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Doubts growing over business lending plan

£80bn scheme could fall flat as companies shun borrowing, City warns ministers

City analysts and business leaders lined up yesterday to warn that the Government's new, £80bn business lending scheme is likely to prove less effective in boosting the economy than ministers hope.

Graeme Leach, chief economist at the Institute of Directors, said the cheap loans for new lending programme announced by the Chancellor and the Bank of England Governor at the Mansion House on Thursday would run into the problem of weak demand for credit.

"Companies alarmed by the euro crisis will not be eager to borrow, regardless of the cost," he said.

This was echoed by Chris Cummings of the TheCityUK, a pressure group representing the financial services, who said the problem in the economy is that businesses are too nervous to borrow and invest, rather than a shortage of supply from banks.

"Our members tell us that there is relatively weak demand from businesses for funding due to the ongoing economic uncertainty," he said.

John Longworth, director general of the British Chambers of Commerce, pointed out that previous efforts to stimulate lending by banks had failed and questioned whether this latest scheme would be any different.

He said. "Additional quantitative easing and the credit easing programme have not had the desired impact on the real economy. Can the Chancellor and Governor make sure these sequels trump the originals?"

Vicky Redwood, an economist with Capital Economics, said there was a danger that banks might not participate in the scheme, out of fear of exposing themselves to potential losses resulting from new lending in an uncertain climate.

There was, however, a warm welcome for the activation of the Bank of England's extended collateral term repo facility (ECTR), which will allow private banks to borrow cash for six months at ultra-low rates. John Cridland, the director-general of the CBI, described it as "a sensible, pre-emptive move" in the light of financial shocks which could emanate from the eurozone in the coming weeks.

Bank shares also did well as investors drew some comfort from the liquidity insurance. Royal Bank of Scotland rose by 7.9 per cent, followed by Barclays, which was up 4.2 per cent.

The Bank of England will hold its first auction of at least £5bn in sterling loans next Wednesday, and sales will be held at least once a month.

Under the terms of the ECTR, the Bank will accept bids for the funds at a spread of just 0.25 per cent above official interest rates, currently at 0.5 per cent.

This is below the 1.25 per cent spread over Bank rate set when the ECTR was announced last December. The cash will also be made available for six months rather than the 30 days originally anticipated.

There were further signs of the UK economy's declining health yesterday. April's seasonally adjusted trade deficit stretched to £4.4bn, its highest level in almost seven years, as exports to the eurozone dropped sharply.

Q&A: Lowdown on the Government's loan initiative

Q How will this new "funding for lending" scheme actually work?

The Bank of England will allow private banks to borrow highly liquid Treasury bonds and bills for three to four years. In return they will have to pledge parts of their existing loan books to the Bank as collateral – which means those assets are transferred to the state in the event that the banks can't pay back what they have borrowed. The Bank will impose a "haircut" on this collateral, meaning that the value of the pledged assets will have to be higher than the value of the loans. But the effective cost of this borrowing should still be significantly lower than other ways the banks can access funding.

Q How does that help the economy?

To access the cheap funding, banks will be required to commit that the money they borrow from the Bank will be to lent to businesses and households which need credit. The Treasury and the Bank have not set a target, but they point out that if the annual flow of lending increased by 5 per cent that would mean £80bn in new loans.

Q Will that happen then?

Impossible to say since it is depends on the behaviour of banks and borrowers. The banks complain there is little appetite for new loans because people are so depressed about the prospects for the economy. The Labour shadow chancellor, Ed Balls, agrees with this, saying it will only change when the Government injects more demand into the economy by cutting taxes and boosting spending. Others fear the banks have so many bad legacy loans on their books that they are determined to shrink their assets come what may. If this is right, even cheap borrowing will not induce them to lend.

Q How is this different from the other new liquidity scheme, the Extended Collateral Term Repo Facility?

This is strictly for short-term borrowing needs and comes with no strings attached. The Bank will allow banks to bid for six-month sterling loans at an ultra-cheap rate. This lending is not supposed to pump up the economy, but to ensure that banks don't run out of cash thanks to shocks from the eurozone.

Q Can this be called a Plan B for the economy?

It's more like Plan A plus. The Government and the Bank of England are keeping fiscal policy tight and sticking to their deficit-reduction schedule, but enacting a fresh loosening of monetary policy. They hope that by pumping enough liquidity into the financial system, this will have the effect of stimulating confidence and demand throughout the economy.