The U.S. financial system could go under without swift action from the global community.
By Andy Xie, board member of Rosetta Stone Advisors Limited
Banning short selling, establishing a government entity for warehousing bad assets, and guaranteeing money market funds have brought relief to financial markets. But this may be temporary. The U.S. still needs to find money to pay the losses from disposing of bad assets, decreasing leverage in the real economy and financial sector, and finding a non-debt-driven method to make the economy grow. The road ahead will be long and hard. The global community may have to work together for a solution.
Market pressure has forced the U.S. government to adopt the barrage of new measures. The origin of the crisis is excessive leverage, especially at Wall Street brokerages. Short sellers have learned to bring them down. They short their shares to create a panic that sends their trading counterparts fleeing. The resulting loss of liquidity bleeds the highly leveraged brokers to death. Obviously, banning short selling allows them to live longer. Ironically, Wall Street created the short sellers or hedge fund industry after the hi-tech bubble burst to juice up its businesses. Like a modern day Oedipus tragedy, they have come home to slay their parents and take their homes.
However, technical changes don't alter the fundamentals. Businesses that live solely on increasing leverage are no longer viable. Deleveraging is inevitable, which could lead to a gut-wrenching recession. Every sector in America is overleveraged. Where can they find the money to recapitalise the economy?
The solution to America's crisis must involve the countries that own US$ 10 trillion in foreign exchange reserves. The U.S. economy is undercapitalised. An internal solution is usually one form of debt replaced with another. The current proposals fall into this category. When the shell game runs out of options, printing money is the only way out. That will eventually lead to the U.S. dollar collapsing and hyperinflation in the U.S. economy.
The world should come together to prevent such a tragic ending. Countries with big foreign exchange reserves like China, Japan, Kuwait, Saudi Arabia and the United Arab Emirates, for example, should sit down with the U.S. government to find a way to recapitalise its economy. They should swap their U.S. dollar assets in debt instruments like treasuries for equity assets like stocks.
The world has a vested interest in ensuring an orderly resolution to the U.S. crisis. If America prints money to solve its problems, it will lead to the destruction of other nations' wealth in U.S. dollar assets and a global depression of unimaginable proportions. Rising leverage in the U.S. has driven the demand growth in the global economy in the past decade. The high foreign-exchange reserves of its trading partners and the excessive leverage of the U.S. economy are two sides of the same coin. It seems that both sides need to participate in a solution.
The U.S. needs to change its policy towards foreign investments. Its xenophobia about investments from non-western nations is a major barrier.
The magnitude of the debt-equity swap needed is massive. The U.S.'s non-financial sector debt rose to 226 percent of gross domestic product (GDP) last year, up from 183 percent of GDP 10 years before. The financial sector debt surged to 114 percent of GDP, from 64 percent during the same period. The real economy may need 40 percent of GDP in extra equity, or US$ 5.5 trillion, equivalent to one-third of America's stock market capitalisation. Foreign capital should be sought for at least half the amount needed.
The capital requirement for the financial sector depends on how much it deleverages. The required deleveraging is probably between US$ 5 trillion and US$ 8 trillion. A significant portion of that is bad assets. As the total losses could be similar to the total amount of capital in the U.S. financial system before the crisis began, it may be necessary to let foreigners become majority owners of its big financial institutions. During the past year, U.S. financial institutions have sold minority stakes to sovereign wealth funds around the world. With no control over these institutions, other nations are of course resentful of the terrible losses they have suffered. In future fund-raising, U.S. financial institutions may have to sell controlling stakes to foreigners.
While the above proposal is a win-win for the world, the odds of it being implemented are quite low. The U.S. still has an unrealistic view of itself. Its domestic politics are too insular and xenophobic. Even though the U.S. is the largest debtor in the world, it behaves like the largest creditor. Americans may need much more hardship to change their attitude.
The next step seems to be to shift private-sector debt to the public sector. The proposed government body to take over bad assets provides such an instrument. In theory, it unwinds by selling bad assets along the way. But who would the buyers be, and who would be responsible for the losses? Everyone in the U.S. has too much debt already. Only foreigners can provide the equity capital required for the final debt-equity swap. However, the unwillingness to accept capital from non-western countries may push the U.S. to print money. The Federal Reserve can purchase whatever papers the federal government issues to cover the losses in the bad-asset disposal. That will lead to high inflation. When foreigners dump their U.S. dollar assets, the dollar will crash, and the U.S. may experience hyperinflation and economic chaos.
To protect themselves against such a scenario, foreign governments should switch their treasury holdings into stocks. These preserve their value better during inflationary times. U.S. stocks are valued fairly. They may decline in the coming months, but they are better value than treasuries now. Central banks should put wealth preservation ahead of all else.
Ironically, if foreigners switch from treasuries to stocks, it will ease the equity-capital shortage in the U.S. economy and discourage the Fed from printing money by pushing up treasury yields. Perhaps foreigners can save America.
First published in Southern Morning Post on September 23, 2008.
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