Jaimini Bhagwati: Double dip recession ahead?

About 10 million US residential mortgages are underwater. This may lead to defaults
Jaimini Bhagwati / New Delhi January 15, 2010, 2:06 IST

January 2010 is the first month of the year and of the decade, and there is a thriving
market in making economic projections. It is evident that there has been a seismic shift in
the global economy’s tectonic plates. The gradual reordering of national economic
rankings over the last two decades came sharply into focus with the financial sector
meltdown at the end of 2008.

Looking ahead, it is reasonably safe to predict that for the next several years, GDP
growth rates in India, China and Brazil would be higher than those in the US, EU and
Japan. Table-I provides projected GDP growth rates for these countries. The accuracy of
these projections could be contested and would vary, depending on the underlying
assumptions. On balance, these numbers reflect a consensus that India, China and Brazil
are expected to grow faster than the other countries listed in the table.

TABLE-I Projected GDP growth rates (%)

2010 2011 2012 2013 2014
India 7.1 7.8 n/a n/a n/a
China 9.3 8.3 n/a n/a n/a
Brazil 4.8 4.5 n/a n/a n/a
US 2.5 1.4 2.0 2.2 2.3
EU 27 0.7 1.3 1.7 1.9 2.0
Japan 1.4 1.0 n/a n/a n/a
n/a - Not available; EU 27 - All European Union member countries
Source: January 2010 Country Reports of Economist Intelligence Unit

The comparatively high growth numbers for India should not make us complacent since
the prospects over the next 12 months are far from certain. This article discusses the
possibility of a downturn in the US stemming once again from defaults in the real estate
sector, and the resulting implications for India.

Currently, one in five or about 10 million US residential mortgages are underwater by 20

per cent or more. That is, the market value of the house or apartment is at least 20 per
cent below that of the supporting debt (Source: Equifax). Empirically, this has been the
single most important factor which motivates homeowners to walk away from their
mortgages. Assuming that on average each home corresponding to the 10 million
mortgages is worth $100,000, owners could default on about $1 trillion of debt. Defaults
of this order of magnitude do not include potential defaults on $770 billion of commercial
real estate mortgages which are underwater (Source: Foresight Analytics).
At the same time, indications are that US consumer spending is not likely to surge soon.
For instance, the number of bank credit cards has come down from a peak of 425 million
in mid-2008 to 335 million in November 2009, and credit card lines are shrinking. As
regards securitisation markets, the combined issuance of Residential Mortgage Based
Securities (RMBS), Asset Backed Securities (backed by assets such as loans, leases and
royalties but not real estate), Commercial Mortgage Backed Securities (CMBS) and
Collateralised Debt Obligations (CDOs) reached a peak of $2 trillion in 2006. In 2009,
the total issuance of these four categories of securities was less than $200 billion. Further,
commercial and industrial loan outstandings have contracted by about 15 per cent in the
last one year. As banks and individuals continue to reduce their debt levels, it is unlikely
that consumer-driven demand can replace government spending, which may be difficult
to sustain at current levels. It follows that if real estate prices were to erode any more,
there is risk of a sharp downturn in the US economy.

Additionally, the crisis of 2008 has not been adequately utilised to make the required
improvements in regulatory and compensation norms. Consequently, bankers may rely on
short public memory and continue to depend on the Greenspan “put”. The difference is
that if there is a financial sector blowout in the second half of 2010, there would be
limitations to which taxpayer-funded support could be provided. Table-II details the
volumes of central bank and government aid for banks till June 2009 in the US and the
Euro area and November 2009 in the UK.

TABLE-II Funding support for banks

$ Trillions US UK Euro area
Central Bank
“Money creation” 3.76 0.32 0.98
Collateral swaps 0.20 0.30 0.00
Government
Guarantees 2.08 0.64 >1.68
Insurance 3.74 0.33 0.00
Capital 0.70 0.12 0.31
Total $ trillion 10.48 1.71 2.97
(% of GDP) (73%) (73%) (18%)
Source: "Banking on the State" P Alessandri & AG Haldane, Bank of England, November
2009

These were extremely generous lifelines for which taxpayers should have received long
maturity call options on bank equity with strike prices at the bottom-end of stock
valuations during the crisis of late 2008. This unrequited generosity has been fed by
accommodating monetary policy with historically low interest rates in the US, UK and
Japan. The resulting liquidity has funded a bounce-back in stock markets around the
world. For example, the S&P 500 stock index is now trading at 22 times trailing earnings,
which is well above S&P’s 135-year average for trailing P/E (price to earnings) of 15.
There are also indications that the Chinese housing market is overheating.
Consequently, the risks for India in the next one year are: (a) sharp reduction in OECD
demand which could again impact Indian exports negatively; and (b) shortage of export
and other credit. If this were to happen, Central and state government finances would be
adversely affected, which could further reduce our collective appetite for reforms. In
anticipation, we could take the following steps: (a) keep mopping up forex inflows and
tie up optional contracts for longer-term forex credit; (b) better align oil and gas pricing
to international prices; (c) push for an agreement on GST implementation timelines in the
first half of 2010 when states would be less apprehensive about their finances. Oil prices
may not pose a risk as a fall in global demand could lead to softening of oil prices.
However, if tensions rise in the Persian Gulf, oil prices could increase even as demand
drops in developed economies.

To sum up, it is increasingly likely that in the last quarter of 2010, there may be another
round of convulsions in western economies. The consequent opportunity costs for India
of not having insurance mechanisms in place and pushing for reforms could be higher
than usual. We are on a trajectory to reach 9 per cent GDP growth and if we slip back to
5-6 per cent, the economic and social costs resulting from reduced means to fund
employment generation could be very high.

j.bhagwati@gmail.com

The author is India’s Ambassador to the European Union, Belgium and Luxembourg.