Tuesday, October 7, 2008

On the current credit crisis

Ya, I totally agree with your observation, the credit crisis has indeed spread wide spread fear psychosis… I can see the effects of it in Hong Kong too; everywhere you could see people speaking about this… In fact, HKUST organized a panel discussion on this issue on the day when the congress finally decided to go ahead with the bailout. People are still not sure how the financial crisis that originated in the US market would affect the other markets (e.g., the Asian ones), but, they seem to be sure that there certainly would be an impact… Well, why wouldn’t it! After all, the emerging markets (especially the ones in Asia) have enjoyed the spillover of the uncalled-for liquidity in the US over the past decade and when the US markets get hit, it should have a spillover effect on the other markets that have benefited during the hay days of the US economy.

Here is my theory about the current financial crisis… Many observers suggest that this crisis is triggered by under-regulation of the financial markets in the US. Although this view could be true, it only explains the $700 billion (which I agree is a phenomenal amount), but it does not explain the base $30 billion of defaulted loans by the borrowers in the US (which though is relatively miniscule, is the underlying asset that bubbled into the $700 billion credit derivative crisis). Of course, some observers might immediately argue that this could simply be an incentive issue. Yes, it is an incentive issue, but the issue could be much deeper than mere agency concerns. The incentive system and competition in the lending market might have prompted the lenders (like commercial banks and other lending agencies like Freddie Mac) to lure borrowers into borrowing loans that they would have difficulty in repaying. However, this isn’t a recent phenomenon, this is how growth in the economy has been triggered for ages. Many of you would agree that liquidity could trigger economic growth. The central bank sets caps on borrowing and lending rates as a means of managing the liquidity in the economy. When the lending and borrowing rates are lowered, it results in greater credit offtake, lesser savings and more spending. This in turn enhances corporate profitability and it creates new jobs, which in turn increases the repaying capacity of the society as a whole and makes the economy stronger. So, what did actually go wrong? It might be important to look at the factors that might have affected this economic cycle in the US to get a better perspective.

The interconnectedness of the markets that Brayden was speaking about perhaps might explain this… I believe that the increase in liquidity in the US market might have had its desired consequence – more credit offtake, lesser savings, greater spending. But, the cycle should have taken a different turn from there… thanks to globalization. The US trade deficit explain some part of this story. Yes, people in the US have been spending a lot and the corporates have been gaining out of this increase in spending, but the share of the US spending that goes to demestic firms should have taken a toll…thanks to cheap imports from emergign economies. So, lesser profitability for US firms, which means lesser jobs in domestic US firms that have traditionally been employing domestic employees. Addionally, the cheap international labor market takes a major share of those remaining jobs in the US (what is popularly known as outsourcing). Net on net, there are fewer good jobs for an average American and lesser is the average repaying capacity of the Americans, which results in increased bad loans…

So… Are we as a global community in a bad shape? Probably not? As I said, the emerging economies have benefitted tremendously from the liquidity in the US and in other developed economies. These economies have seen their growth rate soring and even a high inflation and the resultant checks on liquidity seemed not to have slowed down these economies. Of course, when the key buyers (the consumer in developed economies) reducing their buying spree there would certainly be a reduction in the growth of the emerging economies, but in the last decade or so the wealth of the average individual in these emergign nations have increased and the drop in the buying capacity of the US consumers might be taken care of by the gain in the buying capacity of the consumers of the emerging economies. So… what we see might be just a shift in the financial balance and not an overall collapse…