Thursday, December 10, 2009

Where Will Financial Crisis Hit Next?

1997. Asian Financial Crisis.

What started from Thailand soon spread like a contagion to Indonesia, South Korea, Philippines, Hong Kong, Malaysia, and Singapore, rattling these economies for years.

2008. US Subprime Crisis.

What started off as an aftermath of the housing boom, got a shot in its arm with the collapse of Lehman Brothers, and most of the world is yet to recover from it.

2009. Dubai Crisis.

First the world reacted sharply. Then all of us arrived at the consensus that we overreacted. But in Dubai itself, nobody is sure anymore how the drama will unfold in the coming days. Still, the consensus is that it will be a Middle East problem at the most, and maybe affecting some parts of India like Kerala, maybe Philippines and Pakistan too.

Dubai wanted to build the tallest building, the largest airport, and the biggest shopping mall. For a while – a short while – it seemed as though the geographically tiny emirate would also stake its claim for the biggest national bust in recent years.

No way. US is not willing to share that credit with anyone any soon. Dubai’s debt is $60 billion, Lehman’s was $600 billion.

Dubai is too tiny a crisis. Or is it? Even if it is, is it masking any lessons?

One thing is common behind these three crises. Sorry, two things. Real estate and the dollar.

Thailand was doing a Dubai in real estate when disaster struck. And the economic epidemic spread to those Asian nations that were following a massive leveraged real estate development program.

And needless to mention that the 2008-09 world economic crisis had its roots in US realty.

And needless to mention that Dubai’s problem is a real estate problem more than anything else. The tiny emirate - if it restarts all the current real estate projects - will double the office space from what it is now, which is but sadly 40% unoccupied now. Dubai was that confident of real estate.

Now the dollar connection. Most of the affected Asian nations in the 1997 crisis as well as Dubai have their local currencies pegged to the US dollar. In other words, these currencies’ exchange rates can’t be directly influenced by the markets on a day-to-day basis like the Indian Rupee or the Dollar itself, but remains static at a conversion rate fixed by these Governments.

In fact, the pegging to the US dollar has brought down other economies too even without an associated realty boom, the best examples being the Mexican economic crisis of the 1990s and the Argentine crisis that spanned from mid 90s to 2005.

But it is when both real estate boom and dollar pegging is simultaneously there that a real crisis of astronomical proportions can result. (As an aside, this is how Abu Dhabi still remains strong.) Dollar pegging makes the interest rates fixed by US Federal Reserve as the default interest rate of nations like Thailand and Dubai. For a while this is good, as the money supply or liquidity grows steadily.

For example in the case of Dubai, money supply grew at an annual rate of 30% between 2005 to 2008. But this has the inevitable result of fuelling inflation and negative interest rates, subsequently.

Now, if at the same time a nation decides to develop its real estate exponentially, it is a no-brainer that people will have all incentive to invest in real estate and forego bank deposits. Who can resist a market that is going up unbelievably? Many Dubai real estate prices had nearly doubled between 2005 and 2008.

Now the only relevant question is whether there are any other markets where both these conditions exist. Eerily, there is one – China.

Though the country’s currency is only partially pegged to the US Dollar since 2005, by all practical measures it still remains deeply connected. The Chinese had unofficially strengthened this pegging post Lehman as a last ditch effort to save its economy from collapse as it battles a real estate splurge that would shame even Dubai on the demand-supply mismatch.

If China fails, it has the potential to take the world with it. And for India, it poses the additional burden of a military provocation.

Of course, even without a Chinese failure, and even without rupee being pegged to the dollar, India needs to tread cautiously as it ‘suffers’ from excess liquidity driven by foreign investments that has overheated the capital markets already much ahead of the real economy warming up.

And not at all comforting is a third attribute that Dubai and China share – non-democratic decision making. The Asian economies and the US were capable of a comeback largely on their administrations’ democratic accountability. Without it in place…

Better not think about it.

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