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US Regional Watch

061273d4-5479-4544-a2a7-adea41493e87

14

4

1st Quarter 2009

Tue, Mar 24 2009, 08:47 GMT
by BBVA Bancomer Team

BBVA Bancomer

In this issue you'll find:

• Widespread Responses to the Global Crisis
  
• Government Actions and Economic Outlook in the U.S.
  
• BBVA Compass Sunbelt: Solid Conditions for Recovery
  
• Forecasting GDP with BBVA Compass State Monthly Activity Indexes
  
• State Finances: Wrestling with the Recession
  
• The Impact of the Fiscal Stimulus in our Footprint
  
• Real Estate: Positive Signs in a Dire Market
  
• Mortgage Finance: Experience Abroad
  
• Auto Industry Demand Drivers
  
• Health Care Challenges II
  
• Fact Sheet
  
• Forecasts
  

Widespread Responses to the Global Crisis

Uncertainties still weigh on the global fi nancial system as their transmission to the real economy accelerates

The evolution of the fi nancial markets over the last few months has been characterized by the bankruptcy of Lehman Brothers in September 2008 and its impact on global risk aversion, the shut-down of funding markets, and ultimately, the solvency problems of many fi nancial institutions. Under such a framework, risk and liquidity premiums spiked leaving the governments of the world’s developed economies no other choice but to intervene in the markets. Such intervention contains common elements, for example, increased deposit guarantees or asset acquisition programs implemented to avoid asset fi re sales which could lead to massive banking losses. Yet such measures have had little success and governments have decided to inject capital into ailing fi nancial institutions and to guarantee their bond issuances. These programs have been implemented in an attempt to restore trust in the market and to promote the re-opening of the medium-term funding markets.

At the same time, central banks either had to introduce new measures targeted to ease fi nancial market tensions or expand those already in place. For instance, the Federal Reserve expanded the amount it lends through its liquidity facilities and created a new facility aimed at re-activating the commercial paper funding sector. The European Central Bank decided to carry out long-term refi nancing operations through a fi xed rate tender procedure with full allotment, as well as expand the list of assets eligible as collateral. Finally, the monetary authorities of the leading developed economies and some emerging markets (such as Brazil, Mexico, Korea and Singapore) extended their foreign exchange swap arrangement programs in order to improve access to funding in U.S. dollars.

The success of these attempts has been mixed. Important advances have been achieved on the liquidity front. The increase in lending by central banks to fi nancial institutions has allowed for a sharp reduction of liquidity spreads in interbank markets. For example, the spread between 3 month Libor rates and the expectation of overnight rates for the corresponding maturity has decreased from above 360 basis points after the bankruptcy of Lehman Brothers to less than 100 in February 2009. However, this level is still much higher than those observed during the fi rst half of 2008 (around 50-60 bp). In regard to medium-term funding, guarantee programs for bank debt have allowed some recovery in issuance by fi nancial institutions, but still at a very high cost and at volumes which do not compensate for the drought in securitization markets. These programs have been met with less success in regard to the stabilization of fi nancial institutions, requiring government injection of signifi cant amounts of capital in fi nancial institutions using a variety of instruments.

In any event, the current fi nancial turbulence has already lasted for 18 months. Moreover, this negative outlook has translated to the real economy as the level of global credit has been clearly affected by the fi nancial crisis.

In this regard, the economic recession has hit hard and fast. The economies in the U.S., Europe and Japan have witnessed a strong cyclical deterioration that has translated into growth rates in the fourth quarter of 2008 of -1.6%, -1.5%, and -3.3% respectively (not annualized), confi rming the severity of the crisis and the extreme synchronization of the downturn. As for emerging markets, economic growth has also slowed over the last quarter of 2008, affecting all geographical areas from Asia to Latin America. Overall, as global demand plummets, the effect of the fi nancial crisis on the real economy has been stronger in those countries whose growth had previously been supported by their export sector.

Weak global demand has pushed commodity prices down helping to ease the infl ationary pressures that have been restraining some central banks from cutting interest rates. In fact, headline infl ation in Europe will fall below the 1% level while in the U.S. it will enter the negative range. This risk of defl ation required prompt action by central banks in developed countries, leading them to quickly initiate an easing of monetary policy. As for emerging markets, an easing monetary policy cycle has also been initiated, and will continue as long as developments in the foreign exchange market allow it. In any case, given the severity of the crisis we face and allowing for some defl ationary risks, central banks will have no other choice but to keep interest rates low for a protracted period of time. But as this happens, monetary policy will lose part of its effectiveness making room for fi scal policies to play a central role.

How to implement such a fi scal program will then be a key issue in providing proper stimulus to the economy and breaking the vicious circle between fi nancial and real variables. In the U.S., a centerpiece of President Obama’s domestic agenda to fi ght the recession is a $787 billion economic stimulus plan. As for Europe, national governments have launched their own initiatives on the fi scal arena, but generally they are smaller than the U.S. effort. In addition, the European Union policymaking process, which has been characterized by its lack of coordination, may also be a dead weight in the recovery process. Some emerging countries are also implementing their own fi scal stimulus plans aimed at escaping recession. Case in point, the Chinese stimulus plan is projected to reach more than 12% of GDP for the next two years.

Overall, the current recession and the low infl ation environment will be key determinants for the yield curve. Long-term interest rates will remain low throughout 2009 in spite of the increase in debt issuance that will be needed to fi nance the fi scal plans. For 2010, interest rates should start to increase but they will still remain at levels considered to be historically low.

Looking to the exchange rate market, weaker European growth, when compared to the U.S., will lead to further dollar appreciation. In particular, capital fl ows and interest rate differentials support the view that international investors still prefer America as a fi nancial haven for safe and liquid assets.

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Published on  Tue, Mar 24 2009, 08:58 GMT