Is There a Credit Crunch in Europe?

Vitor Gaspar, Director General of BEPA (Bureau of European Policy Advisers)

Symposium “ The Credit Crunch and Its Implications for Europe”

Tilburg, 5th September 2008

The views expressed are my own and do not necessarily reflect those of the European Commission.

Definition of credit crunch

Credit crunch is characterized by a sudden reduction in the availability, or a sudden increase in the cost, of obtaining loans from banks.

Bernanke and Lown (1991) define a credit crunch as a decline in the supply of credit that is abnormally large for a given stage of a business cycle.

No sudden reduction in the general availability of loans

Figure 1: M2, credit to non-financial corporations and credit to households and individualenterprises in the Euro area, January 2000-June 2008

in billion EUR annualized growth rates (%)

Source: ECB.

2000

3000

4000

5000

6000

7000

8000

janv-00 janv-01 janv-02 janv-03 janv-04 janv-05 janv-06 janv-07 janv-08

in b

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n E

UR

M2 Credit to non-financial corporationsCredit to households and individual enterprises

2000

3000

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7000

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janv-00 janv-01 janv-02 janv-03 janv-04 janv-05 janv-06 janv-07 janv-08

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M2 Credit to non-financial corporationsCredit to households and individual enterprises

0

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janv-00 janv-01 janv-02 janv-03 janv-04 janv-05 janv-06 janv-07 janv-08

grow

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M2 Credit to non-financial corporationsCredit to households and individual enterprises

0

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grow

th ra

te (%

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M2 Credit to non-financial corporationsCredit to households and individual enterprises

Bank deposits are increasing fastFigure 2: Banks’ deposits as a share of M2, and annualized growth rate of banks’

deposits the Euro area, January 2000-June 2008

Source: ECB.

42

44

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54

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oY

%)

Banks' deposits as a share of M2 (lhs)

Banks' deposits growth rate (rhs)

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%)

Banks' deposits as a share of M2 (lhs)

Banks' deposits growth rate (rhs)

No sudden increase in the cost of obtaining loans

Figure 3: Selected interest rates for the Euro area, YoY in %, January 2000-July 2008

Source: ECB.

4

4,5

5

5,5

6

janv-03 janv-04 janv-05 janv-06 janv-07 janv-08

inte

rest

rate

(%)

Non-financial corporations loans, total maturity

Household loans for house purchasing, total maturity

4

4,5

5

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6

janv-03 janv-04 janv-05 janv-06 janv-07 janv-08

inte

rest

rate

(%)

Non-financial corporations loans, total maturity

Household loans for house purchasing, total maturity

Is There a Credit Crunch in Euro Area?

No!

Outline

1. The roots of the turmoil: accumulation of imbalances

2. The trigger and propagation3. Macroeconomic situation and outlook in

the Euro area4. Conclusion

Outline

1. The roots of the turmoil: accumulation of imbalances

2. The trigger and propagation3. Macroeconomic situation and outlook in

the Euro area4. Conclusion

The roots of the turmoil: accumulation of imbalances

The current turmoil should be seen as part of the adjustment to major imbalances that accumulated in the past years:

(1) strong growth in money and credit globally (excess liquidity);(2) large current account deficits in the US (and surpluses in Asia and in oil exporting countries);(3) compressed financial spreads;(4) housing market bubbles in some countries.

The roots of the turmoil: accumulation of imbalances

Loose monetary policy in most countries, but particularly in the USA, led to excess liquidity in international financial markets Global excess liquidity has driven long-term world interest rates to historically low levels, caused asset price inflation and a high demand for the US assets, which resulted in a growing US current account deficit; As US external imbalance has been mainly financed through foreign official lending, it led to the build up of reserves and current account surpluses in Asian countries, particularly in China.

The roots of the turmoil: accumulation of imbalances

Financial spreads have been abnormally low and had to widen as apart of adjustment process to the equilibrium.

Figure 1: Differential between the 3-month interbank rate and the 3-month indexed swap rate (daily data, 2 January 2006- 22 August 2008)

-0,1

0,1

0,3

0,5

0,7

0,9

1,1

2/01/06 2/07/06 2/01/07 2/07/07 2/01/08 2/07/08

Euro Sterling USD

-0,1

0,1

0,3

0,5

0,7

0,9

1,1

2/01/06 2/07/06 2/01/07 2/07/07 2/01/08 2/07/08

Euro Sterling USD

Source: Bloomberg.

The roots of the turmoil: accumulation of imbalancesFinancial turmoil was triggered by disturbance in the US sub-prime mortgage market, which, in turn was part of a housing market correction process.

130

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dex

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Hou

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pric

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dex

Source: Office of Federal Housing Enterprise Oversight.

Figure 2: US monthly housing price index, January 2000-May 2008

216

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Hou

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dex

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Hou

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pric

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dex

Jan 2006-

May 2008

The roots of the turmoil: accumulation of imbalances

Source: Office of Federal Housing Enterprise Oversight.

Figure 3: Annualized growth rate of new house prices in the USA,January 2000-June 2008

-15

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The roots of the turmoil: accumulation of imbalancesThe boom-bust pattern in the housing market has occurred also in Europe (Spain, Ireland) albeit without the sub-prime mortgage twist.

Source: Central Statistical Bank of Ireland, Bloomberg.

Figure 4: Annualized growth rates of housing prices in Spain and Ireland, January 2000-June 2008

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YoY

(%)

Spain (lhs) Ireland (rhs)

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Spain (lhs) Ireland (rhs)

The roots of the turmoil: accumulation of imbalancesAdjustment of housing prices and construction sector had direct effects on economic activity.

Source: Eurostat.

Figure 5: Euro area total and construction employment rates, Q1 2000-Q1 2008, YoY

change (%)

Figure 6: Monthly HPIC inflation and real wages measured as unit labor cost, YoY

change (%) January 2000-July 2008

0

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Employment in construction sector (rhs) Total employment (lhs)

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Employment in construction sector (rhs) Total employment (lhs)

1,5

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%)

HIPC inflation Unit labor cost

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HIPC inflation Unit labor cost

The roots of the turmoil: accumulation of imbalances

Source: Eurostat.

Figure 7: Euro area real GDP growth, annual and quarterly changes, Q1 2000-Q2 2008, (%)

-0,4

0

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oQ (%

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Outline

1. The roots of the turmoil: accumulation of imbalances

2. The trigger and propagation3. Macroeconomic situation and outlook in

the Euro area4. Conclusion

The trigger and propagation

The correction in housing markets affects business cycle developments directly:

Wealth effects depress private consumption;Lower housing prices depress construction.

Increased risks, aggravated by opacity, led to a heightened awareness of the importance of counterparty risk (Taylor and Williams, 2008).

Heightened perception of risk and losses on banks asset portfolios banks will have to undergo a deleveraging process. (Greenlaw, Hatzius, Kashyap, Song Shin, 2008)

Outline

1. The roots of the turmoil: accumulation of imbalances

2. The trigger and propagation3. Macroeconomic situation and outlook in

the Euro area4. Conclusion

Macroeconomic situation and outlook in the Euro area

The outcome of the first quarter proved stronger than expected, partly on the back of temporary factors, such as unusually warm winter weather boosting construction investment, especially in Germany ; While real GDP growth in the Euro area has been strong in the first quarter (0.7% increase QoQ), it decreased by 0.2% (QoQ) in the second quarter of 2008 (flash ESTAT estimate); On an annual basis GDP growth thereby declined to 1.5% in the euro area (down from 2.1% in the first quarter).

Baseline scenario

According to the baseline scenario the euro area economy will continue to grow, in the second half of 2008 and in 2009 (albeit at below potential output growth rates). Economic forecasts are likely to be revised down.Inflation pressures should gradually ease.However, the degree of uncertainty we face is particularly elevated.

Baseline scenario

In short:Smooth slowdown of economic activityAnd gradually:

inflation pressures easefinancial turbulence looses strength

But, however macroeconomic risks are unusually high…

Risk Scenario 1: Financial economic activity vicious circle

Tightening credit conditionsLower economic growthIncreased pressure on financial sector balance sheetsRising interest rates and negative wealth effectsReduction in the number of creditworthy borrowers

Risk Scenario 2: Inflation-financial intermediation vicious circle

Two-year inflation expectations are significantly above 2%Inflation is the main concern of EU citizensExperience of 70s and 80s shows how costly it is to let inflation expectations unhinged

Generate a discrete drop in the performance of the financial system…which impact on economic development and growth

Outline

1. The roots of the turmoil: accumulation of imbalances

2. The trigger and propagation3. Macroeconomic situation and outlook in

the Euro area3.1 Baseline scenario

4. Conclusion

4. ConclusionAdjustment to past imbalances and excesses cannot be avoided.

The baseline remains benign.

The current macroeconomic situation is characterized by an unusually elevated degree of uncertainty.

The factors referred in the presentation permit the construction of a variety of risk scenarios.

Other factors (not mentioned) may affect developments in unforeseen ways.

Is There a Credit Crunch in Europe?

Vitor Gaspar, Director General of BEPA (Bureau of European Policy Advisers)

Symposium “ The Credit Crunch and Its Implications for Europe”

Tilburg, 5th September 2008

The views expressed are my own and do not necessarily reflect those of the European Commission.