WISE MONEY

George Osborne has said that banks must increase lending to businesses rather than boosting bonuses and dividends now that they have weathered the worst of the credit crisis. Britain’s Treasury chief said that banks “have an economic obligation to assist” small and medium-sized businesses.

The statement comes in line with half-year figures released this week that are expected to confirm that the major institutions have returned to profit after two years of turmoil.

Lloyds Banking Group, which is 41% owned by the taxpayer, and the 84% state-owned Royal Bank of Scotland are both expected to post a profit. But Osborne questions the ability of British businesses to raise credit from the banks.

“The danger is that, particularly next year, when there is a huge amount of refinancing required, that the small and medium-sized businesses suffer from a lack of access to working capital,” he said.

Osborne continued that British banks “are in no doubt that the government wants to see reasonable access to credit on reasonable terms in the small to medium-sized business sector.”

The expected bank profits have boosted the recent Cable rally and we are now trading in the 1.58s and well on track to the key 1.60 psychological level.

One in fifth of the 7.66 trillion yuan (1.1 trillion dollars) that Chinese banks lent to local governments is “at serious risk of default”, is the latest potential default risk problem to halt the global recovery. Chinese banks lent vast sums of capital to local Chinese governments for construction projects after Beijing called for nationwide efforts to stimulate the economy.

However, only one quarter of projects financed by the loans have the ability to meet repayments, according to the Century Weekly.

The banking regulators, along with the banks that have the biggest exposure, will carry out detailed discussions with local governments starting in September about how to recoup the loans, the report said.

China has powered out of the global crisis on the back of a stimulus package worth four trillion yuan and the state-backed bank lending, which saw new loans nearly double from the previous year to 9.6 trillion yuan in 2009.

This latest potential default raised concerns in Beijing over a possible new crop of bad loans that could threaten the world’s third-largest economy.

The results of the Eurozone bank stress tests were eventually released on Friday evening showing only 7 of the 91 banks tested were deemed to have failed, and the capital shortfall was estimated at €3.5 bn. Both are very much at the lower end of consensus forecasts, raising questions over the credibility of the tests. Interestingly, a sovereign default or restructuring scenario was not included, as media leaks earlier in the week had suggested.

At the press conference, ECB Governing Council Member Constancio justified this decision by noting that “instruments have been put in place precisely to avoid that scenario”. Nevertheless, as the leaks had suggested, many participating banks voluntarily disclosed their sovereign debt holdings, and this has brought some improved transparency on sovereign debt exposure.

This seems to have averted any euro selling pressures as the single currency continues to trades close to Friday’s 1.29 range against the dollar.

From a data perspective, the euro had already managed to move higher on Friday morning after stronger than expected German business sentiment data. The German IFO business confidence index recorded its strongest rise for 20 years in July.

The closely watched index rose to 106.2 points from 101.8 in June. Germany’s economy shrank by almost 5% last year, but has been recovering due to strong exports. The result was much better than expected, with most economists having expected a slight fall.

We get our first view today at the methodology behind the stress tests currently being applied to European banks to assess their health.The markets reaction will not be instant due to the expected weighty tome of equations and statistics to wade through. However, there is a key point worth noting in advance.

Analysts will be looking for the models to incorporate large haircuts on holdings of Greek bonds, maybe 30 pence in the pound and similar (but not as severe) on other periphery Eurozone countries bonds.

If, as the Financial Times suggests, the haircut in the models is significantly less than 30 per cent, the credibility of the tests and as such the banks they are testing will be completely undermined.

The whole point of these tests is to restore confidence into the banking system so it is vital that the methodology is perceived as credible. We can then wait with baited breath rather than indifference, for the results of the tests on 23rd of July.

The Dollar gave up further ground to Sterling and Euro on the back of the disappointing employment data from the US on Friday.

However, the Forex market is either ignoring or completely in the dark about when Mr Obama will begin to tackle the US budget deficit (I think it may be a combination of both). Currently running at over 9% of GDP, it seems some in the US are unwilling to implement similar austerity measures to those in the UK to tackle the deficit.

And since the US makes up such a large slice of world demand, any budget cuts and the time scale over which they are implemented will have wide reaching implications for its main trading partners, China, The UK and the Eurozone and also for the Dollar over the coming months.

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EU banks have borrowed less than expected from the European Central Bank, easing concerns about liquidity among european financial institutions.
After Tuesday’s sharp falls, stock markets and the euro stabilised on news that the ECB had agreed three month loans worth 131.9bn euros (£108bn). This compared with the 150bn to 200bn euros many had expected.

The euro rose almost a cent against the pound, while European stock markets also made gains. However, eurozone banks are still on welfare support

Banking shares had been under pressure after the European Central Bank confirmed it would be stopping a special 12-month loan facility for euro-zone lenders from yesterday.

Investors were concerned that European banks could face funding problems as a result.

Also this week, the EU has said it is to treble the number of banks that will be subject to public stress tests, as it tries to allay a growing global anxiety over Europe’s finance sector.

The tests are designed to examine how certain banks would perform if there were a repeat of the financial crisis.

The plight of Greece, combined with worries about nations such as Spain and Portugal, means that for the first time the tests would also examine whether institutions could cope in the event of a sovereign-debt default in the eurozone.

The number of those forced to take part in the exercise would expand from the 22 big banks examined last year to include a further 60 to 120 banks, meaning that many not included in last year’s stress-tests will now feature.

They include, for the first time, banks such as German Landesbanken, which are not among the biggest institutions but whose potential weaknesses have contributed to uncertainty in financial markets.

The tests are due to be completed by mid July, with results to be issued on a bank by bank basis.

Global stock markets have fallen sharply on renewed concerns over the European banking sector.
Investors are apprehensive ahead of a deadline this week for banks to repay loans taken out a year ago at low interest rates.

As a result, leading European share indexes slumped about 3%, while US stocks fell more than 2% in morning trading.

The concerns also pushed the Pound to a new 19-month high against the euro.

The pound rose almost half a cent to 1.2389 euros, its highest level since the immediate aftermath of the financial crisis in November 2008.

Last summer, the ECB was forced to offer European banks cheap 12-month loans to help them through the financial crisis. This was a longer repayment term than the usual three to six months.

But the ECB has said it will not offer 12-month loans this time around, raising fears that European banks may again face funding difficulties.

So with heightened concerns about which banks still have bad loans on their books, there is a growing fear among investors about the health of the European banking sector.

The pound strengthened to 1.22 against the Euro yesterday for the first time since November 2008.

Sterling continues to benefit from the UK budget announced earlier this week and the news that one MPC member voted for a rate hike this month. A strong response from the credit agencies took away fears that the UK’s AAA rating could be downgraded.

Concerns over the European debt crisis were on the rise again yesterday with Greek credit default swaps hitting a record high.

ECB president Trichet said he is “pleased” with Germany’s decision to concentrate on fiscal discipline, he also commented that the idea that austerity measures could trigger economic stagnation is “incorrect” and he does not think the risks around deflation will materialise.

Another cause for concern in the Eurozone is the requirement for European banks to repay the $540bn of ‘special’ 1-year loans that they borrowed from the ECB.

The added problem here is that a number of the banks used the loans to buy up bonds in Greece, Spain and Portugal – fixing in a healthy interest margin in the process. Now they have to repay their ECB loans, the banks may decide to offload some of these bonds, which could reignite tensions in European financial markets.

Investor George Soros has warned Germany to leave the euro unless it is willing to embrace a growth strategy, calling Berlin’s current austerity plans  a threat to democracy and political stability in Europe.
“German policy is becoming a danger that could destroy the European Project. A collapse of the euro cannot be excluded,” he told the German weekly Die Zeit.

“Unless Germany changes policy, its withdrawal from the currency union would be helpful for the rest of Europe. At the moment Germany is pushing its neighbours into deflation: this threatens a long phase of stagnation, leading to nationalism, social unrest, and zenophobia. It endangers democracy,” he said.

Mr Soros saw the political effects of wage cuts first-hand during the Great Depression, and narrowly survived the Holocaust as a Jewish boy in Nazi-controlled Budapest. He has since dedicated much of his wealth to philanthropic works promoting freedom and pluralism across the globe, mostly through Open Society institutes.

His comments reflect growing alarm in influential circles on both sides of the Atlantic over the 1930s-style policies of wage cuts and debt-deflation being imposed up the Club Med bloc, Ireland, and parts of Eastern Europe by the EU authorities, at the behest of Berlin.

President Barack Obama clearly had Germany in mind when he wrote a letter to fellow leaders before the G20 summit in Canada this week that surplus countries should do more to shore up global demand. “Our highest priority must be to safeguard and strengthen the recovery: we cannot let it falter or lose strength now. Should confidence in the strength of our recoveries diminish, we should be prepared to respond again as quickly and as forcefully as needed,” he wrote.

China has deflected G20 criticism by starting to free the yuan, leaving Germany facing the full wrath of Washington.

While the German economy is not in itself large enough to shape global events, US officials fear that Berlin’s dominant influence over the European Central Bank and the fiscal machinery of monetary union is dragging most of Europe into an economic swamp. Germany has raised the bar for every eurozone country by announcing €80bn of belt-tightening from next year.

Nobel laureate Paul Krugman told the German press earlier this week that the country was committing the same error as the United States in 1936-1937, or Japan in the 1990s, by withdrawing stimulus before recovery has taken root.

“I don’t have a problem with trying to balance the budget in five or 10 years. The question is whether one should start when the economy is at 7 or 8 percent below its normal capacity and interest rates are at zero. Now is not the time to be worried about deficits.”

Professor Krugman said there was a risk of a “domino effect” reaching Spain and Italy if Bundesbank chief Axel Weber takes over as head of the ECB and fails to offer enough monetary stimulus to keep these countries afloat.

One analyst said that Mr Weber faces an impossible task. “Either they do more QE (quantitative easing), in which case it will set off inflation in Germany and cause Germany to leave EMU: or they don’t do more QE, in which case it will lead to deflation in Southern Europe and force them out of EMU,” he said.

Mr Soros said Germany was treating the deeply-flawed Maastricht Treaty as it were a “sacred text”, warning that monetary union cannot endure for long as a narrow construct based on debt and deficit ceilings.

He said wage rises in Germany are imperative to help lift the whole eurozone, allowing peripheral economies to claw their way out of trouble without fighting the extra headwinds of deflation.

“The truth is that what we have in Europe is not a currency or sovereign debt crisis as many people think, but a banking crisis,” he said.Mr Soros argued that the weaker states cannot easily fund their deficits any longer because some banks are purchasing fewer bonds as a result of damaged balance sheets.

European debt markets remain under high stress on persistent reports that Spain is in secret talks with EU officials and the International Monetary Fund for a support package of up to €250bn (£208bn), the largest rescue in history.The spreads on 10 year Spanish bonds jumped to a post EMU high of 224 basis points above German Bunds as traders brace for a crucial auction by Madrid.

The relentless rise in bond yields replicates the pattern seen in Greece at the onset of crisis. Spain must raise €25bn of debt in a cluster of auctions in July.

Elena Salgado, Spain’s finance minister, reacted angrily to a report in the Spanish daily El Economista claiming that the support plans are well advanced.

“It has been denied by the Spanish government, by the European Commission, and by the IMF. How much more can we deny it?” she said.

The story refuses to die, however. Three German newspapers have run similar stories over recent days, citing German sources. The markets are convinced that some form of contingency planning is underway.

El Economista said officials from the EU, the IMF, and the US Treasury had been discussing a credit line of €200bn to €250bn, dwarfing the €110bn package for Greece. Dominique Strauss-Kahn, the IMF’s managing director, reportedly called a secret meeting of the IMF’s Board of Directors to tackle the crisis.

The loan terms would be softer than the draconian budget cuts imposed on Greece, with the lion’s share of the money coming from eurozone states under their €750bn shield.

It is unclear how the EU would finance a full rescue for Spain. Under the Greek formula, the EU-IMF ratio of aid is 8:3, implying an EU share of around €180bn – with a risk that the sums will escalate. The number of eurozone states available to fund the package is shrinking.

The original hope behind the EU’s €750bn “shock and awe” headline was that the announcement of such sums would end all doubts about the political solidarity behind the euro project, but nationalist body-language from EU capitals and daily spats between France and Germany have sapped confidence.

What haunts markets is fear that Spain may be the last line of defence. There can be no easy rescues after that because the money will run out. If investors ever start to question Italy’s public debt – the world’s third largest – they may face a sovereign version of the Credit Anstalt crisis of 1931.

The Spanish government’s cost of borrowing has hit a new record hign amid renewed concerns over the state of its economy and public finances.
The interest rate Spain is being asked to pay by investors is now 2.23 percentage points higher than that being demanded of Germany.

This widening gap in the bond market marks a drop in confidence in Spain’s ability to repay its debts.

The Spanish cabinet has also approved unpopular changes to labour rules. The changes, which include a cut in the level of severence pay, have prompted a call for a general strike in September.

Spain, which is emerging from a two-year long recession is now pursuing austerity measures. These include a 5% cut to public sector pay in an effort to bring down its borrowing and help restore its credibility among international lenders.
IMF speculation

Its budget deficit is currently running at over 11% of GDP – way above the 3% limit imposed by the EU.

This week the Spanish government has also been forced to deny newspaper reports that it is in talks with the IMF over a Greek-style bail-out package to help it manage its debts.

The Spanish Prime Minister Jose Luis Rodriguez Zapatero is scheduled to meet IMF chief Dominique Strauss-Kahn on Friday, but Spanish officials say the talks are unconnected to the press speculation.

Investors remain concerned about the underlying strength of Spain’s economy.

There are also worries that spending will hamper its recovery from recession, with its unemployment rate of 20% – the highest in the eurozone – a significant concern.

The government has approved long-awaited labour market reforms, which it says will encourage firms to hire more people, easing the jobs crisis.

But the plans have met with demonstrations from unions, who fear the changes will hurt workers’ rights.