Why the market has been down on the Euro and European banks

Austria’s bank exposure to emerging markets is equal to 85pc of GDP
– with a heavy concentration in Hungary, Ukraine, and Serbia – all now
queuing up (with Belarus) for rescue packages from the International
Monetary Fund.

Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for
the UK, and 23pc for Spain. The US figure is just 4pc. America is the
staid old lady in this drama.

Amazingly, Spanish banks alone have lent $316bn to Latin America,
almost twice the lending by all US banks combined ($172bn) to what was
once the US backyard. Hence the growing doubts about the health of
Spain’s financial system – already under stress from its own property
crash – as Argentina spirals towards another default, and Brazil’s
currency, bonds and stocks all go into freefall.

Broadly speaking, the US and Japan sat out the emerging market
credit boom. The lending spree has been a European play – often using
dollar balance sheets, adding another ugly twist as global
“deleveraging” causes the dollar to rocket. Nowhere has this been more
extreme than in the ex-Soviet bloc.

The region has borrowed $1.6 trillion in dollars, euros, and Swiss
francs. A few dare-devil homeowners in Hungary and Latvia took out
mortgages in Japanese yen. They have just suffered a 40pc rise in their
debt since July. Nobody warned them what happens when the Japanese
carry trade goes into brutal reverse, as it does when the cycle turns.
. . .

Just in case you were wondering.  Here is the link.  By the way, this is further evidence that the driving force behind the earlier boom was the global savings glut, and sheer giddiness, not the excessively loose monetary policy of Greenspan’s Fed.  The ECB has pursued a relatively tight monetary policy since its origin.  It also will be interesting to see what trouble arises in Spain, since Spanish banking regulation has been considered a model of how to keep these problems under control.

And here’s Romania fact of the day:

Romania raised its overnight lending to 900pc to stem capital flight…


I ask this question in sincerity and naivety:

Why do the global savings glut and the loose monetary policy have to be mutually exclusive events as you make them sound here?

If Greenspan had pushed a tighter monetary policy, couldn't that savings glut have found its way to the US rather than Latin America, ie, isn't it possible that the savings glut was chasing after these emerging markets precisely because monetary policy was loose in the US?

Rather than this "or" argument you have set up between the glut and the policy as the cause of the boom, can't you say they were both inputs into the same function?

Romania has reserve requirements of 20% in the national currency and 40% in foreign currency. The lending requirements are extremely strict. It has virtually no exposure to subprime lending.

While Romania is not problem free -- government expenses are large relative to government income-- it is pretty clear that whatever the effects there, they are the effects of a global panic, not related to fundamentals.

So at least in the case of Romania, the theory of a "savings glut" seems nonsense.

But I confess that I do not understand completely how this "savings glut" theory is supposed to work. Is the main idea that the opportunities to invest in "quality" projects are diminished, so "capital" goes to risky projects? If so, what is the evidence that the Eastern European investment is inherently risky? The situation looks like panicked banks --who got panicked by the global situation-- are trying to get out of markets towards which they have irrational fear.

The "world of long term declining interest rates" that Danny mentions looks to be, by definition, a world suffering from a glut of savings. Again by definition, that glut was not caused by low nominal interst rates in one country.

In such a world, we expect more people than usual to borrow money and fail to make reasonable return on it. These cases accumulate to an unusal, and in general suddenly apparent, level of inabiliy to repay the money lent. Unless the lenders have been making anticipatory provision for this sytematic risk, they will be under-capitalised as a group. The market will not recapitalise these lenders until it sees the prospect of an attractive return on the investment - for banks that implies a prospect of interest rates that are no longer in long-term decline as well as low share prices.

(Tyler may wish to note that the Spanish banks appear to have made good provision against one set of systematic risks; the Spanish government seems to have doubts about whether the provision is adequate for a second set of systematic losses on top, and has prepared the ground for capital injections if necessary.)

I guess from this elementary exposition (econ 011 perhaps) it follows that,if governments wish their injections of capital into the banking system to work (and to be ultimately profitable for their taxpayers), they have to bump interest rates down pretty soon so that rates have a floor to climb from. There is little gain from so doing until links between base rates and market interest rates are restored; but lower interest rates then also help the balance sheets of indebted borrowers.

The liquidation value of debt rises as rates fall (Danny's "insidious long term time bomb in the wings" - a phrase that is ridiculously attractive and sure to be pirated) and rises with a short term bump when interest rates are cut. However, the liquidation value also falls with declining likelihood of full repayment.

Right now, as Alex says, banks are in a panic. As Alex does not say, that means we are in a credit crunch. As (I guess) everybody agrees, we are falling into a sharp recession; and the financial crisis is making the fall swifter. The policy question is how we make the unavoidable recession short.

The classical receipt to shorten recessions/depressions is
- keep the financial system capitalised,
- recognise the losses quickly and in full (letting those that fall on fools and knaves lie where they fall, but taking others on the public account where necessary to keep the economy moving),
- help the virtuous to maintain spending and restore their balance sheets (through public investment likely to yield an economic return where practicable),
- make sure zombie enterprises die quickly:
borrowing from the future as necessary to finance all that.

Any advances on the classic recipe?

David, great recipe list, BUT
what if a) financial recapitalization is inconsistent with b)recognize the losses quickly?

I claim that Big Banks are not 'needed' by the real economy. The real economy needs a way to park short term excess cash, and a place to get loans. If ALL the Big Banks died, IBM could still get (more expensive) bond financing and, like Google, equity infusions.

Just like there are too many newspapers, thanks to the internet, there are far, far too many overpaid bankers -- the CDS 'fictitious capital' (of Mises & Hayek) has been bought and sold for very slight net benefit in the good times (last 10 years), but huge costs now. Altho the fees to bankers have been hiding the risk adjusted net cost.

Do NOT save the financial system. Save production and distribution companies with direct loans and direct gov't equity; save shippers with gov't granted letters of credit (see Baltic Index); save depositors, but not equity nor bond-holders, of banks. Nor save the banker bonuses. Bah.

Some 8 000 small banks -- grant each a 1 year loan (at 1%?) based on total loans made in the last quarter, and continue supporting ONLY small (small enough to fail!) banks who actually lend money out.

The Big Banks are the zombies that need to die.

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