November 2008

October's co-ordinated central bank initiatives and the effective nationalisation of commercial banks in much of the developed world have encouraged hopes for a resolution of the global credit crisis.

October’s co-ordinated central bank initiatives and the effective nationalisation of commercial banks in much of the developed world have encouraged hopes for a resolution of the global credit crisis. The realisation that there is a limit as to what degree market forces should be left to their own devices, has been a shock for policymakers, especially in the US, but few would now disagree that state intervention was necessary to avert the complete meltdown of the world’s financial system

While the credit crisis is far from over, at least the beginning of the end may now be underway. There are encouraging signs that accommodative central bank measures, such as the provision of huge amounts of cheap liquidity in the short-term money markets, are starting to bear fruit. In an economic model that depends on the ready availability of credit, this is vital, and a return to normality in short-term lending is a prerequisite for the eventual restoration of stability in the financial system world-wide.

However, while the government and central bank action taken so far may help relieve the protracted suffering at the heart of the system, more pain may impact peripheral areas. Hedge funds, for example, have traditionally leveraged their investments, and such funding is likely to be scarce going forward. Also, certain hedge fund practices may be severely restricted, or even abolished, by expected regulatory changes, which would decrease hedge funds’ attractions as an investment form. Other potential victims include private-equity funds, which are seeing the value of their investments dwindle, a development that will probably be exacerbated by the impending economic slowdown; these entities, also known as “buyout” funds, have hitherto financed their activities via the debt markets, but will find such financing hard to come by in future as investors’ appetite for complex “financial engineering” deals has clearly diminished.

And then there is the completely unregulated market for credit default swaps (essentially insurance policies against the non-repayment of debt), most recently estimated as having a size of around $33.6 trillion; it was exposure to this business segment that contributed significantly to the demise of insurer AIG. The lack of supervision in the market means that no-one really knows with whom the ultimate liability for the outstanding contracts lies, and there are widespread fears that some of those concerned may be unable to honour their commitments without incurring financial collapse.

Just a few months ago, investors fretted about the inflationary impact of rising commodity prices. Following steep declines in these prices, especially for oil, such fears have been allayed, only to be superseded by the prospect of an economic recession whose depth and duration will be impossible to assess until the consequences of the credit crisis have filtered through to the real economy.