Spanish Aid Request

Spain has formally requested EU aid, in a move that it would be fair to call widely-trailed. Last week, Roland Berger estimated that Spanish banks would need an extra EUR 51.8bn in a stressed scenario, while Oliver Wyman put the number at EUR 61bn. Also last week, the Spanish 10-year yield fell from over 7% to around 6.5% (there is no way of knowing whether this suggests a change in the situation or whether the ECB was involved — SMP purchases are published (I think) a week after the event.

Bank of England “Action”

The Bank of England offered its first tranche of extended collateral term repo to UK banks. The full £5bn was taken up at the minimum bid of 25bps over the bank rate (suggesting that the banks are not particularly stressed).

In addition, some more details about the scheme to encourage lending to small businesses have come out. The Chancellor apparently wants an extra £100bn of lending; according to bankers quoted by the FT, the most likely scenario is that the first £80bn (=5% of existing non-financial lending) would replace existing funding and would cost 125bps over LIBOR, and above the first £80bn, there would be a 25bps reduction in the spread for each extra 1% increase in net lending down to a minimum cost of 25bps over LIBOR. Recall that the core of the programme is that banks will be able to swap assets with the central bank in return for making this extra lending (details are still sketchy, but this sounds like a Fed rescue programme during the crisis under which banks swapped their MBS for Treasuries).

This scheme is an admission of defeat by the government. Back in 2010, the story was that a reduction in the government deficit would restore a vague variable called “confidence”. Paul Krugman has argued that the model behind this idea was very like the model used by the underpants gnomes in a famous episode of South Park. The gnomes explained their business model thus: “1. Collect underpants; 2. ???; 3. Profit.” Our government’s model for its economic policy was: “1. Slash government spending; 2. ???; 3. Prosperity!” where “???” is pronounced “confidence”. Unsurprisingly, it has not worked like that. So the government has turned its attention to finding ways to increase the level of spending in the economy — which, to give a little bit of credit where it’s due, is the right problem to be attempting to solve.

Will the solution work? I am still not very clear on how the government’s balance sheet enters into this — presumably it would indemnify the BoE against any losses on the asset swap. That is just an institutional fudge to keep Mervyn King happy — the profits of the BoE flow to the government anyway, so to the extent that the BoE suffers losses the government will bear them one way or another. Really what is happening is that the BoE is conducting an asset swap with the banks on the condition that they increase their small-business lending. The asset swap should be helpful — there is a shortage of collateral in the global financial system so measures to improve the quality of collateral held by banks should be helpful. Linking this to small-business lending makes less sense. I suppose it might be that the reason why banks are not expanding their lending to small businesses is that they don’t have an enough of an incentive — i.e. lending spreads are too low — and that the extra incentive might tip the balance. But that doesn’t seem especially plausible — why should lending spreads be too low, given that they are not regulated but set by the banks themselves? It seems to be to be much more plausible to think that a) banks are not expanding their small-business lending because they are trying to keep their balance sheets under control (with an eye on Basel III requirements) and that b) there is a lack of credit demand because of the depressed state of the economy.

On a), the programme will still increase lending to small businesses if it provides enough of an incentive for banks to cut back lending to consumers and other businesses in favour of small businesses, but I cannot see that that would be much help to the economy. On b), this programme does nothing at all to address the lack of demand for credit — which I think is the result of a lack of demand in the economy. The way the government could do something about that would be to spend more — but of course, it won’t do that because it is already committed to the underpants gnomes narrative. The sooner we get a Labour government, the better.


The HSBC China PMI flash estimate was weak again. It is hard to understand what is going on in China because the data available on the economy are very poor. What can one say about it?

China has an investment-driven economy, and in recent years much of the investment spending has come from local government and property investment. Curbs have been introduced on the property market and on local-government investment, and interest rates have been increased, and at the same time the economy has slowed, possibly substantially. In an investment-driven economy, an increase in the interest rate and direct controls on the main drivers of investment ought to slow the economy. I do not see a good reason, therefore, to think that what is happening in China is anything more than a policy-induced slowdown in order to prevent runaway inflation and the formation of dangerous speculative bubbles.

How long will the slowdown go on? It will go on until the government loosens policy. One could argue all day about when that is likely to happen — is the government most concerned about cutting inflation, which is already falling, or about pounding the housing market, or about bringing an end to local-government investment? When one could argue all day, that is an indication that one does not have enough data to reach a firm conclusion. The sign that the government is ready to start loosening policy will be that is starts loosening policy. That has recently happened, with an interest-rate cut (the first reserve ratio cut was some months ago but it is reasonable to argue that this was just to offset the tightening effect of the declining current-account surplus). Thus I wonder whether there might at present be a good entry point into China-exposed stocks.


  • China flash PMI 48.1, fell.
  • French flash PMI’s showed continued contraction but beat expectations.
  • German flash PMI’s disappointed expectations with manufacturing continuing to contract and services flat.
  • Eurozone flash PMI 44.8 a.e. and fell.
  • Eurozone flash services PMI 46.8 b.e. and roughly flat.
  • Eurozone current account surplus fell to 4.6bn d.e. April.
  • UK retail sales 1.4% b.e. May.
  • US initial claims 387k d.e. Worsening trend continues.
  • US flash PMI 52.9 d.e. and fell.
  • US existing home sales fell to 4.55m, d.e. May. A small disappointment; flat trend.
  • US Philadelphia Fed manufacturing index -16.6 d.e. A bad number.
  • German Ifo business climate 105.3 d.e. and fell.

This Week

  • US new home sales (Mon)
  • UK public sector borrowing (Tue)
  • US CB consumer confidence (Tue)
  • US durable goods orders (Wed)
  • US pending home sales (Wed)
  • UK current account (Thu)
  • European Council meeting (Thu)