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Author: 
Dr. Mohamed Ramady
Publication Date: 
Mon, 2007-08-20 03:00

During the recent meltdown of global equity markets, some traders and investors lauded the intervention of central bankers across the world to flood the markets with as much liquidity as needed to keep funding rates under control, but above all, to stop a self-fulfilling prophecy of financial markets contagion. One knows it’s serious when central banks — the very institutions supposed to remain cool and collected — start to panic themselves.

The result of billions of dollars being pumped seemed to be more confusing initially on the markets, with falls matching the dotcom bubble burst of six years ago and the madness of that investment era. At the same time, there seems reluctance by central banks to cut back on their interest rates in their fight to curb both inflation and consumer spending.

That reluctance to cut rates may weigh on markets braced for more losses and possible insolvency even amongst blue chip financial institutions. As some point in the very near term, the financial markets may be forced to decide whether it is indeed safe to extend yet more credit to other financial institutions. “Darwinian” economics — the survival of the fittest — seems to be in action again, as “bad” investment decisions are being punished. With 20-20 hindsight, the worst such decision seemed to have been the issue of mortgages — or subprime mortgages — to millions of Americans who could not service their debts. This subprime market seemed to have washed up in even the most conservative investment bankbooks across the world. According to some analysts, there are estimates that some $300 billion in loans are at “risk”.

The result saw several prominent banks freeze or close high-risk funds, causing fear over a credit crunch. BNP Paribas took the first move by closing three funds because it said uncertainty in the subprime sector meant it could not assess the value of the funds “accurately “ — i.e. they were technically insolvent with no buyers or sellers for these funds. Other banks across the globe announced losses due to subprime portfolios, such as Dutch bank NIBC with its 137 million euros and US bank Bear Stearns which had to spend $1.6 billion to bail out two hedge funds.

It wasn’t the major financial markets of the world that were worried, as central banks as far apart as Australia, South Korea, Malaysia, Indonesia and the Philippines intervened to sell dollars to support their currencies. Even if the central banks of the world stem the financial panic in the short term, there seems to have been a general shift in market perceptions about risk. But risky products, dangerous investment bets and financial fashions have always been around. What is new this time, and how will this latest financial panic play out?

In the short term, investors will be demanding higher interest rate spreads for risk premium, and opt for government bonds and safer currencies such as the yen. Stock market fluctuations are a normal part of stock market activity, and some say that the subprime issue was an excuse for a long due correction of market values which had been on a sharp rise for the past 18 months in Europe and the US, despite higher interest rates. Company profits seemed to be healthy and the world economy, helped by China in particular, seemed to be entering a period of some revival.

However stock markets look to the future — and if they become concerned that corporate profits have peaked and that there is going to be a credit crunch for potential borrowers, then global markets might take some while before they recover. Even if they do, and some markets rebounded after the falls due to attractive stock picking, it looks most certainly that the re-pricing of risk, making it more expensive to borrow for certain kind of investments — is here to stay for a long while. That is, until a new financial derivative is introduced which becomes the flavor of the day, for who had heard about the US subprime mortgage market a year ago?

For investors in the Kingdom, the events across the world might as well have happened on the moon , for yet again the Saudi stock market showed that it was not part of the global markets, gaining a few hundred points to reach levels of 7,800 and got everyone excited about a rebound to over 10,000. This is not going to happen for a long time yet , and the local reaction could have been due to several factors, including continued high liquidity in the market, better than expected second quarter results, and withdrawal of foreign deposits to place in the Saudi market.

What was of interest though, was some muted debate on whether SAMA should play a more active interventionist role in times of market meltdown, similar to the international central banks. Then again, what would an intervention of some $300 billion — the size of Saudi foreign reserves — have achieved in the face of a loss of over $1 trillion as seen in the local markets?

The health of an economy can be gauged by the state of its stock market, as investors also include pension funds and small savers. If share prices fall, these pension funds may have less money to pay future pensions and employee contributions may have to rise. Individual investors may feel less wealthy and cut back on consumption, leading to slowdown in economies. Smaller, more risky or entrepreneurial companies could find it more difficult to get funding, slowing the pace of new innovation and IPO’s.

The markets will be scrutinizing very closely data on consumer spending and confidence indexes.What is more crucial though, is that while big banks can withstand some of their losses due to “stupid mistakes”, what happens down the financial ladder is far more interesting and potentially worrying.

(Dr. Mohamed Ramady is visiting associate professor, Finance and Economics, King Fahd University of Petroleum and Minerals.)

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