World faces prospect of financial tumult
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World faces prospect of financial tumult

ECONOMY TALK

Today, I was supposed to present the third article, Managing Household Debt, in the series "Changing Thailand". In fact, I have finished drafting a payment reduction model which could reduce monthly debt payments by 4.6 times without the hair-cutting debt principal or requiring government financial support. But I will delay that article for now.

Unexpectedly, a big issue of a possible global financial meltdown has arisen following the collapse of financial institutions in the US and Europe. Some fear it could be a repeat of the collapse of Lehman Brothers in 2008, which led to a sharp contraction of the world economy in 2009. Without concerted efforts by major central banks pumping trillions of US dollars, known as quantitative easing, into local economies, the world economy might slip into a deep recession.

The world is no less panicky today with bankrupted Silicon Valley Bank (SVB) in the US and collapsed Credit Suisse (CS) in Switzerland.

The clear indicator is a sharp decline in oil prices despite strong efforts from US Fed and the Swiss National Bank to calm the situation. Just two days prior to the fall of SVB, the WTI crude price was over US$80 (2,750 baht) per barrel, heading towards $100 per barrel owing to rising demand from China. After the SVB was shut down, WTI price lost $5 per barrel. It lost almost another $10 per barrel to $65.8 per barrel when Saudi National Bank declined to inject more capital into the ailing CS.

The critical question, obviously, is whether the situation is now better or worse than those in 2008? Pessimists point out that this time it must be worse because bank failures are happening on both sides of the Atlantic while the subprime mortgage crisis limited itself to the US.

Also, the combined size of SVB and CS is $750 billion, which is larger than the size of Lehman Brothers of $620 billion. Most importantly, the contagion effect of Lehman Brothers' failure was contained by the Fed, which bought up $600 billion of mortgage-backed securities through a quantitative easing programme.

The Fed is most unlikely to do so in 2023 as it is conducting an opposite monetary policy of quantitative tightening to reduce inflationary pressure. Thus, the contagion effect will spread like wildfire. According to the Social Science Research Network, 186 US banks are vulnerable to a rapid liquidity drain like the SVB.

Are readers scared now? I am not, which is not normal to my nature, as I am siding with optimists this time. I have good reasons for that. One has to understand that there are only two causes of bank failure -- inadequate capital and inadequate liquidity. Inadequate capital arises from bad loans or bad investments.

Inadequate liquidity arises from rapid withdrawals of deposits. CS and Lehman Brothers belong to the inadequate capital category, while SVB belongs to the inadequate liquidity category. Let me explain the issues.

SVB, a bank located in a cash-rich, high-tech business area of Silicon Valley, had more deposits than it needed. It had approximately $200 billion in deposits. By the way, I am using round numbers. It used that money to issue $70 billion in loans and invest the rest, $130 billion, in bonds.

No prudent bank should ever do that as such a practice exposes the bank to interest rate risk. But greed overruled good practice at SVB. A year ago, SVB took in a deposit with an interest rate of 0.12% and invested it in US government bonds at 2.14% (10-year maturity) and at 2.6% (20-year maturity).

This simple process created an annual profit of $2.6 billion for the bank. Even at today's deposit rate of 0.98%, SVB would still be making money on its investment if it was not for the massive withdrawals from depositors.

With rising interest rates and rumours that SVB made big losses from bond investments, clients abruptly withdrew a massive amount of money from the bank. To provide cash to clients, SVB was forced to sell its bond investments at today's rates of 3.4-3.8%, resulting in an 11-22% principal loss. End of story for SVB.

The death of Lehman Brothers (LB) was caused by inadequate capital. LB invested about $85 billion in subprime mortgages, which, as its name indicated, are loans issued to those with high credit risk. LB was not dumb. They were fully aware of the credit risks, but at that time, home prices rose more than 10% per year.

After repossession, it was unlikely that lenders/investors would suffer any losses. But that was not forever true. By September 2008, home prices dropped 10.7% from their peak in 2006, causing LB to make an 85% loss on subprime investments, which was four times larger than its capital fund. End of story for LB.

But it is not the end of the story for the US economy. The total amount of subprime loans was $600 billion, not just the $85 billion at LB. Another 465 US banks went bankrupt along with LB. This massive financial loss caused havoc to the US and world economy. Even the Thai economy shrank 0.7% in 2009 despite being a long way from the US.

Credit Suisse had devastating bad asset problems like LB. As of the end of 2022, it was a well-capitalised company with roughly $550 billion in assets and $45 billion in capital funds. It made a loss of $3 billion in 2022 but received a generous capital injection of $4 billion from the Saudi National Bank. The biggest loss was a $4.7 billion loss on an investment in US hedge fund Archegos.

However, CS is probably hiding many more losses as they required more capital in 2023 which Saudi National Bank declined to provide. CS was on the brink of bankruptcy like LB because of inadequate capital. To prevent a possible contagion effect, the Union Bank of Switzerland (UBS), by persuasion and with support from the Swiss central bank, has agreed to take over CS.

To cut a long story short, CS's bad assets are probably much higher than the capital, which $45 billion can cover. To close the takeover deal, the Swiss central bank has agreed to guarantee further losses of $9.8 billion to UBS. If the quality of CS assets does not deteriorate further than the loss guarantee, the situation will be contained, and there should be no contagion effect. The world financial system will be safe for now.

I use the word "for now" because next year, substantial amounts of loans in China are likely to go into default. By September 2022, credit to the non-financial sector was 295.9% of the GDP in China. This non-financial sector debt-to-GDP ratio is far higher than the G20 average of 239%. With a slowing world economy and possible global recession, China is facing tremendous financial risk. Sometime next year, this risk could turn into a nightmare.

Readers, you have about one year to manage your finances before facing a real global financial meltdown in mid-2024. It is time to make all the necessary adjustments to your portfolio.

Chartchai Parasuk

Freelance economist

Chartchai Parasuk, PhD, is a freelance economist.

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