Credit Contagion: A Reality Check

Subprime is actually a relatively small slice of the global debt market. Meanwhile, economic fundamentals remain solid

Problems surrounding potential contagion from the U.S. subprime market translated to a liquidity squeeze last week, prompting central banks around the world to inject liquidity to calm nerves in the financial markets. The central bankers were fulfilling their role as lenders of last resort when heightened private fears threaten the normal flow of financing.

Though we still do not know the extent of the problem, the subprime debt market on its own is not large enough relative to the global financial system to translate to a financial crisis on its own. The sell-off has reflected both contagion concerns and uncertainty related to the liquidity squeeze itself.

For contagion, the market remains short on information though long on fear. We have yet to see whether upticks in delinquencies for lower-risk U.S. mortgage securities will exceed normal cyclical increases. The liquidity crunch will be of short duration as it can be readily addressed with central bank intervention, and hence the duration of Thursday's and Friday's liquidity disruptions should be short.

Supportive Backdrop

While the repricing of risk will entail losses for some investors, the fundamental backdrop remains supportive, with corporate balance sheets and earnings at levels that are solid on an historic basis and a global economy that was enjoying robust growth as we passed through midyear. Global gross-domestic-product growth will be sustained as long as the financial problems do not obstruct the access to financing for viable business operations, aside from the repricing of risky assets.

World GDP growth is poised for a 5.3% gain in 2007, just below the robust pace of 5.4% seen last year. Indeed, world GDP is on its strongest run in at least three decades with four consecutive years of growth in the high and narrow 4.9% to 5.4% range.

Though the slowdown in U.S. GDP growth in the second half of 2006 will depress U.S. annual growth in 2007, growth in the world's other major economies has remained solid, with notable upside surprises over the last few quarters from China and India, alongside respectable growth for Europe and Japan.

Ironically, the trigger for the latest market turmoil was the announcement by the French bank BNP Paribas that it was curtailing access to certain of its funds that had investments in collateralized debt, highlighting that the problems were not confined to the U.S. However, it can be argued that this was evidence of diversification in portfolios around the world, spreading out the subprime losses, making them less of a threat to major financial institutions. No doubt some individual funds are being hit hard, but this need not translate into a financial meltdown that would impair the availability of credit for financing the real operations of world business.

Roller-Coaster Markets

Though credit spreads have widened in recent weeks, this reflects the long-awaited and desirable repricing of risk, and still does not represent a particularly cautious risk appetite by historical standards. In their efforts to prevent a systemic collapse, while seeking to encourage prudent risk pricing, authorities face the traditional dilemma of a "moral hazard."

Stock markets around the world have taken a whack, but remember that this still represents a moderate adjustment that has yet to reach the 10% definition of a "correction," after many indexes had posted record highs in mid-July, before the latest sell-off. The repricing of risk in the credit market should dampen the leveraged buyout activity that had been an important support for the recent stock market rallies. This unwinding need not translate into a collapse in stock markets, which remain supported by the strength in corporate earnings and bolstered by the robust global economic growth through midyear.

The ongoing roller-coaster ride in equity markets highlights the tension between this underlying economic momentum, which supports periodic bargain hunting, and bouts of market fear, which still have left stock prices at respectable levels despite market swings from the mid-July peak.

Currencies have been on a similarly volatile run, reflecting swings in the carry trade that has been a key driver of the foreign exchange market over the past year. The trade, in which investors borrowed the low-yielding yen and Swiss franc to buy higher-returning currencies, has fluctuated with global appetite for risk. The yen, which had been at a four-year low vs. the U.S. dollar, and a record low against the euro in early July, rebounded later in the month amid the global equities sell-off, to hover around a four-month best vs. both currencies.

The opposite swing was seen in Australian and New Zealand dollars, and emerging Asian currencies such as the Indonesian rupiah, the Philippine peso, and Thai baht, which have pulled back from their strongest since the Asian crisis of 1997-98.

Stop-Gap Effort

Recall that markets experienced a similar gyration in February and March, triggered at that time by a temporary sell-off in the Chinese stock market, which spread around the world. The swings were subsequently reversed as global stock markets resumed their climb, with many hitting multiyear or record highs last month, while in foreign-exchange markets, the carry trade weighed on the yen and Swiss franc and supported renewed appreciation in emerging market currencies.

The latest episode of liquidity injection by the central banks thus can be viewed as a temporary stop-gap effort to calm market nerves, rather than a new direction in basic monetary policy. Last Friday, the Fed said it is "providing liquidity to facilitate the orderly functioning of financial markets." The Fed said it will provide reserves "as necessary" to help keep the federal funds market at rates close to the Federal Open Market Committee's target rate of 5.25%.

The Fed's comments do not imply that a rate cut is imminent. Just three days earlier at its Aug. 7 policy meeting, the Fed had maintained its hawkish policy statement, reiterating that its predominant concern is inflation. Indeed, the Fed's confident tone had initially reassured markets, just as they again took comfort from its assurances on Friday.

Maintaining Price Stability

Similarly, maintaining rates at its August meeting, the ECB emphasized the need for "strong vigilance" to maintain price stability, leaving in place market expectations for a rate hike at its Sept. 9 meeting. Of course, continued market turmoil would leave them inclined to pause a little longer, just as the Bank of Japan might find it awkward to follow through with a long-awaited rate hike if it is still pumping in 1 trillion yen ($8.5 billion) in liquidity, as it did in Friday's effort to calm markets.

It would seem that there is sufficient momentum in the world economy to sustain solid global growth through to the end of the year, supportive of markets. In the near-term they will remain at the mercy of subprime and contagion fears, continuing the roller coaster in equities, debt, and foreign exchange. The faint-hearted should hang on tight, as the ride will likely remain bumpy.

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