Global Trends by Martin Khor

Monday 13 October 2008

System “on the brink” as markets plunge

As stock markets crashed last week, the financial system was brought to the “brink of systemic meltdown”, as the IMF chief warned.  More shocks are still in store as the effects of recent bank collapses unfold.

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Just when we thought it could not get worse, it did.   Last week was like a nightmare come true when stock markets around the world went into a tailspin while the credit markets (where banks lend to one another) remained frozen.  And all this despite governments announcing so many new measures to dampen the fires.

Last Friday, many stock markets had their worst day, with Tokyo down almost 10% and London 9%.

It capped a week of continuous bleeding.  Overall, most major stock markets fell by 20% or more in the week:  Japan by 24%, Germany and France 22%, the United Kingdom 21%, the United States (Dow Jones) 18%, China 13%, India 19%, Brazil 23%.

In Malaysia the KLSE composite index fell to 934 on Friday, or 8% lower than the 1016 a week earlier. 

An estimated US$4,600 bil was wiped off the values of shares worldwide in the past week.  The US Dow Jones index fell below the psychologically important 10,000 level, then below 9,000. 

Investors’ pessimism persisted, although Western leaders introduced one new measure after another.  In particular, the UK announced a three-prong 400 bil sterling approach, including injection of equity into troubled banks, providing state guarantees on new bank loans to other banks, and injecting more liquidity in credit markets.

The German Chancellor announced the government would guarantee all private deposits in banks, which was followed by other countries. The US Federal Reserve said it would lend directly to companies through buying their commercial paper (as the private market for such paper had frozen).

Last Saturday, a meeting of finance ministers of the G7 countries in Washington came up with five principles, including a pledge to take decisive action to support “systemically important” financial institutions and prevent their failure.

The meeting did not produce concreteness in common action and is unlikely to be enough to stem the fears in the markets.  On Sunday, the head of the International Monetary Fund Dominique Strauss-Kahn, said the intensifying fears of insolvency of leading banks and financial institutions in the US and Europe had “pushed the world financial system to the brink of systemic meltdown.”

The IMF warned that global equities could fall another 20% in the coming days unless governments deliver concrete action.

Many analysts believe the latest round of the collapse of confidence began when the US government allowed the investment bank Lehman Brothers to collapse last month.

The global reach of this failure was seen last week, when 600 Singaporeans gathered in a park to express their anguish.  The authorities said 8,000 Singaporeans had bought S$508 mil in Lehman-linked structured investment products from local banks and institutions. 

The investors had been promised returns of about 5% per annum, much higher than bank deposit rates. But they now risk losing much of their capital as the underlying stock has  collapsed.  In Hong Kong, US$2 bil of Lehman-linked products had been sold to local people.

More bad news about Lehman will emerge this week.  About US$400 billion of Lehman-linked credit default swaps (CDS) are due to be settled. An initial auction last Friday in New York showed the value of only 9.75 cents to the dollar, which means that banks and investors that sold insurance that Lehman would not default would have to pay out 90.25 cents to the dollar. 

This implies a payout of hundreds of billions of dollars. Will those who sold the CDS be able to meet their commitments?   The failure of other banks such as Washington Mutual and three of Iceland’s banks will also soon trigger more billions of dollars of CDS settlement. 

The repercussions of these developments in credit derivatives could become another major problem about to explode.

The solvency crisis looks set to move beyond the finance sector, as share prices of a few giant U.S. industrial companies also fell sharply at the end of last week.

The oil price also fell dramatically.  From its peak of US$140 a barrel just a few months ago, the oil price fell to $78 at one stage in the U.S. last Friday.  Other commodities also saw their prices sink, with declines of 18-20 percent in one week alone of copper, nickel and tin.   Agriculture prices (such as corn, wheat, sugar soya bean) also fell sharply last week.

Nowhere was the financial tsunami felt more strongly than Iceland.  Not only did their three major banks collapse, but the country itself has gone bankrupt.  Although the banks’ deposits are to some degree guaranteed, it is doubtful the government can meet this obligation.

What was shocking was the big spat that developed between the U.K. and Iceland governments.  The British financial authorities used anti-terror laws to seize 4 billion sterling of assets of Iceland’s bank Landsbanki last week, to protect British savers and institutions that had put their savings in it.

About 300,000 British people had seen their accounts in another Iceland bank frozen a few days earlier.  They had opened their accounts through the internet, attracted by the high interest offered.

The British government also last Thursday acted against a U.K. subsidiary of Iceland’s biggest bank Kaupthing, a move that was blamed by the Iceland prime minister for the final push into the bank’s collapse. 

“Not many governments would have taken that very kindly,” said the Iceland premier Geir Harde of his counterpart Gordon Brown’s action against his banks, in what must be the greatest understatement of the crisis so far.

When Western allies can unilaterally seize the assets of one another’s banks, citing anti-terrorist laws on top of it, it is a clear sign that it’s everyone for himself or herself when the going gets really tough.