As first-quarter earnings come out the losses are going to be huge. Here at home it seems markets have been playing a game of psychology, waiting for political events to run themselves out before selling (see the big selloffs after the passage of the bailout after the election, and today). Most of the talk is still about banks. But abroad the news seems to be not only genuinely worse than expected, but is gradually moving from the private sector to public.
As the UK's government continues to pull out the stops to bail their banks out and prevent a Lehman-style failure, Financial Times has a new article up speculating on the UK's sovereign debt position:
Since the middle of 2007, the trade-weighted pound has fallen by 27 per cent. Furthermore, as the government shoulders contingent liabilities for ever greater amounts of delinquent bank debt, worries are growing about the state’s finances.
This is the largest slide since 1931, before the sterling crisis of September of that year. Provided that the decline remains orderly and does not result in a rapid pull-out of foreign investment, this will be good for the UK because it makes their exports more competitive. Britain's economy, after suffering from a brief crisis, eventually began to recover in 1932 in large part because its currency was devalued.
But 10 percent of the decline has come in the last two days, with the news out of the banking sector. Everything depends on how deep the banks' losses are. With the government now backstopping these large banks, a government default could trigger a renewed systemic crisis in the financial system, exactly what Paulson and Bernanke have been trying to prevent all these months with the bailouts:
British banks have about £4,000bn of assets on their balance sheets, equivalent to 2.5 times gross domestic product. If losses on these assets accelerate, the banking bail-out could segue into a sovereign debt crisis. Investors might push up borrowing costs, then, if rattled, refuse to buy UK government debt altogether, triggering another run on the pound.
So far it has not panned out that way. Spreads of 10-year UK government bonds over German bunds tightened up to Christmas. This year, though, spreads have widened and the cost of insuring against sovereign default has risen. In the credit default swaps market, the UK is viewed as a riskier borrower than France and similar to Spain.
Perhaps the best thing the UK has going for it is that other euro zone countries are in just as bad shape.
Standard & Poor's downgraded Spain's sovereign debt from AAA to AA+. On Monday, it said that
Standard & Poor's said on Friday and Monday that Spain, Greece and Ireland's credit ratings were under threat as the global crisis strains public finances.
Furthermore:
Britain is not alone in its current distress, although the fall in sterling speaks for itself. The sovereign debt of Russia, Ukraine, Greece, Italy, Belgium, Austria, The Netherlands, Ireland, Australia, New Zealand and Korea is all being tested by the markets. The core of countries deemed safe is shrinking by the day to a half dozen. Sadly, Britain is no longer one of them.
The default of a country as large as Britain would be disastrous:
Indeed, if Britain walked away from UK banks' $4.4 trillion of foreign liabilities – worth eight times Lehman Brothers – it would destroy the credibility of the City and take the whole world into deeper depression.
"The UK cannot go down that route because it would set off an asset price death spiral," said Marc Ostwald, a bond expert at Monument Securities. "The Western banking system is already on life support. That would turn it off altogether."
After World War II, the Bretton Woods conference set up the IMF to help countries in default position settle their balances of payments. But the IMF is funded by the same US and European governments who are now in trouble themselves (each IMF member has a quota, but the bulk of the funds come from the US and EU). As of August 28, 2008, the IMF had $201 billion in loanable funds.
Which brings us to the other bailout:
In the span of a few months, the IMF has approved emergency loans for Hungary, Ukraine, Iceland, Belarus, and Latvia worth more than $39 billion, and a request from Serbia will be considered soon
Nor are these bailouts eliminating the market's fear of default. For example, the Ukrainian currency, the hryvnia, has plunged against the dollar and euro, and CDS swap spreads on their sovereign debt remain high. An additional $14.5 billion was loaned to Pakistan, the IMF has already spent almost a quarter of its total reserves.
Furthermore, this is potentially just the tip of the iceberg. In October, during the threat of systemic financial crisis, smaller countries spent huge amounts of their own reserves defending their currencies:
Neil Schering, emerging market strategist at Capital Economics, said the IMF's work in the great arc of countries from the Baltic states to Turkey is only just beginning.
"When you tot up the countries across the region with external funding needs, you get to $500bn or $600bn very quickly, and that blows the IMF out of the water. The Fund may soon have to start calling on the West for additional funds," he said.
Brad Setser, an expert on capital flows at the Council for Foreign Relations, said Russia, Mexico, Brazil and India have together spent $75bn of their reserves defending their currencies this month, and South Korea is grappling with a serious banking crisis.
These developing countries are in trouble because developing countries rely a great deal on foreign capital to fund their economies. When foreigners begin to pull their money out, this causes a large fall in output. We saw this in Thailand during the baht currency crisis in 1997, which rapidly spread to its neighbors, and then to Russia in 1998. But back then we had US consumers to "bail out" the world economy. Now, every country is a developing country. All countries depend on foreign capital to fund their economies.
In last resort, the IMF could begin to act as a world central bank by printing its own money:
The IMF, led by Dominique Strauss-Kahn, has the power to raise money on the capital markets by issuing `AAA' bonds under its own name. It has never resorted to this option, preferring to tap members states for deposits.
The nuclear option is to print money by issuing Special Drawing Rights, in effect acting as if it were the world's central bank. This was done briefly after the fall of the Soviet Union but has never been used as systematic tool of policy to head off a global financial crisis.
Clearly, I do not have all the answers.
But the Obama administration must realize that our problems are not confined to the US economy. It must take preparations for devaluations and defaults in our major trading partners, if these possibilities become necessary, and resist the urge to take advantage of the short- term flight to the dollar at the cost of destroying the (potential) defaulters' economies. Every country that devalues its currency is another country that US exports cannot be competitive with, or a country that does not have capital to invest in the US. In the short term, capital will flee to the US dollar, artificially propping up our currency, and allowing our government to continue to borrow. The US is truly blessed to have the world's reserve currency-- in the short term.
But in the long term, we cannot go into too much debt ourselves. An overvalued currency makes our exports uncompetitive, choking off an economy recovery at home. And currency crises and defaults abroad cause deep falls in output and consumption abroad and geopolitical instability. The end result is falling output, falling trade, and more debt.
The experiment in global economics without complete global institutions is not succeeding. The coming months and years will move us toward greater government control, global monetary and fiscal policy, and a global central bank. Boldness is no longer an option, but a necessity.