Things are different now

In the current global financial crisis, newly industrialising countries are suddenly considered to be comparatively “safe havens”. The subprime crisis has its origins in the USA. If it does not trigger a major recession there, the impact on newly industrialising and developing countries should not be all that dramatic.


[ By Lora Köstler-Messaoudi ]

Problems which had been looming for some time on the US mortgage market have been felt internationally since summer, if not earlier. This crisis is called the “subprime crisis” (see box). The mood on the international capital markets turned bad within a few weeks. Banks stopped granting short-term loans to one another. “Credit crunch” and “credit squeeze” became common buzzwords. It is still impossible to predict the full effects of this crisis on the global economy.

Maria Laura Lanzeni deals with emerging-market issues at Deutsche Bank Research. She says that the subprime crisis will most likely have repercussions in newly industrialising and developing countries. She speaks of a global risk of downturn, should the US economy fall into recession. If demand in the world’s largest economy takes a hit, its import demand will suffer too, compromising income opportunities for exporting nations.

For many developing countries, slower import growth in the USA means fewer exports. The fact that the dollar is falling at the same time exacerbates the effect. The World Bank assumes that economic growth in countries with weak and low incomes will therefore turn out 0.6 percentage points lower on average than would have been the case without the subprime crisis.

Lower growth and trade deficits could then lead to higher interest rates which, in turn, would slow down even more the economies in some highly-indebted nations, as credit-financed investments become more expensive.

According to the World Bank, countries with close trade ties to the USA, such as China and Mexico, will feel the greatest effects, as growth should drop by about half the percentage-rate it does in the USA. In the case of China, such a setback would not be all that dramatic, given its growth rate of up to 10 %. Other Asian economies, however, are expanding less rapidly, so they would be harder hit by a downturn in US demand. In any case, the harder America itself is hit by recession, the more severe the consequences would be for other countries.


Possible financing difficulties

Deutsche Bank expert Lanzeni also points out a second risk: the international credit crunch could lead to worse financing terms in newly industrialising and developing countries. She considers this risk to be comparatively small, however, because newly industrialising countries currently need much less foreign capital than they did during earlier crises. Liquidity is ample in countries of Asia, the Middle East and Latin America in particular, resulting from recent high exports of both commodities and manufactured goods.

In contrast, many countries in Eastern Europe are afflicted with trade deficits. The International Monetary Fund (IMF) considers these countries to be under particular threat. Bulgaria, Romania and the Baltic countries are especially exposed. However, these countries have the advantage over Asia and Latin America of better regulated financial sectors, as Erik Berglof, Chief Economist with the European Bank for Reconstruction argues.

Thomas Koch is chief economist at DEG, the German Investment and Development Company, a KfW subsidiary. He expects an outflow of capital from emerging markets once commercial banks and institutional investors in the USA have to start plugging holes. That would, in any event, slow down investment activity and, accordingly, growth. Should the USA go into a major recession, such repercussions in newly industrialising and developing countries would be severe.

Experts agree that the problems will not really be felt until large capital funds, which are heavily involved in the subprime industry, start to liquidate holdings in emerging markets, in order to recoup losses on the subprime market and become able to fulfil payment obligations. Portfolio investments would certainly be withdrawn, and it is likely that direct foreign investment would also suffer. World Bank analysts assume that such a development would affect countries such as India, Taiwan, South Korea and Thailand. In contrast, investors are unable to withdraw capital from China as and whenever they please. The Chinese government has set a minimum retention time during which capital must stay in the market.


Propping up the global economy

So far, there cannot be any talk of a capital exodus from emerging markets, however. To the contrary, international investors’ interest in newly industrialising countries like Brazil, China and South Africa even grew in summer. Evidently investors regard these markets to be relatively safe havens, whereas they once considered them risky. Christian Deseglise is global head of Emerging Markets with HBSC Investments. He says that, as a result of growth in emerging markets, “the world’s economic centre of gravity” has started to shift. Investor perception has definitly changed.

The Institute of International Finance reckons that capital flows to emerging markets will this year reach a new high of $ 620 billion – $ 47,5 billion more than in 2006. The trend is said to have accelerated after the onset of the subprime crisis. In May, the Institute had predicted a total volume of only $ 545 billion for the entire year. But analysts disagree on whether the phenomenon will continue. Many consider the recent enthusiasm for emerging markets a passing phase, which will soon end – namely when confidence in the US market returns.

Capital inflow into newly indsutrialising countries, however, is not unproblematic per se. Some economists fear the start of a new speculative bubble. Michael Hartnett of Merrill Lynch, for example, points to this danger, and some of the governments affected share his concern. For this reason, in early October, India even proposed restrictions on capital inflows, which would apply to any investors not resident in the country itself.

Heidemarie Wieczorek-Zeul, Germany’s Minister for Economic Cooperation and Development, warns that capital markets in newly industrialising countries could be destabilised, as a consequence of financial innovations, which are hardly known there yet, becoming ever more popular. Indeed, the subprime crisis is evidence of innovative banking products leading to serious problems even in highly-developed and relatively well-regulated economies.


Fundamental change

Despite various concerns, it is obvious that it is the newly industrialising countries which are providing a sense of hope in the ongoing financial crisis. The International Monetary Fund (IMF), in its World Economic Outlook of October, expects a slight decline in global growth. It nevertheless predicts solid expansion, citing the strong impetus from emerging markets.

Indeed, the situation of most emerging markets today differs fundamentally from even five years ago. After recovering from the “Asian crisis” and similar shocks in the late 1990s, the governments of many newly industrialising countries took steps to protect themselves better from the impacts of international financial crises. Many countries economised cleverly in the years of high growth and low interest rates. Public debts were repaid – in full or in part –, trade surpluses grew and foreign currency reserves piled up.

Furthermore, the economic performance of many newly industrialising and developing countries has greatly improved. They have a greater share in the global economy today. Measured in terms of the actual purchasing power of their national currencies, the contribution made by China, India and Russia to the global GNP growth is now bigger than that of all industrialised countries combined. The relative weight of these rising giants in the global economy means that they are no longer easily unsettled by outside influences.

In contrast, developing countries which play a fairly insignificant role in the global economy have so far been spared from the impacts of the subprime crisis to a large extent. James Murigu, the CEO of the Suntra Investment Bank in Kenya, sees no risk of a banking crisis in Kenya, because there is not much foreign engagement coordinated by local banks in that country.

As every financial crisis, the subprime crisis came as a surprise. The financial industry had systematically underestimated risks that had been building up. It is impossible to conclusively predict how the financial sector will overcome this crisis in the long term. While the risk of recession in the USA seemed to be declining in late November, no one can be perfectly sure.

The subprime crisis

Reports on “subprime” lending have been shaking the international finance industry since spring. In Germany, it led to problems for the IKB bank and SachsenLB, among others. In Britain, there was even a run on Northern Rock bank, because worried customers all wanted to close their accounts at the same time. However, the central banks showed unusual generosity in their monetary policy and, thanks to their interventions, the vast majority of banks retained liquidity.

Even a few months ago, “subprime” was a term familiar to just a few experts. It refers to mortgage loans made to people with low credit-ratings. Such loans are an expression of the housing bubble in the USA.
The USA enjoyed an unusually stable economic situation in recent decades. Since 1980, the country’s GNP and unemployment rate have been subject to fewer fluctuations than they were before. Recessions became shorter and less frequent, and they typically turned out less severe. Many people no longer worried about losing their jobs, and more and more home buyers crowded onto the market. As a result, house prices increased.

Mortgages on dream terms tempted even financially weak US citizens into buying houses. Two thirds of families in the USA own a single-family home or condominium. In view of the savings rate of nearly nil, such real-estate property is often their only valuable asset – and provision for their old age.
Higher real estate prices made bigger and bigger mortgages possible. Accordingly, the spending power of home owners rose, encouraging consumption. Growing consumer spending and housing construction contributed around 90 % to US economic growth in the past four years. On the other hand, real estate is on average 50 to 100 % more expensive than it was five years ago, and US citizens are today in debt to the sum of $ 10 billion. About $ 8 billion of that amount is mortgage debt.

A significant number of borrowers on the US real-estate market were in what is called the subprime segment. This is a segment of the mortgage market which caters predominantly to borrowers with low creditworthiness. Typically, these clients either pay instalments late, have previously had to file for bankruptcy, or had loans cancelled in the past two years.

In the meantime, however, property prices have begun to fall. Many Americans who bought property “on tick” now find themselves in serious payment difficulties, as interest rates are increasing steadily, property prices are falling and incomes stagnate. The market for subprime lending has thus slid into crisis, and the mortgage banks, which specialised in that particular segment, are now facing great difficulties.

But why did their problems encroach onto the international capital market? The reason is that mortgage banks used loans as collateral for securities transactions. In this way, they passed their credit risk on to others in the financial market. Investment banks bought mortgage-backed securities, bundled them into new products and then resold them in the form of tranches. These tranches are called MBS (mortgage-backed securities). Tranches with a high contingency risk also promise high returns if things go well.

Risks grew further as hedge funds with little regulation took out bank loans to fund their speculations, and again used MBS portfolios as securities. Those in charge no longer understood the spiralling risks, but mortgage banks happily continued to deal in subprime loans because they believed them to be safe.
This self-sustaining upwards spiral, however, ended when real-estate prices began to fall, interest rates rose and home-owner incomes stayed the same. The logic behind the speculation went into reverse.

Private and institutional investors on the capital market suddenly became less willing to take risks and, consequently, there was a considerable fall in liquidity. Banks were no longer prepared to lend money to other banks in the short term to the extent they had been before. As a result, the central banks of the dominant economic powers have seen themselves compelled to provide cash to the finance sector on short notice. They have thus prevented the subprime crisis from triggering a general credit crisis and causing massive recessions all over the world. (lkm)

D+C, 2007/12, Focus, Page 466