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[Indepth interview]Calm counsel amid market turmoil

So long as the dollar weakness is orderly, which is to say it declines perhaps 10 percent a year or so, exporters should be able to manage the consequences fairly well.

Oct 10,2007
Paul Donovan
The global financial market is gradually showing signs of shrugging off the shocks from the U.S. subprime mortgage crisis that started to rattle the world in mid-August. The key question on the minds of market watchers as well as the general public now is how long the credit crunch stemming from U.S. subprime mortgage woes will linger and whether the widely anticipated global economic slowdown will actually take place.
Paul Donovan, a global economist and managing director of UBS, the biggest bank by assets in Europe, shared his views in a recent e-mail interview with the JoongAng Daily.

Q. What has been the impact of the U.S. subprime mortgage crisis in different regions ― in Asia and Europe, in particular?
A. The direct impact of the subprime loans has been relatively limited. However, as these loans and other instruments have been packaged into derivative structures, their credit-worthiness has been called into question. This has led to a crisis of confidence in the global money markets, in which banks have become unwilling to lend to one another.
All of these effects can be considered global in scope, and it would be wrong to attribute them to any specific region or country.
Clearly, Asian economies have less direct exposure to these instruments, but that does not mean the Asian markets are immune to the consequences. A hedge fund that is forced to close because of a subprime-related position would have to sell its entire portfolio of assets, potentially including assets from Asian markets.
Do you see a chance that the U.S. economy will be headed for a soft landing?
It is worth remembering that recessions are an artificial concept ― there is no “proper” economic definition. A recession, as defined by the U.S. National Bureau of Economic Research, has a 25 percent to 40 percent probability [of happening] in the next two years, in our (UBS) view. This would be caused by further weakness in the consumer sector and a higher savings rate.
However, even if we avoid a recession, as defined by the NBER, it is quite likely that a majority of Americans will be living in an economy that “feels like” a recession. This will not show up in the overall economic data as a recession, because lower-income people have less impact on economic statistics than do high-income people, because low-income groups spend less.

What will happen if the U.S. housing market slump continues? Will the financial crisis it could provoke be bigger than the difficulties brought about by the subprime mortgage squeeze?
We believe the U.S. housing sector will be in recession this year and will indeed experience a 10 percent drop in house prices over the course of this year. This is an important driver of the weakening consumer market in America.
Falling house prices will reduce the amount of money withdrawn in active mortgage refinancing. Last year, the amount peaked at the equivalent of 5.5 percent of annual disposable income ― clearly an important support for consumption. The loss of this source of secured borrowing will reduce American consumption in specific areas; automobiles, home improvements and durable consumer goods are especially vulnerable. This slowdown is already underway and we believe it will continue in the second half of this year.
The drop in house prices is therefore more significant than the problems of subprime loans per se, though both are closely intertwined.
Subprime issues mainly affect low-income Americans, who have limited spending power. The fall in house prices and its impact on mortgage refinancing affects middle-income Americans, whose importance to the economy is considerably greater.

Can the yen carry trade unravel abruptly despite a key interest rate freeze by the U.S. Fed and the Bank of Japan?
There is absolutely no way of reliably calculating the amount of the carry trade, or its impact on financial markets. We believe that the carry trade impact in financial markets has been exaggerated.
The role of retail investors from Japan, investing in other markets versus their own, seems to us to be a far better explanation of the movements of the yen than any supposed carry trade.

Regarding currencies, do you see the U.S. dollar weakness persisting?
America is running a current account deficit that requires the country to borrow nearly $1.5 million every minute of every day, including weekends. The rest of the world has been increasingly unwilling to lend America so much money, or spend that much on U.S. assets day after day. In order to persuade international investors to lend it money, America has had to cheapen its assets by weakening the value of its currency. Hence, the persistence of the current account deficit gives a structural bias to dollar weakness.
Because exporters try to preserve market share in the United States, the weak dollar does not lead to exporters raising prices. Instead they keep their export prices stable and seek to cut other costs, or alternatively, accept lower profit margins.
So long as the dollar weakness is orderly, which is to say it declines perhaps 10 percent a year or so, exporters should be able to manage the consequences relatively well.
Cost discipline, efficiency, productivity growth, and careful management should allow exporters to continue to sell to the United States even in a weak-dollar environment.

China has been posting galloping economic growth ahead of the 2008 Beijing Olympics. Can this rapid growth be sustained?
In terms of China’s growth, we believe that there will be some moderation in economic activity in 2008, but not by significant degree. It is also possible that the official figures will continue to record stronger growth than private-sector estimates. Looking ahead to the medium term, it is inevitable that there will be some moderation from the current high levels of growth.
Trend growth is simply calculated as a combination of population growth and productivity growth. Population increases are slowing in China and the productivity growth is unlikely to accelerate.
China will have to come to terms with issues of pollution and the potential constraint on growth posed by water shortages.


By Seo Ji-eun Staff Writer [spring@joongang.co.kr]


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