No meltdown, but stand by for shocks

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PEERING into the future, Stephen King, HSBC's managing director for economics, sees no clear end to the world financial crisis: "We will survive, but I don't think there's going to be a moment of clarity about how we will emerge from it."

So how will we feel this autumn? "Maybe at the end of the day, things won't be so bad," Mr King says. "But even if the policymakers take the right actions - even if there aren't big job losses - there is still going to be the feeling that things could go horribly wrong."

George Magnus, the chief economist of Warburg Dillon Read, is equally downbeat: "We're all in the dark. We don't know if there are going to be more shocks. We don't know how long this will last."

Mr Magnus offers a straw to clutch at: "Some people are saying it's the 1930s all over again. I don't think so. I think policymakers now understand what's out there. I think they have tacitly agreed that the worse it gets, the more aggressively they will stimulate the world economy."

Warburg Dillon Read forecasts an end to the downturn in late 1999 or early 2000. But, says Mr Magnus: "There are still big questions: How bad will the downturn be? What will happen between now and the end of the downturn?"

Trying to come to grips with the financial crisis and its spillover effects on the world economy, City bankers are focusing on five sub-crisis points.

The risk of a financial system meltdown. The Asian financial crisis unfolded between July 1997 and July 1998. It precipitated the collapse of the Russian economy in August. The collapse of the Russian economy spooked Western investors enough to prompt a flight to quality investments worldwide, which in turn prompted the near default of the US hedge fund Long-Term Capital Management. Now, after an inconclusive set of meetings in Washington last week, we have a further flight to capital, a looming credit crunch, and a big drop in the dollar against the yen and mark. "Old traders are telling me they haven't seen anything like this in 25 years," says Pippa Malmgren, London currency strategist at Bankers Trust Alex Brown.

The City consensus is that the volatility will work itself out with damage to more institutions, but not to the financial system itself. Roman Schmidt, head of syndication at Barclays Capital, says: "I still believe the market is a self-regulating mechanism. I believe the volatility is part of a huge process of de-leveraging. I think the volatility will gradually fade, but you need time."

Others, however are less sanguine. "Fed chairman Alan Greenspan signalled last week that central bankers round the world should stand ready to inject liquidity in case of accidents," says Mr Magnus.

Outlook: more unpleasant shocks to come. No meltdown.

Interest rate cuts. On Thursday the Bank of England cut UK base rates from 7.5 per cent to 7.25 per cent. This action followed similar rate cuts a week earlier in the US, Canada and Japan. But the cuts have made little difference to investor confidence.

The problem, as City analysts see it, is that rate cuts have lost their potency as an anti-crisis tool. "There's a credit crunch developing," says Ms Malmgren. "Banks do not want to lend." A second banker says: "If borrowers cannot obtain actual credit at any price, what difference does it make if central bankers lower the theoretical price of credit?"

A few analysts still believe a massive, coordinated rate cut by the Group of Seven industrial nations could turn market sentiment. But they wonder if continental Europe would join in.

"The European Central Bank meets on 22 December," says Mr Magnus. "It could set its first rates then. I think the setting of those rates could send out an important signal to the world."

Outlook: more rate cuts will come. But they will have little effect on market sentiment unless they are part of a broad anti-crisis package including other initiatives to raise confidence.

Brazil. Since July Brazil has lost $25bn (pounds 14.5bn) of its $70bn in dollar reserves. If this outflow continues, Brazil could go the way of Thailand, Indonesia and South Korea.

To stop the emerging market debt crisis spreading to Latin America, the G7, the Inter-national Monetary Fund, and other international agencies signalled during the Washington meetings last week that they were pulling out all stops to stabilise the Brazilian economy.

But the key to restoring stability lies with Fernando Henrique Cardoso, re-elected as Brazil's president last week. While the City agrees that Mr Cardoso has made reassuring noises about reducing government spending, it is waiting to see the fine print. "Brazil must reduce its government deficit from 7 per cent to 2 or 3 per cent," says Mohamed El-Erian, emerging markets guru at Salomon Brothers Smith Barney. "To achieve this Cardoso must do a deal with the powerful states in Brazil. It is not clear what sort of deal he can do."

Outlook: it seems the emerging market debt crisis will finally be tamed in Brazil. But there could be an unpleasant surprise.

The US stock market. The fear is that the 40 per cent of US households with a stake in Wall Street will panic and dump shares, causing a 1929- style crash. So far, investors appear to be hunkering down to see out the bear market. The Dow Jones Industrial Average thus looks set for a prolonged but orderly decline from its July peak of 9,200. US analysts predict it could bottom out anywhere between 5,000 and 7,000. The main effect is likely to be on consumer spending in the US. "There is a good chance of recession in the US in 1999," asserts Mr Magnus.

Outlook: no Wall Street crash. But a better than even chance that the once-mighty US economy will fade, leaving the world economy with no engine to pull it out of recession.

Japan. The world's second largest national economy is mired in its worst recession since the Second World War. But there are signs that the government is finally responding. Last week Tokyo announced a plan to distribute vouchers and to declare selected Mondays "Happy Days", during which offices would close and voucher-holders could go shopping.

Simultaneously, the government announced it had reached agreement with the opposition on a bank bailout plan. This may wipe as much as $700bn of bad debts off the books of Japanese banks, paving the way for a renewal of lending to Japanese corporate borrowers.

But the City remains sceptical. Japan has a long history of announcing initiatives, then not following through. "As always with Japan," says Mr King at HSBC, "the issue with the announcements is implementation."

Outlook: Japan's economy may have bottomed out. A Japanese rebound is the best news those looking for an exit to the crisis can probably hope for in the next six to 12 months.