FYI | Sep 05 2007
By Greg Peel
With all the talk of the surging economic machine that is China, we tend to forget that China’s economy still pales into insignificance compared to that of Japan. We are concerned about a blow-off in Chinese growth, and now concerned about a stagnation in the US economy, and how that would effect China and ultimately the rest of the world. But what effect might Japan have?
The London Telegraph reports Japanese wages have fallen for the last eight months in a row. Over that period business investment has fallen 4.9%, with the pace of decline gathering speed in the last few months. The Japanese government has applied a “fanatical” fiscal squeeze that has cut the deficit from 8% of GDP in 2003 to 1.5% this year. Critics suggest Japan was too quick to raise the interest rate from zero.
China has now surpassed Japan as Australia’s largest trading partner. Should Australia thus be concerned if the Japanese economy were to go into recession? Well we’re certainly concerned enough about the US economy, so why not number two? And since the yen carry trade began to be unwound as the credit crunch accelerated, Japanese firms have had their profits slashed. The “Seven Samurai”, led by Toyota, Honda and Toshiba, have seen their share prices consequently slashed on the Tokyo bourse. Japan is a significant buyer of Australian iron ore and coal for steelmaking.
Meanwhile, the situation becomes increasingly dire in the US. Concerns are not currently being reflected in a buoyant stock market. The Telegraph reports speaker after speaker at the Fed’s Jackson Hole retreat painted an ever darker picture of the fate of the US economy. Former chair of the White House Economic Advisors, Marty Feldstein, went as far as to call for an immediate 100 basis point cut in the Fed target rate, as opposed to a 25 basis point cut on September 18 that most are expecting. Feldstein believes the US economy is heading for a very serious downturn. Ethan Harris, chief economist at Lehman Bros, suggested the opinion is building that “this has got a lot more serious” than it had been when markets started to recover.
The biggest immediate problem for the US is that large parts of the US$2200bn commercial paper market remain shut. Short term borrowing through the issuance of corporate debt is what keeps the world’s biggest companies rolling along. Toyota, for example, will issue paper to finance raw material costs to build cars, while revenue from cars sold will be used to pay off the debt in a constantly rolling process. The commercial paper market also keeps medium and small companies rolling along. In the past three weeks the market has shrunk by $244bn. This is despite the Fed lowering the discount rate and offering to take asset-backed paper as collateral for 30-day loans. If money does not begin to flow freely back out of short term US treasuries and into the commercial sector soon then there is a very real risk smaller companies will simply become insolvent, and job losses would ensue.
The Telegraph suggests the Fed has been “stunned” by the ongoing freezing of activity in commercial paper. The rush to 3-month US Treasuries has been the fastest on record, eclipsing even 9/11 and the 1987 crash. Hence Chairman Ben Bernanke was moved to issue his statement last Friday suggesting that although not being either obliged or inclined to bail out overstretched financial investors, the Fed will do what it has to to avoid economic recession.
It should have moved earlier, say many critics. If it waits too long to see what the fallout is going to be, and reacts too conservatively, the recession will have already begun.
Adding to concerns in global credit markets is a rise in LIBOR (London inter-bank overnight rate). This may be a non-US credit rate, but given its longevity it is still used as a benchmark in the global financial market. Many credit deals across the globe, including in the US, are transacted at prices based on LIBOR plus a premium. Credit spreads have blown out significantly, and LIBOR has also risen, adding to the additional cost of finance.
Fuelling fear in US financial markets is the great unknown. Who owns all the worthless mortgage-backed securities and how many? September may be a month when some of this information is divulged, as US financial institutions begin to provide pre-results for the third quarter. German bank IKB was one of the first victims to disclose its exposure to subprime securities, forcing a bail-out by the Bundesbank. IKB has said this week its losses could reach E700 billion.
Morgan Stanley economists note that an usual dichotomy has formed between a rising LIBOR rate and a frozen commercial paper market and a rising equity market. Something has to give. At this stage, Morgan Stanley is backing a recovery in debt markets, rather than another collapse in equity markets. It may yet come down to just how dramatic a move the Fed makes on September 18.
