Apocalypse Now! But India’s a safe bet
Venkatesan Vembu | Tuesday, 18 September , 2007, 08:17
Hong Kong: It isn’t just his grizzly facial fuzz that invests Jim Walker with an ursine look: the celebrated CLSA Asia Pacific Markets chief economist, who correctly predicted the Asian financial crisis in 1997, today has a decidedly bearish - even apocalyptic - message to impart about the global economy.
The problems caused by the US sub-prime mortgage crisis - “probably the biggest crisis the global financial market has seen since the Great Depression” - will now spread around the world and cause recession where capital “malinvestment” is pronounced, and perhaps even lead to a global financial sector meltdown, warns Walker.
In particular, China, whose industrial structure has been extended on cheap credit, a mispriced exchange rate and artificially strong external demand, “is the most vulnerable economy in the world”. Invoking a Chaos Theory metaphor, Walker grimly prophesies: “The butterfly flapped its wings in sub-prime USA. The hurricane will be felt in rustbelt China.”
In this gloom-and-doom scenario, however, India - with its insular, largely inward-looking economy - will offer a haven of hope for investors, although it too will not be entirely immune to pressures from a drying up of global liquidity.
The “crystal-ball” that Walker uses to offer this apocalyptic vision is what he calls the “Austrian business cycle theory”, which, he says, has the best track record of predicting boom-bust periods.
This theory puts credit at the heart of the business cycle: when credit expands, the economy booms, but with a lag. When credit contracts, the economy busts, again, with a lag. “There is no way of separating these Siamese twins of economic growth,” he says.
In Walker’s estimation, the sub-prime mortgage “cancer” has already begun to spread to commercial paper, money market funds, hedge funds and structured finance. “It worries me that financial markets are so complacent in the face of the biggest credit contraction we have ever seen,” he adds.
“No one really knows the value of the assets that financial players hold, or what these assets will do when they are brought on to the balance-sheets of the ultimate owners or when they are marked to market,” he sayd.
“No one really knows who they are dealing with and who owns what in the mysterious world of asset-backed paper.” Put all this together, he says, and “you turn risk into uncertainty. Uncertainty is inherently unpriceable and therefore results in a freezing of the system” and a “paralysis in credit creation,” says he.
In the Austrian business cycle theory, even a slowing down of credit creation would be enough to induce much slower growth in the world economy (with a lag).
But when there is a contraction in credit - as is the case now - the speed of correction in the real economy intensifies. “The signs of global recession should be apparent within six months,” says Walker. “We are actually not in recession yet, but we are entering a trend of recession.”
In Walker’s doomsday scenario, as US housing prices continue to fall over the next few months, and defaults continue to climb, US consumer spending will be badly affected, not only by the wealth effect of falling asset values but also a tightening of credit mechanisms. “Americans just won’t be able to borrow as much to keep consumption and business going.”
Of course, the US Federal Reserve (along with European central banks) will cut interest rates, but this will not help contain the slowdown in economic activity, fears Walker.
“A reduced price for money works only when there is a willingness on the part of borrowers to borrow and on the part of lenders to lend.
It is the latter that are now the problem.” As a consequence, players in the corporate bond market will face higher funding costs and lower economic growth projections, and therefore shelve investment plans and cancel existing orders.
It is in such a scenario that China’s vulnerabilities and ‘malinvestment crisis’ will get amplified, reckons Walker. “No other country has benefited more from demand in the US and global central bank profligacy than China, and the problem is that we don’t know how distorted the industrial structure has become as a result.”
China’s growth and investment momentum - alongside its capital misallocation signals of negative real interest rates, undervalued currency and subsidised energy inputs - will ensure that additional capacity in all the wrong sectors will come on stream over the first half of 2008.
Following the Olympic consumption boost, the overcapacity in China will become apparent. As capacity utilisation drops, corporate earnings will collapse, along with the stock market, says Walker.
“China not only has a malinvestment problem, but a stock market bubble as well,” says Walker. “The authorities in Beijing have done an awful job in controlling overheating in the economy or in containing market expectations.”
That, he adds, is “a recipe for a crash.” That recommendation could still take another year to play out, “but eventually it will be the stuff of legends, for the bears.”
What about India?
In all this turmoil, India will offer a safe haven for investors, says Walker. Unlike China, India’s domestic demand story is real, and result-oriented.
“The balance between demand and supply is led by demand, not by supply… It’s also the case that the central bank (the Reserve Bank of India) has been pretty aggressive, and in fact the strongest contrast I can think of between India and China relates to monetary policy.”
Of course, India won’t be entirely immune to a global credit contraction, adds Walker. “The biggest risk for India is that it needs money to maintain its strong growth, and credit will become more expensive or less available.”
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