x Abu Dhabi, UAEWednesday 24 January 2018

Assume Nothing

The economic riddle of the day is how the global economy could be facing a deflationary cycle when the issuer of its reserve currency, the US dollar, is taking steps to ensure an explosion in supply.

The economic riddle of the day is how the global economy could be facing a deflationary cycle when the issuer of its reserve currency, the US dollar, is taking steps to ensure an explosion in supply. The bailout of Citigroup announced yesterday represents a new source of obligations on the US government, not from the money being injected, which will largely come from $700 billion already earmarked by Congress, but rather from the standby lending facility provided by the Federal Reserve as part of guarantees on Citi's $306bn in property-related loans and securities. And that $700bn in earmarked funds is quickly turning into real disbursements: Paulson yesterday said he may now not leave the remaining $350bn in the kitty for Obama to play with. Instead, he may ask Congress to give it to him now to help fund auto loans and such.

At some point, the growing US deficit will need financing, which would require that either the government pay higher interest rates or print more dollars. Either of these actions is inflationary. Yet a number of very smart economists, among them Nouriel Roubini and CLSA strategist Christopher Wood, worry that the global economy faces what Roubini calls stag-deflation, a Japanese-style period when interests rates near zero yet seem to do nothing to stimulate the economy or investment, even as prices drift lower.

US housing prices, for example, continue to decline, but buyers remain on the sidelines. I suspect, however, that it remains to soon to declare that the US or the global economy are in a Japanese-style deflationary cycle. To some extent, the difference may lie in consumer behaviour. Japanese are inveterate savers, and at the risk of generalising, Americans are not. At some point, prices will fall low enough to coax them back into spending. Japanese parsimony had less to do with expectations of future bargains than it did with a sense of material satiation, a reaction to the ugly period of excesses that preceded it.

Socio-economic mores aside, Japan's problem was also that banks were not willing to lend and consumers and businesses were not willing to borrow. Again, savings habits and disinclination to consumption had a role here. Cash-rich corporations don't need to borrow, nor do consumers with fat bank accounts and no desire to upgrade their lifestyles. This unwillingness to take risks is also what bedevilled Indonesia's recovery after the financial crisis of 1998. Banks were too injured to undertake new risks, so they pocketed whatever government bailout bonds they were sold and collected the spread between the interest they earned and the deposit rates they paid. The same is now happening to banks being bailed out with liquidity in the US, Europe and the Gulf. Why lend in a market where defaults are rising? Better to simply collect interest payments and wait out the storm.

But another key element that affected the pace of recovery was a feature of accounting called "mark to market". Japanese banks were never required to writedown the value of their assets until they were sold. So the tendency was simply not to sell them. They were carried at book value and used to prop many a leaky balance sheet. The same is not true in the US, however. Just because banks don't lend and companies don't invest doesn't mean they can pretend everything is all right under the hood. As soon as assets start moving, even a trickle, they will be required to start writing down the value of the assets still on their books to something closer to what the market is demonstrating as their real worth. This will stimulate banks and companies not to hold on to assets that appear to be depreciating but rather to try to realise their value sooner. The original aim of the Troubled Assets relief Programme appeared to be to accomplish this. By putting a guaranteed buyer in the market for asset-backed securities, the government was hastening the unwinding of the positions that would force institutions to unload their assets and de-leverage. Alas, the situation grew too dire for the government not wait for that to happen. But the rules still apply on mark to market, which why the market keeps playing a finger-pointing game at various banks' balance sheets, stress testing them against the likelihood that asset prices continue to tumble. I'm not sure whether UAE banks are required to mark their assets to market. If they are, great. The mergers we've seen in the past week are exactly what I recommended in previous posts. The UAE, and more specifically Dubai, is now moving ahead of the speculative curve and behaving as though it already faces a systemic crisis even though no such crisis has yet emerged. Yes, credit default swaps on Dubai and Dubai Inc debt soared through the roof, as did yields on existing debt. But so far, as far as we know, no borrower has had to seek help from the government in refinancing. Most of them are, after all, government backed. And the great liquidity vacuum as foreign hot money flushes out of the UAE has not created any balance of payment crisis, as it did in Iceland. The government remains flush. Here's the best thing about what Mr Alabbar said: he said something. There's been far too little talk from officials about how the UAE is doing and what it plans to do to ensure that it retains its position of strength going into this crisis. For too long, therefore, the country has been in denial about whether the crisis would affect it and to what extent. So don't let these statements be seen as admissions of weakness. They are belated signals of strength. But, and there is a big but to all of this, there are pressures on the three great assumptions of UAE financial security. Make that four. First, oil prices: they are falling and appear likely to fall further until next year when the market realises that the global economy isn't headed into a new Ice Age and that modern man will still be driving across town to pick up his unemployment benefits. In the meantime, that will reduce oil revenues, possibly eliminating the budget surplus and reducing the current account surplus. That could exacerbate the liquidity problems we already face and force economic growth even lower. Second, government reserves and assets: most of these are held in dollars, which appear likely to depreciate in terms of buying power as the US government deficit balloons. Third, asset quality: Mohammed Ali Alabbar has declared that Dubai's assets exceed its obligations. For now. The problem is that asset prices will be falling, and falling fast in the next year as property markets correct. That will create a wave of technical and strategic defaults, pushing up the level of nonperforming loans in the banking system and putting greater pressure on banks and borrowers. That could challenge one of the other silver linings to the UAE credit crunch: that it is the result of tighter global liquidity, not counterparty risk. So far, there is little concern that a UAE bank might not be sound, but that could change fast if there is a major correction in property pries and with it the ability of borrowers to repay the banks. Fourth, foreign politics: the UAE economy and liquidity available to it aren't in a vacuum. They are directly linked to the political temperature of the region. And no matter how well the UAE is doing in handling its own de-leveraging, the rest of the region isn't doing so well. Look at Pakistan. The situation there is growing worse. The government is having to hike interest rates to win IMF bailout funds even as its frontier areas turn into a war zone with the US. The likelihood of some destabilising political event occurring there seems too large to ignore. Given the crucial role that Pakistani investors and workers play in the UAE economy, it seems that liquidity here may depend to some extent on stability there. warnold@thenational.ae