Chinese Checkers

The subprime storm has abated, leaving major western financial institutions severely battered in its wake. But before one can breathe a sigh of relief, other storm clouds seem to be gathering on the horizon. Foreclosures, bad loans and bankruptcy may now leave hundreds of lenders short of cash. Combined with skyrocketing food and fuel prices, rising unemployment and growing credit card defaults could seriously deflate demand. The ripple effect of a recession, should one materialise in the coming months, will be felt around the world and will severely test the resilience of the rising new economic powers.

The aftermath of the subprime mortgage fiasco has brought new evidence of the world economy’s close integration. For all the bad press globalisation gets, the same financial linkages that helped spread the contagion have proved the saviour of battered investment and hedge funds. When Wall Street giants Merrill Lynch, Morgan Stanley, UBS and Citigroup were crippled by their subprime losses, it was Saudi, Chinese, Japanese, Korean and Singapore investment funds that stepped in with $40 billion to help shore them up.

If the IMF’s estimate that US banks could post losses of $300 billion-400 billion on real estate loans proves correct, the American banking system, itself worth only about $1.2 trillion, would require significant recapitalisation. The sovereign wealth funds that came to the rescue earlier this year may be called upon yet again to step in. But regional banks facing the crushing ripple effect can expect no such cavalry of capital to the rescue.

The falling real estate prices generated by subprime mortgage defaults have spread to the housing market, often driving property to negative equity. The result has been growing defaults on mortgage and home-equity loans for automobiles and small businesses. If house prices fell by 20-30 per cent from their peak, as economist Nouriel Roubini estimates, it would wipe out between $4 trillion and $6 trillion in household wealth. Smaller banks and businesses would be devastated, and consumer spending would have the oxygen sucked out of it. Countries depending on exports to the US as the engine of growth might hear only spluttering from the American consumer.

For now, world exports to the US have not slowed and the falling dollar ensures that the US trade deficit remains high. But the only happy note in an otherwise dismal situation has been a strong growth in US exports — an 18.2 per cent increase over last year kept the GDP growth up, and slightly narrowed the trade deficit. Economists are counting on countries benefiting from the rise in commodity prices to keep US exports growing, and the fast-growing economies of East Asia to keep the world economy humming.

While the size of the US trade deficit is a major concern, international trade has helped keep consumer prices low despite the squeeze of rising oil and food prices. It is perhaps an interesting indicator of trade’s role that Wal-Mart, whose shelves are stacked with mostly Chinese-imported items, has posted a profit. But China’s ability to continue delivering the ‘everyday low prices’ that Wal-Mart boasts of is increasingly doubtful, as fuel price growth is pushing up the costs of shipping goods to the US. This also threatens China’s low-cost advantage: as most of its high-value exports are technology products assembled across South east Asia (almost 80 per cent foreign content in electronic goods), Chinese firms must pay more to produce their export goods. The recent decision by Beijing to cap subsidies on oil and gas, and substantially raise diesel and oil prices also brings the country into closer alignment with the global market, and will further push up export prices. In order to retain market share, China may accept lower margins and still remain competitive, but the much-feared, rock-bottom ‘China price’ may become a thing of the past.

There are also doubts about whether China can maintain its growth tempo by focusing on capital construction and domestic consumption should the US slide into a recession. It is thanks essentially to the voracious appetite of China’s export engine for raw materials that commodity producing countries in Asia, Africa and Latin America have continued to grow at a rapid clip. But if it is hit by the double whammy of skyrocketing energy prices and a slowing US economy, will China be able to sustain its rate of growth?