A deeper malaise

As the consequences of the subprime mortgage crisis spread to financial markets around the world, concerns of the US facing another major recession are also rising. Will US economy finally slip into a deep recession? How will it affect global economies, including China's, if the US economy falls into deep trouble? 

A financial crisis eventually evolving into a major recession looks inevitable in the US right now.

A new National Bureau of Economic Research working paper studies whether the 2007 US subprime financial crisis is truly a new phenomenon different from previous crises, but the examination of longer historical records finds stunning qualitative and quantitative parallels across a number of crisis indicators. The research shows the US crisis that started last year closely follows several indicators that characterize previous crises. Those indicators include a significant run-up in equity and housing prices, the same inverted V shape of real growth, large current account deficits and a run-up in total debt in the years prior to the crisis.

The authors conclude that "the US should consider itself quite fortunate if its downturn ends up being a relatively short and mild one".

True, given the ongoing turmoil in financial markets and deteriorating domestic demand, the US should feel lucky if the recession doesn't last too long.

The real problem this time should be insolvency, which means households and institutions are unable to pay their debts, or they have difficulties refinancing their loans. In this case, debt claims will be defaulted and reduced.

The problem is not simply illiquidity, however, which suggests households and institutions are unable to pay their debts, but a sudden liquidity shock, which makes them unable to have their claims extended. Now it is clear that the insolvency cannot be resolved easily by money injections.

Indeed, despite the Federal Reserve's rate cuts, economic growth in the US slowed notably in the fourth quarter of last year, with recent data indicating weakening manufacturing, consumption and employment. Noteworthy is that the situation is not showing any signs of easing after multiple interest rate cuts and a fiscal stimulus plan. Adding to the woes, the Fed also faces inflationary pressure and serious dollar weakness.

Technically, a recession is usually defined as two consecutive quarters of negative growth. According to the current US economic situation, it is justifiable to expect at least two consecutive negative growth quarters starting no later than the second quarter of this year. We thus consider the potential US recession at least a "technical recession", similar to the one that took place in 2001.

A recession in the US originating with subprime crisis appears imminent now.

Innovation and globalization

Extensive use of financial innovations undoubtedly enhances stability against some kinds of financial shocks, but also possibly increases vulnerability against other risks.

Thirty years ago, credit risk was almost solely borne by financial institutions. Today, credit risk is borne by both financial institutions and capital market participants, thanks to multiple types of securitization products. Securitization certainly reduces systematic risk as financial risk is shifted out of institutions to investors, but also provides a dangerous contagious channel when a financial crisis breaks out. What makes things worse is that financial globalization provides another channel for crisis to spread from one country to others.

Meanwhile, financial globalization does not promote international risk sharing to the levels verified by theory. In theory, financial globalization should be able to provide increased opportunities for countries to decouple fluctuations in consumption growth from those of income or output growth. In other words, financial globalization should be able to reduce correlation between domestic consumption and national output.

Surprisingly, a recent IMF study shows that the benefit of financial globalization is not as promising as people used to believe. Among different groups of countries, developing countries have been shut out of the benefit. Even for emerging market economies, which have been much more integrated into global markets than other developing countries, financial globalization has not improved the degree of risk sharing.

What can we learn from the IMF study? The striking results tell us that the correlation between domestic consumption growth and national output remains very high. If US and Europe experience severe recessions, consumption in both areas will be largely affected; if consumption in the US and Europe is in trouble, emerging market economies such as China and India will be largely affected; if emerging markets are in trouble, in a world where BRIC countries (China, Russia, Brazil, and India) account for more than half of global growth, global economy will be in deep recession. Since the correlation of global stock markets usually mirrors the correlation of global real economies, the US stock market plunges are followed by similar sharp falls in Asian and European stock markets.

To prevent global economy from a deep recession, adjustments in global monetary policy and global fiscal policy should be needed. This is a global issue. China or other BRIC countries cannot save the world economy only by themselves.

The author is board secretary and general manager of International Clients at China Jianyin Investment Securities Co Ltd. The views expressed are his own.

(China Daily 03/10/2008 page3)