The main focus of attention in the international banking world is the writing down of sub-prime loans and capital injections by the sovereign wealth funds. But are we not in danger of overlooking the obvious problem ahead: a world in which the availability of capital has been curtailed both to business and consumers?
To step back, the cause of the sub-prime crisis in global banking was a spate of bad loans to people in the US to buy homes, who should never have been lent money. Those loans were packaged up and sold to global banks, making this domestic problem an international one.
The total hole in the balance sheets of the international banks is now estimated to be $250-300 billion (Dh917bn-1.1trn), compared with write-offs to date of more than $70bn. This is a major financial crisis equivalent to the Savings and Home Loan bankruptcies of the early 1980s in the US, or the LTCM hedge fund collapse of 1998.
However, there is good reason to believe the knock-on effect from the latest credit crunch is going to be much bigger than these past two crises. George Soros has now been joined by his former hedge fund partner Jim Rogers in forecasting the worst recession since the Second World War.
The main reason for such pessimism is that the world became excessively leveraged in the period up to August 9 last year, mainly due to a long period of super-low US interest rates, and that this excessive borrowing is concentrated in the United States, United Kingdom and Ireland, Mediterranean Europe, Eastern Europe and Russia.
These economies have been big contributors to high rates of world economic growth in the 2000s. Emerging markets like China, India and Brazil have been expanding on the back of this credit generation, and their stock markets have massively over-expanded and now face a painful contraction period – which has just started.
At the micro level, consider the impact of tougher rules for credit cards. Citi has just withdrawn credit cards from 161,000 clients in the UK, for example, and these people are not likely to have a credit record that allows them to instantly get a replacement.
Therefore, the purchase of Chinese goods in UK shops that these clients might have made will not happen, and a direct link between the US credit crunch and a recession in the UK high street is established, as well as a fall in exports for China. You have to multiply this micro view by millions of similar instances to arrive at a macro economic outlook, which is clearly far gloomier than the instant TV commentators suggest.
Recessions are not short-term events in capital markets, that bear no relevance to the lives of ordinary people. They mean pain and misery for millions of over-borrowed consumers whose high spending days will be cut short, and who may face losing their homes due to repossession for non-payment of mortgages if their jobs go.
And for business there is the nightmare of contracting sales after a very long period of continuous growth. Suddenly instead of expansion it is survival that counts, and over-borrowed businesses will go bankrupt. So that means redundancies and job cut-backs to respond to a falling market, and that is again bad for the market.
Indeed, it has been so long since the West saw a serious recession, that the downward spiral is forgotten as people optimistically hope a rate cut will save them. Well, banks are not passing on rate cuts but rather using them to support their profit margins, and are not about to make bad loans again in a hurry. Besides it takes time for asset prices to adjust downwards. US house prices fell last year for the first time since the Great Depression, but it may take until 2010 for this process to bottom out. Likewise the bear markets in global stocks may run for years and not months.
So if the credit crunch now turns into a serious downward recessionary spiral, and George Soros and Jim Rogers are correct, where does that leave the UAE? With lower oil prices is the instant answer. Since oil topped $100 recently, prices have been falling back on recession fears and as recession actually arrives, prices will fall further. For a start speculators will exit the oil market as the upward price moment stalls, and then real demand will falter as the industrialised countries and emerging markets go into recession.
Then the government will have to think hard about its policy: keep on spending on infrastructure during a global recession, and benefit from lower construction prices; or trim back expansion plans, in case the demand to support ambitious projects does not return? If nothing else, after seven years of rising oil prices, this will be a moment to take stock. Not every project is a success, and some are more successful than others. A degree of rationalisation and consolidation will look probable in such an environment. There could also be some awkward issues with over-stretched private sector concerns to consider, although probably nothing compared to the problems awaiting more leveraged countries.
The real estate sector would need some careful handling to ensure a soft and not a hard landing. In Dubai the implementation of new regulations to control the handling of funds by developers has helped to cool the off-plan sales boom. Next, the judicious extension of low-cost finance to potential end users should be considered as a way of smoothing the expansion of the market as new supply comes on to the market, and avoiding the creation of unsold inventories.
The UAE is fortunate indeed to have the accumulated wealth of the oil boom of the 2000s at its disposal, and very low levels of mortgage debt, although last year’s expansion of corporate debt might prove to have been a high for the current cycle. Hence, the government has far more room for manoeuvre in insulating the local economy from a world recession than perhaps almost any other nation.
Certainly in this respect the UAE is on a par with Switzerland in Europe or Singapore in Asia or perhaps Australia. However, in the sort of global recession that George Soros and Jim Rogers foresee there is no escape, just a matter of the relative degree of pain and relative performance. To this extent local stock markets are right to instantly discount movements in global equity markets. But in 1999-2000 the UAE rode out the Asian financial crisis and $10 oil, and then the dot-com crash, with only a modest slowdown in business and realty development. And the strengths of the local economy will prove equally resistant to whatever recession is now coming.
UAE’s insulation against sub-prime