economist int unit shooting the repids

8/2/2019 Economist Int Unit Shooting the Repids

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Shooting the rapids

What happens if financial turmoil capsizes the globaleconomy?

April 2008Economist Intelligence Unit26 Red Lion SquareLondon WC1R 4HQUnited Kingdom


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The Economist Intelligence UnitThe Economist Intelligence Unit is a specialist publisher serving companies establishing and managingoperations across national borders. For 60 years it has been a source of information on business developments,economic and political trends, government regulations and corporate practice worldwide.

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Symbols for tablesn/a means not available; means not applicable


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Contents 1

April 2008 www.eiu.com The Economist Intelligence Unit Limited 2008

Contents2 Introduction: Bear market

5 Global crisis: How long? How deep?

6 The US, euro zone and Japan: Debt, default and depression?

7 US: Hard times

10 Spain: End of the fiesta

11 Major emerging markets: Hitting the (great) wall?

15 The financial sector: Beyond sub-prime

15 Housing market: Home, sweet homeless?

19 Commodity prices: A new world, or bubbles waiting to burst?

22 Policy: Regulatory roulette22 Banking rules: Making bad times worse?

26 Global assumptions: Main risk scenario


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2 Shooting the rapids


Introduction: Bear marketA prolonged and deep US recession threatens severe hardshipfor the world economyBear Stearns, once a celebrated US investment bank, has become a byword for

the first great financial crisis of the 21st century. When the Federal Reserve (the

US central bank) rescued Bear Stearns in March it elevated the sub-prime

mortgage meltdown to historic levels, alongside the 1987 Black Monday

stockmarket crash, the 1992 attack on the British pound, Mexicos 1994 tequila

crisis and the 1997-8 triple whammyThailands currency devaluation,

Russias debt default and the collapse of an iconic US hedge fund.

Todays crisis could be much worse than any of those. Financial losses from the

US mortgage rout and the spreading credit crunch are likely to approach

US$1trn, according to the IMF. If the contagion infects an ever-widening group of

assets, the US could plummet into the kind of recession that saw Japan enter itslost decade in the 1990s, dragging down much of the global economy with it.

This report updates the Economist Intelligence Units August 2007 analysis of

the early stages of the credit crisis, Heading for the rocks: Will financial turmoil

sink the world economy? In that report, we saw a 30% likelihood that the US

would fall into a recession, with serious consequences for the rest of the world.

That scenario has now come to pass. The US will endure a recession this year,

and growth is already slowing in most other countries. In this report we discuss

a more dire outcome: a massive, worldwide flight from risk that causes asset

values to plunge, banks to collapse, credit to contract and the world economy to

stall. This is now our 30% scenario.

Free money, costly bubbles(Inflation-adjusted interest rates; %)

Sources: Haver; Bloomberg.

Note. US Fed target interest rate minus consumer price index; ECB target rate minus harmonised EU CPI;Bank of Japan nominal target rate.

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0JapanEurozoneUS

080706050403020120001999

The current crisis was built on the back of a remarkable increase in global debt

earlier in the decade, spurred by interest rates so low that investors could

essentially borrow money for free. That fuelled Americas property bubble,

which spread worldwide through the dark magic of securitised mortgage assets.

As US mortgages defaulted, the securities built around them lost value, eroding

the balance sheets of the investorsnotably banksthat bought them.


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Shooting the rapids 3


Weakening banks have been at the heart of all the worst financial meltdowns,

and the current crisis has been no exception.

The financial strains of the past eight months have had two distinct features. The

first is a deterioration in credit qualitynot just property loans, but corporate

debt that was issued indiscriminately during the leveraged buyout boom,

another legacy of the cheap credit era. The second has been uncertainty over

which institutions held problem debt, and its actual value. This prompted banks

to restrict lending to one another, creating a liquidity crisisan inability to find

willing buyers and sellersthat pushed up the cost of borrowing. One measure

of liquidity, the spread between interest rates in the private interbank market and

ultra-safe US short-term Treasury bonds, rose fivefold in less than a week.

The combination of deteriorating credit quality and liquidity strains has raised

the spectre of an even worse result: the outright collapse of a globally important

bank, which could damage confidence badly enough to threaten the world

financial system. Such risks led to panic selling in financial markets in March

and a remarkable response by central banks, especially the Federal Reserve. For

the first time in its history, the Federal Reserve offered to make loans toinvestment banks, not just commercial banks, and agreed to accept less-than-

stellar collateral in return. The Federal Reserve, which has lowered interest rates

by 3 percentage points since September 2007, also injected vast sums into the

global financial system to prevent markets from seizing up. It crowned its efforts

with the bailout of Bear Stearns. After helping to create the current crisis by

keeping interest rates too low for too long earlier in the decade, the Federal

Reserves swift response has, for now, eased strains in the credit markets.

When borrowing costs soar(Spread between private interbank interest rates and short-term US government debt; basis points)

Source: Bloomberg.Note. 3 month US$ LIBOR minus 3 month US Treasury bill

0.0

0.5

1.0

1.5

2.0

2.5

MarJan07

NovSepJulMayMarJan07

NovSepJulMayMarJan2006

It has not, by any means, ended them. US and European banks have written off

more than US$200bn in assets, and the prospect of more lossesperhaps asmuch as another US$300bnhas caused a widespread tightening of lending

standards in many developed markets. Along with wider borrowing spreads,

this has led to a credit squeeze that will curb consumer and business spending,

threatening the wider economy.

The risk now is that the crisis could spread even further. Property markets in

other countries, especially in western Europe, also look stretched. Emerging

markets have been remarkably resilient, thanks to strong economic growth,

What if a globally important

bank collapses?


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reduced debt and strong reserves. But eastern Europes economies appear

vulnerable, and falling global liquidity and a recession-burdened US will make

for tighter financial conditions in developing countries.

Investors worldwide are reacting to the crisis by selling assets to reduce debt.

Deleveraging is essential, but if it accelerates even the prices of good assets will

fall, triggering another wave of panic selling. That would truly be a bear market

that no central bank could stop.


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Global crisis: How long? How deep?If the US enters a Japan-style lost decade the majoreconomies will struggle to recoverThe complexity of the global financial system and the increasingly linked

nature of world markets mean that predicting how the credit crunch will play

out is unusually difficult. Nevertheless, the Economist Intelligence Unit believes

that the range of possibilities coalesces around three major scenarios.

Scenario 1: Our central forecast (60%)The US economy dips into recession in 2008 but responds to monetary and

fiscal stimulus, rallying in 2009. Other developed economies slow sharply but

avoid outright recession. World trade growth and commodities prices stay high,

and major emerging markets suffer only a modest (and in some cases desirable)

slowdown in activity.

Scenario 2: The main risk scenario (30%)The US economy fails to respond to policy stimulus and suffers a deep

recession and a long period of sub-par growth comparable to Japans lost

decade. This induces a stall in other developed economies, and, through a halt

in world trade growth and a sharp correction in commodities prices, a severe

slowdown in developing ones, including China and India.

Scenario 3: The alternative risk scenario (10%)Successful policy stimulus results in overheating, requiring in turn a sharp

tightening in policy stance to relieve rising inflationary pressures. This, in turn,

prompts a renewed downturn. The need to rebuild anti-inflation credentials

limits the capacity for subsequent policy stimulus, prolonging the economic

weakness.

The assumptions underlying scenario 1 are the basis of our regular publications

and will be dealt with only briefly here, as will the relatively low-probability

scenario 3. This report will address mainly scenario 2, where the combination

of likelihood and impact is most intense.

We look first at the outlook for the developed world, and particularly the US,

the euro zone and Japan. We move on to the large, fast-growing emerging

economiesthe so-called BRICs. Next, we look at the financial services

industryabove all this is a financial crisis, and we examine how events might

play out in that sector. We then turn to commodity markets. With commodities

playing a central role in both financial flows and global growth dynamics, this

is a key area. And finally, we look at how this crisis may influence

policymakers and ask whether we are at a watershed in perceptions of the role

of the state in national and international markets.


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The US, euro zone and Japan: Debt, defaultand depression?The worlds major growth engines are ill prepared towithstand a US slumpCentral scenario60%Under the Economist Intelligence Units central forecast the US experiences a

relatively shallow recession in 2008, but the policy response is sufficient to

stabilise the financial markets and the worst of the domestic construction

downturn is over by early 2009. Growth picks up in 2009, albeit slowly, as

banks and households continue to rebuild their balance sheets. The US's

economic performance is supported by the external sector, as the weak US

dollar helps to spur export growth. Fallout from the US's domestic woes is

limited, largely as a result of a continued brisk (but rather less frothy)performance from emerging markets.

But the euro zone and Japan slow sharply, reflecting the negative impact of the

stronger euro and yen on exports and, in the case of the former, the bursting of

a number of housing bubbles, notably those in Spain and Ireland. Germany,

where consumers are considerably less overborrowed than in many other parts

of the euro zone (and than in the US and the UK), holds up relatively well.

Despite higher productivity than many of its euro-zone peers, Germanys

exports are also hit by the strong currency.

Overall global growth slows, but at 3.7% in 2008 and 3.8% in 2009 (at

purchasing power parityPPPrates) is rather less abrupt than during theprevious US recession at the beginning of this decade.

Risk scenario30%The risks to our relatively benign central forecast are rising. In our main risk

scenario, the US enters a Japan-style extended period of sub-par economic

performance. The transmission channels for this are similar to those in post-

bubble Japan in the late 1990s and the early years of this decade, including the

failure of conventional monetary and fiscal policy. As in Japans downturn, a

prolonged correction in the housing market and the rebuilding of regulatory

capital by banks combine to choke off both demand and supply for loans. (The

Federal Reservethe US central bankcuts the federal funds target rate to 0.5% in

2009 and maintains this rate in 2010. As in Japan, however, this merely serves to

contain systemic risk and does not in itself increase the availability of credit.)

Under this scenario, US consumers also boost savings more aggressively than

in our core forecast, further hitting private consumption growth and businesses

performance. The debt-service burden for US households reached a record high

of 14.3% in the fourth quarter of 2007, despite aggressive rate cuts by the

Federal Reserve last year, indicating how fragile US household balance sheets


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have become and highlighting the need for a rebalancing of household

finances. In response to consumer belt-tightening, companies slash investment

and cut employment.

Again echoing Japan, there is a prolonged downturn in the US property market,

with house prices continuing to fall into the next decade.

US: Hard times

The US endures a recession every eight to ten years, but the slump that is now

under way could become the worst in more than half a century. The Economist

Intelligence Units 30% risk scenario results in virtually no growth in the US

economy this year, a sharp contraction in 2009 and another year of falling output in

2010. This becomes the worst three-year stretch since 1945-47, when the economy

was decelerating after the second world war. Apart from that, only the great

depression of the early 1930s is worse.

Jobs are difficult to find. The US economy loses as many as 5m positions by the end

of 2010, with the unemployment rate jumping from the current 5.1% to well over 8%.

This is the highest level since the 1980-82 double-dip recession, when unemployment

exceeded 9%. Consumer spending, which has not contracted in even a single quartersince 1991, plummets, and personal bankruptcies soar.

As household incomes drop and retail purchases decline, annual corporate profits

fall by 15-20% in both 2009 and 2010. Banks feel the worst of it as consumers and

businesses default on their loans. Signs of this are already emerging: bank write-offs

for bad loans almost doubled in the fourth quarter of 2007, led by a nearly 400%

increase in charge-offs of home-equity loans (both, admittedly, from a low base).

More broadly, quarterly profits in the banking industry were the lowest since 1991,

when the country was also in recession.

The banking crisis spreads beyond the bigger institutions that are now suffering. A

collapse in the commercial property market drags down the mid-sized regional

banks that dominate this sector. The construction industry is hard-hit, as are makersof cars, furnishings and anything that consumers typically buy for their homes.

The property market remains at the core of the economic and financial collapse. The

value of housing in the US climbed by a staggering US$12trn between 1997 and 2006,

more than doubling. By January 2008, average home prices were falling by nearly

11% year on year, according to the S&P/Case-Shiller index. Under our main risk

scenario, US house prices are down by 20% by the end of 2008, and heading,

perhaps, for a bottom at more than 50% below their peak by 2010.

There are plenty of reasons for pessimism regarding prospects for US real estate,

both cyclical and structural. In the case of the former the bursting of the

housing bubble has triggered a steep build-up in the stock of unsold homes on

the marketnearly a years worth of supply in early 2008which will keepsustained downward pressure on prices. Over the forecast period banks will

also be trying to recoup cash on bad loans by selling repossessed homes

according to a US investment bank, Lehman Brothers, around 2.5m such homes

are likely to come to market in 2008-09. (Many US mortgages are effectively

issued on no recourse terms, which in effect allows borrowers simply to

abandon their homes without being liable for any shortfall between the value

of the property and the value of the loan.)

US: savings rate(share of disposable income; %)

Source: Economist Intelligence Unit.

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.012.0

14.0

06

04

02

2000

98

96

94

92

90

88

86

84

82

1980

US: debt-service ratio(share of disposable income; %)


10.0

11.0

12.0

13.0

14.0

15.0

06

04

02

2000

98

96

94

92

90

88

86

84

82

1980


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A further deterioration in the labour market would in turn boost foreclosures,

putting more downward pressure on house prices and leading to a further

deterioration in bank asset quality.

Demographic change is also likely to alter the structural demand for US

property over the medium term. The dwindling numbers of the 40-50

demographic cohort, which is a key driver of the property market, particularly

for larger new homes, and the retirement of the post-second world war Baby

Boomers suggest reduced demand in the years ahead for larger suburban

homes, which have been the staple of post-war US housing.

A recovery of the US financial sector therefore looks unlikely without at least a

stabilisation of the housing sector.

The euro zone is hit hard under our risk scenario, but the momentum from a

good 2007 means that 2009 is the toughest year as the region's economy in

effect stalls, and growth remains well below trend in 2010.

There are two main drivers of the deceleration. First, notwithstanding

aggressive loosening of monetary policy by the European Central Bank (ECB,the euro zone's central bank), the euro sees rapid appreciation in 2009-10we

forecast a 22% nominal appreciation against the US dollar between end-2007

and end-2010. Along with a faltering of demand from the emerging world, this

triggers an even sharper deterioration of export performance, with less

competitive countries such as Spain and Italy struggling the mostindeed, both

experience deep recessions under this scenario.

Second, a continued dearth of global credit as a result of the financial problems

in the US means a more prolonged adjustment in those countries that also

experience housing bubblesagain Spain looms large, but Ireland, France and

others are also hit. Although German consumers enjoy relatively healthy

balance sheets, the slump in exports, which has in recent years been the maindriver of growth, mutes confidence and dampens spending. The tough growth

environment fuels debate within the region about redefining the ECBs single

explicit mandateto control inflationand the euro zones tight fiscal rules.

The UK shares many of the problems of the US, notably overstretched con-

sumers and a housing market bubble that under many measures is even larger

than that of the US. However, vulnerability under our risk scenario is increased

by the important role played by financial services in the economy, both as an

employer and as a factor behind the recent long boom in property prices. The

buy-to-let market adds yet another ingredient to the vulnerability of house prices

in the UK. Anecdotal evidence suggests that distressed owners of these

properties are already trying to unload property portfolios on to the market.

The risk scenario therefore posits a quite brutal correction in UK house prices in

coming years and, as in the US, a protracted period in which UK consumers

rebuild their finances and overall growth remains well below trend. Moreover,

the UKs poor fiscal position leaves less room for a policy stimulus than in the

US. Despite rapid economic growth in recent years the budget has been in

deficit since 2002; even under our core scenario, the fall-off in tax revenue as a

A deep slowdown fuels policytensions within the euro zone


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result of the slowdown in the financial services sector suggests that there will

be little improvement over the short term.

So the UK government struggles to support growth using fiscal policy under our

risk scenarioleaving monetary policy to bear the brunt of the policy response,

and bringing steep falls for sterling against the euro and, perhaps, a decline

against the US dollar.

Japan's lack of room for policy manoeuvre makes it uniquely vulnerable in our

risk scenario. Not only are interest rates still ultra-lowin April 2008 the

overnight call rate was just 0.5%but, with the sickliest public finances in the

developed world, Japan has no room for fiscal loosening. Worse, the sharp fall

in commodity prices expected in our risk scenario, coupled with the yens

sharp rise against the US dollar and de facto stagnation over the forecast period,

make Japan vulnerable to a renewed deflationary shock.

Mortgage lending(% change, year on year)

Source: National sources.

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0 FranceItalySpainIreland

Jan08

OctJulAprJan07

OctJulAprJan06

OctJulAprJan05

OctJulAprJan04

OctJulAprJan03

OctJulAprJan02

OctJulAprJan2001

House prices, which are only just recovering after the bubble-burst of the early

1990s, and the Japanese stockmarket both flag again. Already struggling to raise

profitability, Japans banks flounder in an environment in which interest rates

move back towards 0% and borrowers once again pull in their horns. The US

downturn and a sharp deceleration of Asian growth limit the possibilities to

offset this through overseas operations.

Alternative scenario10%Dangers remain even if our central forecast and main risk scenario prove to be

overly pessimistic and the US achieves a soft landing with only limited fallout

for the rest of the world. The most important is a sustained pick-up in

inflation, and the need for policymakers to tighten policy as a result. Ourcentral forecast assumes that, at least in the developed world, falling housing

markets and the banks reluctance to lend helps to keep the lid on price rises

and that consumer price inflation eases in almost all developed markets.

Inflation would also be restrained by falls in commodity prices (although less

steep than under our risk scenario).

However, a soft landing in developed economies would suggest a continued

bullish outlook for commodities and, along with recent aggressive policy easing

Japan is uniquely straitened in

policy terms


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by some central banks, an increased risk of second-round inflationary effects.

Under our 10% scenario central banks respond by tightening policy, potentially

choking off the nascent private consumption recovery as already highly

indebted consumers struggle with the increasingly onerous cost of servicing

their obligations.

Notwithstanding the adverse impact of the tightening on the economy,

persistently high rates of inflation and the need to anchor inflationary

expectations mean that monetary policy is kept tighter than would be required

in more normal times to restrain demand. Governments also struggle to raise

spending as rising bond yields raise the cost of any fiscal response. A relatively

benign 2008 is followed by a far steeper downturn in 2009-10.

Spain: End of the fiesta

The Spanish economy has been a driving force for GDP growth in the euro area for

most of the past ten years, but the good times are over. The weakness started last

year in the housing market, but has now moved on to other sectors. The Economist

Intelligence Units central forecast sees Spanish GDP growth fall to just 1% in both

2008 and 2009, compared with an average growth rate of 3.8% in 1998-2007. Thisreflects the adjustment needed for an economy weighed down by years of

overinvestment in residential construction, an over-indebted household sector and a

growing external imbalance (the current-account deficit reached 9% of GDP in 2007).

Under the 30% risk scenario, GDP grows by just 0.5% in 2008 and falls by 2% in 2009.

Residential investment as a share of GDP falls by 4% (it hit 9.3% in 2006 and 2007,

compared with an average of around 6.5% for industrialised economies). Absorbing

the excess construction of recent years suppresses the ratio of residential investment

to GDP for years to come. (In Sweden it fell by 71% between the peak in 1990 and the

trough in 1995, following an earlier boom in the Scandinavian country.) House prices

drop dramatically, after having surged by 190% between 1997 and 2007second only

to Ireland and the UK among major industrialised countries.Macroeconomic policy is unable to stop a more serious crunch. With most of the rest

of the euro zone free from similar strains, the European Central Bank (ECB) is unable

to provide a stimulus for Spain. Since departure from the euro is out of the question,

there is no recourse to devaluation to improve competitiveness.

Even the fiscal environment (often considered to be the main strength of the Spanish

economy) is less supportive than previously. Government debt has fallen to

manageable levels and the general government budget balance stood at a surplus of

1.9% of GDP in 2007, but the cyclical component of the surplus is substantial, and

under our risk scenario the deterioration here is dramatic.

In our 10% risk scenario, more emphatic policy action by the ECB helps to contain

the downturn in the Spanish economy. However, as inflation takes hold and the ECB

changes course and tightens policy sharply, it becomes apparent that the correction

has been postponed, not avoided.


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Major emerging markets: Hitting the(great) wall?The global slowdown will rock the BRICs, and might just tipChina into crisisCentral scenario60%Emerging markets are well set to survive a modest and short slowdown in the

developed world, largely because the big, fast-growing economies, Brazil, Russia,

India and China (the so-called BRICs), have become important drivers of global

growth in their own right. In addition, many emerging markets have improved

their economic fundamentals by, for example, reducing external liabilities,

implementing market-friendly reforms and attempting to boost growth

potential. For the most part, high savings have allowed these markets to run

external surpluses, and strong export-led growth has also bolstered domesticdemand. But the view that the global economy has decoupled from the US is

wrong. Continuing volatility on global financial markets in 2008 and into 2009

will worsen emerging-market financing conditions, and weaker US growth will

hit emerging markets through the trade channel; non-OECD growth shouldhold up fairly well, but will be at lower levels than in 2006-07.

Risk scenario30%In the Economist Intelligence Units 30% risk scenario the buffeting for emerging

markets is much more severe. Most significantly, the breakneck expansion of

recent years in China and India comes to an abrupt end as their economies face

pressure on two fronts: from the global slowdown and from a build-up of

problems domestically. Growth in both countries falls sharply in 2009 and

rebounds only modestly in 2010.

Chinas exports have held up fairly well as US growth has begun to slow, but

this is partly because EU demand is still strong. A deeper US recession,

combined with euro-zone stagnation and continued Japanese weakness,dramatically changes that picture and causes export growth to collapse.

At the same time, China faces a slump in domestic demand going into 2009.

Cheap credit, along with the lack of pressure on enterprises to disburse

dividends, has fuelled overinvestment and hence overcapacity in some key

sectors. This overcapacity is compounded by the sudden decline in salesoverseas, resulting in significant downwards pressure on profitability.

Continued high raw material prices and rising wages make the problem even

worse. With sentiment shaken by wider global turmoil, China faces a rise in

non-performing loans, and investment declines sharply. Loss of confidence,

particularly in the wake of share and property price retreats, also affects privateconsumption, encouraging households to save rather than spend.

The economys slowdown also puts strain on the banking system. Direct

exposure to global financial turmoil is limitedChina has invested strongly in

Domestic drive(Domestic demand, % real change,year on year)

Source: Economist intelligence Unit.

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0RussiaIndiaChinaBrazil

07

06

05

04

03

02

01

2000

99

98

1997


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US Treasuries, and only to a limited extent in more risky assetsbut stresses

caused by slower domestic growth cause balance-sheet problems to emerge for

banks, which dampens lending growth.

The state responds forcefully, drawing on the countrys vast reserves to ramp up

spending in the hope of supporting growth. This is not a prediction, but a

certainty. Strong economic expansion is of paramount importance if the

Communist leadership is to maintain the rise in living standards that has takenover from ideology as the foundation of its legitimacy. And this does not simply

mean avoiding recession; as well as satisfying the expectations of a rising

middle class, the economy must generate sufficient new jobs to absorb a

rapidly growing workforce to avoid social discontent and, possibly, violent

challenges to the countrys leadership.

Price pressure(Consumer prices, % change, year on year, av)


0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0RussiaIndiaChinaBrazil

FebJan08

DecNovOctSepAugJulJunMayAprMarFebJan2007

However, despite the governments strong fiscal position, it is unable to avert

the downturn. High inflation constrains fiscal policy expansion initially, and

even after inflationary pressures ease, a combination of falling tax revenue and

the impending need to bail out the financial sector limit the states room formanoeuvre. Growth in China dips to below 5% in 2009, recovering only

modestly in 2010.

Indias slowdown is less severemainly because the Indian economy has less

trade exposure; exports of goods and services were just 22% of GDP in 2006,

compared with 40% for China. However, exports of information technology (IT)

services, an important engine of growth, are hit hard by the deep US recession.

Indias main challenge comes from wide-scale global financial turmoil. Its

booming economy is already showing signs of strain: house prices have soared;

equity valuations are highly stretched; strong wage gains have fuelled fast

growth in domestic demand; and the current account has swung from surplusto deficit.

Indias growth has been fuelled at least partly by large capital inflows, including

portfolio investment, foreign direct investment (FDI), and external borrowing by

expansion-oriented Indian companies. But as credit conditions tighten, some of

these sources of capital dry up. The resultant fall in investment is exacerbated

by a loss of confidence among businesses as the stockmarket plummets.

Although monetary policy follows US interest rates downwards, the

India's self-reliance is a

defence against the credit

crunch


15/28



government is poorly placed to respond to a slowdown: the consolidated fiscaldeficit was an estimated 5.6% of GDP in fiscal year 2007/08.

With India and China slowing sharply and the OECD economies shrinking or

idling, the rest of emerging Asia is also severely hit. The region escapes a repeat

of the financial crisis of 1997-98: its economies have more foreign reserves,

stronger current-account positions and more flexible exchange-rate regimes.

Nevertheless, the main Asian economies have all become more reliant onexports over the past decade, and growth falls sharply as export demand dries

up. South Korea (where exports account for 43% of GDP) and Taiwan (70%) both

see growth slow, and Singapore and Hong Kong, as open economies in which

exports account for over 200% of GDP, also suffer.

Returning to the BRICs, Brazil also slows, bottoming out in 2009. The country is

less reliant on US demand than in the past (exports to the US are down from

around 27% of the total in 2003 to 15% now), but with other important export

destinations faltering, notably the EU (which accounts for 24% of Brazils

exports) and China (6%), the country is vulnerable to trade contagion.

Moreover, the scope for monetary policy to respond to a slowdown isconstrained by inflationary pressures. Current high inflation is driven mainly

by soaring commodity prices. Although these will have come off the boil by

the end of 2008 under our 30% scenario, higher inflationary expectations will

have become entrenched, limiting the scope for policy loosening. In the past a

US recession would have meant an economic and financial crisis for Brazil. The

country is less vulnerable today, but far from immune. In particular, given the

prominent role of high commodities prices in its relatively good recent

performance, the sharp price correction of many commodities under our main

risk scenario represents a serious threat to future growth.

Nevertheless, the financial system looks sound, the economy is fairly

diversified and an annual average growth rate of over 3% in 2008-10 in the face

of a dramatic global weakening is much better than might have been expected

based on historical norms.

Russia, with its strong dependence on oil exports, is at great risk. The fall in oil

prices to close to US$50/barrel envisaged in our 30% scenario, although not

disastrous for oil producers, makes Russia reliant on other areas of the economy

to sustain growth. But lack of diversification and weaknesses in the business

environment mean there are few alternatives. The financial sector also takes a

hit. Given the dominance of state-owned Sberbank, a full-blown systemic crisis

is avoided, but many of the smaller banks, which have relied to some extent on

foreign borrowing to fund the recent credit boom, go under as they struggle to

roll over their obligations. Russian companies, which have borrowed heavily

from abroad in recent years (and face repayments and interest of some 7% of

GDP this year), find it more difficult to attract financing.

Alternative scenario10%Under our alternative risk scenario, the principle danger for these fast-growing

emerging economies is inflation. China and India would still face boom and

Trade contagion and

inflationary pressures areBrazil's main challenges


16/28



bust scenarios, with a marked slowdown of growth in 2009-10 as rising costs

prompt monetary policy tightening and cause investment to be cut back.

Recovery will be protracted. Policy has to remain tight to keep inflation under

control, and export growth becomes sluggish given weakness in the US, the

euro zone and Japan.

The other two BRICs also face difficulties, albeit less serious than in our main

risk scenario. In Brazil, higher commodity prices keep inflation high and force

an aggressive tightening of monetary policy, which depresses growth. Russias

economy initially remains robust, with growth still fuelled by high oil prices,

but later on, as commodity prices start to decline owing to weaker demand

from the OECD, India and China, Russias growth also falters.


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The financial sector: Beyond sub-primeDeleveraging among overstretched financial institutions isa good thing, isnt it?Central scenario60%In the Economist Intelligence Units central scenario the operating climate for

banks remains challenging but a systemic crisis is averted. Financial institutions

have to make further write-downs on impaired assets and some weak

institutions fail. Banks capital adequacy is strengthened through a combination

of rights issues, dividend cuts and reining-in of balance sheets (deleveraging).

Crucially, in this scenario deleveraging does not occur on a scale that would

create a serious negative feedback loop with the real economy. Strengthened

capital adequacy in turn helps to restore confidence in counterparty risk,

freeing up the interbank market and allowing spreads to normalise.

Risk scenario30%In our 30% risk scenario the deleveraging process occurs in a disorderly fashion.

It spreads far beyond its epicentre in US sub-prime mortgages to encompass a

broad range of asset classes (prime residential and commercial property,

corporate debt, equities, emerging markets, commodities). Some of these assets

are unimpaired but are sold at below fair value as banks and other leveraged

entities struggle to pay down debt and remain solvent. A self-reinforcing cycle

sets in whereby declines in asset prices trigger margin calls and further sales by

leveraged investors.

Housing market: Home, sweet homeless?

The Economist Intelligence Units central forecast sees a continued decline in house

prices in the US. Several other economies, such as Ireland and the UK, where house

prices have risen sharply in recent years, also see a decline, but elsewhere any

overvaluation is absorbed by a slowing in price increases rather than a fall. Overall,

house prices in developed economies fall by around 5-10% over 2008 and 2009.

Construction activity continues to fall in the US and in a small number of other

countries, including Ireland and Spain.

In our 30% scenario, the downturn in housing markets spreads, leading to a cumula-

tive fall in prices in the OECD economies of around 30% over the next four years (com-

pared with a historical average of OECD house price busts of 20% peak-to-troughdrops). For the average of 19 industrialised OECD countries, the recent house-price

boom lasted for 59 quarters and led to a price surge of 116.6% from the trough. Previous

booms have averaged 26 quarters in length and seen price surges of just 39.2%.

The bigger the boom, the bigger the potential bust. Using estimates by the IMF on the

gap between actual house prices and the prices justified by fundamentals (income

and interest rates), house prices in 17 major OECD countries are overvalued by only

13% (with countries weighted by the size of their GDP). The surge in house prices

since the beginning of the decade is unprecedented in both geographical spread and


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the size of the surge in prices, so there may be many other countries waiting to join

the downturn.

Countries particularly vulnerable will be the ones that have seen the largest gains in

recent years (South Africa, with a rise in house prices of 395% between 1997 and

2007, looks particularly vulnerable) and where prices have diverged most from

fundamentals (the IMF calculates Irish house prices to be 32.1% above fundamentals,

the highest overvaluation among industrialised countries considered). In Spain andDenmark, and to a lesser extent France, Italy, Finland and Belgium, housing

investment stands at levels well above long-term trends, suggesting a substantial

need for cuts in residential construction.

Under our 30% risk scenario the adjustment hits construction companies directly, but

also affects the broader economy through the financial sector, which is heavily

exposed to housing debt in most countries. The further deterioration in financial

conditions assumed under this scenario contributes to the decline in house prices and

the contraction in investment. At the same time, the downturn in house prices adds

to strains on banks, given the massive exposure of many banks to housing loans.

In our 10% risk scenario, the house price adjustment will be moderated initially by

aggressive policy stimulus. The reflation of the financial system will help to insulate

housing from the credit crunch to a degree. However, countries that have made little

progress on addressing housing imbalances during this initial period will risk even

sharper declines, as fiscal and monetary policy will have to become tighter to get

inflation back under control.

Policymakers respond aggressively. Central banks follow the Federal Reserve (the

US central bank) in drastically cutting policy rates with the aim of helping banks

by a steepening of the yield curve. They also take further measures to ease

liquidity pressures on banks by accepting a wider range of collateral in exchange

for government bonds, at longer terms and on more favourable terms. Govern-

ments loosen fiscal policy. In countries suffering from house price deflation,

governments take on the risk of falling prices by guaranteeing mortgages orbuying them outright. Regulators show forbearance towards financial

institutions in respect of capital adequacy and marking asset prices to market.

Unorthodox policy measures, typically involving the printing of money, are

tried. But the measures taken prove of limited effectiveness as the excesses of

the credit boom are unwound by market forces and asset prices grind

relentlessly lower. Counterparty risk pushes up spreads between interest rates

on government securities and the rates at which banks lend to each other.

A debt deflation cycle takes hold. As banks deleverage their balance sheets,

they choke off the supply of credit to households and firms. This depresses

activity in the real economy, further undermining asset prices and exacerbatingbanks balance-sheet problems. Depressed demand is reflected in falling

consumer prices as well as falling asset prices. Recession deepens and spreads:

having initially been centred on sectors with direct exposure to the property

market (finance, construction, retail), it encompasses manufacturing and

corporate services. Corporate bankruptcies and defaults surge. Weaker banks

fail. This creates panic among the public and in wholesale markets. Runs occur

on sound banks. Wholesale financing seizes up as banks are unwilling to lend

to each other because of counterparty risk.

A dearth of credit hits the

real economy


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Faced with the threat of a systemic banking crisis, the authorities put

considerations of moral hazard to one side and focus on preventing a complete

loss of confidence in banks. They employ a combination of moral suasion and

regulatory forbearance to encourage stronger banks to take over weak ones. But

many failed banks end up being nationalised and any banks that take over

weak institutions insist on public guarantees. This exacerbates public unease

about the taxpayer bailing out bankers and adds to calls for tougher regulation.The authorities are alive to such calls but delay acting on them until the

economy and financial sector stabilise.

Those banks that survive the crisis in reasonable shape gain market share as

customers move their business to them. But any boost to profitability from an

expanded customer base and reduced competition is offset by the difficult

operating climate. Banks have to provision heavily against non-performing

loans and a general deterioration in asset quality. Fee income from investment

banking is much lower than in recent years. There is little investor demand for

debt issuance or securitisation while the excesses of credit boom remain fresh

in the memory. Equity regains favour as a source of funding, although volumes

remain subdued.

Real effective exchange rate (CPI-based)(1998 = 100)

80

90

100

110

120

130

140

150

RomaniaLithuaniaLatviaHungaryEstonia

08070605040302012000991998


Current account balance/GDP %


-25.0

-20.0

-15.0

-10.0

-5.0

0.0

08070605040302012000991998

RomaniaLithuaniaLatviaHungaryEstonia

The structured finance products and vehicles that were at the epicentre of the

crisis and that drove the growth of financial services in the boom years are

consigned to historyfor the time being at least. But banks are still haunted by


20/28



the ghosts of financial innovation as surging corporate default rates wreak

havoc in the settlement of credit default swaps (CDSs), a derivative contract

offering insurance against defaults on loans and bonds. CDSs covered an

estimated US$62trn of debt at the end of 2007, with the net exposure of the

financial system estimated at US$2.3trn.

Deleveraging claims heavy casualties among private equity and hedge funds, the

poster-boys of the boom. Companies acquired in highly leveraged deals struggle

to generate the cashflow needed to service their debts. The loose covenants

applied to loans at the height of the boom merely delay the day of reckoning,

worsening the eventual losses. Hedge funds struggle to demonstrate that they

are capable of generating superior returns without leverage. Pension funds

respond by cutting their exposure to these and other alternative asset classes.

As the world economy slows, emerging markets whose growth has been driven

by debt and asset-price appreciation begin to face problems. Banks in emerging

markets with large current-account deficits and overvalued currencies struggle

to refinance external debt. There are delinquencies on foreign-currency-

denominated mortgages in countries such as Hungary as the carry trade

unwinds and high-yielding emerging-market currencies decline against funding

currencies such as the Swiss franc. Emerging-market governments have to draw

down their foreign-exchange reserves to bail out troubled banks.

Alternative scenario10%In our 10% scenario aggressive monetary easing and liquidity injections by

central banks fuel a return to high inflation rates. The comfortable assumptions

about price stability and central bank credibility that underpinned the recent

golden era for the world economy are undermined. Financial institutions are

initially beneficiaries of such a scenario: a dose of inflation helps to ward off

the threat of insolvency and repair balance sheets. But once inflation hasrestored balance-sheets, central bankers need to tighten policy to get the

inflation genie back into the bottle. This proves difficult, entailing a drastic

tightening that creates the risk of a return to the stop-start cycles that

characterised the 1970s, a decade in which banks hardly thrived.


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Commodity prices: A new world orbubbles waiting to burst?The surge in commodities prices, a major factor in globaleconomic performance, may be coming to an endCentral scenario60%Despite the Economist Intelligence Units downbeat outlook for economic

growth in the OECD, we remain relatively positive on economic prospects for

the developing world and this assumption underpins our forecast for oil and

for hard and soft commodities. We expect oil prices to decline as concerns

about negligible growth in OECD demand depress prices, although the average

price for 2008 will stay over US$90/barrel. OPEC remains convinced that the oil

price is vulnerable to falls, given the level of speculative interest in the market

and the fact that struggling financial institutions may need to sell commodityinvestments to cover losses elsewhere, and will resist raising output. In 2009-10

we expect some increase in supply as new capacity comes on stream, but

market fundamentals will remain tight and we expect only a modest fall in

prices to an average of US$83/b.

60% scenario: stock change and price of oil


-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0

10

20

30

40

50

60

70

80

90

100Brent oil price; US$/b; right scalem barrels/day; left scale

10090807060504030201200099989796959493921991

We are also fairly optimistic about the outlook for most soft commodity prices.

High oil prices mean that robust demand for biofuels will persist, and relatively

strong economic and population growth in the emerging world will support the

prices of grains (particularly for livestock feed) and oilseeds. In addition, climate

change will add uncertainty to the supply of food and feedstuffs and supportsoft commodity prices at higher levels. The outlook for base metals is less

sanguine. The global construction industry is one of the main consumers of

base metals and, given the downturn in many of the largest OECD property

markets, demand is expected to fall, along with prices.


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Risk scenario30%A deep and long US recession, mirrored by slowdowns in Europe and Japan

and marked decelerations in emerging-market growth, sharply depresses

demand for commodities and brings big declines in prices.

In the oil market, OPEC seeks to support prices with output cuts. However,

falling demand and sliding prices undermine unity in the cartel. Countries,such as Venezuela and Nigeria and even Iran, that need high oil revenue to

balance their budgets or meet spending commitments, break ranks and

maintain output at full capacity, thus further fuelling the decline in prices. The

consequent uncertainty in the market deters speculative investors

(notwithstanding the expected weakness of the US dollar).

Prices fall from an average of US$80/b in 2008 to US$58/b in 2009. There is

another fall in 2010, to around US$52/. For the Gulf Arab oil producers, prices at

these levels do not lead to either fiscal or current-account deficits, but they bring

slower economic growth as ambitious infrastructure and development plans

are put on hold. For oil-producing countries with more vulnerable fiscal

positions such as Nigeria, Venezuela, Syria, Indonesia and Iran, the oil price fallrequires fiscal tightening, with negative social consequences, perhaps including

political protest and other social unrest.

Base metal prices fall far more dramatically than under our central forecast;

there is little to support them as demand falls in emerging marketsparticularly

in Asiain line with the economic slowdown. Institutional investors lose

interest, given the depressed outlook for global economic growth. Producing

countries in the emerging worldparticularly Africa, Latin America and

Indonesiawitness severe deterioration in their current accounts. In our central

scenario, the impact of weak US demand on emerging world exports is offset

by the persistent strength in commodity prices, but in this risk scenario both thevolume and value of key exports falls.

The market for fibres weakens, too. Much of the impetus behind the recent

strength of cotton and wool prices has been the rising cost of man-made

alternatives, such as acrylic, where petroleum products are a key input.

Demand for agriculture-based fibres falls in tandem with the falling production

cost of man-made textiles.

A decline in demand for both personal and commercial vehicles amid stalling

global economic growth depresses rubber prices, with much of the world's

rubber output used by the tyre industry. South-east Asia is particularly

vulnerable, given that it produces well over 80% of the worlds output.

Soft commodity prices also slip. The prices for beverages (coffee, tea and cocoa)

that are not generally perceived as essential food items are particularly

vulnerable, but grains and oilseeds also weaken. This is mainly because of

falling demand from the biofuel industry; falling oil prices undermine the

competitiveness of biofuels as an alternative to hydrocarbon-based fuel. Lower

oil prices also erode prices of soft commodities by bringing lower storage,

transportation and distribution costs.

Falling demand hits pricesfor base metals

Industrial raw materials index(1990=100)


80

100

120

140

160

180

20030% risk scenarioCentral scenario

10090807062005

Crude oil(1990=100)


200

250

300

350

400


10090807062005


23/28



The fall in soft commodity prices, although not as steep as that in metal prices,

has the greater social impact since production is far more labour-intensive. The

link between global soft commodity prices and farmers income can be unclear

(given typically high levels of state intervention), but rural incomes suffer under

this scenario in large agricultural countries in the emerging world, such as India,

Indonesia, Brazil, Argentina.

Alternative scenario10%If US policymakers achieve a soft landing for the US economy, with only

limited repercussions for the rest of the world, demand for commoditiesoil,

hard and softwill remain strong over the short-term. Governments in Asia

particularly Chinaand the Middle East are able to continue subsidising or

regulating the retail prices of commodities, so further price rises do not

necessarily lead to a marked reduction in demand in the developing world.

Given supply constraints in many of the main commodity markets (including

oil), these factors lead to sustained rises in global commodity prices. But as

inflation takes hold in the OECD and monetary policy around the world is

tightened, the outlook for commodity prices would eventually darken as

economic growth weakens again.

Food, feedstuffs & beverages index(1990=100)


100

120

140

160180

200

220


10090807062005


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Policy: Regulatory rouletteIs the regulatory regime governing global finance about tobe rewritten?Prior to July 2007, the overarching shape of the financial regulatory framework

in most developed countries was fairly simple. Some types of institutions

(generally those that dealt with consumers) had recourse to emergency

financing from the central bank when things went wrong. In return, they

submitted to strict regulatory oversight. Others, such as investment banks and

hedge funds with limited consumer exposure, had no recourse to emergency

fundsif they ran into difficulties, they went bust. But, with the state bearing no

risk, there was a much lighter regulatory burden.

This implicit contract between financial institutions and the state has been all-

but torn up. Some institutions that were regulated fairly lightly, and did not

have formalised access to state support when times got tough, took risks thatthreatened the stability of the financial system. This was not necessarily

because individual banks had become too big to fail. Interdependence in the

financial system has increased to such an extent that even a small institutional

failure risks a domino effect, dragging down counterparties and risking an

uncontrollable crisis. In these circumstances, it has become very difficult for

governments to allow institutions to collapse.

In the US, the Federal Reserve (the US central bank) had to supply funding to

allow an orderly takeover of Bear Sterns, an investment bank. And in many

countries the central banks are intervening in financial markets in a way that

exposes them to credit and market risks they previously would have shunned.

As a result, the regulatory regime will have to changeif the state is going tostand behind investment banks such as Bear Sterns, it will want more power to

limit the risks those institutions can take.

But regulatory changes will not be limited to increasing the number and type of

institutions overseen. After all, some of the problems arose in institutions

already highly regulated, such as the UKs Northern Rock. So the efficacy of the

regulatory process will also be reviewed, and rules tightened.

Banking rules: Making bad times worse?

A key element contributing to instability during financial crises is the need for banks

to maintain a prudent ratio of capital to assets. When losses mount, as they tend to

during downturns and asset-bubble bursts, they can be absorbed in one of threeways: by cutting dividends (which banks are very reluctant to do); by raising capital;

or by reducing assets.

In the present crisis, many banks have already raised capital, sometimes

substantially. Much of the new capitalsome US$35.9bn between November 2007

and February 2008has come from sovereign wealth funds (investment funds

owned by governments, often from oil-exporting countries). US investment banks


25/28



raised some US$28bn in just a few days around mid-April under pressure from

supervisors.

But the need for balance-sheet adjustments is likely to go a lot further. Global losses

from US residential and commercial mortgages, consumer credit and corporate debt

could amount to US$945bn, of which around US$500bn will be borne by banks,

according to the IMF. Although recent efforts to tap the market have been successful,

banks will find it increasingly hard to raise that much capital, and so will have to fallback on reducing assets to restore capital adequacy.

Under supervisory rules, narrowly defined bank capital (known as tier 1 capital and

comprising mainly bank equity) must not fall below 4% of assets, weighted according

to how risky those assets are. (For tier 2 capital, largely equity subordinated debt, the

threshold is 8%). So if a bank uses US$1bn in tier 1 capital to absorb its losses, it must

cut the risk-weighted loan book by US$25bn.

The risk weighting applied to real estate loans is 35% under the rules of the new

Basel II accord applicable to banks in the EU and internationally active banks in

many other countries, so the blow to the capital ratio will be lower, but still a

multiple of the losses. Given the amounts currently under discussion, this could still

lead to massive cuts in funds available for lending. This, in turn, is one of the factors

threatening to prolong and deepen the crisis.

There have been myriad policy proposals in recent months, with national

authorities focusing on the need to improve oversight of the domestic mortgage

market. But rules governing internationally active banks such as the major

investment banks may be more important. It is these institutions that took

mortgage debt and parcelled it out in complex structured products, allowed

highly leveraged positions to be held in off-balance-sheet investment vehicles,

and underestimated the liquidity, market and counterparty risks associated

with some of the transactions they were undertaking.

Monetary authorities are keen to tighten the rules and reduce the chances that

such risk-taking could threaten broader financial stability. The Financial Stability

Forum (a multinational group of central banks, finance ministries and

multilateral institutions such as the IMF) has made a number of proposals that

are likely to be implemented, including the following.

To strengthen capital requirements for banks, thereby reducing theirvulnerability to sudden asset-price movements and ensure they have the

resources to support any off-balance-sheet exposures. The Basel committee,

which sets capital adequacy rules for internationally active banks, will

announce specific changes later in 2008.

To improve the oversight of banks liquidity positions, reducing the chances ofinstitutions being threatened by a reduction in financial market liquidity.

To improve banks risk management capabilities, through better stress-testingof their market positions against possible adverse price movements. Also to

review the role of credit-rating agencies in the financial system.

To improve disclosure requirements, so financial market participants havebetter information on who owes what (thereby reducing the chances a

generalised drying-up of liquidity). The Basel rules on disclosure will be

strengthened.


26/28



Unsurprisingly, threats of greater regulation are worrying those in the financial

community, who fear that tighter controls will impinge on their ability to be

innovative and make money. They are particularly worried by the prospect of

higher capital requirements, which would limit their ability to expand their

operations aggressively during economic upswings. But the banks themselves

(via the Institute for International Finance) have admitted some substantial

failings, including deteriorating lending standards, poor underwriting standards,

poor risk assessment and a lack of transparency.

Given the political ramifications of the financial crisis (voters losing their homes

or their pensions, a drying-up of credit and a marked economic slowdown or

recession), it seems unlikely that the financial institutions pleas for leniency

will carry much weight. But that does not mean there will be a regulatory free-

for-all. Regulators themselves admit that they cannot eliminate risk in the

financial system, no matter how great their controls. Nor do they want tothe

threat of failure is an important factor in making sure banks try to manage their

risks effectively (although the threat of failure has been deeply discounted by

the increasing interdependence of the financial system and the subsequent

reluctance of the authorities to let institutions go under).

Instead, the choice is between light regulatory controls, which encourage

financial innovation but allow banks to take more risks, and heavier controls,

which reduce risk but also reduce innovation.

Given the excesses of the past few years, it seems clear that some tightening of

the rules is necessary. But despite the current turmoil, most economists would

favour only modest changes. This is because a vibrant and innovative financial

system can help to support stronger economic growth and higher incomes over

the long term, as capital and risk can be allocated more effectively across

society.

Sub-prime mortgages are one example of this, albeit one that highlights the

risks as well as rewards to innovation. The development of the sub-prime

industry made credit available to many who were previously prevented from

buying their own homes or cars. The wave of foreclosures now under way

highlights how the new sub-prime product was used to excess. But most would

agree that allowing low-income borrowers to tap the credit markets can, in the

right circumstances, be a force for good.

So far, most proposals for regulatory reform have been thoughtful and

considereddesigned merely to eliminate obvious excesses. That is in line with

the direction of policy in the developed world over the past 30 yearsa belief

in the power of markets and hence a desire to keep regulation to a minimum.But it is early days. As economies continue to slow, and financial stresses in the

personal and business sectors mount, the pressure for tighter controls may

grow. And it is interesting to note that, although long-term policy

recommendations are still strongly market orientated, the short-term measures

being taken to support the global economy are far more interventionist than we

have seen for many years.

Both banks and regulators

admit they made mistakes as

the crisis loomed

Trust in market solutions maygive way to intervention


27/28



Nationalisation, direct government bailouts, central banks taking positions in

some private-sector financial assetsall these measures, while appropriate as

short-term emergency actions, could help to swing the debate about the

appropriate role of the state in society towards a more interventionist stance.

After all, the belief in the importance of light-handed government is fairly

recentit would be rash simply to assume it can survive a deep and prolonged

economic downturn.

The Economist Intelligence Units central scenario (60% probability) calls for a

short US recession followed by a sluggish recovery, with the rest of the world

economy slowing but continuing to grow. Under these circumstances, although

the emergency policy action taken to keep the downturn to a minimum may

be aggressive and unorthodox, we expect long-term regulatory reform to be

considered and relatively modestalong the lines of that already proposed by

the main regulatory authorities.

However, should our 30% risk scenario come to pass, with a deep and

prolonged US recession being accompanied by recessions elsewhere and the

recovery being extremely drawn out, the regulatory outlook would darken. It

seems likely that policymakers would, in the face of continued balance-sheet

stresses and the threat of further financial failures, adopt a more interventionist

regulatory stance that would limit the ability of the financial sector to innovate.

The US acted in this way after the 1929 stockmarket crash, with the

implementation of the Glass-Steagall Act, which profoundly influenced the

development of the US banking sector. Similarly draconian measures would be

possible again if the downturn proved harsh enough.

Our 10% scenario is one in which the economic downturn is quickly reversed,

with growth and inflation accelerating markedly. In these circumstances,

balance-sheet reflation would provide temporary relief to the financial sector,

stemming bank failures and probably encouraging policymakers to limit thescope of regulatory reform. However, the primary focus in this scenario

would not be on regulation at all, but rather on the standard tools of

monetary policy as policymakers attempted to grapple with rising inflation

and inflation expectations.

It should be remembered, however, that since the policy action necessary to

grapple with rising inflation can often prove recessionary, any banking sector

relief could prove short-lived.


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economist int unit shooting the repids

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