After the Bank of England’s bold and decisive cut by 1.5% to a historic interest rate of 3% on 6 November, the FTSE 100 index went down in response by 2.7% across Europe. The single interest rate cut three times larger than any since the Bank became independent in 1997 to the lowest rate in 53 years failed to re-energize an anaemic market. Household names of giant businesses on both sides of the Atlantic including General Motors and Siemens continue to report gloom and doom. The UK unemployment registers over 1.8 million and rising, expected to hit 2.7 million by 2010. The US unemployment rate has jumped to 8%. Many pension funds are in peril. Confidence is so low that albeit welcome, the dramatic rate cut is viewed by some as an act of desperation. It is evident that making debt more bearable by lowering interest rates alone will not be sufficient to restore the world’s financial system back to health. Even with improved liquidity at their disposal, the shell-shocked banks are too wary of lending to bring the world’s capital markets back to life.
Lawrence Summers, leading Harvard economist, former Treasury secretary and now a member of the Obama transition team, has written earlier in the Financial Times (8 August, 2008) that ‘there can be no basis for confidence that the American economy will recover even in the medium term’ unless vigorous action is taken to address the mutually-feeding vicious circles of falling asset prices, de-leveraging, unemployment and depressed consumption. George Soros has also expounded his ‘Theory of Reflexivity’ whereby self-reinforcing negative spirals could lead to a long and painful process of de-leveraging, threatening to end in a flight from the Dollar and the demise of US economic dominance (The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, PublicAffairs, 2008).
So it is no surprise that governments are turning to far more robust stimulus packages to restore confidence and revive the economy. UK Prime Minister Gordon Brown has signaled that he will cut VAT and rely on government borrowing to spend his way out of the recession. Turning from the audacity of hope to the urgency of now, the Obama team has lost no time in revealing the President Elect’s intention to go for broke in a Big Bang stimulus package of tax-cuts for the middle-class and public investments in healthcare, education, green energy and infrastructure. In the West, especially the UK, more interest rate cuts are on the cards. It is also likely that more and more countries have to come up with stimulus packages of various sizes and dimensions to save themselves from the brink. Wall Street should also welcome the US Treasury’s good sense of not throwing good money after bad in a U-turn of using the $700 billion bailout to re-capitalize the banks instead of buying up the ‘toxic waste’ of problematic derivatives.
Ahead of the G20 meeting on 15 November in Washington DC, China’s State Council was right on cue in announcing a US$586 billion stimulus package over two years. The initiative is hailed by Gordon Brown as the kind of vigorous government intervention the West should follow in addressing an unprecedented global economic emergency. There is some doubt about the real increase in this package as it may include projects already in the pipeline and some expenditure may be financed by provincial or private investments. However viewed, it is still a huge, timely, and decisive package with a 10-prong relief for such crucial sectors as protective housing, rural utilities, regional transportation, healthcare and education in deprived areas, ecological infrastructure, earthquake reconstruction, income and pension subsidies for the needy, VAT reform, enterprise innovation and upgrading, and credit facilities for small and medium enterprises. For China it is also designed to boost internal consumption and to prevent growth from falling to below 7% whereby job shortfalls may threaten stability.
China’s stimulus package is supported by her robust finances including a gigantic foreign currency reserve of over $1.9 trillion, growing at a rate of $1.7 billion every single day. But most of the West’s stimulus packages are based on vastly increased public debt. Including the latest $700 billion bailout, the current debt ceiling of the US is estimated at $ 11.3 trillion, over 80% of the GDP. In the UK, public borrowing already exceeds 50% of GDP. Coupled with weak economic performance, these levels of public debt tend to weaken currency exchange rates. Sterling has already been plummeting. There is an increasing tendency to diversify holdings out of the US Dollar. If confidence in the Dollar should buckle, financial crisis would turn into Armageddon.
The current financial crisis is not a repeat of the past. It manifests in the heart of the global financial system affecting sectors and countries not so much in the developing but in the developed world, which is now buried in mountains of debt. A great deal of this has been breathtakingly leveraged off the balance sheet to generate huge banking profits or to finance private consumerism on an illusion of ever increasing property prices overall. This debt includes the slicing up of derivatives like CDOs (collateralized debt obligations) three times over, Alt-A (or ‘liar’) mortgage loans, and CDSs (credit default swaps). Much still remains to be swept out under the carpet. In the US, there is more household mortgage debt in the last six years than the sum total of what went before in the entire life of the mortgage market. CDSs alone are estimated to involve a notional exposure of $55 trillion, larger than the global economy of $50 trillion. 40% of the estimated 7 million subprime loans are expected to default in the next two years.
Asia’s economies and traditional cultures do not favour household debt. China’s, for example, stands at only 14% of GDP, compared with 140% in the US and 180% in the UK. Combined with the non-convertibility of the RMB (the Chinese yuan), China’s more stringent macroeconomic, banking and exchange controls, and a relative lack of penchant to pursue innovative market fundamentalism in the form of unbridled leveraged derivatives, have managed to shield her from much of the financial and banking excesses underlining the current financial crisis (though not from the global economic slowdown). There is a more or less similar tale amongst many of Asia’s economies.
To restore confidence in the world’s financial system, the G20 countries will need to vigorously address some of burning issues highlighted by the current financial crisis –
(a) a better code of conduct for banks and financial institutions, including how best to regulate leveraged derivatives, mortgage-backed securitization, short-selling, mark-to-market practices in a free-falling market, consumer indebtedness ('responsible consumerism') and the role of rating agencies;
(b) a more stable global financial system with better coordination to minimize financial instability and exchange rate volatility;
(c) mechanisms to reduce the global mismatch between excessive consumption and excessive savings;
(d) a sensible set of guidelines and safeguards to facilitate mutually beneficial investments by sovereign wealth funds;
(e) a better role of the state in market capitalism, not least because many emerging markets, China included, are encouraged to avoid state intervention; and
(f) revamping the old-styled Bretton Woods institutions of the International Monetary Fund (IMF) and the World Bank to ensure a more stable international financial architecture, including a greater say for the so-called CRIMB countries (China, Russia, India, Middle East and Brazil) commensurate with their greater responsibilities.
There is much wisdom in caution and much room for negotiations in devising an effective international framework that will last. The task is urgent but is too important for a quick fix.
There is, however, one area where the world should hasten the steps. The financial crisis has triggered a global slowdown of epic proportions since the Great Depression. Still, as explained earlier, China and some developing economies are relatively less traumatized. While they may not be able to turn around the global economic slow-down, they could at least act as a cushion. They may also be able to play a part in an international antidote helping to nurse the global economy back to health. In this regard, there is no antidote more potent, more pressing, and more extensive in international reach than an early revival and agreement of the protracted and now-moribund Doha Round. This will bring both developed and developing countries together to launch a new era of world trade in the spirit of multilateralism. It will be also seen as a timely breakthrough of sunshine through the looming dark clouds of a global recession.
China and the rest of the emerging markets notwithstanding, the US is still by far the world’s largest economy. The election of Obama as the next President is getting the world excited in the grips of a global financial crisis and economic slow-down. Countries are eagerly awaiting a new kind of leadership in a world of multilateral inter-dependence. He should now seize this historic moment.
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