Economic Outlook - Global Economy - Das' view

www.imf.org

Satyajit Das is a writer with experience in Australian and international financial markets over 30 years. In a 2006 speech called "The Coming Credit Crash" – he argued:

...an informed analysis of the structured credit markets shows that risk is not better spread but more leveraged and (arguably) more concentrated amongst hedge funds and a small group of dealers. This does not improve the overall stability and security of the financial system but exposes it to increased risk of a "crash" during a credit downturn.

1.  European Debt: the risk is that the Greek bailout plan announced on 21 July 2011 can't be implemented due to claims by Finland for collateral leading to others' similar demands and German disaffection that they are not receiving similar collateral. Greece's fall in GDP is too large to successfully make requisite debt repayments: the Greek economy has shrunk by 15% since the start of the crisis. Debt contagion to other European nations remains a real risk and concerns regarding US and Japanese national debts are increasing.
Last week Das wrote "From green to red: is Credit Crunch 2.0 imminent?" which has been reproduced on blogs around the world from The Drum on ABC online to Ritholtz' The Big Picture. He makes four excellent points which we now summarise:

2.  Bank Problems: Global banks are facing serious issues; French and German banks have very large exposures to Greek, Irish, Portuguese, Spanish and Italian debt. Das notes:

If there are defaults, then these banks will need capital, most likely from their sovereigns. As they are increasingly themselves under pressure, their ability to support the banking system is unclear. The pressure is evident in the share prices of French banks; Societe Generale’s share price has fallen by nearly 50% in a relatively short period of time.

This problem is not confined to Europe. Das comments:

Bank of America (“BA”) has recently emerged with analysts suggesting that the bank requires significant infusions of capital. The major concerns relate to BA’s investment in US mortgage originator Countrywide including continuing litigation losses, exposure to European banks, loans to commercial real estate and the quality of other assets, such as mortgage servicing rights and goodwill resulting from its acquisition of Merrill Lynch.

BA claims that its exposure of $17 billion to European sovereigns was hedged. As the world discovered in 2008, it wasn’t whether you were hedged but who you were hedged with and whether they were financially able to perform that was the issue. BA shares have fallen by roughly 40% price over the past month, compared to a 15% decline in the S&P 500. The cost of credit insurance on BA risk has also increased sharply.

BA decision to issue $5 billion in preference shares to Warren Buffett’s Berkshire Hathaway, now confirmed as the market’s lender of last resort, at distressed prices was not a statement of strength but weakness. BA needs more capital in any case and Buffett is betting on both BA and if things go wrong that the US taxpayer will bail him out as they did with his investment in Goldman Sachs.

3.  Money Markets: Banks and financial institutions are finding it increasingly difficult to raise funds. Costs have risen sharply. Spanish and Italian banks have limited access to international commercial funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks, including the ECB.

4. Deteriorating broader economic environment: It is impossible to state it more succinctly than Das, as follows:

• Reduced exposure: American money market funds, which manage around $1.6 trillion, historically invested around 40-45% ($600-700 billion) with European financial institutions. Over the last few months, the money market funds have reduced their exposure to European entities, especially Spanish and Italian banks. The funds have also decreased the term of their loans to the European entities that they are willing deal with to as little as 7 days at a time, in an effort to limit risk. European banks are having to pay higher interest rates, if they can attract funds. 
• Flow on effect to Australia: Despite limited known direct exposure to European sovereigns and their relatively strong financial positions, Australian banks’ credit costs in international money markets have increased by more than 1.00% in less than 3 months. As a result, non-financial institutions are finding finance less readily available and more expensive. Anecdotal evidence suggest that businesses are having difficulty financing normal commercial transactions, recalling the credit problems of late 2008/ early 2009.
• Strong economies showing signs of slowing: Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. The effects of the excessive credit expansion in China and India are showing up in bank bad debts. 
• Feedback Loops: Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures push up budget deficits, requiring greater borrowing. Lower growth feeds into greater business failures that increase bank bad debts, feeding further tightening in lending conditions and the cost of finance. 

The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.

Government policy options are severely restricted. Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing cost. Unconventional monetary strategies – namely printing money or quantitative easing – have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.

The outlook according to Das is decidedly bearish - if not verging on apocalyptic! However, his world view is firmly based on the interconnectedness of markets, about which we in Australia must forever be mindful. There are those who say "as long as China is ok, then so are we", but our opinion is that the economic situations in both the USA and Europe are of primary significance to China as they represent China’s major export markets and consequently the global picture must be borne in mind by us all, wherever we may be.