The recent turmoil in the financial market continues to surface new risk, further tightening the liquidity in the market and exposing the dark side of modern finance where every form of asset can be purchased, packaged and sold again. In the past few years, money was available cheap and easy and a lot of it was chasing comparatively limited quality assets.
As a result, a lot of bad quality asset were purchased without adequate risk assessment or at their correct valuation. Credit rating agencies played along this boom turning a blind eye to the rising risk in sub-prime mortgage market. Banks were all too happy to lend debt to private equity firms and underwrite deals. Before the risk showed on the balance sheet of the lender, it was securitised and sold, thereby dispersing risk to the next player in the market. Since the risk of default was passed on, lending became ruthless and volumes ruled the day. When the lid was open and the underlying crisis exposed, it was a little too late to prevent the boom-bust cycle of US housing market but it comes at the right time to play party pooper for the debt driven take-over boom instilled by private equity and hedge firms.
The big question is how bad the situation is likely to be and what will be its impact on global economy. The debt market will witness difficult times ahead. Reckless lending will be abandoned and every deal will be highly scrutinised. By the very nature of the risks involved in such opaque and unregulated hedge funds investment, it could take weeks or even months before the exact volume of losses and the real victims of this fallout emerge in the open.
Until then, markets are bound to be volatile and central banks on their toes. The borrowing power for the weak will go down while borrowing for the strong will become more expensive. However, the corporate earnings have been very robust which will help withstand the current liquidity crunch without sacrificing the corporate investments. Banks that have ended up with unsold high-risk debt, will be hit the hardest. They are stuck with massive debt to the tune of $300 billion for which there are no willing investors. This will bring their lending business to a crippling halt and the tremors will be felt far and wide.
In fact, the private equity players who were primarily responsible for fuelling the boom in the debt market by borrowing massive amounts from banks for take-over bids will now gain by buying the unsold debt stuck with banks at healthy discounts. Recent interventions from central banks, injecting liquidity into the market, may be the security blanket needed to prevent this crisis from turning into a full-blown disaster. But it is a bit early to predict how far the central bank will go in the eventuality of a few banks collapsing at the end of this brutal correction.
Although the current crisis has taken a toll on Asian equity market in the last couple of weeks, Asia should remain relatively unaffected from any systematic changes in its long-term growth trajectory or a repeat of 1997 Asian financial crisis. This time around, Asian economies have relatively strong fundamentals as compared to 1997.
They are lush with strong foreign exchange coffers and negligible short-term debt. Also unlike 2001 global recession, when all the major engines of the world?US, EU and Japan slowed down, this time around, Japan and EU have shown strong resilience backed by strong corporate earnings, low inflation and reasonable interest rates. As long as there isn?t a total collapse of export demand worldwide, Asian economies should avoid any sharp slowdown in growth.
Asian financial market are not overvalued this time around as they were in 1997 and strong credit growth in Asia has not resulted in serious asset bubbles baring a few sporadic spikes in property markets.
Asia has played a key role in fuelling the bubble in American housing market. Record Asian savings and forex coffers found their way into US treasury notes which helped keep the US federal bank interest rate under check despite the massive current account deficit and strong consumer spending. But the Asia is unlikely to pull out at this critical juncture by selling the US government debt without an alternate viable investment option back home. In fact, it may actually be a good time for Asian corporate to cherry pick high-grade investments with handsome upside when then market recovers.
Apart from banks, American consumers will face a tough time ahead and this may be the biggest risk for the global economy. Strong consumer spending in the US has been instrumental in the export-led growth of Asian economies. This is about to change. Easy and cheap housing loans backed by strong housing valuation will become expensive and hard to come by. Rising fuel cost and credit tightening will surely hit the spending in the months to come. This may have a ripple effect of pushing the US economy into no-growth or negative growth.
Even though the growth of Asian economies in the past five years has been partly due to growth in domestic consumption, growth in exports fuelled by strong US consumption has played a key role and any slowdown in US consumption will be hard to offset.
Historically, the dollar has enjoyed high confidence during a period of extreme uncertainty or volatility in global markets. This has let it accumulate record current account surplus without significant devaluation of the dollar against major currency. However, as a result of the current crisis, if the global investors stop funding this deficit as a sign of losing confidence in the US economy, it can result in a significant drop in dollar value and steep increase in interest rates triggering a certain recession. The longer the current crisis lasts, the deeper its dent would be on the world economy. There have been reports of
how Asian economies have slowly started insulating themselves from the vagaries of the US economy due to strong inter-regional trade and rise of domestic consumerism in Asia.
?Author heads the Beijing branch for Infosys in China and is also a fellow of India China Institute. These are his personal views and can be reached on hirend@yahoo.com
