Global Financial Crisis and Impact on Malaysia

Dr Michael Lim Mah Hui

August 5, 2008 Seminar on Global Economic Trends
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Triple Witches Brew

Trouble in the : U.S. and U.K. Housing Markets Financial Markets Commodities Markets

U.S. Housing Market

$20 trillion industry in a $13 trillion GDP. Household wealth $45 trillion; MBS $6.5 trillion. Housing mortgages $10 trillion; Subprime mortgages $2.5 trillion (25%). Median house price rose 40%(2000-06) to $234,400. Ratio of median house price to median household income rose from 3x (1970-2000) to 5x (2006).
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Figure 1

Property Prices

Source: Richard Duncan, Finance Asia, Sept. 2007

Figure 2

Housing Price-to-Rent Ratio

21 Price-to-Rent Ratio 19

17

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13 1976 1980 1984 1988 1992 1996 2000 2004

Source: D. Papadimitrius et. al. Strategic Analysis, Jan. 2006. Levy Economics, Institute of Bard College

Figure 3

Ratio of Median House Price to Median Household Income

5 4 3 2 1 0 1965 1970 1975 1980 1985 1990 1995 2000 2005

Median house price is 5 times median household income

Source: International Herald Tribune, Sept. 20, 1997 6

U.S.Housing Bubble Bursts

House prices started declining in early 2006. Have fallen 20%. Expect another 10% fall before reaching bottom. Every 10% fall shaves off $2 tr. from household wealth. U.S. growth 70% powered by consumption. Consumers have negative savings rate. Home equity - a rich source of cash & credit for U.S. consumers. If no mortgage equity withdrawal in 2005, real GDP growth would be 0.2% instead of 3.5% (Calculated Risk Research).

U.K. Housing Bubble Bursting

Equally, if not more, overheated as U.S. market. 19962007 prices tripled. 2008 average median house price $370,000 - 6x average salary vs. 3x in 2003. U.K. consumer debt -166% of gross disposable income vs. 127% in U.S. 40% of house sale agreements collapsed due to inability to get mortgage or back-out from sale. Prices fallen 10% and could fall another 20% - 30%

Source: Halifax at MarketOracle.co.uk

Financial Innovations & Financial Crisis

Securitization of loans introduced in 1980s (ABSasset back securities)- package loans into securities for sale. Originate and Distribute (O&D) model allowed banks to transfer risks to other investors; increased volume of loans to the system. Subprime - housing loans to weak credit borrowers using teasers like introductory ARMs, low down/zero down payment, loose documentation. $1.5 trillion subprimes booked in 2004, 2005, 2006 when housing sector peaked and declined
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CDO Market
Collateralized Debt Obligations - higher level of complication and leverage. CDO consists of package of ABS (asset backed securities) arranged in different tranches with different credit ratings, returns, and payment priority. Investors choose which tranche to invest according to risk appetite. Often funding mismatch; cross-selling CDOs CDO of CDS; CDO squared; CDO cube.
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Typical CDO
SUBPRIME MORTGAGES

80%

AAA Tranche

15% 5%

Mezzanine Tranche Subordinated Tranche

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Figure 5

Growth in CDO Issuance/Milestones

400

300 $ BILLIONS

200

100

0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: Presentation on Subprime to ADB by Credit Mortgage Group of TCW Inc., Sept. 2007 13

Crisis Spreads to CDO, SIV, LBOs, Monolines, Credit Cards, Auto loans etc.

When lower tranche gets hit, holders of upper tranches panic and head for exit, causing prices to fall. Investors no longer want to fund CDOs. SIVs (structured investment vehicles). SPVs to short fund high yielding assets like CDOs, MBS. Investors panic, no longer want to fund CDOs, SIVs. Led to freeze in commercial paper market. Credit default swaps market ($60 trillion). 7 top monolines guarantee $4 trillion CDS. Monolines downgraded. Fannie Mae and Ginnie Mae - guarantee $5 trillion of mortgages - also downgraded.
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Model of Financial Instability

Minsky - 3 types of financing. Hedging - cashflow exceeds principal. Principal and interest (P+I) paid. Speculative - cashflow meets I, not P. Ponzi - cashflow does not meet even I. Payment from further borrowing and price increase Mixture determines level of financial instability. Financial innovation push to Ponzi financing. Reduced margin of safety.
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Consequences of financial crisis

Weak financial sector and depleted capital Generalized credit crunch and higher interest rates affecting consumers, house owners, corporations Economic slowdown in U.S. - delayed by exports rising and fiscal pump priming, but unlikely to be averted Continuing uncertainty of financial markets reflected in extreme volatility Inflation + stagnation => stagflation
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Inflation - Number 1 concern now

Some inflation numbers : Rate in May/June 08 vs. (2007) U.S. - 5.2% (2.7%) worst in 17 years China - 7.7% (4.8%) India - 7.8% (4.4%) Europe - 3.7% (2.0%) Malaysia - 7.7% as of June 08, (2.0%) Vietnam - 25.2% (8.3%) Singapore - 7.5% worst in 26 years
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Commodities Market Inflation

Inflation - demand led and supply constraints Era of disinflation over as Chinas role as supplier of cheap labor and goods decline and begins to be major consumer. In China,1988-2005, share of GDP going to labor fell from 53% to 41%. Pressure for wage increase will increase cost of exports and fuel inflation Chinas GDP growth over 10% yearly. Between 2000-2007, GDP tripled from $1.2 tr to $3.3 tr
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Inflation
Geo-political instability in Middle East adds to concerns over supply of commodities particularly of oil. Oil price doubled in less than 12 months, rose 5x from 2003. Prices of agricultural commodities also shot up as demand for bio-fuel competes for use of agricultural products. Rice prices tripled btw Jan and May 2008. Role of financial speculation in commodities also contributory factor
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Whats worse than inflation ?

Stagflation
With the credit crunch and slow down of consumer spending, U.S. economy will suffer stagflation = recession + inflation. Despite significant interest rate cuts and fiscal stimulus, U.S. economy looks set to slide into recession. Credit crunch aggravated by reluctance of banks to lend due to repricing of risk premium, increase in lending rate, shrinkage of capital.
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Stagflation
Policymakers caught between rock and hard place - struggling to raise interest rates and to tighten credit to control inflation. Same measures suppress investment and consumption contributing to slow growth GDP growth in Asia (ex Japan) projected to be about 5% in 2008.
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Impact on Asia and Malaysia

Two theories
U.S. slowdown will pull down rest of the world; Decoupling of rest of world from U.S.

Impact on financial markets Impact on trade Impact on capital flows

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Impact on financial markets

Global equities market more tightly linked. Fall in Asian equities markets even more severe than in the U.S. Equity markets decline: U.S. - 20% Japan - 34% China - 50% Singapore - 30% India - 45% Malaysia - 27%
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Financial Markets
Reasons : withdrawal of foreign equity funds from Asia to cover losses in U.S. China and India markets over-heated Bond markets - emerging market bond yield risen. Banking system still relatively strong and stable. Except for some Japanese and Chinese banks, few banks exposed to subprime assets. Corporate leverage ratio improved dramatically since 1997 crisis. Average debt:equity <50%.
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National Balance Sheet

Asian economies strong national balance sheet :
large current account surplus huge foreign reserves many governments budget surplus or slight deficit (except for Japan) Manageable external debt

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A Note on Malaysian Banking System - some concerns

Total loans > GDP RM 675b vs. RM 505b 2007 loan growth > GDP growth - 8.6% vs 6.3% Loans to household sector (consumption) 56% vs to non-HH sector 45%.
Residential property - 27% (RM 180b) Non-residential property - 9% (RM 60b) Passenger cars - 16% (RM 106b) Personal use + credit cards- 7% (RM 53b) Securities (shares) - 4% (RM 30b)

Working Capital - 29% (RM 195 b)

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Impact on Asian Trade

U.S. absorbs 25% of total world exports Percent trade with U.S. in 2006
China 21%, Hong Kong 15% India 17% Malaysia 19%

Recent data cast doubt on decoupling thesis

Japans exports shrank 1.7% in June for first time in 55 month. Signs of falling demand in other Asian countries.

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Impact on Malaysia - Trade

Malaysia - open economy - exports (RM 605 bil. + imports RM 505 bil.)= 2 x GDP 20% of exports to the U.S. (not including indirect exports through third countries) Manufactured goods = 78% of total exports Electronics and electrical exports = 60% of manufactured goods exports or 47% total exports
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Impact on Malaysia - Trade

Slowdown in E&E was - 4.2% in 2007 and - 9.4% in Q1 2008. Impact will be more severe in H2 2008. Booking to billing ratio dropped from >1 in mid 2007 to 0.8 in mid 2008 Compensated by increase in other manufacturing sectors like petroleum products, optical and scientific equipment, pulp and paper Total manufacturing exports = + 0.3% increase 2007 and +1.0% in Q1 2008
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Impact on Malaysia - Capital Flows

Malaysia - strong balance of payment Current account surplus (2004-2007) from RM 57 bil to RM 100 bil Comfortable foreign reserves (2004-07) from US$ 66 bil to $101 bil = 8 months import and 6.2x short term external debt Since 2005, net outflow of capital investments yearly of about RM 40 bil In 2007, net outflow of direct investments of RM 9 bil (outflow RM 38 bil vs. inflow RM 29 bil) 2007 portfolio investments still positive net inflow of of RM 18 bil. Could be negative for 2008
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MIDA Approved Investments 2005-2008

Malaysia Rgt Millions Domestic Foreign Total Investment Investment Investment 2005 13,173.7 17,882.9 31,056.6 2006 25,765.1 20,227.9 45,993.0 2007 26,506.3 33,425.9 59,932.0 H1 2008 8,421.4 17,747.8 26,169.2 Penang Rgt Millions Domestic Investment 2005 2006 2007 H1 2008 717.4 1,432.5 1,625.2 4,518.5 Foreign Investment 3,907.5 3,918.2 3,143.4 781.2 Total Investment 4,624.8 5,350.6 4,768.7 5,299.7 Employment

21,642.0 13,539.0 8,833.0 N.A.

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Malaysia - MIDA Approved Investments 2005-2007 (RM Bil)

Amount of approved FDI vs. Domestic Investment
2005 = RM17.8 vs. RM 13.2 2006 = RM 20.2 vs. RM 25.8 2007 = RM 33.4 vs. RM 26.5 H1 2008 =RM 17.7 vs. RM 8.4

Some comparisons 2007 - China $75b; India $20b; Vietnam $18b.

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Conclusions
Financial crisis far from over. Will spill over into real economy; U.S. economy going into stagflation; Asian economy slowdown but still positive growth. Bigger threat is inflation; Financial markets highly volatile and has dropped more drastically in Asia; Macro economic fundamentals in Asia relatively strong and robust;
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Conclusions
Trade will be affected - especially in E&E industry in Malaysia with impact on employment; Outflow of portfolio investments 2008 likely; Less impact seen on capital flows. In fact, Malaysia has net capital outflows; Malaysian banking system - loans too reliant on household consumption; not enough for businesses. Consumption bubble.
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Thank You!
By Dr Michael Lim Mah Hui

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