FRANKFURT (MNI) – Significantly tighter credit conditions in the
Eurozone have thus far not undermined a recovery in loan demand as
economic developments continue to surprise on the upside.

Nevertheless, expectations of yet harsher lending conditions for
businesses in the third quarter may prompt concerns that credit
constraints could eventually become a drag on growth.

Recent Eurozone sentiment data have surprised markedly on the
upside.

Germany’s Ifo business climate indicator on Friday posted the
sharpest increase since re-unification in 1990 to reaching its highest
level in about three years. Far from signaling a slowdown in the
recovery, the six-month outlook reached the highest level in over 15
years. “The German economy is back in a party mood,” Ifo said.

Similarly, Belgian business morale unexpectedly recovered in July,
as stronger activity and orders boosted industry sentiment and higher
turnover lifted spirits in retailing and wholesaling. After sliding
since April, the central bank’s sentiment index bounced 1.3 points above
the long-term average.

The European Commission’s sentiment index and Italian manufacturing
morale, released Thursday, also surprised to the upside. The Commission
survey showed gains across all sectors in July, suggesting that the
export-driven recovery may become broader-based.

Across countries, however, the data is less encouraging, signaling
a widening gap between the Eurozone’s core economies and the periphery,
where austerity measures may weigh on growth and confidence. The Greek
index remained exceptionally low, and the Spanish index took a turn for
the worse.

Still, for the Eurozone as a whole recent data should certainly
ease fears of a double-dip recession.

The brighter economic picture was also reflected in a pick-up of
loan demand in the second quarter, according to the ECB’s July Bank
Lending Survey, released Wednesday.

“Results pointed to a gradual improvement in the net demand for
loans in the second quarter of 2010, being only slightly negative for
loans to enterprises and turning positive for loans to households,” the
report said. The recovery is expected to continue in the months ahead.

While economic sentiment appears to have emerged relatively
unscathed from the sovereign debt crisis, the crisis did significantly
impair banks’ funding access, sparking an unexpectedly sharp tightening
of loan standards in the second quarter.

“Banks expect that the current difficulties in accessing wholesale
funding will remain, although not to the same extent as observed in the
second quarter of 2010,” the central bank added.

The further tightening in credit conditions confounded prior
projections of unchanged or easing conditions in the second quarter, and
it may raise concerns about a possible credit crunch that could weigh on
growth.

However, the ECB is likely to dismiss such concerns for the moment,
noting that the most recent tightening of credit standards was driven
primarily by the turmoil of the sovereign debt crisis.

The ECB is likely to argue that the recent stabilization of
markets, and in particular the publication of bank stress tests results
— which it sees as creating much needed transparency — should
dissipate uncertainties and make banks more willing to lend.

Over the medium-term, bank lending and credit conditions may be
tightened somewhat by tougher rules on bank collateral that will make it
more costly for banks to borrow from the ECB as of January 1, 2011.

On Wednesday, the ECB unveiled a new haircut schedule for
securities other than ABS and government bonds. As pre-announced in
April, the new graduated system based on differences in maturities,
liquidity categories and the credit quality of assets concerned will
replace the current uniform add-on haircut of 5% for all assets rated
below A-.

The stricter rules are aimed at reducing the ECB’s risks in lending
to banks after the central bank significantly loosened its collateral
framework in the wake of the financial crisis and stepped up lending,
leading to a significant increase in the size of its balance sheet. The
ECB, however, assured that the “the new haircuts will not imply an undue
decrease in the collateral available” to banks.

Whether the ECB actually implements the tighter rules at the start
of next year as planned will likely depend on the further recovery of
banks and bank lending during the remainder of this year. Were the ECB
to change its mind and suspend implementation of the new haircut
schedule due to fresh financial turmoil, it would not be the first time
during this crisis that it reversed course on a promised return to
tighter collateral rules.

–Frankfurt newsroom +49 69 72 01 42; Email: jtreeck@marketnews.com

[TOPICS: MT$$$$,M$$EC$,M$X$$$,M$$CR$]