Financial Market Instability: A Many Sided Story  (2007+)


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Introduction +

Introduction

The purpose of this document is to explore the 2007 destabilisation of global financial markets. It concerns issues that have the potential to disrupt economic relationships (and a credit bubble?) which have been critical to the uninterrupted global economic boom of the last two decades.

The July-August 2007 instabilities (which were not resolved when this document was drafted) were triggered by losses through 'sub-prime' mortgage lending in the US - and could have adverse global economic impacts.

However this problem is complicated because:

  • the ability of any authorities to govern financial markets is declining - due to both globalization and the reduced role of deposit-taking banks in debt financing;
  • imbalances in global financial markets have long been recognised to be unsustainable. These have relationships with the sub-prime story, eg because; (a) East Asian growth arguably depends on the existence of strong financial systems elsewhere; (b) credit-driven property bubbles were encouraged in US / Australia etc by large capital transfers from East Asia and by cheap Asian imports which artificially restrained inflation and encouraged reserve banks to set low interest rates; and (c) European current account surpluses / capital exports were invested in US property assets, resulting now in severe losses in Europe's financial institutions - a problem which might also affect Japan.

By late 2007 indications were emerging of the wide repercussions of the credit freeze the sub-prime crisis induced, and of other possible sources of financial instability that were not directly attributable to the sub-prime crisis. These suggest that:

  • the latter might merely be a symptom of a larger situation (ie the unwinding of an unrealistic level of past credit creation associated with the way in which global financial and economic systems have evolved and a lack of effective governance);
  • resolution of global financial imbalances is increasingly important - because the credit freeze has apparently turned current account surpluses in Japan and Europe into economic shocks and puts the funding of current account deficits at risk;
  • new techniques for counter-cyclical macroeconomic management may need to be invented urgently, because property housing booms seem to be a by-product of attempting this through monetary policy.
Losing Confidence in CDOs +

Losing Confidence in CDOs -  Collateralised Debt Obligations

The sub-prime side of the story starts with the development of techniques for funding lending through securitisation - eg bundling mortgages together and selling CDOs (ie the associated security, income stream and risks) to bond markets.

This was a genuine financial innovation. It made some people a lot of money. It reduced the risks (and potential for systemic instability) associated with traditional debt funding - ie where banks borrow short and invest long and can be in trouble if a market downturn triggers a loss in value of their investments and a desire for investors to withdraw their deposits.

These techniques have not only been applied to home lending but to the debt funding of other types of investment. They have also been used for leveraged corporate buy-outs.

However CDOs have been oversold to bond markets. The risks associated with mortgages to borrowers with poor repayment capacity were not properly disclosed - presumably because mortgage originators (for example) had incentive to 'do deals' but not to ensure that investors fully understood what was involved. Mortgage originators expected to pass the risk to investors.

Rating agencies also had not done their jobs their jobs well in identifying the risks in purchasing such assets.

Substantial losses have been incurred in some funds, because advances were made to mortgagees in excess of their capacity to pay (especially when interest rates rose).  The process of realising sup-prime losses may still be at an early stage because many sub-prime loans are scheduled for automatic resetting of interest rates at much higher levels over the next 2-3 years.

Some observers suggested that:

  • US sub-prime failures to date haven't come from people unable to meet payments when rates increased, but have tended to reflect failures in the first year before resets - ie by those who were intending to re-sell properties before making payments but were caught out by declining property prices [1, 2]. If so it may be that the future development of these losses may not be as severe as expected;
  • a lot of losses have come from people who could afford to keep up their mortgage payments, but decide not to because house prices have fallen and they have lost equity. If house prices continue falling, the problem will escalate [1]. This implies that a significant source of the problem has been providing mortgages that are a high percentage (eg near 100%) of property values.

Because of the parallel development of other financial instruments (derivatives) that allowed higher returns to those who carried the risk component of CDOs, those marginal losses have translated into complete loss of capital in some funds which took the high risk / high return component of the CDOs. Moreover there are presumably many yet-undisclosed losses on the books of financial institutions and other businesses. Thus other entities will have losses on their books, that they don't even know about yet. The fact that no one's financial strength is now actually clear means that (a) investors will be nervous and (b) effects will drag on for some time.

In particular banks worldwide may have an exposure to around $1000bn of uncertain asset-backed securities issued by associated firms that banks have guaranteed (and on which they might experience $500bn in losses). Also some $1000bn in short term debt needs to be rolled over in the short term. Banks are probably hoarding cash to cover these liabilities, and refusing to lend to other banks because it is not clear how solvent they are [1].

Investors were shocked to discover that there were unexpected and undisclosed risks in complex financial products - and this initially shut down their willingness to invest, not only in securities backed by uncertain mortgages, but also in other similar instruments. This dislocated the process of securitised debt funding through bond markets for business as well as real estate.

This potentially has huge economic and geo-political implications. Structured credit assets had become important in debt financing of investment generally. Moreover processing global investment had become economically important in some countries (eg UK) and the way in which Asian and Middle Eastern savings were channelled into apparently safe investments in US and Europe [1].

Ending a Virtuous Circle

Loss of investor confidence in complex financial instruments is, however, merely a symptom of problems that have been developing for a long time.

Cheap credit had been provided through bond markets with too little (sometimes no) allowance for risk.

Discounting investment risk to virtually zero has been partly a consequence of the development of techniques by reserve banks to prevent financial market 'busts' from affecting the real economy. This was first demonstrated by the US Fed Reserve under Alan Greenspan in 1987, and involved the Fed's willingness to provide emergency credit to banks and others to enable them to ride out the effect of the financial market crisis without having to exacerbate it by selling assets.

Because the Fed's innovative response in 1987 allowed investment to be seen as much less risky:

  • the US the Glass-Seagall Act, which had limited commercial bank exposure to risky investments, was relaxed and eventually repealed in 1995; and
  • interest rates have been able to be low and asset values have boomed for two decades - thus providing households with the wealth to increase consumption and corporate profits (which in turn further boosted asset values).

The latter 'virtuous' economic circle may no longer be sustainable.

Another 'virtuous circle' has been suggested to involve the adoption in US of 'mark-to-market' or 'fair value' accounting practices in 1993. This accelerated the rate at which banks' capital base (and thus capacity for further lending) would increase in a rising property market (with the reverse in a falling market). There were warnings at the time that this could increase the risk of financial bubbles [1].

Liberal financial markets played a very significant role in the development of the US economy during the 1990s - because it was the demand by investors for profits that drove structural changes in US enterprises from the hierarchical organisation that had suited mass production to the networked organisations that were able to acquire and exploit knowledge advantages to meet the challenge from Japanese competition that had seemed insurmountable in the 1980s (see New American Economy, 1997)

Ungovernable Financial Markets

Financial markets had become 'ungovernable' partly because of globalization and the growth of East Asian economies with radically different (and arguably incompatible and unsustainable) approaches to economic, financial and monetary affairs. The emergence of financial innovations that established institutions were not designed to deal with also contributed to the problem.

Global financial markets had become ungovernable (ie no one was in a position to prevent the emergence of systemic risks) because of the inability of the multilateral institutions established by the 1944 Bretton Woods agreement (eg the IMF) to adequately regulate the global financial system.

There was nothing in global financial machinery to prevent East Asian societies (initially Japan) from developing rapidly through economic strategies which contained inbuilt demand deficits to protect financial institutions with bad balance sheets - even though this meant that global growth could only be maintained if (mainly) the US could sustain high current account deficits, which were long financed through rapid asset inflation induced by easy credit. Global machinery was designed to respond when nations had a cash flow problem, and nothing was seen to be wrong (despite the adverse global macroeconomic consequences) when cash flow problems were prevented by a domestic demand deficit even though capital was often not used productively and financial institutions accumulated bad balance sheets.

The global financial imbalances that emerged (referred to below) arguably reflect 'clash of civilization' issues that were simply inconceivable in 1944.

One the result was that developing nations came to prefer current account surpluses and the core function of the IMF (ie providing emergency capital to such countries) thus became largely superfluous.

Globalization may also have made management of monetary policy by reserve banks unreliable, because interest rates are set to achieve inflationary targets - though inflation has been artificially low because of cheap (mainly Asian) imports. Thus interest rates have perhaps been set unrealistically low, leading to excessive borrowing for property investment. [1]. On the other hand it is argued that reducing interest rates would not encourage more risky use of funds - as this is usually said to occur when interest rates rise  [1].

In any event the development of CDOs has reduced the ability of national reserve banks even in the US to control the growth of credit, which they had traditionally done by setting the ratio of deposits to lending which banks needed to maintain (eg say 8%) - hopefully to ensure financial stability for the system as a whole.

Banks can otherwise create a virtually unlimited amount of credit (and thus expand money supply) because whenever they make an advance this tends to result in a deposit somewhere else in the banking system. And creating credit can, in turn, have macroeconomic effects (eg on the rate of economic growth and inflation) and also affect financial and property markets (eg by providing credit for leveraged purchase of shares or real estate).

Banks created 'special investment vehicles' (SIVs) for CDOs which matched investors with bundled assets - for which the banks gained management fees without theoretically having any ongoing direct financial involvement in the SIVs.

For many years CDOs provided a mechanism, outside any authority's control, to create large amounts of credit - and this has been part of the driver of real estate / business investment and household consumption (by drawing upon escalating asset values) which has underpinned strong economic growth in recent years - and created the potential for systemic failure.

An aside: It has also, probably, been a factor in the housing affordability problem which has become politically significant in Australia (and elsewhere). Cheap credit has been available for two decade (through CDOs, through loose monetary policy by Japan's and US reserve banks, and through recycling of Asian current account surpluses). $A assets have been seen as attractive for investment because the $A is viewed as a proxy for investment in commodities (because about 70% of its exports are of minerals and energy) and commodity prices have been booming. Banks drew on this available credit mainly for lending on property - and property prices have boomed

The former chairman of the US Fed, Alan Greenspan, argued in December 2007 that a housing bubble emerged because when reserve banks started to tighten short term interest rates in 2004 this had no effect on longer term rates (ie these stayed low) because financial markets had become too strong for reserve banks to control [1]

Impact on Banks

The non-bank institutions, that now have a significant role in financing, appear to have suffered something like a traditional 'run on the bank' (ie where some losses are made that encourage investors to withdraw funds, so requiring 'fire sales' of assets which compound losses). Reserve banks were established to counter this risk for banks, but don't have power over the non-bank institutions [1].

Moreover some of the non-bank institutions exposed to these losses are bank-associated firms operating under bank guarantees. Because the rules which had restricted their exposure to risky assets were relaxed, some banks are thus exposed to substantial  losses - which may put their solvency at risk, a problem that reserve banks can't deal with by creating more credit [1].

Observers have suggested that the banking system is in serious difficulties.

For example:
  • the problems banks are experiencing in lending may be the result of being forced to bring large quantities of off-balance sheet assets onto their books [1].
  • though the assets had theoretically been off balance sheets, banks chose to assume responsibility (rather than simply allowing SIV investors to carry the losses) because of concerns about the effects on their reputations and fear that legal costs could compound their losses. One observer argued that that the whole SIV phenomenon had been an Enron-like 'scam' [1];
  • banks worldwide made $545bn in leveraged loans in first half of 2007. They got around capital adequacy rules by getting loans off their books. The 'shadow' banking system bundled home loans, credit card or even corporate debt, into off-balance sheet 'conduits' which raised money by issuing short term commercial paper - at higher interest rates for those who took higher level of risk. When doubts started about credit quality, investors lost interest and the problems engulfed banks - who had warehoused loans and guaranteed that they would fund conduits if they could not sell commercial paper [1];
  • these problems won't be resolved until all sub-prime mortgage losses have been exposed; and structured credit assets have been exposed as highly dubious, and may not exist in 5 years [1];
  • this has been an historic crisis for bankers because it has disproven the assumption that mathematical models of past behaviour can be a reliable way to manage hundreds of billions of dollars in financial assets (and create AAA rating assets out of those of poorer quality) and the assumption that old-fashioned local banking in unnecessary; [1]
  • what is happening has been described as the breakdown of the modern-day banking system - which has the potential to dramatically reduce overall lending and generate a nasty recession. Financial innovations that were supposed to spread risk and make investment safer, encouraged investors to take on more risk than they recognised [1];
  • a report for the World Economic Forum suggested that the scale / nature of financial crisis has raised fundamental questions about the current models of financial markets [1];
  • there is now a modern version of the 'extreme liquidity preference' which contributed to the depression of the 1930s [1];
  • problem arose from greed and remuneration systems of investment banks, and failure by regulators. CDOs were around long before the subprime crisis - and are a good product if well priced and transparent. The fact that only subprime (not prime) mortgages were securitized suggests that marketers knew they were dodgy and something to flick to the biggest fool. If there had been no off balance sheets deals and proper policing of derivatives the game would have been simpler. Lack of transparency on pricing and on creditworthiness were  also factors. If subprime mortgages had been securitised in the ordinary way, the damage would have been minor. Standard derivatives (like exchange traded options) still function well presumably because they are well understood, and priced / traded in a standard way (personal communication).
  • a potential re-rating of $534bn of sub-prime mortgage securities in January 2008 will require many banks to write down their holdings - and perhaps seek new capital, which some may be unable to obtain  [1]
An aside: One observer speculated about whether the whole economic system may now be at risk because finance has become a major component of economies of US and others - yet contains fundamental flaws which have been revealed by (but won't be limited to) sub-prime mortgages. Debts have to be repaid, yet the value of underlying assets is unclear. They have been valued on the basis of models, and could be worth much less if 'marked to market'. Much financial enterprise has been built on the assumption of capital gains which can only continue as long as there is a constant stream of new money. Australia's property market seems to be an example, which is exposed to potential for reversal of the 'carry trade'. Reserve banks have recognised the risks, but have not yet been able to deal with the problem. It might be well beyond their ability to absorb the losses. Their acceptance of low quality assets as security for further advances to banks may be necessary, but puts $US and other currencies (and thus global financial system) at risk. Adjustment will take time, and there is a real risk of a very severe economic impact (brief outline of a personal communication)

Economic Consequences

For years investors have been able to virtually ignore investment risk, so capital has been very cheap. If current instabilities don't have a crippling economic effect, credit must inevitably be more expensive in future. As interest rates go up significantly, many investments that would have appeared viable will no longer be attractive, and this must have adverse global and local macro-economic effects.

It can be noted that interest rates to business and consumers have increased [1], though the increase has been relatively modest (ie about 35 basis points on commercial paper) and this was stabilizing by September 2007 [1]. However this only applied to the investment in high quality assets that was proceeding, and gives little indication of what might apply in areas where credit remains frozen. 

In recent years a significant amount of economic activity (in US / UK in particular but also in Australia) has shifted into financial services (ie developing currently-suspect financial instruments) and this segment of the economy will now be in trouble for some time.

The implications of this for investment prospects in Australia need consideration. For example RAMS home loans had based its funding for investment on short term commercial paper [1] and found it difficult to obtain refinancing. Other entities (eg Macquarie Bank) have aggressively mobilized funds for infrastructure investment through techniques that have been suggested to be now at risk. Observers concerned with credit unions have noted that difficulties in raising funds are now global and that Australia is vulnerable because its securitization market relies on foreign investors [1].

The implications for Queensland's state financial position (and taxation) need consideration - especially given the high levels of debt-based infrastructure investment now under way.

The implications for Australia's housing market also require consideration - as banks exposed to heavily indebted households who in turn are susceptible to increased interest rates or unemployment. The IMF has suggested that household efforts to reduce debts could hurt consumption. The Reserve Bank argues that risks are low (eg mortgage arrears are low; Sub-prime lending is only small part of market; household assets have risen faster than debts). However those with the assets may not be the ones with the mortgages, and a large segment of the population has never experienced rising unemployment - and may have taken on too much debt [1]. The Economist Intelligence Unit has warned that Australia is one of three countries at most risk of following the US into a housing slump [1].

Higher interest rates will also have possible implications for Australia's current account position (and exchange rate). Australia has (something like) $700bn in foreign debts most of which apparently represent borrowings for investment in real estate - which need to be rolled over from time to time. This will be at higher interest rates in future - which will increase the current account deficit. It will also inevitably affect mortgage interest rates - and perhaps trigger a downturn in property values. As the latter are a major part of the collateral for the borrowings which balance Australia's current account deficit, funding that deficit could become difficult. The Bank of International Settlements (BIS) has warned that Australia is at risk of capital flight [1] if anything disrupted the 'carry trades' (see below) - and the consequences of this would be devaluation of the $A and high inflation. The real value of accumulated national wealth would be at risk, as would be Australians' ability to control their own future. The fact that the value of the $A has been volatile (and fallen sharply several times) recently can be noted. In December 2007, indicators emerged of the potential for a current account crisis because banks had for some months not gained international commercial funding (see below).

Financial institutions together with resource companies have been the strongest components of Australia's share market. The financial sector has also been a major contributor to income taxes, and the the ability of the federal government to reduce tax rates.

Responses

When the effect of the sub-prime crisis spread to investor aversion to any complex financial instruments, financial markets and business were in trouble.

The European Central Bank started making credit available overnight, when it became apparent that there would be large spill-over effects on European institutions from systemic dislocations triggered by US subprime mortgage losses.

The US Fed has backed the conventional banks with a lot of credit - so firms who might have sought funding through now-suspect financial instruments have somewhere to go. But, as noted above, banks may not pass this on as they have their own problems. One report suggested that such funds tended to be simply invested in government bonds.

In any event, there will be huge numbers of potential borrowers lined up outside a few narrow gates, and interest rates will escalate to reflect risk more realistically.

The US Fed and Australia's reserve bank have also extended credit to non-banking entities that would be outside its normal range of responsibility - an indicated a willingness to accept CDOs as collateral - a step which one observer suggested to be probably unavoidable under the circumstances but potentially puts the value of their national currencies on the line (personal communication).

The US Fed also aggressively reduced the interest rate it charges banks (ie by 0.5% in September 2007) hopefully to stimulate the economy - and thus prevent a recession. However one observer suggested that this would only deal with the problem of liquidity - not with the problem of bank solvency [1]. Another suggested that keeping interest rates low through central bank action would boost house prices, and keeps consumers on 'retail therapy' which could make the financial crisis worse [1]

In December 2007 reserve banks in many countries agreed to collaborate in providing loans to banks in order lower interest rates and ease the availability of credit [1]. Observers suggested that this move would:

  • be beneficial, but address only part of the problem (ie that related to liquidity, and not that related to potential insolvency). [1]
  • not deal with problems other than liquidity (eg potential insolvency, risk aversion due to lack of information, and problems affecting non-bank institutions) [1] ;
  • provide some systemic protection - at the expense of boosting moral hazard [1];
  • probably not prevent the onset of recession, because interest rates primarily affect the economy by encouraging / discouraging housing investment - and no matter how low rates are cut this would not now boost housing investment [1]

Presumably financial intermediaries and rating companies are working to boost the credibility / transparency of their claims about complex financial instruments - so that those complex instruments will start to regain respectability in (say) 12 months.  It has been suggested, for example, that problems in CDOs can be ended by proper disclosure [1].

Proposals have been advanced for tighter regulation of mortgage lending practices.

US president Bush is expected to bail out households who are over-extended on their mortgages (eg with government sponsored credit or tax relief). Something like 2m families seemed likely to lose their homes in the US as interest rates rise, and the adverse effect on consumer confidence has been seen to require action. Government, rather than reserve bank, action was preferred because the latter (ie reducing interest rates generally) would have simply allowed unrealistically cheap lending to continue. Government bail-outs will reduce immediate losses (and cuts in consumer demand) but a potential for longer term losses is being created.

US government-backed mortgage giants Fannie Mae and Freddie Mac have been given authority to purchase mortgage-backed securities - thus perhaps allowing some private losses to be socialized.

Some investors are apparently moving to acquire sub-prime mortgage assets on the assumption that prices are currently very low.

Major banks (encouraged by US Treasury) proposed pooling together to establish a $100bn fund to purchase shaky mortgage backed securities in order to prevent any need for a 'fire sale' of assets. The theory was that there would be value in those assets which current market conditions do not reveal. However some believe that this would merely protect those with the largest losses at others' expense [1], while others have suggested that the proposal could be counter-productive by delaying the introduction of transparency into the mortgage backed security market, and thus delaying the re-emergence of investor confidence [1]. In practice this action did not eventuate.

Another plan has been developed (through US Treasury) to freeze mortgage rate resets for 5 years for owner-occupiers whose repayment history has been good but can't afford higher rates [1]. This would reduce companies' risk of defaulting on their debt [1]

However it  would:
  • do nothing about the very large losses incurred before 2008 or the loss of confidence in structured finance mechanisms - which were already suggested to be large enough to have serious economic impacts;
  • impose unexpected losses on other investors;
  • apply to only a fraction of borrowers;
  • provide only a temporary solution for those whose rates would be frozen; and
  • not apply to property investors (who have apparently been the main source of defaults to date [1]).

Others suggested that the plan would (a) encourage fraud and create a bureaucratic nightmare and (b) probably fail because mortgage securities are owned by many groups some of whom have no incentive to support such changes as they bear no loss in a default [1] or (c) set a dangerous precedent [1]

Communities affected by large numbers of home repossessions seem to be experiencing severe social stresses - and confidence in the ethics of the financial system is threatened. Legal action to recover individual losses may be directed against the banks whose associated firms were responsible for sub-prime lending. This could increase the risk of bank insolvencies.

The responses of financial markets to these development (as always) reflect a balance between greed and fear.

An aside: Such markets are 'efficient' in integrating the diverse information available to thousands of entities in an economy.  However they are not efficient in dealing with systemic changes (ie situations that no one had expected), and it is then that the 'wisdom of a crowd' can become the 'panic of a herd'.

A member of the RBA board suggested that the US economy could go into recession without seriously adversely affecting the global economy, and that US sub-prime problems would be brief [1] - a perception that seems typical of many professional observers but which this document suggests may be overly optimistic (see further below).

In early 2008 it was reported that the US government was alarmed about the situation and had re-assembled its 'plunge protection team' which has power to support markets by buying futures contracts on stock indices. Because of its budget surplus the US government has some (but not unlimited) ability to counter the expected economic downturn. [1]

The US Fed introduced large (0.75% and 0.5%) sudden cuts in interest rates to forestall what appeared likely to be a stock market collapse. This has some effect on the market but observers suggest that it may be inadequate because:

  • such actions were the cause of the current problem [1];
    • An aside: an observer in Europe noted that while rapid reduction in interest rates might encourage US consumers to spend, the effect could be quite the reverse elsewhere (eg in Europe - and presumably also Asia) where perceptions of economic crisis would simply encourage households to further increase their savings. This would not aid in resolving the global financial imbalances which (as outlined below) are part of the background to current problems.
  • cutting interest rates will be inadequate because the problem is a lack of confidence in institutions rather than a lack of liquidity; long term interest rates may not come down; and nothing is going to stop housing price crash which will have huge effect on consumption [1]  ;
  • the intensifying credit crunch is so severe that lower interest rates alone won't compensate for likely downturn. Thus in IMF view fiscal stimuli by governments is also vital [1]. Others however suggest that such fiscal stimuli often do more harm than good by creating unsustainable budgetary positions that generate long term problems [1];
  • reducing interest rates won't encourage investment in housing because banks are limited to prime mortgages (and to existing mortgages) and bond markets won't invest in structured mortgage products until these are reformed. Reforms have not been made because sovereign wealth funds have been willing to purchase these products without reforms [personal communication].

US regulators are reportedly trying to spur a bailout of bond insurers (monoliners) [1]

In late January 2008, major banks expressed some confidence that the problems were being brought under control - because of the above initiatives [1].

Others have more apocalyptic interpretations, For example:

  • George Soros developed a case that current instabilities are more than a normal boom-bust cycle - and reflect a 60 year boom in consumer borrowing and credit growth - which has produced excesses in banking, asset values and financial innovation. Ending this, he argues, will end the dominance of $US and shift balance of power in world economy to creditor nations in Asia / Middle East - though this may not occur just yet [1]
  • in March 2008, it was suggested that Fed's actions had failed. There is a flight to safety by investors - and debt markets remain frozen. Failures in 'term auction' market have forced public authorities to pay high rates for borrowing. Corporate borrowing rates and default risks are high. US house prices are in free fall. There are still many mortgage resets due. Overall losses from credit crunch in US could be $600-1000bn. Losses have extended to prime mortgages, commercial property, home equity loans, car loans, credit cards and student loans. Housing busts in UK, Mediterranean, East Europe and Australia are still coming [1];
  • in late 2008 there will be a new tipping point in the unfolding global economic crisis. This will translate into collapse of US real economy - as part of unprecedented global transition which supposed 'experts' seem unable to see. The global order which has developed around the US since WWII will dissolve - given the US's negative savings, free-falling housing markets and currency values, public and trade deficits, and economic recession and costly wars. others won't suffer as much - as decoupling is taking place [1],

In March 2008 the US Fed:

  • asked banks to forgive part of the principal of mortgages to distressed home buyers to stem the explosion in foreclosures - as so many are involve negative equity [1];
  • buoyed hopes that a broader credit crunch might be averted by offering to lend $200bn in US Treasuries to banks in exchange for debt including mortgage backed securities [1]

The US Government unveiled plans for regulatory reform which observers suggested might prevent a repeat of the crisis, but do little to resolve it [1]

It was also pointed out that the success or failure of efforts to stem problems in the financial system depended a great deal on inter-relationships with the 'real economy'. If the latter responded to stimulatory measures, the economic impacts will be limited - but if it doesn't the impact could be long and severe [1]

Financial Imbalances +

Financial Imbalances

The global context to these developments (which initiated in US financial markets) is significant because of financial imbalances that have developed in recent decades. The US in particular (but also Australia, UK etc) have run large current account deficits, which have been funded by capital account surpluses - while major economies in East Asia (Japan, China, Korea and some others especially oil exporters) have had current account surpluses and large capital outflow (especially to the US).

This financial imbalance has reflected (in part): (a) the shift of many manufacturing industries to low wage economies mainly in East Asia; and (b) the superior ability that the US (and others) have had in financial services - a sector which is now in trouble and thus (as in Australia) potentially unable to attract the investment required to maintain a stable global financial imbalance. 

There is also a complex story behind imbalances related to East Asia - details of which are speculated in Structural Incompatibility Puts Global Growth at Risk.

In brief, the latter suggests that those imbalances reflect a 'clash of civilizations' issue that is more significant than that with Islamist extremists - because the epistemological assumptions (ie assumptions about the nature of knowledge) made in countries with an ancient Chinese cultural heritage (which is quite different to that Western societies inherited from classical Greece)  make it hard to deal with abstract ideas, including financial profitability as a means for coordinating economic activities. Economic activities tend to be coordinated by relationships amongst a hierarchy of social elites, rather than by the profit which can be achieved by independent actors. Capital tends to be used to maximize 'real' production with limited regard for return / profitability, and bad debts accumulate in financial institutions which can only be protected if there is no need to demonstrate a sound balance sheet to borrow internationally. In the 1997 Asian crisis, the countries with current account surpluses (eg Japan and China) avoided problems because they had no need to borrow internationally - and this lesson has been learned.

Rather than merely accumulating foreign exchange reserves to prevent currencies appreciating (the only purpose that Western analysts would expect), in East Asia this seems to have also been a way of protecting the financial system.

However the emphasis on export-driven economic development in order to protect against currency crises due to under-developed financial systems was not confined to East Asia as many other emerging economies adopted similar tactics. Moreover the surge in oil prices after 2002 resulted in large income transfers to oil exporters with a high savings rate whose excess capital was redirected to the the US in particular [1]. 

As suggested above the financial techniques through which these capital transfers have been managed may have been discredited.  By early 2008 both Europe and Japan seemed to have suffered economic shocks because of these imbalances and there was some question about whether commercial funding of current account deficits was still continuing - thus probably giving a reduction of these imbalances a new urgency (see below).

The economic consequence of large current account surpluses is an imbalance between supply and demand (ie a demand deficit) which potentially has the same (domestic and ultimately global) macroeconomic effect as the failure of demand associated with the Great Depression - which led to Keynes' prescription of increased public spending as the means for countering downturns in the business cycle. Thus the 'East Asian' economic models tend to be unsustainable in themselves under a Western-style global financial regime - because clearly not all countries can simultaneously run the current account surpluses they require.

The demand deficit that has been built into the export-driven growth strategies of major East Asian economies (and increasingly by other emerging economies) has been counter-balanced for years by a demand surplus (savings deficit) elsewhere - mainly in the US. The latter has been funded by a capital inflow as:

  • current account surpluses in East Asia (etc) have been invested off-shore by reserve banks to prevent currencies appreciating against the $US, and
  • since its 1980's asset bubble burst, Japan created huge quantities of near-zero-interest credit apparently to prevent its demand-deficient economy from deflating. This credit fed through the so-called 'carry trade' into financial markets in the US / Australia etc and counterbalanced Japan's trade surpluses - thus also preventing the Yen from appreciating.

In Japan's case it is clear that the intent has been to boost the availability of cheap capital in the US (and in other capital importing economies), because the structure of Japan's monetary / financial system apparently restrains any boost to Japan's domestic demand from creating credit at very low interest rates.

Why? Japan's financial system is set up so that, domestically, any stimulus must mainly flow into industrial capacity rather than into consumer demand (see  Why Japan cannot deregulate its financial system). At the time of the Plaza Accord, Japan was pressured to stimulate its economy in order to help overcome its trade imbalance with the US. However, because of its monetary / financial systems (which others did not understand), the only likely effect of doing so was to increase the trade imbalance. 

The rapid creation of credit in the US (and elsewhere) that has underpinned economic growth for decades has been possible without triggering inflation (that would normally have been expected) because producers have lacked pricing power in the face of cheap imports (especially from / through China in recent years). As noted above, this constraint on inflation may have contributed to reserve banks setting interest rates that were so low that a housing bubble developed.

Financial imbalances have resulted in the build up of large US foreign debts - and of questions about the continued value of the $US and its status as the world's reserve currency. The US Fed, government and financial markets have ignored such concerns because investors had no real alternative to sending their surplus capital to the US (either directly or through others). The US had the only financial market able to use large amounts of investments profitably - a traditional perception that is now less certain.

It is possible that the demand deficit in countries (especially Japan and China) that have pursued export-driven economic strategies has contributed to the credit-market dislocation that has now occurred - because, given a shortage of options for investment to meet consumer demand, more dubious destinations had to be found for the savings 'glut'. It is noteworthy that an historically unprecedented boom in US property prices (which now seems to have some features of a bubble) began in 1997 [1] after economies hurt by the Asian financial crisis were encouraged (eg by the IMF) to join Japan and China in maintaining large foreign exchange reserves as a buffer to protect their weak financial systems (not just as a means for managing exchange rates). This (together with the large capital flows associated with the Yen carry trade after about 2000 [1]) escalated the savings glut which US institutions had to find means of investing.

Other views: However not all observers accept this idea - and the US Fed's delay in raising interest rates after the dot-com bust has been seen as the real problem by Professor Anna Schwartz the author of an influential work on the origins of the Great Depression [1].

Reinhold and Rogoff argue that what has happened is similar to recycling of petrodollars to developing countries that preceded the debt crisis of 1980s (Is the 2007 US Sub-Prime Financial Crisis so Different? An International Historical Comparison?). This time savings were recycled to a developing country (sub-prime borrowers) in US. No one foresaw the ability of world's best financial institutions to sink themselves. Reinhold and Rogoff argue that mess in US is similar to that has afflicted other high income economies in the past. [1]

Efforts have been made (since the Asian financial crisis) to improve the financial performance of Asian banks and businesses (and thus reduce their export dependence). However claimed successes seem dubious - and it is possible that the books are often simply being 'cooked'.

Various Chinese officials have speculated about the possibility of dumping the $US and putting up with the economic costs - because financial imbalances are said to be simply the consequence of the US living beyond its means.

Such threats appear hollow because, despite efforts that have been made to normalize China's financial system and reduce its current account surplus, it still needs strong US demand to maintain a current account surplus to defend its bad-debt-burdened institutions and to continue rapid economic growth.

An aside: China has a large current account surplus with the US, but a relatively small one overall because it runs deficits especially with countries (which might be called 'China's tributaries') from whom it obtains inputs for the products that it subsequently exports.

Though Asia's dependence on exports to the US has declined over the past 20 years [1], the problem is that many countries in China's 'tributary' system don't have strong financial systems and thus require current account surpluses to stabilize their financial institutions. Many would be in trouble if China lost the ability to pass such surpluses (derived initially from US demand) on to them.

The idea of a 'Beijing consensus' (as an alternative to the so-called Washington consensus) has been advocated as a model for developing nations - and one feature of this (in addition to its emphasis on state-enforced order rather than individual liberty) seems to be reliance on a current account surplus to protect financial institutions with dubious balance sheets.

Without strong external demand to support China and its 'tributaries', China would probably become political unstable, and its autocratic regime would be likely to lose power because their 'legitimacy' seems to depend on sustaining strong growth. Similar risks seem to other countries with under-developed financial systems (ie Japan and many emerging economies who have export-driven development strategies, as well as major oil exporters).

China's leadership appears particularly determined to reduce its dependency on exporting goods and capital to the US [1], but can't easily do so (eg because running a current account deficit would require China's financial institutions to have strong balance sheets (ie take investment profitability seriously, which would require a cultural revolution), and it's current account surplus could only be shifted to other countries with such institutions).

Perhaps more significant than Chinese threats and current financial market instabilities is the possibility of unexpected withdrawal of Japanese capital - as such withdrawal had a key role in triggering financial crises in the US in 1987 and in Asia in 1997 (see Commentary on 'Liquidity Boom and Looming Crisis'). Calls have been recently made for increases in Japan's interest rates (from near zero) so as to inhibit or reverse the 'carry trade' [1] - which is a major component of funding current account deficits in US (and Australia). Moreover:
  • US Treasury data show that Japan (followed by China) led a large net withdrawal of capital from the US in August 2007 (including a $US52bn net sale of Treasuries), which unless reversed is likely to force up interest rates on US Treasuries [1]; and
  • the Bank of Japan has indicated an intention to raise interest rates - arguing that low interest rates can spark investment bubbles [1];
  • Japan, the world's largest creditor, seems to be bringing the money home. The 'carry trade' is reversing. [1]. The reversal of the carry trade has led to large increases in Yen value, declining competitiveness of Japanese industry and severe stock market falls [1];
  • policy mistakes and official inaction are seen as major contributory factors to Japan's economic downturn in late 2007 [1];
  • Japan seems to be reversing the trend towards liberalization of its financial system - and this is resulting in withdrawal of foreign capital and rapid falls in share market despite reasonable profit levels [1].

The consequence of reversing the flow of capital (apart from strengthening the Yen and reducing Japan's industrial competitiveness) could be financial crises which had massive global economic impact (eg by making it impossible for US demand to drive global growth - while no other country is positioned to fill the gap) and lead to depression, political extremism and (possibly) major wars. However, as what could be at stake in the longer term could be the character of the global financial system and thus of the whole global order (see An Unrecognised Clash of Financial Systems), some pain might be seen to be justified.   The goal which ultranationalist factions in Japan have apparently maintained of casting off Japan's 'merchant soul' (and replacing it with the 'soul of a samurai') should not be forgotten.

Proposals have long been developing (led by Japan) for the creation of an Asian Monetary Fund (AMF) as an alternative to the profitability-oriented IMF which would operate under 'Asian values' (ie presumably a neo-Confucian preference for coordinating economic activity through relationships amongst a hierarchy of social elites, rather than by the financial profitability of independent enterprises).

Speculations about diversification of foreign exchange holdings to the Euro have little credibility, as the the capital surpluses which various European countries have acquired through persistent current account surpluses have caused European financial institutions to be badly affected by the US sub-prime crisis, while Europe's inability to neutralize capital surpluses through commercial investment in the US because of the credit freeze has led to a damaging appreciation of the Euro (see below)

Responses

Global financial imbalances are finally starting to get some attention.

The Bank of International Settlements has been issuing dire threats about possible disaster for some time [1].

The International Monetary Fund has been convening meetings by reserve banks and others to discuss this [eg 1].

Robert Zoellick, as new World Bank head, is advocating the development of deeper bond markets in Asia [1] so that (a) there is less need for Asian savers to invest in US etc (b) capital is more readily available for local private firms ; and (c) there is less reliance on US demand to drive global growth.

However, the latter runs into the cultural obstacles in East Asia to dealing with economic abstracts such as profitability, and the neo-Confucian preference for coordinating economic transactions through relationships amongst social elites.

One analyst has suggested that the best solution to these imbalances is to allow markets to take their course so that US assets fall in value and households reduce their consumption and increase savings [1].

Another suggested that there could be benefits in US slowdown in terms of rebalancing the global economy which could not continue being driven by US growth - providing the associated recession does not go too far [1]

As noted above there are limits to the ability of the US to resolve the problem (eg by monetary or fiscal stimulus) because this would tend to merely recreate conditions like those which gave rise to the crisis. It has thus been suggested that other countries (especially Germany, India and China) should thus provide a strong fiscal stimulus [1] - which they have apparently indicated an unwillingness to do [1]. This potential failure of economic management is further evidence of the vital importance of resolving those global financial imbalances.

Outlook

Future Outlook

In late 2007 uncertainty remained about about the effect of the credit crunch.

Escalating Concerns

One one hand there was concern that it could have unexpected and wide repercussions, and that financial dislocation not directly related to the sub-prime crisis might emerge. For example:

United States
  • deterioration in the US economy and reducing future bank losses from sub-prime exposure was seen to require ongoing cuts in official interest rates by the Federal Reserve [personal communications from US economic analyst] - though inflationary risk and market responses (eg $US weakness) imply a limit to such cuts. Inflation risk and $US weakness have also led to some withdrawal of capital from US Treasuries. Such a withdrawal on a large scale seemed to result in higher interest rates and contribute to the 1987 share market crash;
  • the large cut in interest rates by the Fed in January 2008  to head off possible recession was seen as like the aggressive rate reductions that led to the speculative bubble in housing in the first place. It now won't stimulate a housing boom, but could lead to higher inflation [1]
  • long term private capital inflows to US have ceased, so that despite a reduction in in the US current account deficit, there is now total dependence of foreign reserve banks and sovereign wealth funds to finance the deficit (which had been fully funded by private capital inflows in 2000) [1] - see Funding Financial Imbalances;
  • private investors are increasingly unwilling to fund US current account deficit. As a result, at some point, lowering official interest rates will cease to have a stimulatory effect, as long term rates will start to go up [1]
  • there has been a run on one (quasi) bank in the US - which was forced to suspend withdrawals - and this could be the first of many [1];
  • defaults in US housing markets are extending beyond sub-prime threatening even bigger bank losses. Default rates on home loans have reached 7.3% (with 4% rate for prime mortgages). Prime mortgages are valued at $8tr, while sub-prime are only $2tr. Financial damage could be huge. Crisis is extending to credit card debt, auto debt and student loans. Corporate defaults could rise from 1% to 5-9% in 12 months [1]
  • 10-15m US families may walk away from their homes because of negative equity in the face of a 20-30% decline in property values (which now seems increasingly likely). This would impose $1-2 tr losses on banks (compared with $200-400 bn losses associated with sub-prime mortgages) - and exceed their available capital probably requiring that they be nationalised [1]
  • signs of stress like that in sub-prime lending are emerging in US auto loans [1];
  • Merrill Lynch forecast that subprime turmoil will spread to credit cards and consumer loans [1];
  • cash management accounts of some state governments have suffered unexpected losses [1];
  • efforts by major US banks to defer the impacts of sub-prime losses were suggested to be counterproductive by prolonging uncertainty [1]; 
  • proposals by US Treasury to enable those who can't afford mortgage resets to renegotiate their loans seem to have limitations (see above)
  • lax standards in lending, that are now likely to result in losses, do not seem to have been confined to sub-prime mortgages. For example:
  • reckless lending was not confined to sub-prime mortgages. 50-60% of mortgage lending recently has been reckless. There are also sub-prime auto loans and sub-prime credit cards. The problem extends into companies because easy credit has been made available to firms that might otherwise have failed (resulting in recent years in very low rates of corporate defaults). As credit tightens this will reverse [1];
  • there may be a risk to corporate debt also - because of heavy past borrowings (for acquisitions etc) and the likely deterioration in economic growth [1];
  • securitization has meant that the same disregard for credit quality that affected sub-prime lending has emerged in other packages that financial institutions originated but did not then hold [1] ;
  • investors' concerns are shifting from residential real estate to potential losses associated with commercial real estate and the related securitized products - as (a) these suffered the same poor underwriting standards and loose lending to marginal projects as sub-prime and (b) commercial real estate tends to follow trends in residential real estate after a few months [1]
  • US banks have been loading assets into the (so called) Level 3 category where valuations are based on models rather than on markets. Some $100bn in losses (in addition to those associated with sub-prime) are likely to be exposed by new accounting regulations which prevent this practice [1];
  • even borrowers with good credit ratings may default in US if housing prices keep falling. What seemed like a credit quality problem could be a general problem for home loans. Many just walk away if they have no equity. As close to 100% of property values was loaned, many never gained much equity [1]
  • the 'guns and butter' era in the US in recent years has been associated with significantly increasing government borrowing, while at the same time public spending backlogs have developed [1]. This implies future tax increases that would compound the constraints on consumer demand and business investment implicit in higher credit costs; 
  • US government could lose its AAA credit rating in a few years unless there is urgent action to curb soaring healthcare and social security spending [1] - which seems to be a consequence of population aging;
  • funding of local authorities has been severely affected by sub-prime mortgage crisis - leading to calls for urgent federal aid [1];
  • US is headed for potential bankruptcy because of  (a) huge 'defence' spending (>50% of world's spending) that does nothing to improve national security (b) loss of manufacturing base and (c) failure to invest in social infrastructure [1]
  • sub-prime losses are now widely expected to be $500bn and result in $2tr reduction in lending. Problems are also possible in home equity loans - which have been pushed to the limit of home values. Problems also affect loan insurers, who are incurring sub-prime losses which downgrades their AAA status, and forces sales by pension funds etc of assets that they had guaranteed  [1]
  • there has been an increase in the funding of mortgages in the US, but this has been supported only by funds from official sources [1]
  • US has entered severe recession due to: housing recession; liquidity / credit crunch; high oil prices; falling corporate spending; low job creation; and consumer exhaustion. There is also a risk of systemic financial crisis, as losses spread from subprime to prime mortgages / consumer debts / commercial real estate loans / leveraged loans - and soon rising defaults on corporate bonds. Total losses could be over $US1tr. [1]
  • US is sliding towards a 1930s' style liquidity trap that can't be stopped by interest rate cuts, while proposed fiscal stimulus won't compensate for loss of consumer spending associated with drawing down home equity [1]
  • US recession in 2008 will be much worse than after dotcom crash because the industries now shuddering to a halt (homebuilding and housing dependent consumption) are 6 times greater than IT spending [1]
  • home equity lending - to allow home-owners to increase spending - is proving to be a big source of losses for US banks in the face of declining house prices [1]
  • there seems to be a shift in sentiment in US households towards thrift and away from credit-based consumption - as a consequence of falling jobs and house prices and growing debts. This could have major implications for an economy based on consumption [1]
  • there has been a long term problem affecting US households - that their incomes had not risen as fast as their need to spend. Easy credit had bridged the gap - and this is no longer available. Also households are concerned that retirement savings may not be adequate because of declining house prices and share prices [1]
  • financial market problems are extending beyond mortgage backed securities - and now affect low rated corporate loans; securities backed by student loans and municipal bonds and commercial real-estate [1];
  • there is a potential for defaults on municipal bonds (as well as on the structured credit that the 'monoliners' had offered insurance on). These are traditionally assumed to be very safe because governments can just raise taxes. This assumption may no longer be valid because so much revenue depends on property taxes - and this is declining [1]
  • US economy is not responding to interest rate cuts and Fed is running out of options. A sharp repricing of assets is possible, as is a prolonged recession [1];
  • getting US out of recession will be difficult, as debt-laden households won't spend, banks are in no position to provide credit and federal government is heavily indebted. This implies a long period of 'de-leveraging' (ie reducing debt) and poor economic growth [1];
  • US consumer confidence has fallen sharply because of falls in asset values, and as consumers spending accounts for 2/3 of GDP this must deepen recession [1];
  • US house price index fell 10.7% in January 2008 after a 9% fall over previous year [1];
  • subprime losses were less than some estimates suggest. Some banks have had better than expected results, and Fed and US government have made major contributions to boosting liquidity and spending. A turnaround is possible [1]
 Europe / United Kingdom
  • EU has created the most dangerous credit bubble. Germany entered euro with over-valued currency - and suffered competitiveness problems. The ECB set low interest rates to compensate, and this created booms in other EMU countries. Firms and families became massively over-borrowed, and banks over-lent, on inflated house prices. Some of these countries have large current account deficits, which can't be addressed by devaluation because they are trapped in EMU [1]
  • the Bank of England warned about the effects of the credit crunch [1] - specifically about the fact that equity markets do not seem to have taken account of repricing of risk, and are probably poised for major falls [1]. The UK economy is exposed because it has depended on a housing boom - and housing prices are now starting to decline. The Pound could weaken significantly setting off rapid inflation [1];
  • the biggest casualties of falling $US and the debt crisis will be European companies. The credit crunch and US housing crisis have been less significant than a likely shift in global growth to favour US at the expense of Europe and UK. Declining $US will see exports boom, while falling house prices in US will see imports decline. This boost should offset losses from sub-prime crisis - but be at the expense of Europe, Asia and others.  European countries could emerge with large current account deficits because of the revaluation of their currencies [1]
  • $US devaluation has improved US export competitiveness, reduced the US current account deficit and led France to warn about 'economic war' [1];
  • Banks in UK have sharply reduced their willingness to lend to both households and business  [1]
  • fallout from credit crunch is likely to affect consumer spending in Europe. Interest rates are up because of scramble for increasingly scarce credit. A 50% housing price crash in UK (and other housing boom countries in Europe) is possible. The shrinking availability of credit is also affecting business - especially in Europe where banks are more dependent on inter-bank credit markets. Germany's economy is susceptible to both strong euro and problems in small banks [1];
  • as $US falls to $1.50 to euro, Europe is in political / economic crisis - and EU may not survive in its present form [1];
  • the continued strengthening of euro (due in part to falling interest rates in US and high rates in Europe) is leading to concerns about competitiveness and the need to shift production off-shore and also to a sell-off in sovereign bonds from some countries (eg Spain / Italy) seen as least able to cope with very strong currency [1]
  • hot housing markets in Europe and some emerging economies will cool dramatically. No junk bonds have been issued in Europe for months.  Lenders are refusing to roll over asset backed loans. [1]
  • Swiss banks, who for centuries have presented themselves as safe havens for money in times of trouble, have been badly hurt by sub-prime crisis [1];
  • economic setbacks in UK and Europe can't be blamed just on US sub-prime crisis.  Housing and mortgage markets have been main source of US problem - but the situation in UK / Europe is much worse (in terms of recent escalation of house prices and housing oversupply) [1]
  • Europe hopes to be sheltered but it will be affected because (a) US is still 25% of global economy and will be in severe difficulties (b) the ECB is still worried about inflationary risks which will soon disappear (c) Europe has already been affected by financial contagion - and this will have bad effect on business because of high dependence on banks (d) housing booms / bubbles occurred in Spain, UK, Ireland, France, Portugal, Italy, Greece - and some are starting to deflate (e) rise of euro to 1.50 relative to $US is eroding competitiveness - even in Germany and France (f) consumer purchasing power is eroding due to high oil / commodity / food prices; investor / consumer sentiment is weak. Many countries are verging on recession.  There is little room for fiscal stimulus [1]
  • British banks are taking significant losses - which would not have been a problem if they had been well capitalized, but investors have for years insisted on return of capital so they are very thinly capitalised, and may require additional capital from investors [1]
  • 10m people in UK may be unable to meet their commitments established through easy (mortgage, credit card and personal loan) credit [1]
  • UK is facing the possibility of a financial crisis - because of possible inability to continue gaining international investment to fund government deficits. Spending is up and tax receipts are down - and deficit seems out of control. Economic is heavily dependent on financial services - which are being hurt by credit crunch [1];
  • UK faces severe economic challenge related to: high current account deficit; basing growth on unsustainable asset bubble; fiscal deficit and likely need to raise taxes in a downturn; and increased state share of economy [1]
  • Bank of England is uncertain about what to do is the face of the world's biggest ever peacetime liquidity crisis [1]
  • Irish banks are in severe difficulties because of property price crashes - yet normal measures of support can't be used because Ireland is in eurozone. Nationalization may be the only option [1]
  • UK could experience similar development in property market to those in US. The phenomenon of negative equity is real. There are however fewer loans with low 'teaser' rates. Despite high real demand for housing in UK - prices could fall 20%. Because loans were being made much more readily available to people with limited ability to repay, house prices had been forced up to record levels [1]
  • Eastern Europe faces the risk of a very hard economic landing (according to IMF) because its banking system has built up a large negative net foreign position which relies on continued capital inflow from Western Europe, and the latter can no longer provide the funds to continue this [1]
Asia
  • Japan has gone into recession and suffered a big fall in housing starts because of new laws;
  • policy mistakes and official inaction have been major factors in the slowdown in Japan - and to an extent has slowed growth potential across Asia [1];
  • there has been a significant decline in US imports of Asian manufactures - as well as a rise in US exports in November [1]
  • Singapore's export-dependent economy contracted in late 2007 and Japan's share-market experienced major downturn - suggesting that China's efforts to tighten credit are starting to bite [1];
  • there has been a massive flight to safety by investors across Asia who had initially ignored the sub-prime crisis [1];
  • Japan's share market has suffered large losses, because the Yen has appreciated as the 'carry trade' (which had exported funds to high yield economies including Australia) has been reversed. This has damaged the export competitiveness of Japanese industry [1] - see also below;
  • Japan's financial institutions could have invested in a large part of sub-prime assets which have lost value in US, and still be hiding losses. US and European institutions have acknowledged only $130bn of the estimated $400-500bn in total estimated losses. Japan's institutions have tightened lending very aggressively. The economy is headed for recession. Steel and semi-conductor sales to China have slowed. The Yen-carry trade reversed in August [1];
  • China's manufacturers are under pressure from falling US housing market, a new labour law that increases costs, rapidly rising input costs and loss of preferential treatment for exporters. [1];

  • Asia is experiencing rapid inflation - and this has the potential to end the trend towards increasing prosperity (because basic commodities such as food are increasing fastest, and are people's main purchases). Inflation results both from low interest rate policies (eg in US / Japan), and from skilled labour shortages. High growth with low inflation is no longer possible. Rises have been coming for a decade, but have been masked by subsidies which are now becoming too expensive. Reserve banks will be forced to increase interest rates which will stifle economic growth [1]

Australia

  • Australia is potentially headed for economic trouble, noting rapid growth in economy, credit and consumer spending (despite Reserve Bank efforts to slow these down) and declining export competitiveness [1];
  • some Australian companies (with large debts) are being exposed to cash shortfall as a result of global credit crunch [1];
  • in December 2007 it was suggested that funding Australia's current account deficit through bank borrowing for property investment had effectively ended - and that the reserve bank was bridging the gap [1], though the RBA denied that it was intervening because the $28bn it injected was merely the completion of an earlier swap [1]. Another informed observer suggested that (a) the apparent run down in Australia's foreign exchange reserves reflected the withdrawal of government funds from RBA - which reduced both reserves and equivalent negative forward commitments and (b) banks had been able to borrow [1].
  • smaller Australian banks which have relied upon securitization are under some pressure [1];
  • it has become harder to finance new projects. Over time this will affect private equity and infrastructure [1]
  • Australia's leading infrastructure companies could face much higher funding costs [1] because of implosion of monoline insurers in US [1]
  • there are potential problems in the commercial property sector - because valuations have been set aggressively and used as the basis for borrowing, resulting in high levels of debt on inflated valuations [1];
  • one of Australia's economic strengths has been its unusually large contingent of banking stocks - but this is now turning to a weakness. Those banks had little direct exposure to US subprime crisis, but borrow in the same markets and have been dependent on offshore wholesale markets to finance Australia's strong credit growth. Also they are facing strong competition from HBOS-backed BankWest which is the first foreign bank to take the challenge of developing a strong local network - and this is constraining profits [1]
  • Australia's big banks are facing a system-wide blow-out in bad debts. All are exposed to corporate borrowers struggling to refinance / service loans. Australia's debt-laden commercial property sector could be problem area. Business lending surged after 2002, but for geared purchases of commercial property - not for capital expenditure. Banks are exposed to struggling borrowers (eg RAMS, Centro, MFS and Tricom) [1]
  • the IMF has ranked Australia highly as susceptible to a house price slump [1]

  • there appear to be other signs that the property boom could be ending:
    • Australia faces a housing bust and falling commodity prices [1]
    • 750,000 homeowners in Australia are suffering mortgage stress, and 300,000 are at risk of defaulting on repayments and losing properties in 2008 (double the number of a few months ago). The full impact of credit crunch has not yet been felt. Interest rates are likely to rise further [1];
    • prestige property, which boomed 25% in value last year, could be hit by share market volatility [1]
  • a company which had allowed investors to acquire shares without full financials - in a way comparable to sub-prime mortgage lending - is in trouble [1]
  • companies whose directors have purchased large quantities of shares on margin are proving susceptible to short-selling raids which forces price collapse by requiring those shares to be sold into a falling market [1];
  • banks are facing as increasing liquidity squeeze - because of the much higher cost of their wholesale funds, only half of the cost of which has yet been passed on to borrowers [1];
  • infrastructure funds and property trusts which have large borrowings are losing investor support as cheap credit ceases to be available [1]
  • banks may have to restrict lending because of credit freeze - according to RBA [1];

  • in Australia banks are running out of money - not just having to pay too much for it. This is world's biggest current economic issue - as more companies come to banks to borrow. Banks' capital bases have shrunk at the same time that companies who relied on securitization for funding have approached them for loans. Banks' capital to asset ratios average 10.2 (with 10 minimum in US), so there is little more to lend [1];

  • companies are finding it much harder to get funding for projects [1];

  • a recession in likely in 2009 [1]

Elsewhere

  • the possibility has been suggested of a repeat of something like the Asian financial crisis in Eastern Europe [1, 2]. Others are concerned about possible bubbles in Latin America and parts of Asia as well [1]
  • Russia is suffering from the effects of high oil prices - erosion of competitive foundation of other industries. Inflation is high, property prices are high, there is a critical lack of infrastructure [1]
  • emerging economies are experiencing rapid inflation because, by tying their currency values to $US, they are importing a highly expansionary monetary policy as Fed seeks to stimulate US economy in the face of credit crisis [1]
  • Iceland's banking system is close to collapse, and it may be beyond its government's power to prevent this [1]. The asset base of its banking system is 8 times GDP - drawn from global markets to finance offshore investment. Credit has no been turned off, and currency has fallen in the face of capital flight [1];
  • investor flight could trigger problems for many countries with current account deficits (eg Turkey 8% of GDP; Iceland 16%; Latvia 25%; Bulgaria 19%; Georgia 18%; Estonia 16%; Lithuania 14%; Romania 14%; Serbia 13%) [1]
Global Markets / Systems
  • the banking system in the US / UK / Europe appears to be in serious difficulties which do not simply relate to sub-prime losses (see above);
  • 'dumping' the $US has the potential to undermine the whole global financial system because of the status of $US as world's reserve currency. There is also a risk of a new bout of competitive devaluations [1]. A decision by China to diversify its foreign exchange holdings contributed to significant weakening of $US [1]. Many other (mainly small) nations have indicated an intention to do likewise;
  • declining value of $US has left central banks everywhere with large losses - and this will give rise to political / military tensions [1]
  • some commodity prices fell sharply and investors retreated from perceived high-risk markets [1]; 
  • while some argue that commodities are now in perpetual boom because the world is running out of resources (eg consider the peak oil concept), most resource markets are driven by the industrial cycle - and booms can turn to busts. As the US is in the grip of a credit crisis, capital is fleeing to Asia and the Middle East - and driving investment booms which not only boost commodity demand but also put their currency pegs at risk. When they impose controls, more realistic commodity prices will emerge [1];
  • the rapid increase in money supply that reserve banks are providing in order to maintain liquidity in the face of banking's failure is beginning to spark inflation - which could turn into stagflation [1]
  • while the crisis emerged from sub-prime market, its origins run deeper (ie very low interest rates since 2000 and excessive risk), and it could have unexpected global impacts.  It is leading to repricing of risk, reduced appetite for borrowing, slower growth / reduced profits, lower interest rates, weaker $US, and pressure on countries like China to change exchange rates [1];
  • the initial expectation was that crisis would only affect financial markets and not spill over to the real economy. Then it emerged that real economy (lax lending standards, slowing economy and rising interest rates) was driving the defaults, foreclosures, falling house prices and more defaults [1];
  • though the sub-prime crisis was a limited problem in one market, it has had wide global impacts. The rules under which central banks operate are set by the Basel Committee, and have proven inadequate [1]. To avoid a worse crisis that 1929, one observer suggested a requirement to liberalize the Basel rules that apply to banks' capital base to allow them to cope with being forced to bring large quantities of off-balance-sheet assets onto their books [1].
  • the new Basel II capital adequacy framework for banks is intended to overcome problems in the older systems by allowing banks with sophisticated risk management systems to use their own models for determining the amount of capital they need. However current turmoil in financial markets shows that those methods (which are the foundation of Basel II) simply don't work [1]
  • the financial crisis has been exacerbated by current banking rules. Regulators relied on Basel Rules - and allowed banks to approach their capital limits before issuing warnings. Moreover Basel II Rules (involving marking assets to market) accelerated the downward spiral once problems started  [1]
  • the modern global financial system was supposed to manage risk with greater efficiency through deregulation. But the reverse happened - as the effect of many changes has been to shift risk to those least able to understand it - especially households [1];
  • the a global slowdown which results from financial instability will be deflationary (not inflationary) because it will be the result of a negative demand shock. Stagflation (which some worry about) can only occur when growth slows as a result of a supply shock.  [1]
  • the liberal conditions under which financial markets have operated have been perfect for making money. But problems have emerged. The latest to be revealed involves the derivatives operations by bond insurers - which put at risk the value of bonds they insure. Government intervention in, and control over, financial markets is likely to be much more extensive in future [1]
  • authorities will now impose regulation on financial systems which, while necessary in some ways, will also put grit into the engine of the economy [1]
  • the monetary loosening and fiscal stimulation that the US will at best create the conditions which have led to the current crisis. The priority should be worldwide adoption of policies that allow a big fall in US current account deficit without weakening global activity. The US can't do this alone  [1]
  • $US could become the basis of a new 'carry trade' (rather than Yen) because relative interest rates in US are now low [1]
  • heavily indebted companies (especially those involved in property) are in increasing risk of default because of continued closure of credit markets in Europe and US - which prevents debt refinancing [1]
  • commercial and investment banks in NY are operating on a flawed business model - because executive compensation is large and based on the volumes of securities transactions. This suits a business model which involves the development of complex securities products - but may be inconsistent with what is required for those banks to prosper in future. These problems seem to be being overlooked by Fed [1]
  • large failures in private equity can be expected in 2008 as a result of earlier excesses (in debt funded takeovers of companies) and banks will be hurt [1]. Companies had been bought with high levels of debt with inadequate due diligence standards and false earnings estimates [1] ;
  • 'auction rate securities' are another structured finance product in which failing leaving investors with large losses. This involved regular re-auctioning of long term bonds - which (because interest rate curve normally rises) allowed issuers to get lower rates than normal and investors to get  higher rates on short term investments. Demand for these has evaporated, and banks have withdrawn guarantee to buy (ie to absorb interest rate risk) leaving short term investors holding long term assets at a loss and forcing borrowers to pay penalty interest rates [1];
  • a crash in commodity prices is possible, because these have been driven up speculatively by investors seeking diversification - and assuming that China etc can ensure rapid growth in commodities demand in the face of slowdowns in 60% of global economy [1]
  • de-leveraging is necessary as the credit crunch has shown that financial institutions have too much debt. Hedge funds have started this, but banks haven't. The best way to do this would be through reducing assets - but cutting lending would hurt the real economy [1]
  • the IMF has warned that costs of financial crisis could be nearly $1tr. It referred to (a) collective failure to appreciate the extent of leverage taken on by financial institutions and the associate risks (b) regulators inability to keep up with the speed of changes and (c) the use of off balance sheet vehicles [1]

But, on the other hand, others were more optimistic

  • the losses which sub-prime crisis and property crash might lead to in US are similar to losses incurred in various other financial dislocations over the last couple of decades [1];
  • there is limited evidence of widespread credit crunch. Though credit standards have tightened, bank lending is still increasing. Many US companies have reduced short term debts - and have strong cash flow [1];
  • US economy can withstand the sub-prime crisis because housing is only 5% of economy - and even the worst housing outcomes can not have a broad impact [1] - though the fact that a boom in house prices has underpinned consumer spending (70% of US GDP) well in excess of household income suggests that the economic impact of falling house prices could be quite strong;
  • a US export boom resulting from the weaker $US could help offset the effect of sub-prime losses [1]. The export surge has shrunk the trade deficit by 1.5% of GDP which roughly offsets the 2% of GDP lost in sub-prime assets [1];
  • action by US authorities might be sufficient to reduce the effects of the sub-prime crisis to the point where a US recession is avoided [1] - though possible defects in those actions were mentioned above.
  • credit crisis is almost over. Credit spreads in interbank market have returned to normal. Leading banks are reporting large write-downs which will end their troubles. If this doesn't happen governments will announce public backing for their national mortgage / banking systems, as crisis must be resolved soon because world economy can't continue without normal banking services. The US will avoid a recession because interest rates will be very low. Share prices have already been discounted. Decoupling of global growth from US, won't occur for Europe, but will occur for Asia. .[1]
  • there is no sign of a credit crunch in the Eurozone - as borrowing by business has been rising at a record rate. This and the effect of a strong euro on containing inflation will make the ECB unwilling to reduce interest rates [1]
  • The current credit crunch is not particularly severe. In 1982 when Mexico and Brazil defaulted - all leading US / UK and European bank become effectively insolvent [1]
  • there are reasons to suspect that US financial markets will soon return to normalcy. Liquidity is readily available, and arrangements have been made to increase demand for about $1bn in problem mortgages. Asset prices reflect the view that very severe economic impacts will emerge [1]

And there is always a need for caution in study of any issue, because there will be many other things going on at the same time which it is easy to overlook. Focusing on a 'problem' or an 'opportunity' can lead to pessimism / optimism which proves unfounded because other significant events were ignored. Similarly there is a need for recognition that solutions developed to problems in part of a complex system will have unforeseeable implications elsewhere.

This challenge became particularly difficult in early 2008 when there there was a clear distinction between the escalating problems associated with the 'paper' economy (especially that linked with developed economies) and sound prospects in the 'real' economy (especially that linked with emerging economies). There were, in fact, two 'economies' - one of which was trying to drag the other down, while the latter was trying to lift the former up (with the likely outcome being a bit of both).

Decoupling: A New Urgency?

There has been speculation for years about the extent to which China's growth might have 'decoupled' from dependence on conditions in the US, the world's largest economy - so that it would be able to able to act as an autonomous 'engine' of global growth.

However, despite China's stability during the Asian financial crisis (when growth was maintained partly by high public spending) and attempts to reform financial institutions and to reduce dependence on exports to US (eg by boosting domestic demand and trade with other countries), the case for decoupling remained unconvincing.

The possibility of 'decoupling' took on a new significance in 2007 when recession in the US due to financial problems appeared possible, and it was suggested (for example) that this would make little global difference because of the dynamic growth in Asia (especially in China and India) and also in other countries such as Brazil and Russia, and the possibility of a modest upsurge in Europe [1].

Similarly:
  • the IMF has argued that financial instability will have limited effect because it occurred when economic growth was strong - especially in emerging market economies [1];
  • its IMF's World Economic Outlook projects continued strong global growth - led by low income economies - despite a financial crisis at the core of the world economy [1];
  • take off by developing countries will set stage for the next era of global growth. They are producing major changes in global trade / capital flows. Their success will prevent a downturn in the US from affecting the global economy [1]
  • Merrill Lynch argued  that decoupling is already proved - because global growth outside US accelerated in 2007as US decelerated. Though consumer demand will weaken in US (and UK) it will be strong elsewhere. What is happening is 'rebalancing' - and this creates major opportunities for US export industries [1];
  • in 2007 Asia was little affected by sub-prime problems. World Bank has high expectations for Asian growth - powered by domestic demand growth in China. Exposure to global conditions has been reduced since 1990s because of: domestic demand; current account surpluses and foreign reserves; and a reduction in non-performing loan ratio from 10% in 2002 to less than 5%. There is also a lot of room to cut interest rates or expand fiscal policy to counter any slowdown [1];
  • growth has been strong in Asia in 2007 - driven both by exports and by increasing domestic demand in some countries. Current account surpluses are large while reserves have grown. China's surpluses are falling as a share of GDP. Financial systems have limited exposure to US sub-prime mortgages or complex structured credit products. Growth is now likely to slow because of policy tightening in China and export demand / foreign investment weakening. Asia has reduced its vulnerability to financial crises since 1997 (eg via financial / corporate / monetary reforms). Moreover large foreign exchange reserves are available. Trade interdependence in Asia continues to increase [1];
  • a continued boom in commodities (driven by China's demand) at the time of US economic downturn suggests that decoupling is real [1]

This would have significant implications, eg that:

  • while the US economy would experience problems due to high oil prices, unemployment, a housing slump and an ongoing credit squeeze, this would be offset by an export boom due to a weaker $US while the rest of the world grows strongly;
  • the so-called commodities 'super-cycle' would not be derailed by a US recession, because so much infrastructure is being built (especially in China) [1];
  • as major firms now tend to operate globally, their financial position will be much less adversely affected by a US recession if global growth 'decouples' from the US economy, but not protected in this way (and thus compound other financial system problems) if it does not do so.

By March 2008, the challenge of de-coupling had become far greater because of the spread of losses in the US financial system and the possible need for de-leveraging (ie giving top priority to reducing debts) [1]. This implies not only a long / deep US recession, but that borrowing / investment would be constrained - as would the US's willingness to absorb the surplus savings accumulated in China and other emerging economies.

The de-coupling hypothesis has been disputed on the basis of the limited domestic demand and export dependence of economies such as China's [1].

Others suggest that:
  • China  is so dependent on US / EU markets that a 1% fall in external demand will lead to a 4.5% fall in exports and a .75% fall in GDP [1]
  • the US can't have a recession without a fall in consumer spending (as this accounts for 70% of GDP) - and falls in consumption will hit countries that rely on exports to US. Moreover consumption has been financed by borrowing in recent years - which only makes sense if home prices are rising and this now seems likely to reverse sharply [1];
  • China has developed industrial over-capacity which could be a source of problems if export-led growth fades [1];
  • China's commerce ministry warned that slowing US economy could trigger a drop in exports and lead to a turning point in China's rapid growth. Exports account for 1/3 of growth and 10% of China's GDP. US takes 20% of China's exports (behind Europe). Every 1% drop in US growth will reduce China's exports 6%. Exports to US have slowed significantly in 2007 [1];
  • all the big economies (ie Europe and Japan) show signs of slower growth in parallel with US, so even if emerging economies grow strongly this won't decouple overall growth from US [1];
  • by keeping yuan low, China strengthens its export industries and makes it more susceptible to US slowdown [1];
  • the ideas of self-sustaining Asian growth is premature. Consumption has declined as a percentage of Asian nations' GDP over the last 5 years. While the share of exports to US has fallen (from 23% in 1985 to 17%), the intra-regional trade that has replaced it correlates with US imports - a correlation that is strengthening. Dependence on US knowledge has not yet started to decline  [1]
  • China's effort to steer its economy towards consumption and away from exports and investment is not working. Consumption is only 37% of GDP the lowest in 20 years. While high home prices are blamed: underdeveloped credit systems; declining wages' share of GDP because of efforts to boost profits; central bank efforts to reduce money supply to keep yuan from appreciating; lack of public services; and Confucian emphasis on thrift may be more important [1];
  • decoupling arguments don't take account of shocks from G3. Increasing trade / financial links increase the risk of transmission. High level of intra-regional trade overstates the position, as 70% of this is intermediate goods for export. Only 20% of Asia's GDP comes from final demand in the region. Asia could withstand a modest US slowdown, but not a severe one. It remains heavily dependent on exports [1]
  • China has appeared unaffected by US slowdown only because the latter has (so far) only affected housing rather than consumer demand. While intra- Asian trade has grown this largely depends on US demand.[1]
  • other emerging market economies have done what IMF recommended (eg smaller budget deficits, independent central banks, low inflation, floating exchange rates, current account surpluses, cleaning up banks etc) and this has reduced their vulnerability . However their success also depended on sound global growth, high commodity prices and low risk aversion by international investors. This now could reverse. [1]

  • no country would be immune to a US recession, both directly and because of the impact on China which relies on US exports to drive growth [1];

  • China's leaders have sought to make their country more internationally engaged that it had ever been in the past - so decoupling is most unlikely [1]

In response it has been suggested that China will continue growing even if US exports weaken.

Reasons suggested for this are:
  • China has growing penetration of European markets [1];
  • Asia benefits from both stronger European and domestic demand [1];
  • China's dependence on exports has been over-estimated. While the gross value of exports is 40% of GDP, in value-added terms exports are only 10% of its economy. Domestic demand overwhelmingly drives growth. Moreover Asia and the Middle East accounted for 40% of China's export growth in 2007 - with less than 10% from US. Investment accounts for 40% of GDP - and only 14% of this is linked to exports. Investment will not collapse so long as investment in residential construction and infrastructure remains firm [1]
  • China will be little affected by recession in US, given that exports are diversified and domestic demand and investment is rising. Inflation is a risk but tighter credit and liquidity can prevent over-heating. China's growth in 2008 will be more supported by domestic demand (because of rising incomes) and corporate investment.  Margins in most industries and services sectors are strong - and rising [1]
  • China's growth is fastest in 10 years. A sharp reduction in exports to US is offset by huge housing / commercial property / infrastructure investment. Decoupling is not the issue, and China's growth has never been linked with US eg China grew strongly despite contraction of export markets in Asian financial crisis and US-led global recession of 2001. Export slowdown for China would probably still result in 20% pa growth [1]
  • there have been signs of decoupling driven by large investment outside US. Though sharemarkets (and some analysts) doubt this, Asia might be better able than in the past to withstand US slow-down because of (a) stronger endogenous consumption and investment (b) large pools of savings and pent up demand to replace exports (c) rapid growth of intra-regional trade - though much of this reflects only integrated regional production chain and (d) a lot of room for macro-policy responses to US slowdown [1]
  • the home-grown problems facing US economy and endogenous growth strength of Asia are like 1980s, rather than 1990s. The last time that US experienced housing downturn was in 1980s as a result of Fed's contractionary policies. US also had high fiscal and current-account deficits. But the 1980s were boom years in Asia - with increasingly strong domestic demand and asset markets. This led to excessive asset inflation. The relative position of Asia and US reversed in 1990s - with a severe financial crisis after 1997 and increasing dependence on US demand. But Asia is now stronger with: strong growth; productivity growth due to supply side improvements - and policy reforms; strong corporate earnings and balance sheets; strong consumer balance sheets; strong government fiscal position in China; and little risk of margin calls given China's large external surplus.  [1]
  • China will be little impacted by US slowdown - because any export reduction would be small in relation to overall economy - and would allow reduction in China's import of components.[1]

Furthermore non-East-Asian emerging markets (Russia, Africa, Brazil, Chile, Middle East) collectively are larger than China or US, and their growth is underpinned by large investments and infrastructure pipelines, while their sovereign balance sheets are improving [1].

However the question is more complex.   For example:
  • one reason that China's growth is seen to be sustainable in the face of a US recession is access to European markets and these, as noted above, seem to have their own severe problems;
  • Europe's assumption that Asian growth has decoupled it from dependence on the US, ignores the effect which the US Fed's response to the sub-prime crisis (lower interest rates) had on dramatically increasing the relative value of the euro and eroding the competitiveness of European industries [1];
  • while emerging markets have good liquidity conditions (especially in Asia), large external surpluses, healthy fiscal positions, good household balance sheets, solid corporate earnings and strong output growth, there are policy challenges - eg dealing with social stresses and economic imbalances in China; curbing inflation - and avoid attracting speculative inflows. It will be harder to control economy with limited tools available as private sector develops. China also needs more currency flexibility. There is a shifting global financial / economic architecture - and Asian financial crisis showed that it can take a long time for effects of crises to be felt [1]
  • Asian and Middle Eastern demand for China's exports depend on the strength of demand for their exports - and this is not assured. Singapore's export-focussed economy, for example, appeared to go into recession in late 2007 [1];
  • the improving sovereign balance sheets of the non-Asian emerging economies which are experiencing strong export / investment driven growth [1] suggests that such countries have learned the 'lesson' of East Asia's experience that, providing current account deficits are maintained and financial systems are isolated from global markets large scale investment can be committed without worrying too much about its profitability. However, if those protections were lost, financial crises could be the ultimate result for any making that assumption;
  • it has been suggested that if the US had a soft landing the rest or the world  would decouple. But in 2008 the US will suffer badly - and there will thus be a significant global impact. The US recession will be transmitted through: trade (directly and indirectly); lower commodity prices; effects of weaker $US on others' competitiveness;  financial contagion (which  is already obvious in Europe); impact on confidence; increased risk aversion by investors; economic shocks (eg high oil prices, deflation of housing bubbles worldwide); and limited scope for monetary / fiscal policy stimulus. Countries worst affected include: parts of Europe; those who trade most with US; emerging economies with current account deficits / fiscal deficits; and commodity exporters. China (and via it the rest of Asia) is at risk because of dependence on exports and export growth [1].
  • Japanese analysts see China as a bubble about to burst - based on overheated, asset based boom like Japan's 15 years ago. There is large excess capacity (eg in steel, autos) - and China is trying to slow growth of its economy driven excessively by capital investment and industrial production.[1]
  • stock-market falls suggest that investors don't believe that Asia will be invulnerable to US recession. Concerns arise from dependence on exports, apparently greater exposure of Asian financial institutions to sub-prime losses than previously believed. Japan seems particularly exposed, and has neither monetary nor fiscal tools to boost economy. Investors are concerned about China's exposure;  [1]
  • US downturn makes China's monetary management more difficult:
    • China has problems with overheating and inflation. US interest rate reductions have complicated efforts to raise interest rates to slow growth in China - as this increases inflow of hot money. [1]
    • the PBoC faces a major dilemma. Yuan will only follow $US in value if China's monetary policy settings parallel the US. US policy has become loose to counteract recession risk. If China follows this it will add to inflationary risk, but if it raises rates it will attract capital and have difficulty sterilizing capital inflows. [1]
    • stimulus of US economy with monetary easing could cause problems in developing economies if most resulting liquidity moves into those regions and increases over-investment [1]
    • China's inflation was 4.8% suggesting overheating. It is hard for China to tighten too much when US is headed for recession. Inflation is becoming a social-stability threat. Spending on fixed assets continues to soar despite government efforts to reduce it [1]
    • in contrast to US China is are seeking to put downward pressure on growth. Declining home prices in some boom centres are the first signs of this.[1]
  • China uses its high savings rate to fund its rapid growth through doubtful loans by China's banks. If China were forced to revalue to yuan (through US pressure) this would be exposed.  China is propping up its own version of a bad lending disaster, tied inextricably with US fortunes. [1]
  • in a severe US recession China's growth will slow (eg to 6-7% pa). This is not strictly a 'recession' but will seem like one as 10% growth is needed to absorb 20m workers pa into modern economy. A fiscal boost could reverse this, but would take time to have effect. [1]
  • China's authorities have been less convinced that others of their economic invulnerability - and have become focused on quality of growth. Environment and wealth gap are concerns. Reduced exports are compounding problems related to inflation, deflated share market, rampant property market, chronic pollution and unbalanced / overheated growth. While share-market does not reflect real economy, companies have come to depend on it and on property as a major source of profits - alongside their core businesses in which profits are increasingly squeezed. [1]
  • China's manufacturers are under pressure due to the falling US housing market, a new labour law that increases costs, rapidly rising input costs and loss of preferential treatment for exporters. [1];

  • rapid inflation (which have various causes) is creating the risk of political instability and may force Asian reserve banks to increase interest rates which will stifle economic growth [1]
Limitations in Economic Analysis: The above debate illustrates some limitations of economic analysis in dealing with the complexity of economic systems. For example:
  • the measure that Asian countries have apparently been urged by the IMF to take to protect against financial shocks (building up foreign exchange reserves) has probably increased the risks of such shocks (see above);
  • global growth is argued to have decoupled from US growth because China's economy is strong - one of the reasons for which is its strong exports to Europe. However, indications that Europe is experiencing problems of its own as a spin-off from the US sub-prime crisis (ie loss of industrial competitiveness and frozen credit system) were presumably not available to, or considered by, analysts in reaching that conclusion.

True decoupling would require not just continued strong growth in emerging economies in a sound economic environment, but that they create such an environment (ie provide a strong market for others' exports and destination for investments) so that weaknesses elsewhere can be overcome. This broader challenge would be difficult, because: :

  • such a rebalancing of the global economy would significantly reduce / reverse global financial imbalances, which in turn would require responsibility and large scale reform in emerging economies [1] - and, as noted above, there are cultural obstacles to the reforms needed to allow East Asian economies to run large current account deficits offset by capital account surpluses;
  • slowdown in export-led growth could expose the over-capacity which high rates of (wasteful?) investment have apparently created in China;
  • Asia's rising economies are too small and economically deformed to rescue world growth as US, UK, Australia and various Mediterranean countries with current account deficits run into debt problems. The latter all face housing busts.  China accounts for only 4% of global demand - and its imports have been flat since April. [1] ;
  • productivity growth in Asia has been driven mainly by firms involved in exports, while large segments of their economies are controlled by Chinese entrepreneurs who exploit political connections to amass wealth while making no real contributions to improving productivity [1]. If export driven growth ceases, productivity growth would be much worse.
  • the IMF argued in January 2008 that the impact of credit crunch was so severe that monetary policy alone wouldn't avert a severe crisis - so a strong fiscal stimulus was also required. This might be needed in particular in countries such as Germany, India and China (see above for an explanation of why this would be necessary). To be effective such a stimulus would need to be in activities that increase such countries' import demand - and this would not be achieved through existing economic machinery in China which is mainly attuned to boosting export capacity.   Moreover China's domestic construction industries are already subjected to capacity constraints - so further stimulus in those areas would merely be 'stag-flationary'

The sustainability of China's rapid growth has long seemed uncertain to the present author because of the nature of its economic, financial and monetary systems and the environmental and political constraints it faces (see China's Development: Assessing the Implications).  In fact, it could itself eventually become the centre of a crisis (see Could China Generate a Financial 'Tsunami'?).  The latter refers to :

  • China's apparent dependence on strong financial systems elsewhere to protect it against a financial crisis. In fact limited concern for return on investment has put all major East Asian economies at risk of another regional financial crisis if the US (and others) cease to be willing / able to run current account deficits;
  • the risk of unprofitably investing offshore the large savings that accumulate from a current account surplus, with an under-developed financial system and in a damaged global financial environment; and
  • various indicators of a potential crisis such as investment-driven growth with limited concern for return on capital; the effect of 'hot' money on already over-heated markets; and non-financial risk factors.

The sustainability of China's economic growth (and that of other emerging economies) can't be assessed by considering only their 'real' economic performance (eg exports, investment) - or by looking only at the quantity of investment while ignoring its quality. Their 'symbolic' success (ie financial profitability / productivity) is probably the main criteria that needs to be considered.

If such reforms are not achieved, the 'decoupling' thesis might merely reflect an expectation that the global economy can continue to grow strongly despite the bursting of a 'bubble' in US credit markets, because another 'bubble' in China [1] (and in other emerging economies) might expand for 2-3 years after the US prop is removed. China maintained its growth through the Asian financial crisis because both (mainly US) export demand and public spending were strong. Whether it will be able or willing to surge through an external downturn originating in the US mainly on the basis of domestic investment (at least some of which might create future financial problems) is much less certain. A US downturn could boost China's growth to the point where the many apparent imbalances in its financial, economic and political system lead to failures.

Some speculations about the likely outcome as a result of the global financial crisis which by 2009 had made it clear that China's export-led industrialization strategy would no longer be viable are in Are East Asian Economic Models Sustainable?

There is no satisfactory international forum to discuss these issues (eg the G7 does not include developing countries), so there is a need for a new forum which does if the potential for decoupling to allow the global economy to continue growing in the face of a US crisis is to be achieved [1]

Reducing Financial Imbalances: A New Urgency?

As noted above, the global economy has operated in a condition of stable financial imbalances. East Asian economic strategies (like Europe's to a lesser extent) tend to be export dependent - and demand for their exports can only be maintained if countries with current account deficits maintain capital account surpluses.

Because of this, the US sub-prime crisis has had damaging consequences.

For example, in January 2008 it appeared that the Yen 'carry trade' (whereby low interest credit had been made available in Japan to be invested elsewhere to neutralize Japan's current account surplus) had abruptly reversed [1]. This reversal appeared to result from depreciation of the $US (which led to exchange rate losses for 'carry traders') and had the effect of rapidly increasing to value of the Yen - thus adversely affecting Japan's industrial competitiveness.

Similarly Europe has run into economic problems  (ie damage to financial institutions and lost competitiveness) because of these imbalances.

Europe's ability to keep the value of the euro from appreciating (which would have serious consequences for the competitiveness of key industries) has depended on maintaining a steady stream of investments into the US. In some ways this has been a private bank equivalent of Japan's Yen 'carry trade' (and of the purchase of US government securities by reserve banks in Japan, China etc). Europe's capital surplus problem has become even worse over the last couple of years as some private investment and the foreign exchange holdings of various countries (led by China) was increasingly diversified into euro because the $US was seen to be weakening. Europe's version of the 'carry trade' involved investment in the US - often in real estate - by European financial institutions. The latter were thus amongst the most exposed to the US sub-prime mortgage losses, and their exposure can be gauged from the fact that the European Central Bank was the first to step in to provide liquidity to banks. The negative impact of financial problems affecting banks will be greater in Europe than in US because the role of financial markets in providing capital is much lower.

Also the value of the euro has appreciated very significantly since the Europe-to-US 'carry trade' ended.

By March 2008 it seemed that the annual global accumulation of foreign exchange reserves by reserve banks and sovereign wealth funds was something like $US2tr (about 1/3 of which was accumulating in China). This reflects a presumably unsustainable level of official intervention in monetary systems (in Asia and in oil exporting countries) that has the potential to increase inflation in these emerging economies and result in high levels of ownership of assets by governments who lack the skills to do so successfully  [1]

The potential for a major economic downturn in US to result from the credit crunch has been met by monetary and fiscal stimuli to boost US growth. However, this option is limited because it could merely recreate unsustainable boom conditions like those which gave rise to the crisis - see above.  Unless stimuli are implemented outside the US (to reduce global financial imbalances), it may prove impossible to counteract the emerging economic downturn.

Another potential (or actual) consequence of the global financial imbalances is that not only businesses but also countries (specifically those countries whose demand has has done most to drive global growth) may fail to gain funding. For example, in December 2007 indicators emerged of the virtual ending of commercial funding of the US current account deficit [1] - ie such deficit funding apparently became dependent on government institutions. Similar indications emerged in Australia (see above) though this may have reflected a misreading of the data.

This clearly would not just have implications for the countries with current account deficits, but would equally affect countries with current account surpluses. If commercial funding mechanisms don't work maintaining capital account surpluses in the countries with current account deficits would depend on:

  • funding by Asian / Middle Eastern reserve banks / sovereign wealth funds. This is not assured as:
    • the amounts available are too small to achieve much. The foreign exchange holdings of reserve banks (for example) are a means of influencing exchange rates - and can be compared with the throttle controlling the flow of fuel to an engine. If the flow of fuel is disrupted, the engine won't work no matter what setting is on the throttle;
    • there have been attempts by some reserve banks to diversify investment away from US because of the expected decline in the value of $US;
    • sovereign wealth funds face (perhaps increasingly) strict foreign investment rules because of concerns about the strategic implications of other governments exerting control over sensitive industries [1];
  • a willingness by current account deficit countries to continue borrowing. The latter is not assured . The US sub-prime crisis did not result from any unwillingness by lenders to lend to US (which could have caused a crisis by driving up interest rates, thus discouraging borrowing for property investment and causing a fall in house prices). Rather the problem actually started at the other end [1].

If the credit freeze is not quickly ended and disrupts the international flow of funds, then global economic activity will stagnate.

As these risks become obvious, international negotiations on how to resolve the credit freeze and global financial imbalances are likely to start. Unless there is a 'new deal' related to global financial / monetary / trading systems, the world could easily be in deeper trouble than it was after 1929.

Booms and Busts: Unsatisfactory Tools for Macroeconomic Management?

The ending of the property boom in US may also indicate an urgent need to invent new techniques for macroeconomic management.

Policy action to counter-balance the business cycle was first advocated as a result of the Great Depression in the 1930s.

Why? In very simple terms, if a community generally starts to save rather than invest or consume, then incomes fall and a downturn can be self-reinforcing.

Or there can be over-capacity as a result of many investments to meet a perceived demand, which results unsold stocks and a lack of investment / production until those stocks run down. This can also be self-reinforcing because it reduces community incomes and spending.

Increasing public spending was seen as a way to break out of such a down-turns, while reducing public spending was seen as appropriate to minimize booms (the opposite extreme of the business cycle).

However these methods ultimately proved limited because:

  • it was difficult for governments to know when to boost spending - because of lags in economic signals and in implementation of their spending programs. Thus their efforts to 'counter' the business cycle often turned out to be 'pro-cyclical' (eg to reinforce booms because increased spending coincided with the start of an upturn in the cycle);
  • in the 1970s, counter-cyclical public spending seemed merely to feed stagflation (ie growth in prices with limited real growth in production).

Large increases in interest rates were applied during the 1980s to bring inflation under control. Governments generally abandoned the idea of counter-cyclic spending - emphasising instead a balanced budget over the business cycle. And monetary policy (specifically changes in the official interest rates that reserve banks charge banks) became the preferred method for managing the business cycle.

However this method may also prove to have been inadequate because it has been reasonably argued that the main way in which reducing interest rates has had a stimulatory effect on the level of economic demand is through encouraging housing investment [1] - and thus perhaps contributed to creating a property bubble. More generally it may not only be in property markets that asset booms that are eventually likely to bust are stimulated by cuts to interest rates.

And it is the ending of a massive housing boom in the US which has given rise to sub-prime (and increasingly to prime) mortgage losses. If the above hypothesis proves correct, it raises difficult questions about future management of the business cycle.

Various observers have suggested that:

  • the response to potential US recession (sharply lower interest rates) by the US Fed involves the same tactics that gave rise to the problem. The practice has been not to worry about the development of asset bubbles - but simply to clean up afterwards. This is an irresponsible way to run an economy [1]
  • at some point, lowering official interest rates will cease to have a stimulatory effect, because no one will be willing to fund the US current account deficit [1]
  • the FED is in crisis because its mix of policies addresses old style recessions - premised on inadequate demand but solid financial institutions. It can't deal with the current recession which has its origins in questionable banking practices and a breakdown of investor trust in the integrity of banks and investment houses [personal communication]

The former US Federal Reserve chairman (Alan Greenspan) has conceded that easy money policy contributed to rapid / unsustainable growth of property values - though he ascribes most blame for the financial crisis to securitization of unsound mortgages (Greenspan: I Was 'Partially' Wrong On Credit Crisis)

Monetary policy has been guided by CPI inflation, but this will no longer be sufficient. Mechanisms will need to be developed (in parallel with setting official interest rates) which prevent unsafe asset inflation - a judgement which Alan Greenspan frequently argued was impossible.

The problem is further complicated by the need to reduce global financial imbalances which will make export-driven economic strategies much less viable. This must reduce the effectiveness of monetary policy as a macroeconomic policy tool because it seemed that easing interest rates did not result in a great inflation risk after (say) 1990 mainly because the pricing power of producers was greatly constrained by cheap (mainly Asian) imports. This constraint on inflation is unlikely to be available in future. In June 2011 indications that cheap imports could no longer be relied upon to constrain inflation emerged in the US [1]

The US Federal Reserve has officially acknowledged the need to consider the risks associated with asset inflation in future monetary policy settings (see Bernanke signals new approach to bubbles) - but how this might be achieved is unclear (eg it seems possible that action by reserve banks' predecessors to contain asset values contributed to the stock market crash of 1929 that ushered in the Great Depression [1]).

The fact that a Chinese economist has argued [1] that the adoption of a Keynesian approach (ie attempting macroeconomic management) through monetary policy (as Greenspan had done) was part of the cause of the GFC may also be noted.

In 2010, the IMF argued that too much reliance had been placed on interest rates in attempting to control the macroeconomy, and that budget spending and direct regulation of banks should play a much greater role - with inflation targets being lifted to 4% to give governments a better ability to manage downturns [1]. It was suggested in response that:

  •  raising inflation targets would be likely to lead to much higher interest rates [1];
  • this proposal was merely an attempt to rationalize the use of increasing inflation as a means for the US to reduce its debts and budgetary problems [1]

Options for improved macroeconomic management in the post-GFC environment were seen by others to include: (a) higher inflation targets, and thus higher normal interest rates, in order to provide greater scope to cut rates in a crisis - a practice that might risk revisiting the stagflation of the 1970s; (b) reserve bank targets which did not simply include CPI inflation but also asset inflation; (c) regulatory control of bank lending so that different rules / constraints apply at different stages in the business cycle; and (d) a return to reliance on fiscal policy by governments [1]

In early 2010 it was reported that new 'macro-prudential tactics were being adopted to reduce the risk of pro-cyclical outcomes from monetary policy changes. This involved changes to rules governing bank lending (eg deposits required) rather than changes in interest rates to cool booms [1]

In October 2012 it was reported that Australia's Reserve Bank was becoming concerned that inflation targeting as the basis for monetary policy might contribute to global financial instability - because the combined effect of a high exchange rate and low interest rates could be to generate a house price boom [1]

Global Impact of Booms Stimulated by Easy Monetary Policies - email sent 15/10/12

David Uren
The Australian

Re: Reserve Bank fears low interest rates will spur new housing boom, The Australian, 15/10/12

Your article outlined growing debates (led apparently by the Bank of England) about whether creating property booms and busts (which have contributed to international financial instability) could be an unintended consequence of using monetary policy as a key tool for macroeconomic management.

I should like to suggest that it is not sufficient to examine this question from a domestic viewpoint, because easy money policies enable both: (a) rapidly rising consumer demand in response to the ‘wealth effect’ of asset inflation and: (b) high levels of public spending. They thus exacerbate the international financial imbalances which (together with structural demand deficits / ‘savings gluts’ in some countries) have led to the high debt levels in deficit countries that now put global growth at risk (see and Structural Incompatibility Puts Global Growth at Risk, 2003; Booms and Busts: Unsatisfactory Tools for Macroeconomic Management, 2007 and Impacting the Global Economy, 2009).

John Craig

In February 2013 it was argued that fractional reserve banking system (whereby banks can lend more than they receive as deposits) which has been complemented (since 1913) by credit creation by reserve banks means that ever increasing quantities of credit are required to achieve growth.  In 1980s $4 of new credit was needed to generate $1 new GDP in US, but since 2006 this has required $20 of new credit. Credit goes increasingly to market speculators, and much less to real production. Today's near zero interest rates cripple savers and business models previously based on positive real yields and wider loan margins. Real growth has declined. Japan's economic stagnation over the past 20 years shows what can happen as a consequence [1]

In April 2013 it was suggested that:

  •  reserve Banks are flying blind - because they have no real understanding of the the effect of their monetary policies on advanced economies. Prior to the GFC central bankers had been lulled by low inflation into believing that there were no financial vulnerabilities. The IMF favours continuing ultra-loose monetary policies - but believes that there is a simultaneous need to repair financial systems and address unintended consequences. Three risks were perceived: (a) lax underwriting standards for corporate borrowing in the US; (b) easy money policies spilling over to emerging economies and thus crating foreign currency risks; and (c) a likely surge in interest rates when monetary easing is wound back. Reserve Banks have divided opinions about this [1];
  • Richmond Fed President said massive quantitative easing should cease, as it was not clear it had helped create jobs [1];
  • some see Japan's QE as ending Japan's lost decade - with exchange rate down 20% and stocks up 30%. Others however are concerned about using QE too much. Concerns about QE as 'money printing' are wrong. But there is concern about: low interest rates cutting retirees income; low interest rates may allow firms to delay needed restructuring; projects might be undertaken that won't later be viable; low exchange rates affect international competitiveness. Risks with ending QE include: being too slow to do so; financial markets having built in low interest expectations; bond holders would lose; government budgets would take a big hit. QE has been a policy that was justified by intractable nature of financial crisis - but the longer it remains in place the more disruptive ending will be [1].

In September 2013 it was pointed out (n relation to Japan) that population aging meant that monetary policy might have the reverse of its intended effect - because reducing interest rates constrained spending by older demographics whose numbers were increasing rapidly. Even though it encouraged spending by younger people, the net effect could be economic contraction [1];

China: Victor or Victim?

See also Are East Asian Economic Models Sustainable? and Friction between China and Japan: The End of the Asian 'Century'?

In September 2008 in the face of an impending US financial system failure, Professor Harold James suggested that: (a) the world now needs strong public sector action by a country with substantial reserves to stabilize the global financial system; and (b) China is positioned to fulfil this role, as the US did in an earlier era ('China holds the key to new world order', Australian Financial Review, 20/9/08). His argument was echoed by others (eg Drysdale P., China response to America’s financial meltdown, East Asia Forum, 22/9/08).

Unfortunately  this reflects a Eurocentric view that does not take account of the nature of the monetary and financial arrangements that have been associated with rapid East Asian development due to the region's unfamiliar cultural assumptions. Economies such as China's are more critically dependent on the strength of the US financial system to protect their institutions than they are on exports to the US to drive their growth. Despite large foreign reserves, the initially US-centred crisis is more likely to trigger a new round of something like the 1997 Asian financial crisis (this time also affecting Japan and China) than it is to see such countries stabilizing others.

Explaining the Financial Crisis

In September 2008, prevailing efforts to understand and solve financial system problems centred in the US seemed  to be based on the assumption that they were purely of domestic origin. For example Professor Nouriel Roubini, who had demonstrated valuable insight into those problems, ascribed them to: (a) the development of a bubble in property values; and (b) the emergence of a 'shadow financial system' which has been poorly regulated and undisciplined (eg listen to Financial Crisis: Worst Yet To Come (24/9/08) - in which he explained those contributing factors far more comprehensively and adequately).

However the problem is broader

Relationship with the Global Fiscal Imbalances

The initially US-centred financial crisis can't be properly understood just in terms of systemic problems in US financial institutions. An equally critical factor has been the global financial imbalances (see above) that: (a) are implicit in export-driven / demand-deficient economic strategies in East Asia and elsewhere, and in huge income transfers to oil-exporting nations; and (b) have given rise to a so-called 'savings glut'. There is a need also to consider:

  • the new role that monetary policy has taken in macroeconomic management and in attempts to prevent financial crises spilling over to affect the 'real' economy for the past 20 years;
  • Japan's role as the world's major source of cheap credit;
  • various other factors that are suggested in Global Financial Crisis: The Second Test?.

The US had provided the economic driving force for the global economy. It had acted as 'the consumer of last resort' and thus made export-driven growth a feasible method for economic development. What was less obvious is that the US has also protected dubious financial / monetary regimes (especially those in East Asia) from the need to take sound balance sheets seriously.

Because of their cultural foundations (see below), a very high rate of savings (and a demand deficit) has been critical to the economic strategies of countries such as Japan and China (see Structural Incompatibility Puts Global Growth at Risk). Moreover for many years Japan compounded the demand deficit associated with its high savings, by creating cheap credit that was mainly exported through carry-trades to boost demand elsewhere.

In the 1930 Keynes had identified the risk to sustainable growth of demand deficits, and advocated public spending as the remedy. Counter-cyclical public spending was a central part of economic orthodoxy in the post-WWII years, but tended to lose credibility in the 1970s as governments had difficulty getting the timing right. In practice fiscal intervention turned out to amplify, rather than reduce, economic booms and busts. Monetary policy, based on setting the interest rates that reserve banks charge financial institutions to maintain an acceptable rate of CPI inflation, has tended to take the place of public spending in stimulating or damping economic growth, Moreover easy monetary policy proved effective (originally in the US stock market crash of 1987) in preventing financial crises from affecting the 'real' economy.

Such techniques allowed the US (mainly) to compensate for demand deficits elsewhere with a demand surplus - reflected in its chronic current account deficits. In some ways this had been a 'virtuous circle', as: (a) easy money policies were needed to sustain US growth, given the drag of its current account deficit; (b) easy monetary policy encouraged the rapid growth in asset values, which in turn sustained high rates of consumer, business and government spending and maintained a large trade deficit; (c) cheap imports from Asia inhibited the CPI inflation that would normally make very easy monetary policy seem unwise; and (d) the US current account deficit was balanced by capital inflows mainly from East Asia. However, when asset inflation in the US faced limits, previously 'virtuous' feedbacks turned 'vicious' and have led to the current crisis (see Financial Market Instability: A Many Sided Story). The repercussions will be felt world-wide, not necessarily mainly in the US.

Professor Martin Wolf (amongst others) produced useful accounts of the relationship between financial imbalances and the current financial crisis (eg Challenges for the World's Divided Economy, 8/1/08 and How imbalances led to credit crunch and inflation, 17/6/08).

Origin of Global Imbalances

Furthermore Professor Wolf argued (as have many others) that East Asian economies have sought current account surpluses to build up foreign exchange reserves as a buffer against damage like that many suffered as a result of the 1997 Asian financial crisis (eg The lessons Asians learnt from their financial crisis, 23/5/07).

However the situation is not that simple. Professor Wolf's latter article (like those of other analysts) suggested that 'Asia' chose current account surpluses to guard against future financial crises (though financial system reform would have been better). Unfortunately it was not a matter of choice. Cultural obstacles made it impossible for East Asia to reform in accordance with Western perceptions that financial profitability is the best criteria for judging economic success (eg see The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems, 1998). The problem can be over-simplistically illustrated by the fact that economic activities in East Asia tend to be coordinated through social relationships conducted in accordance with Confucian traditions (China's 'guanxi') rather than by calculations of financial outcomes. However the origin of such practices are vastly harder for Western observers to understand (eg they arguably trace back to the absence, in societies with an ancient Chinese heritage, of Western societies' faith in abstract analysis and rationality as useful means for problem solving).

By way of background, it is noted that the writer had the opportunity some years ago to study the intellectual foundations of East Asian economic models (most particularly Japan's) and concluded that they incorporate cultural features derived from ancient China that are quite different to those Western societies inherited from Classic Greece. A flavour of this is outlined in Competing Civilizations (see East Asia). The latter focuses particularly on Japan and highlights profound differences in the nature of: knowledge; power; governance; strategy; and economic goals. China's approach is different (eg its society is less centralized and its government has no democratic 'face') but the general flavour of its differences from Western traditions seems similar.

China's Vulnerability: Foreign Exchange Reserves Conceal the Financial Defects in Asian Economic Models

Professor Harold James speculated about China's potential ability, through strong public sector action and large reserves, to stabilize the global financial system and economy. He drew parallels with the US's influence in reducing the impact of a global crisis in the 1920s and 1930s.

Unfortunately East Asia (especially China) is financially fragile and its 'bubble' could burst as soon as the US loses its ability (or its willingness) to continue inflating it (see Could China Generate a Financial 'Tsunami'?).  In East Asia large foreign reserves and 'sovereign wealth funds' are a symptom of weak financial systems, not of financial strength.

China's economy seems to be largely driven by investment (about 60% of GDP) with another (say) 10% attributable to exports. Domestic consumption makes a another small (though fast growing) contribution. But China does not have strong economic institutions. The investment that has largely driven growth has involved: (a) DFI by foreign companies hoping for future profits; (b) development of property and domestically-oriented industry by 'businesses' well-connected to China's ruling elite; and (c) provincial governments providing infrastructure. Despite government efforts to promote sound financial practices, much investment will have been made with little regard to the profitable use of capital - noting: (a) cultural traditions which emphasise 'real' things rather than 'abstract' concepts; (b) cronyism; and (c) widespread concerns about over-capacity. Thus China's financial institutions will tend to have poor balance sheets. As long as China has a huge rate of savings, a demand deficit and a current account surpluses (which requires strong demand from other countries, especially the US) this has been hidden. There has been no need to borrow in international markets to finance growth. But China would be at risk of a crisis like that which crony capitalism induced elsewhere in Asia in 1997 if borrowing foreign capital were needed to sustain growth.

China's economy has grown about 10% annually - and its government must maintain something like this because anything less would not provide enough job opportunities for those shifting from the poverty of its traditional rural economy. Failure to provide jobs would create political risks for a faction whose 'legitimacy' in the eyes of China's people has depended on economic growth. Weakening demand elsewhere, as the US-centred financial crisis finally starts to cripple the global real economy, is currently forcing China to compensate by increasing domestic demand (eg by more public spending, reducing interest rates).

Moreover the large role that investment has played in China's GDP implies that the freezing of global credit markets could also cut growth as foreign investors' ability to invest into China (which had accounted for 3% of GDP) is reduced.

However China's ability to grow through stimulating domestic demand is limited as it can't go so far that it runs down its foreign exchange reserves and needs to borrow to finance growth ie China can't do what the US has had to do for the past two decades to stabilize the global economy in the face of weaknesses in demand and financial institutions elsewhere.

China is also apparently constrained in relying on consumer spending to drive growth by the huge imbalance of wealth. 0.4% of the population have been suggested to control 70% of the wealth, so 99% of the people are poor and can't afford to consume [1]

Despite popular assumptions to the contrary China has no 'financial strength' (ie ability to borrow to fund growth). It does not have a developed financial system. It can't continue to grow if this depends on borrowing in international markets.  

China's (approx $US 2tr) foreign exchange holdings don't provide much room to manoeuvre, because.

  • China has had a large current account surplus with the US - but has passed most of this on to its 'tributaries' (ie the countries that produce components for its exports). Its net surplus has been much smaller - and could easily reverse to require drawing down foreign reserves;
  • China needs to maintain a large current account deficit with those of its economic 'tributaries' adopting forms of the 'Asian' economic model to try to protect them from financial crises;
  • China's surplus with US is likely to evaporate. 20% of China's factories are likely to close by the end of 2008 - with others shifting from production for export to favour domestic consumption [1]. Domestic economic stimulus in China (by public spending / reduced interest rates) will further increase the likely net current account deficit and thus accelerate the run down of foreign reserves;
  • China's foreign reserves can't be used to stimulate economic activity. They have already been used (ie they are mainly invested in US Treasuries - which implies that they have been used by US Treasury in funding government spending). If withdrawn to be used in other ways, there would be an offsetting reduction in spending in US to balance increased spending elsewhere (ie no net global benefit); likewise.
  • drawing down reserves to finance a future Chinese current account deficit, would weaken demand wherever the reserves were drawn from (eg US) and thus further increase the need for China to boost domestic demand - which would in turn accelerate the rate at which China's external reserves had to be depleted until its inevitable financial crisis occurs.

China will be highly exposed to a financial crisis in the medium-long term because: (a) there is no certainty that the currently US-centred financial crisis can be prevented from turning into a total 'meltdown'; and (b) even if disaster is avoided the US economy will not have the ability for many years (or perhaps ever) to compensate for East Asian demand-deficits and weak financial systems as it has been expected to do in recent decades.

In the short term China has little choice but to slow its economy to match the economic crash that is likely elsewhere - despite the political instability that this is likely to generate.

The fiscal stimulus package that China announced in November 2008 [1], combined with its shift to domestic demand and towards even less economically motivated spending goals,  is likely to:

  • provide a short term respite from political instability; and
  • make the weakness of its financial system (and its resulting inability to borrow to fund growth) into a major issue in a year or two.

In the long term extensive review of 'Asian' economic models will be vital if the region's economic viability is to be maintained. .

Feedback : In response to an email concerning the argument presented above Martin Wolf (Financial Times) indicated partial agreement - in particular he suggested (email 29/9/08) that

"The argument that China can stabilise the world economy because of its reserves is unsound economics. China does not own a reserve currency. Its reserves are the liabilities of another government that can create an infinite quantity of them. Thus the US will always have more dollar firepower than any other country. Of course, the US could create so much money that the dollar ceased to be an international reserve currency. But then China would be holding worthless paper. So why doesn't China produce a reserve currency? Here John Craig is right. A reserve currency must be freely internationally tradeable and emanate from a first-class financial system. This is impossible for a Chinese government desperate to retain iron control of the country and its citizens. All exchange controls would have to be abolished, fo a start. Reserve currencies are produced by very large and very open economies. China is still engaged in the Asian mercantilist strategy instead, which has contributed massively to the origins of the current financial crisis. (See my forthcoming book, Fixing Global Finance). Asian mercantilism is simply incompatible with global economic leadership. It is an inherently nationalist strategy."

And Professor Harold James indicated (29/9/08) that his analogy with the 1930s was being somewhat misunderstood - as on that occasion there was a need for a country (ie the US) with sound financial position to act but that in fact they did not do so.

"The point of my article was simply to suggest that instead of the PRC holding (at a substantial cost) large quantities of US government debt (the debt of a government that is now engaged in a big bailout) it would be a substantial confidence-inducing measure if the CIC (and other Asian SWFs) took equity stakes in American and other banks. I don’t think that this position is in any contradiction to worries about a really severe Chinese downturn. Indeed this was the point of the Kindleberger reference: when Kindleberger thought that the US should have saved the European financial system, the US was on the throws of an economic downturn more severe than that of Europe."

Press reports have emerged suggesting that the consequences of the writer's speculations may be all too realistic (eg see SocGen issues China alert as fears mount on banks ; Ryan C. etal 'Keep a close eye on China', Financial Review, 29/9/08; and Pettis M., US slowdown = Chinese slowdown, RGE Monitor, 6/10/08). 

By November 2008 it appeared possible that:

  • China was heading for a politically destabilizing economic slowdown (eg to less than 6% growth) - given (a) slowdown to 9% in past growth (b) sharp falls in indicators related to cars; homes; construction; and manufacturing; (c) domestic orders falling faster than exports; (d) collapse in export markets on which economy is heavily dependent - through both production (12% of GDP) and construction of export capacity (20-25% of GDP); (e) excess inventories and overcapacity; (e) inability of reduced interest rates to stimulate investment given overcapacity and bank refusal to lend; (f)  greater-than-generally-believed constraints on fiscal expansion (related to past spending; cost of bad loans by state banks; and higher-than-officially-stated government debts) and (g) a rapidly accelerating US contraction. [1].
  • it was unrealistic to expect China to do much to help others cope, because it has so many problems of its own that are overdue for attention that the GFC has exacerbated. This includes: (a) a high rate of savings and inappropriate / unproductive types of investment because of China's income inequalities; (b) difficulties in stimulating private consumption; (c) excessive spending on large public buildings and upscale housing; (d) corporate reliance on speculation for profitability; and (e) industrial investments that focus on size rather than return on capital [1]

The large fiscal stimulus China then announced potentially provided short term gains (ie restoring growth via domestically-driven demand to head off political instability) while perhaps increasing the risk of a future crisis in its weak financial system (see above). Other observers have suggested that:

  • 90% of the announced $US600bn spending was simply a re-statement of earlier announcements;
  • even with this stimulus China's growth is likely to be less than needed to avoid unrest and provide much less import demand [and thus less support the trading partners who are the 'tributaries' in China's export production regime];
  • though the unbalanced development of its economy is a serious constraint and electricity production (a rough GDP proxy) had fallen 4%, China may have the financial resources to spend its way out of trouble [1];
  • labour's share of China's GDP has fallen to 40% from 52% in 1999 - which seemed to (a) indicate that its emphasis on export-oriented manufacturing had been a poor judgment and (b) be inconsistent with continued political stability [1];
  • China's growth fell to about zero in the final quarter of 2008;
  • stimulatory spending focused mainly on increasing production capacity (for goods for which they may be only inadequate weak demand);.

China's later responses to the global financial crisis are considered in more detail in China After the Bubble: Hope for the Best, Internal Dissent, Fundamental Reform or Aggressive Nationalism?. A core problem that the GFC highlights is the inability of East Asia's economies to independently manage the relationship between supply and demand, because of the lack of emphasis on 'symbolic' (ie financial) outcomes in coordinating economic activities.

Any hopes that China might 'ride to the rescue' of the global financial system and economy needs to take account of the radically different world that would currently emerge under China's influence (see China as the Future of the World? which refers, for example, to its approach to universal values, human rights and the nature of a 'market' economy).

Finally more attention also needs to be paid to Japan (the first country to suffer from the intrinsic financial weaknesses of Asian economic models) as its monetary policy has played a part in the genesis to the current global crisis.

Don't Forget Japan: US authorities have not been the sole source of the credit boom which created the asset bubble that has now burst in the US. Japan's role and motivations also need to be considered - as it has often been the major contributor to the growth of global credit and this has been largely exported through 'carry trades', and through suppressed consumption has continued to run large current account surpluses which have been recycled into external lending (mainly to US).

Japan's response to the bursting in about 1990 of the asset bubble, which resulted in its financial system as it aspired to be No 1 economically in the 1980s, was not to reform its financial system (see Why Japan cannot deregulate its financial system). Presumably doing so was culturally impossible. Rather, in the face of the decade-long deflationary recession that resulted from unresolved bad debts in its financial institutions, Japan stimulated demand by: (a) public spending which ultimately left it with high levels of public debt; and (b) created credit at very low interest rates which was exported through 'carry trades' and thus had the effect of boosting asset values and demand elsewhere (mainly in the US) because Japan's financial system is structured to inhibit domestic spending.

It may be that in an (alleged) 'clash of civilizations' US authorities have been so focused on the threat of (terrorist) attacks on 'Calais' that they have turned a blind eye to the peaceful (financial) invasion that has been taking place at 'Normandy'. Some issues involved are speculated further in An Unrecognised Clash of Financial Systems.

Moreover, when Japan suffered a 27% decline in exports in late 2008, it went into trade deficit (though it remained in current account surplus due to investment income) [1]. There were then suggestions that Japan needed to forgive US government debts, and invest in US infrastructure (seen as a new 'Marshall Plan') as otherwise the US government would not have the capacity to dig the country out of recession - and this would create significant problems for Japan's export-dependent economy [1].   What was un-stated was the problem that would be created for Japan's financial system.

Conclusion

Conclusion

The fact that reasonably sensible responses appeared to be emerging to the sub-prime crisis was encouraging - and suggested that systemic failure would be avoided.  In particular, though sub-prime losses are likely to continue accumulating for some time, arrangements were being put in place to absorb them. Once such losses are identified and written-off they become 'history' and the economy can move forward.  And by late January 2008, major banks reportedly expressed some confidence that the problems were being brought under control and a recession might be avoided [1].

However it seems likely financial instabilities will continue to put economic growth at risk.

There is a possibility that the sub-prime losses may merely be the first cab off the rank in a series of financial instabilities that will result from the explosive growth of credit over the last couple of decades associated with (a) the way economic and financial systems have developed (eg see Structural Incompatibility Puts Global Growth at Risk) and (b) the lack of effective governance of those systems.

Moreover the 'virtuous' circle which has been the basis of the long boom (ie credit creation boosts asset values, which encourages consumer spending to justify the credit creation) may turn into a 'viscous' circle as the boom unwinds.

Thus there is still some way to go - and probably economic pain to be suffered. The problem is global in scope. Others (eg Europe) may suffer as much as the US, and the expectation that global growth might decouple because of strong growth in emerging economies seems little more than placing faith in a 'bubble' that might inflate for a couple more years after another 'bubble' has deflated.

Moreover there are longer term issue that have no clear solution noting that:

  • global financial imbalances, whose relationship with the credit boom in the US / Europe etc has been significant but little evaluated, remain just as unsustainable as they have been but have now become urgent. The problem arguably can't be overcome without a cultural revolution to reform East Asian financial systems;
  • structured financial arrangements, that allowed sub-prime mortgage problems to emerge, were an important part of global financial flows. Loss of confidence in these will require new techniques for managing financial assets - and may, in the meantime, disrupt the financial flows that are the 'nervous system' of market economies;
  • tools available to ensure stability in financial markets mainly involve reserve bank influence over conventional banks - and the latter are now only a small part of the financial system both domestically and internationally. Moreover the international financial arrangements now involve complex cultural questions. Thus financial markets are not only ungovernable (and thus not able to be effectively regulated to reduce systemic risks) but are also likely to prove incomprehensible for some years;
  • techniques for macroeconomic management may need to be reinvented.

Negotiation of a new international agreement on ways to stabilize global financial, monetary and trading systems may be the only way of avoiding disaster. There are severe limits to what the US can achieve in isolation - perhaps merely a recreation of the conditions which gave rise to the credit crunch and efforts to prevent a serious economic downturn which can never be adequate.

Proposals for the development of new international institutions to deal with such crises have been put forward by UK [1, 2].

However given that there are other challenges which are also potentially disruptive (eg consider responses to climate change and peak oil), such institutions will need to recognise the need to do more than deal with financial systems.