Risk of Great Depression says BIS

Telegraph today

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.


The BIS said China may have repeated the disastrous errors made by
Japan in the 1980s


"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.

"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.

advertisement"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, 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" 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.

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 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 $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.

.

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