For much of 2009, gold traded in the range of low-mid $900 per ounce. There was a dip over the summer, with a strong upswing starting in September. Gold is now trading well over $1,000 per ounce, in fact just under $1,100.

Turns out that the government of India was buying gold in mid-October. Over a two-week span, the central bank of India bought 200 tonnes (metric tons) of gold from the International Monetary Fund (IMF) at an average price of $1,045. The IMF — over which the U.S. holds veto power for most actions — got approval to sell the gold from — where else? — the U.S. Congress, last spring.

Previously, the government of India held 350 tonnes of gold reserves. This 200-tonne purchase is a 57% increase in India’s reserves. There’s joy in India, I’ll bet. (It makes me wonder what the Pakistanis think, now that their large neighbor has both nuclear weapons AND a growing gold hoard.)

To read the rest of the story and learn more about China’s golden ambitions, click here.

“I think it will take only three to four years for China to overtake Japan as the second-largest economy in the world,” Merrill Lynch economist Ting Lu, told the Associated Press. Catching up with the United States could take decades, he added.

In a complicated recalculation, the Chinese government yesterday (Thursday) revised its growth figures for 2007 from 11.9% to 13%, bringing its estimated gross domestic product (GDP) to $3.4 trillion – about 3% larger than Germany’s $3.3 trillion for the same year, based on World Bank estimates.

The news came sooner than expected, confirming a seismic shift in global economic power. It took just two years to complete the move from fourth to third after China overtook Britain in 2005.

Germany’s per capita GDP, at $38,800, is still far ahead of China’s $2,800 per capita GDP in 2007, as the country has wide disparities of wealth and poverty. Chinese officials say more than 100 other countries have a higher income per person, the Associated Press reported.

China set out on the road from communist central planning to a market-style economy in 1979 when its GDP was just $300 billion – one-tenth of the 2007 level – according to the International Monetary Fund.

Now, it has set its sights on Japan. Although the world’s top economies – the United States and Japan – are suffering through a withering recession, even the most pessimistic growth estimates for China’s GDP in coming years run about 5%.

If China were to maintain its current level of growth, it would overtake Japan – with a current GDP of $4.3 trillion – in just a few short years.

The U.S. economy, the world’s largest, was about $13.8 trillion in 2007. At its current rate, it would take China just 18 years to depose the United States as the world’s No. 1 economy, according to the Washington Post.

However, the question of whether or not China will continue to grow at its current pace has been complicated by the global recession, which has resulted in massive layoffs and waves of factory closures, especially in southeastern China, the center of its export-driven economy.

Michael Santoro, author of the 2008 book “China 2020,” told CNN. China will have other problems to overcome if it is to maintain its rapid expansion.

“It’s no longer sufficient for China to become a manufacturer of sneakers or toys and the like,” Santoro said. “Now they’re looking to become players in the area of pharmaceuticals and foods and other high value-added products, where safety and quality are important characteristics for improving in the global economy.”

Independent economists estimate China’s economy grew by another 9% in 2008 despite the global downturn. Figures for 2008 are expected to be released this month.

But economists have slashed 2009 forecasts to as low as 6%. That would be the highest of all the world’s major economies, but still worries communist leaders who need to satisfy a public already concerned over thousands of recent manufacturing layoffs.

But don’t expect China to sit by twiddling its thumbs while the recession hammers its economy.  In a Money Morning Outlook 2009 report we described how the People’s Republic has already announced a $586 billion (4 trillion yuan) spending package.

To put that in perspective, this plan amounts to a staggering 20% of China’s gross domestic product (GDP). Compare that to the $1 trillion in U.S. bailouts, which equate to about 8% of GDP.

And in further response, China’s State Council on Wednesday laid out a new plan to boost its steel and auto industries – including about $1.5 billion to develop alternative-fuel vehicles.

Source: China Now the World’s No. 3 Economy, Supplanting Germany

The IMF will lend Iceland $2.1 billion, and Finland, Sweden, Norway and Denmark will loan $2.5 billion to help the country re-float its currency and shore up its banking sector.

The Icelandic krona, or crown, has lost about 70% of its value since the nation’s financial crisis first began. The government put restrictions on currency trade as it wrestled with the crisis, however one of the stipulations of the IMF loan is that Reykjavik once again float its currency. Once it does, it’s likely that there will be a “massive currency outflow,” Iceland’s central bank said.

The krona, which traded at 176 against the euro at a Nov.19 auction, could trade weaker than 250 per euro after the float, Lars Christensen, chief analyst at Danske Bank A/S, told Bloomberg.
“They’ll have to accept that there’ll be a pretty significant pressure on the currency when they reintroduce a free float,” Christensen said.

The IMF said that $827 million of its loan would be made available immediately and the rest in eight installments of about $155 million, subjected to quarterly reviews.

Iceland will also get about $6.3 billion from the United Kingdom, the Netherlands, and Germany to cover foreign deposits at Icesave – a unit of the failed bank Landsbanki Islands.

“Iceland is in the midst of a banking crisis of extraordinary proportions,” John Lipsky, deputy managing director of the IMF, said in a statement. The country “is facing a severe recession, given the high debt level in the economy and significant dependence of the private sector on foreign currency and inflation-indexed debt.”

The debt burden resulting from IMF, European, and Nordic loans totals nearly $11 billion, greater than the nation’s gross domestic product (GDP). The Icelandic economy is worth roughly $7.5 billion, based on 2007 GDP at current krona exchange rates, Bloomberg reported.

Divided amongst a population of 320,000, each citizen would have to come up with $34,375 to pay off the debt. But that’s only if Icelanders stick around.

Up to a third of Iceland’s population is considering leaving the island, the Financial Times reported. That kind of exodus would result in even less tax revenue and economic development and deepen a recession that is already expected to be severe.

The IMF expects Iceland’s GDP to contract 9.6% next year, while Danske Bank’s Christensen estimates the economy will contract by a full 10%.

Source: Iceland Gets $11 Billion Bailout, but Will be Saddled with Debt for Years to Come

The amount the World Bank lends to developing countries such as China, India and Brazil could reach $35 billion for the 12 months ending June 30. That’s almost triple the $13.6 billion doled out to developing countries over the last fiscal year. The bank said it is prepared to commit up to $100 billion over the next three years, with the majority of the funds to be made available through its International Bank for Reconstruction and Development (IBRD).

“The global financial crisis, coming so soon after the food and fuel crises, is likely to hurt the poor most in developing countries,” World Bank President Robert Zoellick said in a statement.

Emerging markets, which were flooded with speculative cash prior to the financial crisis, have seen a rapid withdrawal of private investment. Investment in infrastructure, education, and healthcare projects have been scaled back as a result, undoing much of the progress achieved over the past decade.

“The response to this crisis must be global, coordinated, flexible and fast,” Zoellick said. “It is more critical than ever that the international community acts in a coordinated and supportive way.”

The World Bank has lowered its 2009 growth estimate for developing countries to 4.5%.  The bank projected 6.4% growth for emerging markets as recently as June.

The bank estimates that a 1% decline in emerging market growth pushes an additional 20 million people into poverty.

World Bank estimates for global growth were also revised downward. The bank lowered its global economic growth estimate for 2009 to 1% from the 3% it projected in June. That is significantly lower than the International Monetary Fund (IMF) November 6 estimate of 2.2%.

Growth in developed countries will shrink by 0.1% next year, and global trade may suffer its first decline since 1982, the World Bank said.

World Bank Triples Lending to Developing Countries

Xinhua, China’s state-run news agency, said yesterday that the stimulus package represents “a shift long advocated by analysts of the Chinese economy and by some within the government. It comes amid indications that economic growth, exports and various industries are slowing.”

The decision was announced yesterday by the State Council after Premier Wen Jiabao presided over an executive meeting Wednesday. China reported in late October that its economy grew at a less-than-expected rate of 9% in the third quarter – the fifth straight quarter than growth has slowed, MarketWatch.com reported.

“As the global outlook deteriorates, we expect Chinese macro policy to turn increasingly aggressive,” Merrill Lynch & Co. Inc. (MER) economists T.J. Bond and Ting Lu wrote in a research report Friday. “This is a key theme for China and indeed, the entire Asian region.”

China becomes the latest major country to announce a stimulus package. Governments have been injecting billions of dollars into their economies, as central banks around the world slash interest rates, all in the hope of avoiding a whopper global recession. Just last week, researchers at the International Monetary Fund (IMF) said that world growth would slow to a tepid 2.2% next year, down from the 3.7% growth estimated for this year. The IMF forecast for China slashed the growth rate down to 8.5% next year, down from an earlier projection of 9.3%.

Reports are circulating that the U.S. government may be considering another infusion of its own. The urgency could escalate this week after retailers take center stage and announce their third-quarter earnings. Macy’s Inc. (M), Nordstrom’s Inc. (JWN), Abercrombie & Fitch Co. (ANF) and Wal-Mart Stores Inc. (WMT) all are expected to announce quarterly results.

The retail sales data for October will be released on Friday, though the recent weak sales numbers and earnings announcements should have provided more than fair foreshadowing of the actual monthly results.

Given that consumer spending accounts for 70% of the U.S. economy’s health, don’t anticipate great numbers. And don’t assume these are the worst we’ll see.

Market Matters

With traders predicting a victory by Democrat Barack Obama, the major markets jumped by more than 3% on election day and the Dow Jones Industrial Average closed at a four-week high. International stocks also climbed in anticipation of real “change” coming to the White House.

The euphoria was short-lived, however, as the economic realities returned “the morning after.”  Domestic indexes plunged 10% over the next two sessions in volatile trading.  Cisco Systems Inc. (CSCO), Time Warner Inc. (TWX), and News Corp. (NWS) became the latest companies to disappoint on quarterly earnings.  Likewise, General Motors Corp. (GM) and Ford Motor Co. (F) announced larger than expected losses and dismal sales results for October as execs presented a dire picture of the entire industry.  Circuit City Stores Inc. (CC) started closing stores; Goldman Sachs Group (GS) began handing out pink slips; JP Morgan Chase & Co. (JPM) announced plans to modify mortgage loans for delinquent borrowers.

Weak economic releases (see below) prompted oil prices to plummet again on enhanced recession concerns; the price of gasoline pushed below $2.40 per gallon – reaching its lowest level since early 2007.  For now, inflation does not appear to be a problem.  As for the President-elect, no one ever said it would be easy.  (Then again, optimists note, many of the same fears we face now were present back in 1992 when a relatively unknown Democratic president was elected and his party also controlled Congress. The Dow soared more than 200% during the President Bill Clinton years, the strongest performance in the post-World War II era. We also ended with a budget surplus – but that, at least, may be too much to ask for).

Weekly Market Data

Economic Matters

A hectic week on the economic calendar unfortunately brought little for investors (and the President-elect) to cheer about. The manufacturing sector appears to be in far worse shape than previously thought as the ISM index plunged to its lowest level in 26 years.  Two days later, that same Institute for Supply Management reported that the services sector was weakening, as well. Retailers remained very apprehensive about the holidays and the poorest October sales results since 1969 did nothing to relieve those fears.  JC Penney Co. Inc. (JCP) and Nordstrom’s reduced their earnings projections and only discounter Wal-Mart seemed to benefit from the uncertain times.

As for the highly anticipated unemployment releases, we found that during the month of October, the country shed another 240,000 jobs, its tenth straight month of labor contraction, bringing the year-to-date total losses to 1.2 million. Even worse, the losses appear to be accelerating.

Last month’s unemployment rate skyrocketed to 6.5% (from 6.1% in September) and now stands at its highest level since March 1994. Additionally, recruiting firm Challenger Gray & Christmas reported soaring layoffs (+79%) over the past 12-months, and payroll provider Automated Data Processing (ADP) revealed that the private sector suffered its largest monthly job contraction since December 2001. The dismal labor picture all but confirms a second consecutive quarter of negative growth (GDP), which translates into full-fledged recession. When individuals worry about their jobs, they don’t spend. Retailers suffer, manufacturers suffer, and the overall economy suffers.

We’re already seeing all of this – and there’s more to come.

Overseas, the world’s Central Banks followed in the Federal Reserves’ footsteps by dropping their key lending rates in attempts to jumpstart their respective economies. As Money Morning reported, the ECB (European Central Bank) cut its key interest rate by half a percentage point to 3.25%, while the Bank of England took surprising action by reducing its rate by one-and-a-half percentage points to take it down to 3.0% – an attempt at countering the impact of its rapidly falling housing prices and the ongoing credit crisis.

Weekly Economic Calendar

Source: China Stimulus, Troublesome Retail Earnings Point to Escalating Global Economic Woes

Now, twelve months later, as W’s presidential twilight years draw to a close, another of the West’s leaders journeys to the Gulf region. Like Bush, England’s Gordon Brown is not particularly popular in the polls. But this captain from the west has more pressing issues to deal with than the restoration of his public image; he needs cash to rescue the world’s “emerged” nations from the brink of financial collapse. And so, hot on the trail of the dollars and pounds that have poured from the west into the Gulf ever since oil was first discovered here, Gordon Brown shot his cuffs, donned his best smile for the cameras…and went panhandling.

Making no bones about the goal of his mission, Brown has said that he wants “hundreds of billions” of extra dollars from the oil-rich Gulf States, to be pledged to the International Monetary Fund.

The IMF is already burning through its $250 billion reserves, providing around $30 billion in emergency loans to Iceland, Hungary and Ukraine in the past few weeks alone. Pakistan has also said it may call on the international body for a quick cash advance. Somewhere in the vicinity of $5 billion should do the job, they reckon.

“The Saudis will, I think, contribute like other countries so we can have a bigger fund worldwide,” said Brown after a three-hour meeting with Saudi Arabia’s King Abdullah late Saturday in Riyadh.

“The oil producing countries, who have generated over $1 trillion from higher oil prices in recent years, are in a position to contribute,” he continued, employing the kind of misguided logic that Karl Marx would be proud of. He might as well have gone the whole hog and recited the creed straight from the Critique of the Gotha Program: “From each according to his ability, to each according to his need.”

Usually, when a man finds himself in the unfortunate position of having to beg for alms, he does so with a sense of humility. He may even come to the realization that, but for the kindness of strangers, he might be infinitely worse off. The dire situation Mr. Brown finds himself in, and the crisis in the west that led to his fundraising mission, seems not to have dampened his sense of moral superiority.

Just two weeks ago Mr. Brown severely reprimanded OPEC for its decision to cut oil production in the face of falling prices. The OPEC nations say they needs to defend a floor for prices in order to fund and develop future energy projects; projects that may or may not end up fuelling engines in the countries Mr. Brown is here to represent. Whether or not OPEC is telling the truth, we must admit that we find Mr. Brown’s diplomatic stratagem a tad puzzling.

Brown described OPEC’s production cut as “wrong for the world economy,” arguing that such a measure was “absolutely scandalous” at a time when the world is suffering through an economic crisis.

Translation: “It is wrong that OUR economy must suffer through high oil prices…but we would still like you to use the money YOU made from high prices to solve our problems.”

Pleading for help from one side of the mouth while sharply criticized from the other is seldom an effective tactic. It must be said, of course, that your editor is not here to defend a monopolistic cartel. We’re simply suggesting that if Mr. Brown chooses to go brown-nosing for money, he might think about refining his tactics a little. Either that, or learn to speak Chinese or Japanese…they made (and saved) lots of money from the west too.

Beggars can’t always be choosers but, if they play their cards wrong, they can end up losers.

Source: Beggars Can Be Losers

One such figure came up yesterday. The total ‘value’ of global derivatives – financial instruments which are priced on the back of the underlying assets that they track – has now reached a breathtaking $596 trillion, after a mammoth rise over the previous twelve months.

That started the warning lights flashing…

So what, apart from containing more noughts than a normal human being can cope with, is this titanic number all about?

Let’s start by putting it into context. We can do this by checking out what the world actually made last year. The overall value of goods and services produced is measured by Gross Domestic Product (GDP). And for 2007, GDP for planet earth was reckoned by the International Monetary Fund to be just shy of $65 trillion. No less an organization than the CIA has come up with a similar estimate, at £65.8 trillion, so it must be about right.

So when the Bank for International Settlements (BIS) tells us that last year the total derivatives market grew by 44%, its fastest pace since the Basel-based bank started keeping records just over ten years ago, up go the antennae straightaway. And when that figure of $596 trillion crosses the radar screen, equivalent to more than nine times world GDP, the numbers are looking quite scary.

The money at risk is equivalent to a quarter of world output

Of course, the $596 trillion is a ‘notional’ amount. It’s the nominal value of all the underlying assets against which bets have been placed. But the actual amount of ‘real’ money at risk is still a massive $15 trillion, equal to almost a quarter of world output.

And within the individual areas there’s one even more eye-catching statistic. The value of contracts in credit default swaps (CDS) – a form of market insurance that investors can buy to protect themselves against corporate bond defaults – more than quadrupled last year to $2 trillion, covering a notional $58 trillion of loan debt.

The very size of all these numbers is just about enough to give the jitters to anyone, on the basis that when things can go wrong, they probably will.

When I wrote on this subject before, one respondent claimed that the topline numbers aren’t important because derivative markets are beautifully balanced. His theory was that if every derivatives position were hedging a risk relating to a specific transaction or asset, then derivatives would actually stabilise the world economy. All those noughts would be good news.

Sounds a bit too good to be true. And there are three reasons to be sceptical about this optimistic line of thinking.

Three reasons to be worried

Firstly, what we can call knowledge risk. That’s when derivatives players don’t know what they’re getting into.

A story on Bloomberg at the end of April summed this up pretty well. The chief finance officer of an Indian company was persuaded by his bank to start dabbling in the currency derivatives market. Although the CFO explained to the bankers that he didn’t understand how these products work, apparently they chauffeured him round and bombarded him with charts showing how his company could make a profit with a zero investment.

Too good to be true? Clearly it was. Three months later, two of the contracts had turned sour, incurring losses of $1.5 million and prompting the bank to issue a bankruptcy notice to recover the cash. Meanwhile, our poor CFO had no idea that these derivative bets could go so wrong. But he’s not alone. Indian companies could lose up to $4bn on derivatives, according to Hong Kong-based brokerage CLSA Ltd. Naïvety? Maybe. But we’re all good at repenting at leisure.

Which brings us onto the next potential problem, counterparty risk. That’s when the deal you’ve just done comes unstuck because the people on the other side of the trade can’t settle their side of the deal. A bit like backing the Derby winner, then finding the bookie can’t pay up because he’s run out of money.

Indian banks may lose up to $400m if they can’t enforce derivatives contracts they’ve set up with smaller companies, says CLSA. This is because 10% of these smaller companies may renege on their agreements because they haven’t the cash to settle the deals.

And this is just one country. BNP Paribas analyst Andera Cicione believes that total world CDS losses could hit $150bn. As the CDS market is unregulated, there are no public records showing whether sellers have the assets to pay out if a bond defaults. George Soros himself has warned this week that CDS counterparty risk is “a Damoclean sword waiting to fall.”

What’s worse – and here we come to the third problem – some buyers have now found out that the derivatives they’ve bought haven’t matched up to “what it said on the tin”.

The ratings agency Moody’s has just admitted awarding incorrect ratings to $4bn worth of debt instruments because of a bug in its computer models. Some ultra-complex derivative products, known as “constant proportion debt obligations” and thought up at the height of the credit bubble, incorrectly received over-optimistic triple A – i.e. top notch – ratings. And it took Moody’s nearly a year to find the problem.

As the derivatives market gets bigger and bigger, stories like these only make us ask: do the people who play around in it really know what they’re doing?

Source: Why Derivatives are Getting Much More Dangerous

The consumer price index rose 0.2% in April after edging up 0.3% the month prior, the Labor Department said yesterday (Wednesday). Core prices, which exclude food and energy, rose 0.1%.

Energy prices stagnated after soaring 1.9% in March, but that’s expected to change as both oil and gas have notched a series of record highs this month.

Food prices were perhaps the report’s biggest eye-catcher, climbing 0.9% for the month, the biggest upsurge since January 1990. Fruit and vegetable prices rose 2% and bread prices increased 1.5%, CNNMoney reported. The cost of bread was 14.1% higher than the year-ago period. Milk prices rose 0.9% and are up 13.5% from a year ago.

The Bush administration is currently disputing the International Monetary Fund’s claim that increased production of biofuels is the biggest factor in rising food prices. The IMF estimates that the shift of crops such as corn and soybeans out of the food supply to produce biofuels accounts for almost half of the recent increases in the global food prices.

“Those who are arguing that the president’s increase in the (renewable fuels standard) is contributing to high food prices are incorrect,” Keith Hennessey, director of the National Economic Council, told Reuters.

Instead, the White House is pointing its finger at emerging nations and their growing appetites.

“There are 350 million people in India classified as middle class. That’s bigger than America – and when you start getting wealth, you start demanding better nutrition and better food,” President Bush at a May 2 press conference according to the Economic Times.

Many economists support that position, but Indian authorities took offense.

Food prices have not been rising continually as developing nations grew, Ramgopal Agarwala, a former World Bank economist and senior adviser at RIS, a research institute in New Delhi, told the New York Times.

“They were static until 2006, then in 2007 and 2008 there was a sudden spark,” he said. But India has been growing for the last decade. This is “not last year’s phenomena,” he said.

“I don’t know who advised the president” on his recent comments, Mr. Agarwala added, but his analysis is “subprime.”

The administration – and many agricultural lobbies – have embraced biofuels as an alternative to foreign oil, and contend that ethanol use accounts for only up to 3% of the overall increase in global food prices.

Others, including the American Farm Bureau Federation, believe that it accounts for up to 30% of the surge.

On average, food prices increase about 2.5% each year. This year, according to federal data, the overall cost of food is predicted to jump 3% to 4%.

Source: Consumer Prices Moderate in April but Soaring Food Prices Steal the Show 

According to Business Week, a shocking 80% of the companies in the S&P 500 index watched their market-caps shrink from October through the end the April.

At last count, banks and other financial institutions have written down nearly $320 billion from their books, in a desperate attempt to keep their heads above water. The International Monetary Fund estimates that institutions will write a cool TRILLION off their books before this sub-prime mess finally ends.

And the carnage continues. In just the past week: mortgage lender Fannie Mae posted a US$2 billion loss for the first quarter. Insurance giant American International Group posted a US$7.8 billion loss thanks to a big write down of its derivative holdings (that’s on top of a US$5 billion fourth-quarter loss). Yesterday, Citigroup announced plans to “wind down” about US$400 billion in assets to try to dig itself out of debt. Even Warren Buffett’s beloved Berkshire Hathaway lost a BILLION bucks on derivative investments last quarter.

But few know that while institutions and individuals alike bled funds through these last nine months, a small group of investors quietly reaped the rewards of these unforgiving markets. I can site one particular disparity that bred a much-needed trend change — a change that many were late to recognize.

And while this trend change paid off nicely already — if you were positioned for it — the potential for a second round of gains is quietly approaching. I’ll tell you how to jump on that trend in just a second. But first, let me set the stage…

You Needed a Strong Stomach to
Ride Stocks Last Year

Last year, global stocks experienced quite a rollercoaster ride. Last spring, things were flowing smoothly and markets were shooting higher. Emerging markets were some of the biggest winners, but equities as a whole were sucking up investment capital all over the world.

Then the global credit crunch hit the markets in July 2007. This market shock upset the risk-taking attitude among global traders and shook the life out of stocks.

Since then, the S&P has fallen sharply from its October 2007 highs. Even Chinese stocks, among the largest pre-credit-crunch gainers, are still well off their highs.

The last six months have not been kind to the risk-taking investor class. There have been very few positive developments to support a market rebound. Even still, many stock market participants are holding onto hope in the face of a laundry list of problems.

Too Soon to Raise the White Flag?

But are the warning flags being reined-in prematurely? After all, the risks are not necessarily subsiding:

• Financial firms all over the U.S. and Europe are still struggling to cope with the credit crunch, taking write-offs in the tens of billions of dollars
• Sub-prime mortgage losses and write-downs are expected to grow far larger. Market cuts and bruises are likely to morph into gaping wounds for major lending institutions
• Banks are unable or unwilling to expand lending practices — net losses and ratings downgrades are taking their toll on the banks overall capital

As I said the IMF says institutions will write-down a US$1 trillion from their books before we’re done. Current losses-to-date stand at US$300 billion. So apparently we’re only a third of the way through this mess, I think we can only credit the resiliency of the stock market bulls to the Federal Reserve.

They’ve lowered their Fed funds and discount rates substantially and given investors reason to believe stocks are set to turn back higher, sooner rather than later. It’s a classic case of the “mama-bird-will-save-us” mentality. Investors have expected a hand-fed meal and the Fed is doing what they can to deliver it.

This is One Mess the Fed Can’t Clean Up

Sub-prime mortgage problems in the U.S. morphed into a global credit crisis. And banks got themselves into trouble by investing in what has turned out to be complicated bundles of bad debt tied to sub-prime mortgages. And even though central banks have aimed their focus towards this ultimate concern, they’re dealing with seriously large masses of confusing debt-backed derivatives. And central bank efforts may not be enough to clean up this mess in a timely fashion.

It all started when financial rocket scientists in white lab coats created the most complex investments they could dream up. These irresponsibly contrived investments became known as derivatives.

Turns out, this breed of derivatives act a lot differently in the real world than their creators expected. And now banks are stuck cleaning up losses on investments they don’t understand. The result: Banks have become reluctant to lend money because the need to stockpile extra funds as a sort of “complicated investment insurance” is growing.

Already, hundreds of billions of dollars of bad debt has surfaced on institutions’ balance sheets everywhere. And while the Fed and others have made various efforts, it’s still bad debt and it’s still going to take time to account for the balance of this ill-advised decision making.

It’ll take a while for banks to get back to doing what banks do best — lending money comfortably.

Introducing the Ugly Sister of the FX Markets

Much of last year I focused on a large imbalance that had developed in the foreign exchange market. The British pound had risen substantially to levels well beyond reasonable valuation. And while the pound became exceptionally overvalued versus the U.S. dollar, it was the widening gap between the British pound and the Japanese yen that caught my eye.

As the pound became increasingly overvalued and the yen increasingly undervalued, it became more and more likely that the gap would soon collapse. The agonizing credit crunch became the catalyst that would begin to close this gap.

The chart below compares the British pound to the Japanese yen. Clearly, the British pound has appreciated substantially against the yen over the past seven years. The simple fact that traders and investors shunned low-yielding assets (like the yen) in favor of high-yielding assets (like the pound) explains this major separation.

The country’s leaders should, however, not be lulled into a false sense of security. The International Monetary Fund (IMF) delivered a particularly hard hitting assessment of prospects and given that the economic imbalances in this country are as severe as in the United States there is no room for complacency.

We currently look for the UK economy to grow by 1.8% over 2008, marginally ahead of consensus (1.7%) and down from 3.0% in 2007. Although this would represent a slide back to sub-trend growth the greater concern surrounds the outlook for 2009 at which point the unwinding of the current account and personal indebtedness imbalances, coupled with the stretched state of government finances indicates a very real concern that growth in the future could be even weaker.

UK economy: the ongoing credit crisis

The most immediate problem surrounds the ongoing credit crisis and its adverse impact on the country’s financial institutions. Whilst politicians and banks argue regarding who might be to blame for the problems now affecting the global financial institutions, little has so far been done outside the US at present to resolve matters (although at the time of writing the Bank of England is rumoured to be planning to swap mortgage backed securities for, so far undisclosed amounts of government bonds for as long as possibly 1-3 years, along similar lines to the Fed’s Term Securities lending Facility).

The longer this dysfunctional state of affairs goes on, the greater the chances that serious damage might be done to the real economy. Given the significance of the financial sector to the UK economy’s well being, a prolonged period of dislocation could knock as much as 1.0% point off growth over the next twelve months.

Of greater concern is the adverse impact of the credit crunch on households and their spending intentions. Given that consumption accounts for around two-thirds of total activity, any adverse shocks emanating from the financial institutions are likely to have an even more significant (and lasting) impact. Here recent news has been far from encouraging with difficulties showing up, in particular, in the mortgage market.

The link between the mortgage market and consumption

Unsurprisingly, mortgage demand has fallen sharply over the past three months with potential buyers facing greater constraints than at any time since the last pronounced housing market downturn back in 1990-91. At present average house prices are expected to fall by between 5-10% over the next twelve months but with fairly pronounced regional variations. The figure could yet be exacerbated by the fact that the buyer holds the whip hand and distressed sellers may yet be forced to accept lower offers, particularly where no or only small chains exist.

Although the outlook for the housing market is bleak, the link between falling house prices and falling consumer spending is not obvious. Firstly, house prices have risen a long way in a relatively short space of time and many home owners will still be sitting on substantial equity built up over the past decade.

However, consumer confidence is undoubtedly impacted by falling house prices and concomitant negative media headlines regarding most people’s single biggest investment. In that confidence can be impacted by changes in, as well as the absolute level of, house prices any negative moves are likely to have an adverse effect on potential spending intentions.

Unemployment and savings

The other factor likely to impact on spending is households’ perception of employment prospects. Falling economic activity and falling corporate profitability can become self-reinforcing. Although the validity of labour market data has been called into question, it seems likely that when faced by sharply higher input costs, companies will attempt to maintain margins by cutting back their, generally, single biggest cost, labour.

We view rising unemployment as highly likely as the slowdown gathers pace and therefore, while consumer spending has held up pretty well so far, it cannot be guaranteed to continue as the slowdown begins to bite.

Furthermore, just as in the US, the UK’s household savings ratio recently plunged to all time low levels (see chart below). The combination of falling house prices and increased uncertainty regarding the outlook for the wider economy, coupled with fears over job prospects, are almost certain to encourage consumers to save more and consume less.

UK households’ savings ratio (%)

The corporate sector is less clear-cut

Turning to the corporate sector we believe that the outlook is less clear-cut, but by no means upbeat. Responding to concerns regarding falling demand, companies are likely to cut back investing intentions with construction spending under particular pressure following falls in commercial property prices.

Until Q3 2007 UK-based companies were racking up ever higher profits and margins had reached record levels. Whilst profitability is now under clear downward pressure and analyst earnings forecasts are being revised lower as a matter of course, many companies still have the benefit of being able to draw on retained profits built up over the past decade to see them through the downturn.

From an activity perspective much hinges on the ability of the export sector to limit the extent of the downturn (it alone cannot reverse it). In this context much depends on sterling’s fortunes on the foreign exchange markets.