Even with the passing of the USD700 billion bailout package ("Bailout Plan Wins Approval; Democrats Vow Tighter Rules" by David M. Herszenhorn, The New York Times, 03 October 2008), the financial crisis is not being contained in the United States. It has in fact been spreading across the globe, causing Central Banks around the world to coordinate in cutting their interest rates. (Central Banks Coordinate Cut in Rates, by David Jolly and Keith Bradsher, The New York Times, 08 October 2008)
I agree with the points mentioned by Paul Krugman in his article "Thinking the bailout through" published in The New York Times on 21 September 2008. The USD700 billion is only going to clear some of the troubled mortgage backed securities and not all of the problematic assets. In addition, the selection by the US Government and the Federal Reserve to choose who to save and who not to save has resulted in banks worrying which financial institution would be next to go. These actions have resulted in not just a minor crisis of failing mortgage-backed securities but a liquidity crunch.
Banks are fearful of lending out their money to borrowers. Depositors are fearful of banks who are involved in this crisis to be failing. What is happening, seems to be a total lack of confidence in the banking industry. Depositors could be fleeing to financial institutions who are not involved in this crisis, as a means to safeguard their assets. If this is the case, there could be massive flow of funds from the ailing financial institutions to the healthier ones, which could cause the former to fail. If more financial institutions fail, the effects would spread even to the healthier ones and contagion would just occur with a never-ending cycle.
What can be done to stem this once and for all?
1) Establish all deposits to be safe. Be it from the rich, poor, retail or corporate. This is to give confidence to depositors and preventing a liquidity crush for the ailing banks. (This has to be mainly by the Federal Reserve as it is the US financial institutions which are in trouble and pulled the rest of the banking world onboard.)
2) Establish rules permitting that bank to bank loans would be honoured by the Federal Reserve should the borrower bank fail. This is to provide confidence to other financial institutions and immediately reduce the default risk of loans by banks.
3) Establish strong regulations during this period of time that financial institutions have to rein in the unsecurred credit facilities provided to clients (with the exception of banks). For secured credit facilities, there should be a limit as to the loan amount that can be provided, say around 50% of the market value.
However, the above suggestions can be very difficult to implement. With the total guarantee on deposits and bank to bank loans, the Federal Reserve would be putting more taxpayers money on the table. Moral hazard would be dealt with when the regulations on credit facilities are implemented, but the time frame of over-hauling regulations is long and tedious.
The market may react to the news in a unexpected positive manner even though it may not be implemented yet. We'll only know, if these are truly implemented.
In the meantime, let's prepare ourselves for a long drawn financial crisis.
Wednesday, October 8, 2008
Wednesday, September 17, 2008
The weakness of OTC
On 16 Sep 2008, AIG had to borrow US$85billion worth of loans from the Federal Reserve as its attempts to obtain loans from other financial institutions and raising cash through stock sales failed.
How could AIG face such liquidity crunch? The answer, is mainly the credit-default swaps that AIG is liable to make payouts for. ("Fed Agrees to Lend A.I.G. $85 Billion to Head Off Crisis", by Edmund L. Andrews, The New York Times, 17 Sep 2008)
What could have been done to avoid such liabilities concerning these Over-The-Counter derivatives? These OTC should not be OTC in the first place. They should be traded in an exchange where the buyers and sellers are the market makers. There should not be brokers in the market acting as the market-makers. Yes it might reduce the potential trading liquidity for these OTC swaps, but there will be reduced risk as brokers do not have to take an extended position for 1 side of the OTC swaps.
Brokers if they are market-makers of OTC swaps, could be in AIG shoes, taking on too much of 1 position that would cause huge liabilities to themselves. These liabilities would become too much to bear that a crisis would occur.
The present scenario would be for the Securities Exchange Commission to take an immediate stance and create an exchange for derivative instruments that have been trading as OTC. This would reduce counterparty risk for buyers and sellers as they would be dealing with themselves. Should they deal with just 1 financial institution, they would face the default risk of the financial institution, aka AIG in this case.
How could AIG face such liquidity crunch? The answer, is mainly the credit-default swaps that AIG is liable to make payouts for. ("Fed Agrees to Lend A.I.G. $85 Billion to Head Off Crisis", by Edmund L. Andrews, The New York Times, 17 Sep 2008)
What could have been done to avoid such liabilities concerning these Over-The-Counter derivatives? These OTC should not be OTC in the first place. They should be traded in an exchange where the buyers and sellers are the market makers. There should not be brokers in the market acting as the market-makers. Yes it might reduce the potential trading liquidity for these OTC swaps, but there will be reduced risk as brokers do not have to take an extended position for 1 side of the OTC swaps.
Brokers if they are market-makers of OTC swaps, could be in AIG shoes, taking on too much of 1 position that would cause huge liabilities to themselves. These liabilities would become too much to bear that a crisis would occur.
The present scenario would be for the Securities Exchange Commission to take an immediate stance and create an exchange for derivative instruments that have been trading as OTC. This would reduce counterparty risk for buyers and sellers as they would be dealing with themselves. Should they deal with just 1 financial institution, they would face the default risk of the financial institution, aka AIG in this case.
More challenges ahead
During these last few days, the US financial market was in turmoil again.
15th Sep 2008, Monday, saw fall of 2 world-reknown financial institutions. The 101 year old Merrill Lynch announced it was being bought over by Bank of America and the 164 year old Lehman Brothers Holdings Inc formally filed Chapter 11, declaration of bankruptcy. ("Lehman Files for Bankruptcy; Merrill Is Sold" by Andrew Ross Sorkin, The New York Times, 14 Sep 2008)
16 Sep 2008, Tuesday, AIG announced it was receiving US$85 billion worth of loans from the Federal Reserve as it could not raise the amount in the capital markets. It was facing rating downgrades from Moodys and Standard & Poor due to its falling stock price. With its stock price losing 94% of its value, it could not raise the cash needed through a sale of stock. ("Fed in an $85 Billion Rescue of an Insurer Near Failure" by Edmund L. Andrews, The New York Times, 17 Sep 2008)
What does this show about the financial situation in the US now, petaining to the subprime crisis incident. As I had mentioned previously in my previous post, "Possible Spillover of Sub-prime Mortgage Crisis" on 2 Sep 2007, it seems that situation 2 is being acted out in the financial market:
15th Sep 2008, Monday, saw fall of 2 world-reknown financial institutions. The 101 year old Merrill Lynch announced it was being bought over by Bank of America and the 164 year old Lehman Brothers Holdings Inc formally filed Chapter 11, declaration of bankruptcy. ("Lehman Files for Bankruptcy; Merrill Is Sold" by Andrew Ross Sorkin, The New York Times, 14 Sep 2008)
16 Sep 2008, Tuesday, AIG announced it was receiving US$85 billion worth of loans from the Federal Reserve as it could not raise the amount in the capital markets. It was facing rating downgrades from Moodys and Standard & Poor due to its falling stock price. With its stock price losing 94% of its value, it could not raise the cash needed through a sale of stock. ("Fed in an $85 Billion Rescue of an Insurer Near Failure" by Edmund L. Andrews, The New York Times, 17 Sep 2008)
What does this show about the financial situation in the US now, petaining to the subprime crisis incident. As I had mentioned previously in my previous post, "Possible Spillover of Sub-prime Mortgage Crisis" on 2 Sep 2007, it seems that situation 2 is being acted out in the financial market:
"2) Subprime Crisis > Mortgage borrowers fail to pay up > CDOs worthless > Balance sheets of financial institutions get impacted (depending on impact, some may close, others face a huge profit write off) > Markets may get shocked > Investors seek liquidity > Pull of from markets > Markets fall, herd behaviour occurs > Market falls further > Investors lose confidence > Govts step in > Stability may occur slow or fast depending on the speed and actions taken by govts."
The Federal Reserve and the US Treasury have been quick to enter the financial market and make the critical decision on which companies to help and which companies should not be. It will be years of discussion on whether the actions of the 2 have been proper and just. But at the present moment in time, the fire has not been put out.
The financial market is still in turmoil. With the folding of Merrill Lynch and Lehman Brothers; the falling share prices of AIG and various other companies, financial institutions and other companies which are holding these stocks in their portfolio will be facing unrealized revaluation losses. Being the month of Sep, companies are reporting their earnings for the earlier quarter. However, as the failures of Lehman Brothers, Merrill Lynch and AIG are occurring in the month of Sep, the financial results being reported for the quarter should be considered as over-valuing the company at this point in time.
It means that the financial reports are too historical, even though they are being mark-to-market. Companies should provide interim financial results that indicate the impact of Merrill Lynch, Lehman Brothers and AIG. At least investors would be well informed as to the contagion effect and this should prevent another shock to the market when another quarterly reporting occurs.
Thursday, September 11, 2008
Shareholders' Woes
The infamous phase of the year if not for years or decades, "If you’ve got a bazooka and people know you’ve got it, you may not have to take it out.” ("As Crisis Grew, a Few Options Shrank to One" by Charles Duhigg, Stephen Labaton and Andrew Ross Sorkin, 07 Sep 2008, New York Times) In the end, he still had to use it. Who is he? Treasury Secretary Henry M. Paulson Jr. is him.
At the time of implementation of the bazooka, which is simply to give officials the power to inject billions of dollars into the Freddie Mac and Fannie Mae through investments and loans("Scramble Led to Rescue Plan on Mortgages", Stephen Labaton, 15 Jul 2008, New York Times), Treasury Secretary Paulson only wanted an instrument to calm the market. He was able to calm the markets with the bazooka. But it was only for a short duration.
The market became even more jittery after that, which can be seen from the stock prices of Fannie Mae and Freddie Mac. With each passing day, the market was worried. Should the bazooka be used, who would be the ones affected? Would it be the shareholders, bondholders or both? What would be the repercussion for any of them?
Shareholders would lose the worth of the shares. Bondholders would lose not only their interest paydowns but their principals as well. But who is the group that the Treasury Department is willing to bear the losses? The shareholders or the bondholders? Note that most bondholders are foreign central banks, financial institutions and others ("In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans", Stephen Labaton and Edmund L. Andrews, 7 Sep 2008, New York Times) and if the bonds are defaulted, it would mean that the US has defaulted payments. No country would want this, not especially the United States of America. As such, the only logical group to bear the cost would be the shareholders.
Finally the bazooka was fired. Mainly due to Freddic Mac being unable to rise the USD5.5billion which was needed. Fannie Mae was considered as being too close with Freddie Mac and since Freddie needed help, Fannie should be helped too. ("As Crisis Grew, a Few Options Shrank to One" by Charles Duhigg, Stephen Labaton and Andrew Ross Sorkin, 07 Sep 2008, New York Times)
However, with shareholders bearing the blunt of this explosion. One will begin to wonder who are the shareholders of these GSEs? Are they the financial institutions who are facing the sub-prime crisis, like Citigroup, Lehman Brothers, Morgan Stanleyand UBS just to name a few. If the closing stock price of Fannie and Freddie being USD 0.99 and USD 0.8834 respectively as of 09 Sep 2008, what would this mean to the books of these financial institutions who are holders of these 2 GSEs? Surely, there is a need to mark-to-market. Further losses from financial institutions can be expected due to this conservatorship done by the Treasury Department.
There is one consolation prize from all of this. The market seems to be reacting well to the usage of the bazooka with the Dow Jones and Nasdaq rising. However, only time will tell if this is just a short term bullrun based on feel good sentiment from the bazooka.
At the time of implementation of the bazooka, which is simply to give officials the power to inject billions of dollars into the Freddie Mac and Fannie Mae through investments and loans("Scramble Led to Rescue Plan on Mortgages", Stephen Labaton, 15 Jul 2008, New York Times), Treasury Secretary Paulson only wanted an instrument to calm the market. He was able to calm the markets with the bazooka. But it was only for a short duration.
The market became even more jittery after that, which can be seen from the stock prices of Fannie Mae and Freddie Mac. With each passing day, the market was worried. Should the bazooka be used, who would be the ones affected? Would it be the shareholders, bondholders or both? What would be the repercussion for any of them?
Shareholders would lose the worth of the shares. Bondholders would lose not only their interest paydowns but their principals as well. But who is the group that the Treasury Department is willing to bear the losses? The shareholders or the bondholders? Note that most bondholders are foreign central banks, financial institutions and others ("In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans", Stephen Labaton and Edmund L. Andrews, 7 Sep 2008, New York Times) and if the bonds are defaulted, it would mean that the US has defaulted payments. No country would want this, not especially the United States of America. As such, the only logical group to bear the cost would be the shareholders.
Finally the bazooka was fired. Mainly due to Freddic Mac being unable to rise the USD5.5billion which was needed. Fannie Mae was considered as being too close with Freddie Mac and since Freddie needed help, Fannie should be helped too. ("As Crisis Grew, a Few Options Shrank to One" by Charles Duhigg, Stephen Labaton and Andrew Ross Sorkin, 07 Sep 2008, New York Times)
However, with shareholders bearing the blunt of this explosion. One will begin to wonder who are the shareholders of these GSEs? Are they the financial institutions who are facing the sub-prime crisis, like Citigroup, Lehman Brothers, Morgan Stanleyand UBS just to name a few. If the closing stock price of Fannie and Freddie being USD 0.99 and USD 0.8834 respectively as of 09 Sep 2008, what would this mean to the books of these financial institutions who are holders of these 2 GSEs? Surely, there is a need to mark-to-market. Further losses from financial institutions can be expected due to this conservatorship done by the Treasury Department.
There is one consolation prize from all of this. The market seems to be reacting well to the usage of the bazooka with the Dow Jones and Nasdaq rising. However, only time will tell if this is just a short term bullrun based on feel good sentiment from the bazooka.
Tuesday, August 12, 2008
Write-downs upon write-downs
With the further write-downs of JP Morgan Chase, ("JPMorgan Loses $1.5 Billion Since July" by Reuters, 12 Aug 2008, New York Times) on its mortgage and credit loans, will there be further write downs? Have we reached the end?
JP Morgan Chase's write-downs were partially due to the sale of Merill Lynch's $30.6 billion in risky debt to Lone Star funds for just $6.7 billion. If JP Morgan Chase was pressured to further write-down their investments, other financial institutions would be also pressured, not only by Merill Lynch actions but by JP Morgan Chase's as well. There could be another major round of write-downs which may cause a never-ending cycle of write-downs to occur.
What the financial institutions could do at this point in time, is to take the most conservative valuation and write-down their mortgage investments once and for all. Clear up everything in the balance sheet, get the necessary cash and move on.
They should not write-down slowly which places their stock prices at risk. It only adds jitters to the market and creates lots of uncertainty whenever there is negative news about the mortgage sector.
Uncertainty is something that financial institutions cannot afford at this point in time.
JP Morgan Chase's write-downs were partially due to the sale of Merill Lynch's $30.6 billion in risky debt to Lone Star funds for just $6.7 billion. If JP Morgan Chase was pressured to further write-down their investments, other financial institutions would be also pressured, not only by Merill Lynch actions but by JP Morgan Chase's as well. There could be another major round of write-downs which may cause a never-ending cycle of write-downs to occur.
What the financial institutions could do at this point in time, is to take the most conservative valuation and write-down their mortgage investments once and for all. Clear up everything in the balance sheet, get the necessary cash and move on.
They should not write-down slowly which places their stock prices at risk. It only adds jitters to the market and creates lots of uncertainty whenever there is negative news about the mortgage sector.
Uncertainty is something that financial institutions cannot afford at this point in time.
Sunday, August 10, 2008
Finding a rallying reason
I was mentioning to a friend last night (08 Aug 2008, 10.20pm Singapore time) that the US market would have a bloodbath throughout the trading session due to the announcement of Fannie Mae's ("Mortgage Giants to Buy Fewer Risky Home Loans" by Charles Duhigg, 08 Aug 2008, New York Times) worse than expected results; something similar to Freddic Mac's annoucement on Wednesday's US trading session ("Freddie Mac’s Big Loss Dims Hopes of Turnaround" by Charles Duhigg, 09 Aug 2008, New York Times) and AIG's announcement on Thursday's trading session ("A.I.G. Posts a Large Loss as Housing Troubles Persist" by Mary Williams Walsh, 06 Aug 2008, New York Times).
However, this was not the case on that eventful Friday trading session in the US market. Oil and commodities prices fell due to lower expected growth from Europe and China which strengthen the dollar as investors poured funds into US stocks, causing the market to rise tremendously. ("Shares Rally as Oil Continues to Fall" by Vikas Bajaj, 08 Aug 2008, New York Times).
Would this mean that US stocks will continue to rally and the lowest point has been reached due to the weakening of the oil and commodity sectors? I doubt it.
The market now has become very sensitive to news and it has come to a point when even the slightest positive news will bring a huge rally without the fundamentals as support. Take the instance of Friday's dramatic rally. Even if growth in Europe and China slows down, does it mean that the US economy will out-grow either of them?
The economic problems in the US are not yet over. The 2 Government Sponsored Enterprises "GSEs", Fannie and Freddie, are in dire straits. Problem in the mortgage lending sector is having a huge spillover effect like in AIG's case. Many financial institutions would be forced to revalue a loss on their existing investments if the mortgage sector fails to pick up.
Other parts of the US market will be affected as well, as falling property and financial stock prices make individuals poorer on paper resulting them in cutting down on their expenditure. The broader economic outlook is still gloomy with lots of uncertainity.
However, this was not the case on that eventful Friday trading session in the US market. Oil and commodities prices fell due to lower expected growth from Europe and China which strengthen the dollar as investors poured funds into US stocks, causing the market to rise tremendously. ("Shares Rally as Oil Continues to Fall" by Vikas Bajaj, 08 Aug 2008, New York Times).
Would this mean that US stocks will continue to rally and the lowest point has been reached due to the weakening of the oil and commodity sectors? I doubt it.
The market now has become very sensitive to news and it has come to a point when even the slightest positive news will bring a huge rally without the fundamentals as support. Take the instance of Friday's dramatic rally. Even if growth in Europe and China slows down, does it mean that the US economy will out-grow either of them?
The economic problems in the US are not yet over. The 2 Government Sponsored Enterprises "GSEs", Fannie and Freddie, are in dire straits. Problem in the mortgage lending sector is having a huge spillover effect like in AIG's case. Many financial institutions would be forced to revalue a loss on their existing investments if the mortgage sector fails to pick up.
Other parts of the US market will be affected as well, as falling property and financial stock prices make individuals poorer on paper resulting them in cutting down on their expenditure. The broader economic outlook is still gloomy with lots of uncertainity.
Tuesday, April 15, 2008
The Cracks Are Showing
From the signals of a weak labour market to American retailers filing for bankruptcy protections, the start of a possible major economic downturn in the US economy has begun.
The weak labour market can be seen from the claims of job unemployment benefits by the unemployed. The number of US workers remaining on job unemployment benefits rose to 2.94million in the week ending 29 March 2008, the highest since July 2004. ("US jobless claims drop 53,000 in latest week" by Singapore Business Times, 10 April 2008.) This could be due to companies putting hiring on hold and/or laying off staff in anticipation of a slowdown in demand for their products.
As for American retailers, 8 mostly middle size retail chains have filed for bankruptcy protections while others have started to downsize their operations in anticipation of an economic downturn. ("Retailing Chains Caught in a Wave of Bankruptcies" by Michael Barbaro, The New York Times, 15 April 2008.) Retailers are faced with 2 main problems, consumers spending less and the inability to obtain loans easily from banks.
Consumers are spending more on necessities like food and oil(petrol) which are income inelastic. This results in consumers having less disposable income for other luxury goods which are income elastic. The final effect, retailers having less revenue to cover their fixed costs which for some, are not even able to cover their variable costs such that they are forced to close down. In this case here, they seek bankruptcy protection.
The collateral debt obligations (CDOs) crisis has created a credit crunch among banks as they are cautious in lending towards one other. This has made the Federal Reserve to reduce interest rates to spur lending. However, it seems that the Feds' efforts have been futile as banks are unwilling to lend and/or extend credit facilities to the retail chains. This has created cash flow problems for the retail chains in making payments to their suppliers which only push the retail chains into bankruptcies.
The falling US dollar does not help the economy at all. The weaker dollar creates import-inflation as mentioned in my previous article, "Greater Possibility or Has It Arrived?" 21 February 2008. If the US economy is the final consumer of imported products, with US demand being inelastic, consumers will face increasing price rises such that they would have little to spend. For March 2008, US Producers' prices rose by 6.9% on a year to year basis.("U.S. Producer Prices Up 1.1% in March", by Reuters, The New York Times, 15 April 2008).
The Fed has used monetary policy to try to advert a possible downturn. But to no avail it seems judging by the result of the decline in consumer confidence. ("US consumer confidence takes a beating", Singapore Business Times, 12 April 2008.)
Should monetary policy be ineffective, there is another method. Examine the equation of the Gross Domestic Product:
GDP = Consumption + Investment + Government + (Exports - Imports)
With consumption and investment possibly dropping and imports increasing, the way out for the US Government is to use fiscal policy or have the US economy export its way out from recession. With the US Government providing tax rebates cheques to households, it is hopeful that this would spur the increase in consumption. If not, it is going to be a long recovery from the downturn.
The weak labour market can be seen from the claims of job unemployment benefits by the unemployed. The number of US workers remaining on job unemployment benefits rose to 2.94million in the week ending 29 March 2008, the highest since July 2004. ("US jobless claims drop 53,000 in latest week" by Singapore Business Times, 10 April 2008.) This could be due to companies putting hiring on hold and/or laying off staff in anticipation of a slowdown in demand for their products.
As for American retailers, 8 mostly middle size retail chains have filed for bankruptcy protections while others have started to downsize their operations in anticipation of an economic downturn. ("Retailing Chains Caught in a Wave of Bankruptcies" by Michael Barbaro, The New York Times, 15 April 2008.) Retailers are faced with 2 main problems, consumers spending less and the inability to obtain loans easily from banks.
Consumers are spending more on necessities like food and oil(petrol) which are income inelastic. This results in consumers having less disposable income for other luxury goods which are income elastic. The final effect, retailers having less revenue to cover their fixed costs which for some, are not even able to cover their variable costs such that they are forced to close down. In this case here, they seek bankruptcy protection.
The collateral debt obligations (CDOs) crisis has created a credit crunch among banks as they are cautious in lending towards one other. This has made the Federal Reserve to reduce interest rates to spur lending. However, it seems that the Feds' efforts have been futile as banks are unwilling to lend and/or extend credit facilities to the retail chains. This has created cash flow problems for the retail chains in making payments to their suppliers which only push the retail chains into bankruptcies.
The falling US dollar does not help the economy at all. The weaker dollar creates import-inflation as mentioned in my previous article, "Greater Possibility or Has It Arrived?" 21 February 2008. If the US economy is the final consumer of imported products, with US demand being inelastic, consumers will face increasing price rises such that they would have little to spend. For March 2008, US Producers' prices rose by 6.9% on a year to year basis.("U.S. Producer Prices Up 1.1% in March", by Reuters, The New York Times, 15 April 2008).
The Fed has used monetary policy to try to advert a possible downturn. But to no avail it seems judging by the result of the decline in consumer confidence. ("US consumer confidence takes a beating", Singapore Business Times, 12 April 2008.)
Should monetary policy be ineffective, there is another method. Examine the equation of the Gross Domestic Product:
GDP = Consumption + Investment + Government + (Exports - Imports)
With consumption and investment possibly dropping and imports increasing, the way out for the US Government is to use fiscal policy or have the US economy export its way out from recession. With the US Government providing tax rebates cheques to households, it is hopeful that this would spur the increase in consumption. If not, it is going to be a long recovery from the downturn.
Thursday, February 21, 2008
Greater Possibility or Has It Arrived?
Three months ago, I mentioned that the United States was being in the risk of stagflation. This worried fear is now being echoed by the Federal Reserve found in NYT's 21 Feb 2008, "That ’70s Look: Stagflation" by Graham Bowley and NYT's 21 Feb 2008, "Rising Inflation Limits the Fed as Growth Lags " by Edmund L. Andrews and Michael M. Grynbaum.
Even with the current interest rate cuts, the financial market in the United States is not improving. The current paralysis is affecting not only the macroeconomics of the United States but the entire world as well. The lowering of interest rates has made the value of USD to be even less than before. Using Pacific FX Database (http://fx.sauder.ubc.ca/), the monthly value of Gold Ounces against USD is at it's lowest point in Jan 2008 (not able to use Feb 2008 as the full month as yet to pass), since inception of the database of Nov 1991.
With the value of the USD being at its lowest, it will only cause the trade deficit of USD 711.6 billion for Year 2007 ( http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf) to be more costly if its repayment terms are in the foreign countries' currencies. Luckily for the United States, this has yet to happen as USD is the major currency of trade at the moment. Should it be another country like Thailand or Indonesia which had a huge trade deficit, the financial sectors would have collapse overnight as seen in the Asian Financial Crisis.
As imports become more expensive due to a weaker dollar, corporates and consumers should reduce consumption of foreign goods which would help to reduce the current trade deficit (in USD terms). This would be possible if the income elasticity of corporates and consumers are elastic, such that the decline in the USD value against other currencies will enable corporates and consumers to switch to local products. Should elasticity be inelastic, the weaker USD will only cause a bigger trade deficit which will further burden the US economy in the long run.
The trade deficit is still being financed by Asian countries as they have hordes of USD reserves. This financing will still continue as trade is still being done in USD. But with the falling USD value, these countries may reconsider their reserve currencies portfolio's USD weightage. The falling USD is making these reserves less in value. By re-aligning the USD weightage, the Asian countries would be able to save their reserves from FX losses. However the re-alignment has to be done in a small batches. A huge sudden re-alignment may cause the USD to fall further which may result in a melt-down of the world's financial markets.
The Federal Reserve has to make the important decision, and now! The apparent decisions to cut interest rates is not improving the economy. Either the Fed cuts interest rates up to the point where the current credit crunch is gone and confidence is restored or the Fed increases interest rates to strengthen the dollar to combat import-inflation. However, the latter does have its repercussion.
The increase in interest rates would increase the cost of borrowing for the United States. If there is not enough reserves, which the United States does not have, it will only increase its debt to the world. The United States has a budget deficit of USD 5,035.3 billion as of 2007 (http://www.cbo.gov/budget/historical.shtml).
There could be another possibility, but the US public may not be willing to accept. The Fed could personally insure all US banks and make good all borrowings between banks at this point in time to reduce the credit crunch. However, there could be a public outcry due to the usage of public funds bailing out private companies.
Even if there is no public outcry, this is also not a fool-proof plan due to moral hazard of banks coming into play. Banks, knowing that the Fed would 'sign the blank cheque', enter into risker deals which results in more problems later on. Regulatory controls could be enforced onto the banks to prevent such deals from ever taking place. Would the US financial market, deemed as a free market, ever allow regulatory controls to be implemented?
The world has become more uncertain with inapt decisions by the Fed and intertwined financial markets.
Even with the current interest rate cuts, the financial market in the United States is not improving. The current paralysis is affecting not only the macroeconomics of the United States but the entire world as well. The lowering of interest rates has made the value of USD to be even less than before. Using Pacific FX Database (http://fx.sauder.ubc.ca/), the monthly value of Gold Ounces against USD is at it's lowest point in Jan 2008 (not able to use Feb 2008 as the full month as yet to pass), since inception of the database of Nov 1991.
With the value of the USD being at its lowest, it will only cause the trade deficit of USD 711.6 billion for Year 2007 ( http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf) to be more costly if its repayment terms are in the foreign countries' currencies. Luckily for the United States, this has yet to happen as USD is the major currency of trade at the moment. Should it be another country like Thailand or Indonesia which had a huge trade deficit, the financial sectors would have collapse overnight as seen in the Asian Financial Crisis.
As imports become more expensive due to a weaker dollar, corporates and consumers should reduce consumption of foreign goods which would help to reduce the current trade deficit (in USD terms). This would be possible if the income elasticity of corporates and consumers are elastic, such that the decline in the USD value against other currencies will enable corporates and consumers to switch to local products. Should elasticity be inelastic, the weaker USD will only cause a bigger trade deficit which will further burden the US economy in the long run.
The trade deficit is still being financed by Asian countries as they have hordes of USD reserves. This financing will still continue as trade is still being done in USD. But with the falling USD value, these countries may reconsider their reserve currencies portfolio's USD weightage. The falling USD is making these reserves less in value. By re-aligning the USD weightage, the Asian countries would be able to save their reserves from FX losses. However the re-alignment has to be done in a small batches. A huge sudden re-alignment may cause the USD to fall further which may result in a melt-down of the world's financial markets.
The Federal Reserve has to make the important decision, and now! The apparent decisions to cut interest rates is not improving the economy. Either the Fed cuts interest rates up to the point where the current credit crunch is gone and confidence is restored or the Fed increases interest rates to strengthen the dollar to combat import-inflation. However, the latter does have its repercussion.
The increase in interest rates would increase the cost of borrowing for the United States. If there is not enough reserves, which the United States does not have, it will only increase its debt to the world. The United States has a budget deficit of USD 5,035.3 billion as of 2007 (http://www.cbo.gov/budget/historical.shtml).
There could be another possibility, but the US public may not be willing to accept. The Fed could personally insure all US banks and make good all borrowings between banks at this point in time to reduce the credit crunch. However, there could be a public outcry due to the usage of public funds bailing out private companies.
Even if there is no public outcry, this is also not a fool-proof plan due to moral hazard of banks coming into play. Banks, knowing that the Fed would 'sign the blank cheque', enter into risker deals which results in more problems later on. Regulatory controls could be enforced onto the banks to prevent such deals from ever taking place. Would the US financial market, deemed as a free market, ever allow regulatory controls to be implemented?
The world has become more uncertain with inapt decisions by the Fed and intertwined financial markets.
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