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The long road ahead

Mon, Sep 29 2008, 08:48 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

US lawmakers have reached agreement on a rescue package, and I expect it will be approved by Congress within the next few days although the debate will remain heated. The skeptical reaction of Asian equity markets so far today perfectly captures the situation, in my view: the rescue package pulls us back from the brink and over time it will help restore confidence and normal functioning in financial markets. But the normalization process will be prolonged and difficult, and will have to unfold against the background of a global slowdown which is already underway. Over the weekend we got confirmation that serious financial troubles have spread outside of the US: Belgium, the Netherlands and Luxembourg agreed on a joint EUR11.2bn rescue package for Fortis, and in the UK Bradford and Bingley is heading towards nationalization or purchase by another bank. The extreme dislocations in European money markets are both a symptom and a source of serious stress in the financial sector, exacerbated by the rapidly deteriorating growth environment. If the reaction of European and US equity markets turns out to be equally lukewarm, it will quickly bring back the question of whether interest rate cuts by major central banks will follow. My answer here remains the same: the ECB will have to cut, but will try to resist the pressure until inflation drops at least below 3% (Q1 next year, in our forecasts); the Fed will similarly hold out to see the first impact of the TARP. In the meanwhile, tangible evidence that financial troubles are not limited to the US will offer support to the USD.

Lawmakers have finally reached agreement on a plan to rescue the financial sector; draft legislation has already been circulated, and the House and Senate should debate and approve the bill within the next few days. It has been an exhausting week-long process of soulsearching and political brinkmanship, and the agreement reached captures elements of pragmatism, survival instinct, soul-searching, and reluctance to the idea that the average taxpayer should pay the price of the excesses of the financial sector.

The pragmatism comes into preserving the basic thrust of Paulsons original plan: the government will take impaired, illiquid assets off the balance sheets of banks to help restore confidence and transparency on the banking system, and hopefully facilitate the recapitalization process and the resumption of lending to the real economy. An additional feature would allow the Treasury to offer guarantees on some mortgage-backed securities already issued, something that should also help shore up confidence and encourage trading in the securities.

The plan will include a provision to recoup any losses to the taxpayer after five years at that point, if necessary, the government should propose measures to ensure that the TARP does not add to either the budget deficit or the public debt stock.

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Published on  Mon, Sep 29 2008, 08:51 GMT