Friday, August 29, 2008

Why does it linger?

The Economist brings out a brilliant analysis of why the liquidity crunch refuses to die down.

It’s a long article. Here is my synopsis –

The double shock of decline in house prices and the sudden slump in prices of ABS have come at a time when the global economy is also witnessing a surge in commodity prices. This limits the power of the central banks to cut interest rates as it could stoke inflation further up.

The double shock entails uncertain direction of monetary and regulatory policy. When inflation targets are revised upwards, central banks will crack down so hard on inflation pushing the economies into recession. Further the effect of investment bank rescues will let in a harsh new regulatory regime that will stifle credit and hence future growth.

Then it is the nature of the previous boom fueled by indiscriminate borrowing by people to buy houses that they couldn’t clearly afford hoping to cash in on capital gains and investors buying complex high yield debt products they hardly understood. Both the lenders and investors were beholden to banks and that former wellhead of finance has now run fairly dry. In turn, that explains the absence of bargain hunters, particularly in the debt markets.

Investment-grade debt might look attractive on a five-year view, if all you have to worry about is the risk of default. But most investors in that market have a three- or six-month view; they cannot afford for things to get worse before they get better, in case they are forced into a fire-sale of their assets.

"So the markets (and the developed economies) are waiting for a catalyst for recovery. Lower commodity prices helped for a while, and may help further if they encourage central banks to cut rates. Evidence of a bottom in the American housing market may also do the trick. But the crisis seems certain to linger into 2009, and could even make it into the following year. Successful horror movies tend, after all, to have several sequels."


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