Don't ignore the global warnings

Global sharemarkets have been on a roller- coaster ride lately. It looks like the period of cheap liquidity, large risk appetites and softening lending standards has finally come to an end.

Lenders in the United States had advanced large loans to people who could not really afford them. Default rates have risen sharply and the purchasers of that subprime mortgage debt have seen the value of their assets take a hit. Some hedge funds have gone into liquidation as result, and the cost of credit has risen sharply. There are reports that rising funding costs have led to the cancellation of international financing deals worth more than US$60 billion (NZ$78 billion) since early July. A senior US banker called the situation the worst financial market atmosphere in 22 years.

The credit market turbulence has spilled over into sharemarkets, which quickly retreated from their lofty highs that seemed to reflect the expectation that the easy money party would go on for ever.

Views on where global markets will be headed are mixed. The pessimists expect a continuing downward spiral, but they are a minority at this stage. Optimism is still dominant. When sharemarkets stabilise for a day or two, the optimists see that as evidence that things are under control. Markets have simply eased back to levels seen earlier this year. What is the big deal? The big deal is that nobody really knows how bad the underlying problem is.

How high will the US mortgage default rate go and how much additional downward pressure will that put on the already ailing housing market over there? What will it do to consumer confidence and spending in general? Will the rising cost of credit cause trouble for businesses that have relied on favourable lending terms for their survival?

Statements by politicians and central bankers are of little help in trying to assess the real dimension of the problem. To avoid stoking the fire, they have to sound confident that this is just a localised issue and that it won't spread. US Treasury boss Henry Paulson and Federal Reserve chairman Ben Bernanke have made statements to that effect.

Ten years ago we got similar responses when there was a front of denial about the extent of the Asian crisis and the contagion risk till it was too late.

Recent upward revisions to international growth forecasts prepared by the International Monetary Fund and by private sector economists have been cited as evidence that the world economy will continue to steam along despite financial market jitters. How much value one should place on those forecasts is not clear. The usual lags of publication suggest that they were already out of date when they hit the newswires. This may again prove that economists are very bad at spotting turning points.

Long before the US mortgage crisis developed its momentum, former US central bank chairman Alan Greenspan put the chance of a US recession later this year as one in three. He may have lifted the risk a bit in the light of recent events and some emerging expectation that the Federal Reserve will be less willing to bail the economy out by cutting interest rates than would have been the case under his chairmanship.

The optimists would argue that a US recession won't upset the global apple cart too much, since most other economies are doing well. However, it is difficult to imagine world growth continuing to chug along nicely while the largest economy is suffering from a serious downturn. So far, global market jitters seem to have had little effect on confidence in New Zealand, but that could change quickly if evidence mounts that the US economy is in worse shape than expected.

A global slowdown would hurt export volumes and commodity prices, but a falling New Zealand dollar would provide some offset. A weaker exchange rate would result from the withdrawal of speculative funds and a likely cut in interest rates by the Reserve Bank intended to provide a safety net for the domestic economy.

It is doubtful, however, that emergency rate cuts would have that effect, considering that 85 per cent of mortgages are now on fixed rates and that the average time to refixing is about 20 months. Most existing borrowers would not get much relief for quite a while.

It is also unlikely that lower interest rates would entice much new borrowing and thereby stimulate activity. According to an international study, our housing market is among the most vulnerable in the world, because of inflated prices and high household debt levels. A housing market shake-out on top of increased uncertainty about general economic conditions would cause most households to consolidate.

With recent business confidence indicators pointing to growth of only 1 per cent to 2 per cent over the next year, it is easy to see how a global shock could derail this "soft landing" of the economy.

While this may sound overly gloomy, the risk of such a shock has increased markedly over the last few months. Unfortunately, the relentless rise in household debt suggests that the warning signals are largely being ignored.