Confused by the current financial turmoil? You are not alone. Why are some central banks cutting interest rates even as others raise theirs? And what’s the difference between cutting the main Fed funds rate and the discount rate? Bryan Lee says the key to understanding the crisis is to see it as a three-headed monster: a credit problem in the banking sector, a US-led economic slowdown worldwide, and sky-high inflation the world hasn’t seen in a while.

THE CREDIT CRISIS

Dodgy investments in sub-prime mortgages mean billions in losses that the market cannot even calculate. The result is near paralysis in lending markets and a paranoia which has led to runs on banks like the storied US investment bank Bear Stearns and Britain’s Northern Rock.

What caused this?

THE current woes faced by the United States financial sector have their roots in a housing bubble that formed between 2001 and 2005, when the Federal Reserve kept interest rates low to help the US economy recover after the dot.com bubble burst.

When the housing market started to falter in late 2005, homebuyers who had borrowed beyond their means began to default on their loans. And they were unable to refinance their mortgages as planned when times were better.

By early last year, specialist lenders who gave loans to these risky or ’sub-prime’ borrowers started to collapse as defaults accelerated.

A few months later, the debacle caught up with regular banks and hedge funds around the world, which had indirectly funded the sub-prime loans by buying into complex financial instruments such as ‘CDOs’ (collateralised debt obligations).

Although these investments comprised more than just sub-prime debt, and often were packaged with good loans, entire tranches of these investments have become almost worthless as mortgage defaults mount.

The complexity of the securities makes it impossible for investors to separate the grain from the chaff and give a market value to them.

How is this a threat?

MANY banks bought into sub-prime debt and the market has been left guessing exactly how much losses each financial institution might sustain.

Banks have therefore become more reluctant to lend to one another, even for regular trading activities, as they fear that commitments once assumed vault-safe may not be honoured.

If paranoia sets in and the reluctance to extend credit becomes indiscriminate, the whole financial system could seize up and become paralysed.

Even though banks have collectively written down about US$150 billion (S$207 billion) in sub-prime related losses, there remains much nervousness that more losses may be unveiled.

Aggressive players which fund their activities primarily by borrowing money from other banks are especially at risk of failure, as was the case with the No.5 US investment bank Bear Stearns.

But the heavy reliance on credit by the financial sector in general means that no bank is safe from a run.

Bear Stearns has been rescued with help from the US Federal Reserve. But had it gone under, it would have had serious knock-on effects on the rest of the industry as banks today are intricately linked with one another.

The fall of Bear Stearns has exacerbated the crisis of confidence and adds to fears that no bank is too big to fall.

So far, the credit crunch has been felt most acutely in the US, although there are fears that the malaise is spreading to Europe and Asia, where several banks have already taken big hits on their sub-prime investments.

Indeed, British bank Northern Rock suffered a run last September when it fell foul to tightening credit conditions that emerged soon after the US sub-prime fiasco erupted.

If the US housing market continues to tank, the risk of a global melt-down will rise.

That’s because higher quality mortgage instruments, which European and Asian banks have invested money in bigger quantities, will also be in jeopardy.

What’s being done?

TO ENCOURAGE banks to lend to one another, the US Federal Reserve has been pumping cash, or liquidity, into the banking sector.

It has done this by making available hundreds of billions of dollars in emergency loans since last December.

Last Sunday, it extended the facility to non-deposit-taking banks to 20 primary dealers including investment banks and securities firms. This was the first time it has done so since the Great Depression.

The Fed has also made these emergency funds cheaper. Since last August, it has been slashing what is known as the ‘discount rate’, reducing the interest it charges for these emergency loans from 6.25 per cent to 2.75 per cent.

The Fed also played a key role in keeping Bear Stearns afloat, putting up a US$30 billion guarantee for buyer JPMorgan Chase on Bear Stearn’s most illiquid assets.

It argued that if Bear Stearns had collapsed, it would have led to a larger crisis of confidence that might have taken other banks down with it.

Elsewhere, other central banks have similarly been pumping cash into their financial sectors. A number, such as the Bank of England, have had to bail out failed banks in their jurisdictions.

What’s next?

MORE sub-prime losses seem to be on the cards, with the International Monetary Fund predicting that total write-downs in the global financial world could swell to US$800 billion eventually, from about US$150 billion already reported.

Experts say that there is ample liquidity to go around, but paranoia is still high, preventing the money from circulating within financial markets.

The Fed’s actions have so far had limited effect in preventing confidence from worsening, and economists say the crisis will continue until the US housing market bottoms out.

Only then will the market be able to assess the full extent of losses sustained by mortgage-related investments.

The market can then price these securities and accurately evaluate how much this has hit banks’ bottom lines.

Only then, they say, will the paralysing fear that has kept many investors on the sidelines abate.

Experts say there is ample liquidity to go around, but paranoia is still high, preventing the money from circulating within financial markets.

U.S.-LED GLOBAL SLOWDOWN

The housing slump and the credit crisis in the US has eroded consumer confidence and is plunging the US into a recession. If the recession is deep, economic growth in the rest of the world will also slow down given the US economy’s size and influence in the world order.

What caused this?

AGAIN, it is the housing slump that is at the root of the US downturn, which many now believe has deteriorated into a recession.

Consumer spending, which constitutes about 70 per cent of the US gross domestic product (GDP), is starting to slow as household wealth is falling – for the first time in five years – with declines in home values.

During the recent boom years, many US consumers had depended on the buoyant property market to feed their spending appetites. They re-mortgaged their homes to buy second homes or cars, and banks were willing to lend them the money because house prices were on the rise.

But now that the market has gone south, US consumers are starting to curb their expenditures, especially those who had taken up mortgages beyond their means and are now forced to abandon their new homes.

Households and businesses are being further hit by the credit crisis in what the US Federal Reserve has called a ‘negative feedback loop’.

As banks grow increasingly cautious, their reluctance to provide credit will crimp household consumption and business investment, worsening the slowdown.

How is this a threat?

US GROSS domestic product growth has slowed to a crawl since the final quarter of last year.

The slowdown has hit both the manufacturing and services sectors. Unemployment, which many consider to be the ultimate barometer of economic health, is on the rise.

A slowdown in the US economy will invariably have a significant impact on the world, especially export-dependent countries.

Investment bank Goldman Sachs, for instance, has projected that a 1 percentage point decline in US consumption could hit Singapore’s economic growth by close to 0.6 percentage point. That said, many economists also agree that the emergence of China and other economic fast-growers in the developing world will provide some buffer to a US slowdown.

Also, economies with robust domestic sectors should weather the weaker external environment better.

Experts also note that since the current US slowdown is not focused on the technology sector, unlike the 2001 downturn, electronics-heavy Asia may have a slightly easier time weathering the current slowdown.

What’s being done?

THE Fed has been cutting its funds rate since last September, bringing down the benchmark interbank rate from 5.25 per cent to 2.5 per cent. This interest rate, which is different from the discount rate, is the primary monetary pool that the Fed employs to address economic growth and inflation issues.

It works by directly lowering short-term borrowing costs faced by households and companies. Lower rates spur economic activity by making it cheaper for individuals and companies to borrow money for consumption and investments.

But experts note that the Fed’s rate cuts this time round have had little impact. That’s because long-term rates, which are more relevant to homebuyers and businesses, are still high as banks rein in lending as part of the ongoing credit crisis.

Beyond interest rates and other monetary policy efforts, the US government is also employing fiscal measures to boost the economy.

A US$152 billion (S$210 billion) package comprising tax rebates and business incentives has been planned. There is talk of a second stimulus package as recession risks increase.

What’s next?

THE US recession means that global growth this year will undoubtedly be slower than last year. Much will depend on the severity of the credit crisis and the speed of its recovery.

In the US, economists will be watching for signs of a housing turnaround, which is key for normalcy to return to the financial sector.

The European Union and Japan – the other two economic heavyweights – are expected to suffer slower growth. A weakening US dollar has made the euro and yen strong, and is hurting European and Japanese exporters.

The euro zone’s central bank could lower rates to boost the region’s economies, but appears right now to be more committed to keeping rates high to fight inflation.

The Bank of Japan has fewer options since interest rates are already near zero in the country. Furthermore, the central bank faces a vacuum of leadership as politicians are stuck in a stalemate over who should fill the bank’s top job.

The silver lining is that economists are most optimistic about developing countries in Latin America and Asia.

Strong domestic growth could keep emerging economies in both regions on the boil, they say.

And this would support theories that the developing world is ‘decoupling’ from the fortunes of the wealthy nations.

INFLATION

Red-hot growth in economies like China and India are combining with supply disruptions and speculative fervour to send oil and food prices through the roof. Inflation raises the cost of living and doing business and poses political problems for governments worldwide.

What caused this?

THE world economy has been booming in the past few years, led by the United States, which bounced back from the dot.com debacle on the back of cheap credit provided by the Fed.

At the same time, nationalistic trade barriers were reduced and the resulting soaring of world trade has helped spread the good times to emerging economies, which tapped on cheap land and labour resources to become key beneficiaries of the global manufacturing outsourcing phenomenon.

The extended period of growth has caused aggregate demand for goods and services to catch up with – and in some cases exceed – supply capacities, putting pressure on prices to rise.

In particular, the growing economies of China and India have been sucking up much of the world’s commodities, such as steel, as both countries race to build up infrastructure with their new-found wealth.

The rapid development of the two economies has given rise to the emergence of a significant middle class that is further accelerating consumption growth, from food to luxury goods.

Inflation is also on the rise because of several supply shocks to key commodities such as oil and food.

Ongoing tensions in the Middle East and production disruptions elsewhere have added to price pressures.

Crop failures caused by bad weather, such as the recent devastating winter storms in China, and farmers switching the use of their farmland to the growth of biofuel crops, instead of crops for consumption, have also exacerbated food inflation.

Experts add that the record-breaking commodity prices of late are also partly due to speculative trading by investors who are betting on the price rises to accelerate.

More recently, the US Federal Reserve’s rate cuts and liquidity injections have devalued the US dollar significantly. As commodity prices are denominated in the greenback, the falling dollar means higher prices.

How is this a threat?

INFLATION around the world is sending the cost of living and doing business into an upward spiral.

Energy costs have surged on record oil prices, while food inflation is fast becoming a social and political hot potato for many governments.

Crude oil has gone past the US$100 (S$139) a barrel level, while wheat prices are 2.5 times higher than a year ago.

The problem seems acute in China, which saw inflation hit a 12-year high of 8.7 per cent in February. And since the mainland has become one of the key manufacturing locations for the world, there are fears that inflation there will eventually be passed on to other countries.

Concerns are growing that persistently high inflation could trigger a ‘wage-price spiral’.

As workers become convinced that prices will keep rising, they demand higher wages to protect their purchasing power.

But this in turn would fuel inflation further in a vicious circle that will be hard to break.

While some amount of price increase is inevitable in a growing economy, high inflation rates ultimately hurt as they create uncertainty over how much money earned today will buy tomorrow.

As a result, consumers may hold back on long-term commitments like home purchases, while businesses hold back on investments as they are unsure about their bottom line.

Economists also say that in times of runaway prices, companies and individuals may end up spending more time and resources avoiding inflation, instead of productive activities.

What’s being done?

THE typical way policymakers deal with inflation is to cool economic activity by tightening credit conditions.

But coming at a time when economic growth is slowing and credit is tight because of paranoia in the markets, central bankers are finding it tricky to employ tried and tested means to solve the problem.

The dilemma they have is how to strike a balance between stimulating growth and curbing inflation.

Most of the world’s central banks have decided that inflation is the bigger threat. Many (like in Australia) have therefore raised interest rates, while others (like in China) have reined in lending by requiring banks to keep more cash on hand.

The clear exception is the Fed, which has been doing just the opposite, cutting rates aggressively.

As the US is the epicentre of the financial crisis and the economic slowdown, the Fed has little choice in this.

Still, it has sought to affirm its commitment to the inflation-busting part of its mandate by flagging price rise concerns in its public statements.

Some say that inflation concerns are already causing it to hold back on even bigger rate cuts.

What’s next?

INFLATION pressures are likely to persist at least until the middle of the year, when slowing economic growth could take some pressure off prices.

Indeed, commodity prices had eased last week as investor concerns over the US financial sector and the weakening dollar rose.

Central banks outside of the US, especially those in Asia, will likely continue to prioritise inflation in their policy actions.

For Asia’s export-heavy economies, keeping costs low for manufacturers will be key at a time when their most important customers are suffering.

Source : Sunday Times – 23 Mar 2008