Deep impact- the economy in big trouble




– 06-Aug-2008


The credit crisis blasted off a year ago and as the shock waves reverberated around the world central banks attempted to rescue faltering economies. Sunil Jagtiani reports from Hong Kong on the event’s global impact and prospects for recovery.

The credit crunch erupted a Tyear ago after building up over the earlier part of 2007. Volatility engulfed stockmarkets around the world during that month as central banks pumped vast amounts into the financial system to stop it seizing up following the crisis.

One year on, it is clear that the subprime debacle had a major and deleterious impact on global economic growth and share prices, while also shaking up policy making. Indeed, the fallout from the crisis is still being felt in many countries, with many analysts pessimistic about global economic expansion this year and in 2009.


“Lasting impacts of the crisis will be observed in economic growth, politics and regulation and central banking,” says Andrew Smithers, an economist and the founder of Smithers & Co.

The International Monetary Fund (IMF) said last week that one year on from the crisis global financial markets continued to be fragile and risks to the financial system remained elevated.

The IMF reiterated its estimate that banks and other financial institutions may in aggregate have to endure losses approaching $1 trillion (£502 billion) – a figure that underlines the severity of the subprime problem. The international body forecasts global growth of 4.1 percent this year and 3.9 percent in 2009, well down from 2007’s expansion of 5 percent.

“Credit quality across many loan classes has begun to deteriorate with declining house prices and slowing economic growth,” the IMF says in an update to its Global Financial Stability report. “Although banks have succeeded in raising additional capital, balance sheets are under renewed stress and bank equity prices have fallen sharply.”

America’s subprime mortgage sector, roughly worth about $1 trillion, is typically said to comprise home loans that do not meet top quality criteria. This may be because the borrowers taking out the loans have impaired credit histories, a high proportion of debt relative to income, or a big loan-to-value number.


Financial innovation over recent years allowed banks to sell on mortgages to credit markets, so they no longer had to depend on deposits to finance mortgage lending. Such securitised subprime American loans, many based on variable interest rates, mushroomed amid historically low borrowing costs as borrowers struggled to keep up with rapidly rising property prices.

But then rates went up, house prices began falling and an army of subprime borrowers defaulted on their loans. As the problem grew ever greater, the market for securities whose value is linked to subprime loans collapsed.

That led to huge losses at banks and other financial institutions – the IMF says they have written off almost $400 billion of assets – contributing to a global credit crunch as these distressed institutions set about repairing their balance sheets and pared back lending (see table, opposite).


Inevitably, since credit is key to economic growth, the crunch has slowed expansion. Yet several experts argue it was only a matter of time before some developed world economies, especially America, paid the price for a massive debt binge over recent years driven by low interest rates.

“The underlying problem is not just subprime US mortgages, but excess lending to all private sectors of the economy,” says Smithers. “Debt was too high and growing too fast and risk aversion was too low. In particular, the price of liquidity had reachedabsurdly low levels. As usual, a general excess had its outstanding folly. In this instance it was subprime debt, just as the crazy overvaluation of world stock markets in March 2000 had its particular folly in the high-techs.”

There have been landmark collapses and policy moves since the crisis erupted. In Britain, Alistair Darling, the chancellor of the exchequer, pledged in September that the Bank of England would guarantee all deposits at Northern Rock to stop a run on the bank and shore up confidence in the British banking system. The bank relied on credit markets to fund its mortgage business, and hit trouble when they seized up after the subprime crisis, forcing it to go cap in hand to the Old Lady for temporary funding.

Central banks also pumped hundreds of billions of dollars into money markets to stop them freezing up completely and came up with schemes to give commercial banks access to funding as the subprime crisis grew. America’s Federal Reserve began slashing interest rates, from 5.25 percent in August 2007 to 2 percent by April, including an extraordinary three-quarter point cut in January as global stockmarkets plunged over fears about the impact of the subprime crisis.

In February, President George W Bush signed off on a $170 billion stimulus package to shore up American economy. The following month Bear Stearns, one of Wall Street’s most venerable investment banks, in effect collapsed over its exposure to securities backed by subprime mortgages. It was bought by JP Morgan Chase for just $240m in a deal backed by the American central bank funding to preserve the stability of the financial system.


Last month, America’s Congress passed a sweeping housing rescue plan to help struggling homeowners stave off foreclosure amid tumbling prices. The plan also shores up Fannie Mae and Freddy Mac, the government-backed American mortgage finance titans, which own or guarantee about $5.2 trillion in home loans, equivalent to about 40 percent of the overall value of American mortgages. The failure of Fannie or Freddie is viewed as unthinkable.

Since the crisis broke, Citigroup has incurred asset writedowns or credit losses of more than $50 billion. The figure for Merrill Lynch tops $45 billion and is more than $30 billion for UBS. Sovereign wealth funds from the Middle East and Asia have stepped in to help distressed Western banks recapitalise. The new-found power of Asian sovereign wealth funds in particular, such as the China Investment Corporation, has stirred a separate controversy.

The banks are still suffering. Merrill Lynch said on July 28 that it was likely to write off another $5.7 billion because of the subprime crisis in the current quarter, adding that it would raise more than $8 billion by selling new shares.

Housing markets are rolling over and economic growth forecasts are being cut around the world (see boxes below and opposite). For instance, Lehman Brothers, an investment bank, says the British economy will grow just 0.3 percent in 2009. Even China, whose economy has boomed over recent years, has started to worry about weaker growth as exports to America slow sharply.

“Growth will slow, on a trend basis, particularly in the UK and US, which have been under-saving and under-investing, but getting by in the short-term through the boom in financial services and by financing consumption with large external deficits,” says Smithers.

“Disappointed expectations by voters will lead to populist measures, which will tend to hinder world trade and increase regulations – these will make matters worse and further impede growth,” he adds.

Stockmarkets around the world have fallen since last year (see chart, page 12), with the slide worsening as the subprime crisis accelerated from August. The MSCI World index fell 6.5 percent from January 1 2007 to July 25. The British stockmarket is down about 13.5 percent, while America is down about 10 percent. Falls in Asian bourses, former investor darlings, have been especially steep.


Robin Bowie, the chairman of Dexion Capital, a hedge fund specialist, says there might yet be some time to go before investors could say the worst part of the subprime crisis was over.

“I suspect it will not be until 2010,” he says. “Equity prices are likely to go down in waves. The first one is complete and the next wave is likely to start in October. A lot of people have made money from clever financial engineering and that is now being unwound.”

Mark Hall, the manager of the BWD UK Select Growth Trust, says his firm’s “best guess” for the point of “maximum pain” was the second quarter of 2009.

“Looking forward, a UK recession is fast becoming our central case scenario,” he says. “Any hope [that a] buying opportunity in UK … cyclical stocks would be in 2008 now appears to have been extinguished.”

The worldwide surge in inflation because of high oil and food prices has complicated the job of ameliorating the impact of the subprime crisis and credit crunch on economic growth.

Consumer prices in several countries are well above maximum target levels set by central banks, raising fears of wage price rises and the possible return of the scourge of endemic inflation. Yet raising rates risks choking economic growth given that the world is struggling through the subprime imbroglio.

Many experts continue to be acutely worried about the trajectory of the American economy, the epicentre of the crisis. They are also troubled about the possibility of stagflation – slowing economic expansion combined with high inflation, which is said to be bad for many asset classes.

But Charles Gave, the chairman of GaveKal, a Hong Kong-based consultancy, argues that the American economy was heading towards the last part of the crisis and that stagflation was unlikely.

“The subprime crisis has morphed into a credit crisis,” he says. “When you have a credit crisis, the currency must go down to boost external demand to replace domestic demand, so you lower interest rates. You put on a very steep yield curve to allow the banks to recapitalise. You try to recapitalise the banks through rights issues or new capital as fast as you can. So if you look at what the US government has been doing for the last year since the crisis erupted, they have done a pretty good job.”

However, he points out that over the past 12 months America’s Fed had shrunk its balance sheet by selling almost $300 billion worth of its own portfolio of Treasury bonds and buying a slightly smaller amount in mortgage bonds.

“So the Fed has been able to manage the credit crisis without increasing the money supply,” he says.

“That has huge implications. Since inflation is always and everywhere a monetary phenomenon, and if the central bank is not printing money, and if commercial banks are not able to lend – bank lending in the US is plummeting as we speak – then exactly how are we going to find the money to finance inflation?”

Gave says inflation was set to fall to much lower levels than anyone currently expected. “A credit crisis is always a deflationary phenomenon,” he says. “Inflation is going to be waning pretty soon as a lot of commodities are rolling over.”

Crude oil, for instance, was trading at about $124 per barrel at the time of writing in late July, well down from a record high above $147 hit earlier that month.

But it was still 25 percent up in the start of 2008, and much higher than lows of below $10 hit in the late 1990s.

Gave said he was more concerned about the prospects for Europe, whose banks have substantial exposure to securitised American subprime loans, than for America. “The credit crisis is suddenly almost as big in Europe as it is in the US,” he says.

“The policy there is exactly the opposite of what should be done. The European economy is going to fall literally out of bed, it’s staring at a huge recession.”

The European Central Bank in July raised interest rates for the first time in more than a year. It hiked its main interest rate by a quarter point to 4.25 percent in a bid to curb inflation running at 4 percent, against the central bank’s target of close to but below 2 percent. The euro has been strong as a result.

Housing markets in France, Spain, Italy, Ireland and Britain had been driving European growth along with German exports, but both these engines had stalled, Gave says.

“In Spain, you have more empty houses than in the US, for an economy which is not even one-tenth of the size. German exports are starting to collapse because of the overvalued euro and the global slowdown.”

In contrast, American exports had risen sharply thanks to the weak dollar, while sectors in America like oil, agriculture and alternative energy were booming, helping to offset the retrenchment in housing, the financial sector and carmakers.

“The US has done what is necessary,” Gave says. “They are at the tail-end of the crisis. The real issue is what is going to happen in Europe.” l

Stockmarket performanceTotal writedowns and credit losses since January 2007 ($bn)

Impact on Europe

The rise in European inflation owing to higher food and energy costs, and the risk that wage increases could follow, have taken centre stage recently as the region’s key economic concern.

That in turn has pushed the subprime crisis, and the credit crunch it triggered, out of the spotlight. Indeed, the International Monetary Fund said recently that inflation’s march had started to rival the subprime crisis as the key worry globally.

But Lehman Brothers say in a recent research note that the credit shock had been “easily trumping” the food and energy shock in terms of its impact on European economic growth so far.


“The latest consensus survey of economists’ forecasts shows further downward revisions this month to euro area and UK growth expectations for both this year and next,” it says.

The main cause of the revision was souring expectations for consumer spending, the bank said.

“The two big shocks hitting the European economy – as in the US – are the income shock from surging food and energy prices and the credit shock. There is a debate as to which of these is the most important.”

Lehman says forecasters had been giving a higher importance to the impact of rising food and energy prices in the economic slowdown. If they were right, it adds, then if the shock eased as oil prices fell, growth “should bounce back”.

“But if that is wrong, and it is the credit shock that is the main factor behind the drop-off in growth, then the fall back in oil prices, while welcome, is unlikely to offer much relief,” it says.

Lehman says that “a simple look at the data across Europe points strongly in the direction of the slowdown being driven by the credit shock”.

That conclusion is based on the fact that downward revisions to growth forecasts are sharper for European economies with higher adjustable rate household debt as a percentage of income, such as Spain or Britain.

“As mentioned earlier, this does not seem to be the view of most forecasters,” Lehman says. “Neither, it seems, is it the view of equity markets – which have rallied strongly as the oil price has dropped back – or central banks.”

But the bank points out that “within Europe at least, the economies that have fared worst in the situation – the UK, Spain and Ireland – are also the ones experiencing the most significant credit shocks. The food and energy shock, by contrast, has been broadly comparable across economies.”

Lehman forecasts euro area economic growth of about 1.4 percent in 2008 and 0.8 percent in 2009. The comparable figures for Britain are 1.1 percent and 0.3 percent.

Impact on Asia

Many parts of the world have felt the impact of the subprime crisis, including the Asia-Pacific. The region had been lauded for rapid, China-led economic expansion over recent years, but the fallout from the crisis has led to concerns about whether that rosy picture is fast becoming outdated.

Tehmina Khan, a regional specialist at Capital Economics, says Asia’s financial system is holding up so far. That represents something of a stark contrast with the stress felt in America, for instance.

“The Asian financial system has so far proved to be fairly resilient to the US subprime crisis. Asian exposure to opaque asset-backed securities has been well below that of other – primarily Western – economies,” she says.

But it would be premature to think that region had escaped the worst of the crisis, she adds.

“The region remains vulnerable to asset price volatility in general. In addition, policy options for Asian central banks are increasingly constrained by domestic inflationary pressures and slowing external demand,” Khan says.

Economic policy across Asia could thus face an increasingly “bumpy ride” over the year ahead, the London-based economist argues.

Aggregate subprime losses in Asia had been estimated at $11.5 billion (£5.8 billion), Khan says, with about two-thirds of that in Japan.

That was “well within regional capital buffers and are also a lot lower than losses in other parts of the world”.

Stronger regulatory oversight following the debilitating 1997 Asian financial crisis, lower demand for higher yielding foreign assets and the fact that credit securitisation was still something of a novelty in Asia helped to explain the lower losses.

“Nevertheless, Asia has not emerged completely unscathed. Global financial turbulence has manifested itself in the form of sharp equity falls across the region,” she says.

For instance, the MSCI Asia-Pacific index is down about 17 percent over the year to July 25. Asia also remains vulnerable to asset price volatility in other areas, particularly in housing markets, which could have “serious consequences for household and bank balance sheets”, Khan says.

House prices have already begun slowing or falling in parts of China and countries such as Australia and New Zealand, which in turn has an impact on the wider economy.

In the southern Chinese city of Hong Kong, for instance, housing transaction volumes have fallen, estate agents are reportedly firing staff and property stocks are performing poorly.

Khan says volatile short-term private capital inflows “exceeded foreign direct investment into the region last year” and remained a source of concern.


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