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An Asian view of the global financial crisis

By Andrew Sheng (chinadaily.com.cn)
Updated: 2008-11-14 19:56

Special Coverage Exclusive: An Asian view of the global financial crisis

Contents:  Preface  A historical inflexion point  The macro question  The micro origins  Lessons for China and Asia  Back to basics  One world, three paths  Status quo  The rise of regional markets  Romance of the three regions  Conclusion

Preface

Future historians will compare the 2008 Great Global Credit Crisis with the 1930s Great Depression, which set in motion the Second World War and changed the financial landscape for nearly 80 years.

Similarly, the present crisis is likely to witness major changes in economic theory, philosophical outlook and in institutional structure. This essay explores the present crisis from the perspective of Asia.

History always goes full circle, although not in the same manner. An interesting comparison with the Great Depression is the failure of the current neo-classical economic theory, which in the 1920s advocated balanced budgets and minimal government intervention.

Arising from this free market philosophy, the US and several European countries went back to the Gold Standard that pushed them further into deflation. It was this failure of theory that gave the impetus for Keynesian economics, under which governments can use fiscal policy to stimulate growth when monetary policy could not revive confidence if interest rates were already near zero.

Structurally, the bank failures that followed the Depression also gave rise to the Glass-Steagall Act, which separated banking from the securities business.

Just like the Roaring 1920s, it was the long period of prosperity in the early years of 2000 that gave rise to the excesses of 2007/2008. Western economists, led by Fed Chairman Ben Bernanke, blamed the Savings Glut in East Asia for the excessive low interest rates and high liquidity that provided conditions for the deterioration in credit quality.

Those who look at the global situation more objectively would realize that there is a major demographic difference between the surplus and the deficit economies. The surplus economies have younger population, which are still building up their savings to prepare for old age and long-term social security.

These emerging markets benefited from the spread of technology and better corporate and fiscal governance that raised corporate and government savings in addition to the higher household savings. On the other hand, the deficit economies in the West have aging populations already enjoying high standards of living, whilst their fiscal positions were deteriorating due to the continual pressure to cut taxes and increase social spending.

Their higher corporate savings were not sufficient to compensate for the large deficits that gave rise to the Global Imbalance. In 2007, it was estimated that the US had to import about US$1 trillion foreign capital annually to finance its deficits or roughly $4 billion per working day.

Clearly this deficit was unsustainable. But no one expected that over two years between June 2004 to June 2006, the 17 step increases in Fed Fund rates of 425 basis points by the Fed from the low of 1 percent to a peak of 5.25 percent would lead not only to a decline in property prices, but also a near collapse of the US and European banking systems.

In February 2007, when the subprime mortgage loan problems surfaced, everyone thought that since the outstanding amount was only $757 billion, of which losses were estimated at $150 billion or roughly 1 percent of US GDP, the matter was manageable. No one realized that it was the tip of the iceberg.

In the one month since the failure of Lehman Brothers on 15 September 2008, the world's banking system nearly collapsed like a domino, with stock markets seeing almost meltdown.

Banks in the US and Europe were partly nationalized and investment banks disappeared as a separate unit in the US. An estimated $27 trillion or over 40 percent was wiped from global stock markets in the year to October 15. On October 10, the Dow Jones Index hit an intra-day low of 7,773.71, just under half of its peak a year ago.

The Bank of England has estimated that the mark-to-market losses in bond and credit securities would be in the region of $2.8 trillion, double what the IMF predicted at $1.4 trillion. This was equivalent to 85 percent of global bank's tier 1 capital of $3.4 trillion.

Furthermore, between April to October 2008, various central banks and governments had provided implicitly or explicitly $8 trillion of funding for their wholesale markets to prevent total seizure. At the same time, the Fed cut the Fed Fund rate by 100 basis points in 2007 and another 325 basis points back to 1 percent per annum by 29 October 2008.

There is a striking parallel between the present US interest rate policy and the way Bank of Japan dealt with the 1990 Japanese bubble crisis, except that the US arrived at almost zero interest rate policy much faster.

Although subprime problems originated in the US, their impact spread far wider, because European banks shared nearly half of the losses. The sharp retrenchment in interbank lending was however a global affair, spreading to emerging markets like a tsunami.

The Mexican peso and Brazilian real had to be defended against sharp depreciation and Indonesia closed its stock market for 3 days. Hong Kong and Singapore faced investor protests against the default of Lehman mini-bonds.

A number of countries had to fully guarantee their bank deposits. Oil prices collapsed back to just over $60 compared with $146 per barrel in July 2008. From an institution that six months ago faced almost no new lending, the IMF suddenly found itself once again lending to Iceland ($2.1 billion), Hungary (€12.5 billion), Ukraine ($16.5 billion) and credit negotiations with Belarus and Pakistan.

As commodity prices collapsed around the world and various emerging markets got into payment problems, the IMF created a short-term lending facility amounting to $100 billion.

The complexity of the 2007/8 crisis is such that we need to examine the current credit crisis from at least three perspectives – that of history, macro and micro-economic conditions.

Based on these perspectives, this essay looks at three possible scenarios (rather than predictions) where China and East Asia could position themselves in the next decade. In essence, since success of economies hinges on governance, it is the quality of Chinese and Asian governance that will be severely tested in the coming years.

To be continued...

The author is chief advisor with the China Banking Regulatory Commission and former chairman of the Hong Kong Securities and Futures Commission.