Worrying cracks

Breaking Views

As recently as last Wednesday, the early August market panic looked to be winding down. Equities were again flirting with record highs. More than two-thirds of the risk aversion had been reversed, according to a SocGen index. The commercial paper market was still almost frozen, but a rescue was on the way, in the form of a US-government supported $US75bn super-SIV.

But then the news turned bad. The super-SIV looked increasingly like a super-sieve: full of holes. Oil reached $US90 a barrel, too high for comfort. Caterpillar and Wachovia both predicted bad US business conditions would continue. The G7 finance ministers offered nothing stronger than hand-wringing on currencies and markets.

So by Monday, both world stock markets and the dollar were dropping. The recently banished talk of a US recession had returned. There were a few signs of risk-taking – most notably plans for an expensive, equity financed bid for UK brewer Scottish & Newcastle – but overall, fear was again in the ascendant.

How long will it take for markets to regain their poise? That depends on whether the challenges are primarily financial or economic.

If finance is the issue, a resolution should come soon. After all, the asset-backed commercial paper market, the source of the sudden market illiquidity, is only a $US100bn problem – a little local difficulty in the $US50 trillion global economy. Once the banks set some lower prices and take their losses, the world's steady growth should once again keep markets reasonably strong.

But maybe the subprime crisis is a sign of a something more serious. After all, the US housing boom was part of a great global imbalance – US over-consumption matched with the willingness of US trade creditors to buy low-yielding dollar-denominated debt. The crack in the credit markets could have been caused by a tectonic shift in that relationship. If so, more financial earthquakes are almost inevitable.