• One year on, the credit crisis still has some way to run
• There is no evidence yet of a bottom in the US housing market, which is key to the current crisis
• In fact, the crisis is spreading from the US to the globe
• But the world is split between the haves and have-nots
• Those with sound fundamentals will benefit, those without will have tougher times ahead
• We expect the West to see more bank failures, slower or no growth, lower inflation and interest rates
• For the emerging markets, especially Asia, this may be the pause that refreshes as economic activities move from breakneck to solid
• Analysis inside on Brazil, Indonesia, Jordan, Kenya and Thailand
• Plus focuses on FX and Commodities

Synopsis

Credit crisis continues

Overview: The credit crisis - one year on
The credit crisis started a year ago has still got some way to run. There is not likely to be any let up in the near term and we have, as yet, not seen the full impact of deteriorating credit card and other consumer debt. In fact, the crisis is spreading from US financial sector to the whole global economy. For next year, we expect more Western financial institutions to fail, Asia moving from breakneck to solid growth while the West from slow to no growth. Also, we expect inflation fears to subside and interest rates to fall.

FX: The paradox of thrift
Current US optimism is overdone, but USD will gain from pro-active policies and valuation. Asian currencies have further to fall into H1-09 as inflation concerns give way to growth. Further out, USD will suffer from rebounding liquidity and competition for capital inflows.

Commodities: Commodity confidence crunch
Crude oil prices fall 18% m/m, erasing June's gains and leading the commodity complex lower. Cyclical demand concerns outweighing supply risks for now. Broadly, we expect commodity prices to consolidate at a lower level as the cyclical downturn progresses and the direction of the USD is less clear, but they will still be at historically high levels.

Brazil: Monetary tightening to continue

Indonesia: The comeback of PDI-P

Jordan: Riding the storm

Kenya: Forecasting post-crisis growth in Kenya

Thailand: In search of a growth engine

Forecasts and sovereign risk tables

OVERVIEW

Alex Barrett
Head of Client Research, +44 20 7885 6137, Alex.Barrett@standardchartered.com

• One year on, the 'credit crisis' has still got some way to run
• The crisis is spreading from US financial sector to whole global economy
• Inflation fears will subside and interest rates should fall

The credit crisis - one year on
Last week marked the one year anniversary of the 'rant' by CNBC's Jim Cramer (the host of a US financial programme) at the serious state of the markets and the US authorities' lack of action to deal with the housing market problem. (It is well worth watching for anyone who has not already seen it.) He called for the Federal Reserve to 'open the discount window' and to 'cut rates'. Within two weeks the sub-prime losses in the US froze the world's money markets when several European financial institutions acknowledged losses in their asset-backed securities portfolios. The severity of the losses, and their unexpected location, broke an already fragile market. Funding for securities portfolios dried up and the cost of inter-bank borrowing soared as banks lost faith in each other.

The Fed did respond, cutting rates heavily, opening the discount window to a wider range of institutions and accepting a wider range of collateral. Other western central banks also extended their repo facilities, though worries about inflation allowed them less room to cut rates aggressively. However, the situation is far from being resolved. Back in March we estimated the total losses of the US financial system to be well in excess of USD 500bn and now, if anything, we expect it to be worse. Already US financial firms have declared losses of USD 250bn out of global losses of over USD 500bn, as outlined in Table 1. Losses so far in Asia-Pacific have been small but many of the problems that we have seen in the US housing market are also present in the Australian housing market, where the slowdown has been delayed by booming commodity markets. The losses have spread from sub-prime to higher credit-quality mortgages. The losses and market seizure have caused the demise of the fifth biggest US broker-dealer, Bear Stearns, as well as the first bank-run in over 100 years in the UK. Northern Rock was then forcibly nationalised. Many financial institutions have been taken over, gone under or had to restructure radically.

During 2005-06 there were no closures or assistance for any bank by the Federal Deposit Insurance Corporation (FDIC). But since the start of 2008, eight FDIC-guaranteed banks have failed, which we show in Table 2. This is out of a universe on over 8,500 FDIC guaranteed banks in the US.

The main reason for these failures is the housing market. Even though the last month has seen some evidence that the US housing market is no longer accelerating to the downside, there is no evidence yet of a bottom in prices, and the overhang of unsold homes is still enormous. Chart 1 shows the Case-Shiller house price index, 18.4% off its peak. Chart 2 shows there are 11 months of unsold inventory out there, a number that is still climbing.

There is not likely to be any let up in the near term and we have, as yet, not seen the full impact of deteriorating credit card and other consumer debt. Recent card company results fell short of estimates with significantly increased provisions for losses. US retail sales have been helped by the Q2 tax rebates so there is more pain to come. The pain is also spreading, with retail sales falling in the UK and Europe and the corporate sector in the West, which entered the crisis in sound financial condition, is finding that the increased costs of borrowing, the unavailability of credit and the drop in retail sales are starting to take their toll. Banks are putting aside increasing amounts of provisions for future client defaults. There will clearly be more financial institutions that fail both in the US and elsewhere.

Another aspect of the credit crisis has been the flight to emerging markets and commodities following the Fed's unscheduled decision to cut rates on 17 August 2007 (just ten days after keeping rates unchanged at the scheduled meeting). Though we never subscribed to it, there was a view that Asia (and EM in general) was 'decoupled' from the turmoil in the US. With the US consumer responsible for 30% of world consumption we always felt that the EM would be 'insulated' rather than 'decoupled'. Increased domestic consumption and the ever-increasing importance of new inter- and intra-regional trade corridors were always going to be important supports, but were clearly not of the scale required to replace the US. Growth in EM has weakened, partially in response to the weakness in the G3, but also partly because of the tightening of monetary conditions in response to inflationary pressures. EM does face a cyclical slowdown, but from very high levels of growth. The longer-term outlook is still very positive, though. The secular shift of economic power from West to East will continue and the eventual end of the credit crisis will almost certainly leave Asia and much of the rest of EM in a much stronger relative position.

The prospects of continued growth in EM and weakness in the USD led to big moves in commodity markets, especially for oil and food, in the last 12 months. Oil has rallied from below USD 70 per barrel in August 2007 to reach a peak of over USD 145 per barrel last month. Though some of this move was geo-political, little was 'speculation' as the buying of oil futures does not affect the amount of oil available for consumption. Most of the rise came from increased demand and the inability to deliver enough 'cheap' oil - a result of higher drilling and exploration costs and the lack of investment over many years. The recent fall in oil prices is a welcome relief for the world but the move is unlikely to last long given demand growth from Asia and other EM. Similarly, demand and supply remain the key factors in food prices and we should not expect much, if any, reduction in prices. Chart 3 shows oil and wheat prices.

Inflation remains the predominant issue for EM, mostly because of commodity prices. Inflation has hit much of EM hard as its exposure to commodities, given their investment-intensive growth, is high and oil/energy-use efficiency is often low. Moreover, food-importing EM has suffered with its higher Engel co-efficients. The response across EM to inflation has varied. China, for instance, tightened the availability of credit sharply starting in October 2007, with apparently positive results. Producer (factory gate) prices are still accelerating but the CPI seems to have peaked. Other parts of EM are initially benefitting from the commodity boom, but there are clear risks that the seeds of bust are sown in the boom. In the Gulf, in particular, where there are few instruments to tackle inflation because of the currency pegs, inflation could become embedded. At some point in the future the GCC countries must address their monetary and currency regimes. Hopefully sooner rather than later.

We remain relatively sanguine on inflation. The deflationary effects of the credit crunch and the increase in the prices of oil and food, which reduces other discretionary spending, undermines inflationary pressures in many, though not all, economies. Money supply, which is notoriously difficult to measure, globally was running at elevated levels for a number of years prior to August 2007. Thanks to easy monetary conditions in the US, fast liquidity growth in China and the Gulf, combined with the creation of liquidity through financial engineering and the world was awash with cash. As ever, this money found its way into unproductive 'investments' and over-consumption, especially in the US and UK (but also elsewhere).

Are we now at a tipping point for the global economy? The data seems to show that in several key markets money growth is slowing. In the UK, for example, the amount of money available to companies and individuals is collapsing, as Chart 4 shows. In China, money supply seems to be moderating, though the authorities are already looking to protect growth, partly relaxing the loan quota and easing up on the appreciation of the CNY. With property and equities under pressure throughout Asia and households being squeezed by high commodities maybe inflation will take care of itself.

The nature of the credit crisis has gradually evolved over the past year from a pure liquidity logjam, into a broader deleveraging trend, as solvency doubts rose, and then, finally, into a broad real economy crisis, not just in the US but across the global economy. Confidence indicators and cyclical leading indicators have plunged in many developed economies (with the UK looking particularly vulnerable). In our footprint, there is more tangible evidence of an abrupt slowing in the pace of trade growth. For the moment, the straws in the wind are not encouraging. Singapore GDP rose 2.1% y/y in Q2 and we have flagged the risk of a technical recession in 2008. China's export growth has been slowing steadily from the 25% annual growth of 2005-06 and will be just close to 0% in real terms by year-end.

However, there is a fine line to tread for the US and other policy makers worried about whether the credit crisis could finally spill over into a broader global economic crisis. For the EM economies at least, this may be the pause that refreshes. Heading into the market melt-down, they had been on a tear; real growth averaged 7 .5% over the years 2004-2008 - real output in EM conomies climbed by a third in just four years. But financial market distortions powered over-investment in (arguably unproductive) residential housing stock in the developed economies, while vital infrastructure investment failed to match the requirements of super-charged output growth across EM. A redistribution of savings as well as a retooling of financial markets are required - but underlying investment demand is still healthy across EM.

And for the next year? First, expect more Western financial institutions to fail or be restructured. Second, expect the lack of credit to lead to slower economic activity, with Asia moving from breakneck to solid growth, and the West from slow to no growth. Third, expect inflation to ease as growth slows and deflation returns as a key risk for the West. A geographic rotation of the policy response to the crisis will be required. Whilst the US Federal Reserve may have hesitated back in early-August 2007, since then much has been done in terms of both monetary and fiscal stimulus. Additional US monetary policy easing carries risks - it could drive dollar commodity prices even higher, and undermine confidence in fiat currencies. At root, it may simply postpone some erosion in US living standards and have adverse distributional consequences (potentially harming those on fixed incomes). Going forward, the policy response may be more vigorous outside the US with central bankers globally, ranging from the European Central Bank to the BSP in the Philippines turning their attention from fighting inflation to supporting the pace of economic expansion. This sea-change is already evident in China (our 01 August OTG was headed China: Loosening Begins). Against this backdrop, it would not be surprising if the US dollar develops a firmer footing in coming quarters.

The Fed and much of the world went into the credit crisis one year ago worried about inflation and believing that the crisis would be short-lived. It was not. The process of unwinding the excesses of the last few years will take time, and will probably involve three broad steps. First, liquidity will be reduced, second insolvencies will increase and finally, economic activity will fall. We are somewhere between steps one and two. Economic activity still has some way to fall. As deflation and slowing growth causes inflation fears to subside, rates should fall as well. This started as a US centred crisis but the effects will be felt globally. Overall the world will be split between the haves and have-nots. For countries and especially companies with good liquidity, solvency and sound business models there will be great opportunities to buy assets and build businesses. For those without there will be even tougher times ahead.

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