The big bailout and its implications

The biggest bailout of the financial markets in the US is in progress and it is important to know the reasons for why this has become necessary and the implications of this on the US dollar.

Outcome of a successful bailout

The world economy in the past few years has been characterized by huge financial imbalances that have been complementary. Over the last 4 yrs the developing countries in the world have run a current account surplus of 2.5 trillion dollars. In the year of 2008 alone this figure has been over 800 billion dollars. These surpluses have helped finance the US current account deficit over the last few years. This has helped maintain a low interest rate regime and create the housing bubble which set the stage for the recent financial crisis. Over the last few months the dollar has been weak (10% fall against Euro, 15% fall against the Australian dollar etc)because the stability of the financial markets (in terms of conservatorship of Fannie Mae, Freddie Mac and AIG, collapse of Bear Stearns and Lehman brothers, sale of Merrill Lynch), cut the interest rates from 5.5% to 2% (during the great depression, raising the interest rates from 1.5 to 3.5% to maintain a strong dollar has been attributed to making things worse), injection of 400 billion dollars in liquidity and the prevention of total collapse of the housing market have been taken on by the Federal reserve and policy initiatives not seen in the US since the 1930’s. The possibility of a total collapse of the American financial system looked possible around 9 months ago and could lead to the new great depression. The banking losses could have been so large as to overwhelm the financial system. There has been a write off of 520 billion of bad loans during this period, half in the US and the other half in Europe. Total equity of the banking system in the US is 1.3 trillion dollars. The IMF estimates that there will be a further 500 billion of losses in the next 6-9 months.

Now the focus shifts from monetary policy by Federal Reserve to the intervention by treasury with the 700 billion dollar rescue package (unlike the RTC measure during the S&L crisis where over a 1000 thrift institutions went bust and was bought by the government for nearly 400 billion paying lowest price for assets to be later sold for 200 billion causing the tax payer to bear the rest). This will be used to buy the assets (estimated at 500-600 billion by the IMF) from the banks at a value between marked-to-market rates (rates that the banks value assets as per accounting rules) and hold-to-maturity rates in a way that isn’t too negative for the banks (by keeping purchase rates low) in terms of having to raise more capital and also not putting the tax payers at risk (by keeping purchase rates high). This could stabilize the US economy by middle of next year and prompt a rally in financial stocks and reduce risk of bankruptcies. If the rescue package does not come through then it could result in 300-400 bank failures, further fall of bank stocks and prolong the credit crunch by reducing the ability to make loans. In case the price offered for the assets are close to the marked-to-market rates, there is the possibility of banks not wanting to sell them at low valuations and this causing more failures and needing further capital infusion in time (as was the case in Japan in the 90’s). So 700 billion dollars may not be big enough to buy all the illiquid assets (1.5 trillion dollars worth at hold-to-maturity value) at a rate that will satisfy the institutions holding them unless there is a move from transparency to prudence i.e. by changing accounting rules.

So if things go well, the package could be positive for the economy and positive for the dollar. The deficit would however go to over a trillion dollars next year but the hope is that the imbalances would fund this as China would possibly intervene to keep their currency low by purchasing more of US treasury bills (200-300 billion). Saudi Arabia needs US military support and this would help fund the deficit as well. So this will keep the dollar in a trading range and help in a recovery by end of 2009.

Other considerations

The bailout has already deteriorated the US government’s balance sheet. This however does not signal an imminent weak dollar as with the experience shown in Japan where a similar episode in 91-92 still resulted in a stronger yen in 93. The purchase of dollar denominated assets has been slowing down from the beginning of the credit crisis in Aug 2007 but this is likely to pick up after the bailout.

There are 2 forces at play here. One is the inflationary pressures that would arise if the US government was to monetize the losses and as a result print more money and the other is the deflationary pressures (probability higher than the inflationary scenario) due to the non-existence of the investment banks and thus bringing down of leverage in the system (conversion of trillion dollar investment banks like Morgan Stanley and Goldman Sachs to bring down leverage from 40 times to around 12 times) which would somewhat prevent the move from US dollar to real assets in some cases (especially in cases where there is a peg against the dollar as in the case of Hong Kong and the middle east where there is limited scope for monetary policy) thereby adding to strength in the dollar but would also tend to be dollar negative in case inflationary pressures tends to rear its head first before deflationary pressures set it.
The dollar however has fallen from being 70% of the world’s reserve currency to 63% and this is likely to trend downwards. There is also a case for movement from fixed currency regime (USD) to bi-polar reserves (USD and Euro) or even multi-polar reserves (Asian currencies in addition to USD and Euro). This is because the US currently has a low interest rate regime and the countries pegged to the USD have high inflation. By moving to a bi-polar currency regime, there can a mix of Euro (which is more inflation control driven) and the USD (which is market driven) this giving a good balance when looking at pegged currency.

The dollar will remain volatile in the short run regardless of whether the bailout passes. The key drawbacks in the bailout could be the inability in clearly defining the class of the assets (high grade debt sliced and packaged with debt of poor quality) and in determining which institutions should be getting funds from the bailout (risk for smaller institutions being ignored for helping bigger ones and the complex interlinking between the institutions). By the time the bailout is implemented there is bound to be many failures albeit of smaller banks and thus tending to reduce the demand for US assets.

There are 2 primary reasons for countries holding US based assets. One for purposes of liquidity and the other for purposes of investment. The liquidity factor still is dollar positive as there is flight from risk (as indicated by the increase in custody under the New York Fed) but the investment factor is dollar negative due to the ongoing credit crisis and causing the dollar to be volatile. The bailout package would serve to allay fears of a meltdown but not yet build confidence. There is interplay of confidence crisis, liquidity crisis and solvency crisis. There is some way to go before all the three are under control.

The other point to consider is the cost of the bailout. Today the US government intervention will save Wall Street. But what happens when Uncle Sam needs help. The current cost includes 700 billion dollars in the bailout, 200 billion in liquidity already provided for Freddie and Fannie bailout, 85 billion for AIG rescue. This amounts to over a trillion dollars added to the deficit (8% of GDP needing 4.5 to 5 billion each day to fund itself) and the question arises as to whether the Chinese and the Saudis will want to continue to fund. This is because today foreign countries hold about 1.5 trillion in US treasury and about a trillion in US agency paper (which is mostly gone now after the bank failures). Would the foreign countries be able to soak up the additional 1.8 trillion deficits in addition to the 2.5 trillion currently held in treasury bills and agency paper? The answer is most likely a “no”. The alternative would then be for the US government to print money and monetize the losses. This would be inflationary for the entire world. So with the issuance of bond or with the printing of new money it looks like a down trend for the dollar in the next 18-24 months.

In the near future the tendency would be move money to relatively risk free assets and there is no easy replacement for US treasuries. Gold is generally considered a good hedge against inflation but not at times of massive de-leveraging as is the case now. In case of a dollar weakens in the coming months, it would cause the commodity prices to rise again after factoring in reduced demand from a slowing world economy and thus causing imported inflation.
Another consequence of the bailout could be higher government bond yields (over 5% for 3.8% currently) to keep the 4.5 to 5 billion USD inflows needed everyday in the assumption that the assets bought with the bailout can be sold for a profit in the coming years to be able to return to a current account surplus. The consumer spending decline the coming quarters would add to the higher household savings rate from 0 to about 2% thus shoring up the current account. The non-oil current account deficit has shrunk by 1% of GDP and what has kept it high has been the oil price increases.

In terms of world GDP, the US has a fourth, European Union almost another fourth and the rest of it is mostly with Asia and Japan. However it is only the US fixed income markets that allow almost half of the investable surpluses to be put into. Even if people wanted to move into yen or Euro denominated assets, the choices are thus limited and this making dollar a currency of choice in the near term. A weak dollar is not in any countries favor as it would hamper growth.

Conclusion

In spite of the bailout being dollar negative, there isn’t clear alternative to the dollar in the short run and long term viability of dollar denominated assets as a legal tender would be determined by how soon the alternatives emerge. The Renminbi could serve as the reserve currency of choice taking into the consideration the vast size of Chinese economy in future but that would need measures like convertibility and a developed fixed income market.

The bailout itself only address the aspect of taking bad debt off the bank's balance sheet but as to whether it will help re-capitalize the banks is yet to be seen. Moreover it does nothing to address the problem of reducing household debt and thus can leading to much more foreclosures in the coming months. In short the bailout may prevent an immediate meltdown but does not solve the problem wholistically.

Note : This blog is based on discussions from the world economic forum.