The markets seem to be questioning the government’s ability to find a workable solution to this current turmoil in other words government’s ability to find a FIX. And this is becoming increasingly evident by the way markets have reacted in the past few weeks. Although one might say that the market itself is INEFFICIENT by design and DYSFUNCTIONAL in the current environment. And there are also those who would say that the whole MESS was created by the same market participants themselves in the first place. People who thought the party would never end and carried on with their reckless business practice. So going by the norm that the market is always right is a probably flawed perception? Well, whatever one might say, it’s hard to entirely disagree especially when we have a market that is increasingly behaving like a yo-yo. It either gets too optimistic or finds itself in a fluke rally only to shed all its previous gains or it takes an extreme negative view on everything loosing foresight.
Some would disagree with the above observation and some might agree. Whatever side you are on, one can safely say that without government support the market may not have survived.
But even with government support the market is not working as it should.
Is the government missing something?
Well, the government has not been able to address the CORE issue ( the other big elephant in the room ). LIQUIDITY is not the only dark cloud hanging over the market there is also a big question mark over the SUSTAINABILITY of the whole system. While all the actions on the part of the government has so far been on resolving the liquidity issue the government has failed to address the sustainability question. The market is extremely fearful of nasty surprises going forward.
Should we worry about the Sustainability of the system?
Besides bailing out the banks the governments of the developed world and some in the developing world are borrowing heavily to finance their stimulus packages which are aimed at fighting the deepening recession. Their fiscal position is under a lot of pressure. Some governments’ in the developed world are now running double digit budget deficits. And there are no reasons to suggest that these deficits won’t increase further especially when jobs losses are mounting and the recession is deepening shrinking the tax revenues.
How badly is the economy doing?
Let us look at the numbers to get some perspective. Based on the latest data, the business confidence is now at the lowest in 26-years in Germany, exports have plunged by over 7.3% in the fourth quarter causing the Europe’s largest economy to contract the most in over 20 years; the jobless rate in the 16-nations Euro region is now over 8.4%,the lowest growth seen in decades; the U.K. economy reporting the lowest growth since 1980, unemployment at the highest in 16 years, consumer confidence the lowest in over three decades in the UK; the U.S. economy shrinking by 6.2% in the fourth quarter the worst growth since 1982, unemployment reaching the highest since 1992 rising to 7.6%; Japan’s exports plunge by over 45% in Jan 09, GDP growth rate fell by over 12.7% annually the highest since 1974; we are seeing export oriented economies including of Singapore, Korea, Taiwan ,Nordic region along with others fall into deeper recession.
The economies like Brazil, China, India, Russia and others who were supposed to be resilient to the global economic downward are now under pressure too. The news from Brazil, India and Russia are not very encouraging. Brazil’s unemployment rate has now jumped to the highest in over 8 years; the growth rate is at lowest since 2003. India (Asia’s 3rd largest economy) grew at the slowest pace since 2003. Russian retail sales grew at the slowest pace in more then 10 years, the GDP may contract by over 2.2% in 09. Chinese government will also have to revisit its 8% growth target. Though there are some signs that the Chinese economy might be recovering after Beijing implemented the US $ 585 billion stimulus package however it is too early to tell whether the positive numbers are temporary or unclear seasonal numbers. There is a strong possibility of China not growing above 7% in FY 09.
The list of bad news is getting bigger. In short the recent numbers paint a pretty grim picture of the health of the economy and there are no reasons to assume that the worst is over. The global economy is still hurting. World economic growth outlook for 2009 is very gloomy indeed. It is difficult to envisage a global recovery without the US economy getting back on the growth trajectory. Although, we expect the US $ 787 billion stimulus package will help the US economy going forward there are no reasons to assume that the economic conditions will improve in H2 of 09.
Is the government taking too much risk?
Taking the above into account one can’t help but wonder is relying on future tax revenues to keep bailing out banks and financing stimulus packages a good idea? Especially when you consider that there is too much uncertainty about the growth prospect of the economy.
Is this sustainable?
It is safe to conclude that Governments balance sheet is under extreme pressure and probably close to CRITICAL LEVELS. Some governments in the CEE area might already be BROKE! There is no doubt that bigger nations in the EU will have to carry them.
The Governments’ are probably expecting the economy to turn around quickly and hoping that banks (especially in the developed world) won’t throw any nasty surprises going forward. Makes you wonder if they have concluded that the worst is over and the economy could be on the ascending course soon? Well, we will have to wait and see ! In spite of the recently announced bank bailout packages by the governments in the UK, US and in the EU it will be ill-advised to assume that the CRISIS in the banking sector is now over. Some analysts would argue that by agreeing to insure the assets of RBS and possibly Lloyds banking group, the UK government has managed to draw a line in the sand. Well, we will have to wait and see. The exercise is risky to say the least. Any additional losses (which is expected) on the insured assets would take the government’s balance sheet further in the RED. There is a very strong possibility that banks will have to raise more money to keep afloat and might need additional government support. The recent announcement by HSBC to raise over US $ 17.7 billion to bolster its capital is a testament that banks would need more capital to keep afloat.
Will the government (especially the US and UK) be able to provide additional support to the banks?
To answer this question we need to get a good understanding of the financial strength of the governments. By looking at the numbers we should be able to get a good sense of the fiscal position of some of the major economies. Let’s just look at the U.S. and U.K., shall we? According to the “U.S. treasury, Financial Report of the United States, 2002-2008, the total Federal Government deficit now stands at over US$ 65.5 trillion( under GAAP accounting). This US$ 65.5 trillion deficit exceeds the world’s total GDP. Shocking right! Well, that’s why US is considered too big to fail. Now let’s get a UK perspective too shall we? Looking at UK government’s getting out of CRISIS spending so far, the government has spent over two trillion in funding its stimulus program and various bank bailouts. This is on top of close to a trillion committed in form of loan guarantees. According to the Centre for Policy studies UK’s national debt could be over 103% of the GDP (based on last year numbers).
Numbers don’t look pretty, do they? The balance sheets are at CRITICAL levels.
There is a big question mark over the government’s ability to provide additional bailouts to the banks without seriously undermining their currencies and credit worthiness
To make things worse the latest numbers out from the U.S., UK, Europe, Asia or LATAM are not encouraging at all and there is nothing in them to suggest that we are close to the BOTTOM. Although, we expect the steps taken by various governments around the world (in form of stimulus packages and bailouts) would help arrest the downturn in the economy, however, it is unclear how long that might take. And any nasty surprises down the road could deepen the CRISIS.
The road ahead
There is still a big question mark over the SUSTAINABILITY of the banks and their business model. Further losses will put the banks and the governments guaranteeing their toxic assets over the CLIFF especially considering the fact that the assets of the some banks considered too big to fail dwarfs the total GDP of some European economies.
There is a very strong possibility of a crisis in CEE (Central and Eastern Europe) spilling over to Europe and to the rest of world. The worst hit would be the European banks. They hold between 55%-95% of the market share (depending on the country) in the region through their subsidiaries. It is estimated that banks have lent over US $ 1.6 trillion in CEE (Central and Eastern Europe). Based on estimates, the combined exposure of Austrian banks in the CEE area could be over 73% of Austria’s GDP. Default on banks books could push Austria over the CLIFF. Besides Austria other European economies will be hit badly as well. The new program launched by the three the development agencies including of EIB, EBRD and World Bank to lend up to Euro 25 billion to Easter European banks will not be enough to save them. It will only be a drop in the ocean.
The health of the world economy is deteriorating. And there is no doubt that we are in the midst of a major global crisis of historic proportion not seen in generations. Even though, we have all the major world economies are doing their very best to FIX the ailing economy it’s hard to tell if some would survive the crisis without an outside help. Failure of one country could spill over to others and seriously hamper the recovery process. We can never accurately predict the shortcomings so it makes sense to have a PLAN B (back up plan). It’s better to be safe then sorry. We should envisage that finding a sustainable FIX may require major economies of the world to come together and deploy their combined resources and skills to help us overcome this CRISIS.
The question is will the world come together?
The answer lies in history. There are precedents when the world has come together and combined its efforts and resources to solve major global crisis. Do we need to give examples? Nah I don’t think so!
The markets worldwide are getting hammered. The cost of two years contract to protect against any potential decline in the S&P’ s 500 index is now over US $ 15,160 on Chicago board of Options exchange compare with US$ 6,800 ( approx) in 2007, more than 220% increase in just two years. Since the beginning of the CRISIS, we have seen over US $ 10.5 trillion of equity value being wiped out. These numbers clearly indicate that we are in the middle of a SEVERE BEAR market.
Looking at the performance of the global market we can safely conclude (without a doubt) that none of the markets are immune to this turmoil. And the longer this CRISIS is allowed to continue the worst it’s going get for everyone.
The world leaders are now beginning to recognize that this is a global CRISIS of catastrophic proportion which could have lasting consequences if left to run its course. The so called decoupling of the emerging world from the U.S. has not materialized. It turned out to be a false impression after all.
There is a realization setting in among world leaders that they will have to work together. We are seeing unprecedented level of cooperation among central banks of the world and regional economic blocks i.e. ASEAN, EU and others. Asian and EU nations have already taken coordinated actions and are closely working with each other. Asian central banks have recently agreed to create a pool of US$ 120 billion to shield the local currency. The idea of an Asian version of IMF to shield the central banks is also gaining ground. Last month, Japanese government agreed to increase its bilateral facility to Indonesia. German government officials have recently said that they may have to consider bailing out the smaller in economies in the Euro zone.
We are seeing signs that the governments around the world are now beginning to realize that if their coordinated efforts don’t deliver results then may have to consider combining their resources and efforts to overcome this global economic CRISIS. Unfortunately, the measures taken by various governments so far on individual basis runs the risk of being quickly eroded if the markets continue to lack in confidence. It is perhaps time to look at THE BIG PICTURE and consider a large scale initiative carrying the support of the world.
What could be a possible solution?
It is probably the right time to consider an international entity created by G 20 to rescue the financial institutions from a meltdown under a global financial rescue initiative (GFRI). This entity could be structured along the framework of an aggregator Bank which will compliment the existing bailouts measures taken by various governments and allow them to use the additional resources available through the GFRI if and when needed to save their economies from getting buried in the burden of mounting debts that might create hyper inflation and another asset bubble going forward.
The strength of G 20
The combined GDP of G20 countries accounts for 90% of the world’s total and their trade volume is over 80% of the global trade.
How much could they commit?
Under the GFRI the G-20 countries could commit a small percentage of their GDP to this entity through their Central Banks or ministry of finance.
Based on a median of all projections we can estimate that the total loss on U.S. securities and loans alone could reach over US 3.3 trillion. For safety we could work with a higher number of let’s say US $ 4 trillion. Some of these assets will probably recover in value but some might not. A good chunk of these toxic assets would be absorbed by the existing bailouts in place to support the financial system. There is now a strong possibility of non U.S. assets turning sour. We are already seeing how various asset classes besides sub prime are now being affected. Well, if the patient is not treated the disease may well spread in other healthy parts of the body that could lead to fatality. The same applies for economy. Going forward, we will need to get a good assessment of the health of the economy. The additional commitment from G20 could act a cushion. It may be used if and when required
Can we get a good estimate of the real depth of the toxic assets clogging banks balance sheet?
We should be able to get very good estimates of the amount of toxic assets the banks are holding in their balance sheet. This is an auditing exercise. I must say, by auditing the banks, we do run the risk of discovering that there is a huge black hole and the system is probably INSOLVENT. Some banks might already have a good estimate of what their exact exposure could be but to avoid any surprises let the independent auditing be mandatory. Then put them through a series of stress test to get a good estimate of the amount of capital an individual bank/ financial institution will require to remain healthy. The stress test should be design to get a good estimation of what amount should be written off and what could still be recovered from the toxic assets held by the bank. Using a scale of 1 to 10 (10 being 100 percent) rank the recovery rate of the toxic asset assets. For example an asset with a 5 ranking will be marked at 50% of its value at maturity. And then put them under an eligible to apply candidate category.
What sort of the numbers are we talking about?
For safety and to keep a good buffer let us assume that the financial institutions may collectively have additional losses of over US $ 2 trillion on their assets going forward.
Taking the above into account the new entity created by G 20 under the GFRI could have commitments in the amount of US 2 trillion or upwards to avoid any surprises down the road. The life of this entity could be at least 25 years to give it a strong chance of success. The commitments or funding from G 20 countries could be in the form of government bonds issued directly to the entity created under the GFRI. The commitments will obviously vary from country to country (because of their GDP).
The newly created entity may carry the same ratings as World Bank.
What would be a possible working structure?
Financial institutions falling under the eligible to apply category could approach the entity created under the GFRI to replace its toxic assets with high quality assets under an asset swap agreement. These financial assets could be in the form of guarantees or bonds or CDs issued by the new entity directly to the bank. To determine a fair value when replacing the toxic assets the entity could take a median of the monthly rate of depreciation in the value of the recoverable toxic assets and it could agree to hold the toxic assets until maturity. The banks/ financial institution will pay an annual fee to the entity for holding the toxic assets. This exercise would restore the confidence in banks balance sheet by sanitizing it from the toxic assets.
It will probably be a good idea to allow the entity to hold equity positions in the financial institutions on a case by case basis to bolster their capital.
Will the GFRI created entity be the looser in all this?
The entity (aggregator bank) created under GFRI would have all the expertise and resources to manage, restructure distressed assets and find value. Banks/Financial institution using the GFRI could pay an annual fee. Also with the methodology used for estimating the fair value for the recoverable toxic assets, there is a strong possibility that the entity will make money.
So how does this all benefit the G20?
Most of the economies in G 20 are feeling the strain on their fiscal positions and it’s getting worst everyday. The budget deficits are getting bigger because of the stimulus packages along with other rescue packages (for banks, auto sectors etc) they are putting in place to fight the downturn in their respective economies. And in spite of the steps taken by various governments so far, the market has not reacted positively because it lacks confidence in the individual governments’ ability to FIX this GLOBAL CRISIS.
The GFRI will send a strong signal and instill a lasting confidence in the market without which the markets around the world won’t see sustainable rallies and economic growth. That’s the BIG PICTURE.