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Market Comment: Sovereign bubbles bring new threat to growth

A year ago the main aim was to counter threats of economic
collapse and depression.

Today, the worst is probably behind us. But sustained recovery is not
guaranteed, with a double-dip recession a serious danger and new sovereign debt
bubbles heightening the risk of more instability.

While most economies recorded big GDP falls in 2009, there will be a return
to positive growth sometime in 2010. But the recovery can easily be derailed
after a brief initial bounceback. Even if we avert the threat of a double-dip,
the world economy faces major obstacles that could limit expansion.

Huge cutbacks of stocks, which accentuated the deep recession, are now
easing. This, together with huge injections of monetary and fiscal stimulus,
will boost global activity in the next few quarters. But these factors are
temporary. Sustained recovery requires steady growth in consumer spending,
investment and world trade. Unfortunately, a strong medium-term recovery seems
unlikely to be achieved.

High unemployment and pressure to cut excessive personal debt will dampen
consumer spending. Banks are weak and risk-averse, while inadequate access to
bank lending will limit capital investment. Most seriously, the need to slash
budget deficits will dampen growth as most governments will be forced to raise
taxes and cut public spending.

As house prices recover in many countries, helping to alleviate one area of
toxic lending, new sovereign debt tremors show that excesses can unleash
dangerous bubbles in the most unexpected corners. The debt moratorium announced
by state-owned Dubai World in December was the most dramatic development. But
the downgrading of Greece’s sovereign rating is, in fact, more serious.

The markets are unsettled by uncertainties over the timing of “exit
strategies”. Official interest rates cannot stay at their current low levels
indefinitely. Huge quantitative easing programmes will have to be scaled back.
But if central banks withdraw the stimulus too abruptly, both equities and bond
markets would suffer and the fragile recovery would falter.

Desperate measures are a licence to print money
The pace of economic decline has intensified and policymakers are rapidly
running out of ammunition. With UK interest rates falling towards zero, there is
talk of ‘quantitative easing’, a polite way of describing printing money. In
normal times, we associate this practice with countries such as Zimbabwe. But
fears of slump and deflation are forcing extraordinary measures.


The European Central Bank has cut its policy rate to 2.50%. Though the cut was
the biggest in the euro’s 10-year history, it still disappointed the markets as
being inadequate in the face of mounting recession threats. Further eurozone
rate cuts are expected early in 2009, at least to 2.0% and possibly to 1.5%.

The UK has intensified its policy easing; it is now the most aggressive
European rate-cutter, with Bank rate down to 2% in December 2008, the lowest for
50 years. In spite of sterling’s sharp fall, and the risks it signals, the UK
will probably cut rates to 1% early next year.

By pledging to buy up to $600bn mortgage-backed assets and offering to lend
$200bn to support other loans (cars, credit cards), the Fed has expanded hugely
its balance sheet and is already engaged in quantitative easing. Congress has
also agreed bailouts to the ailing car industry. President-elect Obama’s newly
appointed national economy team is set to introduce a massive fiscal package
immediately after the 20 January 2009 inauguration.

Few doubt the US’s determination to avoid a slump, but the risks to US
creditworthiness are real.

Chinese developments have been ominous and the leadership is very worried.
As well as slashing interest rates, China has started to reverse the yuan’s
appreciation. If China, with its massive trade surplus, devalues on a big scale,
risks of a destructive trade war with the US would escalate.

Central banks act, but the signs are inauspicious
Third-quarter 2007 growth was better than expected in the US, Japan, the
eurozone and the UK. Early fourth quarter figures show US growth in jobs,
exports and retail sales. The economy is still relatively strong in areas other
than housing. With inflation rising, there is a case for waiting before easing
policy. But the banking system is not functioning properly.

Money market rates have risen to seven-year highs as investors and lenders
become more risk averse. In response, the Fed, ECB and Bank of England all
announced measures to pump liquidity and facilitate the supply of central bank

The markets are unimpressed. The US Fed cut its policy rate to 4.25% on 11
December. The markets wanted a bigger cut and an additional cut to 4% is now
expected early in 2008. But US consumer prices recorded in November their
largest rise since 2005. The Fed will have to be cautious. Moving below 4% could
be too risky. The Bank of England has cut Bank Rate to 5.50% and at least two
additional UK cuts, to 5%, are now widely predicted for 2008. But if sterling
weakens sharply, as many analysts fear, UK inflation could accelerate.

In contrast, the European Central Bank left its policy rate unchanged in
December, at 4%. With eurozone inflation surging to 3.1% in November, the ECB is
still adopting a hard line. But growth is set to weaken. The ECB will have to
cut rates to at least 3.75%, to counter the threat of excessive euro strength.

Laurence Summers, former US Treasury secretary, summarised the pessimism
dominating the 2007 festive season: “The odds now favour a US recession that
slows growth significantly on a global basis.” Acute US housing sector weakness
is a major concern.

But the pervasive gloom is mainly driven by growing fears that the credit
crunch may unleash a vicious circle of liquidity shortages, falling asset
values, damaged bank capital, reduced credit supply and a major economic
downturn. The deep pessimism is exaggerated, given the recent global strength.
But the dangers are very real.

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

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