Authors:

      Ira Kalish

      Director, Global Economics and Consumer Business

      Deloitte Research, a part of Deloitte Services LP

Authors' profile: 

      Ira Kalish is Director, Global Economics and Consumer Business at Deloitte Research. He specializes in global economic issues as well as the effects of economic, demographic, and social trends on the global retailing and consumer products industries. Mr. Kalish conducts research on global economic issues and has authored in-depth reports on economic and consumer issues in many of the world’s major countries. In addition, Mr. Kalish has been widely quoted in the news media. His remarks have been published by The Wall Street Journal, Business Week, The Economist, The Financial Times, and USA Today to name a few. Mr. Kalish holds a bachelor’s degree in economics from Vassar College and a Ph.D. in international economics from Johns Hopkins University.

The medium-term direction of the global economy will be set largely by two countries: China and the US. Together, these behemoths account for a sizable share of global economic growth, and especially import growth – thereby stimulating exports and economic growth in the rest of the world. Hence, how they perform matters. Moreover, the financial imbalance between these two countries has already had serious consequences for growth, exchange rates, and interest rate. More may follow. Currently, the global economy is undergoing a transition from one era of economic expansion to another. The transition itself was brought on by the bursting of a bubble in the US housing market. Yet bubbles don’t emerge at random. They usually have a cause in the form of an economic event. In this case, the event was the huge flow of liquidity from China to the US. And, of course, bubbles always eventually burst.

Setting the stage

In the past decade, there has been a massive flow of funds from China to the US. Why? The answer is that China and other Asian nations save a larger share of their output than they invest, while the US invests more than it saves. The result is that Asia, principally China, sends it excess savings to the US. For many years this has been a win-win situation for both countries.1 For China, funding America’s external deficit has enabled the US to cheaply import Chinese exports. This, in turn, has kept millions of Chinese workers employed producing exportable goods.

For the US, importing China’s savings has enabled the country to enjoy a high level of borrowing without high borrowing costs. This is party due to the fact that China’s government has directly funded the US external deficit through currency intervention. That is, in order to hold down the value of the Chinese currency and keep exports cheap, the Chinese government has purchased dollars and held them in the form of US Treasury securities. This intervention, along with similar intervention by other countries with large surpluses, has funded a large share of the US external deficit. The result is that China’s government has amassed a huge stock of foreign currency reserves – now in excess of US$1.4 trillion. For the US government, being able to fund budget deficits by selling bonds to a foreign government has held down long-term interest rates.

Yet there is no such thing as a free lunch. The US now has a very large external deficit that may not be sustainable in the long-term. Unwinding that imbalance could ultimately be painful. China, in the course of purchasing dollars by printing its own money, has caused a rapid expansion of its money supply with resulting increases in inflation. Indeed the inflation rate has risen from less than zero four years ago to more than 6% today.

Moreover, the massive flow of capital from China to the US has had some unanticipated effects as well. That flow, by contributing to low US interest rates and excess liquidity, caused US investors to seek new outlets in order to achieve higher returns. In the past few years, equity markets were not as attractive as in the past due to the aftermath of scandals, new regulations, and the unwinding of the technology stock bubble. Instead, investors looked to property. In a growing economy with low interest rates, it is reasonable to expect that home prices would rise. And indeed they rose. Yet something more happened. As home prices rose, people started to expect prices to rise further. They started to pay prices unrelated to the expected return from renting out the homes. Instead, people paid prices related to their expectation that prices would rise further. A speculative bubble took hold.

For the property market, this turned out to be a problem. In 2005-06, mortgage lenders dramatically increased their origination of sub-prime mortgages – those offered to consumers with low incomes and poor credit histories. Banks sold these mortgages to other institutions that repackaged them into securities that were then sold to investors, the latter being enticed by the high potential return on such securities. Often, consumers were enticed to take on such mortgages with low, teaser rates for the first few months. Then the mortgage would revert to a market interest rate2. While rates were low and home prices were rising, this was not a problem. Yet when interest rates rose and home prices stalled, holders of sub-prime mortgages started to default in large numbers.

In the past, when homeowners ran into trouble, the banks that originated their mortgages wound up in trouble. Indeed as recently as 1980 only 10% of US mortgages were securitized compared to 56% in 2006. Today, we face a situation where many of those sub-prime mortgages have been re-packaged, securitized, and sold to the secondary market where they have quickly disappeared – only to reappear in unexpected places when trouble developed. And that is how the credit crunch began.

Credit crunch

Starting in the autumn of 2007, the world found itself in the midst of a panic of sorts emanating from problems in the US sub-prime mortgage market. The good news is that, unlike in the past, there are clever and powerful central banks that have the capacity to add liquidity to the financial system. Still, even when they inject liquidity, they cannot erase losses nor can they erase risk. Thus, there can still be consequences from financial failure. Such consequences are being experienced today and will probably persist for a while.

In the past, problems in the credit market were reflected in the solvency of banks. In the last two decades, however, securitization was supposed to reduce the likelihood of problems in financial markets by dispersing risk. And while risk was dispersed, it was not reduced. Instead, a new kind of risk has been created. That is, there is some uncertainty as to the location of risky assets. This lack of information or lack of transparency has contributed to the seizing up of credit markets. Moreover, much of the risk turns out to reside with banks, often through off balance sheet vehicles. The difference now is that we often don’t know where that risk resides until trouble emerges.

Several aspects of the financial environment contributed to this crisis. First, some mortgage originators did not undertake careful due diligence. Second, they had a strong incentive to lend to risky borrowers as investors, seeking high returns, were eager to purchase securities backed by sub-prime mortgages. Third, securitization has taken on new dimensions with the development of exotic derivative financial instruments for which there is not a substantial liquid market. The lack of liquidity meant that, when trouble emerged, these assets could not easily be dumped. Nor could they be easily priced.

What happens next?

As of November 2007, there is a high degree of uncertainty about the length and depth of the credit crunch. Thus, it is difficult to offer a short-term forecast. Instead, this article will focus on the medium term outlook. The important question is how global growth will be affected by the turmoil in financial markets.

First, since the turmoil began, there has been a substantial re-pricing of risk. This is probably a good thing as markets had likely become sanguine about risk. Still, you can have too much of a good thing, and that is certainly the case now. Spreads on asset backed securities have widened and the markets for commercial paper, high yield bonds, and interbank lending have been dramatically squeezed. Major banks have written off sizable losses thereby adding to a constriction of credit. While the asset market that started this crisis was located in the United States, the impact has been trans-Atlantic. This is true, in part, because the assets in question were sold into a global market, mostly into Europe. Banks in Europe have experienced losses and credit conditions there have been negatively affected.

At the very least, the crisis will probably have a negative impact on US and, to a lesser extent, European growth during 2008. While numerous scenarios can be suggested, the most likely in our view is for either a moderate slowdown or mild recession in the US, moderate slowdown in Europe, and not much impact in Asia. Some countries that depend heavily on exports to the US will suffer accordingly. Latin America, in particular, falls into this category.

What are some alternative scenarios?

The possibility exists that the crisis could become larger or more prolonged due to economic contagion. That is, asset markets unrelated to the market for mortgage backed securities could suffer a loss of liquidity as credit markets seize up and as investors shun risk and seek safety. There is a long history of such contagion – although not all contagions have led to economic slowdowns. Contagion is not necessarily a result of rational assessment of risk, but it happens nonetheless and can have serious consequences.

Another possibility is that the crisis will be prolonged by a failure to restore transparency, liquidity, and credibility to financial markets. This happened in Japan following the bursting of its financial bubble in 1990. The Japanese central bank failed to provide adequate liquidity and the Japanese government failed to adequately assist banks in cleaning up their balance sheets. The result was an unusually long period of stagnant growth and deflation. This scenario seems unlikely given the quick early responses by various central banks to the current crisis.

Finally, there remains the possibility that the current turmoil will not have much of an impact on the global economy at all. There is historical precedence for this. Recall the US equity market crash in 1987. The US Federal Reserve immediately pumped liquidity into the system and the economy probably grew faster than would otherwise have been the case. Now, following the credit crunch that began in August 2007, the Fed has reversed course by increasing liquidity and lowering interest rates – something that might not otherwise have happened so soon. The end result could actually be no change in growth with only the financial sector taking a hit.

Thinking about the long-term

Today, there is fear that, after a period of unusually strong global growth, the recent financial problems could augur a new era of slower growth. Is this possible? Yes. Is it likely? No. Barring radical changes in policies, it is reasonable to expect that long-term global growth will not change radically either. On the other hand, long-term growth could change in some countries. Consider the following possibilities:

China Due to a slower birth rate over the past two decades, the labor force will grow more slowly in coming years. Absent acceleration in the growth of productivity, this could lead to a slowdown in economic growth. On the other hand, privatization of the financial system will lead to more productive business investments. A better return on investment could lead to accelerated growth.

USA A new era of rising commodity prices combined with a declining dollar could drive the Federal Reserve to maintain tighter monetary policy in order to restrain inflation. This could mean somewhat slower long-term growth.

European Union Reforms that liberalize the labor market in major countries could lead to expanded employment as well as more efficient deployment of labor. The result could be a temporary acceleration in economic growth.