Act 2 Of The Credit Crisis Will Be More Dramatic

Source : The Business Times, October 18, 2007

IF you thought that the crisis that erupted in leading credit markets recently was scary but happily short-lived, then don't relax yet. This is just the intermission, and 'Act 2' (as former US Federal Reserve chairman Alan Greenspan has referred to it) threatens to be a good deal more nasty.

And if you think that emerging markets in Asia and elsewhere, which have moved to all-time highs in the wake of the recent crisis, are the safest place to invest while money and credit markets in the advanced economies sort out their problems, then think again. When the curtain goes up on second act of the drama, it could be a more dramatic performance than Act 1, and with a more global impact.

In an apparent attempt to pre-empt this sequel, three major US banks (Citigroup, JP Morgan and Bank of America) announced on Monday that they were launching a 'super fund' to buy US$75-100 billion of financial assets from so-called structured investment vehicles or SIVs set up by major banks and asset management groups. The idea is to inject liquidity and confidence back into financial markets shaken by recent market turmoil.

Markets responded positively for a while but then bankers, dealers and others began asking why this emergency measure is needed if things really are as under control as they have appeared to be. What do regulators know that the market is not yet aware of, they wondered.

What indeed? It was the US Treasury that did the arm twisting of leading banks to get them to finance this scheme (by guaranteeing the price of special funding needed to pay for it). Past experience has shown that when central banks have to lock up commercial bankers in a room until they agree to help fund a major financial bailout, then something of systemic proportions is at stake.

Among those that are privy to what is going on behind the scenes, none are prepared to say what it is, because the name of the game is confidence rebuilding. While they talk a lot about the need for transparency in financial markets, central bankers and regulators do not usually like to practice it themselves. So we have to read behind the lines, with the help of nods and winks from people such as those to whom I have been talking. For example, while the IMF in its latest World Economic Outlook published this week takes a studiedly optimistic line on the likely impact of recent events on the global economy, one official acknowledged that things could get more ugly if this 'central scenario' does not play out as hoped.

That scenario envisages that global gross domestic product (GDP) growth will still reach 5.2 per cent this year and will decline only fractionally to 4.8 per cent next year. But as the report acknowledged, 'risks are firmly on the downside, centred around the concern that financial market strains could deepen and trigger a more pronounced global downturn'. What this means is that if instead of financial markets reverting to more or less normal in coming months, turbulent financial conditions continue and credit continues to tighten, then that could have a significant impact on growth.

To drive home the point, the IMF's Global Financial Stability Report Update, also published this week, warned that 'while some of the worst turbulence may have subsided, the period of adjustment will take time and setbacks are possible and it will not be costless'.

The impact on banks of dealing with off-balance sheet vehicles (SIVs etc) could yet trigger a major credit crunch. Emerging markets, not least those in Asia, seem to have weathered the turbulence quite well so far but as one IMF official at the highest level told me this week, there is no room for complacency on this score. The problems that are currently embroiling leading global markets and financial institutions could well spread to emerging markets in future, he suggested.

One reason for this is that the now infamous yen carry trades where cheap yen, borrowed or otherwise, is used to finance investments in higher yielding currencies. These trades appear to be a major driving force behind an emerging market price bubble, and they are on the rise again. According to the IMF, it is not just portfolio investors that are using the carry trades to pour billion of yen into emerging market equities, corporates are also big yen carry traders. Contrary to the view that structured investment products are chiefly a Western phenomenon, the IMF suggests that size of the market in Asia (centred mainly in Korea and Taiwan) has topped US$100 billion. Investors in these markets are 'exposed to a rise in volatility', it says.

Enjoy the intermission before the curtain goes up again, but don't open the champagne yet.

Tokyo correspondent Anthony Rowley is in Washington for the IMF/World Bank meetings.