Financial Crisis In The West Is Not Over Yet

Source : The Business Times, June 12, 2008

It's necessary to dig deep into the data to determine what exactly is going on

IN RECENT years the world economy has boomed. Now we are seeing a slowdown. This slowdown is centred on the United States but its impact will be seen around the globe. Even though there is a need to be cautious about immediate economic prospects, there are many reasons to be positive about longer-term prospects.

Look closer: The Bank of England said in a report that markets may be overstating losses leading the FT to report that the Bank believed the credit crunch was history. But a second look shows it was focusing on the sub-prime market, which was factoring in a default rate of 38%, implying that 76% of lenders would lose half of their money.

The world economy - but in particular in the West - is in a financial crisis. Every financial crisis is different. The outcome depends on a number of factors: the economic fundamentals, the policy response and confidence. Of these, the hardest to predict is confidence. In recent weeks there has been a return of confidence to many parts of the financial sector. In turn, this had led many asset markets to stabilise, and has even led the market to believe that the next move in US interest rates is up.

I would warn against believing that the present financial crisis is over. Indeed, why should one believe those financial firms that are now telling us the credit crunch is over, when only a few weeks ago some of those firms did not know the value of the positions that they themselves were holding!

I would like to believe that this is the end of the credit crunch, but I do not think it is. To use a Churchilian phrase, we believe that we are at the end of the beginning, not at the beginning of the end. Or, to put it another way, we believe that we have finished the first phase of the crisis, and now we are about to enter the second phase.

The first phase since last August has witnessed a period of intense financial stress. The second phase will be how this feeds into the wider economy. And in particular, there will be a focus on how the US is affected and on how any problems in the US impact the rest of the world.

One way to picture this is that a race is on, with policy-makers and central bankers trying to stabilise the financial sector before economic problems hit. In my view, policy-makers will fail on both counts. They will not be able to prevent a downturn and, despite recent policy actions, parts of the financial sector in the West may be too fragile to cope.

The economic downturn will see defaults rise, bad loans increase and the price of assets change. Financial firms in the West are likely to see a further deterioration in asset quality if the economic outlook deteriorates, and if property prices fall.

There will be a negative wealth effect. There will be a negative credit effect. Any deterioration in the economic outlook could expose more skeletons in some parts of the financial sector, with concerns having been expressed about areas as diverse as US commercial real estate, monoline insurers, US government-sponsored agencies and the credit default swap market.

Policy-makers need to help minimise any of the spillover from the financial sector into the economy, but they also can't overlook the enduring aspects that led to this crisis and that contributed to financial instability. For us here, the questions to ask are what are the immediate consequences and what are the longer-term lessons?

Here I will focus on the lessons for the financial sector. There is deleveraging. Parts of the securitisation market have effectively closed. And within the financial sector, we have moved from one extreme to the other.

Whereas in recent years markets were not pricing for risk - or perhaps one should say participants in the market were not pricing for risk - now we are seeing in many Western markets, particularly in the US and UK, not only higher pricing for risk but also a reduction in the quantity of risk that is being taken.

This will lead to a reduction in lending. In recent months we have witnessed a host of banks facing liquidity constraints and then capital constraints, prompting them to sell assets and to shrink their balance sheets.

At the beginning of May, the Bank of England released its impressive half-yearly Financial Stability Report. Looking at the global situation, the Bank of England said that markets may be overstating losses that will be seen. This led the Financial Times to proclaim in its front-page headline that the Bank of England believed the credit crunch was over.

Nothing of the sort! The Bank was focusing on the sub-prime market, which was factoring in a default rate of 38 per cent, which would imply that 76 per cent of lenders would lose half of their money. Whilst it is possible that the particular sub-prime market may be too pessimistic, it would be wrong in my opinion to imply anything for other financial markets.

This downturn is already more complex, more nuanced and it is necessary to dig deep into the data to determine what exactly is going on. In short, it depends on where you sit and on what you do. Different businesses, different people will be impacted in different ways.

The Bank of England, in that report, also said that there are large discounts in the market for illiquidity and for uncertainty. That is certainly right. And for banks there has to be a genuine fear that continued liquidity constraints could lead to capital problems. I would suggest that central banks are providing more liquidity not only to address immediate issues but also in the hope that this will prompt banks to increase their transparency regarding writedowns and to raise more capital.

Further consolidation is inevitable within the banking sector. The fact that earlier this year some Western banks had to turn to sovereign wealth funds (SWFs) for an injection of capital is as clear a sign as one needs of how the balance of power is shifting.

The injection of capital by SWFs prevented at that time a consolidation of the banking sector. SWFs have rightly been seen as the new power brokers, alongside private equity and hedge funds.

But they also highlight the growing importance of sovereign players, seen also in rising foreign exchange reserves, and also likely to be seen in the greater role of governments in markets. Indeed the latest crisis in food prices has already led to some calls for markets in staple foods to be closed, to discourage speculation.

Whether that happens or not, I think in coming years we may see more government-to-government barter transactions, particularly in the areas of commodities.

The writer is the chief economist and group head of Global Research, Standard Chartered Bank, London