And how it can seize the opportunity and surge forward
WE NOW have a perfect storm with the perfect ingredients — easy liquidity, poor alignment of incentives, inadequate assessment and management of risks, greed, and lack of due diligence.
The surge of the energy price — a bubble of its own — was the catalyst. To fight inflation, the United States government hiked interest rates. The housing bubble burst and mortgage default surged. With property foreclosures and defaults in mortgage payments, mortgage-backed securities were now viewed as high risk with low value. When large investors holding them attempted to unload their holdings, the action spiralled into even lower valuations.
But, the bad news did not stop there. At the beginning of the sub-prime crisis, the US government did not take decisive actions; instead, it still played the interest rate game. Fundamentally, the US borrowed too much. One could counter that by producing a lot of income growth. Unfortunately, with globalisation, the US economy now only made up about a third of the world economy. Thus, the US monetary authorities could not readily generate a surge in the US economy.
The recent spate of write-downs of losses arising from bad investments was the right thing to do, but, they came a little too late in the game. Without a clean revelation, investors were suspicious, especially after seeing some losses. The result is a systemic large-scale markdown of the real value of many financial instruments, largely stemming from fear.
The US government’s attempt to alleviate fear in the financial markets by bailing out some, but not all, had the unintended consequence of heightening investor suspicions. Trapped investment banks now found refinancing capital even more expensive. One after another, the banks had to either create a bailout (call it accepting a fire sale) or file for bankruptcy.
What this means for Singapore
The financial turmoil has real consequences on the economy. If we get up in the morning and find that our financial assets have dropped by $200,000, what would we do? We would scale down our expenditures, perhaps not dining out and having a simple home-cooked meal instead. The financial meltdown drags down our consumption levels. The high cost of capital also discourages corporate investment. We have a severe economic downturn in real terms.
Asians are affected in two ways. First, the slowdown in US consumption and investment affects our exports, and thus our earnings. Second, the losses in the US suffered by Asian banks and other financial institutions damage their books and their ability to lend. Tighter credit curtails investment. (We hasten to add that not all Asian banks are affected equally. For example, Singapore banks have insignificant exposure to Lehman’s instruments while Japan and Taiwan banks have billions. Credit is available in Singapore in a prudent manner.)
LESSONS TO BE LEARNT
This is not a simple storm and it will take time for it to pass. It is not clear what the best course of action should be. Yet, a few things are clear.
First, financial institutions should make clear what they have suffered and recognise the losses. The Japanese financial firms’ coming-out action in this regard is the right move, although it does not spare them from negative market reactions to the exposure. But not doing so will only heighten investors’ fear and worsen the current credit crunch.
Second, real fiscal economic stimulations to counter financial market over-reaction are not really nonsensical.
Third, with the weakened US aggregate demand, the pan-Asian market will be more important. Asian economies should seize this chance to strengthen the interreliance on each other’s consumer and credit markets; it is time to further foster the pan-Asian market concept.
Fourth, we should learn from this crisis. It teaches us to recognise the need to evaluate how and where financial innovations and policy initiatives will challenge our regulation and market systems. In the sub-prime case, the noble initiative to encourage home ownership and fancy financial engineering created a breakdown in the otherwise sound public regulations and monitoring system of the US.
Finally, for me, I hold on dearly to the maxim: Do not invest in what you do not know.
The writer is Dean and Stephen Riady Distinguished Professor of Finance, NUS Business School.
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