World Economy 2008 – What does the future have in store?

After the Subprime crisis came out in the open, analysts and economists around the world have been burning the midnight oil to build what-if scenarios in an effort to gain a sneak peek into the future. For the benefit of those who came in late, here´s a quick flashback of the story so far and the sequence of events that triggered it.

The event that was topmost on the list in the last few months was clearly the sub-prime crisis. In the coming months and possibly years, this will arguably be the single most important event in recent times to set the tone directly or indirectly for most economies linked to the US. Another development that contributed to the story was the growth of sovereign wealth funds (SWF). These are state owned funds created from the surplus within the countries´ central banks. Surpluses arise primarily from growing exports of countries or from the fact that retail savings are more popular than invesments in many countries (e.g in Asia). Countries such as Abu Dhabi, Norway, Singapore, China and Russia have some of the biggest funds. Conventionally, US Treasury bills have been a hot-favourite for many of these SWFs, but this seems to be changing as SWFs have started scouting for higher return options. However this changing trend does not have a direct correlation to our current story.

Traditionally, a large part of the US deficit has been funded by other countries with surplus savings and SWFs. As an example, China with its US$1.4 trillion surplus kitty has seen its investments in the US growing steadily over the years. The excess liquidity in the US economy coupled with low interest rates, sparked off the US investors´ interest in new avenues for investment that would yield better returns. Conventional alternatives such as the Stock market had lost its sheen after being rocked by scandals. This had resulted in tighter regulations for companies. The technology bubble had also burst early in the decade.

There appeared a new option for investors - real estate. Borrowing money to finance property purchases had become a cakewalk. Excess liquidity had to find an outlet and due diligence took a backseat. Banks/mortgage companies with their overflowing coffers started lending to borrowers with less than perfect credit histories. This initiated a vicious cycle as investors started paying more than the fair value for the property in the hope that prices would rise further. And rise they did, as demand outstripped supply. Real estate became the new playground and soon speculative activity overtook genuine investments.

Credit risk was still an area of concern for the lending institutions. So financial engineers took over, created financial instruments and transferred the credit risk of default to other willing buyers, by way of securitization and off-balance sheet arrangements. In a situation where complex financial arrangements rule the roost, it is difficult to pin-point where exactly the risk gets concentrated.

When property rates began to fall, the tide started to turn and all stakeholders started realizing that the party was over. The chain reaction extended to the rest of the economic ecosystem. People requesting new loans were turned down by banks and actual spending (including retail) decreased. The psychological perception of doomsday approaching rapidly, added fuel to the fire and accelerated the process. Institutional investors that had invested in other emerging countries started withdrawing funds to meet their own liquidity requirements in the US. Central banks tried to intervene by injecting liquidity into the market. However, the result was far from expected.

This is where game theory and economic concepts come back into play. Nightmares, just like dreams, have to come to an end sooner or later - well at least as far as conventional wisdom is to be relied upon. What soothsayers will not be able to accurately predict is, when. Several sectors in the US, like real estate, are already in or slipping into recession. Whether this trend extends to other sectors or not, is still an open question.

In the worst case scenario, the credit crisis will worsen and drag other sectors into its embrace. Just as it did in the post-stock-market-scandals era, the loss of faith in financial systems can get prolonged, as people, fearing that the worst isn´t over, start saving for a rainy day and inadvertently put on the brakes on the economy. Speculation will decrease as investors become more risk-averse and start relooking at safer investment options, albeit with lower returns.

Are there parallels to be drawn with other economies? Japan went through a real bad patch in the 90´s. This impacted the domestic economy for a long time and began the era of deflation and zero growth. In the case of Japan, the central bank did not intervene early enough. However, this is not the case in the current US scenario. So it is unlikely that the US story will follow Japan.

Re-packaged financial assets were mostly sold outside the US, especially to countries in Europe. Heavy-weights in the banking sector have already started writing off their bad debts. Players in the financial sector will tighten their belts and old fashioned concepts like transparency, accountability and risk management will come back to the forefront, well, at least till the start of the next bubble.

On a more positive note, emerging economies such as India, considered to be relatively de-linked (at least in comparison to China) from the US, could continue with their business-as-usual strategies, albeit with minor hiccups along the way. The current trend of investments in such countries is more in infrastructure (roads, power, ports, rail etc) as opposed to financial markets. The recent stock market spike and its subsequent crash has not impacted infrastructure investments, if the new multi-billion dollar infra focused Private Equity funds are any indication.

The story is far from over and until the next report on the topic comes out, in light of newer developments and better hindsight, all we can do is keep our fingers crossed and hope the current remediation actions by the various stakeholders bear positive results.

May 07, 2008 by  Sameer Kamat

Source American Chronical