The new era banking order that has to come: Arno Lawrenz

Arno Lawrenz, the Chief Investment Officer of Atlantic Asset Management, a specialist Fixed Income asset management house which currently manages R2.4bn in various fixed income mandates. He writes that it would seem as if the Central Banks around the world have been so suitably frightened by the latest Halloween movie - Nightmare on Wall Street - that they have opted to dish out the treats in a big way!

Bailout package has followed bailout package in country after country. Then, to add layers to the cake, the World Bank, IMF et al have also stepped up to the (empty) plate to help those who can't afford to help themselves. So now that the realisation has set in that the party really is over and that the music really has stopped playing, the hard reality is that someone, somewhere has to foot the bill, and perhaps more pertinently, can that someone actually afford it?

To answer that, we need to look back at the nature of the party itself. The western favoured model of consumption-driven growth, characterised of course by the massive rise in the ratio of debt to disposable income and sustained by ultra low interest rates, has finally reached its zenith. For, while consumption (demand) was leveraged up through debt-financing and made sustainable in that the servicing of that debt was both easy and encouraged due to the low interest rates and lax regulation, the basic laws of economics still held. This meant that supply constraints would inevitably result in rising prices. This was the pattern we observed in the rising inflation trends during the course of 2006 and through to the first part of 2008.

Whilst today we see Central Banks scrambling to cut rates as aggressively as they can, it was barely 4 months ago that many of them were hiking rates to counter the inflation trends. The dominoes started to fall when the providers of finance for the debt-financed consumption overextended themselves to the same (and in many cases to a larger) degree than the consumers themselves. So you ended up with overleveraged consumers and overleveraged banks (not to mention the overleveraged hidden banking system in the hedge funds!) Space restricts an analysis of how this collapsing domino effect started, but suffice to say that once started, it has triggered the start of a new Era and we have witnessed the end of an old Era.

When financial markets stabilise, as they ultimately will, it will NOT be to herald a return to "Business as Usual." This is what it means to be in a new Era! The deleveraging process that will characterise the first phase of this new era implies a truly massive reconstruction of balance sheets on an individual, corporate, banking and national scale. The bailout packages, liquidity facilities and sustained rate cuts seen so far are all intended to help in the recapitalisation of banks' balance sheets, for without a strong and functioning bank system, any economic growth is doomed.

So Central Banks, faced with a moral hazard argument, have had no choice but to open their doors and try to start a new party. Who will foot the bill and pay for these treats? Ultimately it will be the taxpayers, being corporate and consumers themselves. How ironic that those who will foot the bill are themselves going to be in a process of attempting to rebuild balance sheets through saving and investment. This squeeze will almost certainly result in a lowering of economic growth rates that will be sustained for some time.

Here's another angle though - in the same way that banks, hedge funds, consumers have been able to use a low cost of capital to leverage growth and returns, on a national scale, countries themselves were also able to do the same. In particular, the manufacturing-oriented, export driven Emerging Markets who had ridden on the back of the Consumption Era boom will be vulnerable to the reverse effect as the deleveraging process starts to bite. Much of the capital investment into Emerging Markets to build supply capacity will now end up as dead capital. An overhang of supply capacity will cause many infrastructural spending programs in some EM's to be cut back. The result? Lower economic growth. Several countries who were skating on thin ice as far as their mode of economic growth and means of finance were concerned have already suffered - Iceland, Hungary, Argentina, Pakistan to name a few in a growing list.

Three trends are likely to emerge in this new era :