October 16, 2008
By Nitin Desai
The global financial system is on life support. But at present the focus is largely on palliative rather than therapeutic measures to prevent what has been described, in a totally mixed metaphor, as a melt down of a system which has frozen up. Quarantining of toxic assets, capital infusions into over-leveraged institutions, deposit protection, interest rate cuts and frequent exhortations to avoid panic are the name of the game today. In the medium term, measures to revive the housing market and monetary and fiscal stimulus are likely.
The financial crisis will affect the real economy. The impending recession in the industrial world is now expected to last well into 2010. The belief that emerging markets like India and China would be less affected is already being disproved. In India, even if we get over our domestic financial crisis, the economy will be affected by the inevitable slow down in exports and remittances and the drying up of foreign finance for investment. If the recession in the industrial countries deepens into a depression than all current bets on what the future holds are off.
Alan Greenspan, who must bear much of the blame for the irresponsible financial system that is in a state of collapse now, was an acolyte of Ayn Rand whose novel Atlas Shrugged is based on the idea of industrialists and creative individuals going on strike to demonstrate to the world how essential they are. We are now seeing a version of this scenario as panic stricken bankers run for cover and the financial system seizes up and disrupts the flows of real savings and investment.
The crisis has arisen because, in the words of Nouriel Roubini, who has been crying wolf for some time, “a housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression.”
The turmoil that we are seeing is having one perverse effect. The dollar exchange rates are moving in the wrong direction as US fund managers cash their overseas assets to meet their own liquidity needs and as some misguided souls move their money to the US in a search for safety. The dollar has appreciated by 19% vis-à-vis the Euro since its mid July low. The yuan was appreciating gently in 2008 but the movement seems to have stopped and the rate has remained more or less unchanged since late August. The dollar was on track vis-à-vis the yen but appreciated between March and August and since then has come back to the March level which is a depreciation of about 9% from the August level. The rupee of course has slid dramatically in the past few months.
It looks as if we may have to have a dollar depreciation crisis before we are through. Without that, the realignment of exchange rates that we need for a global macro-economic equilibrium will not be realised.
The roots of the present crisis lie in the macro-economic imbalance in the world economy with an out-size and unsustainable deficit in the USA and huge surpluses in China and Japan. It is this that led to easy liquidity and excessively cute financial engineering. Projections of the changes required to reach equilibrium require the dollar to depreciate sharply against the yuan and yen. The Chinese currency is barely a quarter of the way to the projected equilibrium and has stopped moving lately. The Japanese currency is about half way there and is moving. The movements of the dollar vis-à-vis the euro and the rupee are in a perverse direction. One does not know how the dollar rate crisis will manifest itself but the trigger could be a loss of confidence in US banks by large corporate depositors.
The realignment of exchange rates is the short to medium term element in the restructuring of the global financial system. The longer term changes will involve institutional and geographical changes that could be far reaching. Some elements that had become dysfunctional like the over leveraged stand alone investment banks have already started disappearing and some more (over leveraged hedge funds?) will perhaps meet the same fate. Wholesale markets in unsecured credit will take time to recover. Some new elements, like the sovereign wealth funds, have surfaced recently and others will emerge from the current chaos. Some will be a product of how the crisis is resolved. One big unknown is the role that China with its huge reserves will play. Will it ride to the rescue of the present system as Arvind Subramniam wants?
A welcome casualty of the crisis has been the Greenspan ideology of allowing free play for market forces even if it leads to asset bubbles. Right now the central banks of the world are running a welfare system for the finance industry, rescuing mismanaged institutions even while some fat cats walk away with the cream they skimmed off for this mismanagement. The moral hazards created by the too-big-to-fail institutions will lead to stronger public oversight over all financial institutions and the reality of contagion from one country to another will ensure more organised global surveillance.
The big change will be in the geography of the industry. New York’s role as the centre of the world financial system is under threat and is probably over if the US slips into a deep recession. The new centre could emerge in London or the Euro zone where the infrastructure of financial services is sufficiently developed to provide the sort of service that New York provided. Dubai, Hong Kong and Singapore which are closer to the sources of investible surpluses and maybe even Mumbai and Shanghai will get a larger bite of the big apple.
We are in the midst of what Schumpeter would call creative destruction. But even as the existing structures are being demolished we need to start thinking about the architecture of the new city that will be built on the ruins of the present system. And we must remember that this new city too will be as disaster prone if we do not correct the macro-economic imbalances that are at the root of the current earthquake in the system.