ECB will step in with rates cut whatever Greece’s fate

THIS week’s equities rout grabbed the headlines. But the real worry lies elsewhere. Namely, in the seizure of the European interbank lending market – which, as I shall explain, also has dire implications for the US financial system. Looming Greek insolvency may be the bullet in the gun, but the target is likely to be everyone’s local bank. As a result, the markets are repeating what they did in the aftermath of the Lehman Brothers collapse: ceasing to provide liquidity to the banking system.

The problem is wider than banks not lending to fellow institutions. European banks need US dollars to finance their international obligations. They get these dollars by arranging complicated short-term currency swaps for euros. The bellwether indicator of European bank solvency is therefore the cost of arranging these three-month and one-year euro-dollar basis swaps.

In the early summer, as the second Greek bailout started to unravel, the cost of dollar basis swaps went through the roof. Lenders are demanding premium rates because of the risks involved, and there is a shortage of dollars in the market.

Two weeks ago, after the premium rocketed to near 2008 levels, the European Central Bank (ECB) moved to supply banks with emergency dollars. But this week, after Standard & Poor’s cut the credit rating of Italian banks, the cost of one-year basis swaps shot to its highest since December 2008. The problem is that US money market funds won’t finance swaps with European banks suspected of being exposed to sovereign default. The ten largest American funds reduced their exposures to European banks by 9 per cent in July, according to Fitch, the ratings agency.

It is easy to see why the Americans are worried. European banks represent nearly half of the $658 billion (£425bn) in exposures of US money market funds, with French banks alone representing around 14 per cent. And Paris banks are heavily exposed to Greek sovereign debt.

As a result of this gridlock in the money markets, European institutions face a funding gap that may be as high as almost $4 trillion, according to the Bank for International Settlements. This represents the difference between the maturity of banks assets and their short-term liabilities. Add to that the impact of a Greek default, which could leave European banks needing 200bn euros to recapitalise, and you can see why bank shares have dropped by a fifth since February.

Yet the buck – proverbially and literally - does not stop in Europe. European banks, faced with a dollar shortage, are now axing lending to the ailing US economy. Two of France’s biggest banks – BNP Paribas and Société Générale – are already dumping dollar-denominated assets. BNP expects to reduce its dollar loan book by $42bn by year end.

Meanwhile, France, Germany and Spain are telling everyone (loudly) that their domestic banks are in no need of fresh capital. That explains why shares were in freefall this week. Expect the ECB to cut rates soon and offer 12-month bank financing – Greek default or not.

Lack of transparency did Swinney no favours

I WAS nonplussed by reports that business will have to pay “an extra” £850 million in tax to the Scottish Government, as a result of this week’s Holyrood budget. Has John Swinney suddenly turned anti-business?

No, but Swinney did himself no favours by failing to spell out clearly what revenue increases he expected from non-domestic rates (NDR). You have to trawl deep into Wednesday’s 250-page spending review before you discover the extra £850m. However, to be clear, this is the cumulative, additional revenue expected over three years, with around £500m arriving in 2014-15.

Most of the extra NDR comes from inflation and anticipated economic growth, not any increase in tax rates. The inflationary index is calculated by the Treasury and I think it’s on the low side. Growth is also determined using Treasury guidelines. Here, though, I’d prefer to err on the pessimistic side, which could cause Swinney problems.

The rest comes from the new levy on larger retailers (£40m by 2015) and ending rates relief on empty properties (£36m). Competition among the big supermarket chains should ensure the levy is not passed on to customers. But if you can’t lease out your property, how can you pay NDR?