Thunder

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By Cees Bruggemans

This Thunder Will Pass.

Nice theme the Minister of Finance used for his medium-term budget framework last week.

But which thunder did he have in mind?

A typical summer Highveld thunderstorm, starting by 4pm and all cleared by 7pm? Or the equivalent of Shaka Zulu, raging for years, laying waste to our interior, with the demographic, economic and psychological consequences still felt 200 years on?

Current events are no ordinary thunderstorm. And though Shaka wrecked much mayhem, he was only a local phenomenon. What we have now is global.

Events still keep rippling outward from the original detonation. Poor US credit decisions, subsequent exotic securitization of much toxic debt, pleasingly and reassuringly rated, and its gullible unquestioning absorption by the global financial system, created a global Chernobyl.

Apparently not only Russians know how to mess up. But this is in a category of its own, the financial equivalent of nuking the Mid-East and wishing us all a nice day.

The veil was pierced in August 2007, when a French bank developed a problem. Brother banks must have been in a high state of preparedness, knowing only to well what their own books looked like.

Anyway, the plaintive cry for central bank assistance from this weakened brother set in motion an avalanche of self-preservation. The new principle: trust no bank.

As the global comprehension of the bad loans grew, and market values plunged, further amplifying bank paper losses, banks had to increasingly recast their balance sheets even as their capital was being destroyed.

It took a year with only the odd bankruptcy, but by August this year the ninepins finally started to collapse in union. Global banks stopped lending, indeed credit collapse was next.

Even as global policymakers heroically matched systemic hits with growing lifeboats, to the point of effectively guaranteeing the global banking system in principle, the slow motion fallout was still steadily progressing.

From being a budding financial sector firestorm, the phenomenon transformed itself this October into an even bigger, fully-fletched economic one, as the real economy spillover finally came fully into view.

Credit collapse in critical areas of the global economy signaled deep and prolonged recession in the US, Europe and Japan, threatening to take other bits and pieces with it, also unceremoniously pulverizing emerging market (EM) growth prospects.

This fed the global financial panics with renewed vigour.

As equity and commodity market prices kept collapsing, a typical firestorm phenomenon, observed in WW2 in places like Dresden, Hamburg, London and Tokyo, came into being.

An inferno needs fuel, foremost combustibles and then lots of oxygen. Combustibles there were aplenty, in the forced deleveraging observable daily in New York, London and Tokyo, as overleveraged hedge funds, banks, insurers, private equity funds, pension funds, individuals, global companies and others had liquidity calls, panic redemptions and carry-trade unwinding to meet.

And thus they sold, and sold, and sold.

And what they sold most of all was the stuff still mostly out of harms way, but exotic and offshore and ultimately exposed to currency risk. With home bias resurrected with a vengeance, the money centres sold the periphery and oxygen became sucked out of all extremities.

With many EM banks and corporates Dollar and Yen funded for years, because of low interest rates and their own currency appreciation, a mad scramble was induced as the global centres sold and remitted, and EM entities tried to cover their open positions by buying Dollars.

Enormous EM sell-offs and outflows of capital resulted, shocking most EM currencies lower, increasing local inflation risk (despite oil’s demise), threatening further interest rate hiking (as in Hungary), further threatening financial and economic decline.

As the 1970s should have taught, during an intense financial shock even 1000% interest penalties overnight won’t prevent the shock event from playing out, as France and Italy then discovered.

What a puny 3% annual rate increase hopes to achieve today is anybody’s guess. Instead, with domestic collapse in progress, one should welcome the external support offered by the temporary currency depreciation.

The current global firestorm probably has more weeks to run. Global equity and commodities will likely sell off more, oil potentially ending up below $50 despite output cutbacks, before eventually reversing.

EM currencies should sell off more, also Euro and other commodity producers.

This suggests one more bailout to come. Leading central banks have Dollar swap facilities in place to assist in times of turbulence. Most emerging markets haven’t.

But culling EM looks as inadvisable as letting your banks go bust. EM is now too big to fail, either because they have sizeable reserves (China, India) or the regional cost, also geopolitically, would be far too big (Eastern Europe, South East Asia, Latin America).

The IMF is undercapitalized (only $200bn available, while $1 trillion is needed). This suggests G7 governments authorizing their central banks and/or with a stroke of a rapid pen enlarging the IMF balance sheet (politically unlikely?) to bail EM.

Source: Cees Bruggemans, FNB, October 27, 2008.

 

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