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Dexia’s midnight bailout adds to fears over banking stability

GLOBAL ECONOMIC prospects have worsened considerably in recent months. The financial markets have remained generally downbeat, with share prices falling temporarily below the lows seen in August. Hopes of official interventions, mainly by central banks, have produced occasional rallies. But the dominant mood remains one of fear.

Falls in government bond yields to historic lows signal worries that the recovery is stalling and may go into reverse. The BRICs and other emerging markets are still expanding relatively strongly, in contrast to weak growth and high debt levels in the mature economies of the US, Europe and Japan. But the problems facing the eurozone have become particularly severe and protracted, and are now posing major risks to the global economy and to the UK. Many of our growth forecasts have been downgraded.

US economic performance remains weak and unsatisfactory. Politicians are still reluctant to address the core issues. The weak housing market, with prices 4% lower than a year ago, remains a major obstacle to stronger growth. But fears of a US recession are exaggerated.

Many key indicators, though disappointing, have been stronger than expected. GDP quarterly annualised growth was a weak 1.3% in the second quarter of 2011, after a minimal 0.4% rise in the first quarter. But second-quarter growth was unexpectedly revised up from 1%, easing fears of a relapse.

US job creation remains inadequate. Since April 2011, US employment has increased by an average of 72,000 per month, compared with an average increase of 161,000 for the preceding seven months. However, the US economy created 103,000 new jobs in September; not sufficient to reduce unemployment below 9.1%, but still better than expected.

Stick or twist

The purchasing managers’ indices, published by the Institute for Supply Management, show surprising US resilience in September, in manufacturing and services. Politically, the frail US record on jobs and growth threatens President Obama’s re-election hopes. But the US economy is now outperforming Europe. Even so, the US Federal Reserve remains concerned over growth and has decided to adopt further measures.

After taking the unusual step of pre-announcing that its key policy rate is likely to stay at its present exceptionally low level at least until mid-2013, the Fed launched Operation Twist. This is an initiative aimed at pushing down long-term interest rates and giving a boost to the weak US economy. The Fed announced that it would buy $400bn of long-dated treasuries, funded by the sale of an equal amount of treasury bonds with three years or less to run. The Fed is not obliged to keep rates on hold until 2013. But our forecast is that the fed funds rate will stay at 0-0.25% until at least the final months of 2012.

In contrast to the mediocre US situation, eurozone prospects have worsened sharply. After poor second-quarter GDP figures, which show minimal growth of 0.1% in Germany and zero in France, the September purchasing managers survey points to eurozone contraction in both manufacturing and services. Speculative attacks against Spain and Italy have escalated, as their sovereign credit ratings have been cut further in recent weeks. Sovereign debt problems are threatening the stability of banking sectors across the eurozone. France is not under threat, but its position has become more uncertain.

ECB support

The crisis facing Dexia, the French-Belgian-Luxembourg banking group, has forced the three governments concerned to bail it out, reinforcing concerns over banking sector stability. The markets still expect Greece to default, but this is by no means certain. Since a Greek default could precipitate a wider banking crisis engulfing Germany and France, Germany could decide that bailing out Greece is cheaper than allowing it to default

Weak growth and risks to banking stability are posing threats to the eurozone’s survival. In response, the European Central Bank (ECB) is likely to change its interest rate strategy. Previous concerns with inflation are now being reassessed. With hindsight, it is clear the increases earlier in the year in the ECB key policy rate, from 1% to 1.5%, have been premature. The ECB kept its key policy rate unchanged at its 7 October meeting, but a reversal of at least one of the earlier rate increases is likely in the next few months. New increases in the ECB policy rate are now very unlikely until well into 2012.

Meanwhile, the ECB has provided extra support to the money market, with bond purchases and additional injections of liquidity. New plans by the eurozone’s leaders to recapitalise banking systems in their countries have helped to restore a measure of stability to the markets. But disagreements between the core eurozone countries and the periphery remain unresolved. Prospects for the eurozone remain highly uncertain. Although the euro is likely to survive as a single currency, there is a serious danger that some members may be forced, or may choose, to leave the eurozone in the next few years.

In the UK, second-quarter GDP growth was revised down from 0.2% to an even tinier 0.1%. New figures show that the UK recession was even deeper than previously thought. In reaction, the Monetary Policy Committee has surprised the markets with a bigger than expected increase in its quantitative easing programme, from £200 to £275bn. This is helpful, but not sufficient, unless it is supplemented with effective measures aimed at boosting lending to small businesses. ?

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