As the sub-prime phenomenon works its way through the world's financial systems, its potential impact on a relatively comfortable global macro-economic situation is raising concerns. It will take a few quarters for any impact to become visible in the consumption and GDP growth numbers; until then, the debate is largely dependent on historical precedents and deductive reasoning. Views have been expressed across the spectrum, from "no impact at all" to "global recession". As in most such situations, the extremes are relatively low-probability outcomes; to the extent that there is a mainstream view, it would probably accept that some damage will be done to economic performance, particularly in the US, but hardly to the point of signalling doomsday for the rest of the world economy. In India, the evidence of a slowdown has been mounting but is yet to hit the GDP numbers. That may happen in a quarter or two. | |
| The main channel through which the crisis in sub-prime housing loans will impact the economy is the "wealth effect" on consumer spending. As property prices fall, the equity that millions of American households have built up over the course of the real estate boom will naturally erode. By making them feel less wealthy than before (and quite a bit of the consumption growth of recent times has been fuelled by taking additional mortgages on houses as their prices went up), this will induce them to consume less. More significantly, negative equity is a trigger for households to default on their home loans. If prices were to fall far enough, widespread defaults may spread to more creditworthy segments of borrowers, enlarging the sub-prime problem into a prime one, which has huge implications for financial markets around the world. From the consumer spending viewpoint, the US is a huge importer of goods and services from both Europe and Asia, so a US slowdown will inevitably spill over into other countries. From the financial perspective, widespread default on US home loans can lead to a drying up of liquidity for many assets and severe constraints on the availability of funds for business and investment. |
| |
| However, it is not yet obvious that the price dynamics seen in the sub-prime housing market have transmitted to higher price segments. Prices appear to be moderating, not falling sharply. While there will be a lot of pain as home loan foreclosures increase (the August total in the US will be more than twice the level in June), as things stand today there is a reasonable likelihood of the defaults being contained before matters get out of hand. Further, notwithstanding the debate on appropriate central bank responses to financial crises, the fact remains that most banks are in a position to lower interest rates and infuse liquidity into markets, thus limiting the downside risk. |
| |
| As far as Asia is concerned, even a significant slowdown in the US economy may not translate into a sharp deceleration in exports; as US consumers attempt to economise on their purchases, cheaper imports from China and other Asian exports may become more attractive. Meanwhile, as far as the immediate financial turbulence is concerned, the Asian countries are sitting pretty on huge foreign exchange reserves, which, so far, have provided them adequate protection. Also, all these economies, as a result of increasing affluence, have become less dependent on exports to the US and Europe and are able to rely more on domestic and regional demand. Asia, while not immune from a US recession, appears to be relatively well insulated. In fact, that may well be one enduring lesson from this episode; while globalisation facilitates the transmission of any crisis, it also simultaneously increases the ability to mitigate it. |
| |
