Credit meltdown

The side effects of the year-long global financial market upheaval have hit hardest in the countries that had binged on easy credit - first and foremost the United States, but also Britain and Spain.

Thanks to steep food and energy prices that are shrinking consumer discretionary spending and hindering central banks from responding to the credit crisis with lower short-term interest rates, the problems look set to spread far and wide.

"Amid convulsing financial markets, we see increasing evidence that the global economy is entering a significant slowdown period, with the weakest readings to come," says Steven Wieting, an economist with Citigroup in New York.

One year after markets seized up on concerns over failing subprime mortgages, banks have incurred some $400 billion in losses and write-downs. That leaves them with less to lend, slowing the flow of credit to the consumers and companies that power the global economy.

US consumers who banked on rising home values to finance their retirements and pad their disposable income are now faced with the prospect of saving the old-fashioned way - spending less than they earn. That points to a prolonged period of subpar economic growth in the United States, with collateral damage spreading globally.

"In Asia, Europe, and Latin America, while the pace differs, growth is slowing virtually everywhere," says Morgan Stanley economist Richard Berner. "The culprits: spillovers from the US slowdown, higher inflation, reduced energy subsidies, tighter monetary policies and tighter financial conditions."

Deutsche Bank estimates that the cutback in credit will reduce US economic growth by nearly 1.5 percentage points annually through 2010, and a similar decline is likely in the euro zone.

Vicious circle

The direct effects of the credit contraction are most apparent in the United States.

Subprime mortgages, given to borrowers with poor credit histories, have virtually disappeared. Banks are pulling back on the home equity loans that helped finance a five-year consumer spending spree from 2002 through 2006.

Terms have been tightened on a host of loans, including those made to small and large companies, and on financing for commercial construction. Even credit card offers have slowed.

The Federal Reserve, the US central bank, remains concerned about the possibility of a vicious circle, in which slower bank lending constrains economic growth, leading to still slower bank lending.

Already, companies are trimming spending, putting off new store openings or factory investments. Capital spending fell at a 3.4 percent annual rate in the second quarter, according to Merrill Lynch economist David Rosenberg.

The US economy has shed jobs for seven consecutive months, something normally associated with recession. Rosenberg says the pace of job cuts may increase in the coming months because many companies have reduced workers' hours rather than eliminate positions.

With the average workweek down to a record low of 33.6 hours in July, there is not much room left to cut.

Oil punch, credit punch

In Europe, the impact of the credit contraction has been more subtle. Unlike the United States, where many of the major Wall Street firms also own Main Street bank branches, the European banks that have incurred the heaviest losses are less involved in direct lending to consumers.

With the exception of Britain, Spain and Ireland, bank lending in Europe was a far more cautious business in the first place, which means the landing is not as hard. Indeed, soaring oil prices have probably exacted a bigger toll on spending.

"I think the sharp rise in fuel and food prices has been by far the worst hit to global growth," says Marco Annunziata, chief economist in London for UniCredit bank.

"The credit crunch is also hurting but not as much as we feared, at least not yet. Moreover the impact of the credit crunch is uneven: it has been far more severe in countries like the US and UK," he adds.

Oil prices have dropped by about $25 per barrel in recent weeks, and if that trend holds, it would certainly ease the inflationary burden. But other trouble zones remain.

European Central Bank data, if anything, show that the interest rates people have to pay on average for mortgages rose more quickly in the year before August 2007 than in the period since.

A benchmark mortgage loan measure for the euro zone shows the rate of interest demanded rose from 5.15 percent in August 2007 to 5.33 percent in May 2008, the latest month for which data are available.

While that is perhaps not insignificant, the rise was five times bigger in the year up to August 2007, when the interest rate went from 4.21 percent to 5.15 percent.

The question is whether the region can withstand the side effects that are still to come. Deutsche Bank economist Torsten Slok says the combination of tighter credit, high inflation and slowing US consumer demand will weigh heavily on global growth, and no region will by fully immune.

"The first-round effects from the burst of the US housing bubble may well come to an end within the next nine months, but the second-round effects are likely to depress growth in industrial countries for several more years to come," Slok and his colleagues at Deutsche Bank wrote in a note to clients.

"Recession in both the US and Europe is a distinct possibility before the negative forces presently weighing on these economies dissipate."

Agencies

(China Daily 08/11/2008 page11)