Because of decades of deregulation in the financial sector and the increased intertwining of financial markets around the world, the current global economic turmoil will almost certainly result in fundamental changes in the way markets operate and businesses raise capital.
Standard & Poor's Ratings Services believes any return to relative stability and renewed growth will involve greater regional and global coordination in banking and securities oversight. We expect governments to reverse a long trend of deregulation and privatization in the financial services sector, strengthening their sway with lenders to unlock credit markets and help prevent future freezes.
Investors, however, may find fewer places to park their money. Risk aversion in the wake of declining valuations in the structured finance market, specifically in the U.S., will likely continue for the foreseeable future. Any revival of this market will be accompanied by significant change—simpler structures and pricing commensurate with, or at least closer to capturing, the inherent risks.
Globalization makes it difficult for any national regulator to tighten oversight significantly because business can readily be moved to other financial markets. Therefore, more coordination among regulators will be needed. And as markets become more global, so will financial centers. Standard & Poor's believes trading will be concentrated in three major centers: the U.S., Europe, and Asia. This will foster 'round-the-clock trading.
"The role of government in financial systems around the world will increase significantly, and conventional boundaries between the state and markets will be subject to challenge," says Standard & Poor's Asia-Pacific Chief Economist Subir Gokarn.
The winners in this game will be international cities that welcome foreign banks and their workers. This attraction of transplanted employees and acceptance of different languages and cultures will be essential to successfully coordinating financial regulation. Toward this end, we expect New York and London to remain among the world's financial centers; Asia's leader should be a toss-up between Hong Kong and Singapore.
At the same time, improvements in communications technology and computer trading mean market players no longer have to be in a financial center to trade there. Because of this, regional centers will probably be less crucial for job creation than they have been. We expect markets to be more dispersed, with secondary centers becoming more important and national financial capitals remaining essential for certain types of trading or for domestic companies.
Increased cooperation among regional regulators and an end to decades of deregulation and privatization in the financial services sector may help stave off recession in areas that are still financially healthy (such as China) and may shorten the suffering in countries already in—or about to suffer—recessions. But perhaps just as important to global economic stabilization will be investors' return to the midpoint between the insatiable appetite for risk (and the resulting high returns) that fueled the boom in structured finance and the ardent risk aversion that has contributed to the closing of credit markets and the historic tumbles on the world's stock exchanges. Although this will take time to materialize, more prudent pricing of assets and the desire to reach for yield will inevitably take place, accompanied by the next wave of economic exuberance and the froth for the next bubble.
Like all periods of global economic and financial turmoil, this latest episode will give way to a stretch of growth and stability. But clearly, a number of things must happen before this can occur.
What Has to Happen First
In the U.S., the economy must stabilize before financial markets can recover. We think the worst of the slump lies ahead—despite the government's stimulus package—but the economy has proved more resilient than we expected.
Standard & Poor's expects the downturn to be mild but protracted, reaching a trough in the spring followed by a sluggish recovery. Even though some signs hint that home sales are nearing the bottom, a sharp rebound in oil prices or extended financial turmoil could prolong and deepen the slump. On top of this, consumer spending is likely to drop even further in the coming months. However, because we expect only a moderate increase in unemployment, to 8% by late 2009 from 6.5% now, spending will probably stabilize by the spring.
The bigger risk, in our view, is that the U.S. economy and financial markets will echo Japan's experience in the 1990s. In 1999 the Bank of Japan lowered benchmark interest rates to zero, but because banks were impaired by heavy loan losses, money did not find its way to customers. A decade of stagnation in the Japanese economy followed.
"We think Federal Reserve Chairman Ben Bernanke understands the mistakes that the Bank of Japan made in the early 1990s," says Standard & Poor's North American Chief Economist David Wyss. "However, understanding what they did wrong doesn't mean we know what to do right. There is a risk of just making different mistakes."
A Streamlined Structure
The Federal Reserve has once again cut its key rate to 1%, and futures markets indicate that traders expect another half-point cut in December. This comes as the central bank has assumed the role of lead regulator in the U.S., even though the extent of its reach remains unclear. If other countries seek to coordinate their regulatory policies with ours, it is unclear which U.S. entity they would do that with. As a result, we expect one consequence of the current turmoil to be a streamlining of the regulatory structure, even if the U.S. does not appoint a central regulator.
The federal government's stakes in the financial services sector also highlight the likelihood of increased oversight, as regulators see the need to have a hand in managing these investments. This is an issue not only in the U.S. but also in Europe, where governments have taken even larger stakes in lenders and where a semi-nationalized banking system is more accepted.
The European economy is also in a recession. A contraction in business investment because of tighter margins, the prospect of weaker demand, and far less favorable financing conditions has deepened and broadened the downturn across the Continent in the past four months. As banks curb lending because of liquidity concerns and the commercial paper markets remain shuttered, companies are feeling greater strains on their financing.
A recession in the U.S. will clearly dampen growth in Asia as well, mainly by hampering export growth. In the past few years, the significance of the U.S. market for Asian exports, albeit still high, has declined. But Asia can offset this, at least in part, by keeping its countries' exports to their regional neighbors steady.
As in the U.S. and Europe, the abatement of inflationary pressure in Asia creates the opportunity for monetary stimulus. Many countries in the region have trimmed interest rates and addressed problems in the financial system by infusing large amounts of liquidity, both as a macroeconomic measure and to support specific institutions or segments of the system.
Although we expect economic growth to slow in Asia through 2009, it will likely remain relatively firm by global standards.