Recent headlines:

Cost of credit or availability of credit?

Posted by cij on Oct 8th, 2008

In conjuction with our upcoming property debate let us delve abit into the credit crisis that is currently plaguing the economy. This article is re-published from Contrarian Investors’ Journal. If you wish to leave any comments, please click here.

As you will already know by now, the Reserve Bank of Australia (RBA) cut interest rates by 1% today, which was more than what the financial market expected at 0.5%. What a bold move! Or is it a sign that the RBA is panicking? Or perhaps is it a result of a plan by central banks around the world to synchronise their rate cuts in order to soothe the global credit market?

There are plenty of commentaries about this surprise move by the RBA and we wouldn’t repeat them here. But there is something in the RBA statement that caught our eye:

The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast.

The issue is not so much that the cost of credit is too high. Rather, the availability of credit is becoming the issue. What’s the implication?

Remember, back in Econ101 at university, you may have learnt to draw the demand-supply graph whereby the ‘market price’ is the intersection between the demand and supply? The assumption behind the demand-supply graph is that supply is always available as long as one is willing to pay the price. Thanks to freeze-up of the global credit market, this assumption is no longer true. That is, credit may not even be granted even if one is willing to bid for it at a higher price.

Assuming that the credit crisis will drag on, this means that more and more borrowers may soon find that lenders are no longer willing to lend despite being willing to do so previously. In other words, lending standards will be tightening even further. The implication is that more and more borrowers (whether businesses or households) who need to refinance or roll-over their loans may suddenly find that the supply of new credit are being denied.

This will be the point when the crisis in the financial markets spread to the real economy. As Alan Kohler wrote in Interest rate give and take,

If credit ain’t available, it doesn’t matter what it costs.

We would like to hear what everybody else think about this. If you have written a related article on your website, we encourage you to leave your website’s link over here. Similarly we also welcome you to link back to this article from your website.

This article is re-published from Contrarian Investors’ Journal. If you wish to leave any comments, please click here.