Global credit crunch: turbulences and outlook

Turmoil in financial markets worldwide since the summer of 2007 has dampened consumer spending and undermined investor confidence.

Consumer goods companies will feel downward pressure on their profit margins as consumers worldwide spend less and banks are reluctant to make funds available to the corporate sector amid market uncertainties.

Key points

  • During the second half of 2007, the world’s financial markets have been experiencing fluctuations and uncertainties stemming from a crisis in the US sub-prime mortgage market;
  • Lenders in developed economies, notably the USA and the EU countries, will tighten credit conditions as a response to market uncertainties;
  • In developed countries, households will no longer have easy access to credit, which will lead to dampened consumer spending. Meanwhile, companies will likely feel downward pressure on their profit margins due to both restrained consumer spending and a lack of funds to expand production;
  • Developing economies, on the other hand, will likely experience slowing export growth (as a result of dampened global demand) and thus a slowdown in economic expansion;
  • Central banks in many countries are expected to cut their key interest rates in late 2007 and early 2008 in a bid to revive consumer and investor confidence and thus restore economic growth. The US Federal Reserve already cut US interest rates from 5.25% to 4.75% in September 2007.

Background

Turmoil in the world’s financial markets started with a crisis in the US sub-prime mortgage market at the end of 2006:

  • By definition, sub-prime lending is the practice of lending to borrowers who do not qualify for the best market interest rates (i.e. the primary market rates) because of their poor credit history or inability to prove their income. As such, sub-prime loans are risky for both creditors and debtors due to the combination of high interest rates and the applicant’s bad credit history or unstable financial situation. Sub-prime lending covers a wide range of products, from sub-prime mortgages and car loans to sub-prime credit cards;
  • The US sub-prime mortgage market started to hit crisis at the end of 2006 when it emerged that there have been an estimated US$100 billion worth of sub-prime mortgage defaults from less than credit-worthy borrowers in the USA;
  • The large-scale default in the US sub-prime mortgage market has come at a time when stock markets worldwide were tumbling, leading to a number of hedge funds becoming worthless and interventions from national banks. Subsequently, several mortgage lenders (including the major sub-prime mortgage lender New Century Financial Corporation in the USA) have declared bankruptcy;
  • The crisis in the US sub-prime mortgage market and global stock market turbulences escalated into a global crisis in July 2007. Since then, the global financial markets have been described as being increasingly volatile due to increased credit and market risks.

Implications for developed economies

The credit crisis in the US housing market and consequently in other markets have wide-ranging effects on companies and consumers in developed countries:

  • Lenders are expected to tighten the criteria they use to assess credit card applications, making it more difficult for households to spend on credit. This will lead to a decline in consumer credit and, consequently, a reduction in consumer spending. In 2006, global consumer expenditure stood at US$28,731 billion, an increase of 2.6% in real terms over 2005;
  • As recent turmoil and uncertainties in the financial markets restrict the ability of banks to lend money to the corporate sector, this will make it difficult for firms to obtain funds and expand production;
  • Difficulties in expanding business and production and declined consumer spending when the Christmas shopping season is approaching will put downward pressure on the profit margins of many consumer goods companies. Across the globe, companies are dependant on consumer spending, especially in the USA and other developed economies;
Global real GDP growth and global consumer expenditure (in 2001 prices): 2001-2006
Source: Euromonitor International from IMF.
  • House prices in the USA have tumbled as cheap and easy mortgage loans to millions of American homebuyers suddenly dried up. This has led to fears that a similar situation will spread to housing markets in other countries. In the UK, for example, there are widespread speculations that house prices are heading for a fall in 2008 for the first time in many years. Falling house prices will negatively impact consumer confidence due to a decline in the wealth effect;
  • Falling house prices means that mortgage lenders will not be able to recoup their losses in the situation where home owners are unable to meet their repayment commitments. Consequently, due to worries about market volatility and their potential mortgage losses, the banking sector will suffer from higher costs of credit as banks raise the interest rates they lend to each other. Amid such a crisis, the value of banks will likely decline as banks’ share prices are going down;
  • In the context of financial market volatility, investors will have to re-assess the risks they are taking when making an investment. This will likely result in a reduction in the overall investment level in developed markets as foreign and domestic investors become more cautious. In 2006, the value of total investment in Western Europe stood at US$3,000 billion, accounting for over one-fifth of the entire regional economy;
  • Unemployment across the developed world is likely to rise as companies cut back production and investment. This would reduce household incomes and effectively restrain consumer spending.

Implication for emerging markets

The global financial market crisis will also be felt by stock markets, companies and consumers in developing economies:

  • Export growth will slow as a result of dampened global demand. As many developing economies are export-oriented, the slowdown in export growth will severely affect the rate of economic expansion in many emerging markets. For example, economic growth in China in 2006 was mainly driven by a surge in the trade surplus to US$194 billion (up from US$134 billion in the previous year), thanks to bilateral surpluses with developed economies (notably the USA and the EU markets). However, China is striving to boost private consumption and turn it into a key driver of economic growth. This will help to reduce the reliance on exports and the vulnerability to world market fluctuations;
China’s trade surpluses: 2002-2006
US$ million

Source: ADB.

  • Local producers and traders who have been catering for export markets will have to cut back their production. Investments in export-oriented manufacturing will thus be reduced, leading to an overall decline in both local private investment and FDI inflows;
  • The scaling back in production and investment will lead to workers being fired or made redundant. This will increase unemployment rates and adversely affect household incomes;
  • When unemployment is on the rise, households in developing countries will be inclined to save rather than spend or make purchases on credit. Consumer spending will thus decline and consumer goods companies will find that market growth in fast-growing developing countries can potentially slow;
  • Large daily drops have become more frequent on the financial markets in important emerging economies such as China, India and Brazil, as these markets respond to market fluctuations across the developed world as well as reflect the far-reaching impacts the global financial and credit crisis has on economies in the developing world.

Future scenarios

The IMF has warned that the adjustment process following the current global financial turmoil is likely to be protracted. Credit conditions will not likely normalise soon and some of the practices that have developed in the credit markets will have to change. As a result, the banking sector will continue to face uncertainties and difficulties whilst companies and consumers can expect continued stringent lending conditions as well as a scarcity of funds in 2008.

It is expected that central banks in many countries will cut their key interest rates in late 2007 and early 2008 in a bid to revive consumer confidence and encourage private consumption and investment. This will hopefully help to restore economic growth. The US Federal Reserve has already made the first move and cut US interest rates from 5.25% to 4.75% on 18th September 2007.

Although the IMF has not published its updated world economic forecast, it has warned that growth in the global economy will likely slow down in 2008 as a result of the significant ongoing correction in financial markets. Some analysts forecast that the US economy might only grow by 1.0% or 1.5% in 2008 (down from 2.2% projected for 2007) whilst the annual growth of the UK economy could slow to between 1.5% and 2.0% (down from 2.3% projected for 2007).