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A creditless recovery?

Can we get a significant industrial recovery without a pick-up in bank lending? This is the question that’ll be posed by next week’s numbers. They are likely to show that purchasing managers are reporting rising manufacturing output whilst the Bank of England says non-financial firms are paying off debt; since September 2008 firms have reduced their bank debt by £80bn, equivalent to over five per cent of annual GDP. And the Bank of England’s recent survey of credit conditions suggests the availability of credit to companies isn’t going to greatly increase soon.

Hence the question: is a lack of credit really a constraint on recovery?

The historic evidence is not much help here. It shows that there has been only a weak correlation between bank lending growth and manufacturing output. But this is not as encouraging as it seems. The lack of correlation is because strong lending did not much boost output, rather than because output has done well when lending contracted.

There are three reasons to think a creditless recovery is possible. But all are questionable.

1. A lot of credit growth has been to non-industrial firms, such as real estate companies. This means the credit “cycle” and the industrial “cycle” are different things.

However, manufacturers supply materials to the building industry. Anything that depresses construction will, therefore, be bad for manufacturing.

2. If exports grow, output will rise and bank debt fall as firms use revenue from overseas to pay down borrowing.

This happened last year; non-oil exports rose 9.4 per cent in value terms and 4.3 per cent in volume terms in the 12 months to Q4. However, next week’s numbers are expected to show that bank lending in the euro area has fallen for the last three months. If the UK is to enjoy continued export-driven growth, therefore, our main trading partner must also enjoy a creditless recovery.

3. If companies start spending the cash they’ve built up over the last ten years – say by increasing capital spending - output will grow and bank debt will fall, as the recipients of capital goods orders use the revenue to pay off borrowing.

Sadly, there’s little sign of this happening to any degree yet: corporate cash holdings have been more or less flat in the last two years. There’s a good reason for this. Firms have accumulated cash because they haven’t seen good investment opportunities; why should this change soon?

A creditless recovery is therefore possible, but not at all certain.

But even if we do get one, it’ll not be an unmitigated good. The likeliest way we’ll see one would be if firms do start to invest their cash balances. However, as it is probably larger firms that have such balances, such a process would see big firms getting bigger whilst smaller, credit-constrained ones struggle. Although this might benefit equities – as the larger firms tend to be quoted – it’s not entirely healthy for the economy for the big to get bigger.

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By Chris Dillow,
20 February 2012

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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