Category: Commentary

We Have Problems; Emerging Markets Have Big Problems

The increasing damage the global financial crisis is inflicting on emerging markets has been getting a lot of attention lately (those are four separate links, for those with time on their hands), much of it very thoughtful. I would like to immodestly point out that my co-authors Simon and Peter were early to call this one (along with Nouriel Roubini, no doubt), in an op-ed in Forbes.com back on October 12.

That aside, it seems more and more likely that we are witnessing a repeat of 1997-98, just on a grander scale. Credit default swaps on Russian sovereign debt are trading at over 1,000 basis points, which essentially means that investors think the country is more likely to default than not – this just months after the high price of oil seemed to make Russia a dominant regional economic power, and just weeks after Russia was negotiating to lend money to Iceland (as of a couple days ago, it was still possible that Russia would participate in the IMF bailout of Iceland). Argentina, as Simon pointed out earlier, has the honor of being the first country to expropriate private property under the cover of the financial crisis. The Economist published a chart showing CDS spreads on sovereign debt across Eastern Europe showing that Ukraine, the Baltics, Hungary, Romania, and Bulgaria are all at risk. (Many of those spreads are already much higher than in the chart: Ukraine at 2617 bp, Russia at 1038, Turkey at 775, the Baltics between 650 and 1000.) Hungary in particular is showing eerie echoes of 1997-98, as the government takes emergency steps, including increasing interests rates by three full percentage points, to combat speculators betting that the currency will fall – a battle that few countries were able to win a decade ago.

Continue reading “We Have Problems; Emerging Markets Have Big Problems” →

Argentina on My Mind

In the various measures of vulnerability for emerging markets (middle income countries open to capital flows) that are now being examined and re-examined carefully, Argentina does reasonably well. Its banking system does not appear to be highly exposed to problems in the US and Europe, and its macroeconomy – while not in great shape by any means – is far from being among the most dependent on continued capital inflows from abroad.

Argentina does produce and export a lot of commodities, and these prices are falling, so this creates a potential difficulty for government finances. Still the government’s proposed response is a stunner: President Cristina Fernandez de Kirchner announced Tuesday that she plans to take over (i.e., nationalize) 10 private pension funds (the Argentine Congress would have to approve this; we’ll know soon how that will go). The pension funds hold a great deal of government debt, so grabbing them would presumably get the government off the hook for that debt. But what about people’s pensions?!?

Most importantly, does this indicate that governments around the world feel they can break contracts and expropriate property freely just because all economies have encountered some sort of trouble and many industrialized countries are “recapitalizing” something? If the global crisis is becoming a smokescreen for confiscation, then our problems just got a lot worse.

Lehman CDS Settle; World Doesn’t End

Yesterday was the last day for settlement of credit default swaps linked to Lehman debt. One of the fears raised in the dark days of September was that the failure of a bank like Lehman would create hundreds of billions of dollars of liabilities for companies that had sold insurance on Lehman debt, and that market participants had no way of knowing who was good for that money, because many sellers were hedged and might be counting on payment from another seller, who might be counting on …

Well, the financial system is still standing. While we won’t know who lost money until the next quarterly earnings are announced, no one defaulted on the CDS. In part, this was due to the fact that as Lehman bonds fell in value, sellers of CDS had to post collateral to buyers, so a lot of the losses had already been recognized. (I believe AIG was an exception to this, because they had a AAA bond rating and hence did not have to post collateral until they were downgraded.) Perhaps things would have been worse without the many liquidity-increasing steps the Fed took over the last month; if you have to raise cash in a hurry, it is far easier to get it from the Fed now than it was in the past. In any case, it appears we have one less thing to worry about, at least for now.

Nobel Laureates Debate Financial System Regulation

The Economist is hosting a debate on financial system regulation between no less than two Nobel Laureates, Myron Scholes and Joseph Stiglitz. (Be sure to read the opening statements before the rebuttals, or it may not make sense.) The debate is less over specifics than over the general question of how much regulation there should be. They may be lying low right now, but there will surely be legions of executives and economists arguing that we actually need less regulation in order to foster financial innovation.

The Economist recruited Scholes to defend this view, but unfortunately he puts on a rather tepid defense. I read his arguments three times and I think they boil down to this: Crises stem from too much leverage, and therefore bank capital requirements should be increased. (He also says, however, that “Determining the amount of leverage to be used by financial institutions is a business decision.”) If banks need additional capital in a crisis, it should be provided by the government and priced accurately. In his rebuttal he also proposes a new accounting framework, potentially implemented by a regulator, that provides a more accurate assessment of the risk faced by a financial institution. So, as far as I can tell, it boils down to: (a) higher capital requirements; (b) government capital in times of crisis; and (c) better accounting. For the rest, we can count on existing laws against things like fraud. Unfortunately, the only evidence he provides for the thesis that “more regulation is bad” is that economic growth was lower from the 1930s to the 1970s, which he calls an era of regulation, than since the 1970s, an era of deregulation. (Like everything in history, economic growth levels are overdetermined, meaning that you can find a dozen different explanations of any given historical phenomenon.)

Stiglitz doesn’t do such a great job proving the “more regulation is good” thesis, either; his evidence is that countries with “strong regulatory frameworks” are less likely to have financial crises. But Stiglitz gets at the basic question: is unbridled financial innovation good or bad? Does it really lower the cost of capital enough to compensate for the costs of crises like the current ones? Which innovations are good and which are bad? Can we get the good ones without the bad ones?

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Why Banks Won’t Lend – My Theory

Some people have said that Americans go to hockey games to see fistfights and go to NASCAR races to see car crashes. This thought occurred to me over the past few days while reading The New York Times online. If there were a New York Times index, it would indicate that the financial crisis is over. I can’t recall the last time a financial crisis-related story was at the top of the home page. (Today’s Fed intervention into money markets may have been on top, but by the time I got there the lead story was Kirk Kerkorian selling stock in Ford.) Instead, we’re back to the presidential election and Iraq. For a while there, it seemed like we might have the car crash to end all car crashes in the financial system, with banks failing left and right. Now, it looks like we’ve just got a boring old recession, where millions of people will lose their jobs. Move along.

But even if the multi-car pileup has been averted, the cars are still just barely limping around the track. The problem seems to be a lack of fuel – credit, in this case. Andrew Ross Sorkin in that same New York Times points out that banks are taking their money and stuffing it into a mattress instead of lending it to companies. (Yves Smith at naked capitalism says that consumers are doing the same thing, which, while personally wise, is not the best thing for the economy.) Now, banks only make money by lending money. So why aren’t they lending?

Continue reading “Why Banks Won’t Lend – My Theory” →

Sign of the Apocalypse: The TED Spread Gadget

Back in the glory days of 1999-2000 (I was in Silicon Valley at the time, and for us that was the real boom, not this housing thing everyone else likes to talk about), otherwise reasonable people would spend an inordinate amount of time checking stock tickers on their computers. It was probably one of the things, along with email, that first made the Internet a mass phenomenon. (For you kids out there, no, we didn’t have YouTube.) Well, in a perverse, bizarro-world echo of those times, now you can track the TED Spread using a Google gadget (you can add it to your iGoogle home page, or, I believe, to Google Desktop). So now you can distract yourself at work worrying about the fate of the financial system, without even having to go to Bloomberg.

By the way, it’s at 2.56, down from 4.64 on October 10. So the first battle is going well, although there are many more to fight.

(Thanks to Planet Money for catching that.)

Korea Joins the Bailout

South Korea was one of the major casualties of the 1997-98 “emerging markets” crisis. I put “emerging markets” in quotes because, at the time, Koreans were very proud that their country had the 11th-largest economy in the world. Today it is 13th, by nominal GDP.

Yesterday South Korea announced its version of the bailout plan that is sweeping the world – $30 billion in foreign currency reserves made available to its banks, and a $100 billion guarantee on new foreign debt of its banks. But in Korea, the stakes are higher than in the US and other G7 countries. Korea is another of those countries whose banks’ have a disproportionately high level of foreign currency obligations. Rolling those over suddenly got a lot harder in the last month, for reasons we all know; now as creditors fear that banks may not be able to pay them off, the currency declines, making them even harder to pay off, and so on. The central government has $240 billion in foreign currency reserves, but that may or may not be enough to support its banking sector, which has $235 billion in foreign liabilities.

Korea is important not just because my family is from there, but because it is so big, economically – three times as big as Iceland, Hungary, and Ukraine put together in GDP terms. If the crisis spreads to countries of Korea’s scale, it’s not clear that the IMF has the resources to bail them out (and an IMF bailout would be enormously unpopular in any case).

Banks Can Borrow Money; You, Not So Much

The TED spread is down again today to 3.20 (down from 4.64 at its peak ten days ago). This means that banks are beginning to lend money to each other, which means we are less likely to see serial bank failures and a complete collapse of the financial system. This is good.

However, all is not rosy. Mortgage rates unexpectedly shot up last week – from 5.87 to 6.38 percent for a 30-year fixed-rate mortgage in the US – in a demonstration of the law of unintended consequences. Apparently, what happened was this. During the panic, investors lent money only to the US government, not to banks. However, since the nationalization of Fannie Mae and Freddie Mac, they have been regarded as as safe as the US government, and hence benefited from abnormally low funding costs. As banks become more attractive places to lend money – particularly because of the government guarantee on new senior debt, which means existing debt gets safer (banks can issue new guaranteed debt and use it to pay off the existing debt) – Fannie and Freddie become relatively less attractive. So their borrowing costs go up, and because they play an enormous role in the US mortgage system, mortgage rates go up.

The short-term jump is probably not something to get too worried about, since it basically corrects an anomalous feature of the last few weeks. However, it points out a larger problem. The Fed and Treasury are like firefighters. They decided that the top priority was preventing a collapse of the financial sector, and I agree with that priority. But now that banks are beginning to lend to each other, the next priority is resuscitating the real economy, and for that banks will have to lend to real people and real companies. We aren’t there yet.

Recession in China?

OK, that may be a bit of a stretch. But there’s little doubt that the global recession will take its toll on China’s double-digit growth rates.

One (emailed) response to our recent Washington Post op-ed criticized us for overlooking the role of China (although we did discuss China in the following Forbes article). In particular, the reader said, “it is my opinion that China holds all of the cards and I believe they will likely play some of them early in the next U.S. administration” – this because of China’s role in financing the U.S. deficits by investing in Treasuries. This may be true in the long run, although of course China cannot try to damage the U.S. economy without also crippling its own export-dependent economy. More immediately, though, China is facing an old-fashioned slowdown of its own.

All Things Considered did a story this past week on the impact of the global slowdown on Chinese exporters. One figure jumped out at me: 80% of the toy factories in Guangdong province have closed.

Also, the Baltic Dry Index, a measure of bulk cargo shipping costs and hence of global demand for heavy stuff (largely commodities) has fallen off a cliff this year (see the second chart in that post) – one reason why the Shanghai Composite Index is down more than 60% this year.

China is a place I won’t claim to understand. But as we all know, the Chinese government relies on an unsteady equilibrium in which it uses economic growth to legitimize the political system and convince the growing middle classes not to question the political order. Tocqueville’s observation (which I alluded to in my previous post) about the tendency of political strife to arise not out of prolonged abject misery, but when increasing expectations are dashed, could turn out to be particularly appropriate for China.

Update: Thanks to Randy for his comment (below). I fixed the error regarding the Baltic Dry Index.

Update: The Economist has a post with almost the same title as this post – but no question mark.

Emerging Market Developments

One of our readers raised some good questions about emerging markets on another post, and I’ve been planning to give you a brief update about events outside the G7, especially since we’ve been warning about potential problems.

First, according to Satyajit Das on Planet Money, Iceland’s stock market has lost 80% of its value, its currency has lost 95% of its value, and people are beginning to wonder if the country will have enough foreign currency to import enough food. In Iceland, as many people have reported, the main issue is a rapid de-leveraging as a banking sector that grew rapidly using foreign borrowing collapses as credit dries up.

Second, Hungary and Ukraine are looking for aid packages – Hungary received 5 billion euros from the European Central Bank, Ukraine was looking for $14 billion from the IMF. Dominique Strauss-Kahn, the managing director of the IMF, said, “Many countries seem to be experiencing problems because of the repatriation of private capital by foreign investors or the reduction of credit lines from foreign banks.” In other words, in a global credit crisis, people don’t want to lend to emerging markets. (The FT also published more analysis of Eastern Europe by Stefan Wagstyl.)

Finally, Newsweek has a story about the crisis in Pakistan. While domestic political instability certainly predates the financial crisis, now the economy is also under pressure. One problem: “Whereas the previous government was able to finance its current account deficit through privatization proceeds, bonds issues, and foreign direct investment, these channels have dried up with Pakistan’s security woes and the global credit crisis.” As of today, Pakistan is potentially looking to the IMF for an aid package. I assume most American readers know why instability in Pakistan is a bad thing.

One common thread is that, when lenders stop lending, emerging markets are among the first to lose access to money. Iceland is perhaps the most extreme case, where entire economy had the characteristics of an overleveraged Wall Street bank. But other countries with significant foreign-currency debts are suffering from crises of confidence by external lenders who want to get their money out before everyone else does.

Besides potentially causing steep domestic recessions and severely reducing the purchasing power of local populations, emerging market problems spill back into wealthy countries in at least two ways. First, as banks (or countries) default on their debt, lenders in those wealthy countries have one more asset they have to write down on their balance sheets. Second, the fewer strong economics out there, the fewer people available to buy our exports. Finally, the other thing we should be concerned about is political instability. Economic crises – especially after periods of increasing prosperity (see Alexis de Tocqueville) – have a way of triggering political crises in which unsavory authoritarian governments, or at least anti-Western, anti-capitalist governments, come to power. Let’s hope it doesn’t come to that this time.

Slouching Toward Recession

In any other week, the blizzard of bad real-economy news this week would have been a major story. Not this week, though, when the bailouts announced on Monday and Tuesday left the economic world in a state of cautious optimism and the stock market actually closed up for the week (admittedly, after a terrible previous week). Let’s just summarize:

Construction: Housing starts in September were 31% down from a year before, lower than expected, and building permits were down 38%.
Retail spending fell 1.2% month-over-month in September, after declines in the previous months.
Industrial production fell 2.8% month-over-month, far more than expected.

And remember, the acute phase of the credit crisis only began in the middle of September when, in the space of four days, Lehman failed, AIG was bailed out, and Paulson and Bernanke announced that we were all in serious trouble. The mood of general panic that set in then and only began to dissipate this past week is only partially reflected in these figures. In case anyone isn’t sure why these numbers matter: when consumers buy less, and companies produce less, that’s when companies lay people off.

I don’t think I’m frightening anyone here, since just about everyone thinks that we’re already in a recession. I just want to reiterate the point that even if the credit crisis begins to lift, the preceding slowdown in the real economy has become a major problem that will need major action to solve. Hence the importance of the discussion of fiscal stimulus that is kicking into gear among both economists and politicians.

The G8 called but they didn’t leave (much of) a message

On Wednesday, a colleague drew my attention to the fact that the G8 had issued a statement on the global economy from Grand Rapids, Michigan. I quickly glanced at their points and thought they didn’t add much beyond what had been said at various G-numbered, EU-type, and other subgroups over the weekend: we’re doing a lot, things will get better, trust us, etc.

Still, I was impressed that the G8 had got together quickly and, of course, the fact that Russia had joined hands with the G7 (this is how you get to 8) might be significant given the strains currently apparent in Russia and apparently looming elsewhere. So the following morning I opened the Wall Street Journal to learn more about the form of their meeting and background on the context, including any supplementary communication of messages (i.e., any such statement usually comes with spin.)

To my surprise, I found no mention in the Journal that day (sorry if I missed it; let’s say it wasn’t an article the front page, and if it was in the short highlight points, it was in very small print.) I had an opportunity on Friday to ask someone who tracks the White House closely, and he confirmed the statement came after a phone call or series of calls involving President Bush (who was visiting Michigan) and generally was not much of a news event.

Now, I wouldn’t want to make too much out of this particular incident. And I do think that, overall, policymakers at the G7 level and their close colleagues elsewhere have had a better week. But I do begin to wonder if people are relying on G7-G8 stewardship of the global economy as they have in the past.

And rule #4 in the crisis manager’s handbook is quite clear: when you have nothing to say, say nothing.

Sentiment

I’ve spent quite a bit of time over the past week talking with people caught up in the financial crisis, one way or another. Some of these people are deeply involved in finance, while others are quite far from finance but now see many more connections that they previously realized.

Three thoughts keep reappearing in these conversations:

1) People’s expectations have definitely been shaken up. For some it was the original Paulson proposal ($700bn to be used at his discretion), coming only days after he and Mr. Bernanke said that the economy was “fundamentally” fine – by which they meant we would dodge a recession. For others it was President Bush’s first speech on the subject, in which he said that if Congress did not pass the relevant legislation (now called the TARP), there would be very bad consequences. And for others it was the dramatic sequence of events last weekend, from the meeting of the G7 to the abrupt U-turn on bank recapitalization, first by the Europeans and then by the US. In any case, pretty much everyone I’ve talked now understands that we are no longer facing “business as usual”.

2) At the same time, there is still great confusion about what is going on, precisely why, and what are the options going forward. I think this confusion is quite general, and I regard myself as no exception. In fact, as one of my colleagues at the Peterson Institute for International Economics wisely noted last week, “if someone says they are not confused by the current situation, they are not leveling with you.” As a result, we start to think about changing things we do, but it is reasonable to hesitate before taking real action. I was asked earlier this week (for a weekend show produced by Marketplace, which will air on Saturday) what I am doing differently, compared with a month or a year ago. The answer is nothing much, at least in terms of investment or spending, at least for now.

3) And it’s the “at least for now” part that is worrying. Obviously the “authorities” (jargon for the people who run the country) in G7 and other industrialized countries woke up to the true situation about 5 or 6 days ago, and they took what is – for them – dramatic action. I have never seen them move so far so fast, and we have tried to recognize and applaud those moves at every opportunity. But now we wait, holding our breath, to see the effect on confidence. I look at the US and European stock markets, as does everyone else, and my mood swings with it. But I also look at what is happening in credit markets, particularly in emerging markets. This does not look encouraging. I think it is time to work seriously on measures that will reduce the costs of and speed the recovery from what appears to be a serious imminent global recession. This is now our priority; to help, please post your ideas as comments here.

Can We Afford the Bailout?

Even the most casual observer will have realized that the U.S. government is laying out a lot of money to combat the financial crisis. Which raises the obvious question: can we afford it?

The first important thing to keep in mind is that the U.S. government, unlike every other government in the world, has the ability to borrow virtually unlimited amounts of money. The U.S. dollar is still the world’s reserve currency, and Treasury bonds are still the risk-free asset of the global economy. In times of crisis, when smaller countries find it harder to raise money, the U.S. actually finds it easier, because investors are ditching whatever risky assets they are holding and buying U.S. Treasury bills and bonds instead. Currently, the U.S. is paying virtually no interest on short-term borrowing (and probably negative interest in real terms).

Continue reading “Can We Afford the Bailout?” →

Credit Crunch Easing?

There is some evidence that the mood in the financial sector is very cautiously optimistic. The TED Spread is down 18 basis points to 3.89%, from a high of 4.64% a week ago. (This is 3-month LIBOR minus 3-month T-bills, and hence a measure of banks’ willingness to lend to each other rather than to the U.S. government.) Still, it may take weeks for banks to have cash in the places they need it and feel comfortable loaning money again.

The highly informative and frequently updated blog Calculated Risk (link also in our sidebar) is doing a daily post on this and other credit market measures, so if you’re addicted you may want to go there.

True junkies may prefer Across the Curve, which focuses exclusively on credit markets, including some you’ve never heard of.