In this issue ...

• In brief
• US/International - Lingering credit crisis poses downside risks
• Thailand - Power struggle threatens economy
• Pakistan - Economy sails close to crisis
• Guinea - Government hints at stricter fiscal terms for miners
• Zambia - President's death unlikely to spark chaos

In brief

Developments since mid-August

US/International - Lingering credit crisis poses downside risks

The remarkable turn in the US credit crisis last week has increased the risk of US recession and of the crisis 'going global', though it is premature to say that the world economy is bound for a hard landing.

Eventful week. The drama started on 'Black Monday' - 15 September. By the following Monday, 22 September, it had claimed five victims.

• Lehman Brothers/Merrill Lynch, 15 September. Wall Street investment bank Lehman Brothers files for bankruptcy, while its peer, Merrill Lynch, agrees to accept a buyout by Bank of America.
  
• AIG, 16 September. The Federal Reserve agrees to bail out insurance giant AIG with a loan of up to US$85 billion. In return the US government takes almost 80% equity in the company.
  
• Morgan Stanley/Goldman Sachs, 22 September. The only two two remaining large investment banks on Wall Street transform themselves into 'bank holding companies'. In doing so, they become subject to more regulation and supervision. This will mean a need to de-gear and de-risk. But in return they will get access to the Fed's full array of lending facilities and can accept deposits that will hopefully crisis-proof them in future.

Crisis origins. These developments represent the latest phase in a crisis that surfaced in June 2007 - the month investment bank Bear Stearns was forced to bail out two of its hedge funds heavily exposed to sub-prime mortgages. After the Fed started raising interest rates, defaults on these sub-prime mortgages - frequently taken out by over-extended borrowers - began to rise and inflated home prices to fall. Securities backed by these mortgages - often over-optimistically rated - plunged in price, obliging the institutions that held them to post large mark-to-market writedowns. A similar collapse took place in the value of credit default swaps (CDSs) providing protection against default on the mortgage-backed securities (MBSs).

Many institutions holding these MBSs and CDSs came under suspicion of insolvency and funding to them dried up. Among the first victims of this process were the so-called SIVs (structured investment vehicles) and conduits into which banks had piled their MBSs. When these entities began to face debt rollover difficulties, the banks were obliged to take them back onto their balance sheets.

Then other institutions with 'toxic' sub-prime exposures succumbed.

• Bear Stearns - forced in March to accept an emergency rescue loan from JP Morgan Chase backed by a US$29 billion guarantee from the US Treasury.
  
• Indymac - seized by regulators in July after it suffers a deposit run. Indymac's failure is the largest collapse since Continental Illinois National Bank goes bust 24 years ago - heralding the Savings & Loan (S & L) crisis in which more than 3000 banks close their doors.
  
• Fannie Mae/Freddie Mac - obliged to accept 'conservatorship' from the government in July. This entails the government injecting up to US$15 billion of fresh capital into Fannie and Freddie in exchange for a large equity share that heavily dilutes existing shareholders. Both institutions buy home mortgages from banks and bundle them into asset-backed securities which they sell on to capital markets. They then recycle the capital back to the mortgage market. Together they own or guarantee half of America's US$11 trillion-plus of home mortgages. As such, they are a vital source of liquidity to the mortgage market. Neither institution is insolvent or illiquid, or accepts sub-prime mortgages. And both continue to enjoy access to capital markets. As other lenders withdraw from the mortgage market, moreover, Fannie and Freddie step forward, to the point where they are extending nearly three quarters of new mortgages. But in July, after their share prices plunge by 50% and their borrowing costs shoot up, the Administration becomes concerned that they will curtail their purchases of mortgages from regional banks and 'thrifts', triggering insolvencies at these institutions and worsening the housing market downturn. The capital injection is designed to head off such a risk.

As a result of all these failures and rescues, the investment banking industry has now to all intents and purposes disappeared. And the so-called 'shadow financial system', consisting of SIVs, conduits, money market funds, monolines, hedge funds and the like, has become a shadow of its former self.

Extraordinary steps. This reshaping, moreover, takes place despite extraordinary efforts by the Fed to supply liquidity and boost confidence.

• Between August 2007 and March 2008, it slashes the Fed Funds rate from 5¼% to 2% - a record reduction for a nine-month period.
  
• In March it opens the 'discount window' (through which it supplies liquidity in return for collateral) to investment banks - a step not seen since the 1930s. It also begins to accept a broader range of collateral than previously and extends access to Fannie and Freddie.
  
• In December, it introduces a series of term lending facilities, allowing US banks to access longer term funding. Next step: turning up at yard sales, as one wag recently put it.

Paulson Plan. Potentially more significant than any of these moves is Treasury Secretary Henry Paulson's proposal, announced 19 September, for a US$700 billion bailout fund to take the toxic waste from distressed financial institutions. Promising an end to ad-hocery, the 'troubled asset relief program' calls for the Treasury to buy the MBSs at a price below face value, but above their present deeply depressed value. In this way, a floor is established under their prices, bringing an end to the mark-to-market writedowns and allowing instead the possibility of some writebacks. Pressure on banks' capital positions thereby lifts, allowing the credit squeeze to ease. Meanwhile, the MBSs are put into a 'bad bank' akin to the Resolution Trust Corporation that was used to buy up distressed mortgages during the 1980s S & L crisis. Assuming the Treasury doesn't overpay for the securities relative to the credit losses they ultimately suffer, it actually ends up making a profit for the US taxpayer, or at least contains its loss.

That is the theory, at any rate. The objections are basically twofold. First, the fund may be too small, so the toxic waste can't all be shifted. Instead it festers in the financial system, infecting more and more institutions. In which case, the credit squeeze intensifies, dragging the US and possibly the world economy into recession. Alternatively, the fund overpays for assets, which would be good for Wall Street, but bad for Main Street, the taxpayer and the US government's credit standing.

The plan needs Congressional approval. Democrat and Republican lawmakers alike have been critical, noting that it favours Wall Street too much and homeowners facing foreclosure too little. Congress is scheduled to recess at the end of this week, although it could extend its debate through a special session. Lawmakers won't enter their pre-election campaign recess without passing a plan, though Paulson's is unlikely to escape without modification.

Spillovers. For now, the spillover effects from Wall Street to Main Street look to be contained.

• Second-quarter annualised US GDP growth was recently revised up to 3.3% from 1.9% - a far cry from recession.
  
• Granted, the second quarter has benefited from three concurrent boosts - a weak dollar, government rebate cheques and strong international demand - all of which are now fading.
  
• And slowdown is now underway in Europe and Japan.
  
• But emerging economies, particularly the all-important 'Chindia' and 'BRICs', are still expanding briskly.
  
• All in all, the IMF foresees - in its latest forecasts released on 9 September - world economic growth slowing from about 5% in 2007 to about 3% during 2008, before rebounding to about 4% in the fourth quarter of 2009.

That is its base case. There is still a risk of negative financial and economic trends reinforcing each other in a vicious circle. For example, a jump in mortgage foreclosures could further depress housing prices, which scares consumers from shopping, while decapitalising banks and tightening credit conditions even further. If such a cycle were sufficiently vicious, a full-scale US and world recession could result.

The Paulson plan - or some version of it - could be the circuit-breaker. But at a minimum, there are likely to be more financial institution failures and rescues, more volatility in debt and equity markets, and a period of sub-trend global growth.

In other words: more gloom, if not doom.

Thailand - Power struggle threatens economy

Thailand's political crisis, now well into its third year, is escalating again, and starting to threaten tourism, FDI and credit ratings.

The latest chapter in the crisis has proceeded as follows.

• 26 August. Anti-government protesters from the People's Action for Democracy (PAD) storm the prime minister's compound in Bangkok and stage a sit-in, demanding the government's resignation. Arrest warrants are issued for nine leaders of the group on charges including treason.
  
• 1 September. Pro-government supporters mount a counter-demonstration. Fighting breaks out between the two sides, causing one death and 40 injuries.
  
• 2 September. Prime Minister Samak Sundaravej imposes a state of emergency in Bangkok, banning gatherings of more than five people and placing the city's security under military control.
  
• 9 September. The Constitutional Court disqualifies Samak from the premiership saying he has a conflict of interest because he hosted two TV cooking shows while in office. It directs him and his cabinet to stand down within 30 days. Samak's People Power Party (PPP) say they will renominate him for the premiership.
  
• 12 September. Following that renomination, a parliamentary vote is called. However, the PPP vote fractures and the house fails to gain a quorum. PAD leaders say they will keep up their protests until there is more substantial reform of the political system.
  
• 17 September. Parliament elects a new prime minister, Somchai Wongsawat.

Underlying these events is a steadfast refusal by the PAD to recognise the result of the last election and the legitimacy of the government it produced. The PAD accuses the PPP of vote-buying in its rural strongholds and of being too close to former prime minister Thaksin Shinawatra and using its power to shield him from charges of corruption. (Prime Minister Somchai is a brother-in-law of Thaksin.) Some PAD leaders advocate a largely appointed parliament rather than an elected one. For its part, the PPP says the courts and the army have taken sides against it to defend a conservative, elitist class from the demands of poor, rural Thais for a greater say in government.

Neither side seems prepared to back down or talk compromise. So it is difficult to see a quick return to normality. One disturbing development has been the preparedness of the PAD to resort to militancy. It has blockaded airports used by foreign tourists in the southern provinces, halted rail and bus services, threatened to cut utilities to government buildings, and called a general strike on 3 September.

A variety of international observers are becoming concerned.

• At least 12 countries, including Australia, have issued warnings to their citizens about civil unrest. This is potentially a hard economic knock, because tourism is a mainstay, accounting for 6% of GDP. In response, the government lifted its state of emergency on 15 September, saying it didn't want to scare away tourists.
  
• Foreign investors have so far held their nerve, but many are now expressing concern, including about the politicisation of the judiciary. Japanese carmaker Toyota, for instance, has said it is still planning to invest in a new diesel engine plant and to introduce a new hybrid petrol-electric eco-car, but is watching the political situation closely.
  
• Ratings agency Standard & Poor's said on 2 September that recent events had raised the likelihood that deep political divisions will translate into 'serious and widespread' violence. It expressed in particular discomfort with the 'precedence of extra-constitutional measures and the reliance on interventions from the monarchy'. It said an outbreak of violence could prompt it to downgrade the country's sovereign credit rating. At BBB, Thailand is investment grade, but has only two notches to fall to become speculative grade.

No rerun of the 1997 financial crisis is in prospect, because unlike then, Thailand now has much stronger economic shock absorbers - including fiscal and current account surpluses, a more flexible currency, and large foreign currency reserves. But one concern is that the country settles into a pattern where populist parties win elections, only to be challenged in the courts and streets. The resultant uncertainty and disruption could act as a significant drag on growth.

Pakistan - Economy sails close to crisis

The new government is unstable and distracted, yet has to face a host of thorny problems - notably a big terms of trade deterioration, accelerating inflation, twin budget and current account deficits, a foreign reserve drain and deteriorating domestic security.

As a net oil and food importer and textile exporter, Pakistan's terms of trade have been hammered this year as oil and food prices have soared and textile prices have softened owing to weak international demand. In addition, inflation is soaring, reaching a new high in August of 25% on a year before. Foreign exchange reserves have fallen to only two months' import cover and the Karachi Stock Exchange has lost around 40% of its value since April, while the cost of insuring against a sovereign debt default has risen sharply.

The global credit squeeze will continue to limit Pakistan's access to funds, and the world economic slowdown will put increasing strain on the current account. To stabilise the situation, the new government needs to rein in public spending and secure support from international creditors. But its task will be hindered by the deteriorating security situation and the fragility of the national coalition government.

Guinea - Government hints at stricter fiscal terms for miners

The government is pressing on with a mining contract review that may result in fiscal terms more in its favour.

Guinea's finance minister said on 8 September that his government would speed up a mining contract review, adding that most mining agreements were not necessarily in the national interest. His mining minister colleague said that the government would be seeking World Bank technical help with the review.

A 'consensus' government formed in February 2007 to end 15 months of violent strikes and street protests began a broad-ranging review of 13 contracts in April 2007, but has so far dealt in detail only with licences held by America's Hyperdynamics and Russia's RUSAL. However, President Lansana Conte dismissed this government in May, taking back full executive power despite accords reached with trade unions in February 2007. This new government is continuing the review.

Guinea is the world's largest bauxite exporter and has iron ore reserves that prompt some to call it 'the next Pilbara'. According to the IMF, foreign investors, including BHP-Billiton and Rio Tinto, plan to invest US$27 billion over 2007-15 in bauxite/alumina, iron ore, gold and diamond projects. However, the legal and regulatory regime for mining companies is uncertain. Anglo-Australian mining group Rio Tinto said on 10 September that the government had agreed to 'move forward' with its licence for the giant Simandou iron ore mine after earlier saying it would cancel the licence.

In Guinea, as in other countries, governments are increasingly looking to gain more of the windfall revenue from international commodity prices that have soared since 2003. The finance minister's statement that most existing agreements weren't necessarily in the national interest hints at a push by the government for fiscal terms more in its favour.

Zambia - President's death unlikely to spark chaos

An election scheduled for October, triggered by the death of President Levy Mwanawasa last month, is likely to be won by the government candidate because of opposition disunity.

There is a good chance of policy continuity following the election, because the opposition is fragmented and there is a first-past-the-post electoral system. Broadly speaking, the population divides evenly in its support for the ruling Movement for Multi-Party Democracy (MMD) government and opposition parties. There was some talk that the two main opposition parties, the populist Patriotic Front (PF) and another opposition party, the United Party for National Development (UPND), might field a joint candidate, probably the PF's Michael Sata, to really challenge the government candidate. But that hasn't happened: Sata plus the UPND's Hakainde Hichilema have both put themselves up for election. Commentators expect that Banda will be the candidate who will will pick up a plurality, if not majority, of votes, and that is expected to be enough to get him across the line. In that event, most expect that the government would continue its basically sound economic policy of recent years.

A ruling party victory isn't, however, assured, and if Sata, who almost won the 2006 election and is the most popular opposition candidate, wins, some observers believe that the investment climate could deteriorate. During the 2006 election, Sata reportedly criticised Chinese investors and threatened to expel them, along with Lebanese and Indian traders. In July he was also reported to have been critical of Chinese investors on America's National Public Radio, though he has recently also made more moderate statements saying that he welcomes Chinese investors in the mining industry. He has also said that he wants a review of Zambia's taxation system 'to reduce income imbalances while raising workers' purchasing power'.

Some mining investors will reportedlyseek to lobby the new president to moderate a windfall profits tax introduced in April, which they claim, with IMF support, is punitive at high copper prices. While the windfall profits tax is unlikely to prompt any existing investors to disinvest, it could discourage prospective new investors.

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