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

1. Macro
Global Economics
Q1 2008
Goodbye to all that
From excess to deficient liquidity…
...as 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. 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. 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. 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. Macro
Global Economics
Q1 2008
4

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. 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. 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. 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 stephen.king@hsbcib.com
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 stuart1.green@hsbcib.com
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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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