Against the tide: There’s more crunch to come


David Roche
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The effects of the sub-prime crisis are spreading and could cost 2.5% of world GDP. Emerging market economies will not be immune.

We are in a bear market for risk assets. Numerous hits to the financial sector are still to come that will keep global liquidity shrinking and asset prices under pressure.

Central bank actions have been successful in normalizing inter-bank rates and Federal Reserve chairman Ben Bernanke will make more interest rate cuts. Also, the US administration has introduced a large fiscal policy boost. But the credit crunch is not over and it will continue to weaken the real economy and the balance sheets of the financial sector.

Losses in the financial sector from the sub-prime crisis have reached $150 billion. Many US financial institutions have had to recapitalize themselves through funding from strategic investors (turning to the foreign sovereign wealth funds), cutting dividends, undertaking share buybacks and cutting the workforce.

But there is still much further to go. Although Libor spreads have narrowed, the crunch in the rest of the credit markets has intensified, as measured by the yield spreads for corporate debt over government paper and by the spreads for the cost of getting protection against debt defaults in the credit derivatives markets.

The final bill to the global financial sector from the sub-prime crisis and its spread into prime mortgage, consumer and corporate debt markets could reach $1.3 trillion, or 2.5% of world GDP, depending on how far residential property prices slump and how deep is the ensuing economic downturn.


Pessimism has finally moved to equity markets. Up to last November, they were in denial. Credit markets had been expressing the crisis in their prices, with a shift to safe-haven government paper, with US 10-year treasury yields and equivalent European bond yields dropping to just above their post-war lows.

But equity investors continued to hope that the credit crunch would not affect the real economy. Or, if it showed signs of doing so, the Fed would come flying to the rescue with substantial interest rate cuts. Now, though, the flow of economic news has dented that optimism. Equity markets had their worst start to a year for 30 years.

Losses from the credit crisis

To date, in $billions

Source: Independent Strategy

The financial crisis will damage the real economy because it will mean a sharp contraction in global liquidity (made up of bank lending, securitized debt and derivatives).

Banks in Europe and the US have tightened lending standards, particularly for real estate loans. As corporate defaults rise in a slowing global economy, lending to households and businesses will decline. In economic recessions, the banks always rein in lending.

Securitized debt issuance has fallen sharply. And global recession will mean more pain for the sellers of credit protection. Defaults on corporate bonds now threaten to bankrupt monoline insurers. The losses from the credit derivatives and insurance markets could be as big as the whole of the sub-prime crisis again.

A global housing slump and the sub-prime mess will drive down economic growth in the OECD in 2008-09. The US housing market slump is by no means over. House prices are down by about 6% from their peak so far. Also, the housing slump has spread to Europe. In the UK, a survey of surveyors and estate agents was at its most pessimistic since the last housing bust in the early 1990s. In continental Europe, house price growth is dropping fast, in many places towards negative territory.

Will emerging economies decouple from the OECD? This remains the lingering hope of investors. Although corporate debt (especially high-yield paper) has slumped and developed equity markets have started to falter, emerging market debt spreads remain well below average levels, even if they have risen from the lows of early last year.

Hopes dashed

But this is the year in which emerging markets hopes will get dashed. First, despite the improvement in economic fundamentals since the last crisis in 1998, many emerging economies are still vulnerable to a credit crunch and a global slowdown (Turkey – foreign indebtedness; central and eastern Europe – huge trade deficits and a worsening real estate market; Russia, Kazakhstan and Korea – overstretched banks).

Second, many emerging economies have done well on the back of rocketing commodity prices (oil, metals and food). With a recession in the OECD, demand for these commodities will drop and Chinese demand will be no offset. The Brics will drop in a way that their name implies.

David Rocheis president of Independent Strategy Ltd, a London-based research firm.