The corporate liquidity ratio – companies’ holdings of short-term assets divided by their short-term borrowing – is a good leading indicator of the economic cycle. A falling ratio may indicate that corporate profits are weakening and / or companies are expanding their operations too rapidly. In either case, future retrenchment is more likely, involving cuts in investment and jobs.
In the UK, the ratio of private non-financial companies’ M4 money holdings to their bank borrowing – a proxy for the liquidity ratio – began to fall significantly as long ago as 2005. It has continued to decline in recent months, matching the low reached in the early 1990s recession. This signals ongoing business contraction at least through mid 2009.
Worryingly, a similar trend is now in place in the Eurozone. The chart shows the ratio of Eurozone companies’ M3 holdings to bank loans with an original maturity of up to five years. This began to decline significantly in early 2007 and is currently at its lowest since 2003.
The higher level of the Eurozone ratio compared with the UK is of limited comfort. Unlike their UK counterparts, Eurozone companies borrow significantly on a long-term basis from their banks – about half of outstanding loans have an original maturity of more than five years. Including these in the calculation would push the ratio well below the UK level.
As in the UK, the decline in the Eurozone ratio initially reflected rapid growth in borrowing but slowing monetary expansion has been the key driver more recently. The annual rate of change of non-financial companies’ M3 holdings fell from 13% in November 2007 to 3% a year later – the lowest on record since 2000.
The appropriate policy response to the corporate liquidity squeeze is Fed-style quantitative action to boost aggregate broad money supply growth. Such measures are required just as urgently in the Eurozone as the UK.
