Deja Vu: Second Phase of the Global Credit Crunch has started

Every passing day seems to bring back a sense of gloom that is similar to what we witnessed during the fateful years of 2008, just preceding the collapse of Lehman brothers. The only difference this time is that it is countries that are in the firing line. The bond markets seems to discounting a very severe recession in Europe, while the Equity market seems to be discounting a low growth scenario or at worst, a very mild recession. Unfortunately, historically, the bond markets have been most accurate in predicting a crisis, while the equity markets have been mostly wrong. There is a steady list of countries that have slowly started reducing their estimates for growth. This is because the problems on the horizon surpass the problems the world faced during 2008-09. A more worrying storm cloud is the possible opening up of the dispute in the US about reducing its fiscal deficit – which in the past led to a downgrade of its rating by S&P.

It is commonly believed that Governments' may have realised the magnitude of the issues and are very keen on solving the problem. Unfortunately, we have this picture over the past three years. They have kicked the can for a long time and we may not have the luxury of doing it again, except for the very short-term. An attempt has been made to summarise some of the major issues. The data is essentially compiled from different sources. It is imperative to note that none of the issues are a bolt from the blue - just that policy makers have ignored them for so long, and they do not have the luxury of doing that again. It would be erroneous to believe that any country is safe. Each country has its own set of problems.

• Europe is the epicentre of the problems of the world. The bond markets there seem to indicate that the problems are not about to be solved and it is likely that Italy and Spain will need some form of bailout during 2012-13. End of elections in Spain have forced the attention on the country with bond yield jumping sharply. 
• A major constraint factor on the economy is that European Governments need to  refinance nearly Euro800 billion of debt in 2012 (excluding Ireland, Greece and Portugal).
• European Banks themselves have a problem as they need to raise (or sell assets to the tune of nearly US$2.5 trillion in order to meet their Tier I Basel Capital Requirements.
• Any decline in yields is possible only due to large scale buying from European Central Bank that has emerged as the sole buyer for bonds of stricken countries. It has already bought Euros 197 billion of bonds from the Euros 440 billion European Financial Stability Fund. These statistics are only increasing the panic as it means that unless urgent remedial action is taken, there is a fear that EFSF itself will run out of money. 
• France is about to witness a major deterioration of its fiscal health, though it is unlikely to require a bailout. But the manner in which borrowing costs for France are rising, make is unsustainable. A downgrading of French Credit Rating (a matter of time) will reduce the lending capacity of the EFSF by nearly 35%. Imagine what would happen if Germany is downgraded. 
• Borrowing costs of most of the highly indebted countries has nearly doubled in the last one year, while revenues have been less than estimated, thereby making it clear that the problem is likely to get worse.
• The problems in Europe are going to become worse as M1 money supply data indicates money is flowing out from the troubled Eurozone countries to those considered safe or to the USA. M1 has been collapsing in the trouble countries at annualised rates from 5% to about 8%.
• The panic in the bond and currency markets seem to indicate that unless policy makers intervene, especially central banks, the situation could lead to a complete chaotic collapse by at least one or more countries.
• Credit market may be about to freeze or become dysfunctional: Banks are stopping business with each other and are instead parking money with the central bank – mostly the US Federal Reserve. Foreign Deposits with the US Federal Reserve have nearly doubled to US$715 billion from about US$350 billion at the beginning of the year.
• Instead of lending, banks are prefer to invest in US Treasury bonds – such investments have gone up from about US$1.1 trillion in 2008 to about US$1.69 trilllon in October. The US Government is able to borrow at less than 2% for upto 10 years – less than those levels reached during the Great Depression. 
• European banks are parking more than Euros 225 billion on a daily basis with the ECB instead of lending – an event seen only twice: (a) in the immediate aftermath of the collapse of Lehman and, (b) at the start of the Greek crisis – in both cases it was because banks were worried about a uncertain future.
• The problems in the Banking sector are compounded by falling industrial production, rising unemployment and inability of policy makers to even outline a future course of action. The full blast of the austerity measures will be felt only from Q3 of 2012, thereby indicating that 2012 and 2013 will be worse than the present.

The impact of the problems in EU will be aggravated due to the magnitude of an attempt to cool down overheating economies in the Emerging markets.

China is especially susceptible to a slowdown. 

• Nearly 60% China’s exports are geared towards USA and Eurozone. Since 2008, China has increased its credit growth along with a US$600 billion stimulus, effectively absorbed the impact of any slowdown in 2008.
• China has limited room to repeat this feat: Its bank credit to GDP is up from 100% to 130%. Its bank credit expanded at a compounded annual growth of 21.2% from 2005 to 2010. This has led to an inflationary spiral and rampant speculation in property markets. China is now trying to control inflation. This has forced it to curb credit growth. In Q3 total financing in China was down by 30% forcing businesses to borrow at rates that even exceeded 50% annually – clearly unsustainable. 
• Their M2 grew only by 12.9%, less than the targeted 16% - indicative of its own set of problems.
• The rise in oil prices and rising wages (which jumped by about 22% last year) only make matters worse for the country which is mostly dependent on exports. 
• Falling property prices will only make matter worse for people, governments (which derive more than 40% of their income from property transactions) and the banks. Property prices are down in nearly 33 of the 70 largest cities.

India is in a particularly problematic position: 

• It runs a current account deficit, and iscal deficit and declining tax collections may in the worst case lead to a revenue deficit.
• Capital investments are down by about 45% in the last year, inflation and interest rates continue to be chokingly high. High oil prices have only made matters worse.
• The global headwinds and other problems are likely to last at least till the end of March 2012, if not beyond.
• The reason why this is likely to get worse rather than better is that there has been a steady deterioration in the corporate balance sheets. The interest coverage ratio of nearly 300 companies in the BSE 500 that have announced their results has declined from 8.42 in March 2011 to 4.48 in September 2011. In the case of Real Estate firms it has declined from 4.76 in December 2010 to 2.88 in September 2011.
• The rise in sales has come at the cost of margins and by expanding credit. The debtor days has risen from 38.3 days a year ago to 41.1 by end of September 2011.
• The problem of rising NPAs in the banks is likely to force the banks to slow their loan growth, thereby hurting corporate profits, with greater pressure on smaller companies. Corporate profits are likely to continue to fall for at least another 2-3 quarters. 
• The growing demand for funds from government and companies will lead to crowding out of the smaller player. The funds crunch will only increase over the next 2-3 quarters. Take for example the airline and power sector: together their liabilities (public and private sector crosses nearly Rs.2.5 lakh crores). Even if 5% of those become NPAs, banks will be in big trouble.
• The liability of the Airline sector to all its suppliers including banks is about Rs.80,000 crores of which Rs.40,000 is owed by Indian and the rest by the private sector airline companies. 
• While the post-tax earnings of Nifty 50 are down by 2.7%, in the case of the Sensex it is down 2.1%. In the case of Nifty Midcap 50 the profits are down by nearly 20%. The EPS projection for the Sensex is down from 1492 in March 2011 to about Rs.1331 presently. Such downgrades are likely to pickup steam in the next few months. 
• A combination of these factors is likely to pressurise Industrial Production in the next few months.

What needs to be done? 

• The exponential growth in volatility over the next few months will be the worst enemy for companies and governments.
• There is an urgent need for Government’s to take up coordinated intervention in the bond markets in order to stem the rot. Unlimited bond buying could be a very short term solution, but a good starting point.
• The longer they delay this, due to political opposition, the greater the cost to the real and financial sector at later date. The EU will need to provide immediate stimulus that ranges from Euros 1-2 trillion at least over the next year if they are to buy more time. 
• This could be accompanied by a slow move towards greater fiscal consolidation by building a framework for issuing Eurobonds by a central authority. 
• If these short-and medium term measures are not taken up, invaribly the crisis will drag on and that in turn will lead to a self-fulfilling downward spiral which could even culminate in the collapse in the Euro system.