x Abu Dhabi, UAEWednesday 26 July 2017

Gordon Gekko, RIP

The US and global economies stand on a knife's edge this week. Will $700 billion be enough to arrest the landslide in asset prices? The new government bailout will boost US debt by 13 per cent, push down the dollar and rekindle inflation. Given the risk of a severe collapse in asset prices that loomed last week and the subsequent global recession, economists say this scenario is more desirable. If nothing else, it has reversed the implosion of risk appetite among investors, which should continue to resuscitate emerging markets, particularly those whose commodity exports give them a natural hedge against the dollar's slide.

The US and global economies stand on a knife's edge this week. Will $700 billion be enough to arrest the landslide in asset prices? The new government bailout will boost US debt by 13 per cent, push down the dollar and rekindle inflation. Given the risk of a severe collapse in asset prices that loomed last week and the subsequent global recession, economists say this scenario is more desirable. If nothing else, it has reversed the implosion of risk appetite among investors, which should continue to resuscitate emerging markets, particularly those whose commodity exports give them a natural hedge against the dollar's slide. It will allow for the continued, orderly de-leveraging of the industry from its excessive exposure through derivatives to falling property prices. In particular, financial shares should do well as worries subside that they face exposure to US property-related losses. With the US government now providing a market for those securities, there is a limit to the damage. Most importantly, the US government will be buying US property-backed securities from all banks, no matter whether they are US or foreign. Now Asian and Middle Eastern banks, like ADCB, who've been quietly sitting on big subprime losses can step forward and be made whole. The key question now is how hard a bargain the US government will drive when purchasing so-called toxic securities. The more it pays, the higher the cost to taxpayers, so significant scrutiny should be on the government to pay as little as possible. Paying too much also increases the moral hazard involved in bailing out out the financial industry. On the other hand, if it pays too little, it may allow weaker institutions to fail. That might hurt confidence in the bailout, though it might be a good thing to force a more controlled consolidation in the industry. At the very least, it will end the shotgun weddings we've seen in the past two weeks. Merrill is probably gnashing its teeth right now. Keep in mind that the bailout is very unlikely to end up costing the government the full $700 billion it is pledging. Many of the toxic securities it buys will someday start to appreciate. Others it will sell, offsetting the cost. While comparisons are being drawn to the RTC, which helped bailout the US savings and loan industry in the early 1990s, the current bailout seems more like the bailouts in 1997-1998 in Thailand and Indonesia. There, the IMF took the role of the US government now, providing emergency financing to local central banks, which then injected capital into failing local institutions in the form of recapitalization bonds. The banks paid for these ? in Indonesia's case ? with their bad debts and collateral. In Thailand's case an agency was set up that bought bad assets with government cash. A major bone of contention was how much the banks got paid for their bad debts. Since many of the borrowers were politically connected or even owned the banks they borrowed from, the moral hazard was enormous in giving them back anything at all. In Indonesia, critics complained that cronies of former President Suharto were bailed out and allowed back into the corporate sector with little more than a slap on the wrist. Many analysts shrugged their shoulders, pointing out that the cronies were essential to getting Indonesia's economy moving again. In the US, high payments will be seen as a reward to rich and profligate investment bankers, hence there will be efforts in Congress to include legislation limiting executive pay and/or providing more direct relief to US homeowners, despite the fact that many are guilty of the same profligacy and greed that drove bankers into the subprime hole. Yet the leading Wall Street executives may also be crucial to getting the American financial sector going again. Another major source of controversy in financial sector bailouts is over who buys the assets from the government and at what price. In Southeast Asia, the only willing buyers of bad debts and underlying assets were foreign investors. Critics in Thailand and Indonesia cried out that the government was selling the nation lock, stock and barrel to foreigners. The backlash against foreign influence set the stage for the rise in Thailand of Thaksin Shinawatra, whose subsequent ouster amid corruption allegations has paralyzed Thailand. In Indonesia, the sale of major corporate assets to foreigners went more smoothly, though there are efforts now underway to unravel major investments in the telecoms sector by Singapore. Assuming that the US government will have to sell some of the toxic assets it buys to foreigners, some of whom will be sovereign wealth funds, there is the potential for a backlash later when those assets start to perform again. Assuming the financial landslide has been stopped, the danger now is that the US goes into a long period of economic downturn as Asia did after 1997. This would be negative for commodities demand globally. One key factor in Asia's post-crisis recession was that the recap bonds sold to banks gave them an easy way to turn profits without having to lend to companies or individuals. It took a long time to convince banks to start providing capital to the economy again. In the interim, it was good for bond and stock markets, because Asia had long been over-reliant on bank lending anyway. But it did lengthen Asia's recovery time. After buying toxic securities from financial institutions, the challenge in the US will be how to encourage banks to get back out there supplying credit efficiently again. With the Fed's conversion of the last two remaining investment banks, Morgan Stanley and Goldman Sachs, into banks subject to close government regulation, the end of the Wall Street era has come. The dominance of free-wheeling leverage is giving way to the return of cold, hard cash. For Shariah-compliant lending, this represents a watershed ? as the world turns from excessive borrowing and interest, Islamic finance will have new marketing appeal. But with the demise of the so-called post-war Anglo-Saxon model will come the return of an older Anglo-Saxon model ? mercantilism, a stress on the accumulation of assets and an emphasis on achieving terms of trade that facilitate this. Given the role of US debt in financing the recovery of Europe after World War II, the Asian miracle of the 1980s and 1990s, the creation of a non-Communist Eastern Europe after 1991 and now the re-entry of China into the global economy, it seems this would lead to a new era of relatively slower global growth. This represents a dramatic shift in the direction of globalization. The Anglo-Saxon model of high leverage and free markets created much growth, but lately had also been yielding high and rising disparities of income that were proving socially destabilizing. In the past few years, even advocates of the free-market system have been warning that the world needed better and more expansive social safety nets to protect the have-nots from the haves. With this humbling of Wall Street, trickle-down economics may be discarded. A new era of resurrected socialism may be upon us.

warnold@thenational.ae