Some analysts argue that the current subprime crisis is a “black swan” event. A black swan is a metaphor for something that could not exist and stems from the ancient western belief that, prior to the discovery of black swans in Australia in the 17th Century, all swans were white. A black swan is used to describe the occurrence of a highly unlikely event with unprecedented and devastating effects.
I disagree. The subprime crisis itself is not a black swan event, though the resultant credit crunch and confidence crisis may qualify. This is because all the events and factors leading up to the current crisis were known.
From a macro perspective, the Asian financial crisis and the subprime debacle share similar causes and symptoms – namely a prolonged period of low interest rates leading to moral hazard, imprudent lending, regulatory oversight, excessive investment and asset bubbles. But the advent of financial derivatives has made the subprime crisis more complicated.
The US current account deficit ballooned to above the crisis threshold of 5% of GDP before the subprime crisis broke, just like in Asia before the 1997/98 financial crisis. Notably, Thailand, where the Asian crisis started, had a current account deficit of over 8% of GDP prior to the crisis; the US had a current account deficit of 6% in the year before the subprime crisis.
The Americans have gone into a debt-financed spending spree for over a decade, pushing the loan-to-deposit ratio in the banking system to over 100%. Everything from personal consumption to portfolio investment has been funded by debt. The blow-out in the US loan-to-deposit ratio resembles vividly the situation in Asia prior to the regional crisis. Asia financed its excessive spending by foreign borrowing, and so have the Americans. Foreign debts in both America and the three Asian countries that needed bailouts by the International Monetary Fund (Korea, Thailand and Indonesia) all soared before their respective crises.
The gross US foreign debt level is even higher than the corresponding levels in the Asian crisis countries. However, nearly all of America’s foreign liabilities are denominated in US dollars, due mainly to the dollar's reserve currency and international trade status. Moreover, the US government still enjoys strong international confidence in its debt servicing and repayment ability. Hence, the US has not suffered a sudden seizure of capital inflow, and there has not been a US dollar crisis. This is quite different from the Asian crisis when massive capital outflow caused a regional currency crisis alongside the financial crisis.
When one considers Asia’s role in the US financial crisis, it is certainly not a black swan. First, shiploads of cheap goods from Asia, notably China, helped keep US inflation down. This prompted the Americans, and the Fed, to think that they could spend lavishly without igniting inflation at the same time. Second, the more than $4.3 trillion of foreign reserves held by Asian central banks, combined with billions of petrodollars from the Middle East, provided the US with enormous liquidity. This was mostly poured into US Treasuries and mortgage-backed securities, suppressing US bond yields, inflating the housing bubble and encouraging excessive US household borrowing to fund consumption.
In a nutshell, frugal Asians, notably the Chinese and Japanese who account for over 40% of the world’s central bank reserves, have lived below their means with savings flowing westwards to allow the spendthrift Americans to live beyond their means. While it lasted, this cross-Atlantic saving-spending mischief became a stable disequilibrium, enabling Asia to supercharge growth by lending to America so that it could buy Asian exports. Now that the party is over, Asia will suffer too as the financial excess implodes.
The deepening of the US subprime crisis, despite the Fed’s repeated massive liquidity injections, shows that the markets have failed to clear on their own and the global financial system has stalled. The crisis may be getting closer to the end game – either a global financial meltdown or a full-scale government bailout. History and the recent government bailouts suggest the latter.
In the coming months, forced consolidation will speed up, with more bank failures expected. The situation in Europe is worse, due to the ECB’s, until recently, inflexible, tight monetary policy. Outside monetary policy, it seems that a bank nationalisation process has begun in Europe. But the lack of a central financial regulator and treasury has raised doubt over Europe’s ability to implement a coherent crisis response and forced the European countries to adopt a case-by-case approach in providing blanket guarantees to depositors to protect their financial systems.
This short-term fix in Europe is very negative. Not only is it expensive, but it also protects the bad banks at the expense of the good ones. Delaying the process of forcing weak banks to close will only slow the normalisation of lending and encourages moral hazard, which could be even more costly to taxpayers down the road.
While Asian growth experienced a V-shape rebound a year after the Asian crisis, thanks to its young and vibrant economic structure and a quick return in confidence, don’t bet the same will happen in Europe and the US. Even with the Tarp (Henry Paulson's $700 billion Troubled Asset Relief Programme) and the concerted bailout efforts by the European authorities announced earlier this week, history shows that the post-bubble adjustment in developed economies will take a long time.
After the Resolution Trust Corp was set up in 1989, it took almost a year for US stocks to bottom, two years for credit conditions to normalise and the economy to bottom, and three years for the housing market to trough. In its 1992 financial crisis, the Swedish government also enforced a wholesale government bailout to guarantee all bank liabilities and recapitalise the banks, but the Swedish stock market and economy still took more than two years to recover.
The post-subprime crisis adjustment will be about asset deflation and de-leveraging, especially in the finance and household sectors. This type of adjustment will last for years because it takes a long time for the financial sector to rebuild capital.
The subprime crisis is a man-made crisis. In the coming years, regulators will try to right the problems by re-regulating banks. They will not let banks securitise lending and shift it off their balance sheets to create new lending capacity. The developed world’s banking sector will become slimmer, less risky and less profitable. Money markets will also be smaller and dearer so that banks will have to rely more on the traditional funding source of deposits. Plain vanilla banking of simple lending and borrowing will return, fancy derivatives will be gone.
Spendthrift debt-financed US consumers will have to retrench also; the US current account deficit will have to continue to shrink to rebalance global savings and investment habits. Thrift will replace leverage throughout the developed world. The huge bailout costs also means taxes across Europe and America will rise in the coming years, further crimping consumption power.
The likelihood of a global recession in 2009 has risen sharply. Medium-term global growth will experience a structural downward shift, unless the developing world raises consumption sharply. And that looks unlikely in the short-term. Consumers worldwide will shift towards value and away from luxury spending, suggesting that mid-market goods and services providers will out-perform luxury brands in the years to come.
Finally, the fall in consumption in the developed world will put an end to the emerging markets’ export-led development model that has supercharged their growth for over a decade. This also means that profit growth in the export-led economies and sectors will be constrained for years.
Chi Lo is a research director at Ping An of China Asset Management (HK). |
