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Monday, 20 October 2008

More concerted efforts, policies to fight crisis

Rate cuts and massive fiscal package expected

PANIC has gripped world financial markets in the last couple of weeks, threatening to flip global economies into a long drawn out recession.
Financial calamity awaits economies on a scale not seen since the Great Depression: the financial world as we know it has changed.
What started out as a crisis in structured subprime instruments has morphed into a systemic financial meltdown characterised by skyrocketing credit spreads, lack of liquidity in money markets and what appears to be a run in the global banking system.
On the real economic side, advanced economies representing 55% of global gross domestic product (US, Europe, Britain, Canada, Japan, Australia, New Zealand and Japan) entered a recession even before the massive financial shocks began late September, making the liquidity and credit crunch even more compelling.
Capital Flight
‘Whooosh....’ that cheerful sound of capital flooding into Asia early in year from the US/Eurozone has now been replaced by a whimpering sound of retreat.
South Korea has seen its central bank pump US$40bil in the spot and forex markets to stem the fall of its currency which has slumped by 12% to the dollar; Singapore is officially in recession and Indonesia is flirting with a credit crisis impacting bond portfolios, perpetuating an exodus of foreign funds.
India and China, despite sound domestic consumption and liquidity, have also not been spared from the global fallout, although still largely confined to financial markets. So the theory of Asia ‘decoupling’ from advanced economies remains a case of hope over reality.
The last few days have seen economic blocs and regions ‘recoupling’ — the recoupling of emerging markets was initially limited to stock markets that fell even more than those of advanced economies as foreign investors pulled out of these markets; but then it spread to credit markets and cascaded into money markets and into currency markets, bringing to the surface the vulnerability of many financial systems that had experienced credit booms, and that had borrowed short in foreign currencies.
Countries with large current account deficits, large fiscal deficits and large short-term foreign currency liabilities/borrowings have been the most fragile.
The delusion that the US economic contraction would be short and shallow — a ‘V-shaped’ six month recession — has been replaced by the certainty that this will be a long and protracted ‘U-shaped’ recession that may last at least two years in the US and close to one and a half years in the rest of the world.
Given the rising risk of a global systemic financial meltdown, the probability of a decade-long ‘L-shaped’ recession — like the one experienced by Japan after the bursting of its real estate and equity bubble — cannot be ruled out.
Markets will soon start to agonise about price deflation, debt deflation, liquidity traps and what monetary policy makers should do to fight deflation when policy rates get dangerously close to zero.
Policymakers Intervene
Three steps were required at the outset to curtail the credit crisis. Firstly, the willingness by governments to buy risky assets in troubled banks. This was done.
Secondly, to keep the world’s financial infrastructure intact by injecting liquidity into the global financial fabric itself. This was done.
And lastly, a sharp cut in interest rates — which was met by a global coordinated cut of 50 basis points (bps) by the world’s largest economies.
The global rate cuts were on an unprecedented scale meant to stop a recession from becoming a depression. They were not meant to re-ignite a credit boom, unclog the money markets, or infuse stock markets with liquidity.
What rate cuts do is generate a positively-sloped yield curve on government bonds. Textbook economics will show this leads to banks re-capitalising themselves as they borrow at the short end, lend to governments at the long end (buying sovereign bonds) and make spreads.
This should boost demand for government bonds, in turn helping to finance deficits. And so, the rate cuts were long overdue. In fact, more cuts are likely.
Nevertheless, financial markets continue to be volatile, depicting the skittish behaviour of investors.
Bond volatility was also higher amid stress in money markets and a historic dislocation of the 30-year US Treasury and swaps.
The difference between Libor and the rate the US Treasury pays for equivalent money is 10 times wider than the gap in 1990, and spreads keep widening.
Extreme times call for extreme measures, and so the financial system demands global solidarity, radical policies and a concerted effort in fighting this crisis. In days to come, the following steps may need to be taken:
?–? Another round of policy rate cuts to the tune of 50 — 100 bps collectively
?–? A temporary freeze on foreclosures, giving a brief respite to house owners
?–? Blanket guarantee of deposits by financial institutions and insurance companies, especially in Asia
?–? A massive fiscal package, directed at boosting consumption, reduction in taxes, social rebates aimed at increasing disposable income
?–? Central banks injecting equity directly into banks
This financial crisis will truly test the durability of globalisation, and hence, the policy priority will have to be to act; and act decisively.
by Baljeet Kaur
The author is managing director and vice-chairman of KFH Research Ltd. Kuwait Finance House is one of the largest Islamic banks in the world and the first Islamic Bank with an economic and investment research arm KFH Research.

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