INTERNATIONAL. Dr Gerard Lyons, Chief Economist for Standard Chartered, said in a speech that although we are experiencing the worst crisis for 80 years, there are some positives that should not be overlooked. The phase could yet turn out to have a happy ending, with emerging market economies likely to emerge stronger than ever.

Speaking to 200 bankers and financiers at the Standard Chartered breakfast held during the International Monetary Fund (IMF) meetings in Washington recently, he said that policy actions until now have pulled the financial sector back from the brink. As in Japan in 1997 the policy response has focused on injecting capital, providing liquidity and restoring trust. But financial sector worries will persist and the economic outlook in 2009 is grim. The US and UK in particular face deep recessions, said Dr Lyons. 

Emerging economies are not decoupled, and China and India will slow sharply. Emerging economies will rebound sooner and stronger, with 2010 likely to be a recovery year for them. 

This is not the first financial crisis. It will not be the last. So far it is the worst for 80 years and may yet prove to be worst of all-time. Yet, although all financial crises are different, their outcome depends crucially on the interaction between three key factors: economic fundamentals, the policy response and confidence. And of these three the hardest to call is confidence.

The economic fundamentals are poor in the US and UK, the two worst hit crisis countries. The policy response, having been too piecemeal, is now focusing on the need for a systemic solution. Meanwhile, and partly because of the hitherto piecemeal approach, as well as a deteriorating economic climate, confidence has been shot to pieces. It is this that is most worrying. Once confidence has been lost a crisis moves out of control.

There have been many comparisons of this crisis with previous ones. In particular, with the Great Depression. One of the telling features of that time was the policy mistakes that were made, including the inability of policy makers to act in a proactive way to address problems. US policy makers appear to have learned lessons from the Depression, particularly in terms of monetary policy and on the need for a proactive policy response.

Yet Standard Chartered has argued that a better benchmark for what we are now seeing is Japan in the latter half of 1997. Japan’s bubble burst in 1990. The Nikkei peaked in December 1989 and - even now - is still less than half of its value then. Although the bubble burst in 1990, it was not until 1997 that the financial crisis came to a head. That year there was premature fiscal tightening in Japan. Moreover it was the year that – to use American jargon – the problem spilled over from Wall Street to Main Street. That is, it was the year problems really spread from the financial sector to the wider Japanese economy.

Although the bubble had burst in 1990, jobs were still created until 1997, when the employment situation turned negative. The deterioration in the jobs market is particularly relevant for comparisons with the present US crisis, as the outlook for the US jobs market is now deteriorating. In Japan, in late 1997, in the space of a couple of weeks we saw three major financial failures: Yamaichi, Hokkaido Takushoku Bank, and Sanyo Securities. To put that in perspective, Yamaichi was the biggest Japanese post-war failure and at the time when it went bust it was the main headline news in both the US and UK, such was the shock.

In response the Japanese took decisive action, and it is that action that we should bear in mind now. The government injected capital into the banks, buying preferred stock and subordinated debt; the Bank of Japan embarked upon a zero interest rate policy and, importantly, used its balance sheet in an aggressive manner; a consolidation of the banking sector was forced through, which now leaves some of the biggest Japanese banks in good global shape; moreover, the whole system pulled together.

Judging from the short-selling in the US markets immediately before Dr Lyons' speech it is not clear this is happening in the West. The issues were capital or solvency, liquidity, and trust. All are important. And a liquidity issue can quickly become a solvency issue if not addressed.

In terms of current problems we face both a financial and an economic crisis. It is important to differentiate between each of them. Both will feed on one another, but both need to be addressed individually. Normally the financial and banking sector goes into a recession or downturn in good shape, but not this time.

In terms of the economic crisis, we have already had a ‘double whammy’, particularly for many emerging economies.

First, with rising food and energy price inflation this Summer and now with the economic impact of this financial crisis. The rise in food and energy prices is being corrected, as speculators and investors reverse previous positions and as global demand slows. Generally, falling commodity prices help the present global situation, but as in the Great Depression it is important that policy makers do not assume that this in itself will help economies self-correct. During the Depression there was a belief that falling prices would boost people’s and firms’ spending power, but when economic expectations are so poor, and prices may even be expected to fall further this does not happen. Just as confidence is vital, so too are expectations about the outlook. Hopefully we will avoid an asymmetric response, as in the Summer rising energy and commodity prices led to misplaced inflation fears, particularly in Europe. Now, it is hoped, easing prices will trigger sharp reductions in interest rates, as inflation worries are replaced by deflation fears in the year ahead. There can be many false dawns in a financial crisis.

When we look at the present financial crisis in the US, or in Western Europe, the lessons from Japan are clear, said Dr Lyons. Now, in the West, there is a need to inject capital directly into banks to address the solvency issue; to address liquidity problems directly, through a combination of measures; and help restore confidence between banks in order to address the present blockage in the money markets where banks are not lending to one another and where the transmission mechanism of monetary policy has broken down. But even with all these the economic situation will deteriorate.

The fact that there is a financial crisis should – in itself – not be as much of a shock as it seems to be to so many people. The nature of the crisis when it arrives is always impossible to predict. In recent years there have been many warnings, most notably from the Bank for International Settlements. The fact that people did not predict that Lehmans or other specific institutions would fail is not the issue. If a car is being driven at a hundred and fifty miles an hour on difficult roads we cannot say exactly on what corner the car might crash, or what the outcome of the accident will be, but we can warn with confidence that an accident is possible, and even likely.

The speed at which the crisis has taken hold is breathtaking. But when one thinks that for year after year at IMF gatherings there have been warnings about the need for a more balanced world economy – and a few years ago there was much concern about “crowded trades” and about derivative products and the foundations on which they were built – perhaps we should not be that shocked. Derivative products were once described as being like Hell, easy to get into but impossible to get out of once there.

Fear and determination

At this year’s IMF meetings, the way Dr Lyons described the mood is a combination of Fear and Determination. Fear about how the crisis is unfolding and about its consequences. Determination, particularly in policy circles, to do something about it. The G7 communique that was released the Friday night before his speech provided a clear focus on five areas, and although its lack of detail was at the time a concern to many, the commitment to stop any systemically important firm from failure, given the aftermath of Lehmans, was important. (In the days following the speech the detailed measures announced in the US, the UK and across Europe alleviated fears and helped provide some stability to the financial system).

Part of the problem was that as the crisis started to unfold the policy response, particularly in the US was piecemeal. But following the Congressional approval of the Paulson plan we moved to a systemic solution, which is vital given that this is a systemic crisis. The initial piecemeal approach was akin to putting out fires. Bankers are loath to criticise the policy makers, as they had to respond quickly to shock after shock. And in many respects they did a good job. Yet the unintended consequences of some of the decisions soon became clear. The failure to protect the preferred stock holders in the bail-out of Fannie and Freddie, or to protect the senior debt holders in Washington Mutual, dampened the ability of banks to raise fresh capital and encouraged many investors to opt for the certainty of short-term instruments, despite their low returns.

Lehmans collapse, a disaster

Meanwhile, the desire to prevent pro-cyclical behaviour, whilst understandable, led to a ban on short-selling at just the time when many hedge funds had similar complex trades; stopping short-selling at that time - combined with the fear in the aftermath of the failure of Lehmans - contributed to a mad dash for liquidity in recent weeks and set in motion the aggressive selling we have seen globally. That was compounded by the fears about the stability of the financial system.

Positions that only two weeks ago were seen as fundamentally sound have been sold aggressively. And as the economic outlook deteriorates, equities may suffer further. Perhaps the one thing everyone in Washington – or at least most of them – have agreed on in recent days is that the collapse of Lehmans was a disaster – both because it created uncertainty about which institutions were viewed as systemically important – and more because of the huge negative ramifications it had across the whole financial industry. Yet, at that time, the authorities appeared unable to afford to take on the risks associated with Lehmans. When it went under, the interconnectedness of the system was plain to see. We have seen some problems with money market funds, a drying up of the commercial paper market that, in turn, led firms to draw down bank lines. And added to all of this, the problems with AIG draw attention to the wider problems facing the insurance industry.

Now, we have a systemic approach. And there is likely to be more to come; at the Bretton Woods Committee on Friday, of which I am a member, it was mentioned that a clearinghouse for CDSs should be in place by November. It has also been said that the Fed has a large amount of ammunition that it has yet to use. All this should reassure.

As in Japan in 1997 the focus in the US, the UK and across Europe will be on boosting the capital of banks, restoring liquidity to the system and restoring confidence and trust within the financial system. In addition, here in the US, the Troubled Assets Relief Programme (TARP), or Paulson plan, is aimed at addressing toxic assets. In the UK, meanwhile, we do not yet such toxic assets – but we will – as our economy is only about to enter the recession that has already taken hold here in the US. Thus, in the UK the problem is more focused on the seizure in the wholesale funding markets, and although that is a problem in the US it appears on a different scale.

Former Fed Chairman Alan Greenspan has said that the situation in the US can only stabilise when the housing market corrects. Namely when the value of the key underlying asset accounting for the toxic problems stops falling. But that does not mean that action cannot be taken in the interim to help. And it touches on the need for transparency and the importance of expectations; the greater the transparency the better, but also if expectations are for the economy to deteriorate then this will weigh on the financial sector. To restore trust between banks, there needs to be trust in the other bank’s position. And with balance sheets of many banks being badly run for some time this will take time.

When we step back and look at this crisis we tend to group the problems into three, interrelated areas:

• risk management, and the lack of pricing for risk. This issue was well signaled, particularly with reference to ‘crowded trades’;
• the need for liquidity management, particularly in stressed conditions. Again this was an area well signaled, particularly last year when problems were seen in structured investment vehicles;
• and pro-cyclical conditions, or an environment in which as asset prices rose, the market, sentiment and the overall environment fed on itself. It was like adding fuel to a fire. Central banks keeping interest rates too low added to this. The expectation that rates would stay low contributed to an environment where leverage and gearing rose to high levels. The use of more complex instruments and the incentive structure in firms probably added to this.

Visiting Wall Street earlier this year, someone described this as the three G’s in the US: Glass-Steagall, Greenspan and Greed. In a downturn, like now, authorities appear keen to cut out pro-cyclical behaviour (when in a hole stop digging) but in an upturn there appears less enthusiasm.

Perhaps the biggest surprise of this crisis is that the problems did not hit in the part of the industry that concerned many a few years ago, namely hedge funds, but that it hit in the regulated and well established part of the financial industry. A common theme it seems in those crisis hit areas was the high gearing and excessive leverage.

This in part explains events of recent weeks, and adds to worries about the future. The mad dash for liquidity has had a global impact. It has also resulted in dollar hoarding around the world, including countries as diverse as South Korea, Nigeria and India. In turn, the dollar has been a beneficiary, helped too by a flight to quality. Across many economies, including the emerging world, access to liquidity and to capital funding is drying up. And the concern in the West will be that deleveraging by banks will result in less credit being available for firms and people, hitting companies and consumers.

And whilst one can understand why countries are keen to address domestic problems in order to limit the damage to their own economies, it is important that we have a global response. Indeed, there is much that needs to change in the future. For instance, in recent years we have had too much focus on the prudential risk of an individual institution and not enough on the regulation of the whole system.

Apollo 13 moment

There is a need to keep a perspective. Over the years many parts of the financial industry have done well as the system has helped achieve strong growth and rising prosperity for many. Furthermore, banks that ran their balance sheets well have not suffered during this crisis, although of course all equity prices have fallen. Indeed, when we look at the longer-term lesson for the financial industry it is to keep what has worked well, and correct what went wrong. Given this the film Apollo 13 comes to mind.

In the Apollo 13 film there is a scene where someone says to Gene Krantz, the head of mission control, that this is NASA’s worst moment. In response, Krantz says he disagrees. In fact, he says, if they get the three astronauts back safely to earth it will be NASA’s best moment. This might be a good analogy for the financial crisis. The point being that if after such a shock the system survives then we should see this as a positive in terms of how the challenges were overcome and the lessons for the future.

Just as the world then looked to NASA to save the astronauts it looked to those in charge to save the system now, learn the mistakes and move on. Whilst one should not underestimate the financial crisis, if steps are taken to address the problems in the system then what emerges might be seen as a positive. Not all parts of the financial system are bad – parts of it have serviced the Western economies well, but clearly as this crisis has shown, parts of it do not work well.

The markets need to have confidence that the policy steps and the private sector measures taken will be successful. The need is threefold: to address liquidity; restore capital in the banking sector; and to restore trust in banks with an aim to reducing inter-bank rates. But even with all of these, the economic situation will deteriorate.

What then is the economic outlook?

If Apollo 13 is the film for the financial crisis, what is the best film to describe the economic outlook? One of this year’s Oscar winners comes to mind, No Country for Old Men. In that film the catch-phrase is, “You can’t stop what’s coming”. In that film the reference was to aging. But in economic terms we can’t stop the recession that is about to hit us. When one looks at the outlook it is important to differentiate the financial crisis and the economic crisis. But despite best efforts to stabilise the financial crisis, the economic situation will still deteriorate.

The world’s two largest emerging economies will suffer a long, deep recession, far worse than the market is contemplating. Yes, the world’s two largest emerging economies. No, not China and India, but the US and UK. Both of these countries have all the characteristics of emerging economies, with debt levels through the roof, widening income disparities, trade and current account deficits, and a huge dependency on foreign capital inflows, including hot money.

The main story in the US and the UK is continued deleveraging, as they need to correct imbalances.

In previous statements, Standard Chartered has been very pessimistic about prospects for the US, arguing at that time that the US economy was heading into recession and that interest rates would fall to 1%. It is amazing, in some respects, how optimistic the mood has been here in the US, until recently.

The US saves too little, and spends too much. At the time of the last US recession in 2001 it was the corporate sector whose balance sheet was in poor shape. As a result of that recession the US corporate sector got its balance sheet back into shape - and also large corporate America has become more global in its outlook, so much so that some of the largest US firms are now well positioned across parts of East Asia, including China. Indeed, the Summer of 2007 the talk was that three parts of the US were in good shape: large corporates, exporters because of the weak dollar, and farms. Despite this, two parts of the US economy are in poor shape: households and the financial sector. Both need to get their balance sheets back into shape, much as the corporate sector did seven years ago. Indeed, US consumers need to spend less and save more.

In recent years, in the US as well as in the UK, a combination of factors drove consumer spending: ample credit, a strong housing market and a good jobs situation. This has all changed. Credit is now tight. Over the last year, banks have rationed credit and charged more for what they did lend. Now, with the financial crisis and the need for deleveraging, credit will become even harder to access. Housing has already fallen sharply - but is set to fall further in the US. Meanwhile, jobs are probably the most important indicator to watch, and the employment situation is now deteriorating on both sides of the Atlantic.

Even before the recent crisis, it looked inevitable that the US and UK would go into recession. Now this crisis makes the scale of the economic downturn far worse. There will be some helpful factors in the year ahead, such as the correction in oil and gasoline prices, and the likelihood of lower rates and cheaper mortgages as yields decline. But even allowing for this, the outlook in the US is grim. A 1.5% correction is a good guess. A 4% set-back is not impossible. That is where the risks lie. In each of the last two years the worst case scenario has effectively materialised. The same could happen in the year ahead.

The great thing about the US economy is its ability to reinvent itself and rebound. Large corporate America did just this after the 2001 recession. The election of a new President, helped with further policy easing, could give a much needed boost to confidence and to national self-esteem. But, even allowing for this, my fear is that the scale of the balance sheet restructuring that is needed points to not only a sharp correction in 2009 but also a period of stagnation in 2010.

In the UK, the situation is, if anything worse. Facing similar challenges to the US, we have yet to enter our recession. Three months ago, Standard Chartered reviewed our UK economic forecast and forecast that the UK would contract 1.8% next year. This forecast, far more pessimistic than the consensus at that time, which was for low but still positive growth. Now forecasts are being cut sharply. Although the UK rescue package will aim to prevent banks cutting lines to people and firms that may be hard as the economy contracts. A contraction of 2.5% is possible, particularly if deleveraging by the banks in troubles restricts
lending to small and medium sized enterprises (SMEs) and to people.

In Europe, the outlook is poor. Earlier this year the markets referred to the economies in trouble as PIGS, it could easy be P-I-I-G-S. Ireland and Spain face recession as their housing booms are followed by busts. Portugal, Italy and Greece, meanwhile, are all suffering from a loss of competitiveness and, because of the Euro, are unable to devalue. The shock absorber for those economies will be weaker economic activity. Indeed, even Germany, the world's strongest exporter is likely to fall into recession. Add in the problems facing France and all of Europe's major economies face challenges in the year ahead.

In this environment the misplaced inflation fears that surfaced this Summer are now likely to abate. Standard Chartered has continued to argue that - with the exception of regions such as the Gulf where monetary policy is tied to the dollar - it was growth and not inflation that was the main problem. In fact, by this time next year, deflation may be the major concern. This is both because of the intense competitive pressure evidenced in global supply chains and the deflationary pressures resulting from the financial
crisis.

Thus we should expect official interest rates to decline further in the West: to 0.5% early next year in the US. In the UK the Standard Chartered recommendation is to cut rates sharply and soon. The fear is
that the rate cuts will be little and late, as instead Sterling falls and fiscal policy is relaxed. UK rates should go to 1% by the end of next year, but they may fall to 2%, the same level as where rates in Europe may decline to.

In this environment, the word that crops up frequently is ‘protectionism’. The fear is that as the economic outlook disappoints we will see a rise in protectionism, with the result that global trade and capital flows are hit, and the economic outlook is further damaged. This is possible. Nothing can be ruled out.

All this is in sharp contrast to this time last year when sovereign wealth funds were the hot topic. Since speaking about them at the Standard Chartered IMF breakfast a year ago, Dr Lyons has testified to both the Senate Banking Committee and the Congressional Foreign Affairs Committee on this topic. It is important to talk about them in the context of state capitalism.

The role of the state is becoming more important, particularly across the emerging world. Indeed, in a good article in International Affairs at the start of this year, Robert Kimmitt, Deputy Secretary at the US Treasury talked of the rise of the four sovereigns: in addition to sovereign wealth funds, there were foreign exchange reserves, government pension funds and state-owned enterprises. One of the concerns about the greater role of the state is that it plays by different rules, and not always commercial ones. How times change. The fears about sovereign funds a year ago have since seen a number of Western financial firms turn to them for capital, and now we see in the US, and across the UK and Europe the state taking large stakes in big banks and the financial sector. State capitalism has become a global issue and the full consequences of this have yet to be thought through and will be with us for some time.

Emerging economies

If Apollo 13 and No Country for Old Men are the analogies used above, what can we say about emerging economies? The initial thought would be to think of the film Singing in the Rain. But if one remembers the famous scene from that film of Gene Kelly actually singing and dancing in the rain the reality is that he did get soaked.

This may be particularly relevant when one looks at emerging markets now. When one looks at the immediate outlook for emerging economies in the year ahead one should not be complacent. The outlook is grim. But it is better than the West.

Standard Chartered has continued to stress that emerging markets are not decoupled but that they may be insulated and better able to cope. The point is that if the US economy went into a recession it would impact the world, but that emerging economies and Asia in particular, would be better able to cope than in previous cycles. Given the increase in globalisation in recent years it was harder for economies or regions to be decoupled from events in the West. This insulation may have protected them from a global hurricane, but they are not insulated from a nuclear fall-out. And that is what we are now seeing, as a result of this financial crisis. The way to view this is a significant cyclical setback at a time when the longer-term structural factors are positive.

Unlike previous crises, where emerging economies were often the culprits, this time they are the victims. Those able to cope will be those with high savings and sound fundamentals. But there are a number of emerging economies that are particularly vulnerable. This vulnerability can be divided into three groups:

• those with current account deficits;
• those with high levels of debt;
• and those where the financial sector may be exposed, say to liquidity
  stresses.

The region that looks the most vulnerable is emerging Europe: large current account deficits, dependence on foreign money for financing, high levels of debt, rapid credit growth and badly exposed banking sectors. The foreign liability exposure of central and eastern European countries is particularly high. Although emerging Europe covers a myriad of countries it would not be an exaggeration to say they all face challenges and, more likely, problems, with capital flight, currencies weakening, spreads rising, an uncertain outlook for rates and economies heading into downturns. Those most at risk include Hungary, Ukraine, some of the Baltic countries like Estonia and Latvia and some Balkan countries like Romania and Bulgaria. The contagion to banks in Western Europe, including Scandinavia and the Nordic region
should not be overlooked.

In Latin America, meanwhile, there has been some anxiety in recent days that this region will suffer as a result of both a slowdown in commodity prices, given the high commodity content of exports from a number of the countries there, particularly the three Andean economies Venezuela, Peru and Colombia, and also because of a slowdown in exports to the US, with Mexico particularly exposed. However, despite this, and despite the recent sell-off, it is hard to be too pessimistic about Brazil’s longer-term prospects, but even there the economy may slow significantly in the next year to 2% to 3% growth.

Africa, meanwhile, is resilient, not having overstretched itself during the boom and thus is unlikely to suffer too much on the downside. But even so, the region will slow.

Whilst the IMF talks of 6% to 7% growth, the common view is for growth nearer 4%, softer than recent years but still positive. Indeed there are many positives happening on the ground across Africa, but the infrastructure needs and investment that is taking place could suffer. We have already seen a withdrawal of portfolio investors from the key markets, leading to greater exchange rate volatility, nowhere more so than with the Rand. Other markets are affected, but this is mainly due to thin liquidity, so a small move has a big impact on the exchange rate, and in most cases we are yet to break out of ranges that would have been seen as more normal only three or four years ago.

Once investors have already liquidated their positions, as we saw with Ghana given its balance of payments difficulties earlier this year, stability is generally restored to the currency. Nigeria has seen sizeable outflows, but currency reserves are considered a sufficient safeguard; the currency has held steady but the economic impact is yet to feed through.

Return to fundamentals

Oil producers are not yet suffering from the recent correction in oil prices. In part this is because many countries have budgeted for oil prices not too far from previous levels, or even lower. Demand from China will be high, despite the present slowdown. Moreover, because of the financial crisis, many oil producers will find it harder or costlier to attract capital, thus pushing up the cost of production. Thus many oil producing countries will need to open up their markets to attract capital inflows.

Whilst the Middle East and Asia are awash with liquidity there are pockets of near-term focus. There is the issue of Dubai where the property market boom has run its course. It is the ability to weather this storm by attracting capital inflows that is key.

A few years ago at the IMF breakfast there was talk about the fact that the US was spending and not saving. Now, it is time to focus on fundamentals. There is a need to return to fundamentals in the West. America needs to spend less, save more. Households and the financial sector need to get their balance sheets back into shape. All this will be painful to achieve.

When one looks at emerging economies it is important to keep focused on the fundamentals. We are seeing the emergence of new trade corridors as inter-regional trade is rising sharply, between Asia, Africa, the Middle East and Latin America, often with China at the centre. The infrastructure boom that has been underway across the Middle East, large parts of Africa and across economies such as China and India is likely to continue, although there may be near-term funding issues. And we are still likely to see the emergence of a middle-class across Asia.

In the West, people still underestimate the pace and the scale of change on the ground in economies like China or the GCC, and the catch-up potential of countries such as India, Indonesia and Brazil. Moreover, and particularly relevant at this time, we should not overlook the potential volatility of economies such as India and China.

Emerging economies face a tough next twelve months. A deep US recession, a sharp global slowdown, a significant downturn in world trade, the heat taken out of commodity markets. All of these will add to a difficult external climate for emerging economies. And given the boom of recent years, a number of economies are vulnerable to outflows of funds, as we are now seeing. Yet research shows two-thirds of recessions over the last 150 years have lasted less than one year. And this is worth bearing in mind now. The problems in the West may well last longer.

Whether one is pessimistic or very pessimistic about the world economy, emerging economies have the ability to rebound quicker and stronger.

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