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The main risk to the world economy is a deflationary spiral in asset prices The tremors in financial markets have gone far beyond their beginnings in the US subprime mortgage sector, and indeed far beyond the borders of the US. The full impact on the markets, and the repercussions on the global economy, remains unclear, but we can sketch out three broad scenarios:

• Scenario 1. The Economist Intelligence Unit’s central forecast, to which we attach a probability of 60%, sees the impact being contained by timely monetary policy action, with only a modest effect on the global economy.

• Scenario 2. Our main risk scenario, with a 30% probability, envisages the US falling into recession, with substantial fallout in the rest of the world.

• Scenario 3. Should the US enter recession, another, darker scenario arises: that corrective action fails, and severe economic repercussions cascade from the US into the world economy with devastating effect. We attach only a 10% probability to this outcome, but the potential impact is so severe that it warrants careful consideration.

Since scenario 1 informs our regular output and scenario 3 has a low probability, the bulk of this report focuses on scenario 2.

Subprime failures, liquidity shortages and deleveraging
Broadly speaking, there are three main routes through which market turmoil could have its impact. The first is the direct effect on holders of subprimerelated assets. The second is the liquidity crunch that is occurring in response to uncertainty over who holds the dubious assets and the extent of their exposure.

The third is the repricing of risky assets in response to the subprime crisis, and, as a corollary, the reduction of leverage in the global financial system. The three mechanisms carry different levels of threat. The US subprime crisis will have a direct impact on all those holding subprime-linked assets, including those subprime mortgage lenders who are still in business. This is a relatively small asset class, so losses should be contained. The Federal Reserve (US central bank) estimates the total losses at US$50bn-100bn, compared with total debt in the US non-financial sector of US$29.3trn at the end of March 2007. Although the Federal Reserve’s estimate may be too low and mortgage-related losses may widen beyond the subprime sector, total losses should be manageable.

The liquidity issue is more worrying. Because it is difficult for lenders to assess other financial institutions’ exposure to subprime losses, their willingness to lend even to each other has been curtailed. As a consequence, the supply of funds in money markets has been squeezed, restricting the supply of short-term financing for financial institutions and threatening a systemic liquidity crisis.

However, modern central banks have an impressive arsenal against such a crisis, and the biggest have been quick to act, providing massive cash injections to the money markets. The Federal Reserve has also cut its discount rate (the rate at which it lends to banks if they need emergency cash).

Deleveraging is the most serious risk of all
The third issue is the most serious of all- a repricing of risky assets and deleveraging by investors. As investors and financial institutions reappraise the risks associated with different assets, prices of all sorts of instruments (equities, corporate and government bonds, commodities and even works of art) will adjust to new (generally lower) levels. For any given level of risk, financing will be more expensive and will be rationed. Private equity’s heyday has passed.

Acquisition targets will be smaller and the leverage applied to deals less extreme. Assets under management by hedge funds will fall. Casualties of the recent turmoil will close. Survivors will find it harder to attract fresh capital as pension funds and other mainstream investors rethink the wisdom of their allocations into alternative assets. Banks, still the centre of the financial universe notwithstanding the growth of derivatives, will have to deleverage in order to offset liabilities which they are forced to bring onto their balance sheets. This downward pressure on asset prices and paying off of debt have the potential to crimp the broad global economy, extending far beyond the original subprime area.

Subprime losses, a drying-up of liquidity, and a generalised repricing of risk and deleveraging will be concerns under all three of our forecast scenarios. The difference between the three economic outlooks hinges on the severity of their effects. Subprime losses will be significant under all scenarios, even our central forecast that serious economic fallout is avoided. Liquidity concerns will vary between the scenarios, depending on the speed with which market participants identify which institutions are nursing big losses and the ability of central banks to keep the money markets operating. But it is in the issue of deleveraging where the main differences between the three risk scenarios lie. In our central forecast (scenario 1) it occurs in a gradual, orderly fashion. In our main risk scenario (scenario 2) recession in the US leads to wider payment difficulties with mortgages and to corporate bankruptcies. This leads to a more aggressive rationing of credit on the part of banks, with adverse feedback effects into the real economy.

Our worst-case scenario (scenario 3) encompasses a systemic financial crisis, including bank failures, declining asset prices and widespread insolvency problems.
Monetary policy will play a key roll in determining which scenario comes to pass. Many want central banks to cut interest rates aggressively, and quickly. But, although the authorities have learnt their lessons from the great depression (when the Federal Reserve kept monetary policy tight), they face difficult policy choices.

They do not want to encourage moral hazard by being seen to bail out investors and speculators who have made risky bets. Memories are still fresh of 1998 when interest rate cuts in response to the failure of a hedge fund, Long Term Capital Management, contributed to the stockmarket bubble of the late 1990s.

But if liquidity injections are insufficient to restore money markets to normal, or deleveraging starts to occur at a rapid pace, the crisis will cease to be a purely financial one and will start to have clear economic consequences. In such circumstances, central banks will feel that they have little alternative other than to cut their policy rates.

There are questions about how effective cuts in policy rates will be in improving financing conditions if - as is likely there is a general tightening of lending standards following the excesses of the past few years. In our central forecast, we assume that monetary easing does work and helps the US to avoid recession. But it is easy to see how a worse outcome could occur.

In trying to identify which of our three scenarios will come to pass, it is interesting to consider how the world economy came to be in this situation.

The subprime problem is symptomatic of a broader cycle of an increase in indebtedness, associated with asset price appreciation and a mispricing of risk.

Recent years have seen a sharp decline in the volatility of asset prices, luring many investors towards riskier assets. The associated price gains have made these assets appear even more attractive, as have the poor returns available on low-risk instruments such as the government bonds of the main industrialized countries. Seeing what looked like a one-way bet, many investors borrowed heavily to invest.

Consequently, equities, real estate, emerging markets, commodities, even works of art and, of course, subprime mortgages, all appreciated dramatically in value. The recent market disruption has led to a substantial decline in prices for some risky assets, and the potential for further losses is high. Under our central forecast, measures including effective intervention by central banks will mitigate these problems, allowing markets to rebalance in an orderly fashion without undue repercussions for the wider economy.

The likely economic outcome under our main risk scenario
However, under our main risk scenario interventions would only be partly effective and the depth and duration of turmoil on the markets would be extended, with implications not just for financial markets but for the ‘real’ economy too. With investor confidence waning, a steady fall from the recent peak in risk asset prices would begin.

The damage would not be confined to the US-across the developed and emerging world, risk asset prices are already under downward pressure. To take equity markets as one example, a 20% peakto-trough fall seems plausible, given movements in recent weeks.

As risk asset prices fall further, banks - under pressure to improve their balance sheets- will force investors to liquidate even their good investments to meet margin requirements. As this process expands, more assets will be sold, triggering further price declines and margin calls. At its worst, this self-reinforcing trend could see prices chasing each other down across asset classes in a debt deflation spiral.

Housing prices in the US, in particular, have further to fall, but property valuations are also high relative to rents in other industrialised countries (see box “Housing markets: Living in a bubble”). According to the OECD, inflation adjusted house prices in major economies (excluding Japan and Germany) rose by 6.4% in 2000-05, up from 4.2% in the previous five-year period. Average growth rates had never before risen above 3.1% for any five-year interval since 1975, and this surge suggests a global housing bubble.

Japan provides a dire example of how bursting asset bubbles can play out.

Japanese stock prices rose by 200% between the end of 1985 and the end of 1989, before falling by 60% by the end of 1992, and house prices followed a similar trend. Largely because of this, Japan’s economy was essentially stagnant for the next ten years, plagued by deflation and debt. The surge in Japanese asset prices, admittedly, was faster than it has been in the US of late - there was talk of the Imperial palace in Tokyo being worth more than the entire US state of California - but the effects of falling asset prices in the US would be serious nonetheless.
A US recession would cause a cascade of damage
The US would be most directly affected by the financial downturn envisaged in our main risk scenario.

We would expect growth to slow to 0.2% in 2008, compared with a 2.3% projection in our central forecast. US households would face major losses on equity and real estate investments. US companies, which have relied heavily on consumer spending for their profits, will cut back on investment as demand falls and financial conditions tighten.

The effect on the rest of the world would come through two channels: deteriorating global financial conditions and weakening demand from the US.

Higher risk premiums would have an immediate fallout for companies. At present, corporate leverage in the non-financial sector globally is modest.

Companies have worked hard to improve balance sheets after rampant borrowing and investment during the dotcom bubble in the late 1990s. As profits have soared, companies have relied on their earnings to finance investment plans. But profits will fall under our main risk scenario, reducing opportunities for businesses to self-fund investments. Beyond that, companies in many countries still rely heavily on banks and financial markets for funding, both of which will be hit by tightening credit. More importantly, the slump in US private consumption will cause many export-oriented companies worldwide to reassess investment plans, since demand is a bigger factor in investment planning than the cost of capital.

Decoupling from the US?
The growing size and influence of European and Asian economies means that the US has less influence on global growth than it did a decade ago. Indeed, minor fluctuations in US demand do not have a noticeable effect on growth in the rest of the world. But the sharp slowdown in the US envisaged in our main risk scenario would seriously affect global growth because no other economy is large enough and dynamic enough to pick up the slack. Although the euro area has performed well of late, this followed several years of buoyant global demand that strengthened employment growth and investment in western
Europe. A withdrawal of US demand would cause Europe’s recovery to falter.

Nor is Europe, with its relatively high savings rate and concern over pension security, likely to replace the US as the “consumer of last resort.”

Neither is Japan in a position to pick up the economic mantle from the US.

Growth in Japan over the last five years averaged 1.7%, of which more than onethird came directly from exports. Consequently, a downturn in export demand from a languishing US economy will, under our risk scenario, undermine the Japanese expansion. Japan has limited room for a policy response, since short term interest rates are already at 0.5% and the country boasts the worst fiscal position of the developed world. As in the euro area, Japan’s prospects will be undermined by a sharp appreciation of the yen, which will be boosted in our main risk scenario by a massive unwinding of so-called carry trades.

During the first half of 2007, China’s contribution to global GDP growth surpassed that of the US for the first time. But if it is wrong to say that the euro area and Japan have decoupled from the US, it is even more dubious to make this claim for China and emerging Asia generally. Intra-Asian trade has surged in recent years, but this largely reflects the increasing integration of supply chains across Asia. According to the Asian Development Bank, 70% of trade within Asia (including China but excluding Japan and Taiwan) consists of intermediate goods used in manufacturing processes, and a large share of goods still ultimately end up in rich, developed countries. Consequently, the sharp US slowdown envisioned in our main risk scenario will cause real pain for many
Asian economies, although the full effect may only hit the region (and other emerging markets) with a delay. Many governments, including China’s, will also try to dampen the impact of a US downturn by intervening to keep their exchange rates relatively steady against the US dollar. But US politicians will rail against what they see as unfair currency policies, targeting China in particular and leading to a rise in trade tensions.

In our main risk scenario, Latin America will be hit harder than other emerging markets because it depends more than most on the US market, and because of still-elevated debt levels that need to be financed from abroad (despite considerable progress on this front recently). Eastern Europe will suffer from slower growth in the euro area. Several of the more highly leveraged countries, such as Turkey, will be hurt by tightening financial conditions, increasing the risk of a crisis. The Middle East and many African economies will suffer from a fall in commodity prices. Yet even in our main risk scenario, crude oil prices will still be high by historical measures, averaging US$42/barrel in 2008.
As many oil exporters have been unable to absorb surging energy receipts domestically, the impact of the deteriorating terms of trade on them will be only moderate.

The cascade of repercussions around the globe is the subject of the remainder of this report, which focuses on the implications region by region.

Source: The Economist Intelligence Unit