Goodbye To All That...From Excees To Deficient Liquidity


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Interesting report - all about how the world economy turned to extreme deficient in liquidity from excess and easy credit !

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Goodbye To All That...From Excees To Deficient Liquidity

  1. 1. Macro Global Economics Q1 2008 Goodbye to all that From excess to deficient liquidity… the credit squeeze threatens the transatlantic economies… ...but can de-coupled emerging markets limit the damage? By Stephen King and Stuart Green Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it
  2. 2. Macro Global Economics Q1 2008 The excess liquidity of recent years has gone down the plughole. In its place is a credit squeeze. The persistence of elevated money market rates over recent months indicates a financial system in crisis. Banks fret about their off-balance sheet and counterparty risks. Business models are threatened by a loss of faith in securitisation. With the financial sector becoming ever more cautious, we are making downgrades to our growth forecasts for the transatlantic economies. As growth softens, and the credit squeeze intensifies, we expect more aggressive rate cuts from the major central banks. Fed funds may fall to just 3% by the final quarter of 2008. Lower US rates will lead to looser monetary conditions in the emerging markets, allowing domestic demand in the emerging world to hold up surprisingly well. However, strong emerging market growth points to elevated commodity prices, making the control of inflation more difficult in the developed world. Central bankers may not be able to cut interest rates as far as they would like to. In response, budget deficits may end up a lot bigger than they are today. Goodbye to all that It was good while it lasted. The excess liquidity of recent years was, though, bound to come to an end at some point. Whereas we’d thought the borrowers – notably American households – would bear the brunt of any adjustment, it’s the lenders who, so far, have suffered the most. This creates an international dimension to the sub-prime crisis. The lenders are, of course, not confined to US banks. Through securitisation and the innovation of ever-more-complex financial products, all sorts of international investors have found themselves burdened with now often-worthless sub-prime debt. Apart from raising some obvious questions about the funding of the US current account deficit – which, in recent years, has been increasingly dependent on the sale of mortgage-backed securities to sometimes unsuspecting foreigners – the scale of the crisis raises doubts about the securitisation model. After all, this was the process through which the danger of banking crises was supposedly reduced through the spread of risk ever-more thinly. 1
  3. 3. Macro Global Economics Q1 2008 Instead, we are left with investors who have a sense of revulsion towards many previously-popular products and a bunch of hitherto off-balance sheet assets which are rapidly being brought back onto banks’ balance sheets. The net result is a financial system in crisis. What does this mean for the global economy? We raise four questions. What is the direct impact of the financial crisis on the transatlantic economies, which seem to have the biggest exposures? What happens to inflationary pressures, which have yet to ride off into the sunset? Can emerging markets continue their de-coupled journey? And, if they do, can they offer any respite for those in the eye of the credit storm? The direct impact It’s early days, but already there are some signs of weaker transatlantic economic activity. The momentum of economic growth has slowed and credit surveys show a significant tightening of conditions. These effects are likely to continue. In our view, the links between official interest rates, broader financial conditions and the overall economy are becoming increasingly unstable. With the US housing market already in crisis, with the UK housing market threatening to move in the same direction and with bad assets springing up all over the place, we are making downgrades to our developed world growth outlook. We now expect developed economy GDP growth of just 1.8% in 2008, mostly a reflection of growth downgrades to the US, the UK and the eurozone. Inflationary pressures Although growth is slowing, inflationary pressures are not going away very easily. With eurozone inflation above 3%, it’s no great surprise that hopes of sustained interest rate reductions are not held with as much conviction as might seem appropriate in the light of an ongoing credit squeeze. The persistence of inflation reflects the shifting balance of global growth. With a bigger proportion of the world’s economic expansion accounted for by emerging markets, commodity prices are unusually elevated. Many emerging economies are at a stage of development which is very commodity-intensive. Global growth weighted towards emerging markets thus tends to have a very high income elasticity of demand for commodities. Elevated commodity prices have led to a deteriorating trade off between growth and inflation in the developed world, reflecting a worsening terms of trade. This doesn’t necessarily mean that central banks should not be cutting interest rates – if the financial system is gummed up, the case for action remains strong – but it certainly suggests that central banks may proceed with unusual caution. De-coupling With chill recessionary wind swirling over the transatlantic economies, fears of a repeat of 2001, when emerging markets were hit hard, are on the rise. However, the 2001 economic downswing was a reflection of global technology risk, whereas the latest situation seems to be more a transatlantic housing and credit risk. While there’s a good chance that global imbalances will unwind further – partly because the US will no longer easily be able to fund its deficit through the sales of copious quantities of mortgage- backed securities – part of the unwinding is likely to come not so much from collapsing US imports but, instead, from elevated demand in the emerging world. 2
  4. 4. Macro Global Economics Q1 2008 Although many people argue the case for revaluations of emerging market currencies, enthusiasm for such adjustments is likely to dwindle as fears of a major US downswing take hold. Why revalue if your exports are also likely to be hit by a sudden loss of US demand? Instead, emerging economies will continue to tie their currencies to the US dollar and, hence, their monetary policies to the Federal Reserve. With falling Fed funds, emerging market monetary conditions will loosen, leading to strong domestic demand growth and relatively high inflation. This is unlikely to be sustainable forever – a similar situation occurred in the early-1990s yet was followed eventually by the Mexican and Asian crises – but the knee-jerk assumption that a transatlantic slowdown will drag the whole world into a recessionary mire may not be correct. We expect the gap between developed and emerging world growth to widen in 2008. Respite Buoyant emerging market performance may be just enough to prevent the transatlantic economies from going into recession. While domestic demand in the US, the UK and parts of the eurozone will be under the cosh, exports may continue to surprise in the light of the emerging markets boom. Nevertheless, fears of a recessionary downswing are likely to dominate the newspaper headlines in the months ahead. Central banks will continue to inject liquidity in the hope of restoring order to money markets but, even if they succeed, the crisis may already be moving into a second phase, where banks begin to cut back on their lending to the economy at large. At the very least, this will require further interest rate reductions. We expect Fed funds to drop to just 3% by the end of 2008, with Bank of England bank rate down to 4.5% and the ECB repo rate down to 3.75%. Will this be enough to return the transatlantic economies to economic health? Monetary action will certainly be a welcome shot in the arm, but if we’re in the middle of a balance sheet deflation – the reverse of the excess liquidity boom of earlier years – more controversial action may eventually be required. Bad debts may have to be removed from the financial system with the use of taxpayers’ money. Homeowners who can no longer afford rising monthly repayments may need government help if a sudden rise in foreclosures is to be avoided. And, ultimately, if the financial system really is failing to function properly, governments may have to bypass the banking system to put money back into the economy. The most obvious way to do that is to sell government bonds to the central bank and use the proceeds to deliver monetised tax cuts. A long way off, perhaps, but there are ways of pumping up the economy even when the normal transmission mechanism of monetary policy is broken. 3
  5. 5. Macro Global Economics Q1 2008 4
  6. 6. Macro Global Economics Q1 2008 Key forecasts 6 Country and territory sections US 40 Canada 42 Monetary fiscal policy Mexico 44 assumptions 7 Brazil 45 Argentina 46 Goodbye to All That 8 Chile 47 From liquidity to drought 8 Eurozone 48 Germany 50 The key issues 10 France 52 Inflation the emerging concern 14 Italy 54 Spain 56 US still the global price-setter? 15 UK 58 Link to US manufacturing has eroded 15 Norway 60 Not just a dollar issue or speculation 16 Sweden 61 Switzerland 62 Decoupling – fact not fiction 17 Hungary 63 Resolving global imbalances 18 Poland 64 Russia 65 Reaching conclusions 20 Turkey 66 Saudi Arabia 67 Global economic forecasts 23 South Africa 68 GDP 24 Japan 69 Australia 71 Consumer prices 26 New Zealand 72 Short rates 28 China 73 Hong Kong SAR 74 Long rates 29 India 75 Exchange rates vs USD 30 Indonesia 76 Exchange rate vs EUR GBP 31 Malaysia 77 Philippines 78 Consumer spending 32 Singapore 79 Investment spending 33 South Korea 80 Taiwan 81 Exports 34 Thailand 82 Industrial production 35 Vietnam 83 Wage growth 36 Budget balance 37 Disclosure appendix 84 Current account 38 Disclaimer 87 5
  7. 7. Macro Global Economics Q1 2008 Key forecasts __________________ GDP ________________ _______________ Inflation ________________ 2006 2007f 2008f 2009f 2006 2007f 2008f 2009f World (nominal GDP weights) 3.8 3.5 3.0 3.5 2.7 2.8 2.9 2.4 World (PPP weights) 5.2 5.0 4.5 4.7 3.2 3.6 3.6 3.1 Developed 2.8 2.4 1.8 2.4 2.3 2.1 2.1 1.7 Emerging 7.3 7.3 7.0 6.8 4.3 5.4 5.5 4.8 North America 2.9 2.2 2.0 3.0 3.1 2.8 2.4 2.0 US 2.9 2.2 1.9 3.0 3.2 2.8 2.4 2.0 Canada 2.8 2.6 2.1 2.2 2.0 2.1 1.6 1.8 Latin America 4.7 4.6 4.4 4.2 4.2 4.7 5.0 4.4 Mexico 4.8 3.1 3.3 4.1 4.1 3.8 4.0 3.3 Brazil 3.7 5.4 5.0 3.7 3.1 4.4 5.0 4.5 Argentina 8.5 7.8 6.2 5.4 9.8 8.5 9.3 9.5 Chile 4.0 5.5 5.2 5.1 2.1 7.7 3.5 3.0 Western Europe 2.9 2.7 1.6 1.9 2.1 2.1 2.4 1.9 Euro-13 2.9 2.6 1.6 1.8 2.2 2.1 2.6 1.9 Germany 3.1 2.6 1.6 2.0 1.8 2.3 2.3 1.5 France 2.2 1.9 1.7 1.8 1.9 1.6 2.2 2.0 Italy 1.9 1.7 1.0 1.3 2.2 2.0 2.7 1.8 Spain 3.9 3.8 2.4 2.8 3.6 2.8 3.7 2.4 Other Western Europe 3.1 3.0 1.7 2.2 2.0 2.0 2.0 1.8 UK 2.8 3.2 1.5 2.1 2.3 2.3 1.8 1.7 Norway 2.1 3.3 2.8 3.1 2.3 0.8 3.0 2.5 Sweden 4.4 2.6 2.3 2.7 1.4 2.2 2.6 2.3 Switzerland 3.2 2.8 1.9 1.8 1.1 0.7 1.7 1.2 EMEA 6.0 5.8 5.8 5.6 5.8 7.9 7.3 5.9 Czech Republic 6.4 5.7 5.2 5.0 2.6 2.7 3.7 2.5 Hungary 3.8 1.6 3.3 4.5 3.9 7.9 5.3 3.0 Poland 6.1 6.6 5.6 5.2 1.0 2.7 3.5 2.1 Russia 6.7 7.6 6.7 6.0 9.0 11.9 11.0 9.0 Turkey 6.1 4.4 5.5 5.4 9.6 8.8 8.0 5.7 Ukraine 7.1 7.1 6.8 7.0 9.1 12.8 6.0 5.5 Egypt* 6.8 7.1 6.4 6.2 4.2 9.6 6.5 6.2 Israel 5.2 5.5 4.4 4.2 -0.1 3.1 2.9 2.4 Saudi Arabia 4.3 3.5 5.7 6.3 2.3 3.9 5.4 4.5 UAE 9.4 6.6 7.4 6.8 10.5 9.5 9.0 8.7 South Africa 5.0 5.4 5.3 5.0 4.6 6.5 6.3 5.5 Asia-Pacific 5.3 5.3 5.1 5.3 2.0 2.2 2.6 2.4 Japan 2.4 1.9 1.6 2.2 0.2 0.0 0.4 0.4 Australia 2.8 3.9 4.5 4.3 3.5 2.3 3.2 2.7 New Zealand 1.9 3.4 2.4 2.7 3.4 2.6 2.5 2.5 Asia ex Japan 8.8 8.9 8.4 8.1 3.6 4.4 4.8 4.2 China 11.1 11.4 11.0 10.5 1.5 4.7 4.1 3.0 Asia ex Japan China 6.8 6.7 6.0 5.9 5.2 4.2 5.3 5.2 Hong Kong 6.8 5.9 5.0 4.5 2.0 2.0 3.9 4.3 India 9.6 8.9 7.1 7.4 6.3 6.4 6.8 6.9 Indonesia 5.5 6.3 6.5 5.3 13.1 6.5 8.5 8.6 Malaysia 5.9 6.2 6.2 5.8 3.6 2.0 2.8 2.6 Philippines 5.4 6.9 5.9 5.6 6.3 2.7 4.1 4.6 Singapore 7.9 8.1 7.3 6.5 1.0 2.0 3.9 1.6 South Korea 5.0 4.8 4.5 4.7 2.2 2.5 3.3 3.2 Taiwan 4.9 5.0 4.0 4.5 0.6 1.6 2.4 1.9 Thailand 5.1 4.4 5.0 4.6 4.7 2.3 3.1 2.5 Vietnam 8.2 8.3 8.5 8.1 7.5 8.1 9.9 7.1 Notes: Calendar year; except for * which is based upon Egyptian fiscal year (July-June); Global and regional aggregates are calculated using chain nominal GDP (USD) weights Source: HSBC 6
  8. 8. Macro Global Economics Q1 2008 Monetary policy Q1 2007 Q2 2007 Q3 2007f Q4 2007 Q1 2008f Q2 2008f Q3 2008f Q4 2008f US Targeted Fed funds 5.25 5.25 4.75 4.25 4.00 3.75 3.25 3.00 Japan Overnight call rate 0.50 0.50 0.50 0.50 0.50 0.50 0.75 0.75 Eurozone Repo rate 3.75 4.00 4.00 4.00 4.00 3.75 3.75 3.75 UK Base rate 5.25 5.50 5.75 5.50 5.25 5.00 4.75 4.50 Canada Overnight rate 4.25 4.25 4.50 4.25 4.00 3.75 3.50 3.50 Source: HSBC Fiscal policy Country 2007 2008 US The federal budget deficit in FY2007 was USD163bn, or about 1.2% of GDP. Receipts We expect the federal budget deficit in FY2008 to be USD240bn (about 1.7% of GDP). totalled USD2,568bn, an increase of 6.7% from FY2006. Outlays rose to USD2,731bn, up Outlays could rise by around 8%, while expected revenue growth of 5% reflects a 2.9% from FY2006. Defence outlays increased by 6.6%, while combined Medicare and slowdown in GDP growth. The Treasury department will soon release a new tax study with Medicaid spending rose 9.7%. These were offset by declines in other spending, including suggestions on lowering corporate taxes, although no specific legislation has been for disaster assistance and student loan programs. recommended yet. Japan Fiscal policy is expected to tighten about the same degree as in 2006, as the other half of The degree of fiscal policy tightening should diminish, since no major tax hikes are the 1999 income tax cuts are rolled back. This, together with another round of increases of expected. However, there will continue to be fiscal drag from annual hikes in social public pension contribution rates, should keep the fiscal drag at around 0.5% of GDP. security premiums and steady cuts in public capital formation. Eurozone Fiscal policy was tightened by around 0.6% of GDP) in 2007, mainly reflecting the impact of Fiscal performance is expected to be roughly neutral with a small bias towards the German and Italian fiscal measures (see below). loosening, largely reflecting France and Spain. Note the latter is still likely to be the only EMU big 4 economy running a fiscal surplus. The Eurozone deficit should stay around 1.0% of GDP. Germany The deficit is projected to fall to 0.2% of GDP (2006: -1.6%). The financial effects of The key element of the tax reform is the reduction of the corporate tax rate to 15 % the taxation measures which started in January 2007 (including the VAT rate hike) from 25 %. Thus, the corporate tax rate burden should decline from around 38.7% to should boost revenues by around 1 % of GDP. However, the better fiscal position is 29.8%. The unemployment contribution rate will decline to 3.3% from 4.2%. How- only partly driven by an improved structural position. ever, the time period of benefits for older unemployed persons will be enlarged. France The deficit is likely to be slightly higher than government projections, which were On our calculations, measures announced and passed will result in tax revenue based on a 2.25% growth forecast, whereas we expect growth of 1.9%. The deficit growing more slowly than the government expects. In addition, the government will could reach 2.6% in 2007, since tax revenues are likely to suffer from the slowdown use the proceeds of selling a 3% stake in EDF for public spending, not debt in consumer spending. However, corporate income tax revenues should remain reduction. The measures announced to limit growth in public spending are marginal, robust. Changes in taxation will lead to slower growth in tax revenues in late 2007, and are unlikely to have much of an impact in 2008. As a result, the deficit could but their full impact will come in 2008. move close to 3% if the economy were to grow by 1.7% in 2008. Italy Italy’s reduction of its fiscal deficit to about 2.4% of GDP this year from 4.4% in 2006 Italy’s debt burden remains high (107% of GDP in 2006) and hence fiscal “austerity” has been impressive, although the 2006 budget was negatively affected by one off has to continue. The 2008 budget includes a sizeable cut in corporate taxes. factors. The 2007 budget was also helped by higher income through tax rises. Combined with slower economic growth, this implies a widening of the budget deficit, although we expect it stay below 3% of GDP. UK In the pre-budget report (PBR) the Chancellor revised up total borrowing to £38bn. The PBR projected an overall borrowing of £36bn in FY08-09. In our less optimistic Taking into account public borrowing to date, it looks again as though the Chancellor GDP projections we expect borrowing of nearer £40bn. The removal of a capital will end up borrowing more than anticipated. allowance for corporates in April 08 is likely to lead to a large increase in investment in the first quarter of 2008 and subsequent fallback. Canada Canada continued to run a budgetary surplus of CAD9.3bn in the first six months of the Canada is expected to maintain a small budgetary surplus in FY2008-2009. Weaker fiscal year, from April through September. This is on track to meet the Government’s than expected revenues would be offset by a scaling back in debt reduction plans. projected underlying surplus of CAD11.6bn for FY2007-08, taking into account the CAD4.8bn of tax reductions proposed in October. The Government plan calls for debt reduction of CAD10bn this year. Source: HSBC 7
  9. 9. Macro Global Economics Q1 2008 From excess to deficient liquidity… …as the credit squeeze threatens the transatlantic economies… …but can de-coupled emerging markets limit the damage? From liquidity to drought 2…and in the UK Stephen King Economist House prices to UK House prices to HSBC Bank plc (UK) No one ever defined it precisely but, in the first +44 20 7991 6700 av. earnings av. earnings half of 2007, the world was awash with excess 10 10 liquidity. Funds were freely available for all 9 9 Stuart Green Economist manner of ventures, whether they involved house 8 8 HSBC Bank plc (UK) 7 7 +44 20 7991 6718 purchases, private equity, leveraged buyouts or 6 6 emerging market equities. Central banks fretted 5 5 about this excess liquidity, fearing that an absence 4 4 of investor discretion would eventually lead to 84 86 88 90 92 94 96 98 00 02 04 06 08 dire economic consequences. House price-to-earnings ratio 1. Houses have looked expensive in the US… Source: Halifax, ONS, and Thomson Financial Datastream House price to US House price to av.earnings av.earnings 3. Rising house prices formed the collateral for more debt… 7 7 US household debt % disposable % disposable income income 6 6 140 140 5 5 120 120 4 4 100 100 84 87 90 93 96 99 02 05 80 80 House price-to-earnings ratio 60 60 Source: Thomson Financial Datastream, and HSBC 90 92 94 96 98 00 02 04 06 Source: Thomson Financial Datastream, and HSBC 8
  10. 10. Macro Global Economics Q1 2008 4…..encouraging a transatlantic borrowing binge designed to bring them back down again. Official % disposable UK household debt % disposable interest rates have been cut, liquidity has been income income injected and eligible collateral has been increased yet 160 160 all, until recently, to little avail. 140 140 6. Inflation has been rising in emerging markets 120 120 % Yr Consumer price inflation % Yr 20 20 100 100 80 80 10 10 90 92 94 96 98 00 02 04 06 0 0 Source: Thomson Financial Datastream, and HSBC -10 -10 5. Global private equity activity doesn’t look quite so healthy 05 06 07 Brazil China Mexico Russia Private equity deals USDbn 2000 600 Source: Thomson Financial Datastream, and HSBC 500 1500 400 7. Money market rates are elevated in the US… 1000 300 200 % US % 500 6.0 6.0 100 0 0 5.5 5.5 Jan-00 Jan-02 Jan-04 Jan-06 by number (LHS) by value (RHS) 5.0 5.0 Source: HSBC 4.5 4.5 4.0 4.0 And now the liquidity has dried up. Ahead of 06 07 08 them, central bankers can now only see a parched 3 month interbank rate Fed Funds target rate economic landscape where, once, money flowed all Source: Thomson Financial Datastream, and HSBC too freely. We have gone from a flood to a dribble, a change of quite extraordinary proportions. And 8…in the UK… so far, despite the central banks’ best efforts, the % UK % drought continues. 7.0 7.0 Admittedly, this is an overstatement. Credit growth remains firm in many parts of the world. Across 6.0 6.0 emerging markets, economies are booming and inflation is very much on the rise. But for the 5.0 5.0 transatlantic economies – the US, Canada, the UK and parts of the eurozone – the credit shock has been 4.0 4.0 sizeable. Most obviously, since July, money market 06 07 08 3 month interbank rate BoE base rate interest rates have remained at remarkably elevated levels despite a range of central bank initiatives Source: Thomson Financial Datastream, and HSBC 9
  11. 11. Macro Global Economics Q1 2008 9…and in the eurozone The key issues % Eurozone % Where, though, do we go now? There are four 5.0 5.0 key issues: 4.0 4.0 What does the drying-up of liquidity entail for domestic economic performance in the 3.0 3.0 affected countries and regions? Even if, in some areas, liquidity has dried up, 2.0 2.0 06 07 08 are we yet safely out of the inflationary woods? 3 month interbank rate ECB repo rate If some countries are hit through a credit Source: Thomson Financial Datastream, and HSBC crunch, will others be dragged down as well? Or, alternatively, are we living in a truly de- That this has been, so far, a transatlantic problem coupled world? is, perhaps, no great surprise. We argued in “Be And, if we are in a de-coupled world, will careful what you wish for” (21 November 2007) there be any positive feedback effects from that the US housing crisis had become more a strong growth in the emerging markets back problem for the international lender than for the into the credit-constrained economies? domestic borrower. We noted, in particular, that the rest of the world had been happily buying US The absence of liquidity has to be seen in the asset backed securities and argued that most of the context of the earlier period of excess. We’ve foreign investors probably resided in Europe. argued before (see “Fear and Loathing”, Global This, of course, fits very easily with the bad news Economics, 2007Q4) that, apart from the obvious stemming from both the US and the European impact of low US interest rates earlier in the banking sectors. It’s worth noting, for example, decade, one of the biggest influences on excess that IKB and Sachsen Bank, two small German liquidity was the actions of emerging market institutions, proved to be the canaries in the central bank reserve managers, who invested their mineshaft for the latest crisis. burgeoning reserves in mostly safe assets including vast amounts of government paper. By doing so, yields on these assets were driven down to unusually low levels, thereby encouraging 10. US Corporate bonds – including asset-backed securities – seem to be mostly held in Europe Non-China Offshore Middle East Emerging Financial Japan UK China Euro Area Oil Exporters Asia Centres Portfolio weights* Equities 16.3 46.5 0.5 36.8 51.3 22.2 36.3 Treasuries 61.1 9.0 56.5 12.6 34.0 47.7 10.2 Agencies 13.1 4.5 36.1 9.3 8.8 21.8 10.8 Corporates 9.6 40.0 6.9 41.4 6.0 8.3 42.8 Total exposure to US assets In percent of GDP** 23.9 25.4 23.7 12.3 20.3 18.8 - Notes: * Breakdown of portfolio holdings of US assets ** This cannot be calculated for offshore financial centres because GDP is not available for all offshore financial systems from TICS data. Data in percent; holdings as of June 30 2005. Corporates include asset backed securities. Source: IMF 10
  12. 12. Macro Global Economics Q1 2008 institutional investors to look elsewhere for crisis. This argument, though, has unravelled all returns. The appetite for more exotic products – too rapidly. First, too many “bad” assets were asset backed securities (and, within them, bundled together and sold off to unsuspecting mortgage backed securities), collateralised debt investors who will now look twice before buying obligations and their ilk – started to increase. exotic products. Second, too many of the bad Securitisation expanded rapidly and, as it did, the assets were hidden away in banks’ own off- gap between ultimate borrower and ultimate balance sheet vehicles, such as conduits and SIVs. lender widened more and more. Far from being spread thinly, many risky apples didn’t fall far from the tree. 11. Emerging market central banks hold a lot of reserves USDbn Total foreign exchange reserve holdings USDbn 13. Most issuance of asset backed securities has been mortgage backed securities 4500 4500 % GDP % GDP Issuers of ABS - Net acquisition of 4000 4000 financial assets 3500 3500 3000 3000 6.0 6.0 2500 2500 4.0 4.0 2000 2000 1500 1500 2.0 2.0 1000 1000 500 500 0.0 0.0 00 01 02 03 04 05 06 07 -2.0 -2.0 Developing Countries Developed Countries 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Source: HSBC Total Mortgages Other Source: Thomson Financial Datastream, and HSBC 12. They’ve invested the reserves in government paper, keeping yields well below consensus expectations* % US 10-yr bond yield % Since our last Global Economics quarterly, the 7 7 situation has worsened. The money market strains which the majority of central banks 6 6 thought would only be temporary have persisted. 5 5 The strategies adopted by the central banks to deal with these problems have succeeded only very 4 4 recently, and the effects may not last. Meanwhile, there are increasing signs that the money market 3 3 crisis is beginning to spill over into the economy 00 01 02 03 04 05 06 07 08 at large. Credit surveys in the US, the eurozone Note: * Red line shows consensus forecast made at the beginning of each year for the and the UK suggest that, for a given level of end of that year. official interest rates, credit conditions are being Source: Thomson Financial Datastream, and HSBC. tightened. October’s Federal Reserve Senior For a while, many commentators argued that Loan Officers’ Survey, for example, suggested securitisation was entirely a good thing. Risks banks were busily tightening their lending which used to reside in lumpy fashion within the standards to mortgage-seeking households and banking system were now spread very thinly also to real estate companies. across a wide range of investors, apparently reducing the danger of an old-fashioned banking 11
  13. 13. Macro Global Economics Q1 2008 14. Some initial signs that credit conditions are becoming 17. Households suddenly can’t get mortgages more awkward for US commercial and industrial companies % Domestic respondents tightening standards for % % Domestic respondents tightening standards for CI % residential mortgage loans loans 60 60 70 70 July survey 40 40 50 50 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 90 92 94 96 98 00 02 04 06 90 92 94 96 98 00 02 04 06 Prime Nontraditional Loans to large and medium-sized firms Subprime All residential Loans to small firms Source: US Federal Reserve Source: US Federal Reserve None of this should come as any great surprise. 15. Loan rate spreads over cost of funds are widening After all, the bottom has fallen out of the mortgage % Domestic respondents increasing spreads of loan % backed securities market, as revealed in the Fed’s rates over Banks’ costs of funds 80 80 flow of funds accounts. After many years where July survey funding from the sale of mortgage backed securities 40 40 grew almost exponentially, the third quarter of 2007 0 0 showed an extraordinary collapse, as a global -40 -40 buyers’ strike took hold. Fortunately for the US -80 -80 housing market, the Federal Home Loan Banks 90 93 96 99 02 05 plugged the gap in the third quarter but, without Loans to small firms Loans to large and medium-sized firms new funds, this mechanism won’t last indefinitely. Source: US Federal Reserve 18. US Financial sector borrowing/issuance* - GSE’s have stepped in as securitisation has dried up 1500 1500 16. Commercial real estate is facing a tough time 1000 1000 % Domestic respondents tightening standards for % 500 500 commercial real estate loans 80 80 0 0 July survey -500 -500 60 60 Q106 Q206 Q306 Q406 Q107 Q207 Q307 40 40 Open market paper + Corporate bonds 20 20 GSE issues 0 0 Agency- and GSE-backed mortgage pool sec. Bank loans n.e.c -20 -20 Other loans and advances (FHLB foreign loans) -40 -40 90 92 94 96 98 00 02 04 06 Note: *All figures are US$bn, seasonally adjusted annual rates Source: HSBC, Federal Reserve Source: US Federal Reserve 12
  14. 14. Macro Global Economics Q1 2008 The persistence of wide money market spreads, collateral against which banks will extend more together with government bond yields lower than loans. If, instead, the securities fall in value, banks could reasonably be justified on the back of may be more reluctant to create loans, in which case incoming economic data, suggests a major shift in monetary growth is likely to be curtailed. asset preference. If asset backed securities and Expressed this way, it’s not so surprising that their various derivatives are no longer flavour of central banks have struggled to reinvigorate the the month, cash and near-cash alternatives very transatlantic monetary system. While they’re much are. Government bonds, after all, are pumping money into the economy, the banks are backed by the taxpayer and, therefore, are a lot licking their wounds from persistently declining safer than the various tranches of collateralised values (and, in some cases, an inability to offer debt obligations backed by low quality assets, any value) on a range of hitherto reliable financial whatever the rating agencies used to claim. products. Declining collateral values have, in 19. Economic data surprises can’t explain low bond yields turn, inflated counterparty risk, placed a stake Index % through the heart of the securitisation model and 30 5.3 led banks to doubt whether, at any point in recent 25 years, they had enough liquidity on their balance 20 4.8 sheets to deal with possible crises. 15 10 4.3 Thus a gap has opened up between official 5 interest rates and the ultimate performance of 0 3.8 transatlantic economies. Economic models Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 typically assume that banking systems are stable US surprise index (LHS) 10 yr bond yield (RHS) and function smoothly across the economic cycle. The latest episode suggests these models now Source: Thomson Financial Datastream, and HSBC have to be radically re-calibrated. Those who rely on Taylor rules, for example, will have to think Cash and near-cash substitutes are basically being again because the connection between official hoarded. The implications are easily spelt out interest rates, growth, spare capacity and inflation through the use of the famous Fisher identity, is in danger of breaking down. MV 37 ZKHUH 0 LV WKH PRQH VWRFN 9 LWV velocity of circulation, P is the price level and T is If so, many of the factors that have driven buoyant the volume of transactions (hence PT is the same as economic activity in recent years will go into nominal GDP). Money hoarding simply means a reverse. If excess liquidity led to rapid house collapse in velocity (V) which, other things equal, price inflation, house prices are likely to fall. If will tend to depress PT, thereby pointing to lower people borrowed excessively on the back of ever- levels of activity and inflation. The obvious way rising house prices, they may now have to repay out of this is to boost M which is why central banks debt. If stock prices were buoyant in response to are happily pumping money into the system. the perceived extra demand created by private However, the vast bulk of money is not created by equity and leveraged buyouts, then they may now central banks. Most of it is endogenous to the struggle to perform quite so well. If banks were banking system and depends for its existence on happy to extend more and more loans on the back rising collateral values. If, for example, asset of ever-rising collateral, they may have to think backed securities rise in value, they can be used as again. And if securitisation as a whole goes into 13
  15. 15. Macro Global Economics Q1 2008 reverse, even for only a modest period of time, helped to contain wage and manufactured goods then the transatlantic economy will be facing prices in developed economies, the rise in some very chill winds indeed. If there was excess commodity prices that has accompanied the rapid liquidity, it’s now time to say goodbye to all that. growth in emerging markets - as part of the globalisation process - suggests that this may Inflation the emerging concern increasingly be seen as a relative rather than Just as the outlook for global liquidity has turned absolute shift in the price level. less certain, however, so too has that for inflation. At present, most inflationary pressures relate to The stellar rise in commodity prices (see chart 20) the profile of energy and food prices, particularly over recent years has undoubtedly forced a more within the emerging world where such elements lively debate around the inflationary outlook, and directly account for a disproportionately large indeed how the globalisation theme has influenced share of the movement in consumer price indices. developed economy inflation. The greater influence Although supply factors are important, we’re of global rather than country-specific factors in the focussing here on the demand for commodities, determination of domestic inflation levels has for and in particular the impact of the rapid expansion the most part been viewed as a beneficial of the BRIC (Brazil, Russia, India and China) development, facilitating a period of low and stable economies. Their outsize demand for resources inflation within the G7 economies over the past may have contributed to a sustained boom in decade. The augmentation of significant capacity commodity prices that has prompted a fresh into the global supply chain, it is argued, has deterioration in the inflation outlook in both allowed for a more sustained period of robust, non- developed and emerging economies. inflationary growth in developed economies than could otherwise have been expected. The linkages between the industrialised and 20. Real commodity prices*: some prices have gone through emerging worlds, therefore, could be about to the roof assume a new dimension. If the round of early 400 400 interest rate cuts in the United States provides a 350 350 further stimulus to emerging markets, and by 300 300 extension commodities, then the associated threat 250 250 200 200 to price stability may eventually prove to be a 150 150 constraining influence upon particularly those 100 100 central banks in developed economies that have an 50 50 acute hatred of inflation. As such, policymakers 0 0 across the globe may face a plethora of unhelpful 90 92 94 96 98 00 02 04 06 Food Agric. RM Metals Oil external influences. A policy mix that fails to satisfactorily address developed economy growth Note: *IMF commodity price series deflated by US CPI concerns or the threat of inflation in the Source: Thomson Financial Datastream, IMF, and HSBC developing world could easily result. Such a trend may, for instance, go a long way to For example, the surge in Euro-zone inflation of explaining the persistent tendency to over- the past few months, hitting 3.1% in November, estimate developed economy bond yields over the has proved worse than even the most pessimistic past decade shown earlier in chart 12. But whilst forecasts. Although the headline rate may peak in the threat of overseas competition may have the next few months as the base effects turn more 14
  16. 16. Macro Global Economics Q1 2008 favourable, this development has certainly therefore, the rapid pace of industrialisation in the provided the opportunity for the European Central BRIC economies may instead exert a progressive, Bank (ECB) to reiterate its overriding sustained influence upon commodity markets. commitment to price stability, as if such an This point is of crucial importance to the broader invitation were ever needed. The extent to which inflationary outlook and, as such, the degree to this inflationary spike will constrain policymakers which a new inflation (or terms of trade) in the Euro-zone is rather a moot point at present, constraint may be imposed upon policymakers in given that interest rate cuts are not expected for industrialised economies even as domestic activity several months. Nevertheless, as with earlier slows. Importantly, the US economy may no comments from the Federal Reserve, the inflation longer be the price setter of commodity prices, risk cannot be easily dismissed. with the composition as well as the level of global US still the global price-setter? growth proving increasingly influential. Of key relevance to the current situation is the Link to US manufacturing has relationship between commodity prices and the eroded changing composition of global growth. In a note Comparing the monthly changes in a broad index published at the beginning of 2007, (see “A of commodity prices, such as the Standard Shifting Centre of Gravity”, January 2007) we Poor’s Goldman Sachs Commodity Index (SP outlined the rising economic leadership of the GSCI), and US manufacturing output over time emerging economies within a global context - in certainly highlights an apparent breakdown in essence the ‘decoupling story’ – and the previously well established pricing relationships. supportive impact this was exerting on the US The SP GSCI is seen as a particularly useful economy as rising export demand helped offset measure of commodity price inflation due to its the impact of the housing recession. production weighting basis. Here, the relative The likely consequences for certain commodities importance of each commodity price movement markets, metals in particular, from this process within the overall index is determined by its share were also detailed. Essentially, emerging nations of global commodity production, and by extension possess a higher income elasticity of demand for its economic importance. commodities than developed economies, with 21. US manufacturing activity and SP GSCI spot index most estimates of China’s income elasticity of 10% 75% demand for oil being close to double that of the typical OECD economy. The price elasticity of 50% 5% demand of emerging economies is also thought to 25% 0% be lower, due to the more limited opportunities to 0% switch to alternative energy inputs, implying less -5% -25% substitution away from oil than a $100 per barrel -10% -50% price would typically suggest. 72 76 80 84 88 92 96 00 04 A greater concentration of global growth within US manufacturing versus trend, LHS Annual change in SP GSCI spot price, RHS such economies will, by extension, influence commodity demand to a greater extent than the Source: Thomson Financial Datastream, and HSBC headline activity data alone may indicate. Rather than experiencing a one-off shift in demand, 15
  17. 17. Macro Global Economics Q1 2008 The design of the index, therefore, should allow it to match those that would be expected to be returned capture the impact of movements in global growth during the course of a commodity price cycle. upon commodity prices as a whole in a reasonably During the entire sample period (January 1972 to accurate manner. In turn, how the SP GSCI series October 2007), monthly increases in US correlates with the activity of a particular nation or manufacturing output from an above trend position economic bloc may provide guidance on how that have coincided with an annualised rise of 10.9% in region influences developments within commodity commodity prices, and monthly declines a 2.9% markets. In theory, monthly changes in industrial annualised return. When US manufacturing activity activity, and the level of industrial output in relation was seen to be below potential, increases in output to potential, should therefore be important corresponded with a annualised 13.5% gain in determinants of monthly commodity price changes. prices, and declines a loss of some 9%. This Chart 21 illustrates a calculated measure of a US relationship has also held between January 1990 and manufacturing output gap (showing the difference the current day. The degree of coincidence between between actual and trend output expressed as a US manufacturing output and the movements of the percentage of the trend) and the annual rate of SP GSCI spot index appeared particularly strong change in the SP GSCI spot index. Periods of between 2000 and end-2003, perhaps unsurprisingly above and below trend growth in US manufacturing given concerns of a US-led global downturn during activity have in the past coincided with peaks and the period. Once more, however, this relationship troughs in commodity price inflation, suggesting a appears to have diminished in more recent years, reasonably close relationship between the two series. with commodity prices rising strongly even when US manufacturing output was seen to be both below 22. SP GSCI spot index annualised returns in relation to US manufacturing, US$ terms trend and declining on a monthly basis. US Mftg output versus trend: ____ Above trend___ ___ Below trend ___ Not just a dollar issue or Monthly direction Increasing Declining Increasing Declining of output: speculation SP GSCI performance*: Still, given that this divergence is a relatively new 1972-present 10.9% 2.9% 14.4% -9.0% phenomenon, it is tempting to look for alternative (5.0%) (7.1%) (4.8%) (6.2%) explanations that may account for this ‘aberration’, 1990-present 11.4% -9.1% 21.5% -4.2% (5.1%) (5.9%) (5.2%) (6.1%) rather than accept the de-coupling argument in full. Commodity prices can, after all, be buffeted by a 2000-2004 37.1% -22.7% 54.7% -16.9% (7.0%) (4.4%) (5.3%) (6.7%) variety of factors unrelated to economic growth. 2004-present 18.7% -12.7% 27.1% 64.0% The steady decline in the US dollar since the (5.4%) (8.5%) (5.9%) (6.2%) beginning of the decade, for instance, has often Note: *Figures show annualised monthly performance of SP GSCI spot index when US manufacturing output is above trend and increasing/decreasing, or below trend and increasing/decreasing. Figures in brackets are the standard deviation of these returns. been forwarded as a ready explanation for the Source: HSBC and Thomson Financial Datastream conflicting trends in US activity and commodity markets. As commodity prices are typically dollar- Table 22 provides further detail, showing the denominated, fluctuations in the greenback can annualised return of the SP GSCI spot index cause nominal price shifts even if the real or against monthly changes in US manufacturing physical value of these assets remains unchanged. output when activity was estimated to be both above With the dollar having been on a predominantly and below potential. Again, the results roughly downward trend in recent years, some appreciation 16
  18. 18. Macro Global Economics Q1 2008 in prices would still have been possible without Decoupling – fact not fiction necessarily questioning the position of the United Indeed, de-coupling has been a fact of economic States as the key determinant of commodity prices. life in recent quarters. As table 24 shows, the pace A further alternative explanation to the de-coupling of US domestic demand growth has been not argument is the rising degree of investor much stronger in the first three quarters of 2007 participation within commodity markets over the than it was in 2001, at the height of the tech-led past few years. The motivation behind this growing recession. Yet emerging market growth has involvement is thought to relate more to the remained remarkably buoyant, unlike the near- perceived benefits that commodities as an asset class collapse that occurred in some countries in 2001. may offer to a balanced portfolio of investments, 23. Emerging markets a lot stronger than they used to be rather than entering commodity markets for the % Yr Emerging market GDP growth % Yr purposes of speculation alone. As such, this 10.0 10.0 development would have been expected to have 8.0 8.0 added predominantly upward pressure to commodity prices as investment positions were established. 6.0 6.0 However, when analysing the SP GSCI in euro 4.0 4.0 rather than dollar terms and re-running the analysis 2.0 2.0 contained in table 22, a clear break within the 0.0 0.0 relationship between US manufacturing and 2000 2001 2002 2003 2004 2005 2006 commodity markets is still evident since 2004, with prices rising strongly even as US activity was Source: Thomson Financial Datastream, and HSBC declining and seen to be below trend. In addition, the evidence of a speculative bubble or of investor 24. Emerging markets a lot more robust today given US domestic demand weakness participation producing a distorting effect within % Yr 2001 2007* commodity markets is also far from compelling. US Private final demand 1.4 1.8 US Exports -5.4 8.0 Speculative activity, rather than causing higher US GDP growth 0.8 2.1 prices, may in fact be the product of an underlying, Emerging Market GDP growth 3.2 8.1 structural increase in commodity prices, rather than Note: *2007 values calculated using first 3 quarters. Source: Thomson Financial Datastream, and HSBC. the cause. The accompanying boost to liquidity may simply have helped this trend to be more The secular case for de-coupling is powerful. In easily expressed. And even if we accept that our view, emerging markets have embarked on a increased speculative activity may have period of sustained rapid economic growth as they accentuated the rising trend of commodity prices, take full advantage of more liberal capital applying any rigorous test for this effect is hindered markets, new technologies and, importantly, the by the paucity of available data. Overall, the size of shifting political landscape since the fall of the the investment funds that have flowed into Berlin Wall in 1989. Their economic commodity markets in recent years, when performance is reminiscent of the gains made by compared to the value of the physical production, Germany, Japan, France and other European does not appear large enough to have accounted for nations in the 1950s and 1960s, when incomes per the rapid price appreciation alone, again suggesting capita slowly caught up with those in the US. some fundamental ‘decoupling’ influence. 17
  19. 19. Macro Global Economics Q1 2008 Indeed, given incomes per capita in many Resolving global imbalances emerging markets are still incredibly low, the Beyond these factors, though, it’s worth thinking scope for continued out-performance on economic about likely changes in global imbalances in the growth appears to be very high. years ahead. One of the peculiarities of the 2001 If, though, we leave the secular case to one side, recession was the absence of any major reduction there’s still the key cyclical issue. Can the in the US current account deficit. It contracted by emerging world cyclically survive a sustained US- only 0.5% of US GDP or less than 0.2% of non-US led economic slowdown? Or, instead, will the global GDP. This was not a big change, suggesting emerging world succumb to a collapse in much that the global recession was truly global and not the same way that we saw in 2001? really US-led (if it had been, the US deficit would presumably have shrunk a lot more). It would be foolish to suggest that a transatlantic slowdown would have no effect on the emerging 25. The US current account deficit didn’t really shrink very much in 2001 world. The issue is one of magnitude. There are, % GDP US current account % GDP though, reasons for hope: 1.0 1.0 0.0 0.0 First, we’ve already seen that emerging -1.0 -1.0 markets have continued growing despite an -2.0 -2.0 already relatively weak domestic demand -3.0 -3.0 picture in the US -4.0 -4.0 -5.0 -5.0 Second, the tech bubble was global in nature -6.0 -6.0 and all equity markets fell simultaneously, -7.0 -7.0 90 92 94 96 98 00 02 04 06 including those in many emerging markets. While there are some obvious property Source: Haver Analytics bubbles in the emerging world, they have yet to succumb to the sub-prime crisis that’s hit 26. This time, it may have to shrink more – and funding from the transatlantic economies ABS is already falling sharply USDbn USDbn Third, many emerging economies were major 500 500 volume suppliers of technology products at 400 400 the height of the late-1990s bubble and, 300 300 therefore, were inevitably in trouble when 200 200 recession came. It’s not so obvious that they 100 100 0 0 have the same connections with the US or -100 -100 European housing markets 95 96 97 98 99 00 01 02 03 04 05 06 07 Official purchases Corporate bonds Fourth, although the information is murky at Corporate equity FDI best, it seems more likely that the bad assets associated with the housing bust are held Note: Data expressed as a four quarter moving average at an annual rate Source: Thomson Financial Datastream, and HSBC mostly in America and Europe and not in the emerging world (although it’s difficult to be sure about the ultimate owners of assets held in the US or Europe on a custodial basis) 18