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Economist Insights

Undersupplied and undemanding

28 October 2013Asset management

When people think of economics, they usually think of supply

and demand (and trying to remember which one slopes up

and which one slopes down). One of the (many) dirty little

secrets of economics is that we never actually get to see a

demand curve or a supply curve in the real world. All we ever

see is the price and quantity where demand equals supply.This means we have a big identification problem: when prices

or quantities change, is it because of a change in demand or

a change in supply?

This is not just an academic issue. In the Eurozone, credit

to nonfinancial corporates has fallen since 2008, with the

decline accelerating over the last two years. This could be

because demand is lower or because supply is lower, or both

are lower. The difference is important for the policy of the

European Central Bank (ECB). If lower supply is to blame,

it suggests that lower central bank rates might be helpful.

However, it may also suggest that policies to improve bank

balance sheets are resulting in less risky lending (whichwould include lending to many nonfinancial corporates).

In contrast, if lending is falling because there is a lack of

demand for credit from potential borrowers, there may be

little that the ECB can do about it. Lower demand for credit

from businesses usually occurs because the businesses are

pessimistic about the future.

One rough way to identify the causes is to look at what

is happening to both prices (i.e. interest rates charged on

loans) and quantities (the amount of lending/borrowing).

Companies like to borrow more when interest rates are low.

If demand is higher that means that the amount of borrowingthat firms are willing to take on rises even if the interest

rate does not change. Usually interest rates rise in response

to higher demand. This would imply that times when both

interest rates and lending are rising are times when demand

is growing stronger. In contrast, in times when both interest

rates and lending are down then demand is weakening.

Banks are willing to make more loans when interest rates

are high (the reverse of what the borrowing firms want).An increase in supply means that the banks are willing to

make more loans even if the interest rate has not changed.

It follows that at times when interest rates fall but lending

increases, supply is growing stronger; and fewer loans and

higher interest rates mean that supply is weaker. These

distinctions of supply and demand movements are imperfect,

as both supply and demand could be moving at the same

time, but they do suggest which factor is dominating.

Joshua McCallum

Senior Fixed Income Economist

UBS Global Asset Management

joshua.mccallum@ubs.com

Gianluca Moretti

Fixed Income Economist

UBS Global Asset Management

gianluca.moretti@ubs.com

Chart 1. Demand and supply and demand

Change in interest rates and loans for nonfinancial corporates from

monetary financial institutions

Source: European Central Bank, UBS Global Asset Management

20132012

20112010

2009

2008

-350-300-250-200-150-100-50050100

150

-400 -200 0 200 400 600 800Change in lending, 4Q (EUR bn)

Changeinrates,

4Q(

basispoints) Stronger demand

Stronger supply

Weaker supply

Weaker demand

Five years after the financial crisis, and in the Eurozone loans

to businesses are still depressed. It is not straightforward to

identify if this is caused by a change in demand or a change

in supply, but this distinction is crucial for policy-makers.

The Eurozone as a whole has gone through several different

phases but it seems now that weak demand is dominating.

As usual, the problem is not uniform across the Eurozone

over the last year, the periphery has experienced both

weaker supply and weaker demand, the core looks to have

stabilised and the coreiphery is starting to diverge from

the core and see weaker demand. The situation highlights

the limitations of monetary policy tools.

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The Eurozone appears to have gone through a few phases

(see chart 1). Before the financial crisis in 2008 there were

clear signs of rising demand both interest rates and loans

were on the up. Once the financial crisis hit, the pace of loan

growth slowed although it was still positive over the year,

but interest rates fell. This suggests that supply was stronger;

which should not be surprising because the ECB cut its policy

rates and this makes it cheaper for banks to lend. As the crisis

worsened, weak demand dominated to push both interest

rates and lending downwards. This period of 2009 to 2010

was the worst for nonfinancial corporates. A period of broad

stability followed in 2011 and into 2012, but the last year has

seen weak demand once again dominating.

This is really bad news for the ECB. In more normal

circumstances, it could hope to stimulate supply to offset

demand. Unfortunately policy rates are already incredibly

low and the ECB has already provided unlimited funding

for banks through its short and long-term refinancing

operations. The only other viable option is to find some

way to restore confidence in the Eurozone banking system.

The asset quality review that kicked off last week is a start

because it helps to identify the problem. Unfortunately, thereis no clear mechanism in place to deal with any troubled

assets that are identified. Complacent markets are letting

politicians get away with ignoring the need for a Eurozone-

based resolution mechanism; at the moment the burden of

resolution would fall on bondholders or national sovereigns,

which does not encourage confidence. All this could just end

up replacing one problem with another.

As usual in the Eurozone, the problem is not uniform across

all countries. And as usual, the problem is worst in the

periphery. Dividing up the Eurozone into three groups of

countries the core, the periphery and an in-between group

of the coreiphery (France, Belgium, Italy and Slovenia) the

divergence becomes clear (chart 2). At the start of the crisis

everyone was still treating the Eurozone as one region, so all

three groupings moved together. After 2010 the cracks in

the Eurozone appeared and the core and coreiphery started

to move differently. The core and coreiphery saw a small

rebound in demand while the periphery experienced a sharp

weakening of supply the result of much higher borrowing

costs for periphery banks.

Over the last year, the periphery seems to have experienced

a mix of both weaker supply and weaker demand: interest

rates were unchanged but lending continues to collapse. Thecore looks to have stabilised but the coreiphery is starting

to see weaker demand, showing a growing divergence from

the core as investors start to realise the differences between

these regions.

The ongoing decline in Eurozone credit to nonfinancial

corporations highlights the fragmentation of the Eurozone

and the limitations of monetary policy tools. First, cutting

rates in order to boost supply will only have a limited effect,

and it cannot offset a collapse in demand for lending if

firms are pessimistic about the economy, they simply will not

want to borrow almost regardless of the price. Second, the

ECB sets policy for the whole Eurozone, and until confidence

is restored across the whole Eurozone banking sector, policies

to support bank lending have the greatest effect on the areas

that need it least; in other words, the strongest areas like

the core. Third, an asset quality review without a resolution

mechanism and financial support from the Eurozone isunlikely to be very useful at restoring confidence. The ECB

has supplied pretty much all the support it can; maybe it is

time to demand more from Eurozone governments.

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Chart 2. The undemanding periphery

Change in interest rates and loans for nonfinancial corporates from

monetary financial institutions, by Eurozone region

Source: European Central Bank, UBS Global Asset Management

Note: Core = Germany, Netherlands, Austria, Finland, Luxembourg, Estonia and

Malta. Coreiphery = France, Italy, Belgium and Slovenia. Periphery = Spain, Portugal,

Ireland, Greece and Cyprus.

-300-250-200-150-100-50

050100150

-20 -15 -10 -5 0 5 10 15 20Change in lending, YoY %

Changeinra

tes,

4Q(

basispoints)

200820132013

2013

Weaker supply

Weaker demand Stronger supply

Stronger demand

Core Coreiphery Periphery