Jeremy Warner's Outlook: China syndrome fuels latest bout of panic in markets

Recession: public debt to soar; Mark to market: don't shoot the messenger; Look who's talking on City pay
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Whether governments have solved the banking crisis or not, it seems to have come too late to save the world from recession. From rising unemployment in Britain to slumping retail sales in the United States and evidence of sharply slowing demand for raw materials in China, evidence of a possibly serious economic contraction in the making is now all around. Shares slumped again yesterday in recognition of this increasingly bleak cocktail of negatives.

Everyone knew instinctively that the Chinese economy would slow markedly after the Beijing Olympics, even though spending on this show-piece event was an insignificant proportion of the Chinese economy as a whole. China has for long wanted to take the heat out of soaraway growth, and in a command economy, it's not so difficult to achieve these objectives.

For a long time now, official Chinese estimates of likely demand for raw materials have sharply lagged the more fanciful forecasts of mining companies and commodities funds. With Rio Tinto's public acknowledgement of slowing Chinese demand yesterday, the scales have suddenly fallen from everyone's eyes. We cannot rely on Chinese growth to act as the locomotive of the world economy.

Regrettably, it is still not possible to know how bad it's going to get. Relatively low inflation, allowing for steep cuts in interest rates, makes this downturn quite different from the onset of all previous post-war recessions. On the other hand, the scale and nature of the banking crisis also makes it unique. We know things are going to get bad. But we don't know how bad.

Recession: public debt to soar

Nevermind the £37bn the Government is raising through the debt markets to recapitalise the banks, not to mention all the other aspects of public support for the banking system – counted in hundreds of billions.

If all goes according to plan, the Government should get all its money back and some on the banking bailout package.

Much more concerning for the long-term health of the public finances is that it is now plain as a pike staff the economy is heading into a serious recession, the effect of which will be to shred the Government's fiscal rules, with the budget deficit soaring to 6, 7, perhaps even 8 per cent of GDP. In a recession, two things happen. Tax receipts collapse and social security spending rockets.

Heavy reliance on tax receipts from a once-booming City makes this dynamic worse for Britain than it is likely to be elsewhere. Paradoxically, the banking package helps a bit on this front. The Government is lending to and investing in the banks at generally higher rates of return than what it costs the taxpayer to borrow the money. The net gain could be as much as £5bn to £10bn, which goes some way to compensating for the loss of tax revenue from bonuses and profits.

Even so, the shortfall is going to be extreme, and that's even before the Government gets round to attempting to reflate the economy through tax cuts or heavier public spending. How much public debt are investors prepared to take before they send interest rates soaring and collapse the currency?

If what we are heading into is a repeat of what happened in Japan in the 1990s, then the Government can issue all the debt it likes and investors, averse to almost everything else, will only lap it up. Inflation is elevated right now, but nobody believes it will remain that way.

The danger is much more a deflationary than an inflationary one. In such circumstances, interest rates fall and savings gravitate to credit-worthy government debt.

Yet there must be limits. Having started the process of bailing out the banks, the Government must now finish it. The numbers are already humongous, but there is still lots of potential for them to grow larger still.

In the US, Treasury yields are already rising, despite lower inflationary expectations, to reflect the risk that supply might eventually swamp demand. Like everything else in the brave new world we are sailing into, these are uncharted waters.

Mark to market: don't shoot the messenger

Is this the last rites for mark-to-market accounting, a form of book keeping thought by many to be one of the root causes of the credit crunch, or at least of making it much worse than it needed to be? Well perhaps not quite. The EU is falling into line with the US in sanctioning changes to accounting standards that will, in "rare" circumstances, allow banks to move assets from their trading books, where they must be valued according to market rates, on to their main loan books, where they can be valued on a hold-to-maturity basis. The London-based International Accounting Standards Board has already said that the current banking crisis might be considered one of those rare instances.

Yet demands by France that derivative products can also be swapped on to loan books in this way have been firmly rejected. The IASB has done well to hold the line, for any attempt to window dress the accounts of banks right now to make them look better than they really are will only further undermine confidence.

Already a number of reasonably sensible adjustments have been made to fair value accounting in recognition of the credit crunch. For instance, banks are no longer required to mark to the levels established by distress sales.

But it would be silly to go much further than has already been agreed, and a big mistake to suspend the rules entirely, as demanded by some. Fair value accounting has worked in perverse and unintended ways in the crisis of the last year. Many previously liquid forms of debt security have become completely untradeable, causing a collapse in the price of the few sales that do take place to way below likely maturity values.

This forces banks to impair their assets accordingly, which in turn contributes to the perceived solvency problem many of them have encountered. Once a bank's liabilities are thought to exceed its assets, confidence goes and lenders are reluctant to fund the bank's needs. The atmosphere of mistrust between lenders grows and the system breaks down.

Yet though fair value accounting may have accelerated the crisis, it can hardly be thought of as a cause and in any case, despite these rules, there is still a yawning gap between what banks have written off and the much larger amounts many believe are necessary to reflect the reality of what has occurred. It is this credibility gap, more than fair value accounting, which is causing the loss of confidence.

All banking crises follow the same pattern, in that during the boom a lot of bad lending takes place, which then has to be painfully recognised and worked out of the system. Mark to market at least ensures that this happens in a speedy fashion. There's not a lot of point in blaming the messenger for the underlying problem of bad lending. Bad debts that become hidden, rather than recognised, only prolong the agony.

Only by clearing out the rotten stuff can the system reboot so that efficient capital allocation can begin anew. Japan remains as a salutary lesson in what happens if bad debts go unrecognised, for the effect is to starve the economy of the capital it needs to fund innovation, enterprise and renewal.

Look who's talking on City pay

Much chuckling among City veterans over the missive sent out by the Financial Services Authority's Hector Sants instructing regulated firms to ensure that their remuneration policies are consistent with sound risk management. Before joining the FSA, Mr Sants, the classic poacher turned gamekeeper, held down a series of high-powered jobs in the City. As head of European equities at UBS in the mid-1990s was part of the management team that presided over two notorious instances of the sort of "bad or poor" remuneration practices he lists in his letter.

The first concerned UBS's cornering of the convertibles market, which was achieved by mispricing the product, and eventually resulted in substantial write-downs for the bank. The guys responsible were never required to pay back the massive bonuses they received while they were still the toast of the trading floor. Something very similar happened in structured products a little later. On that occasion, the fallout was so bad that it led directly to the enforced merger of UBS with Swiss Bank Corporation. I don't want to criticise the FSA chief executive, who in the past month has done an heroic job in saving the British banking system from meltdown. His execution of the rescue plan is widely regarded as masterful. What's more, everything he says on City pay is entirely sound, but no wonder he's so articulate on it all. This is one of those cases of do as I say, not as I did.

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