to a level where extended shut downs, short work weeks or outright discharges have to be resorted to, we could be given a cruel wake-up call. If property prices continue to fall tempting buyers to hold off thus reducing demand further, it will become progressively more difficult for developers to continue carrying their unsold inventory, with banks breathing down their neck to meet interest costs when no revenue is coming in. We could well see things precipitate in the property market too.
So in summary the answer to the three questions: yes this recession is different and more painful but hopefully will not aggravate to a depression. We have been spared the immediate impact of the credit crunch thanks to the culture of thrift we inherited from our fathers. We will not be spared the impact of the recession, which will hit us with a time lag over the summer, and while hoping for the best we should prepare for the worst.
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