Jacob Saulwick and Telegraph, London
June 26, 2007

THE risk of a 1930s-style economic slump has been heightened by "euphoric" markets tapping cheap global credit, one of the world's pre-eminent financial institutions has said.

In its annual report the Bank for International Settlements noted that the conditions which led up to the Great Depression of the 1930s and the Asian crises in the 1990s were reflected in the current environment.

"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," the bank said.

The BIS, the central bankers' bank, pointed to a confluence of 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.

"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 40 per cent of China's state-owned enterprises are losing money, exposing the banking system to likely stress in a downturn.

It said China's growth was "unstable, unbalanced, unco-ordinated 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 built up in the boom years had suffocating effects.

But the bank also said that tightening interest rates during an upswing was likely to bring significant practical difficulties - a fact the Reserve Bank of New Zealand knows well.

The RBNZ has lifted interest rates to 8 per cent this year in an effort to slow the economy and ward off price rises. But the high rates have attracted global investors who have driven the New Zealand dollar to record highs.

The Australian dollar has also been boosted by relatively tight interest rate settings, hitting an 18-year high of US84.99c yesterday.

The bank's concern about the development of asset bubbles in real estate and share prices was mirrored by participants at a World Economic Forum on East Asia conference in Singapore yesterday.

"There is a high degree of complacency, coming out of the long period of low interest-rate environment, and a low volatility environment," Singapore's Second Finance Minister, Tharman Shanmugaratnam, said.

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BIS warns of Great Depression danger from credit spree

By Ambrose Evans-Pritchard
The Telegraph, London Monday, June 25, 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 newfangled credit instruments, soaring levels of household debt, extreme appetite for risk shown by investors, and entrenched imbalances in the world currency system.

"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 40 percent 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, unbalanced, 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" afterward -- 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 built 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 6.5 percent of GDP, a rise in US external liabilities by over $4 trillion from 2001 to 2005, and an unpredented 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 $470 billion in collateralized debt obligations (CDO), and a further $524 billion 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.

CDOs 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 buyouts touched $753 billion, 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.