Stores 2008 Global Powers of Retailing - (Page 40) 2008 global powers of retailing Global economic outlook 2008 The medium-term direction of the global economy will be set largely by two countries: China and the US. Together, these behemoths account for a sizable share of global economic growth, and especially import growth – thereby stimulating exports and economic growth in the rest of the world. Hence, how they perform matters. Moreover, the financial imbalance between these two countries has already had serious consequences for growth, exchange rates, and interest rate. More may follow. Currently, the global economy is undergoing a transition from one era of economic expansion to another. The transition itself was brought on by the bursting of a bubble in the US housing market. Yet bubbles don’t emerge at random. They are usually caused by an economic shock — which in this case was the huge flow of liquidity from China to the US. And, of course, bubbles eventually burst. Moreover, the massive flow of capital from China to the US has had some unanticipated effects as well. That flow, by contributing to low US interest rates and excess liquidity, caused US investors to seek new outlets in order to achieve higher returns. In the past few years, equity markets were not as attractive as in the past due to the aftermath of scandals, new regulations, and the unwinding of the technology stock bubble. Instead, investors looked to property. In a growing economy with low interest rates, it is reasonable to expect that home prices would rise. And indeed they rose. Yet something more happened. As home prices rose, people started to expect prices to rise still further. They started to pay prices unrelated to the expected return from renting out the homes, and, instead paid amounts based on their expectation that prices would rise further. A speculative bubble took hold. It is a bubble because, like a soap bubble, it cannot last forever. This particular bubble was no aberration. There have been many property price bubbles in the past, all ending in tears. In this case, the rise in short-term interest rates in the period 2004-06 augured the end of the bubble. The US Federal Reserve, wary of rising inflation expectations, increased rates in order to cool the economy and avert inflation. For the property market, this turned out to be a problem. In 2005-06, mortgage lenders dramatically increased their origination of sub-prime mortgages — those offered to consumers with low incomes and poor credit histories. Banks sold these mortgages to other institutions that repackaged them into securities that were then sold to investors, who were enticed by the high potential return on such securities. Consumers were often enticed to take on such mortgages with low, teaser rates for the first few months, after which the mortgage would revert to a market interest rate. While rates were low and home prices were rising, this was not a problem. Yet when interest rates rose and home prices stalled, holders of sub-prime mortgages started to default in large numbers. In the past, when homeowners ran into trouble, the banks that originated their mortgages wound up in trouble. Indeed as recently as 1980 only 10% of US mortgages were securitized compared to 56% in 2006. Today, many of those sub-prime mortgages have been re-packaged, securitized, and sold to the secondary market where they have quickly disappeared — only to reappear in unexpected places when trouble developed. And that is how the credit crunch began. Setting the stage In the past decade, there has been a massive flow of funds from China to the US. Why? One of the main reasons is that China and other Asian nations save a larger share of their output than they invest, while the US invests more than it saves. The result is that Asia, principally China, sends it excess savings to the US. For many years this has been a win-win situation for both countries. Chinese funding of America’s external deficit has enabled the US to cheaply import Chinese exports. This, in turn, has kept millions of Chinese workers employed producing exportable goods. For the US, importing China’s savings has enabled the country to enjoy a high level of borrowing without high borrowing costs. This is partly because China’s government has directly funded the US external deficit through currency intervention. That is, in order to hold down the value of the Chinese currency and keep exports cheap, the Chinese government has purchased dollars and held them in the form of US Treasury securities. This intervention, along with similar intervention by other countries with large surpluses, has funded a large share of the US external deficit. The result is that China’s government has amassed a huge stock of foreign currency reserves — now in excess of $1.4 trillion. For the US government, being able to fund budget deficits by selling bonds to a foreign government has held down long-term interest rates. But there is no such thing as a free lunch. The US now has a very large external deficit that may not be sustainable in the long-term. Undoing that imbalance could ultimately be painful. China, in the course of purchasing dollars by printing its own money, has caused a rapid expansion of its money supply with resulting increases in inflation. Indeed the inflation rate has risen from less than zero four years ago to more than 6% today. Credit crunch In the era before the Great Depression of the 1930s, economic downturns were usually called “panics.” Why? The reason is that economic downturns usually resulted from sudden changes in financial market sentiment. People literally panicked when something went wrong such as a failure by a borrower to meet its obligations. The result was that people withdrew money from banks, banks failed to lend, and real economic activity declined. G40 STORES / January 2008 www.deloitte.com/consumerbusiness http://www.deloitte.com/consumerbusiness
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