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Financial crisis: Getting facts right-I

By Surjit S Bhalla
December 27, 2008 13:45 IST
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What can we look forward to in the financial markets for 2009? We can begin by asking those who got this tumultuous year right. That leaves almost nobody as everybody got most markets wrong, and frightfully so.

Some, very few, did forecast correctly; their assertion was that the US economy would crash because of years of over-consumption.

This overdue correction in the savings rate would bring the US economy down and with it the stock market, the bond market and the dollar.

They got 1 out of 3 markets right; they had forecast that US bond yields would go to 8 per cent plus, but the year is ending with yields close to 2 per cent, the lowest in post-war history.

Since August 2007 (the start of the sub-prime crisis as recognized by the FED and major investment banks), bond prices have appreciated by 23 per cent. Instead of the dollar crashing, it has appreciated by 5 per cent since August 2007. So who can we turn to?

Reality Check 1 -- The Lehman Mistake: The US sub-prime crisis has had three stages. The first phase was August 2007 to March 2008, an eight-month period for markets to adapt to a new world order.

The second phase was from Bear Stearns to Lehman in September, or a 13-month period from when the story of sub-prime broke. The third period is Sept 2008 to now and continuing.

Now there is a rumour going around that Lehman just accelerated the inevitable hurtling of the world economy towards a never-before decline. By a strange coincidence, these I- told-you-so bears also believed that Lehman should have been allowed to fail because of "moral hazard" reasons. Nothing like suggesting remedies to get one's forecasts to come true -- a bit like insider trading!

What we do know is that the Lehman-induced deleveraging -- sale of close to half a trillion dollars by everybody at the same time -- caused world trade to freeze like never, ever.

No one had money to pay for deliveries. This caused factory output in trade (export-led) economies like Japan to show the biggest monthly decline in 55 years (November decline 8 per cent over the previous month).

The Lehman non-bailout fiasco caused the redoubtable and large stable of frontier economists at the IMF to change their forecasts of world GDP growth by over 1 per cent from their own forecast of two weeks earlier!

Yet we have the moral hazardistas claiming that Lehman was nothing more than a mere accelerator towards the inevitable; and the inevitable was something that none of them (or us) had forecast even a month earlier.

Better to admit that Lehman changed the world order, at least for a few quarters or years. It is a bit questionable to think that for 13 months world financial markets did not anticipate post-Lehman, but once Lehman happened, they reacted in super-fast mode.

And then to argue that Lehman was just incidental to the inevitable Global Depression (along with the not so inevitable collapse of the US dollar and everybody fleeing the security of US treasuries).

Reality Check 2 -- De-Coupling: It is now conventional wisdom that the world is even more coupled than Siamese twins. If the US sneezes the world gets pneumonia. But the US starting sneezing in August 2007, and got pneumonia when Bear Stearns collapsed 7 months later in March 2008.

Yet output growth in China and India proceeded at a pace just 1.5 to 2.5 per cent less than the heady pace of 2007. Given the dire circumstances of deep-coupling, one would have expected emerging market output growth to decline considerably faster and to a much lower level in the pre-Lehman period. It did not.

For sure, with trade and purchases freezing in Oct-Dec 2008, inventories piled up and output declined sharply. Exactly what is to be expected given the deep freeze.

But does it follow that the freezing will stay frozen? Is it realistic to expect that all 5 billion individuals in the developing world will alter their consumption, their aspirations, and their investments for the many months (years?) that it will take for the US economy to recover.

So how unlikely is it that emerging economies like China and India will show a recovery faster than the West? If likely, then isn't that a rejection of the now so prevalent coupling thesis?

Stated differently, if out of 30 months there is decoupling for 24 and coupling for 6, is that evidence of coupling or decoupling?

Reality Check 3 -- GDP forecasts for 2009: The race to the bottom continues. Respect for the analyst goes up by how much closer the estimate is to what happened during the Great Depression.

The boldest estimate for the US economy to start showing a positive number (albeit from a deeply depressed level) is July 2009. Which means that the minimum length of the US recession will be 19 months, which will make the 2007-2009 recession the longest in US post-war history. It is no longer a radical statement to say the biggest decline since the Great Depression.

For people to remember you as a forecaster, you need to make the bottom-most forecast. But it does not mean you will get it right.

There are reactions to this unprecedented decline and shock to world activity. The world economy should react somewhat positively to all the positive shocks being hurled its way.

Monetary and fiscal stimulus of historical proportions -- not just in one country but across the world. Add to it the stimulus from very low oil prices. All of this does not add up to bottomless forecasts for world GDP growth in 2009.

But if the post-Lehman world is a long-term reality, then September 2008 will go down in history as a structural break -- much like October 1973, when overnight, oil prices quadrupled.

Coupling yes, if post-Lehman is the new long-term reality for emerging economies like India. How likely? Find out in Part II of this article on Jan 10, 2009.

The author is Chairman, Oxus Investments, a New Delhi-based asset management company. The views expressed are personal.

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Surjit S Bhalla
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