Volatility and the global economy
It has been a remarkable few weeks. Emergency liquidity injections by the European Central Bank. Rate cuts from the Federal Reserve. The near-collapse of Northern Rock with accompanying (genial) panic on the streets. And the unwinding of a...
It has been a remarkable few weeks. Emergency liquidity injections by the European Central Bank. Rate cuts from the Federal Reserve. The near-collapse of Northern Rock with accompanying (genial) panic on the streets. And the unwinding of a strongly-held consensus that the world suffered from too much growth, too much liquidity and too much inflation.
At the heart of the problem has been a period of excessive lending triggered by three key factors:
• overly-low US interest rates earlier in the decade;
• a "hunt for yield" triggered by unusually low yields on government paper; and
• financial innovation associated with the growth of structured products.
All told, these three factors led to a deterioration in lending standards which contributed to the boom in US housing earlier in the decade. As the latest crisis has unfolded, it has been discovered that those most exposed have not been the borrowers but rather the lenders who were not sufficiently protected from a systemic deterioration in the sub-prime market.
Analysing the impact of this shock is not easy. It is so geographically diverse. Those at risk are not only those with significant sub-prime exposure (for example Northern Rock).
There are two important themes. First, as the perception of sub-prime elephant traps has grown, so fear and loathing have grown within money markets. Elevated money market spreads suggest banks simply do not trust each other, leaving them to stuff their "excess liquidity" under the mattress. Second, even if money market conditions eventually improve, lenders will have to think again about their willingness to extend credit to often unknown borrowers, given the effects of securitisation.
It is the second issue which is likely to have the bigger impact on economic developments heading into 2008. In the best of all worlds, rate cuts will lead to a return of buoyant liquidity conditions through Long Term Capital Management (LTCM).
While the LTCM story is a source of comfort, there is worry that it does not quite capture the nature of current difficulties. LTCM proved to be a singular elephant trap which, once avoided, allowed the bull-market journey to continue. The diffuse nature of the current problems complicates matters. Most obviously, the scale and timing of any tightening of credit conditions within the private sector remains, at this stage, unclear.
A more plausible scenario might be associated with improved sentiment towards the end of the year as money market spreads narrow, followed by a more gloomy assessment in the first half of 2008 as lending attitudes begin to seize up. Certainly, it is doubtful that homeowners will quite so easily be able to get hold of 120 per cent loan to value mortgages, or mortgages at eight times annual salary, or self-certification mortgages. As a result, the current malaise in the US housing market may intensify, with the focus shifting from volume to price declines.
The eurozone might seem to be immune from these developments - plenty of banks have got themselves caught up in the sub-prime crisis but housing market overheating is restricted to Spain, Ireland and, possibly, France - but, even for the European Central Bank (ECB), there are risks. To date, the eurozone economy has been supported by strong export growth, primarily to emerging markets.
However, should both the US and UK economies slow down, one-third of eurozone exports would be under threat, a factor that may eventually weigh on the ECB. It would be wrong, though, to characterise the world economy as a whole in such a way. While growth fears are building in the industrialised world, the almost-universal theme across emerging markets is excessive inflationary pressures. Ironically, any US slowdown is likely to make matters worse. The key issue is the link between US monetary policy and emerging market monetary conditions. Already, there are plenty of signs of emerging markets overheating - from strong equity price gains to clearly-rising inflation. To bring these excesses under control, emerging economies will need to tighten monetary policy.
However, because in many cases their currency regimes are linked to the US dollar, they will not be able to do so, unless they allow their currencies to appreciate strongly. Moreover, if the US Federal Reserve cuts interest rates, emerging markets will find monetary tightening even more difficult to pull off.
This arrangement is a considerable source of instability for two reasons. First, any hint that emerging markets might jettison their currency links with the US dollar could leave America's currency imploding.
Second, should emerging markets choose not to revalue or float, they are likely to contribute to higher global inflationary pressures. Strong domestic demand will encourage commodity price gains which, in turn, will leave imported inflation higher in the US and Europe than might otherwise have been the case.
• This report was compiled by Peter Calleya, Manager Corporate Strategy & Research, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
At the heart of the problem has been a period of excessive lending triggered by three key factors:
• overly-low US interest rates earlier in the decade;
• a "hunt for yield" triggered by unusually low yields on government paper; and
• financial innovation associated with the growth of structured products.
All told, these three factors led to a deterioration in lending standards which contributed to the boom in US housing earlier in the decade. As the latest crisis has unfolded, it has been discovered that those most exposed have not been the borrowers but rather the lenders who were not sufficiently protected from a systemic deterioration in the sub-prime market.
Analysing the impact of this shock is not easy. It is so geographically diverse. Those at risk are not only those with significant sub-prime exposure (for example Northern Rock).
There are two important themes. First, as the perception of sub-prime elephant traps has grown, so fear and loathing have grown within money markets. Elevated money market spreads suggest banks simply do not trust each other, leaving them to stuff their "excess liquidity" under the mattress. Second, even if money market conditions eventually improve, lenders will have to think again about their willingness to extend credit to often unknown borrowers, given the effects of securitisation.
It is the second issue which is likely to have the bigger impact on economic developments heading into 2008. In the best of all worlds, rate cuts will lead to a return of buoyant liquidity conditions through Long Term Capital Management (LTCM).
While the LTCM story is a source of comfort, there is worry that it does not quite capture the nature of current difficulties. LTCM proved to be a singular elephant trap which, once avoided, allowed the bull-market journey to continue. The diffuse nature of the current problems complicates matters. Most obviously, the scale and timing of any tightening of credit conditions within the private sector remains, at this stage, unclear.
A more plausible scenario might be associated with improved sentiment towards the end of the year as money market spreads narrow, followed by a more gloomy assessment in the first half of 2008 as lending attitudes begin to seize up. Certainly, it is doubtful that homeowners will quite so easily be able to get hold of 120 per cent loan to value mortgages, or mortgages at eight times annual salary, or self-certification mortgages. As a result, the current malaise in the US housing market may intensify, with the focus shifting from volume to price declines.
The eurozone might seem to be immune from these developments - plenty of banks have got themselves caught up in the sub-prime crisis but housing market overheating is restricted to Spain, Ireland and, possibly, France - but, even for the European Central Bank (ECB), there are risks. To date, the eurozone economy has been supported by strong export growth, primarily to emerging markets.
However, should both the US and UK economies slow down, one-third of eurozone exports would be under threat, a factor that may eventually weigh on the ECB. It would be wrong, though, to characterise the world economy as a whole in such a way. While growth fears are building in the industrialised world, the almost-universal theme across emerging markets is excessive inflationary pressures. Ironically, any US slowdown is likely to make matters worse. The key issue is the link between US monetary policy and emerging market monetary conditions. Already, there are plenty of signs of emerging markets overheating - from strong equity price gains to clearly-rising inflation. To bring these excesses under control, emerging economies will need to tighten monetary policy.
However, because in many cases their currency regimes are linked to the US dollar, they will not be able to do so, unless they allow their currencies to appreciate strongly. Moreover, if the US Federal Reserve cuts interest rates, emerging markets will find monetary tightening even more difficult to pull off.
This arrangement is a considerable source of instability for two reasons. First, any hint that emerging markets might jettison their currency links with the US dollar could leave America's currency imploding.
Second, should emerging markets choose not to revalue or float, they are likely to contribute to higher global inflationary pressures. Strong domestic demand will encourage commodity price gains which, in turn, will leave imported inflation higher in the US and Europe than might otherwise have been the case.
• This report was compiled by Peter Calleya, Manager Corporate Strategy & Research, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.