Financial meltdown dissected

Published Oct 11, 2008 12:00am

THE worst global financial crisis since the 1930s is more than just an economic phenomenon. It may turn out to be the most important event since the collapse of the Soviet Union and the fall of the Berlin Wall in 1989.

A unipolar world emerged following the disintegration of the Soviet Union. The year 2008 may go down in history as the year in which the Anglo-Saxon financial model collapsed and global economic power shifted from the West to the East.

Since January 2008, the US stock market capitalisation has fallen by about 40 per cent, its worst performance since 1937, wiping out almost $7.3tr in wealth, or equivalent to about 53 per cent of the US’s GDP.  Some of its biggest and most powerful banks have collapsed. About 3.6m Americans have their lost homes since the sub-prime mortgage crisis began and more continue to lose their homes.

The US is now in a recession, and the unemployment rate is rising rapidly and forecast to reach 7.1 per cent early next year according to Goldman Sachs. The US budget deficit for

2009 could be close to $2tr, or 12.5 per cent of its GDP.

The financial crisis has its roots in the mysterious world of sub-prime mortgages, derivatives and credit default swaps. What began as a borrowing binge by US consumers eager to own homes on easy — as it turns out, unsustainable — terms offered by a financial industry flush with liquidity has rocked the very edifice of the western model of finance. Joseph Stiglitz, a Nobel Prize–winning economist from the US, recently wrote, “A unique combination of ideology, special-interest pressure, populist politics, bad economics, and sheer incompetence has brought us to our present condition.”

When mortgage payments by home owners with low incomes and poor credit histories became due, many of those customers began to default or seek to defer their payments. These so-called sub-prime mortgages total $2.3tr, sending shockwaves through the housing industry as they began to turn sour. But sub-prime lending is just one of the reasons of the crisis. The collapse of America’s financial giants was brought about by excessive greed of banks, mindless deregulation, lax supervision, and a false belief represented by the bipartisan Washington Consensus that financial markets know best. Handed a gun and set minimal rules, the financial ultimately market shot itself in the foot.

One of the weapons the market used was derivatives, which are complex financial instruments whose values change in response to the changes in underlying variables such as bonds, stocks, commodities, interest rates, credit risk, etc.  They are not traded on any exchange and are hard to value or trade during market turmoil. By the end of 2007, the total notional amount of all the derivatives had risen to $596tr from $220tr in June 2004. While the banks have announced losses from the mortgage loans to the tune of nearly $700bn, losses from derivatives pose a much bigger and unknown risk. The risk that the bank next door could be sitting on large losses has led banks to stop trading with each other and sparked fears of banks falling like dominoes, shattering the confidence in the whole system.

The worldwide cost so far

In just the last few weeks, the governments of the US, UK, Germany, France, Belgium, Iceland and Sweden have announced bailouts totalling $1.8tr to rescue the troubled banks. In September, the US nationalised its two biggest mortgage banks, or virtually half of its mortgage lending market, to save them from bankruptcy.

On Oct 7, Britain announced that its largest banks are to be partly nationalised to avert a banking collapse. Under the UK bank rescue, the government is to put up to £250bn into the banking system in an effort to keep banks lending. It will also offer a guarantee to banks issuing medium-term debt, which could mean backing a further £250bn of bank borrowings. But the UK government is likely to demand dividend cuts and the end of big bonuses at the banks in return.

In addition, the central banks of the US, Europe and Japan have pumped nearly $1tr into the money market to restore confidence and to avert more bank failures.

The UK move came as central banks around the world announced an unprecedented coordinated cut in interest rates in response to mounting fears about the impact of the financial crisis on the world economy. The US Federal Reserve, the European Central Bank, the Bank of England, and the central banks of Canada, Switzerland, Sweden and the United Arab Emirates have all cut their main lending rates by 0.5 percentage points.

In Latin America, central banks are being forced to draw on record foreign reserves built up during the six-year commodities rally to stop their currencies from sinking. In the last couple of days, Brazil sold dollars for the first time in five years and Mexico offered $2.5bn in the spot market after their currencies fell to decade-old lows. Chile may follow suit after its peso fell to the lowest in almost four years. A new world order?

The IMF has warned that the world economy is now entering a major downturn in the face of the most dangerous shock to mature financial markets since the 1930s. “The situation is exceptionally uncertain and subject to considerable downside risks,” according to the IMF.

The US may face its longest recession in a quarter century despite it $700bn plan to rescue the battered banking industry. The stock markets continue to fall, the money markets in the US and Europe are practically shut, and credit has dried up. Economists say it now appears the economy shrank in the third quarter of this year as credit-crimped consumers cut spending for the first time since 1991. Stock markets continue to fall, money markets in the US and Europe are practically shut, and credit has dried up, which is bound to hurt all those who borrow from international markets.

Asian stock markets have not been immune to the crisis and have fallen sharply reflecting slower growth forecasts. However, according to the IMF, the Chinese economy is still likely to grow by 9.3 per cent, Russia’s by 5.5 per cent and India’s by 6.9 per cent. Their foreign exchanges reserves are reportedly around $1.8tr, $582bn and $283bn respectively. The total reserves of these three countries represent 38 per cent of the world’s total and 12 times the reserves of the European Community (EU).

With the US and Europe in turmoil, their governments piling up huge deficits to rescue banks, and their capacity to provide aid to the developing countries’ seriously impaired, a dozen sovereign wealth funds, none of them from the US or western Europe, are now the world’s largest and most powerful investors.  These funds, controlled by Asian and Arab governments, are sitting on an estimated $7-8tr. A few have selectively helped some western banks.

Japan and China are the two largest foreign creditors of the US: Japan holds $593bn of US treasury bills, followed by China with $519bn. The US is now completely dependent on Asia for financing its losses and deficits and hugely dependent on the Middle East and Venezuela for meeting its oil needs.

The shift in the global economic power balance, once a matter of long-term projections, has been dramatically accelerated by what has been described as the fall of Anglo-Saxon financial capitalism as we knew it for a long time.

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