Liquidity in Europe Hesitates

Monday, May 24, 2010
By Paul Martin

By Dan Denning
TheDailyReckoning.com
May 24th, 2010

If you’re a glass half-full kind of guy, then Friday’s action in stock was encouraging. Here in Australia, the indexes opened up down by almost three per cent. Yet by the end of the day, they were able to claw their way back to much smaller losses. Yes, stocks are at nine-month lows. But it felt like a victory, didn’t it?

Then, in Friday’s U.S. session stocks staged a huge final hour rally. The Dow Jones industrials had been down below 10,000 at one point. But in a flash (a flash dash!) the index suddenly reversed itself and finished 1.24% higher. So what does that tell us?

Absolutely nothing, most likely. In a market like this, what you don’t know is a lot more important than what you do know. And what we do know turns out to be very little anyway. Just based on valuations, stocks are now a bit cheaper than they were a month ago. But price is not the same thing as value.

And besides, there are so many known unknowns and unknown unknowns it’s hard to know where to begin! But let’s start on the other side of the world and tackle the question of whether there is a short-term funding crisis in Europe. Or, in plainer speech, is the Credit Crunch back and better than ever?

The optimistic view is that the real economy in Europe is recovering, albeit slowly. A key purchasing manager’s index in Europe hit a three-month low, but it was still positive. And the line of argument in this camp is that the real economy will grow slowly, but is nowhere near as dysfunctional and systemically unstable as financial markets are.

Financial markets, for their part, are trying to digest two political moves. The first move is the legislative efforts to curb credit growth (the U.S. reform bill). That might reduce bad bank lending. But it would almost certainly limit credit growth. And in a system that requires on a lot of short-term credit to finance activity, it means less activity, lower real growth, falling asset values, and economic contraction.

The second issue is the growing weight of Europe’s dead hand on the market. This will feel familiar to Australian investors lately. What we mean is that one of the big results of the Greek crisis is a call for economic policy coordination. This is being euphemistically called “economic governance.” But it’s actually an attempt for more centralised and coordinated European regulation and policy making.

Because the problem with the EU is that it’s not centralised enough.

The credit markets are telling us they are not convinced that Europe’s policy makers can coordinate a response to huge sovereign debt levels in Spain, Greece, Portugal, and Italy. As the sense of anxiety by financial firms becomes more acute, they become a lot less trusting of each other. Banks who are unsure about what’s on another bank’s balance sheet don’t lend. These shows up as an increase in the London Interbank Offered Rate, the rate banks charge one another in overnight lending.

Bloomberg reports that, “Traders in the forward market are betting the premium of the three-month dollar London interbank offered rate, or Libor, over what investors expect the overnight federal funds rate to average known as the Libor-OIS spread will climb to about 42 basis points next month and about 61 basis points by September, according to UBS AG data. The spot spread was about 27 basis points May 21.”

“This is a quintessential liquidity crisis,” William Cunningham tells Bloomberg. He’s the head of credit strategies and fixed-income research at State Street Corporation in Boston. “It’s not inconceivable to imagine a situation where the markets behave so poorly, the liquidity behaves so badly, and risk-tolerance just evaporates that particularly in Europe consumers contract, businesses stop hiring and stop investing, and economic activity halts.”

Granted, the current situation is nowhere near as bad as October of 2008. Libor soared by 364 basis points then and the whole inter-bank lending market was nearly frozen. But if the political climate continues to generate so much instability, the financial markets are going to get pretty cold.

Does any of this have any effect on the real economy here in Australia? Well, last week the National Australia Bank sent retailer Clive Peeters into administration because the bank was unwilling to loan the electrical goods seller $38 million. That seems like chump change these days. So why cut them off?

As Adele Ferguson reports in today’s Age, corporate Australia is sitting on $180 billion in short-term debt it must refinance in the next two years. Over the last 18 months or so, Aussie banks have been silently hoping the economy would improve enough that extending credit to small- and mid-size firms wouldn’t endanger the balance sheet.

Mind you it’s not the big firms that are in trouble here. During the credit crisis, big Aussie blue chips tapped the equity markets for another $90 billion in capital. This did not always benefit shareholders if the company sold equity cheaply. But it did buttress the balance sheet.

The trouble is that small- and mid-sized businesses can’t simply raise equity. They depend heavily on short-term bank financing. When the cost of that financing goes up because of tighter global liquidity, or when Aussie banks simply become more cautious to protect their own balance sheets, then you get the local consequence of the credit depression: the inability of smaller firms to borrow.

Meanwhile, the government continues its public relations war against the mining industry. You have to wonder what the government hopes to win by trashing the industry in front of international investors like this. The obvious answer is: money!

To be fair, whether production or profits should be taxed is an interesting question. And whether a tax or royalty should be levelled as the state or Federal level is also an interesting questions. By “interesting” we mean debateable if you accept at face value the government’s right to tax private enterprise. We’re not saying we like it.

But this line of attack that, “the community has not received a fair return for its non-renewable resources during boom times” is a bit rich, isn’t it? This again presumes that it is the community which owns Australia’s mineral resources. Does it?
If you accept that argument, then it follows that the community owns every kind of national resource, not just land and property but labour and intellectual capital too. If the government is entitled to tax the mining industry for what it believes to be unfair profits, why not the banks? Why not any kind of activity which policy makers determine is not providing its “fair share?”

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