The latest money and credit data, published yesterday, will have made grim reading at the ECB. After picking up strongly during 2007, broad money growth – the focus of the ECB’s second pillar to guide its monetary policy – has been on a downward trajectory as the financial crisis and the global recession have taken hold, with annual growth reaching just 1.8%Y/Y in September, the lowest reading since the data series started in 1971. As if that was not bad enough news, credit growth also fell further, with loans to the private sector actually falling, compared with a year earlier, for the first time since that series started in 1992.

Chart 1: Broad money and credit growth

Source: Bloomberg and Daiwa Securities SMBC Europe Ltd.

These figures illustrate clearly the marked downturn in the euro area economy. However, in gauging their significance, the ECB – like policymakers in other major economies where money and credit growth have also been limp – must disentangle two different economic effects. On the one hand, credit growth could be weak because demand for funds has fallen sharply, reflecting households and businesses retrenching during the recession. But on the other hand, credit could also be constrained by banks tightening their lending standards, thereby limiting the availability of finance.

With that in mind, the results of today’s Bank Lending Survey will have been scrutinised closely within the Eurotower. Unlike the crude credit data, this survey tells us how lenders have changed their credit standards, and how the demand for loans has evolved. And, although the survey data are qualitative, they do suggest that the weakness in household lending over the past six months largely reflects supply constraints, as demand for funds has actually risen over the past two quarters, while credit conditions have continued to tighten (see Chart 2).

Chart 2: Lending standards and demand

Source: ECB and Daiwa Securities SMBC Europe Ltd.

On a more positive note, the survey also revealed that banks expect to ease their credit standards – at least for businesses – over the next three months. That is a welcome development, and suggests that the credit cycle could soon begin to turn. But, at the same time, we should not get carried away. The net balance of banks expecting to ease credit standards was marginal at just +1%, indicating that overall conditions would be broadly unchanged, and banks still expect to continue tightening conditions for household borrowers. Furthermore, the cumulated net tightening during the financial turmoil has not yet started to reverse, and remains very substantial (Chart 3). So even if banks do start to ease conditions slightly in Q409, there would still be the clear risk that continued rationing of credit may undermine the pace of recovery in the euro area economy.

Chart 3: Credit conditions facing households and businesses*

* Relative to 2005. Dotted observations are expectations for January 2010. Source: ECB and Daiwa Securities SMBC Europe Ltd.

Tight credit conditions in the euro area reflect the fact that banks are still restructuring their balance sheets. While the European authorities have made it clear that they will not allow a major institution to fail, banks are still in the process of deleveraging and raising capital, while, at the same time, loan losses are continuing to rise, albeit perhaps at a slowing pace. These factors would tend to lead banks to ration credit, and focus on low-risk borrowers – and these tendencies would only be exacerbated by the high degree of uncertainty currently surrounding the economic outlook. As such, credit conditions are unlikely to improve swiftly as the banks continue on their path back to health.

All of this suggests that the ECB will remain cautious about the outlook for the euro area economy. That means no change in interest rates at next week’s ECB policy meeting – and, if the economy pans out as we expect, with sub-trend GDP growth during 2010 and inflation remaining below the ECB’s target of just under 2%, probably no change to rates over the next twelve months. Instead, the Governing Council may focus on its other, non-standard, measures. Following the ECB’s one-year refinancing operations in June and September - where banks borrowed €442bn and €75bn, respectively, at the ECB's 1% main refi rate - it will probably proceed in a similar way with the third one-year operation, which is pencilled in for December. But if, as we expect given their reluctance to lend, banks' demand for funds falls further, that would likely suggest that banks now have sufficient liquidity. As such, the ECB may even be tempted to scale back its future longer-term operations, and let its liquidity support unwind naturally as past operations mature.

Colin Ellis, European Economist

Disclaimer:

This research report is produced by Daiwa Securities Capital Markets Co., Ltd and/or its affiliates and is distributed by Daiwa Capital Markets Europe Limited in the European Union, Iceland, Liechtenstein, Norway and Switzerland. Daiwa Capital Markets Europe Limited is authorised and regulated by The Financial Services Authority and is a member of the London Stock Exchange, Chi-X, Eurex and NYSE Liffe. Daiwa Capital Markets Europe Limited and its affiliates may, from time to time, to the extent permitted by law, participate or invest in other financing transactions with the issuers of the securities referred to herein (the “Securities”), perform services for or solicit business from such issuers, and/or have a position or effect transactions in the Securities or options thereof and/or may have acted as an underwriter during the past twelve months for the issuer of such securities. In addition, employees of Daiwa Capital Markets Europe Limited and its affiliates may have positions and effect transactions in such securities or options and may serve as Directors of such issuers. Daiwa Capital Markets Europe Limited may, to the extent permitted by applicable UK law and other applicable law or regulation, effect transactions in the Securities before this material is published to recipients.

This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FSA and should not therefore be distributed to such Retail Clients in the United Kingdom. Should you enter into investment business with Daiwa Capital Markets Europe’s affiliates outside the United Kingdom, we are obliged to advise that the protection afforded by the United Kingdom regulatory system may not apply; in particular, the benefits of the Financial Services Compensation Scheme may not be available.

Daiwa Capital Markets Europe Limited has in place organisational arrangements for the prevention and avoidance of conflicts of interest. Our conflict management policy is available at http://www.uk.daiwacm.com/about-us/corporate-governance-and-regulatory. Regulatory disclosures of investment banking relationships are available at http://www.daiwausa.com/.

For more details, please contact:

Colin Ellis, Fixed Income Research
Daiwa Capital Markets Europe Limited
5 King William Street, London, EC4N 7AX

+44 (0)20 7597 8339

colin.ellis@uk.daiwacm.com

For up to date Research analysis, see our blog site here.

Sign up for news/events alerts