GLOBAL ECONOMY WEEKAHEAD-Getting money flowing after stress test

WASHINGTON, May 10 - Now that the largest U.S. banks have completed their stress tests, the bigger stress is figuring out how to get credit flowing normally so that the global economy can start growing again.

In the United States and in Europe, central bank surveys show that lending remains extraordinarily tight even though official borrowing costs have been cut to record lows.

"It's not really the price of credit. It's the availability," said Howard Archer, chief UK and European economist at IHS Global Insight in London.

The problem is the underlying economy is still hurting -- despite all the talk of "green shoots" of recovery -- which means more people will lose their jobs and fall behind on bill payments. Banks are worried their losses will grow.

Figures due next Friday are expected to show the euro zone's recession deepened in the first quarter, and economists widely expect that the region won't return to growth until 2010 or perhaps even 2011.

The weaker the economy, the weaker the banks. That is what last week's U.S. stress tests aimed to address -- how big of a capital cushion would the biggest firms need should the economy deteriorate even further? The number the regulators came up with was just under $75 billion, far less than once feared.

Last week, Finnish Finance Minister Jyrki Katainen called for joint stress tests in Europe, but a top banking regulator said bank examinations and bailouts were a national responsibility and there would be no pan-European stress test.

The International Monetary Fund has estimated that European banks need to write down $750 billion in bad loans and raise as much as $725 billion in capital through 2010 -- figures that many European officials have dismissed as too high.

FEEDBACK LOOP

The financial crisis, which first exploded in August 2007, has underscored the strong link between the state of the financial system and the health of the broader economy. When banks curb lending, the economy slows, jobs are lost, bills go unpaid and banks suffer losses.

Economists call that a "feedback loop," and many of the steps that central banks have taken to shore up lending were aimed at breaking it.

Dean Maki from Barclays Capital in New York said there were signs that the feedback loop "appears to be turning positive."

"It is still the case that a financial market deterioration seems to pose the biggest risk to the anticipated economic recovery, though at this point it is not clear what the trigger for such a disruption might be," he said.

While a healthier economy would certainly help banks, there is no guarantee that credit flows will rebound to pre-crisis levels once the recession ends.

The problem is not simply that banks are reluctant to lend. The securitization market where loans were repackaged into securities and sold to investors has yet to return to normal working order, and that is restricting credit.

For example, the amount of commercial paper, which companies use regularly for short-term financing, is down 26 percent from the average level in 2007, according to Drew Matus, an economist with Merrill Lynch in New York.

At the same time, companies and consumers are leery of taking on more debt while uncertainty is running high over the job market and the economy.

"Even if credit is available, you cannot force people or firms to take loans," Matus wrote in a note to clients.

Matus thinks lending will start to expand again in late 2009, provided the economy is healing. He said stabilization in the housing and job markets would go a long way toward easing credit conditions.

That doesn't mean everything will go back to normal.

"Although credit markets may thaw and banks increase lending, credit will continue to prove a scarce commodity for some time," Matus said.