What will be the effect of the US administration’s latest plan to save the world on emerging markets such as India? Stock markets have moved up hoping that it will succeed.
The plan calls for a public-private partnership—with the public part of the partnership bearing most of the risk—to take toxic assets off the books of banks, so that they can start lending again.
So there are two objectives here: helping the economy get back on its feet and making the US banks whole. There’s also a political objective: getting the banks back into shape while avoiding having to nationalize them. That is one reason for the markets to cheer and for the US financials to bounce back. Needless to add, if the plan fails, nationalization will be the only option left.
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Investors around the world will welcome any improvement in the US economy. And bank lending will play a big role in any upturn in the economy. But consider the data on bank credit in the US.
As on 11 March, bank credit outstanding was at $9.8 trillion and expanding at a year-on-year (y-o-y) rate of 3.3%. In contrast, at the beginning of the year, on 7 January, bank credit outstanding was $9.844 trillion and expansion was at a y-o-y rate of 6.2%.
Clearly, the pace of bank credit is decelerating rapidly. The same is true for commercial paper (CP). Outstanding CPs in the US have declined by $205 billion year-to-date and by $354 billion over the past year, a drop of 19.3%. Hence the worries about banks not lending.
Are banks not lending because of the toxic assets they hold, or because the US economy is deteriorating and they are worried about their loans turning bad? There’s ample reason to believe the latter reason is very important. By contrast, consider the recent downward revisions made to forecasts of global and US growth.
The International Monetary Fund (IMF) now says the US economy will contract by 2.6% this year and will grow by a mere 0.2% in 2010. And that projection is based on the assumption that “financial market conditions improve relatively rapidly in the second half of 2009, based on the implementation of a detailed and convincing plan for rehabilitating the financial sector…”.
OECD says that its members will see “very negative growth” this year. In short, there are reasons for bank lending in the US to remain circumspect, regardless of whether US treasury secretary Timothy Geithner’s plan works.
Now, consider the second objective of making the US banks healthy. There are question marks over the price at which the assets will be unloaded, and too low a price could lead to large write-downs at banks and a need to raise more capital. That’s the big risk in the plan not just for the US banks but for emerging markets as well.
A background paper, titled Global Economic Policies and Prospects, prepared by IMF for the G-20 meeting of leaders, ministers and central bank governors in London clearly says that “escalating bank losses in advanced economies are pushing banks to contract balance sheets and curtail credit flows to hedge funds and other emerging market investors”. The study points out that cross-border assets as a share of bank balance sheets declined for the second successive quarter in the third quarter of 2008, while global syndicated loan volumes were cut in half in the fourth quarter.
What of the future? The IMF paper doesn’t mince words. It says that cross-over funds—retail funds invested in a wide range of assets—have largely reduced emerging market exposures and are unlikely to consider re-establishing positions due to the outlook for emerging economies and higher comparable returns available on mature market credit assets.
It forecasts significant portfolio outflows in 2009 and in 2010, a big slowdown in foreign direct investment and predicts that emerging market sovereign bond spreads will rise further and will decline only modestly in the next two years. It means the lack of access by emerging market companies and banks to external funding will continue, funding costs will remain high and there will be continuing concerns about debt rollovers and foreign currency convertible bond conversions on corporate balance sheets.
Finally, even if the US and other plans by Western governments and central banks to bail out the banks succeeds, it may not be enough to restart fund flows to emerging markets. As the IMF note puts it, “recent bank support or rescue programmes in advanced economies may be accelerating the curtailment of cross-border bank flows. In particular, banks receiving public support may feel pressure to expand domestic lending at the expense of their foreign operations”.
A slight improvement in the US housing data and a marginally better initial reading for the eurozone purchasing managers index data for March have fuelled optimism that a bottom is now in place. But, as the IMF analysis indicates, there are plenty of headwinds ahead for the market to battle.
Graphics by Ahmed Raza Khan / Mint
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