• The US credit crisis is rapidly spilling over from sub-prime to Alt-A, and to other credit markets
• We estimate the crisis could cost America USD 1.5trn, or USD 500bn for the financial sector
• It is still manageable, but needs quick and coordinated actions from not just the US, but the G7
• There will be contagion from the US to the rest of the world
• Countries with current account deficits and USD-tied currencies will be challenged
• But the cyclical setback will not stop the structural shift of world economic power away from the US
• Analysis inside on Brazil, Dubai, Hong Kong, India, Japan, and Taiwan
• Plus analysis on Asia, FX and Commodities

Synopsis

Monthly Analysis of Asian, African, Middle Eastern Economies - 20 March 2008

The USD 1.5trn question

Overview: A tale of two worlds

Are they dynamos or dominoes? This, in a nutshell, is the question the markets are asking. Will China, India and the rest of the world continue to power ahead, despite a US downturn, or will they be brought crashing down by events in the US?

Asia: The rise of pragmatism

In Korea and Taiwan, economic sense once again prevails over populist politics and this is likely to drive major shifts in economic policies in coming months, if not years. In fact, similar developments have been evident in other Asian economies, though in somewhat different settings.

FX: To peg or not to peg: Four Myths

We expect a revaluation of GCC currencies in coming months. This is the best alternative to a trade weighted basket targeting approach. We also expect even more strength in the Kuwaiti dinar (KWD) in coming months.

Commodities: Reason to be cheerful, but watch demand

A weakening dollar and intensifying inflation concerns attract investors. Fundamentals remain compelling as supplies are tight, but slowing demand is a key risk for base metals and energy.

Brazil: Economic insulation

Dubai: Property boom needs to be managed

Hong Kong: From import to domestic inflation

India: Twin deficits to widen

Japan: Down but not out

Taiwan: Longing for change

Forecasts and Sovereign risk tables

OVERVIEW

Gerard Lyons
Chief Economist and Group Head of Global Research, +44 20 7280 6988,
Gerard.Lyons@standardchartered.com

Alex Barrett
Head of Client Research, +44 20 7280 6137,
Alex.Barrett@standardchartered.com

John Calverley
Regional Head of North American Research, +1 416 361 7105,
john.p.calverley@aexp.com

• The current crisis may cost the US financial sector USD 500bn
• It is not big, but needs proactive and coordinated responses from the G7
• There will be contagion, but will not stop the shift of world economic power

A tale of two worlds

Are they dynamos or dominoes? This in a nutshell is the question the markets want to answer. Will China, India and the rest of the world continue to power ahead, despite a US downturn, or will they be brought crashing down by events in the US? To answer this, let us focus first on how things are likely to turn out in the US. Then second, let us focus on what the present situation is across the emerging world. And then third, we focus on the likely implications.

US balance sheet shifts

First, let us take the US. One of the many lessons of the last month is the speed at which things can change. The most dramatic reflection of this was the collapse of Bear Stearns. Less dramatic, but equally telling, was the shift in thinking about the economy's prospects. Now the market accepts the idea of a recession, although still surprising in our view is the general perception that the downturn may still be short-lived. But this too may well change soon. We are sticking with our view that this will be a long and deep US recession, leading to further pain in the financial sector. The combination of an economic recession and financial crisis will prompt further Fed aggressive action, and for the moment we stick with our view that the funds rate will hit 1% by Q3 and stay there for some time. We do not share recent worries that have surfaced in some quarters about inflation and, if anything, if our rates forecast is wrong, we think it would be more likely that rates hit 1% sooner than we think, or even fall further, say to 0.5%.

One of the most dramatic factors in the US is the extent to which balance sheets have changed over the last few years. The US current account deficit has remained sizable for some years now, showing that the US is spending too much, and this shortfall has been made up by borrowing from the rest of the world. This in itself has left the dollar weak and vulnerable. But the counterpart to this deficit has been a shift away from corporate and government debt, to consumer and government debt. Consumers, in turn, have made up this shortfall by borrowing heavily, either on their homes or on their credit cards. In recent years borrowing against properties averaged about $118 billion per quarter, a huge amount when one considers that the recently announced one-off fiscal boost was only about one-third bigger than one quarter's mortgage equity withdrawal, and that boost was regarded as large at the time!

One aspect of this is that the real clash should be between corporate America, which has received a large share of the spoils of growth in recent years, and between US households, who have been squeezed. But it is not corporate America that has come under scrutiny, rather the financial sector, and quite rightly too, for the way it sold debt to a household sector only too willing to borrow and spend. There is also a perception that anti-foreign sentiment has risen, although this is hard to determine, but it keeps open the fear of a protectionist backlash ahead of, or after, this November's elections.

What went up, must go down

In terms of the consumer what went up, is now going down: credit availability, jobs, confidence, and now housing. The latter’s price is falling at an annualised rate of over 20%, according to the widely used Case-Shiller Index, and based on data at the end of last year, as Chart 1 shows. Other housing measures show similar downward trends, albeit of differing scales. Thus delinquencies are rising, and banks that made the loans are being hit. Chart 2 shows the more conservative Office of Federal Housing Enterprise Oversight (OFHEO) measure of housing, which only looks at primary residences which have conforming i.e. Fannie Mae (FNMA) or Freddie Mac (FMAC) backed mortgages, and this is falling for the first time since the index was introduced back in 1973.

The hole is big, but manageable

Although there has been much talk of this being a sub-prime crisis, such lending was just the most extreme example of the over-abundance of credit and under-pricing of risk. The losses are spilling over into Alt-A and Prime mortgages and, with the deteriorating economic conditions, are likely to spread to all other consumer credit. All of this only adds to concerns about the economy and the financial sector. There are various forecasts about the likely cost, based on an assessment of the overall decline in house prices (to return to historical ratios of house prices to consumer prices would imply a 40% fall), a loss-given-default, (with estimates ranging up to 50% it seems), and based on the default rate for homeowners with negative equity (estimates range from 20% which seems too low to 50% that may be too high). All of which might provide a ballpark gross loss of USD 1.5trn. However, not all these losses lie with the banks. Moreover the banks have loan loss reserves and also can offset losses against tax. This would therefore reduce the loss for the leveraged sector, say to USD 500bn. This is the capital that needs to be replaced if the financial system is not to shrink drastically - we could assume that this USD 500bn of capital supports up to USD 5trn of debt.

A figure of USD 500bn is not that large in relation to potential new investment capital, once people are more confident about the risk. Nor is it large relative to the government's budget so even if the government provided this money there is no great fiscal problem or consequent inflation threat. But, until it is provided, by the private sector or the government, banks will continue to look to cut back their exposure, shrinking assets, reducing lending and being cautious. In addition the reduction in housing wealth will have a significant negative wealth effect. A 25% fall in housing, would be equivalent to a loss of about 70% of personal income. Add in the recent decline in the stock market and this reduces the ratio of net wealth to personal income back close to the lows of the last 50 years. Hardly surprising therefore if the savings ratio rises significantly, and over a number of years, reinforcing our view that this consumer-led downturn will be long and drawn out.

The situation in the US is made more serious by the falling incomes of the median households. A study of 2005 tax returns showed that while income across the US increased by 9%, the bottom 90% saw their incomes fall by 0.6% whilst the top 1% saw their incomes grow by 14%. The bottom 90% and the top10% of Americans both earn about 50% of total income - a disparity not seen since 1928. With the credit crunch disproportionately hitting the mass of over-extended consumers the economy looks potentially very vulnerable. The corporate sector that sells into the US market will not be particularly encouraged to invest heavily in the US in such a climate, although exporters might, particularly as the dollar declines. But overall, this will add to pressure for the government to provide a fiscal stimulus, to add to the Fed's easing.

What then is happening in the rest of the world?

Despite all the bad news in the US, the rest of the world appears in relatively good shape. The transmission mechanism by which a US downturn hits the rest of the world is multiple - as one would expect given the size of the US economy. That being said, the rest of the world has coped so far. The direct impact of a US downturn is via slower export growth, but the indirect effects may be equally significant, particularly when one takes into account the financial linkages and the impact on confidence. There has already been a significant slowdown in export growth in Asia. The financial linkages have been most evident through a tightening in offshore dollar liquidity. This has been compounded in South Korea and in India by onshore restrictions on short-term foreign borrowing. Add in current account deficits and equity outflows and the result has been large swings and significant weakness in both the INR and KRW versus the dollar. In contrast, other currencies across Asia, not hit by restrictions and benefiting from current account surpluses, have seen their currencies firm.

Despite the US downturn, it is inflation worries as much as growth concerns that are overhanging markets around the world. Ghana, for instance, was the latest to tighten domestic monetary policy this week, raising its prime rate from 13.5% to 14.25% as annual inflation hit 13.2% in February, versus a 5% central bank target.

The big challenge is food and energy prices. In dollar terms these continue to firm, with many factors coming into play. The recent firming of commodity prices, despite a weaker US, reflects a combination of supply driven events, but also reflects still strong demand and the influence of China. In terms of China, it is not just China's demand that drives commodities, but also changes in China's own domestic capacity to produce many of these commodities. If one gets China right, one is likely to get many of these commodity markets right. Moreover, copper and zinc are heavily geared to the global construction cycle, which has continued to benefit from the global infrastructure boom.

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