Tag: #strategy

“Why is Richard Koo’s profile rising in China?”

Because the Chinese government knows there is a disease called “balance sheet recession”.

The key chart

Trends in “excess credit growth” in China since December 2012 (Source: BIS; CMMP)

The key message

“The Chinese government knows that there is a disease called balance sheet recession, and they should know how to handle it”

Richard Koo, quoted by Bloomberg on 10 July 2023

Richard Koo is the Chief Economist at the Nomura Research Institute who developed the concept of “balance sheet recessions”. These recessions occur when “a nationwide asset bubble financed by debt bursts” (Koo, 2008). According to a Bloomberg article this week, “Koo’s ideas are being taken seriously in China”.

In this post, I explain why this is the case. I revisit my January 2023 arguments and update the data points and charts from “The missing link in the China re-opening story?”. I begin with the same question that I posed at the start of the year:

What happens if rather than seeking to maximise profit/utility as traditional economics assumes, the Chinese private sector (PS) turns to minimising debt or maximising savings instead? What if China experiences a balance sheet recession?

What does the data tell us?

While China’s PS indebtedness has declined from its 3Q20 peak, it remains above Japan’s “peak-bubble” level. Affordability risks remain elevated in China too. The PS debt ratio is not only high in absolute terms, but it is also elevated in relation to its long-term average. Chinese debt dynamics have shifted from excess growth in corporate credit growth, through excess growth in household debt, to a “passive deleveraging” phase. The risk remains that this extends to full PS debt minimisation i.e., a balance sheet recession.

Following recent re-intermediation, the Chinese banking sector is relatively exposed to the risks associated with these dynamics. The bank sector debt ratio exceeds the level reached at the height of the Spanish private sector debt bubble, for example, and is currently the highest ratio among BIS reporting economies.

What are the implications?

China’s debt dynamics point to potential demand (debt minimisation) and supply side (bank sector debt) constraints to future consumption.

From a policy perspective, Koo argues that the Chinese government must ramp up spending to offset private sector deleveraging. According to Bloomberg, he recommends a fresh wave of fiscal stimulus, targeted towards the real estate sector.

From an investment perspective, these factors need to be included in the investment narrative. It was a mistake to ignore private sector debt dynamics at the start of the year. It is a mistake to ignore them now…

Why is Richard Koo’s profile rising in China?

Personal background

I met Richard Koo in Tokyo when I was a graduate trainee at Nomura Securities in 1986. I left Nomura in 1988 to build the top-rated Japanese equities team (for European clients) at Baring Securities. I subsequently moved on from Japanese equities in the early 1990s to develop a career in banks research and macro strategy. I continued to follow Koo’s work, read his books and applied his approaches to my own analysis of monetary and macro developments in other advanced and emerging economies. We share a common analytical foundation based on a sector-balances framework.

My January 2023 message

In January 2023, I questioned the so-called “China re-opening” narrative. My scepticism centred on the level of Chinese private sector debt, the growth in HH debt and the affordability of private sector debt.

I asked, “What happens, for example, if rather than seeking to maximise profit/utility as traditional economics assumes, the Chinese private sector turns to minimising debt or maximising savings instead? What if China experiences a balance sheet recession?”

The July 2023 update

Trends in Japanese, Spanish and Chinese PS debt ratios since 1980 (Source: BIS; CMMP)

China’s private sector indebtedness exceeds the “peak-bubble” level seen in Japan in 4Q94. The private sector debt ratio was 220% GDP at the end of 4Q22, below its recent 225% peak but still above Japan’s peak debt ratio of 214% GDP. Note the similarity in debt ratio trends in Japan (debt bubble), Spain (debt bubble) and in China (see chart above). History rhymes…

Trend in the Chinese PS debt service ratio since 2000 (Source: BIS; CMMP)

Private sector affordability risks remain elevated too. The private sector debt service ratio (PS DSR) is not only elevated in absolute terms (20.6%) but it is also elevated in relation to its long-term average (15.7%). The PS DSR peaked in 3Q20 (see chart above) and has trended between 20-21% since then.

Trends in stock of HH and NFC debt (RMB tr) and PS debt ratio (% GDP, RHS) (Source: BIS; CMMP)

The Chinese private sector has already entered a period of passive deleveraging (see chart above). In other words, while to outstanding stock of debt continues to increase, it has been growing at a slower pace than nominal GDP since 3Q20.

Chinese debt dynamics have shifted from excess growth in corporate debt to excess credit growth in household debt and then to passive deleveraging. The risks remain that these trends extend to an extended period of private sector debt minimisation – i.e., a balance sheet recession.

Bank credit as a percentage of total PS credit (%) since 2007 (Source: BIS; CMMP)

With recent re-intermediation (see chart above), the Chinese banking sector is relatively exposed to the risks associated with current debt dynamics. The bank sector debt ratio (see chart below) exceeds the level reached at the height of the Spanish private sector debt bubble, for example, and is currently the highest ratio among BIS reporting economies (excluding Hong Kong).

Trends in Japanese, Spanish and Chinese bank sector debt ratios (% GDP) (Source: BIS; CMMP)

Conclusion

China’s debt dynamics point to potential demand (debt minimisation) and supply side (bank sector debt) constraints to future consumption.

From a policy perspective, Koo argues that the Chinese government must ramp up spending to offset private sector deleveraging. According to Bloomberg, he recommends a fresh wave of fiscal stimulus, targeted towards the real estate sector.

From an investment perspective, these factors need to be included in the investment narrative. It was a mistake to ignore private sector debt dynamics at the start of the year. It is a mistake to ignore them now…

Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.

“Is there such a thing as the EA mortgage market?”

Yes, but it’s complicated…

The key chart

Trends in total EA mortgages (EUR bn, LHS) and annual growth (% YoY, RHS) (Source: ECB; CMMP)

The key message

The answer to the question, “Is there such a thing as the EA mortgage market?” seems obvious. Of course there is.

We know its size (€5,228bn), its structure (biased towards fixed rate lending) and its importance to banks (40% of total lending). We also know the current cost of borrowing (3.44%) and the speed with which higher policy rates have passed through to this cost (147bp so far). We can monitor the rate of growth in mortgages (3.0% YoY in nominal terms, -3.7% in real terms) and in monthly flows (slowing sharply).

Not so fast…!

The complication here is that these aggregate data points mask very important variations at the national level. These include:

Size (€5,288bn): five national markets dominate (“the big five”). Germany and France account for 56% of total EA mortgages alone and for 85% together with the Netherlands, Spain and Italy.

Structure of new mortgages (over 75% fixed-rate): varies from over 90% variable-rate in Finland, Lithuania, Estonia and Latvia to over 90% fixed-rate in Slovenia, Slovakia, France, Belgium and Ireland. Among the big five, relatively high exposures to fixed rate lending in France, Germany and the Netherlands, relatively low exposures in Italy and Spain.

Exposure to mortgage lending (40% of total lending): ranges from 50% in Malta and Slovakia to 25% or less in Luxembourg and Greece. Among the big five, above average exposures in the Netherlands, Germany and Spain, below average exposures in France, and more noticeably in Italy.

Cost of borrowing (3.44%, April 2023): ranges from 5.32%, 5.27% and 4.99% in Latvia, Lithuania and Estonia respectively to 2.24% and 2.61% in Malta and France respectively. Among the big five above average costs in all markets with the exception of France. Note that French banks have (1) relatively high exposure to fixed rate mortgages and, (2) unlike most other EA lenders, are constrained by the Banque de France on the amount they can charge borrowers.

Transmission mechanism of higher policy rates (147bp, so far): most rapid in Lithuania, Latvia, Estonia, Portugal, and in Italy and Spain among big five – all markets with above average exposure to variable-rate mortgages. Weakest in Malta, Ireland, Greece, and among the big five in France, Germany and the Netherlands. With the exception of Malta, these markets all have relatively high exposures to fixed-rate lending.

Growth (slowed to 3.0% YoY in April 2023, the slowest rate since May 2018): Skewed heavily towards German and French growth dynamics (1.1ppt and 1.0ppt of total 3.0% respectively). Large variations in nominal growth rates from 9.8% and 9.5% in Lithuania and Estonia respectively to -4.0% in Greece and -1.9% in Spain and Ireland. Among the big five, above average growth in France, Germany and the Netherlands, but below average growth in Italy and Spain. In real terms, mortgage growth peaked at 5.0% YoY in December 2020, eight months before the peak in nominal growth. It turned negative in February 2022 and has been negative ever since (-3.7% YoY, April 2023). Only Belgium and Malta are experiencing positive mortgage growth in real terms.

What does this mean?

The EA mortgage market is as an aggregation of heterogeneous, national markets that differ greatly in terms of size, structure, importance, cost, transmission mechanism and growth rates.

The challenge for bankers, investors and analysts alike is to understand these differences and their implications. The far greater challenge for the ECB is to incorporate them all in the design of a “one-size-fits-all” monetary policy. The context, in part, for this week’s ECB press conference on Thursday 15 June 2023.

Is there such a thing as the EA mortgage market?

Market size

Trends in the outstanding stock of EA mortgages (EUR bn) (Source: ECB; CMMP)

The outstanding stock of mortgages across the EA was €5,228bn at the end of April 2023 (see chart above).

Five national markets (the “big five”) dominate in terms of size and account for 85% of the outstanding stock collectively (see chart below) – Germany (€1,574bn, 30% share), France (€1,333bn, 26% share), the Netherlands (€555bn, 11% share), Spain (€505bn, 10% share) and Italy (€426bn, 8% share).

National mortgage markets ranked by size (EUR bn, LHS) and cumulative market share (%, RHS) (Source: ECB; CMMP)

Mortgage types

Twenty year trends in share of variable rate loans in total new mortages (%) (Source: ECB; CMMP)

At the aggregate level, just over three quarters of new mortgages are fixed-rate mortgages, up from 13% in March 2022 (see chart above). The structure varies, however, from over 90% variable rate mortgages in Finland, Lithuania, Estonia and Latvia to less than 10% variable rate mortgages in Slovenia, Slovakia, France, Belgium and Ireland (see chart below).

National mortgage markets ranked by exposure to variable rate lending (% new loans) (Source: ECB; CMMP)

Among the big five markets, the share of variable rate mortgages in new loans ranges from 41% and 39% in Italy and Spain to 20% in the Netherlands, 16% in Germany and only 4% in France. Note also that, in aggregate, the exposure to variable rate mortgages in the EA is currently higher than in the UK (18%).

Exposure to mortgage lending

National mortgage markets ranked by exposure to mortgages (% total loans) (Source: ECB; CMMP)

Mortgages account for 40% of total lending to EA residents at the aggregate level. This exposure ranges from 50% of total loans in Malta and Slovakia to 23% and 25% in Luxembourg and Greece respectively. Among the big five, banks in the Netherlands (48%), Germany (43%) and Spain (41%) have above average exposures to mortgage lending, while banks in France (39%) and, more noticeably, Italy (28%) have lower-than-average exposures.

Composite cost of borrowing for house purchase

National mortgage markets ranked by cost of borrowing for house purchase (%) (Source: ECB; CMMP)

In nominal terms, the CCOB for house purchases ranges from 5.32%, 5.27% and 4.99% in Latvia, Lithuania and Estonia respectively to 2.24% and 2.61% in Malta and France respectively (see chart above). Among the big five markets, the CCOB is above average in Italy (4.15%), Germany (3.89%), the Netherlands (3.62%) and Spain and only below average in France (2.61%).

Note that French banks have (1) relatively high exposure to fixed-rate mortgages and (2), unlike most other EA lenders, are constrained by a limit, set by the Banque de France, on the amount that they can charge for mortgages. In short, they have a lower sensitivity to the positive benefits of rising interest rates.

Note also that the CCOB of borrowing for house purchases remains below the current rates of inflation (HICP) in all of the EA economies except Luxembourg, Cyprus and Belgium.

Pass through of higher policy rates

National mortgage markets ranked by pass through (bp) of higher ECB policy rates (Source: ECB; CMMP)

The composite cost (CCOB) for new loans to EA HHs for house purchase has increased by 147bp since June 2022 to 3.44% in April 2023.

The pass through from policy tightening has been greatest (in nominal terms) in Lithuania (315bp), Latvia (284bp), Estonia (274bp) and Portugal (251bp) and in Italy (197bp) and Spain (179bp) among the big five markets.

The pass though has been weakest in Malta (11bp), Ireland (74bp), Greece (84bp) and in France (126bp), Germany (132bp) and the Netherlands (141bp) among the big five markets.

Change in CCOB since tightening (bp) plotted against current CCOB (% April 2023) (Source: ECB; CMMP)

Growth in mortgage lending

Trend in annual growth rate (% YoY, nominal) of lending to the private sector (Source: ECB; CMMP)

The annual growth rate in EA mortgages slowed to 3.0% YoY in April 2023, down 2.8ppt from the August 2021 peak of 5.8%. Growth has slowed 2.4ppt since tightening began in 2022. April 2023’s growth rate is the slowest rate of growth recorded since May 2018.

Contribution (ppt) of big five and “others” to growth in EA mortgages (% YoY) (Source: ECB, CMMP)

Germany and France have been the main contributors to aggregate growth since 2015. In April 2023, Germany and France contributed 1.1ppt and 1.0ppt to the total YoY growth of 3.0% alone. Netherlands and Italy contributed 0.4ppt and 0.2ppt respectively. The most obvious contrast between the post-2015 recovery in EA mortgage demand and the pre-GFC period is the lack of contribution/negative contribution from Spain for large parts of post-GFC period, reflecting the bursting of the Spanish real estate bubble.

National mortgage markets ranked by nominal growth rate (% YoY) (Source: ECB; CMMP)

Large variations exists in the nominal YoY growth rates at the country level. In April 2023, these ranged from 9.8% and 9.5% in Lithuania and Estonia respectively to -4.0% in Greece and -1.9% in both Spain and Ireland. Among the big five markets, growth was above average in France (4.1%), Germany (3.8%), and the Netherlands (3.6%) but below average in Italy (2.7%) and Spain (-1.9%).

Trends in mortgage growth rates expressed in nominal and real terms (Source: ECB; CMMP)

Inflation also complicates the analysis of EA mortgage dynamic. In real terms, mortgage growth peaked at 5.0% YoY in December 2020, eight months before the peak in nominal growth. It turned negative in February 2022 and has been negative since then. In April 2023, mortgage lending fell -3.7% YoY in real terms.

National mortgage markets ranked by real growth rate (% YoY) (Source: ECB; CMMP)

Conclusion

The EA mortgage market is as an aggregation of heterogeneous, national markets that differ greatly in terms of size, structure, importance, cost, transmission mechanism and growth rates. The challenge for bankers, investors and analysts alike is to understand these differences and their implications. The far greater challenge for the ECB is to incorporate them all in the design of a “one-size-fits-all” monetary policy. The context, in part, for this week’s ECB press conference on Thursday 15 June 2023.

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“If you wanted to create panic about EA banks….”

…you might focus exclusively on narrow money.

The key chart

Recent trends in monthly flows (EUR bn) and YoY growth rates in EA monetary aggregates (Source: ECB; CMMP)

The key message

If you wanted to “create panic” about euro area (EA) banks you could focus exclusively on negative YoY growth rates and monthly outflows in narrow money (M1), and then develop a narrative about money destruction and an impending credit crisis. After all, the EA is experiencing the fastest contraction in M1 since the creation of the Economic and Monetary Union in 1999, and banks have experienced eight consecutive months of negative flows in narrow money too.

Unfortunately, there are a number of problems associated with this “panic narrative”. It ignores simple concepts such as opportunity cost and portfolio rebalancing and mispresents the causal links in money creation.

  • The opportunity cost problem: unprecedented tightening by the ECB has led to a rapid increase in the opportunity cost of holding ON deposits, in contrast to most of the past decade. It has triggered a partial reallocation of ON deposits to other ST deposits. M2-M1 (other ST deposits) increased 21% YoY in April 2023 – also the fastest rate since the creation of the EMU.
  • The portfolio rebalancing problem: The phasing out of net asset purchases and TLTROs has incentivised the issuance of bank bonds (up €170bn) since September 2022. This has led to portfolio rebalancing away from deposits (down €200bn over the same period) to longer term liabilities that do not form part of monetary aggregates (by definition).
  • The causal link problem: the principal way in which bank deposits are created is through commercial banks making loans. Banks are not simply intermediaries that take in deposits and then lend them out (“loanable funds theory”). Instead, banks create money. Growth in private sector credit peaked in September 2022 (7.0% YoY) and has slowed to 3.3% in April 2023, however. This reflects the relatively rapid pass through from higher policy rates to the cost of borrowing, weaker loan demand and tighter credit standards. Slower credit growth implies slower deposit growth (ceteris paribus).

In short, recent EA monetary dynamics are unprecedented in some respects. They are not a cause for panic over EA banks, however. They reflect instead a combination of an increase in the opportunity cost of holding money, portfolio rebalancing, weaker credit demand and tighter credit standards.

This is not to suggest that the message from EA banks is a positive one. On the contrary, it remains one of weaker economic activity and a challenging policy context in which the ECB is expected to continue tightening as economic stresses mount.

An important message, but a very different one to the “bank panic narratives” seen elsewhere…

If you wanted to create panic about EA banks

Focus on narrow money

Growth rates (% YoY) in EA narrow money since 1999 (Source: ECB; CMMP)

Narrow money (M1) in the EA is contracting at the fastest rate since the creation of the Economic and Monetary Union (EMU) in 1999 (see chart above). The annual growth rate in M1 turned negative in January 2023 (-0.8%) and has decelerated each month since then: -2.7% YoY in February 2023; -4.2% YoY in March 2023 and -5.2% YoY in April 2023.

Monthly flows (EUR bn) in narrow money since June 2022 (Source: ECB; CMMP)

EA banks have also experienced eight consecutive monthly outflows of narrow money since September 2022, largely due to the outflow of overnight deposits. The outflow in April 2023 was €-75bn, compared with €-135bn in March 2023, and €-140bn in February 2023 (see chart above).

From here, it is tempting to create a “panic narrative” for EA banks. Tempting, but wrong…

Problems with the panic narrative – “opportunity cost”

Growth rate in M3 (% YoY) and contribution from ON deposits and other components (ppt) (Source: ECB; CMMP)

The first problem with the panic narrative is that it ignores the fundamental economic concept of opportunity cost.

Note that for most of the past decade, narrow money has been the main driver of EA broad money growth. The chart above illustrates the growth rate in broad money (M3) and the contributions to growth made by ON deposits (the light blue columns) and all other M3 components (the maroon columns).

The exceptionally large contribution and accumulation of ON deposits in the EA (and elsewhere) over the period reflects (1) the extended period of low interest rates and, more recently, (2) the COVID-19 pandemic. Unorthodox monetary policy reduced the opportunity cost of holding ON deposits dramatically and the pandemic resulted in a sharp rise in both forced and precautionary savings.

Policy tightening by the ECB since June 2022 has been notable for both its scale and pace. The pass through from higher policy rates to the cost of overnight deposits has been very slow/limited and has lagged the pass through to the cost of other forms of ST deposits, however.

In short, the opportunity cost of holding ON deposits has risen rapidly since the start of policy tightening.

Spread between rates on other HH ST deposits and HH ON deposits (ppt) (Source: ECB; CMMP)

The chart above illustrates the spread (or opportunity cost) between HH deposits redeemable at notice of up to three months and deposits with an agreed maturity of up to two years – the components of M2-M1 – versus HH ON deposits over the past 20 years.

The opportunity costs of holding notice deposits, and terms deposits with maturities of up to one year and between one and two years hit lows of 32bp, 13bp and 18bp in December 2021, June 2021 and March 2021 respectively. Since then they have risen to 106bp, 194bp and 194bp respectively, levels not seen since early 2013.

Spread between rates on other NFC ST deposits and NFC ON deposits (ppt) (Source: ECB; CMMP)

The chart above illustrates the spread (opportunity cost) between NFC time deposits – again M2-M1- and NFC ON deposits over the past twenty years. In this case the opportunity costs of holding term deposits hit lows of -33bp in November 2021 for maturities up to one year and 4bp for maturities between one and two years. Since, then they have risen to 215bp and 243bp respectively, levels last seen during the GFC.

Growth rates (% YoY) in M1 and M2-M1 since 1999 (Source: ECB; CMMP)

ECB policy has triggered a reallocation of funds from overnight deposits to other ST deposits. The growth rate in M2-M1 rose to 21% YoY in April. This is, in turn, the fastest rate of growth since the creation of the EMU.

Monthly flows (EUR bn) on EA monetary aggregates (Source: ECB; CMMP)

Inflows into other ST liabilities, M2-M1 and, to a lesser extent, M3-M2 have been important but still insufficient to compensate fully for the outflows in overnight deposits (see chart above). Hence, monthly flows of M3 have been negative in six of the past seven months.

Problems with the panic narrative – “portfolio rebalancing”

The second problem with the panic narrative is that it ignores portfolio rebalancing to other financial instruments. Note that money supply is derived from the banks’ ST liabilities and does not include longer-term liabilities since they are not close substitutes for money.

According to the ECB, bank bond issuance has increased by almost €170bn since September 2022. The terms and conditions of TLRTO II were recalibrated at this point resulting in sizeable repayments of funds borrowed under the programme and an increase in (more expensive) bond issuance. Bond issuance was close to total c€200bn decrease in the bank deposits over the period.

In short, M1 dynamics reflect both a substitution of ON deposits with time deposits (opportunity cost) and shifts to bank bonds (portfolio rebalancing) and, to a lesser extent money market fund shares. Funding costs may be rising but there is no evidence of liquidity-driven panic.

Problems with the panic narrative – “causal links in money creation”

The final problem with the panic narrative is that it misrepresents the causal links in money creation. Contrary to what is often taught (“loanable funds theory”), banks are not intermediaries that take in deposits first and then lend them out. Instead banks create money.

“Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money”

(Bank of England, 2014).

Growth rates in (adjusted) private sector credit (% YoY) since 2003 (Source: ECB; CMMP)

The principal way in which bank deposits are created is through commercial banks making loans. Growth in private sector lending peaked in September 2022 at 7% YoY, however (see graph above). In April 2023, growth has slowed to 3.3% YoY from 3.9% YoY in March 2023 and 4.3% YoY in February 2023. The moderation in bank lending reflects the relatively rapid pass through from policy rates to the cost of borrowing, weaker demand and tighter credit standards.

Growth rates in M3, M1 and private sector credit (% YoY) (Source: ECB; CMMP)

Conclusion – focus on the wider message not the panic narrative

In short, recent EA monetary dynamics are unprecedented in some areas. They are not a cause for panic over EA banks, however. They reflect instead a combination of an increase in the opportunity cost of holding money, portfolio rebalancing, weaker credit demand and tighter credit standards.

This is not to suggest that the message from EA banks is a positive one. On the contrary, it remains one of weaker economic activity and a challenging policy context in which the ECB is expected to continue tightening as economic stresses mount. An important message, but a very different one to the “bank panic narratives” seen elsewhere…

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“Does President Lagarde have an easier job…”

…than Chair Powell or Governor Bailey?

The key chart

Quarterly consumer credit flows expressed as a multiple of pre-pandemic average flows (Source: ECB; FRED; BoE)

The key message

Does President Lagarde have an easier job than Chair Powell or Governor Bailey? In one important respect, yes.

Demand for consumer credit remains very subdued in the euro area (EA) in absolute terms and in contrast to trends observed in the US and the UK.

The European Central Bank (ECB), Federal Reserve and Bank of England each face delicate balancing acts between reducing inflation (their core mandates) and weaker growth. On the one hand, higher interest rates are supposed to deter borrowing and hence reduce aggregate demand and inflation. On the other hand, increased borrowing is one way that households can offset the pressures of falling real incomes.

“Higher interest rates provide incentives to households to save more now and postpone consumption from the present to the future”

Philip Lane, October 2022

In terms of reducing inflation, the fact that demand for consumer credit remains very subdued in absolute terms and in contrast to trends observed in the US and the UK makes President Lagarde’s task easier (if not easy!).

The EA has experienced eight consecutive quarters of positive consumer credit flows since 2Q21 (see key chart). These flows have yet to recover to their pre-pandemic levels, however. In 1Q23, the quarterly flow totalled €4.1bn, down from €5.2bn and €4.9bn in 4Q22 and 3Q22 respectively. Perhaps more importantly, the 1Q23 flow was only 0.4x the pre-pandemic average quarterly flow of €10.2bn.

Investors positioned for growth in the EA might take some comfort from the recovery in consumer demand in March 2023. The monthly flow rose to €2.6bn from €1.6bn in February 2023, but was still only 0.76x the pre-pandemic average flow of €3.4bn.

That said, the relatively subdued nature of EA consumer credit demand suggests that the risks to the ECB’s balancing act lie more towards weaker growth/recession. A different balance of risks to those faced by Chair Powell and Governor Bailey.

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“Still tightening as stresses mount”

Three warning signs from the rolling over in EA money and credit cycles

The key chart

Trends in nominal YoY growth rates in M3, M1 and private sector credit
(Source: ECB; CMMP)

The key message

As growth in euro area (EA) money supply in February 2023 falls to its slowest rate (2.9% YoY) since October 2014, the “message from the money sector” includes three key warning signs for the ECB and for investors in the region:

  • Warning sign #1: banks’ top-line growth. Banks continue to experience net outflows of ST liabilities and a substitution away from low-cost overnight deposits to more expensive “other ST deposits”, at the margin (this is not just a US story). At the same time, credit growth is slowing i.e. negative price and volume effects.
  • Warning sign #2: house prices and household consumption. Monthly flows of mortgage and consumer credit have slowed sharply, to well-below pre-pandemic levels.
  • Warning sign #3 (re-enforced): weakening economic growth outlook. Leading, coincident and lagging monetary variables are slowing sharply and in a coordinated fashion at a time when access to finance is becoming more difficult and more expensive.

On 16 March 2023, ECB President Lagarde commented that, “we are beginning to see the transmission of our monetary policy.” Eleven days later, the money sector is adding the important detail – increased stresses for banks, households and the economic outlook for the euro area.

Will the “data dependent” central bank listen to its money sector and, if so, how will it respond? The risks of policy mistakes are rising as quickly as money and credit cycles are falling…

Still tightening as stresses mount

Trends in broad money growth since 2003 (% YoY, nominal terms)
(Source: ECB; CMMP)

According to the latest ECB “Monetary Developments in the euro area” data release (27 March 2023), growth in broad money (M3) fell to 2.9% YoY in February 2023, down from 3.5% in January 2023 and 4.1% in December 2022. February’s growth rate was the slowest since October 2014.

Trends in broad money growth (% YoY) and breakdown of contribution (ppt)
(Source: ECB; CMMP)

The sharp slowdown in narrow money (M1) is a key driver here. Recall that at the point of the January 2021 peak in M3 growth (12.5%), M1 contributed 11.3ppt to this total growth in broad money (see chart above).

This reflected the fact that households (HHs) and corporates (NFCs) were hoarding cash, largely in the form or overnight deposits, despite the fact that they were only earning a return of 0.01%. In stark contrast, narrow money fell -2.7% YoY in February 2023 as overnight deposits fell -2.7% YoY.  

As money supply growth slows sharply, the message from the money sector behind these headline figures contains three key warning signs for the ECB and for investors in the region.

Warning sign #1 – banks’ top line growth

Monthly flows of ST liabilities by type (EUR bn)
(Source: ECB; CMMP)

Banks continue to experience net outflows of ST liabilities and a substitution away from low-cost overnight deposits to more expensive “other ST deposits”, at the margin. Continuing the theme from “Competing for funding”, EA banks have experienced outflows of ST liabilities in four of the past five months. This reflects six consecutive months of overnight deposits outflows (the blue columns in the chart above). Inflows in other ST deposits (within M2-M1 above) and, to a lesser extent, marketable securities (within M3-M2) have not been able to compensate. They also come at a higher cost.

Trends in private sector credit growth (% YoY) and breakdown of contribution (ppt)
(Source: ECB; CMMP)

At the same time, credit growth is slowing. Adjusted private sector credit (PSC) growth peaked recently at 7.1% YoY in September 2022. NFC credit grew 8.9% at this point and made the largest contribution to total loan growth (3.5ppt). HH credit grew 4.4% and contributed 2.3ppt.

By February 2023, PSC growth had slowed to 4.3% YoY. NFC credit growth slowed to 5.7%, but remained the largest contributor to total PSC growth (2.2ppt). HH credit growth slowed to 3.2% YoY, a 1.7ppt contribution to total PSC growth.

Warning sign #2: house prices and household consumption

Trends in monthly mortgage flows (EUR bn)
(Source: ECB; CMMP)

Monthly flows of mortgage and consumer credit have slowed sharply to below pre-pandemic levels.Monthly mortgage flows slowed to €5.1bn in February 2023, from €13.7bn a year ago (see chart above). Note that the growth in the outstanding stock of EA mortgages peaked at 5.8% in August 2021 and slowed noticeably after June 2022. February’s growth rate was 3.7% YoY, the slowest growth rate since November 2019.

Trends in monthly consumer credit flows (EUR bn)
(Source: ECB; CMMP)

Monthly consumer credit flows fell to €1.9bn in February 2023 from €3.4bn a year earlier (see chart above). Note that while consumer credit flows have recovered, they have remained below the average pre-pandemic flows of €3.4bn throughout the post-pandemic period. This is in contrast to trends observed in the US and the UK.

Monthly mortgage and consumer credit flows as a multiple of pre-pandemic average flows (Source: ECB; CMMP)

With monthly mortgage and consumer credit flows falling to 0.30x and 0.33x their respective pre-pandemic average monthly flows(see chart above), the EA money sector is sending clear warning signs for future house prices and HH consumption in the region.

Warning sign #3 (re-enforced): weakening economic growth outlook

Trends in real M1, HH credit and NFC credit (% YoY, real terms)
(Source: ECB; CMMP)

Leading, coincident and lagging monetary variables are slowing sharply and in a coordinated fashion at a time when access to finance is becoming more difficult and more expensive. Real growth rates in M1, HH credit and NFC credit typically display leading, coincident and lagging relationships with real GDP. The sharp and coordinated slowdown in these variables has been sending warning signs from some months now. If historic relationships between these variables continue, this suggest that economic activity will decelerate over the next quarters.

Conclusion

On 16 March 2023, ECB President Lagarde commented that, “we are beginning to see the transmission of our monetary policy.” Eleven days later, the money sector is adding the important detail – increased stresses for banks, households and the economic outlook for the euro area.

Will the “data dependent” central bank listen to its money sector and, if so, how will it respond? The risks of policy mistakes are rising as sharply as money and credit cycles are falling…

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“Behind a nation of non-savers”

The largest fall in UK real living standards since records began

The key chart

Trends and OBR forecasts for UK households sector balances (% GDP)
(Source: OBR; CMMP)

The key message

Hidden behind the headlines of yesterday’s (15 March 2023) UK budget are three important trends:

  1. The shift from large UK household (HH) surpluses (the main counterpart to government deficits) to…
  2. …little or no net HH savings or borrowings…
  3. …and rising financial inequality

Official OBR forecasts suggest that UK living standards will experience the largest two-year fall in real living standards since records began, bringing real HH disposable income (RHDI) per capita back to 2014-15 levels. Drawdowns on HH savings will not fully compensate for falling RHDIs, hitting consumption and growth in the process.

Expect these trends and rising financial inequality to be centre stage in the build up to the next UK general election – even if they were missing from yesterday’s budget coverage.

Behind a nation of non-savers

UK HHs built up large financial surpluses during the COVID-pandemic and the energy crisis. These surpluses were the main counterpart to the UK government’s large fiscal deficit (see chart below).

The impact of COVID on UK HH and government sector balances (% GDP)
(Source: OBR; CMMP)

According to latest OBR forecasts, the HH sector will move from a net lending position in 2022 to balance in 2023, however, as savings are drawn down to support consumption (see key chart above).

What factors are behind a nation of non-savers, and what do they mean for the UK’s economic and political outlook?

Trends and forecasts for RHDI (% YoY)
(Source: OBR; CMMP)

The OBR expects RHDI to fall by 2.6% in 2023, as inflation (4.9%) continues to outstrip nominal earnings growth (3.6%). This follows a fall of 2.5% in 2022 (see chart above).

Trends and forecasts for RHDI per capita (£ thousands)
(Source: OBR; CMMP)

The OBR also forecasts that RHDI per person (a measure of living standards) will fall by 6% between FY22 and FY 24 – the largest two-year fall in real living standards since records began in the 1950s. If correct, RHDI per person would fall to its lowest level since FY2015 (see chart above).

In response, HHs can either save less, borrow more and/or consume less. The OBR’s forecasts focus on the first factor. HH’s saving is expected to fall to zero in 2023 and 2024 to “support consumption in the face of weak real income growth.” As the “cost-of-living crisis” eases, the savings ratio is forecast to recover to around 1%, still well below the post-financial crisis average (see chart below).

Trends and forecasts for HH savings ratio (% disposable income)
(Source: OBR; CMMP)

Lower savings will only partially offset the drop in real incomes, however. This means that private consumption will fall in 2023 by 0.8%. Note that the OBR estimates that this fall would be 1.5ppt higher if the savings ratio remained at 2022 levels. Looking further ahead, the forecasts suggest that consumption growth recovers to an average 1.7% a year out to 1Q28 – better than forecast in November, but still unexciting.

HH savings ratio by income decile (% disposable income)
(Source: BoE; CMMP)

What is missing here is the outlook for financial inequality. Lower-income HHs have much less flexibility to adjust their spending in response to rising prices and are less likely to have a cushion of savings to protect them. Recall that HHs in the bottom three income deciles save less than 6% of their gross income. This contrasts with HHs in the top two income deciles who save more than 30% of their gross income (see chart above).

Conclusion

Official forecasts suggest that UK living standards will experience the largest two-year fall in real living standards since records began, bringing real HH disposable income (RHDI) per capita back to 2014-15 levels. Drawdowns on HH savings will not fully compensate for falling RHDIs, hitting consumption and growth in the process.

Expect these trends and rising financial inequality to be centre stage in the build up to the next UK general election – even if they were missing from yesterday’s budget coverage.

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“Still unbalanced and dependent”

OBR forecasts present a brighter outlook, but fundamental challenges remain

The key chart

Trends and OBR forecasts for UK sector balances (% GDP)
(Source: OBR; CMMP)

The key message

The OBR’s latest “Economic and fiscal outlook” (published 15 March 2023) presents a brighter outlook for the UK economic and fiscal outlook – a shorter and shallower downturn, higher medium term output and lower budget deficits and public debt.

Viewed from our preferred sector balances perspective, however, the forecasts indicate that fundamental challenges and economic imbalances remain.

According to the OBR….

While the Chancellor and other fiscal hawks celebrate lower deficits, the UK’s household (HH) sector will move from a large surplus to a balance as savings are drawn down to support consumption during the squeeze on real disposable incomes. (This means no net HH saving or borrowing over a sustained period – really??). Private consumption will still fall in 2023, however (by 0.8%), as lower savings will only partially offset the decline in incomes.

Corporate (NFC) investment will disappoint too. The NFC sector moves from a modest surplus (ie, disinvestment) to balance as investment picks up, but only gradually.

With the private sector running small surpluses (as opposed to the small deficits forecast in November 2022), borrowing from the rest of the world remains sizeable and persistent.

In short, the OBR expects a return to the pre-pandemic world of economic imbalances. The good news, for what it’s worth, is that the private sector is forecast to run a small surplus rather than a deficit as before (and as predicted in November 2022). The bad news is that the UK economy is forecast to remain heavily dependent on net borrowing from abroad. A familiar story…

Six charts that matter

The impact of COVID on UK domestic sector balances (% GDP)
(Source: OBR; CMMP)

Don’t forget the context (see chart above)!

The counterpart to the large government debt built up during the pandemic (-26% GDP, June 2020) was large financial surpluses for UK households (+18% GDP, June 2020) and, to a lesser extent, UK corporations (+7% GDP).

From here, and according to the OBR….

Trends and OBR forecasts for government net borrowing (% GDP)
(Source: OBR; CMMP)
Trends and OBR forecasts for HH sector balances (% GDP)
(Source: OBR; CMMP)
Trends and OBR forecasts for NFC sector balances (% GDP)
(Source: OBR; CMMP)
Trends and OBR forecasts for RoW sector balances (% GDP)
(Source: OBR; CMMP)

In short, the OBR expects a return to the pre-pandemic world of economic imbalances (see chart below).

Trends and OBR forecasts for UK sector balances (% GDP)
(Source: OBR; CMMP)

The good news, for what it’s worth, is that the private sector is forecast to run a small surplus rather than a deficit as before (and as predicted in the previous OBR forecasts).

The bad news is that the UK economy is forecast to remain heavily dependent on net borrowing from abroad. A familiar story…

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“No growth in productive lending”

Does the lack of growth in UK corporate lending since 2008 matter?

The key chart

Trends in sterling lending to corporates since 2003 (£bn)
(Source: BoE; CMMP)

The key message

The outstanding stock of sterling lending to private sector companies (NFCs) in the UK was £455bn at the end of January 2023. This is £61bn or 12% below the peak of NFC lending back in August 2008.

Does the lack of growth in UK corporate lending since 2008 matter, and if so, why?

NFC lending represents the largest segment of productive “COCO-based lending” i.e. lending that supports both production and income formation. Note that while an increase in NFC lending increases the level of debt in the economy, it also increases the income required to finance it.

Back in July 2015, the UK government argued that the financial services sector, “is critical for supporting the rest of the economy, allocating resources and facilitating long term productive investment.” Fast-forward 90 months, and only 17 pence in every pound lent in the UK supports NFCs is generating sales revenues, wages, profits and economic expansion, however. (This contrasts with 39 cents in every euro lent in the euro area.)

Rather that supporting production and income formation, UK lending has become increasingly skewed towards supporting capital gains largely through higher asset prices (78% of total lending). Mortgages alone account for 53p in every pound lent in the UK, for example.

This is an important part of the context for the Chancellor’s Budget on 15 March 2023. In considering options for stimulating growth in the UK economy, Jeremy Hunt, might ponder the question, “what is the purpose of UK banking?”

Proposals that stimulate investment and encourage a shift back towards more productive forms of bank lending would be welcome.

Please note that the short summary comments and chart above are abstracts from more detailed analysis that is available separately.

“Not so synchronised!”

Contrasting messages from the UK and EA money sectors

The key chart

Trends in monthly consumer credit flows expressed as a multiple of pre-pandemic averages (x) (Source: BoE; ECB; CMMP)

The key message

While the UK and euro area (EA) money sectors are sending consistent messages about the slowdown in mortgage demand, their messages about consumer credit demand are contrasting and diverging.

Monthly consumer credit flows recovered in the UK in January 2023, back to their pre-pandemic levels and to their highest level since June 2022. In contrast, they fell and remain depressed in relation to their pre-pandemic levels in the EA.

This matters for two reasons: (1) increased borrowing is one way that households can offset the pressures from falling real incomes and (2) consumer credit is the second most important element of productive COCO-based lending.

More policy challenges for the ECB…

Not so synchronised

UK consumer credit flows

The monthly flow of UK consumer credit increased to £1.6bn in January 2023, from £0.8bn in December 2022. This was the highest net borrowing since June 2022 and was 1.3x the pre-pandemic flow of £1.2bn. The 3m MVA of consumer credit flows increased to £1.2bn in January, from £1.0bn in December, very slightly above the pre-pandemic flow (see chart below).

Monthly flows of UK consumer credit (£bn)
(Source: BoE; CMMP)

EA consumer credit flows

In contrast, the monthly flow of EA consumer credit fell to €0.3bn in January, down from €1.5bn in December and only 0.1x the pre-pandemic average flow of €3.4bn. The 3m MVA of consumer credit flows decreased to €1.3bn in January, from €1.7bn in December, 0.4x the pre-pandemic average flow.

Note that consumer credit flows in the EA have failed to recover to their pre-pandemic levels (see chart below).

Monthly flows of EA consumer credit (EUR bn)
(Source: ECB; CMMP)

Why this matters

This matters since increased borrowing is one way that UK and EA HHs can offset the pressures from falling disposable incomes (along with reduced savings).

Consumer credit is also the second most important element of productive COCO-based lending, after corporate credit. It supports productive enterprise since it drives demand for goods and services, hence helping corporates to generate sales, profits and wages.

More policy challenges for the ECB…

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“Deflating the EA mortgage market”

German and French dynamics drive the slowdown

The key chart

Trends in the stock (EUR bn) and growth rate (% YoY) of EA mortgages
(Source: ECB; CMMP)

The key message

The euro area (EA) money sector is sending a clear message at the start of 2023 – the ECB is succeeding in deflating the region’s mortgage market. Good news for financial stability, less positive for investors positioned for a recovery in EA growth.

Deflating the EA mortgage market

Trends in EA mortgage lending annual growth rate (% YoY)
(Source: ECB; CMMP)

Annual growth in the outstanding stock of mortgages slowed to 3.9% in January 2023, down from 4.4% in December 2022 and the recent peak of 5.8% in August 2021 (see chart above). Monthly mortgage flows also slowed sharply to €2.8bn in January 2023, down from €25.7bn a year ago and their recent peak of €30.1bn in June 2022 (see chart below).

Trends in monthly HH mortgage flows (EUR bn)
(Source: ECB; CMMP)

Mortgage dynamics in Germany and France are key drivers here. These markets account for 30% and 25% of the outstanding stock of mortgages and contribute 40% and 25% to total mortgage growth respectively (see chart below).

EA mortgage lending (% YoY) broken down by country (ppt)
(Source: ECB; CMMP)

At the point of peak EA mortgage growth in August 2021, Germany mortgages grew 7.2% YoY and contributed 2.1ppt (36%) to total growth. At the same time, French mortgages grew 8.2% YoY and contributed 2.0ppt (34%) to total growth.

Trends in annual growth (% YoY) in EA, German and French mortgage lending
(Source: ECB; CMMP)

Fast forward to January 2023, and German mortgage growth slowed to 5.2% YoY and contributed 1.5ppt (38%) to total growth. More importantly, French mortgage growth had slowed to 3.9% YoY and contributed only 1.0ppt (26%) to total growth. Note also that (more volatile) monthly flow data indicated net repayments in both Germany and France in January 2023.

Trends in annual growth in EA lending (LHS) and contribution from Germany and France (RHS) (Source: ECB; CMMP)

The trends summarised above are positive from a financial stability perspective. CMMP analysis highlighted RRE vulnerabilities in Germany based on the combination of house price and lending dynamics, the extent of overvaluation and the lack of appropriate macroprudential measures back in November 2021. It also warned of the risks associated with the rate of growth and affordability of French household sector debt in January 2022.

They are less positive for investors positioned for a recovery in EA growth, since mortgage demand typically displays a coincident relationship with GDP growth. Previous posts have noted a synchronised slowdown in mortgage demand in the EA and the UK, albeit with a more rapid deceleration in the former region. The Bank of England will publish UK mortgage data on 1 March 2023. More to follow then…

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.