Industry and Sector Research

Editorial

Halting the crisis at what cost?

The instability that has taken hold in world financial markets is quickly altering the course of the world economy, tipping it from an outlook of abrupt economic downturn to one of much more profound breakdown in OECD markets. Stockmarkets in the space of a month have shed nearly 30% of their value. This would not be problematic were there none of the yo-yo fluctuations we have been seeing on ever more record scale, whether upward or downward. It is not the price volatility in the markets that is increasing, but rather the volatility of the price volatility! Behind this observation is a complex mathematical calculation, but I can express it in more prosaic terms: for very many assets, we can no longer define a price. This, by the way, is one of the points of dispute in the Paulson plan adopted after so much difficulty by the US Congress, aimed at using $700bn to buy the banking system’s bad debts, similarly to the different European plans announced on October 12. The point of the dispute: the price at which the aforesaid bad debts are to be purchased for now does not exist. It is not so much liquidity that is lacking in the market (the amounts of cash being injected each day by the central banks are equally record-breaking) as the fact that billions of assets have become illiquid. Illiquid, that is, simply because they have no price attached to them, something that in economics constitutes a serious problem. Now, of course it’s impossible for governments or heads of central banks to admit that they no longer understand very much – but with the IMF and its successively revised assessments of the cost of the financial crisis, putting it first at $1,000bn, then at $1,300bn and now at $1,400bn, what other conclusion can we draw?

For all that, how could the volatility of the price volatility of financial assets also impact on the real economy, from the international conglomerate all the way down to the small artisan business? Well, to issue credit within an economy, i.e., to lend to businesses, the banking system has to create money. The creation of this money is at a legally established ratio to a reserve of money that is issued by the central bank and traded between banks on the interbank market. Since no actor is quite certain anymore of being repaid one day by the other actors –measuring the risk is practically impossible – the interbank market has seized up, and, as a result, the financial system has to limit the credit it issues in the real economy or considerably increase the cost of credit.

The consequences of this transmission to the real economy will be severe: beyond the postponing of investment projects, there will be increasing cash flow problems, and this will lead to many bankruptcies. This issue of Global Sectors Outlook shows that every sector of the world economy is now entering into slowdown, due to both the economic crisis and the financial crisis.
How to stem the spiral? While a coordinated response by the central banks has not yet been conclusive, and while it is certain that measures taken by OECD governments (the US on one side and European nations on the other) will prove helpful, responsible behaviour on the part of every single actor is now also a key factor in the future outcome of the problem.

Karine Berger

Source: Bulletin économique - Secteurs internationaux - Hiver 2008

The crisis: act II?

The world economy started 2008 in a financial storm. The subprime crisis, resulting from the collapse of the real estate bubble in US and from securitisation methods, has spread to the heart of the financial markets. With the steady stream of announcements made of write-downs in bank assets by several billion dollars – losses potentially engendering systemic risk – the pressures on the financial markets have continued to mount: falling share prices and increased volatility are simply the downside of a sudden lack of liquidity.

Volatility peaked around mid-March, suggesting that the worst of the financial crisis, strictly speaking, may have passed, or in any event that Act I was over. In this environment, the performance of real economies in Q1 could come as a surprise.
With 0.2% GDP growth in the US, 0.6% in France and, especially, 1.5% in
Germany, every country posted better growth than expected, while, against all expectations, activity in the OECD countries accelerated at the close of the winter. But at same time, the expectations of those who constitute the economy – producers and consumers –were down on both sides of the Atlantic.

Businesses know that they are about to enter into a clearly more difficult stage of the cycle, facing both increasingly hard financing conditions and a slowing in demand. This is because the shock waves spread to a greater extent than anticipated to the entire business and household financial markets. The spread of the crisis to the real economy via the restriction of credit in spring 2008 was only just the beginning. Why? Because, to compensate for their refinancing costs, the banks could either increase interest rates for corporate lending or decrease lending amounts. Or both.

When a credit crunch begins in a given market – in this case, construction – economic history teaches us that it often blindly spreads to other markets. Logically, because of the overvalued state of property markets in the US, Spain and, to a lesser extent, the UK, their construction markets were the first to be hit. What is less logical, it is that credit conditions for other productive sectors also hardened to a degree during the first quarter. The Bank of France’s April survey of credit distribution shows that banks are planning not only to continue raising their margins, but also to reduce the amount and the duration of loans, both to large companies or small businesses. As to restrictions on credit to individuals, these are especially noticeable in the US; Europe, for its part, still seems little affected. Even so, consumers are in a state of readiness, and, in the euro zone, consumption slowed in the first quarter. The stage is set for Act II of the financial crisis of 2008.

Karine Berger

Source: Global sectors outlook - Spring / Summer 2008