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A reader for Global Business Context Jan 2010

(The web link is at the start of each article) Everything you want to know about the bank crisis Iain Macwhirter Published 01 May 2008 As the financial crisis enters what the governor of the Bank of England has called a "new and dangerous phase" Iain Macwhirter has been looking at the big questions How bad is it? This is the worst financial crisis in 60 years, and it has shaken the banking system to its foundations. Even the Chancellor, Alistair Darling, has compared the crisis to the Great Depression and he is not given to overstatement. Banks are in the business of lending money they don't have - it is called "fractional reserve banking". But every so often the banks succumb to irrational exuberance, lend too much and find their reserves have been eaten up too fast, forcing them out of business. This is what happened to Northern Rock, and is now happening to all the big banks. That is why they had to be rescued to the tune of 50bn last month by the Bank of England - ie, us. They will be back for more. Do the banks know what they are doing? Well, they know now. During the house-price bubble, the banks were lending recklessly to people with no prospects. In the US it was called "sub-prime" lending, and amounted to organised fraud. Loans were knowingly given to "Ninjas" - people with "no income, no job or assets" - who could never hope to repay them. Britain too had sub-prime lending. At the peak of the boom UK banks offered "suicide loans" of up to 120 per cent of the value of the house with only self-certification of income. The mortgage holders were in negative equity as soon as they got the keys. These people are in real trouble as mortgage rates rise and house prices fall. Northern Rock lent out roughly 200,000 of these in the two years before it went bust and had to be nationalised. This makes the government the biggest holder of sub-prime mortgages in Britain. How could the banks be so stupid? Partly this was down to the delusion that house prices could only ever go up. But the other reason was a practice called "securitisation". The banks packaged the dodgy loans into interest-bearing bonds and sold these to financial institutions across the world. This took the loans off the banks' balance sheets and allowed them to lend even more money they didn't have. The banks thought, wrongly, that they no longer bore the risk of default on these mortgages because they had been sold on to other people. This was a big mistake. The debts came winging back. Now the entire financial system is in cardiac arrest because banks no longer trust each other. Didn't the regulators see this coming? Regulators such as the Financial Services Authority and the Bank of England were asleep at the wheel. The Treasury, Bank and FSA are run by relatively lowpaid civil servants who are in awe of financiers and their lifestyles. They believed that the banks were run by masters of the universe who knew what they were doing, with their mathematical formulas and leveraged deals. In fact they were run by bonus-greedy wide boys, who gave no thought to the future and had no concept of social responsibility. The City bonus culture encourages shorttermism and risk-taking. It was in these people's interest to pretend the credit boom could go on for ever, and that securitisation had taken the risk out of lending money. They thought they wouldn't be around to clear up the mess. In fact, even when the roof did fall in, those such as Adam Applegarth of Northern Rock still got their pay-offs and bonuses - in his case a "golden goodbye" of 750.000. Shareholders seem unwilling to curb the greed of the new generation of CEOs who run City firms. The regulators don't even try.

Does this affect my savings? The good news is that the banks want your money, so they are putting savings rates up. The bad news is that most of the banks are in effect insolvent and are posting epic losses on their irresponsible lending. Many are in danger of going out of business, but the Bank of England doesn't admit it for fear of causing panic. However, the collapse in the share prices of banks such as Royal Bank of Scotland and Halifax Bank of Scotland tells you all you need to know. The entire banking system of Britain is now on life support from the state and even the Bank of England's reserves are not unlimited. If your bank goes under, only the first 35,000 of your savings are secure under banking laws. The only bank that gives a 100 per cent guarantee of depositors funds is, paradoxically, Northern Rock, which is government-owned. Perhaps the government will nationalise more banks if they go bust. But maybe it won't be able to. Is anywhere safe? At times like these investors reach for so-called "safe havens" - assets that tend to rise as the value of currencies falls and provide a hedge against inflation. Precious metals are the most obvious, which is why gold rose to more than $1,000 (500) an ounce recently, though it has since fallen back. Oil has become a hedge, which is why its price keeps going higher. Many UK pension funds and investment houses are putting money in commodities such as wheat, rice and other foods in the belief that they can only go up and up. Most of us would think that profiting from starvation is morally reprehensible, but the market doesn't do morality. And be warned: commodity prices can go down as well as up. The safest haven is National Savings and Investments indexlinked savings certificates, which everyone should hold. What else can individuals do? There's really no way of heading off the debt nemesis. Britain is even more indebted than the US was at the height of the boom. Personal debt here has risen to 1.4trn, and house prices rose by even more absurd multiples than in the US. British property is overvalued by 30 per cent, according to the International Monetary Fund. This could mean another trillion wiped off the total value of British homes, now worth around 3trn. The only way people can protect themselves is to pay off all their debts, fast. People living in houses larger than they need should consider selling before prices fall. First-time buyers should not under any circumstances be encouraged into the market, even if they can find a mortgage. Avoid discretionary spending, such as those silly sandwiches we buy for lunch, because you will need the cash to pay for higher food prices. In most parts of the country it is a lot cheaper to rent. Joining a car club can save thousands. What is the government doing? The government thought it could jump-start the mortgage market by giving a 50bn bung to the banks in an attempt to reignite the housing boom. It will regret it. It was irresponsible of the Bank of England to accept the banks' dodgy mortgage bonds in exchange for billions in cast-iron Treasury bonds because the banks know that their mortgage bonds are largely worthless, otherwise they would have offloaded them by now themselves. The banks will be back for more as they post more losses. The governor of the Bank of England has made a point of saying there will be no financial cap on the bonds-for-gilts swap. Why is the government bailing out the banks? The default position in the Treasury is that house prices will always go up in the end. It hoped the banks would return to lending to first-time buyers, the housing market would revive and consumers would again be able to use their homes as cash machines. It is not going to happen. Abbey put its rates up even further on the very day the banks left No 10 with 50bn in their back pockets. The banks know that house prices will fall sharply over the next two years and are withdrawing from the home lending business. If we finance the banks, can't we tell them what to do? Gordon Brown should be asking that question! The neoliberal thinking that has dominated the Treasury for the past two decades sees no role for state intervention - except to pay the banks when they get into trouble. It is socialism for the banks; capitalism for the rest of us. Moreover, there is a disturbing overlap between the higher levels of government and the big banks because of the privatisation of aspects of the state through mechanisms such as the PFI/PPP. It is no accident that when Tony Blair left office he walked into the Wall Street bank J P Morgan for a reported salary of 2m for a part-time job.

What about the US Federal Reserve? The Fed was captured by the banks a long time ago, which is why it has pursued reckless policies such as negative interest rates, which benefit Wall Street but not main street. The Federal Reserve became a cheerleader in the creation of the debt society and largely created the house-price bubble that has now burst with spectacular consequences. After the dotcom crash of 2000, the then Fed chairman, Alan Greenspan, held interest rates far too low for too long. The US, like Britain, became a nation of property speculators. Everyone thought that as long as house prices rose, Americans could keep spending, even as middle-class incomes stagnated in the 1990s. Now it has collapsed, Greenspan's successor, Ben Bernanke, has tried to save the banking system by inflating another bubble. But cutting interest rates has not worked. The cost of borrowing has actually increased. What does it mean for the global economy? The global dimension is truly worrying. World trade is still fairly buoyant even as the credit crisis deepens, but no one expects this to last. China and India are still heavily dependent on American consumers buying their cheap TVs and toys. If they buy less, these economies will be put under severe strain. What is most worrying is the stability of the global market in financial deri vatives. The market in these exotic financial instruments is now worth some $500trn - nearly ten times the value of all the companies on the world's stock exchanges. The US investment guru Warren Buffett has called these derivatives "financial weapons of mass destruction". What is to be done? The days of laissez-faire in international finance are over - or should be. The banks have admitted that they cannot be left to regulate themselves and have had to be bailed out by the state in one of the greatest financial rescues in history. The banks have been given free access to public funds in a way that the British manufacturing industry never enjoyed in the Seventies when the UK still made things. The credit crisis has destroyed the intellectual credibility of neoliberalism. This is a turning point in world affairs and in economic and political thinking. The free-market orthodoxies of the past 30 years have crashed and burned. However, change will not happen of its own accord. If the government had the will do to so, it could emulate the policies of President Franklin D Roosevelt in the 1930s and regulate the economy in the national interest. This will mean tackling social inequality, the bonus culture and the lack of accountability in financial services. Instead of just propping up bankrupt banks, the government should be democratising them - mobilising their assets to stimulate the productive economy, repairing infrastructure, researching and developing new markets and refitting the western economies to combat climate change. It does not have to be like this. But without change, we will just go into another cycle of financial boom and bust. Iain Macwhirter is an award-winning political columnist for the Herald British banks may face second credit crunch in the New Year Rising unemployment may prompt new capital raisings Saturday, 27 December 2008 By Mathieu Robbins and Sean Farrell The worsening economic slowdown is increasing fears that Britain's banks will have to raise still more capital next year in a market starved of investors. Investment bankers are preparing for a second round of capital raising by UK lenders on top of the 65bn already declared. Having rebuilt their balance sheets after toxic debt writedowns, the banks face an increasingly dire economic outlook that threatens to take ordinary loan impairments from individuals and businesses to levels not seen since the early 1990s. Under those worst-case conditions, impairment charges at the domestic banks Barclays, Royal Bank of Scotland and the combined Lloyds Banking Group could hit 60bn next year, according to Credit Suisse analysts.

"There could be a second credit crunch for banks, with a whole new round of writedowns late in 2009 as the economy filters back to banks," a senior investment banker said. "They have so far only provisioned for the credit crunch so they will need to undertake a whole new round of capital raising." A trading update earlier this year from HBOS, which will be bought by Lloyds next month, made grim reading for the sector. Impairments from commercial and residential property shot up, and the bank warned of more bad news to come as unemployment, the biggest driver of bad debts, continues to rise. The economy is slowing faster than expected, official figures showed last week, with the key services sector suffering most. The authorities fear a continuing spiral of economic pain as a lack of credit forces businesses and individuals into bankruptcy, triggering further losses for banks and still tighter credit availability. The Governor of the Bank of England has said getting banks lending is the most important task for combating the recession and has not ruled out full nationalisation of the sector. Some industry analysts believe the Government could be forced to move early in the new year to enforce a further capital raising, this time to shore up credit for an economy moving sharply into reverse. But with cash in short supply the banks will struggle to raise the funds. Royal Bank of Scotland's share offer failed last month despite its deep discount, leaving the Government owning almost 58 per cent of Britain's second-biggest bank. Barclays turned to sovereign wealth funds for its recent 7bn capital raising because it did not believe institutional investors had the appetite to provide funds. But sovereign wealth funds are either less willing to provide cash to the sector as the economic downturn spreads to markets like Dubai, India and China, or are determined to extract a high price for their support, as Abu Dhabi and Qatar did with Barclays. The UK authorities have not ruled out taking further stakes in the banks or even full nationalisation. The Government's holdings already include all of Northern Rock and a majority stake in RBS, and it is set to own more than 40 per cent of Lloyds Banking Group. If the state is reluctant to spend more, the banks might have to turn to private equity, which has billions to invest but no access to the leveraged loans it traditionally uses to maximise returns. The banks could try to head off that outcome by encouraging restructurings at businesses struggling to repay their debt, rather than letting them go bankrupt and crystallising losses. This would lead to a slew of debt-for-equity swaps and leave swathes of the economy owned by the banks. "A lot of banks have been looking at debt for equity swaps because new money is harder to come by than equitising a company's historic debt," a leading corporate lawyer said. 'Second credit crunch' close 12:32 | 15.01.09 Banks massive exposure to commercial property is likely to trigger a second credit crunch, corporate finance adviser Close Brothers warned this week. Banks are exposed to around 250bn of UK commercial property debt, of which half needs to be refinanced in the next four years. Close believes the scale of the issue has not been appreciated and is likely to trigger further writedowns and, when combined with the impact of a worsening wider economy, a second credit crunch in due course. Based on the assumptions of an average 70% loan-to-value ratio and a 50% peak-to-trough drop in property values, Close expects there to be 140bn of total unrealised losses on commercial property, split equally between debt and equity.

The commercial property world has not seen a significant downturn since the early 1990s, when the financing structures deployed were much simpler and less aggressive, said Gareth Davies, managing director in Closes European restructuring and debt advisory group. Banks adopted a strategy of selling assets into a distressed market. However, this caused a death spiral with ever-decreasing prices. Therefore, alternative solutions to restructure the indebted sector are required this time around for example, debt conversions, new third-party investment or partial asset sales. There will be significant risk and difficulty in implementing a consensual funding strategy between the multiple stakeholders in these complex structures. For instance, there will be many differing agendas to align. In addition to enhancing the risk of a restructuring or refinancing failing, secondary market investors will take advantage by acquiring ransom strips with the aim of exploiting their nuisance value to be refinanced or bought out at a profit, further amplifying the problem. Brace yourselves for Credit Crunch II . . . its coming, and is the fault of US private equity firms, Josh Kosman, author of an alarming book, tells Phil Thornton (The Times) Over-leveraged, over-ambitious and over here. The American private equity firms who stormed into the UK to buy up a range of British companies from pubs to retailers have left behind a mountain of corporate debt that threatens to trigger a second credit crunch, which in turn will leave hundreds of thousands of people out of work. According to a book published this week, half of all private equity-owned companies on both sides of the Atlantic are likely to collapse between now and 2015. It could lead to nearly two million people losing their jobs in the United States and perhaps 300,000 in the UK. The core of the problem is debt. Private equity firms, both United States-based and home-grown, often snapped up their targets by putting up a minority of the purchase price and funding the balance with debt. Rather than assume the debt, they saddled their new subsidiaries with the liabilities. The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis warns that ten years of private equity deals generated more than $1 trillion (607 billion) in new debt, the balance of which will come due just when these businesses are least likely to be able to pay it off. Despite its title, Josh Kosman, the books author, says that the threat is as great if not greater in Britain as it is in the US. The market became so saturated that, unfortunately, I think the effects there could be worse than in the US, he told The Times. In the UK the impact is going to be huge; indeed, it is already becoming a problem. This month Linpac, a Birmingham-based maker of plastic packaging for McDonalds and Tesco, became the latest private equity-owned company to hit the buffers. Montagu Private Equity, which acquired Linpac in an 860 million deal six years ago, saw its equity wiped out under a takeover by a consortium of lenders. Mr Kosman said that American private equity firms had rushed to invest both in British companies and to pump money into British private equity funds. It is awesome that England is so open, but if I was in England I would be pretty upset because you had Americans coming in and buying up your companies ... It was basically the Americans, whether pension funds or the firms directly, profiting from squeezing your businesses. And now you are left paying the bill. He contrasted this with what happened in Italy. Heads of companies very publicly said: I would never sell my company to a private equity firm. They are looking pretty smart right now. Mr Kosman highlighted a particular trend of private equity firms buying and selling companies to each other. A lot of the deals in England in the last few years before the recession were buyout firms buying and selling to

each other, which means that firms were squeezed once, twice, maybe even three times. So there is not a lot left to save, he said. If a private equity firm can show me that we cut costs, including jobs, but we improved the business and look how much better it is seven years from now, I would shut up. But, by and large, that is not what you find. The great majority of the time the company is hurt in the long run. Thats why I am so critical because it hurts the company, not just the workers. Mr Kosmans argument is not without its critics. The British Venture Capital Association, which represents 450 private equity firms and advisers, believes that the authors analysis is flawed. There have been plenty of success stories, Nathan Williams, its spokesman, said. The reason private equity has been able to raise billions of pounds and grow so quickly as an industry is because of its success in generating returns for investors, such as pension funds. Mr Williams said that private equity-owned firms would cut jobs just as other companies had downsized in the face of recession, but he dismissed claims of mass layoffs Where companies are struggling, there is a determined effort on the part of lenders and banks to do whatever they can to minimise job losses and make sure the company continues as a going concern and it is well placed for the upturn when it comes, he said. He pointed to examples of private equity firms buying companies out of administration. KPS Capital Partners bought Waterford Wedgwood, the pottery and china company, from administration in July, saving about 300 jobs. That is the flip side, Mr Williams said. But if Mr Kosman is right, what can Britain do about it? I think its pretty hard, as I think much of the cast is set both in America and in England, he said. Some of the fallout is unpreventable. Your Government is not going to step in to bail out most of these companies because there is not the political will and it would be very costly. Unfortunately, it is a huge hit. The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis is published on November 12 (Portfolio, 19.99) Financial Director of LSE warns of second credit crunch Feb 10 2009 by Tom Scotney, Birmingham Post The UK is facing a second credit crunch as massive unsecured personal debt becomes a problem as unemployment rises, the director of the London School of Economics has said. Sir Howard Davies told an audience in Birmingham that the worst effects of the lending problems caused by City traders had worked its way through the system although the after effects were still being felt by banks and their owners. But he said the increasing unemployment caused by the recession would mean more people defaulting on personal loans, often including unsecured borrowing like credit cards. He said: We have probably seen the worst in the most complex areas, for example derivatives all that really fancy alphabet soup stuff. I think much of that has already washed through the system and I would say most of that has been written off, although with consequences for the bank. But of course as the normal recession strikes then you get a new wave of bad debts on things like consumer debt, credit cards and straightforward consumer loans. He added that one of the chief lessons learned by governments and central banks from the financial crisis would be to take debt seriously as a part of monetary policy in future after being caught unawares. He said: I think there will be some important changes when things get a bit better, and one will be that credit is back as a future of monetary policy. In the last few years, we have focused quite narrowly on inflation. And one lesson emerging from this crisis is that this can give you a misleading analysis of conditions. Now we are seeing the consequence of over-borrowing we will in future need to pay much more attention to credit conditions.

Central banks were somewhat fooled by very low retail price inflation. Someone joked about CPI, calling it Chinese Price Inflation, and its true that huge volumes coming out of China were driving down prices. Sir Howard was speaking at the biannual investment conference held by Brewin Dolphin at the Council House in Victoria Square. The lunchtime event attracted more than 120 guests from the professional community. He was joined as a speaker by Mike Lenhoff, the chief strategist and head of equity research at Brewin Dolphin. Speaking at the conference, he said: The credit crisis has resulted from a financial system that has lost its capacity to function. The result of this is the recession we have on our hands. However, financial markets have been adjusting to the shock of this and a lot of the bad news associated with this recession has been discounted. Nevertheless, while we have seen the biggest financial upheaval of our time, we are also witnessing the biggest policy response from governments and central banks the world over. I believe that the measures that are being delivered by policy makers will help to restore the functionality of the financial system and we will get through this recession. By the end of 2009, we are hopeful that we will see the beginning of the recovery.,8599,1952416,00.html?iid=tsmodule Bank Lending Is Still Down. Should We Be Worried? By Stephen Gandel Friday, Jan. 08, 2010 The falling number of bank loans is emerging as the No. 1 economic concern of 2010. But while many expect the credit crunch to continue, falling bank loans might not be as bad a problem as many people think. "If the economic indicators were not recovering, then bank lending would be prime culprit," says top Wall Street strategist Edward Yardeni. "The weak borrowing market just doesn't seem to be stopping the economic turnaround." Nonetheless, many policymakers and analysts are worried. In late December, President Obama summoned the heads of the nation's largest banks to the White House to urge them to make more loans to small and mediumsize businesses. Federal Reserve Chairman Ben Bernanke too has mentioned in recent speeches the continued credit crunch as an economic concern. (See how Americans are spending now.) Indeed, the numbers are eye-catching. As of Dec. 23, the latest date for which data are available from the Federal Reserve, bank lending, at nearly $6.7 trillion, was down $100 billion from the month before. In the past year, the volume of loans outstanding by banks in the U.S. has fallen by more than $500 billion. Bank loans have been trending down for a while. Worse, most analysts don't see bank lending turning around anytime soon. Paul Miller of FBR Capital says a combination of banks' wanting to take fewer risks and lower demand for credit from consumers and businesses will cause banks to continue to make fewer loans this year than they did last year. "Available credit for the U.S. is receding and that's the economy's real lifeblood," says Christopher Whalen of research firm Institutional Risk Analytics. "This is a disaster." But while the number of bank loans is falling, the well of credit for corporations is far from dry. In fact, the 22 largest banks in the Treasury's Troubled Asset Relief Program issued or renewed $127 billion in business loans in November, roughly the same as five months ago. And bank lending, now at $6.7 trillion, is at the same level it was at the end of 2007, when the economy was still expanding. That would be a problem if we had serious inflation. When asset prices rise and loan values don't, that can signal economic stagnation. But at a time when many asset prices are falling, it makes sense that loan volumes would be falling as well. After all, the collateral is worth less. (See pictures of TIME's Wall Street covers.)

What's more, unlike the situation at the height of the credit crunch, corporations are able to raise money from investors. On Tuesday alone, corporations sold $23.5 billion in bonds, making it the second most active day in debt sales by companies on record. In 2009, corporations issued $712 billion in investment-grade bonds, up from $646 billion in 2008. Bank analyst John McDonald of Wall Street firm Bernstein Research says most people are focused on how the lack of loans will hurt bank earnings. Lending is, after all, how banks make money. But in the past year or so, banks have had to sock away more and more cash into their reserves to account for their growing number of bad loans. That's caused earnings to plummet. With loans falling, reserve ratios the measure of reserves to loans are growing. That means banks will be able to divert less profit into those rainy-day accounts, which should boost bottom lines. Finally, unlike the stock market or consumer confidence, bank lending is a lagging indicator. Businesses look for loans to expand once the economy is growing and orders are coming in again. And banks, since they get hurt so badly in recessions (particularly this one), become very risk-averse at the beginning of economic cycles. "In the initial stages of a recovery, banks are never handing out cash," says Lakshman Achuthan, a managing director at the Economic Cycle Research Institute. "It never happens that way, and we have had plenty of recoveries." Asset markets: The danger of the bounce. Once again, cheap money is driving up asset prices Jan 7th 2010 (From The Economist print edition) THE opening of the Burj Khalifa, the worlds tallest building, in Dubai on January 4th had symbolic as well as architectural significance. Skyscrapers have long been associated with the ends of financial booms. The Empire State Building opened in 1931, two years after the Wall Street crash. The Petronas towers in Kuala Lumpur were unveiled in 1998, in the depths of the Asian crisis. Such towers are commissioned when money is cheap and optimism about economic growth is at its height; they are often finished when the champagne has gone flat. The past three decades have been good for skyscraperbuilding. The cost of borrowing money, in nominal terms, has fallen sharply (see chart 1). Small wonder that one bubble after another has appeared in financial markets, with the subjects of investors dreams ranging from emerging markets and technology stocks in the 1990s to residential housing in the decade just ended. Nor is it surprising, with money so cheap, that consumers and companies have indulged in regular borrowing sprees. When investors borrow money in order to buy assets, they push prices even higher. But this also makes markets vulnerable to sudden busts, as investors sell assets to pay their debts. The credit crunch of 2007-08 was the result of this process, with the debts greater and the price swings more violent than at any time in the past 30 years. Critics argue that central banks, by focusing on consumer- rather than asset-price inflation, have encouraged bubbles to grow by keeping interest rates too low. By intervening when markets fall, but doing little to curb them when they rise, they have offered investors a one-way bet. Such critics are worried that, in their eagerness to bring the credit crunch to an end, the authorities may be making the same mistake again. Official short-term interest rates are below 1% in much of the developed world. Emerging markets, through their currency pegs, tend to import these easy-money policies, even though most of them are growing faster than the rich economies are.

Low rates have certainly persuaded investors to move money out of cash. Investors withdrew $468.5 billion from money-market funds in the course of 2009. The carry tradeborrowing in low-yielding currencies to invest in high-yielding onesis back in full swing. The Australian dollar has been a popular beneficiary. Equity markets have rebounded strongly: the MSCI world index is more than 70% higher than its March low. Even bigger gains were seen in emerging markets, with the Brazilian, Chinese and Indonesian bourses all more than doubling, in dollar terms, last year. Those rallies have by themselves helped boost economic sentiment and have brought to a halt the vicious spiral of 2008, in which falling markets forced investors to offload assets at fire-sale prices. At the same time, in the English-speaking markets of America, Australia and Britain, the stabilisation of house prices has bolstered consumers balance-sheets. Again, low interest rates have been a crucial supporting factor. Optimists argue that the markets are now in a sweet spot. The global economy is recovering, with most developed countries coming out of recession in the third quarter of 2009. The authorities, concerned about the fragility of the recovery, will be reluctant to raise interest rates in the near term. Thus investors have been given a licence to buy risky assets. Is this policy approach creating yet another set of bubbles? Some, including Alan Greenspan, chairman of the Federal Reserve during the euphoria of the 1990s and early 2000s, believe that bubbles can be spotted only in retrospect. Others, such as Jeremy Grantham of GMO, a fund-management group, argue that they can be identified by a surge in prices (and valuations) to way above their previous trends. In the model of market madness outlined by Hyman Minsky, a 20th-century American economist, and by Charles Kindleberger in his book Manias, Panics, and Crashes, bubbles start with a displacementa shock to the financial system, perhaps in the form of a new technology such as railways or the internet. This provides the narrativethe rationale that persuades investors to join in. They start to believe that this time around things will be different and that asset prices can reach new heights. The next stage is rapid growth in credit, which inflates the bubble. As investors borrow money to buy the asset in question, the resulting price rise makes the narrative more credible. At the peak, however, investors no longer pay much attention to fundamentals, buying simply on the belief that prices must rise further. This stage is marked by very high valuations and by popular enthusiasm for asset purchasesmarked in the 1920s by shoeshine boys passing on share tips and in the early 2000s by the popularity of property programmes on television. Eventually, like a Ponzi scheme, a bubble runs out of new buyers. Prices slump. Euphoria gives way to the final stage, revulsionuntil the cycle can begin again. How do todays markets look in the light of that model? The best place to start is in the developed world. There has been a displacement, in that the credit crunch caused central banks to slash rates and led governments to unveil schemes to support banks, guarantee assets and allow budget deficits to soar. Whereas investors were highly risk-averse in late 2008, they have been encouraged to take their money out of cash and to invest in higher-yielding assets like equities and corporate bonds. But although money is cheap, there has been no sign of the private-sector credit growth that marks bubble phases. Indeed, small businesses still complain that bank loans are hard to find. In the euro area, the broad measure of money supply has even fallen in the past 12 months. In America, broad money grew at an annualised rate of only 1.2% in the six months to November. As further evidence that there is no bubble, bulls point to the relatively modest level of prospective priceearnings ratios; the MSCI world index is trading on a multiple of 14 based on prospective earnings in 2010, according to Socit Gnrale, around the long-term average. However, prospective multiples can be very

dependent on the optimism of the analysts who make the forecastsand such analysts are in the business of selling shares. A better long-term measure is the cyclically adjusted priceearnings ratio, which averages profits over the previous ten years (see chart 2). On this measure, valuations are nowhere near the 2000 peak. They are, however, still pretty high by historical standards; Smithers & Co, a firm of consultants, reckons they are nearly 50% above their long-term average. Even now, after a dismal decade for shares, Wall Street is offering a dividend yield of only just over 2%, compared with a long-term average of 4.5%. In housing, a measure based on rents shows that American prices are back to fair value but prices in Britain, France, Spain and Australia are all 30-50% above their historic averages. Low mortgage rates (and government schemes to head off foreclosures) have stopped prices falling to the lows of previous downturns. That said, although prices remain higher than average, private investors have shown little of the enthusiasm they exhibited in past bubbles. Activity in the housing market is subdued. Investors withdrew $36 billion from developed-market equity funds in the course of 2009, according to EPFR Global, a data group. Emerging optimism More plausible candidates for bubble status can be found in emerging markets. The rally in the developed markets has been driven by relief that a second Depression has been avoided, rather than by any great optimism about a new era. But emerging-market exports have survived the crisis remarkably well. They were clobbered in late 2008, when the collapse of Lehman Brothers sent the corporate sector into shock and many businesses slashed their order books. Crucially, however, China experienced not much more than a mild slowdown and recovered to grow by around 8% in 2009. As investors look to the future, emerging markets have many advantages over their developed rivals. One, plainly, is higher potential rates of economic growth. Another is that many emerging economies have stronger fiscal positions than their Western rivals; they are the creditors financing the American budget deficit. The balance of power has already shifted. In 2003 the stockmarkets of America, Britain and Japan formed 73% of the value of the MSCI all-country index; by the end of 2009 this proportion was just 59%. Enthusiasts like Jerome Booth of Ashmore, a fund-management group, argue that this trend will continue, because emerging economies stockmarkets are underweighted in world indices, given their share of global GDP. As the world rebalances, Mr Booth argues, investors from emerging economies will increasingly want to channel their savings to their own markets, rather than financing Western governments. Western investors are already showing an interest in these markets: investors shifted $64.5 billion into emerging-market funds last year. This optimism explains why emerging markets now trade at a premium (measured by the ratio of market prices to the accounting value of assets) over developed markets. In the past, such premiums have usually presaged a setback. In addition, emerging markets are seeing much faster credit growth than their developed rivals. In China, for example, broad-money growth in the 12 months to November was almost 30%. Such growth is the logical result of pegging a currency to the dollar, and thus importing a monetary policy which may be right for America but which is too loose for the fast-growing Chinese economy. Some of that credit growth is leaking into asset markets. The Chinese premier, Wen Jiabao, said in late December that the government would use taxes and interest rates to stabilise the property market. House prices in Hong Kong are more than 50% above fair value, according to The Economists estimate. Though they are not yet back at 2007 valuations, it is easy to imagine


that emerging markets will develop bubbles if a combination of low interest rates and pegged currencies continues. Another area where a bubble might be developing is in gold. Gold is an unlikely cause of euphoria, given that investors use it as a bolthole when they worry about inflation, currency depreciation or financial chaos. But the metal has seen a speculative peak before, most notably in 1980, when its price touched $835 an ounce, before losing two-thirds of its nominal value over the next 20 years. The main rationale for buying gold at the moment is that, in the face of the credit crunch, most governments would like to see their currencies depreciate to boost their exports. If paper money is being debased, that is bullish for gold, an asset that central banks cannot create more of and that is no one elses liability. The gold bugs may be right. But the price has already quadrupled from its low and suffers from no real valuation constraints; it has no yield or earnings against which to measure it, so it is hard to say when it is expensive. Dylan Grice, an analyst at Socit Gnrale, has mischievously suggested that, if the Bretton Woods system (under which the Fed was obliged to exchange its stock of dollars for gold with other central banks) were operating today, bullion would trade at $6,300 an ounce. An age-old problem It seems likely that, if developed countries keep interest rates low for a long time, bubbles will emerge somewhere. The argument against tightening policy now is a strong one, given the fragile state of the economic recovery. But to central banks it always is, whether the economy is healthy or not. It is hard to imagine any circumstances in which the authorities will have the foresight (or the courage) to prick a bubble. It cannot be done when the economy is weak. And when the economy is strong, as it was in the late 1990s, central banks argue that higher asset prices are justified (back then, by the productivity improvements brought by the internet). Central bankers tend to see higher asset prices as a validation of their policies and to shy away from second guessing the markets. Illustration by Derek BaconBen Bernanke, the Feds chairman, argued in a recent speech that better regulation, rather than tighter monetary policy, would have been the key to pricking the American housing bubble in the past decade. Plans for preventing future bubbles may depend on controlling the banks, rather than setting the general level of interest rates. Lower loan-to-value ratios would avoid the excesses of subprime lending while higher capital ratios would prevent banks lending too much at the peak of the cycle. If the authorities can do little to stop a bubble inflating, what can they do if markets suffer a further relapse? Interest rates cannot be reduced further and it is hard to see the markets tolerating even bigger budget deficits. That leaves quantitative easing (QE), the policy under which central banks create money to buy assets, usually government bonds. Even that may have its limits, if private investors decide to sell government bonds as fast as central banks try to buy them. Bears argue that the global economy is already far too dependent on government stimulus. Every basis point of [American] growth in [the third quarter] came from government stimulus, directly and indirectly, says David Rosenberg of Gluskin Sheff, a Canadian asset-management firm. Schemes such as cash for clunkers temporarily boosted car sales but these quickly slipped again once government subsidies stopped. The latest example occurred when pending American home sales fell by 16% in November in anticipation of the end of a homebuyers tax credit (which has since been extended until the end of April). These subsidies depend, in large part, on the ability of governments to fund huge deficits at relatively low cost. And that is perhaps the biggest issue of the moment. A matter of life and debt On the one hand, the gap between short-term interest rates and long-term bond yields is extraordinarily high. That allows banks, in particular, to borrow at low rates from the central banks and invest the proceeds in government debt; the same trick was used to rebuild bank profits in the early 1990s. Russell Napier, a market


historian and an analyst at CLSA, a broker, thinks that purchases by a combination of Asian central banks and developed-world commercial banks are causing a bubble to develop in government-bond markets. Investors may be looking to Asia for inspiration. Japan has run huge deficits for 20 years and still has ten-year bond yields of under 1.5%. If investors think the American economy is in for a similar period of stagnation, then Treasury-bond yields of almost 4% (see chart 3) look attractive. On the other hand, some point to the huge growth in central banks balance-sheets and to the use of QE. This indirect monetisation of the budget deficit is, in their view, just another way of debasing the currency. The Feds entry for total factors supplying reserve funds has jumped from $942 billion in the week before the collapse of Lehman Brothers to almost $2.3 trillion. In Britain, the Bank of Englands QE programme has, in effect, financed the entire government deficit for one year. But both the Fed and the Bank of England seem to be winding down their QE programmes and these may not be around to support bond prices next year. However, there is scant trace of any rapid reduction in budget deficits, at least in Britain and America. Governments that have attempted to tackle them, such as Irelands, have faced protests and strikes. As a rule, governments find it far easier to increase their debt than to reduce it. In the absence of rapid economic growth, debt reduction usually means a period of austerity, a hard thing to swallow, especially when the creditors are foreign. Icelands president has just refused to approve a deal repaying debts to Britain and the Netherlands in the face of public opposition. Governments also fear that premature fiscal tightening might only send the economy back into recession. That was the mistake made by the Roosevelt administration in 1937 and by the Japanese in 1997, when they raised the consumption tax. Finance ministers may be unwilling to take unpopular courses of action until the rating agencies downgrade their debt or the market forces the issue, by pushing bond yields sharply higher. Already, there have been signs of market impatience with some countries, such as Greece, which have been slow to address the problem. Investors may eventually demand coherent strategies from the Americans and the British; Pimco, probably the most influential private-sector bond investor, said this week that Britain faced a cut in its credit rating without a credible debt-reduction plan. The markets are beset by a series of contradictions. They are dependent on extraordinary amounts of government stimulus. But that stimulus is in turn ultimately dependent on the willingness of markets to finance governments at low rates. They should be willing to do so only if they believe that growth prospects are poor and inflation will stay low. But if they believe that, investors should be unwilling to buy equities and houses at above-average valuations. At some timemaybe in 2010those contradictions will have to be resolved. And that will trigger another nasty bout of volatility. The financial crisis and East Asia July 26th, 2009 Guest Author: Wendy Dobson, University of Toronto, Canada East Asian economies were relatively well insulated against the financial impacts of the global financial crisis but their dependence on trade through regional production networks and export-led growth strategies made them vulnerable to the sharp contraction of demand from the North American and European economies. The International Monetary Fund projects sharp real GDP declines in 2009, with Japans economy shrinking by -6.2 per cent, Taiwans by -7.5 per cent, South Koreas by -4 per cent and Singapores by -10 per cent; China is the outlier, with positive growth expected to be 6.5 per cent. Even so, China has experienced a huge growth contraction from 13 per cent in 2007. Japan was hardest hit by the contraction of export markets: its current


account surplus is expected to shrink from 4.8 per cent of GDP in 2007 to 1.5 per cent in 2009. Chinas will shrink slightly but Koreas and Taiwans will expand. There is a strong reaction in the region to this revealed vulnerability. Governments are asking how they can reduce their dependence on exports to the advanced industrial economies and rely more on regional and domestic demand. This reasoning leads to an emphasis on alternative growth engines in the region (such as potentially large demand in China and India) and on ways to deepen the linkages among the regions economies. Unexpectedly, the G20 leaders summits organized on an ad hoc basis to manage the financial crisis may turn out to be the catalyst for a sharper focus on deeper regional integration. Six Asian economies are members, the three Northeast Asians plus Australia, India and Indonesia, and each is an equal at the global table. This new definition of the six as equals in global strategy could be the basis for a more strategic approach to trade and finance in the region that replaces current ad hoc arrangements. Northeast Asia gets high marks for promoting and maintaining economic openness, peace and stability in the region with some exceptions. Although Northeast Asian governments like other G20 governments took some protectionist measures during the crisis, leaders at the first Japan-China-ROK Trilateral Summit in December 2008 expressed their determination to avoid protectionist actions. Openness to trade and FDI is pursued through ad hoc regional trade agreements but the impacts are mixed when they are riddled with exceptions and when inconsistent rules of origin raise transaction costs. Efforts are also underway to create an emergency financing mechanism through the Chiang Mai Initiative and to increase the depth and liquidity of regional financial markets through the Asian Bond Market Initiative and the Asian Bond Fund but progress on governance frameworks is slow. Some prominent East Asian thinkers see the region at a crossroads. Asia is unique: by 2030 three of the worlds four largest economies will be located there and the worlds two largest populations live side by side. By 2020 China will produce 44 per cent of Asias economic output and India and Japan will account for 17 and 15 per cent, respectively, as estimated by the Asian Development Bank in its 2008 study Emerging Asian Regionalism. Together the three will be 20 per cent larger than the US economy. As China and India emerge as economic powerhouses they will compete with Japan and each other for influence and leadership of the region unless a serious commitment to community building creates common goals and channels for closer cooperation. Evolving regional institutions have ASEAN at the core and other countries joining extensions depending on the purposes of the group. This ASEAN-Plus architecture expanded after the Asian crisis when the heads of the ASEAN economies, Japan, China and South Korea formed ASEAN + 3 to draw lessons and prevent such a calamity from happening again. Since then ASEAN + 3 has taken both finance and trade initiatives, most of which are bilateral in scope. The East Asian Summit expands the group to include Australia, New Zealand and India, a logical extension based on jurisdictional criteria but also one that dilutes Chinas influence. The absence of an acknowledged leader, however, constrains the scope and speed of deeper integration in East Asia. Without an accepted champion to provide focus and set priorities governments have to be content with incremental change. For some time ASEAN has been regarded as the core, particularly by China which assumes any initiative it might take would be highly suspect by the smaller countries. Cooperative regional institutions serve Chinas objective of developing closer friendly relationships in the neighborhood and its desire to counter-balance US influence but the impetus must be provided by others. Good relationships with its neighbors also allow China to concentrate on its many distractions at home. Regional leadership is further complicated by the relative absence of the United States which is not part of the ASEAN-Plus institutions and participates mainly on a bilateral basis and through APEC. The long term prospects for Asias nascent economic institutions will depend on support from the large players, on consistency with global institutions and on results. The G20 meetings were both a missed opportunity for regional responses to the crisis and a catalyst for future action. They were a missed opportunity in that governments acted on their own. The Chiang Mai Initiative swap mechanism was inactive; some even assert that if the common fund arrangements are not finalized by mid-2009 the initiative will be abandoned. National treasuries and central banks responded in uncoordinated fashion. There was no collective Asian strategy that pulled together the domestic, regional and global impacts of the large stimulus packages in China, India and Japan and other members. No prescriptions were forthcoming from the group and no targets for their own


cooperation. Indeed, one reason the Chiang Mai Initiative mechanism was not drawn upon during the crisis may be because most economies have more confidence in unilateral actions to self-insure against financial crises by running current account surpluses and managing their exchange rates to build foreign exchange reserves. At the end of 2008 according to IMF statistics, the combined reserves of China, Japan, Singapore, India and Hong Kong totaled almost $4 trillion which is far in excess of any guidelines for protecting against balance of payments shortfalls. Yet the G20 was also a catalyst in addressing the leadership deficit in regional cooperation. The membership of the Asian 6 countries confers an expectation that they will think and act in the global interest. This expectation could translate into this or a sub-group providing strategic leadership to replace the ad hoc initiatives of the past. A more strategic approach would serve the objective of rebalancing the dependence on export-led growth by Asian economies with more regional and domestic demand. But there was little talk about allowing exchange rates to be market-determined or to reduce self-insurance. Instead they looked to exploit the vast potential demand in China and India, arguing that more of the regions savings should be intermediated within the region and that intra-regional production networks could be deepened by investing in regional infrastructure to speed up intra-regional shipments, by promoting trade in green technologies and by greater reliance on trade in services. In conclusion, the G20 opened a new channel for both regional and global cooperation and may serve as a catalyst for strategic leadership within the region. This catalytic role is still playing out since there was no coordinated regional response to the global crisis in 2008-09. The G20 is a convenient and timely band wagon which, while still led by the Americans and Europeans, is also a vehicle for initiative and leadership from its Northeast Asian members and the Asian 6. Wendy Dobson is Professor of Economics in the Joseph L Rotman School of Management at the University of Toronto in Canada. This essay is a digest of a larger paper in preparation for the Northeast Asian Security Project at the Maureen and Mike Mansfield Foundation, Washington, DC.