Lesson 1. This is more than a sub-prime crisis. The scale of the financial crisis we face goes beyond housing and sub-prime. In the past years, the extraordinarily low volatility environment, coupled with a healthy gap between the return on capital and the cost of capital, led to excess leverage in some sectors. The money markets froze up, reflecting not only the sub-prime crisis, but also a general 'bank run' on the capital markets in developed countries.
Lesson 2. Central banks are potent, but the private sector is critical, too. In our view, the co-ordinated liquidity action (as opposed to co-ordinated monetary action) by various central banks yesterday was very important, and potentially positive for the outlook for the financial markets and the global economy. The Fed effectively introduced a lower-cost, anonymous, variable-rate auction version of the discount window that is aimed at providing additional liquidity beyond the cash market.2 To the extent that this enhances general confidence (and it is still unclear whether banks would be marginally more willing to lend to each other, now that the relative demand and supply for term liquidity are altered), the term interest rates in the interbank market should start to decline. The corporate bond and money markets' initial reaction has been remarkably muted, and the reaction of the global equity markets has been outright negative so far. But it is perhaps correct to assume that, if this variable rate tender proves to be too modest in size (US$20 billion next Monday, December 17, 2007), the Fed will raise the amount auctioned and/or will introduce other tools to achieve its objective. In short, the willingness of the Fed to go to the extreme should not be in question, even though its ability to close the LIBOR-OIS spread requires a change in the behaviour/psychology of the private sector.
Lesson 3. Extraordinary powers of globalisation. The rise of the emerging powers (BRIC and other EM economies) has suddenly become blatantly evident this year. Their ability to withstand the multiple sell-offs in the global financial markets this year has been absolutely remarkable; a year ago few would propose the notion that EM could be a 'safe haven'. Further, this structural rise of the real economies of EM within a fundamentally asymmetric arrangement between capitalists in the West and labourers in the East is quickly evolving into a more symmetric arrangement: EM is now a source of capital flows, not just a destination of FDI from the West. This, in our view, is a historical watershed, and marks a turning point in the balance of economic power in the world.
Lesson 4. The rise of sovereign wealth funds. SWFs have indeed turned out to be a powerful driver of risky asset prices. At fire-sale prices, SWFs have been particularly active with financial institutions in the developed world, which they broadly consider as strategically important. In our view, this is not a fad, but the beginning of a long-term trend, as the SWF will form the single-most powerful new category of investors in the world, with Japan likely the next new member. Bottom line 2007 has been marked by powerful macro trends and crosscurrents. Many of the themes dominating 2007 will likely be at least as relevant in 2008.
Stephen Jen is a well respected analyst at Morgan Stanley.
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