Outlook: HBOS's virtuous circle starts to pay dividends

Rising settlements; Chinese torture
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The Independent Online

James Crosby, the chief executive of HBOS, has made it his strategy to deliver decent levels of top- and bottom-line growth by feeding off the soft underbelly of his banking competitors, and to judge by yesterday's figures, he seems to be succeeding. The loan book is expanding like topsy, and across all product ranges from small business lending to cash savings and investment business, HBOS claims to be gaining market share at its rivals' expense. Less clear is for how much longer Mr Crosby can keep up the present breakneck pace of growth.

If history is any guide, rapid expansion of the loan book nearly always ends in a nasty road crash, as credit quality deteriorates and bad loans mount. HBOS insists that this time it will be different. How many times have you heard that before? The City's problem with Mr Crosby's strategy has all along been that though it promises to deliver value for customers by improving on the still lamentably low level of competition in the retail banking market, it isn't necessarily good for the bottom line. That worry persists despite the evidence of yesterday's 29 per cent rise in pre-tax profits.

Yet there are a number of reasons for believing Mr Crosby may indeed be right. The first is that the further expansion into commercial and small-business lending has been handled sensibly and professionally through the good services of an experienced business lender, Bank of Scotland. The bank's high exposure to some larger-than-life private equity players such as Philip Green, the Barclays and Rocco Forte, has raised eyebrows among rivals, but increasingly they have come round to the view that it is they who are missing the trick, not HBOS.

The second is that HBOS does genuinely seem to have established a virtuous circle of growth, where higher volumes enable it further to reduce its cost-to-income ratio, which in turn enables it to provide even better value products, which in turn generates more growth, and so on. Recently launched value products include the Halifax One credit card, which offers 0 per cent on outstanding balances for the first nine months and 9.9 per cent APR thereafter, and the 6 per cent regular savings product. So far the strategy has delivered according to plan. The cost-to-income ratio came down from 45.2 per cent in 2002 to 41.6 per cent last year, which is better even than "Fred the Shred's" 42 per cent at Royal Bank of Scotland Group. Mr Crosby promises to achieve less than 40 this year, when he also hopes to breach the 20 per cent barrier for return on capital.

None of this seems to do much for the share price, which continues to trade on a big discount in terms of the earnings multiple to Royal Bank of Scotland and HSBC. Mr Crosby promises to stick to his knitting, believing that the stock market will eventually reward him for it. Not for Mr Crosby the siren calls of the investment bankers, with their forked tongued promise of a better home for HBOS's capital in hair-brained acquisitions overseas. Instead, Mr Crosby continues to see plenty of opportunity for organic growth in the UK, the more so as many of his UK rivals seem to regard the UK market as over the hill. It's hardly rocket science, but the best way to serve your shareholders is first and foremost to serve your customers. HBOS seems to be succeeding in textbook fashion.

Rising settlements

To judge by yesterday's inflation-busting pay settlement with more than 200,000 builders, Britain actually rather needs the Polish and Latvian hordes which are said to be gathering at our borders, ready to swamp our job centres with cheap labour the moment the accession treaty comes into force. The more the better.

The going rate for pay settlements across the private sector as a whole is still around 3 per cent. The bigger numbers being agreed in the construction industry are being attributed to skill shortages and surging demand for private housing construction. Yet if the economy grows at the pace the Treasury and the Bank of England now think likely, labour shortages will fast become a reality across a wide range of different industries and settlements of this sort will become the norm. According to revised figures released yesterday, the British economy grew more strongly last year than previously thought. In fact, it grew by 2.3 per cent, which, given the hiatus in economic activity surrounding the Iraq war, looks a spectacularly robust performance.

The Chancellor was widely accused of exaggerating the numbers so as to make his public spending plans look more affordable when just two months ago he forecast growth for this year and next of 3-3.5 per cent. Now even the Bank of England agrees that growth is likely to be at the top end of that range. City economists are fast falling into line too, such has been the scale of the turnaround in business and consumer confidence so far this year.

Above-trend growth on this scale can only mean one thing; higher inflation. The strong pound will alleviate these inflationary pressures to some degree, but wage settlements at 8 per cent fast become infectious and with the Chancellor determined to squeeze the economy for yet more tax in the Budget, everyone will want a bit of what the construction workers have just won. Nobody is yet talking about rates of inflation approaching those of the 1970s or late 1980s. Yet inflation at even 4 or 5 per cent would require some painful interest rate therapy. The Chancellor may not want to pay the Eastern European immigrants any benefit, but he sure wants their labour and skills.

Chinese torture

With the world economy once more enjoying near-boom conditions, the currency swings that so concerned policy makers just a few months back seem suddenly to have lost their importance. If everyone is growing again, then the next guy's competitive currency devaluation doesn't seem to matter as much as it used to, when one region was growing at the expense of another. Today, even eurozone growth seems to be picking up strongly. Yet the currency "misalignment" that has grown up between the dollar and the euro hasn't gone away. Predictably, the statement agreed at the G7 in Florida earlier this month, to the effect that excess volatility in currency markets was bad for economic growth, failed to have any effect at all in halting the euro's steady appreciation against the dollar, nor will it until the underlying problem, which is America's trading relationship with the Far East, is removed.

US Treasury officials yesterday began two days of talks with their Chinese counterparts on, among other things, the continued existence of the yuan peg against the dollar, but neither side held out any hope of the peg being abandoned any time soon. The truth of the matter is that the peg continues to suit both countries, and as long as that's the case, the most that will happen is that peg gets is fine tuned, say to a slightly wider trading band than the present one. With one eye on the ballot box, the Bush Administration must continue to lobby for currency liberalisation, for the present depressed value of the renminbi against the dollar is costing US jobs.

Yet there is also a big upside in the status quo. Asia is fast becoming the motor of world economic growth, and China is its biggest piston. To support the peg, the Chinese must print money to buy dollar assets. In this way, China helps to finance America's gigantic current account deficit and because most of its currency intervention is directed at US Treasury bonds, it helps bridge the Budget deficit too. In other words, China is helping to keep American prices and interest rates low. The effect is the same with Japan, which is trying to depress the value of its currency through massive intervention.

Neither America or Asia has much interest in seeing this relationship brought to an abrupt close, even though the US Treasury Secretary, John Snow, promises to hold China's "feet to the fire" in removing the renminbi peg. It's only election rhetoric.