September 1, 2007

Re-pricing of risky assets from subprime crisis

8:15 AM: Re-pricing of risky assets is the most alarming threat to arise from the subprime mortgage crisis, says Economist Intelligence Unit report

The tremors in financial markets have gone far beyond their beginnings in the US subprime mortgage sector, and indeed far beyond the borders of the US. The full impact on the markets and the repercussions on the global economy remain unclear, but a new report by the Economist Intelligence Unit forecasts that the most alarming threat to global financial markets arises from the re-pricing of risky assets, and the associated deleveraging by investors.

In its newly-released special report Heading for the rocks. Will financial turmoil sink the world economy?, the Economist Intelligence Unit puts forward three main routes through which market turmoil could have a major impact on global markets. The first is the direct effect on holders of subprime-related assets. The second is the liquidity crunch that is presently occurring in response to uncertainty over precisely who holds the dubious assets. But the key threat is the fundamental re-pricing of risky assets and a reduction of leverage.

According to Alasdair Ross, editor of the report, “unusually low volatility of asset prices in recent years has lured many investors into more speculative investments. Poor returns on low-risk assets and the easy availability of credit further raised the incentive to move to riskier instruments, and many investors borrowed heavily to purchase them. This wall of money has allowed many asset markets to appreciate dramatically in value.”

“However, with investors reappraising the risk in their portfolios, prices for many assets have fallen sharply. The need to match declining portfolio values with reduced leverage is expected to result in further asset sales in the months ahead, as investors sell holdings in order to repay debt. As a consequence, a sustained downwards movement in prices across most risk-asset markets seems inevitable. ”

Other key findings of the report include:

 30% probability of the US falling into moderate recession. The Economist Intelligence Unit forecasts a 30% probability of the US falling into a moderate recession. This would have a substantial fall-out for the rest of the world.

 Cascade of damage. Although the financial downturn will affect most directly the US economy, the effect on the rest of the world will come through two channels: deteriorating global financial conditions and weakening demand from the US. The growing size and influence of European and Asian economies means the US has less influence on global growth than it did a decade ago. But a sharp slowdown in the United States would seriously affect global growth because no other economy is large enough and dynamic enough to pick up the slack.

 10% probability of a US slump. If corrective monetary policy action fails, the cycle of repricing of risk-assets and consequent deleveraging could spiral out of control. This would result in a long- lived period of economic weakness in the US, with severe economic repercussions for the world economy.

 When bubbles burst. What’s behind the financial storm that is ripping through the world economy? Nothing less than one of the biggest asset bubbles in history. The falling stock prices, soaring credit costs and roiling currencies that have shaken financial markets trace back to 1997, when the value of housing in the US began to jump. Nine years later, the value of property had surged by US$12trn. Asset bubbles almost always end in tears, and the US housing market is no exception. Banks and investors are now being punished for ignoring risk, lending recklessly and thinking property prices would always rise.

August 29, 2007

Mixed signals in interest rate policy

4:00 PM: Before I discuss the Bank of Thailand's latest interest rate policy, let me tell you a bit about my long absence from this blog.

I have been back from a long holiday to Phetchabun. It was a long drive from Bangkok to Phetchabun, taking us almost half a day including stopovers along the way for food and drinks and a bit of sightseeing.

I must admit that the route from Saraburi through Lopburi to Petchabun is one of the most beautiful scenaries in Thailand. It was a very pleasant drive if you want to escape from Bangkok and to appreciate the beauty of the Thai countryside. Phetchabun stands in the way between the Northeast and the North.

The tamarind from Phetchabun is most rewarding. Phetchabun has long been known as the Land of Tamarind. Incidentally, it is my favourite fruit. You need to have a strong stomach to withstand the tarmarind bout.

Khao Kho looks like another Switzerland. Lots of resorts, hotels and private estates are mushrooming on the mountain range of Khao Kho. In the old days, it was a jungle that the communists used as their stronghold to wage the war against the central government.

The weather was cool most of the time last week. It was very refreshing to rise up in the early morning and watch the cloud above one's head. This getaway is useful if you're pondering about the next wave of the subprime problems to hit Thailand.

4:45 PM: The Bank of Thailand has decided to leave its key policy rate unchanged at 3.25 per cent. This is not totally unexpected, although earlier market expectations were mixed.

Some, including Deputy Prime Minister Kosit Pampiemraj, have earlier urged the banking authorities to cut the rate to stimulate domestic demand amid the uncertain economic outlook and the increasing riks of the US subprime loan problems. But others believed that the BOT might have arrived at the end of the cycle of its monetary policy easing.

**********************************    

5: 45 PM: The BOT now still keeps an eye on inflation although the government might want it to cut the rate further to boost consumers' and investors' confidence. Inflation has been surprising on the downside in 2Q07. In fact, in Jul 2007, prices fell 3.4% month on month pushing the average inflation rate for the first half of this year down to just 1.1%.

DBS Research cautioned in its report issued today: "This, however, is a temporary phenomenon in all likelihood. Given cost pressures from elevated oil and commodity prices, as well as high capacity utilization rates, we expect businesses to be keen to pass higher costs to consumers once the political situation returns to normal.

"Indeed, by our estimates, inflation expectations should be around 2.7-3.0% by end 2008 and the real repo rate ought to be in the range of +200bps. By extension, this implies that the policy rate should be 4.7-5% by end 2008. This would require another 200 basis points rate hike through 2008.

"While this is feasible, this would mean pretty rapid rate hikes through 2008. As such, we think the BoT should be more forward looking and assess whether they can reverse the easing bias without hurting consumers and investors next year.