US Rate Cuts Won't Defuse Sub-Prime Mess: 'Mr Yen'

Source : The Business Times, November 2, 2007

Asia, though not much affected so far, must be vigilant

Interest rate cuts by the US Federal Reserve - which have amounted to 75 basis points since Sept 18 - are unlikely to defuse the US sub-prime mortgage crisis, according to the influential economist Eisuke Sakakibara.

Mr Sakakibara: The key issue is the uncertainty surrounding the valuations of sub-prime assets and other structured products held by many financial institutions

Mr Sakakibara, formerly Japan's vice-minister for finance and international affairs and now a professor at Tokyo's Waseda University, also warned that global financial markets are likely to face further bouts of volatility. What we have seen thus far 'is only the tip of the iceberg', he said, adding that the problem will probably linger for 6-18 months.

Speaking at a lunchtime forum organised by newly listed Uni-Asia Finance Corporation, Mr Sakakibara pointed out that interest rate cuts by the Fed were likely to be ineffective in addressing the problems emanating from the US sub-prime mortgage sector because the cost of funding is not the key issue; rather it is the uncertainty surrounding the valuations of sub-prime assets and other structured products held by many financial institutions.

He indicated, however, that the 'superfund' proposed by some major American banks (including Citigroup, Bank of America and JPMorgan) to buy sub-prime assets could be helpful, as might a move to provide government financial support to distressed borrowers, which is being discussed in the US Congress. But such initiatives would take time to work.

Mr Sakakibara, who was Japan's vice-minister for finance during the Asian crisis of 1997/98, cautioned that although Asia has been relatively unaffected by the US sub-prime woes thus far, it needs to be vigilant. He recalled that during the Asian crisis, US policymakers thought that the American economy would be relatively insulated - until they were shocked by the Russian bond default of 1998 and the ensuing collapse of a large hedge fund.

The world economy is highly integrated now, he said, and it is highly possible that the US - still its primary engine - will slow down sharply or even go into recession. In such an event, Asia cannot be unaffected.

While Asian economies are doing well and will account for an increasing share of the global economy, right now, Asian asset markets are 'somewhat bubbly', Mr Sakakibara said. 'The situation in Asia seems too good, and usually a 'too good' situation doesn't last.'

When it does turn, the decline could happen 'very abruptly'.

Of all the Asian markets, China is 'the biggest bubble', Mr Sakakibara added, with both investment and GDP growth expanding at breakneck speed.

Chinese policymakers know they have to tighten monetary policies sooner or later, and a major adjustment in China's asset markets is inevitable, perhaps in 2008, after the Olympics. If China's economy slows down in tandem with the US, that would exacerbate the problems for the global economy, Mr Sakakibara warned.

The economist - who was known as 'Mr Yen' when he was a policymaker because his statements were viewed as affecting currency markets - said that as long as the Bank of Japan is unable to raise interest rates, the Japanese yen will remain undervalued. The bank actually did want to raise rates in September, he added, but refrained from doing so on account of the US sub-prime mortgage problem.

With near-zero interest rates at home, Japanese investors are continuing to seek higher-yielding investments overseas, and while this trend persists the yen will probably continue to trade within the range of 110-115 to the US dollar, he said. But if, owing to some trigger such as a dramatic US slowdown, the outflows from Japan dry up or reverse, the yen would rebound sharply from its 'really cheap' current level, he said.