Thursday, 15 August 2013

QE, credit rationing and an obsession with housing

So what did central bank long-term asset purchases (QE) achieve?  There has been a fair amount of noise in the press after two Fed economists, Vasco Curdia and Andrea Ferrero, published a paper seeking to answer the question

The paper concludes that the effects are small and indeed, that forward guidance around the future path of interest rates is more important. Overall, they estimate that the boost to GDP from QE and the Fed’s forward guidance amounted to about 0.13%, while inflation was boosted by around 0.03%. Cue a typical response from The Telegraph, in which Richard Evans wrote ‘Did QE punish savers for nothing?’

The view within the Fed seems to be that the effects of QE are entirely due to the downward pressure that asset purchases have on bond yields. Hence the importance of forward guidance. Driving down long-dated bond yields helps, but locking in expectations of a protracted period of very low short-term rates helps more.  Personally, I think this is a pessimistic view of what QE has achieved, while also failing to address what I see as two negative side-effects of - firstly that it QE distorts asset markets and risks creating imbalances which will be dangerous in the long run, and secondly that it does nothing to address the weakness of loan supply, and demand for individuals and small businesses, only really helping those who can tap into capital markets (directly or indirectly). 

The UK MPC explicitly recognised the crowding out effect of QE from the start. UK investors sold gilts to the Bank of England and used the money to buy something else. The hope was that this would divert money towards the parts of the economy that were in need of investment. You could be forgiven for concluding that they mostly bought houses or foreign assets, since the housing market recovered and the pound fell and you could reasonably argue whether that helped growth much, but that's another story. 

I've always though the UK interpretation was more realistic - QE 'works' both by lowering borrowing rates and by forcing investors into less conservative asset allocation decisions. I have also, in the process, concluded that QE results in money being cheaper for those who can get it, but does not alter the fact that money is ‘tighter’ or more rationed overall. I reach that conclusion because large-cap companies and higher-grade borrowers who can tap capital markets directly, are helped by the effects of. If, in the UK, the Bank of England buys gilts off private investors, it stands to reason that some of that cash can be re-deployed in the corporate bond market instead, easing access for borrowers. But it doesn't do anything to alter the fact that banks are shrinking their balance sheets and bank lending is being constrained.

One counter to this is that the weakness of bank lending is down to weakness in demand, rather than a limit on supply. Thorsten Beck of Tilburg University  in particular, has done a lot of research and written reams on why SME borrowing has been cut back since the credit crisis. I would observe, that since the first 6 months of 2013 have seen UK non-financial private institutions issue, in net terms, GBP 11.8bn of new capital while over the same period  M4 lending shrank by £54bn, and monetary financial institutions net cash raising has been a repayment of £41bn, there is at least cause to wonder if QE has kept capital markets working while the banking system has been shrinking. Maybe that is because the SMEs, which are reliant on the banking system for funding don't want to expand, but at first glance it looks as though they are faring less well in this regard than their bigger competitors. 

Meanwhile, the margins that banks have been charging for loans have tended to be wider in the post-crisis period than they were before, and that does at least raise the possibility that the reason loan demand was weak, was that the price of loans were high. Is that rationing? A shift in the cost of funds for bond (and equity) issuers, relative to the cost of funds to anyone calling their friendly local bank manager, definitely rations money.

But it all comes down to housing, apparently....

At this point, I observe that 1) there is some (but not conclusive) evidence that QE has helped big companies more than smaller ones; 2) that if the US view that forward guidance is more important the UK is in trouble because forward guidance has sent UK market interest rates sharply higher; and 3) the good news is that bank loan spreads seem to be narrowing a bit, that the Bank's credit survey indicates that both demand for and supply of credit is increasing, and economic recovery (albeit patchy) is underway. 

However, when I call up people who work at British banks and quiz them about the data, they tell me that a large part of the answer comes from the UK’s obsession with real estate (in all its forms). Pre-crisis, up to 70% of lending was to real estate in one form or another – mortgages, companies investing in real estate, developers buying land, pension funds treating it as an asset class and so on After the crisis, two things happened. The first was that regulators told the banks they had far too much exposure to this sector. So they have retrenched. And secondly, bankers found out they had forgotten how to lend to anyone else. A generation of lending officers at the major banks don’t really know how to lend money to an engineering firm to buy new equipment to ‘make stuff’.  They haven’t ever really had to do it as the UK’s manufacturing base has been left to rot. They know how to lend money to a property developer to buy, develop and sell a piece of land or a block of flats. 

The net result is a lack of lending.  The banks needed to shrink balance sheets. They also paid more for capital that they could lend out. And they weren't very good at trying to lend to those parts of the economy that might have wanted money. Meanwhile, without doubt, the appetite to borrow has decreased in the real estate sector. .

So the collapse in bank lending is because the UK economy is just doing a really bad job of re-engineering itself away from an over-dependence on real estate. But hey, it's not all bad news! The housing market is recovering. And according to the RICS survey this week, it is recovering around the country. Maybe that's why the banks are  lending. Maybe that's  why credit demand is picking up. It’s all linked. QE has helped the housing market, and an economy which is (still, after all these years) crazily over-sensitive to real estate, is feeling better about itself. And bankers can get back to the only kind of lending they really understand. Once upon a time, we were a nation of shopkeepers, but the High Street was made redundant and now we are a nation of on-line shoppers and house-owners... 

Of course, if this is true, there's a big risk we just see a property bubble reflate itself, the economy give the impression of thriving for a couple of years and then we'll be back in a mess but hey, that's better than never having any fun at all and maybe the wise politicians who run the country will use the recovery to invest in regional, educational and industrial policies to really help re-balance the economy away from finance real estate, towards manufacturing and other 'real' industries. Maybe..... 

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