As the housing market continues to struggle and the Bank of England Base Rate remains historically low, Matthew Wyles asks how long it will take for the economy to recuperate following these testing times.
With 2008 now behind us, it is clear that the global financial services market bears the battle scars of a hugely challenging year. There is little doubt that at points, the world's banking system faced a real threat of collapse, and while that threat has receded significantly, confidence will take much longer to recover.
In part at least, the recession was brought on by savage but necessary de-leveraging in the global credit markets and, as 2009 progresses, the effects of this flight to quality will continue to affect very considerably both the availability and cost of finance.
The Government has clearly recognised that improving the banks' ability to fund is crucial to improving the economic situation and while the various schemes that have been introduced are essential, they are also expensive and leave the UK banking system hugely reliant on their continuation. The latest initiatives, announced in January 2009, are more of the same and are similarly geared towards enabling and encouraging banks to lend more.
The general thrust of what the Government is trying to do is broadly appropriate. It is also to be hoped that with the renewed efforts to improve liquidity in the market there will be a more co-ordinated approach within the Tripartite, bringing an end to the contradictory situation of banks being provided with expensive new capital to service while simultaneously being expected to reduce margins by lowering mortgage pricing and passing on rate cuts in full.
While the banking system is not yet out of the woods, HM Treasury will doubtless be hoping to avoid a full blown nationalisation of any of the big UK banks. Ministers are right in believing that, as a general rule, banks will perform better in private, rather than public, ownership. And of course, it should not be assumed that even the UK Government has access to unlimited credit; full nationalisation of a big clearing bank could prompt market concerns about the already substantial liabilities of the UK taxpayer.
Devaluation and inflation
There is the clear risk of a further decline in the value of Sterling but that, in the short term at least, is not necessarily bad news, provided such devaluation is orderly and the retreat does not turn into a rout. With a weak currency, however, comes the risk of rising inflation and a higher cost of borrowing. If UK inflation was to suddenly take off, the country's economic woes could be exacerbated by the need for a significant rise in interest rates: the so-called ‘stagflation scenario'.
As this article went to press, the Bank of England had just announced a further reduction in the Bank Base Rate to 1%. The consequent media commentary inevitably made frequent reference to ‘uncharted waters' - the fact that the monetary policy authorities have no historical reference point for the way the economy is likely to behave in such an environment. This is absolutely true, which is what makes the situation so dangerous. Even more perilous is that policy makers are now shifting their attention away from interest rates and towards untested and radical alternative measures, especially quantitative easing.
Quantitative easing can involve a country simply printing more money and pumping it into the system. Conceptually, it is a bit like inoculation - when inflation goes negative, you create an opposite force by doing things that ordinarily would prove hugely inflationary. Zimbabwe has seen the consequence of printing money to try and get out of the hopeless fiscal mess into which it has descended. Simplistic as it may sound, there is a lesson there. Quantitative easing can destroy the value of a currency because it tampers with the volatile forces of supply, demand and confidence - it is a hugely potent weapon and we have precious little experience in wielding it. Ultimately, the quantitative cure may be worse than the recessionary illness.
The dilemma that the policy makers now face is that they cannot risk waiting to see how effective their interest rate cuts have been - a delay in applying further treatment to the patient could prove fatal. But this is balanced by the risk that they may do too much and the process of easing will overshoot which will release the destructive genie of rampant inflation from the economic bottle. If that genie is liberated, the current recession will look like a children's tea party. All of this is complicated by the fact that the politicians know that there is going to be an election in 2010.
The Government's plans certainly include a huge increase in state borrowing. Realistically, it needs to borrow in Sterling and thus have a vested interest in a relatively strong currency. The weaker and less credible that Sterling becomes, the more difficult and expensive the Treasury will find it to raise debt. Some analysts suggest that it is time the UK gave up Sterling and embraced the Euro.
Yet the experience of some Euro economies like Greece is not encouraging. The Greek economy needs a weaker currency to compete and is finding the Euro a huge burden. Competition from economies such as Turkey and Bulgaria is proving a huge problem for Greek industry, including tourism, and many Greeks feel that the Euro is draining the life blood out of the country. The challenge faced by the single currency remains - how can one exchange rate and one interest rate be right for such a disparate group of economies, all moving at different speeds?
While falling interest rates have been good news for most borrowers, consumers who rely on income from their savings have been hit hard. There is rising frustration on the part of private clients who, with cash to invest, are becoming progressively more dissatisfied at the low returns available on conventional savings products. While institutional credit markets are displaying limited risk appetite, demand from private clients may be tempted up the risk curve in search of better value - we are already seeing stronger retail flows into strategic bond funds, for example. Of course, a lot of savers will be more interested in hoarding cash in a safe place than in the returns they can achieve. The British public have now learnt that the highest savings rate is not always the best.
The low interest rate environment has also led to much reduced remortgage activity as borrowers realise that their contractual revert-to deals now look both cheap and flexible against the new business products offered in the market.
One of the many reasons, of course, for the sharp downward movements in UK interest rates has been the end of the long bull run in residential property, which lasted for well over a decade. Although the availability of mortgage finance may improve during 2009, demand is likely to remain sluggish, certainly while consumers remain convinced prices have further to fall.
The fundamental imbalance in the UK housing market between supply and demand, however, remains unaltered. Huge pent-up demand for home ownership will start to be released either when prospective buyers think prices have hit the bottom of the cycle or, more probably, when the first upswing in prices strengthens consumers' confidence that the worst is over. While in the short term prices may continue to fall, a recovery is almost inevitable in the medium term. Rising inflationary pressures, if they come, will probably accelerate a recovery in the property market.
Of course, while falling prices have helped to reduce the lack of affordability facing many first-time buyers, these same customers must now raise a much more substantial deposit to get their mortgage, and even more if they want the best deals. There is scope therefore for lenders to look at widening the availability of finance to first-time buyers by designing products which cater for higher loan-to-value ratios, probably aimed at the better quality credits. Lenders have a vested interest in stimulating demand in the housing market and it should be possible to create the kind of offer that creates value for lender and borrower alike.
Economic forecasting is a thankless task. The inevitable conclusion, however, is that whatever the strategy adopted, the next few years are going to be tough. The best we can hope for is that our policy makers chose the right course and ultimately steer us into open water. But in uncharted territory, luck will be almost as important as judgement. n
Matthew Wyles is group distribution director of Nationwide Building Society and chairman of the Council of Mortgage Lenders
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