1930s depression in sight

Daily Telegraph

BIS warns of Great Depression dangers from credit
spree

By Ambrose Evans-Pritchard

Last Updated: 9:02am BST 25/06/2007

The Bank for International Settlements, the world's
most prestigious financial body, has warned that years
of loose monetary policy has fuelled a dangerous
credit bubble, leaving the global economy more
vulnerable to another 1930s-style slump than generally
understood.

"Virtually nobody foresaw the Great Depression of the
1930s, or the crises which affected Japan and
Southeast Asia in the early and late 1990s. In fact,
each downturn was preceded by a period of
non-inflationary growth exuberant enough to lead many
commentators to suggest that a 'new era' had arrived",
said the bank.

The BIS, the ultimate bank of central bankers, pointed
to a confluence a worrying signs, citing mass issuance
of new-fangled credit instruments, soaring levels of
household debt, extreme appetite for risk shown by
investors, and entrenched imbalances in the world
currency system.

advertisement
"Behind each set of concerns lurks the common factor
of highly accommodating financial conditions. Tail
events affecting the global economy might at some
point have much higher costs than is commonly
supposed," it said.

The BIS said China may have repeated the disastrous
errors made by Japan in the 1980s when Tokyo let rip
with excess liquidity.

"The Chinese economy seems to be demonstrating very
similar, disquieting symptoms," it said, citing
ballooning credit, an asset boom, and "massive
investments" in heavy industry.

Some 40pc of China's state-owned enterprises are
loss-making, exposing the banking system to likely
stress in a downturn.

It said China's growth was "unstable, unbalance,
uncoordinated and unsustainable", borrowing a line
from Chinese premier Wen Jiabao

In a thinly-veiled rebuke to the US Federal Reserve,
the BIS said central banks were starting to doubt the
wisdom of letting asset bubbles build up on the
assumption that they could safely be "cleaned up"
afterwards - which was more or less the strategy
pursued by former Fed chief Alan Greenspan after the
dotcom bust.

It said this approach had failed in the US in 1930 and
in Japan in 1991 because excess debt and investment
build up in the boom years had suffocating effects.

While cutting interest rates in such a crisis may
help, it has the effect of transferring wealth from
creditors to debtors and "sowing the seeds for more
serious problems further ahead."

The bank said it was far from clear whether the US
would be able to shrug off the consequences of its
latest imbalances, citing a current account deficit
running at 6.5pc of GDP, a rise in US external
liabilities by over $4 trillion from 2001 to 2005, and
an unprecedented drop in the savings rate. "The dollar
clearly remains vulnerable to a sudden loss of private
sector confidence," it said.

The BIS said last year's record issuance of $470bn in
collateralized debt obligations (CDO), and a further
$524bn in "synthetic" CDOs had effectively opened the
lending taps even further. "Mortgage credit has become
more available and on easier terms to borrowers almost
everywhere. Only in recent months has the downside
become more apparent," it said.

CDO's are bond-like packages of mortgages and other
forms of debt. The BIS said banks transfer the
exposure to buyers of the securities, giving them
little incentive to assess risk or carry out due
diligence.

Mergers and takeovers reached $4.1 trillion worldwide
last year.

Leveraged buy-outs touched $753bn, with an average
debt/cash flow ratio hitting a record 5.4.

"Sooner or later the credit cycle will turn and
default rates will begin to rise," said the bank.

"The levels of leverage employed in private equity
transactions have raised questions about their
longer-term sustainability. The strategy depends on
the availability of cheap funding," it said.

That may not last much longer.