Stores 2008 Global Powers of Retailing - (Page 41) 2008 global powers of retailing Starting in the autumn of 2007, the world found itself in the midst of a panic of sorts emanating from problems in the US sub-prime mortgage market. The good news is that, unlike in the past, there are clever and powerful central banks that have the capacity to add liquidity to the financial system. Still, even when they inject liquidity, they cannot erase losses nor can they erase risk. Thus, there can still be consequences from financial failure. Such consequences are being experienced today and will probably persist for a while. In the past, problems in the credit market were reflected in the solvency of banks. In the last two decades, however, securitization was supposed to reduce the likelihood of problems in financial markets by dispersing risk. But dispersing risk did not reduce it. Instead, a new kind of risk has been created, since no one knows for sure where risky assets reside. This lack of information, or lack of transparency, is creating uncertainty that has contributed to the seizing up of credit markets. Moreover, much of the risk turns out to reside with banks, often through vehicles that are off the balance sheet. The difference now is that we don’t know where that risk resides until trouble emerges. Several aspects of the financial environment contributed to this crisis. First, mortgage originators lacked an incentive to undertake careful due diligence. Second, they had a strong incentive to lend to risky borrowers as investors, seeking high returns, were eager to purchase securities backed by sub-prime mortgages. Third, securitization has taken on new dimensions with the development of exotic derivative financial instruments for which there is not a substantial liquid market. The lack of liquidity meant that, when trouble emerged, these assets could not easily be dumped. Nor could they be easily priced. At the very least, the crisis will probably have a negative impact on US and, to a lesser extent, European growth during 2008. While numerous scenarios can be suggested, the most likely is for either a moderate slowdown or mild recession in the US, moderate slowdown in Europe, and not much impact in Asia. Some countries that depend heavily on exports to the US, particularly those in Latin America, will suffer accordingly. What are some alternative scenarios? The possibility exists that the crisis could become larger or more prolonged due to economic contagion. That is, asset markets unrelated to the market for mortgage backed securities could suffer a loss of liquidity as credit markets seize up and as investors shun risk and seek safety. There is a long history of such contagion — although not all contagions have led to economic slowdowns. Contagion is not necessarily a result of rational assessment of risk, but it happens nonetheless and can have serious consequences. Another possibility is that the crisis will be prolonged by a failure to restore transparency, liquidity, and credibility to financial markets. This happened in Japan following the bursting of its financial bubble in 1990. The Japanese central bank failed to provide adequate liquidity and the Japanese government failed to adequately assist banks in cleaning up their balance sheets. The result was an unusually long period of stagnant growth and deflation. This scenario seems unlikely given the quick early responses by various central banks to the current crisis. The possibility remains that the current turmoil will have only minimal impact on the global economy. There is historical precedence for this. Recall the US equity market crash in 1987. The US Federal Reserve immediately pumped liquidity into the system and the economy probably grew faster than would otherwise have been the case. Now, following the credit crunch that began in August 2007, the Fed has reversed course by increasing liquidity and lowering interest rates — something that might not otherwise have happened so soon. The end result could actually be no change in growth with only the financial sector taking a hit. What happens next? As of this writing (November 2007), the high degree of uncertainty about the length and depth of the credit crunch makes it difficult to offer a short-term forecast. Instead, this publication will focus on the medium term outlook. The important question is how global growth will be affected by the turmoil in financial markets. First, since the turmoil began, there has been a substantial re-pricing of risk. This is probably a good thing as markets had likely become sanguine about risk. Still, you can have too much of a good thing, and that is the case now. Spreads on asset backed securities have widened and the markets for commercial paper, high yield bonds, and inter-bank lending have been dramatically squeezed. Major banks have written off sizable losses thereby adding to a constriction of credit. While the asset market that started this crisis was located in the US, the impact has been trans-Atlantic. This is in part because the assets in question were sold into a global market, mostly into Europe, where losses experienced by banks have adversely affected credit conditions in the region. Dollar movement Meanwhile, as of this writing, the value of the US dollar continues to fall. From 2002 until late 2007, the dollar fell 38% against the euro, 30% against the British pound, and 39% against the Canadian dollar. However on a trade-weighted basis, the dollar fell only 24% during this period. Why the difference? The answer is that many emerging countries with which the US trades have intervened in currency markets to keep their currencies from appreciating. Most notable, of course, is China. Yet China has been gradually revaluing its currency for the past two years and may accelerate that process. www.deloitte.com/consumerbusiness STORES / January 2008 G41 http://www.deloitte.com/consumerbusiness
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