NYT: 'Could This Be The Global Financial Meltdown?'

FREE FALL The plunge of China’s stock market added to worries in the United States about the decline in the housing market and loans to risky borrowers.


The World
Shanghai What-If: How a Shock Can Become a Shock Wave



By EDUARDO PORTER
Published: March 4, 2007

http://www.nytimes.com/2007/03/04/weekinreview/04porter.html




COULD this be the global financial meltdown? Less than a week ago, it might have seemed preposterous to suggest that a 9 percent fall in the Shanghai stock exchange could jolt markets across the world, triggering declines in everything from European stocks to American corporate bonds.

Yet such unlikely chains of events have been known to occur. Less than 10 years ago, the devaluation of the Thai baht on July 2, 1997, triggered a wave of currency collapses across East Asia and beyond.

By December of that year, the currencies of Indonesia, Korea, Malaysia and the Philippines had depreciated by about 75 percent, on average. Then the ruble fell. The Russian government defaulted on its domestic debt. By the time the dust settled, Brazil had devalued the real, Turkey had devalued the lira and the Argentine peso had collapsed.

Economies contracted from Ecuador to Singapore. And the high-flying hedge fund Long Term Capital Management, which had borrowed heaps of money to make risky bets across the globe, was only saved from the brink through a bailout organized by the Federal Reserve.

“These panics can be set off by any number of things and spread in many wondrous ways,” said Alan Blinder, an economist at Princeton University who was vice chairman of the Federal Reserve from 1994 to 1996. “Every one of these is different.”

The world, of course, is a different place than it was in the late 1990s. Developing countries are in much better shape, mostly growing fast and running trade surpluses rather than deficits. Many have repaid much of their foreign debt. And they have piled up humongous reserves.

Moreover, despite a slowdown in the United States, the global economy appears to be doing swimmingly. Growth in Europe and Japan has picked up. The International Monetary Fund expects the world economy to grow around 5 percent in 2007, about the same pace as last year.

Even so, there are some dangers lurking, notably America’s enormous trade deficit. But decisions by investors last week to dump risky assets like stocks in China or Brazil and instead buy safer bets like United States Treasury bonds actually makes it easier to finance America’s shortfall.

Still, the financial commotion last week underscored the extent to which financial markets everywhere are propped up by the same shaky crutch that has played a prominent role in the events leading up to crises in the past: overconfidence. “It was a bit of a wake-up call to investors about the risks out there,” said Kristin J. Forbes, an economist at the Massachusetts Institute of Technology who was on President Bush’s Council of Economic Advisers from 2003 to 2005. “Up to now investors had become too complacent about risk.”

Facing paltry yields on high quality assets like United States Treasury bonds, and diminishing returns on more stocks in industrial countries, investors have delved farther afield in pursuit of higher returns.

They rushed again into developing countries — pouring more than $500 billion into “emerging markets” last year and a similar amount in 2005. At its peak on Feb. 8, the Bombay stock market index was 49 percent higher than a year earlier. The Mexican market index was up about 55 percent in the year at its peak on Feb. 21. Even after the crack on Tuesday, the Shanghai stock market index is still twice as high as it was a year ago.

Investors have also rushed to buy dicey assets closer to home, like corporate bonds with a relatively high risk of default.

Last year, even as the housing market started tottering, investors snapped up $483 billion in bonds backed by sub-prime mortgages issued to the riskiest borrowers. The year before they bought over $500 billion worth of the shaky paper.

And many large investors, from pension funds to hedge funds, have doubled up their risk-taking not only by making these bets with borrowed money, but by borrowing it in Japan, where short-term interest rates have been exceptionally low. This could expose them to abrupt losses were the dollar to fall against the yen.

The question is, how does this all unwind?

According to the benign scenario, which most economists are betting on, including Ms. Forbes and Mr. Blinder, last week’s financial troubles will be short-lived — merely an instance of investors recovering their sense of risk and pulling back from some of their crazier investments, but doing no harm to the real economy.

“So far the betting is this is more a healthy correction rather than a plunge,” said William Cline, a senior fellow at the Peterson Institute for International Economics.

Still, crises move in mysterious ways. And there are plausible paths for the financial turbulence to worsen. As Ms. Forbes acknowledged, “The crisis of the future never looks like the crisis of the past.”

Let’s imagine, for instance, that one unlucky hedge fund borrowed oodles of yen to invest in sub-prime mortgage-backed bonds and Turkish debt.

Let’s also say that the yen continued to rise, as it did last week, as more investors caught by the financial crunch sold their losing investments to buy yen in order to repay their Japanese borrowings.

Meanwhile, mortgage-backed bonds and Turkish debt continued to fall.

This could mean trouble for the hedge fund, which would find itself owing yen that were rising in value but owning assets that were falling in value.

That might mean trouble for the banks that lent it money. And if the hedge fund were forced into a fire sale of Turkish bonds, say because it needs more collateral to back up a loan, it could be a problem for Turkey, because the sudden flood of its bonds on the market would cause their prices to drop. And if the price of its bonds fell, Turkey would have a tougher time trying to raise the cash it needs to finance its current deficit.

If Turkey were to go ...

As Mr. Cline put it, “these things are so predictable in hindsight.”