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Market Comment: Western debt addiction strengthens Asian hand

The new year started on a positive note with US shares at
15-month highs and market traders bullish over growth and corporate earnings.
However, behind the façade of confidence, one finds serious worries.

Near-term hopes of recovery are mainly driven by China and India. Robust
growth in these Asian giants, while Europe and the US suffer the worst recession
since World War II, provides a stark reminder that the shift in global power to
the East is accelerating.

However, China and India are signalling concerns that their economies may be
overheating and, as both have taken measures to restrict lending and avoid
bubbles, the New Year exuberance in the markets has cooled.

We must accept that, realistically, global prosperity will increasingly
depend on developments in Asia. But China still relies on export-led growth and
this will make it more difficult to rebalance the world economy. Unless the
Chinese allow their currency to strengthen and their huge trade surpluses shrink
appreciably, countries such as the US and the UK will not find it easy to reduce
their excessive reliance on borrowing, consumption and overblown housing
markets.

In the US and Europe, uncertainties over widely-expected policy tightening
are disturbing the markets. Reassurances, mainly by the US Federal Reserve, that
interest rates will stay low “for an extended period” are not being taken at
face value. In response to concerns that interest rates are set to rise in 2010,
businesses and governments have issued bonds at a frenetic pace in the early
weeks of January, raising almost $80bn.

Inflation
Conflicting fears of inflation and deflation remain unresolved. The optimists
hope that abundant liquidity and very low rates will be maintained in the early
stages of recovery, helping to boost corporate profits and bank capital.
However, surging public debt may dictate greater caution.

The UK is recovering more slowly than other economies but concerns over
sovereign risk may force action on the deficit and on interest rates sooner than
expected. In the US, the Fed will maintain ultra-low rates as long as possible.
However, there are signs that the quantitative support will be slowly removed.

FEBRUARY 2009
Real economy plunge threatens new collapse – In the earlier
phases of the crisis, financial weakness was the driving force; real economies,
which were initially resilient, succumbed only gradually. But the post-Lehman
plunge changed the situation radically. Financial easing has failed to underpin
the real economy. Instead, huge falls in activity threaten to unleash new
financial turmoil.

The US, the eurozone and the UK will all register quarterly declines of 1% to
2%. It is clear that this recession will be worse than that of the early 1990s.
Only forceful measures may ensure that the downturn is not as bad as in the
early 1980s.

Rates
The US Fed has cut its key policy rate to a range of 0% to 0.25%, a record low.
With rates effectively at zero, quantitative measures are now the main focus of
US policy, particularly action to reduce mortgage rates. Other key economies
will continue to act more slowly than the US. In January, the European Central
Bank (ECB) cut its key rate from 2.5% to 2.0% and the UK has lowered rates from
2.0% to 1.5%. While further cuts are expected soon, towards 1%, both the ECB and
the UK will move slowly to quantitative easing.

Recent financial improvements have not totally dissipated. Narrower spreads
between interbank and official rates signal easier liquidity and credit
conditions. New fears over banking sector stability are emerging. Citigroup
reported its fifth consecutive quarterly loss and is splitting its business.
Bank of America announced its first loss since 1991 and cut its dividend to one
cent per share, after receiving new emergency government funds in mid-January.

Ominous reports outside the US include a record quarterly loss at Deutsche
Bank and big job cuts at Barclays. Bank shares are facing renewed downward
pressure. Unless governments can stabilise the relentless decline in real
economic activity, we could face a new and more dangerous financial crisis.

FEBRUARY 2008
Gloom deepens as bank losses mount – The gap between interbank
rates and policy interest rates, a key index of liquidity shortages, is much
lower than in the early stages of the credit crisis as central banks have
succeeded in boosting liquidity. The bad news is that the crisis has moved to a
new and more dangerous phase. Citigroup and Merrill Lynch have announced huge
losses and there are fears over the strength of the banking system and the wider
effects of the global credit crisis. Bank capital has become a vital, scarce
resource. New capital injected by Chinese and Middle Eastern investors is
helpful but confidence has fallen in the face of worsening recession fears.

Employment
US jobs rose only 18,000 in December, while falling retail sales and relentless
housing weakness add to the gloom. Other figures signal a US slowdown – not a
recession – but the alarm bells are sufficiently shrill to force the
administration and Congress towards a package of tax cuts. The Fed is supporting
fiscal stimulus and is signalling further aggressive easing. Having already cut
its key interest rate by 100 basis points since August 2007 (from 5.25% to
4.25%), it announced in January an emergency 75 basis points cut, to 3.50%.
Further US rate cuts, to 3%, are expected later in 2008.

Rates
Pressures for interest rate cuts are also building up outside the US, but the
pace is more relaxed, because recession fears are less acute and inflation
concerns have higher priority. The Bank of England has kept Bank Rate at 5.50%.
A cut to 5.25% is widely expected early in February, followed by a cut to 5% by
May. The futures market signals further UK cuts to 4.25% or 4.50%, but, given
sterling’s weakness and strong price pressures, cuts below 5% are too dangerous.

In the eurozone, with inflation above target at 3.10%, the ECB maintains a
tough stance. The key ECB rate has been at 4% since June 2007. With growth set
to slow, the ECB would probably cut its key rate to 3.75% by April 2008. On the
currency markets, the US dollar remains under pressure. But sterling is
vulnerable to sharp speculative attacks.

David Kern of Kern Consulting is chief economist at the British Chambers
of Commerce. He was formerly NatWest Group chief economist

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