Complacency Reigns Supreme

Ironic as it may seem, the world seems to be in a celebration mode, despite all the indications that new storm clouds are gathering in different places. The events of 2008 and even 2009 seem to be distant memories that are now the realm of abstract debates on the part of the academia or at best the blogging world. The fact that this seems to occur at a time when all efforts by the central banks and policy makers seem to eke only a marginal growth in the headline growth related statistics. A close scrutiny of the global economy, on the contrary, would surprise any observer that we have somehow managed to escape an even bigger crisis. This is probably due to the phenomenally supreme ability of our policymakers who seem to have become adept at short-term crisis-management solutions. Unfortunately for them, in their urgency to find quick-fix solutions to the generational systemic problems, they seem to have averted an immediate crisis while leaving the doors open for a larger crisis sometime in the future. Due to their preoccupation with some of the larger issues, there seem to be very subtle changes in the economy, which they have been to take cognisance. Even if they realise that these are important problems they seem to be trivial before the other challenges created in the aftermath of the bursting of the credit bubble in 2008. However, we may have reached the logical limits as to how much longer the world economy could continue to trudge along the bottom with such issues. 

There are a number of indications that the economies of the advanced countries may be entering into a period like the 1970s and early 1980s when there was low growth accompanied by high commodity prices. This is not to mean claim that the economic environment is similar to that era. On the contrary, the world economy seems to be facing a storm that has combined the negative aspects of different eras, which has created more confusion. Low growth and low inflation in some areas that has led to quantitative easing, which in turn has sparked growth and asset bubbles not in the country of Quantitative easing but in the emerging world. The net result of all this may be gradually due to a number of factors, the business environment has faced a deterioration. This means that it is unlikely that the private sector is unlikely to take a lead role in investment, instead it would probably be more content (and profitable) to speculate in the financial markets. I believe that the world economy may have passed its more sanguine moments. A cursory glance at only a few issues is bound to raise more, questions and more confusion.

It is clear that Spain (and after that Italy) are going to be the centre of attraction, albiet for the wrong reasons , over the next few months. The Yields on Spain's 10 year bond have risen from 4.63 percent in November 2010, to about 5.45 percent in its last bond auction for 2010. This is unlikely to reduce unless ECB decides to aggressively buy Spanish bonds. But, even such aggression would only lead to temporary and more importantly marginal improvement, if history is any guide. The ECB has so far bought €71bn of Greek, Irish, and Portuguese bonds in a bid to cap yields (despite Bundesbank objections and probably in breach of EU treaty law) but so far it has done nothing other than give private investor an exit route. They seemed to have dumped their junk on the ECB and exited even if it has meant taking losses. This has raised questions about the solvency of the ECB itself, forcing it to raise its capital base before the bond market get another fright about its solvency. Any questions about the solvency of the EU institutions would be nothing short of a unmitigated disaster. The ECB said it would raise its subscribed capital by €5billion to €10.76billion - yet another temporary solution. 

Even as these short-term solutions are experimented, the problem grows even bigger. It is clear that ECB could face losses on their bond purchases as well as loans worth €334billion to Greek, Irish, Portuguese and Spanish banks. These loans were intended to be temporary and necessary to tide over the short-term liquidity problems. A recent report by Goldman Sachs claims that EMU states hold $760bn (£487bn) of Spanish debt securities, while France has $252bn, Germany $212bn, Luxembourg $77billion , Ireland $62billion, The Netherlands $61billion, and Belgium $48billion. Outside EMU, Britain has $69bn and the US $26bn. Cynically stated it is clear that a number of insolvent nations are holding the assets of other insolvent nations and when everybody is on the same side of the losing trade, nobody needs to care. 

Add to the above problem a new issue highlighted by UK's Financial Services Authority Report. The Report stated that UK's four largest banks – Royal Bank of Scotland, Lloyds Banking Group, Barclays and HSBC – have till date set aside nearly £71bn in provisions (about US$110 billion) but their losses on consumer debts alone will reach US$150 billion if write offs return to precrisis averages and nearly US$225 billion if they rise to the levels seen in the early 1990s recession. This should never have been a cause for concern but for the fact that the tier one capital base of the lenders is about US$450 billion. All that would be an issue if UK consumers were to face problems - which they will because of the government's draconian cuts that have just started. What would happen to UK banks if the Eurozone situation deteriorates? The short answer: They would be wiped out unless there is a massive bailout. The four lenders have an exposure of about £210bn exposure to Spanish and Irish debt – about 75pc of total capital. Another £288bn is in German and French debt, which may suffer if the eurozone crisis worsens. A similar situation for the banks of other countries awaits them. Add to this the fact that nearly €300billion o f public and private debt in Spain needs to be rolled over in 2011 while European banks need to refinance or raise nearly €1 trillion in 2011 and 2012. One wonders where all this money will be raised and what sort of problems will news that there problems have reached a breaking point lead to for the world economy and the financial markets?

Will all these problems come to fruition in 2011? Extremely low probability, unless the EU policymakers shoot themselves (this time not in foot but in the heart). First the Policy makers will invariably change all the laws so that one need not disclose the problem (remember dilution of mark-to-market!). Then they will provide more incremental tranches of aid and last will simply bail them out by introducing variants of 'QE' - like QE1 & QE2, we may have 'ECB QE', 'Peoples Bank QE', etc The net result would be that the world will still be grappling with the same set of problems in 2012, only that they would have grown in proportion and magnitude. The markets will take short-term fright and then recover as the largest players can get enough of liquidity support from their respective central banks. 

A bigger problem awaits the world because if there is such a great requirement of funds then where will all that money come from and where are the interest rates headed. Each passing day seems to raise more questions rather than provide answers.