• Many asset markets have stabilised recently, but we believe we are at the end of the beginning, not the beginning of the end
• In the next phase, negative credit and wealth effects will drive banks and households to de-leverage further
• There is likely to be a long US downturn because US consumers will take time to rebuild balance sheets
• We need to improve our management of risk, liquidity and pro-cyclicality
• As such, policymakers across Asia need to quicken financial sector development
• Analysis inside on Brazil, EU, India, Pakistan, Vietnam and Zambia
• Plus focuses on Asia, Middle East, FX and commodities
  

Synopsis

Monthly analysis of economic and financial market developments - 15 May 2008

End of the beginning

Overview: The worst is far from over
In recent weeks, confidence has returned to many parts of the financial sector. This has led some asset markets to stabilise, and has even led the market to believe that the next move in US interest rates is up. However, we believe that we are only at the end of the beginning, not the beginning of the end.

Asia: New villain - food
Food inflation is the biggest near-term threat to many Asian economies, even for food exporters. Sharp relative price changes complicate traditional monetary policy, especially at a time of lower export demand. Central banks in the region should be mindful of the asymmetric risks between monetary tightening and easing in addressing the issue.

Middle East: Food prices expose differences
Food inflation is fuelling unrest in the Middle East and North Africa (MENA) region. There are different implications for different parts of the region. Egypt and the Levant countries will be the worst hit, we believe.

FX: Rate expectations
The markets are being too optimistic about the eventual US recovery. This may undermine the USD as US data deteriorates further. A consumer-led downturn is likely to be longer lasting than a corporate-led one. The KRW is sensitive to both high oil prices and further bad credit crisis news. We maintain our call for relatively fast Chinese yuan appreciation in 2008.

Commodities: Shifting sands
Commodity markets have taken a battering over the last few weeks, not on fundamentals but on changing global conditions and sentiment. Non-energy commodity prices have eased back significantly from the speculation-induced highs of March. Overall, we believe that global conditions are still supportive of high commodity prices, but there will be less upward momentum for the rest of 2008.

Brazil: A sovereign wealth fund? Not so fast

EU: A slowing impetus

India: Evaporating exuberance

Pakistan: Challenging times ahead

Vietnam: In need of firm hands

Zambia: Resource nationalism and currency strength

Forecasts and Sovereign risk tables

OVERVIEW

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

• The current crisis is far from over
• Banks are set for further consolidation and deleveraging
• Need to better manage risk, liquidity and pro-cyclicality

The worst is not over

The Western credit crunch
In recent years the world economy has boomed. Now we are seeing a slowdown. This slowdown is centered on the US, but its impact will be seen around the globe. Even though there is a need to be cautious about immediate economic prospects, there are many reasons to be positive about longer-term prospects. I will address some of those key structural issues later. Here I will focus on the present situation.

The world economy - but in particular the West - is in a financial crisis. Every financial crisis is different. The outcome depends on a number of factors: the economic fundamentals, the policy response and confidence. Of these, the hardest to predict is confidence. In recent weeks there has been a return of confidence to many parts of the financial sector. In turn, this had led many asset markets to stabilise, and has even led the market to believe that the next move in US interest rates is up.

I would warn against believing that the present financial crisis is over. Indeed, why should one believe those financial firms that are now telling us the credit crunch is over, when only a few weeks ago some of those firms did not know the value of the positions that they themselves were holding!

I would like to believe that this is the end of the credit crunch, but I do not think it is. To use a Churchilian phrase, we believe that we are at the end of the beginning, not at the beginning of the end. Or, to put it another way, we believe that we have finished the first phase of the crisis, and now we are about to enter the second phase. The first phase since last August has witnessed a period of intense financial stress. The second phase will be how this feeds into the wider economy. And in particular, there will be a focus on how the US is affected and on how any problems in the US impact the rest of the world.

One way to picture this is that a race is on, with policymakers and central bankers trying to stabilise the financial sector before economic problems hit. In my view, policymakers will fail, on both counts. They will not be able to prevent a downturn and, despite recent policy actions, parts of the financial sector in the West may be too fragile to cope. The economic downturn will see defaults rise, bad loans increase and the price of assets change. Financial firms in the West are likely to see a further deterioration in asset quality if the economic outlook deteriorates, and if property prices fall. There will be a negative wealth effect. There will be a negative credit effect. Any deterioration in the economic outlook could expose more skeletons in some parts of the financial sector, with concerns having been expressed about areas as diverse as US commercial real estate, monoline insurers, US government sponsored agencies and the credit default swap market.

Policymakers need to help minimise any of the spill-over from the financial sector into the economy, but they also can't overlook the enduring aspects that led to this crisis and that contributed to financial instability. For us here, the questions to ask are what are the immediate consequences and what are the longer term lessons? Here I will focus on the lessons for the financial sector. There is deleveraging. Parts of the securitisation market have effectively closed. And, within the financial sector, we have moved from one extreme to the other. Whereas in recent years markets were not pricing for risk - or perhaps one should say participants in the market were not pricing for risk - now we are seeing in many western markets, particularly in the US and the UK, not only higher pricing for risk but also a reduction in the quantity of risk that is being taken. This will lead to a reduction in lending. In recent months we have witnessed a host of banks face liquidity constraints and then capital constraints, prompting them to sell assets and to shrink their balance sheets.

At the beginning of this month the Bank of England released its impressive half-yearly Financial Stability Report. Looking at the global situation, the Bank of England said that markets may be overstating losses that will be seen. This led the Financial Times to proclaim in its front-page headline that the Bank of England believed the credit crunch was over. Nothing of the sort! The Bank was focusing on the sub-prime market, which was factoring in a default rate of 38%, which would imply that 76% of lenders would lose half of their money. Whilst it is possible that the particular sub-prime market may be too pessimistic, it would be wrong in my opinion to imply anything for other financial markets. This downturn is already more complex, more nuanced and it is necessary to dig deep into the data to determine what exactly is going on. In short, it depends on where you sit and on what you do. Different businesses, different people will be impacted in different ways. The Bank of England, in that Report, also said that there are large discounts in the market for illiquidity and for uncertainty. That is certainly right. And, for banks, there has to be a genuine fear that continued liquidity constraints could lead to capital problems. I would suggest, that central banks are providing more liquidity not only to address immediate issues, but also in the hope that this will prompt banks to increase their transparency regarding writedowns and to raise more capital.

Further consolidation is inevitable within the banking sector. The fact that earlier this year some Western banks had to turn to Sovereign Wealth Funds (SWFs) for an injection of capital is as clear a sign as one needs of how the balance of power is shifting. The injection of capital by SWFs prevented at that time a consolidation of the banking sector. SWFs have rightly been seen as the new power brokers, alongside private equity and hedge funds. But they also highlight the growing importance of sovereign players, seen also in rising foreign exchange reserves, and also likely to be seen in the greater role of governments in markets. Indeed the latest crisis in food prices has already led to some calls for markets in staple foods to be closed, to discourage speculation. Whether that happens or not, I think in coming years we may see more government to government barter transactions, particularly in the areas of commodities.

There are many lessons from this financial crisis: One is that the financial industry is cyclical. The headline in the New York Times read, "End of the leveraged era". When was the headline? Recently? No, it was 1990.

One lesson from previous financial crises is that some cycles can be bad. There have been eighteen post World War Two financial crises in the West. This has included, for instance, Finland in 1991, Norway in 1987, Spain 1977 or Japan during the nineties. In the worst, the fall in output from peak to trough was around 5%, and it took three years for the economy to return to trend. "It's different this time!" seems to have been what was said on the way up. And it is also what appears to have been said on the way down. The lessons from previous crises is that they can be long, the clean up costs can be high, and in the worst ones, there were many false dawns, when at some stage it may have appeared that the crisis was past the worst.

Certain aspects of this crisis were different. The role of structured products, and the role of the originate and distribute model, particularly with respect to the mortgage market and to Special Purpose Vehicles, are often cited as the features of this crisis. But there were also key factors that led to this crisis and which have been evident in previous ones, in particular, low risk premium as the market did not price for risk, and the strong self-feeding correlation between the financial system and the real economy, with the availability of credit almost adding fuel to the fire.

In recent years there were many warnings, from many people, ourselves included, about the potential problems facing the financial sector. In some respects it was as if the market heard but did not listen. A good example of this was a very well attended session in the auditorium at the Bank of England, in December 2006 entitled, "Pricing for Risk." The message was clear. The market was not pricing for risk. Those there heard, but, to use a football analogy, it was as if the audience did not merely want to know who might win or lose a football match, they wanted to know the exact time and minute the goal would be scored, and in the absence of that they would continue behaving as they had. In short the market heard the risks, but was not prepared to change. People did not listen. Also, one might say when the market did listen, it did not understand, appearing to believe that the endorsement of the rating agencies covered them against all types of risk, when it clearly did not! It was clear that something would go wrong, but it was not always possible to say, what and where, although the US sub-prime was what one might call a "canary in the mineshaft", a sign that not all was safe.

This crisis clearly highlighted that the industry is global, of which there were many examples, whether it be the German bank IKB struggling with asset bank commercial paper at the end of July that required a cash injection from KfW, or the fact that a US sub-prime problem led to the fall of a building society Northern Rock in the UK.

There are also some broader issues that need to be addressed, these can fall under a number of broader categories, of relevance to both the private and the public sector. There has already been much focus on the regulatory regime and how it needs to adjust. It has often been said that the ideal situation would be maximum supervision and minimum regulation. The danger with much of the debate on regulation is that it risks being backward looking. Often the safeguards are not there for what does go wrong. After much focus in recent years, we seemed to have avoided a hedge fund crisis that was once feared. Yet liquidity has been the concern. We need minimum capital and liquidity buffers, especially regarding the warehousing of risks off balance sheet. For the private sector, there will be many lessons, including the need to abandon flawed business models, cut costs and cut non-core businesses. And whilst the aim for much of the private sector in the West appears to be the desire to be Leaner and Fitter, my fear is that much of it may end up being Skinnier and Weaker.

Overall, it would seem that the broader lessons fall under three categories: One, risk management in firms. The pricing of risk needs to improve.

Second, addressing the issues of liquidity. A recent speech by the Bank of England’s Nigel Jenkinson outlined the key points, with which it is hard to disagree, including the need for more contingency funding plans, the need to address the sources of liquidity risk under stressed conditions, that the management of liquidity risk requires a robust framework, and the need to support improved market functioning through better disclosure and stricter market discipline.

Third, the need to deal with pro-cyclicality, across industry in areas such as the need for risk-adjusted bonuses, and within policy.

Yet, even though this financial crisis is concentrated on the West, policymakers in Asia are not immune from criticism. This may seem harsh but it is justified. Another way, widely used, of looking at this credit crunch is to view it in terms of global imbalances. In recent years we have seen a booming but an imbalanced global economy. For some years now economists have been calling for a return to balance. Such a return has a number of different aspects to it, including a period of weak, below trend US growth, steady growth in Europe and Japan, a weaker dollar and the need for stronger domestic demand across the emerging world, including Asia. In recent years, Asia's savings glut has seen a recycling of savings from the East to the West - savings have gone uphill, to coin a phrase. In addition to Asia's savings glut we have also witnessed large current account surpluses, and hence savings, across the Middle East, as oil prices have soared. This recycling of savings from Asia and the Middle East has allowed the US to live beyond its means. It has allowed the US to sustain a large trade deficit for a considerable time. Now that is unwinding. Yet, savings need to be intermediated in the emerging world. But capital markets in the emerging world are not deep enough to allow this yet. This highlights one underlying and often overlooked aspect of this crisis, the underdevelopment of capital markets in the East. Policymakers need to help drive this change, as deeper and broader capital markets would help switch high savings into increased domestic demand. One lesson of the 1997 Asian economic and financial crisis was the need to deregulate a country's financial sector at a speed best suited to domestic needs. Yet the response in many countries has been an inertia, which has meant that even though there has been development of financial sectors it has lagged in many instances economic needs. Thus, we need to see policymakers across Asia help drive the development of financial sectors at a faster pace.

And, of course, there are the wider economic implications as this crisis now feeds into the real economy. Take the US, the economy at the epi-centre of this credit crunch. How will it be impacted? For some time now we have been cautious about the US. The US economy is in recession; even though latest GDP figures were positive, this was largely because of higher unsold inventories and the impact of net exports, with a weaker dollar helping exports. We expect second and third quarter GDP to contract. This is likely to be a longer lasting US downturn than has been the case as the area pulling the economy down is the US consumer, rather than the corporate sector. Consumers will take far longer to re-build their balance sheets, spending less and saving more, meanwhile they will also drag on corporate sector performance. The last US recession in 2001 was a shallow, V-shaped recession focused on the corporate sector; this is likely to be a U-shaped recession felt by consumers. Rising food and energy costs is squeezing the amount that people have available to spend elsewhere. In addition, a slowing jobs market, falling housing market and much tighter credit conditions are forcing consumers onto the defensive. In coming months, we need to be prepared not just for further problems in the US, but also for markets to become more cautious regarding Asia.

Asia

Simon Wong
Regional Economist, +852 28211042
Simon.Wong@standardchartered.com

• Food inflation is the biggest near-term threat to many Asian economies
• Sharp relative price changes complicates traditional monetary policy
• Current trends threaten most Asian economies, even for food exporters

New villain – food

It has been widely observed that the current rise in inflation across most of Asia has been driven by food prices. A less appreciated trend is how much prices in the non-food sector have lagged behind. As Chart 1 shows, GDP-weighted price measures that we have constructed show food inflation consistently outrunning overall inflation in recent years. The divergence has widened in 2007 to unprecedented levels. The emerging picture is thus not only rising inflation per se but also a steep jump in the region's food prices relative to non-food prices, by 4.3ppts higher in 2007 and a cumulative 9.4ppts between 2002-07. Contrast this with the high inflation era of 1979-1985, when region-wide inflation was a cumulative 27% but food prices only outperformed non-food prices by 1.3ppts during the period, and it becomes clear that Asia has a different inflation challenge this time around1.

An unsettling comparison
There are some similarities with the US during the mid-70s. It saw a similar spike in food inflation (a 15% gain in relative prices between 1973-1974, as we show in Chart 2), and surging oil prices (following the 1974 oil price hike) that plunged the economy into the 1974-75 recession. More unsettling still, the period was accompanied by the Federal Reserves tightening policy in an effort to combat inflation. The Nixon administration stepped up its intervention in terms of farm subsidies, soybean export bans, along with other wage and price controls. All these strike an eerie resemblance to the latest developments in Asia, where more central banks are turning hawkish on food inflation and more governments are talking about measures to secure their own food supplies.

Not a question of who will lose, but who will lose more
The key question, then, is who among the region's economies are more vulnerable if and when the current rise in food prices turns out to be protracted. One thing for sure is that high inflation, however caused, will mean a loss in real income for all economies that will undermine real consumption in general. In the current case, higher food prices will not only directly undermine real food demand but will likely also spill over to other sectors as low income elasticity for food tends to increase households' food spending at the expense of their non-food spending.

Yet what is more damaging are the redistributive implications. Food inflation is like an extreme form of regressive tax that hits the poorest hardest, both within and across economies. From this perspective, the more vulnerable economies are clearly those with relatively low income levels and high food spending. As seen in Chart 3, Vietnam, China, Indonesia and the Philippines are the economies that have a large food share in their consumption basket and have seen the fastest food inflation. Indeed, some have already seen rising fiscal and social distress as existing safety nets struggle to adjust to recent sharp changes in relative prices.

Aside from income, rising food prices will also affect the region's economies through their external balance. Asia as a whole runs a net deficit in its agriculture trade of around 0.5% of the region's GDP, and as such it stands to lose in the event of a broad rise in world agriculture prices. Of course, this picture varies greatly across economies, with the external balances of net exporters like Malaysia, Thailand and New Zealand standing to benefit, while those of net importers like Hong Kong, Taiwan and Korea will deteriorate (see Chart 4). Having said that, we should emphasise that even for the biggest exporters, the gains in their trade terms that come from price appreciation have to be discounted against the income loss coming from higher domestic inflation.

Double jeopardy
For Asia, this appreciation in food prices also comes at a particularly difficult time, when the region is already facing a year of markedly lower global export demand. Indeed, the latest round of export data from Japan to the Philippines has confirmed our earlier scepticism of the decoupling story and pointed to far lower external-driven growth for Asia in coming quarters, if not years. Under these circumstances, the threat of surging food prices undermining domestic consumption clearly presages a broader slowdown for the region.

Authorities across the region confront a policy dilemma -- whether to tighten to combat inflation or loosen to sustain growth, whether to maintain budget discipline or heed the call for food poverty relief. While there is no one-size-fits-all answer, the nature of this inflation episode does suggest that fiscal policy can be an effective tool since it allows targeting of the most distressed groups, with an immediate impact.

Monetary policies face asymmetric risks
On the other hand, monetary policies are not a great tool -- since food demand and supply are inherently inelastic in the short term. As such, we expect monetary policies in the region to focus on maintaining stability in the non-food sector in face of higher food prices and a possible slump in external and domestic demand. This suggests that the appropriate level of monetary policy tightness could come below the level justified by headline inflation going forward. Even so, central banks should be mindful of the impact that tight monetary policies could have on food production factors (e.g. farm credits, insurance costs) that could perversely further restrict supply and push up prices in the short-term. While maintaining a loose policy bias clearly runs the risk of "appearing soft" on inflation when the headline figures are running high, we think that is a risk worth taking.

Price stability? What price stability?
Beyond the immediate threat, we think that food inflation also calls for a rethinking of the optimal monetary policy model for the region's central banks. There are clearly discrepancies between current price developments and the classical definition of inflation, namely a persistent rise in the general price level, that challenge the very logic behind using the CPI as the predominant policy target. In particular, it is a well-known fact that a fixed-weight construct like the CPI tends to overstate the welfare loss when underlying prices diverge greatly, as now. While these issues seem mundane, they lie at the centre of our understanding of the concept of "price stability", a core concept in modern central banking.

The shifting regional food trade dynamics
As a final note, Chart 4 also compares food trade balances in 2006 against where they were one decade ago, and it is clear that, with the exception of Thailand and Indonesia, surpluses among the net food exporters generally narrowed during the period. Meanwhile, deficits among the net importers were stable, though China saw its shortfall widen from 0.2% to 0.7% of GDP. Given the sheer size of China's economy, this widening translates to an estimated additional net absorption of USD 13bn (in 2006 prices) in agricultural produce from the international market, compared with a total net absorption of USD 42bn for the whole region.

1 Due to data limitations, only China, Japan, Australia and the Philippines food inflation are available for this earlier period.

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