Uncertain times ahead for the global economy - BIS

By Neil Behrmann

June 2007, The Bank For International Settlements (BIS) has published an annual report that is uncomfortable but essential reading. It should shake up sanguine finance ministers, economists and investment bankers.

Beware the consensus, warns the Basle-based central banks' central bank. This is the optimistic view that the global economy and stock markets will continue to be buoyant. At worst any downturn will be shallow and be followed by a renewed non-inflationary boom, the optimists say. The BIS, however warns that there is a very real risk that a gigantic global speculative credit, equity, real estate and commodity bubble could implode. This would not only bring about a sharp reversal in asset prices, but a downturn in consumer spending and a decline in economic activity worldwide.

Comments Prescient

The report is being taken seriously as the comments have proved to be prescient. It was written weeks before Wall Street was shaken by the biggest hedge fund crisis since Long Term Capital Management folded in 1998. Two hedge funds of Bear Stearns have speculated in opaque esoteric illiquid debt products and are effectively bust.

Investors are doing their utmost to flee and greedy bankers who lent the hedge funds an estimated US$10 billion to US$20 billion are trying to recover their money. The penny has finally dropped. Banks have begun to review their credit lines to other hedge funds and private equity firms.

The danger is that private equity firms and their partners have borrowed hundreds of billions of dollars at low interest rates in yen, Swiss francs and other currencies to buy companies on global stock markets. The banks have been happy to lend them money because they have been able to package the loans and sell them on to hedge funds, pension funds and wealthy individuals.

Banks have also been happy to lend people money to buy real estate. The sub-prime loans have also been packaged and sold to hedge funds. But as can be seen from the Bear Stearns fiasco, the hedge funds have also borrowed money to buy the packaged loans.

Dropping the parcel

The problem arises when someone drops the parcel, as has happened to Bear Stearns. It is probable that other hedge funds will fail. Banks then cut back on lending to both hedge funds and private equity firms. Mergers and acquisitions that have boosted global stock markets would taper off, leading to a correction in equity markets.

Hedge funds would be forced to sell equity holdings, commodities and other assets. Numerous companies that have been taken over via so called leveraged management buyouts have also taken on large debt. If economies and business turn down, these leveraged companies could fail, causing a further downturn in stock markets and economies.

How events surprise economists

The Great Inflation in the 1970s took most commentators and policymakers completely by surprise, as did the pace of disinflation and the subsequent economic recovery, comments the BIS.

Virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and South-east Asia in the early and late 1990s. Each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived.

Asia and other emerging markets have become particularly vulnerable as foreign mutual and hedge funds have poured money into these markets. Any downturn in the developed nations home markets would lead to withdrawals from Asia and other nations.

The BIS recalls the euphoria about Japan in the 1980s. Many commentators then believed that it was only a matter of time before Japan would overtake the US as the biggest economic power. The subsequent slump and deflation that still plague Japan are well chronicled.

Chinese uncertainties

The Chinese economy seems to be demonstrating very similar, disquieting symptoms, cautions the BIS. It cites ballooning credit, an asset boom, and 'massive investments' in new buildings and heavy industry. Some two-fifths of China's state-owned enterprises are loss-making, exposing the banking system to stress in a downturn. China's growth is 'unstable, unbalanced, uncoordinated and unsustainable'.

In the past year central banks have been raising interest rates in an attempt to control the boom and inflation. But they are holding a monster by the tail. A further increase in interest rates could easily tip the scale towards market slump and economic downturn.

This is what happened to Japan at the beginning of the 1990s. The US Federal Reserve and other central banks would then have to start cutting rates again. What then? Volatile and dangerous times lie ahead.

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