IMF and G-7 Say: No More Lehmans


Western financial leaders assure an anxious world that all bank deposits will be guaranteed and any necessary steps will be taken, however unorthodox

Now the great confidence game begins. In high-powered forums that accompanied the G-7 and International Monetary Fund in Washington this past weekend, Western financial leaders sought to assure panicky bankers and money managers in no uncertain terms that all of the measures needed to halt a worldwide meltdown are in motion.

While short on the details many market analysts had hoped for, the broad brushstrokes of forceful, coordinated action by Western governments were unveiled: No more Lehman Brothers-like failures of major financial institutions will be allowed. All bank deposits will be guaranteed. The banking systems of the G-7 nations will be flooded with almost unlimited liquidity. And if all that fails, any other tool—regardless of how economically unorthodox—will be used if needed. The British government's widely anticipated move to take majority control of the Royal Bank of Scotland Group and HBOS is expected to be the first of many such actions across Europe. Fifteen European Union countries that use the euro as currency met in Paris this weekend. They pledged to provide guarantees of new bank debt through 2009, authorize the purchase of preferred shares to invest in problematic banks, and provide recapitalization funds where needed.

The message of Banque de France Deputy Governor Jean-Piere Landau at an Oct. 12 breakfast meeting at Washington's elegant Willard Intercontinental Hotel was typical. "I think the conditions for stability are met," Landau declared. "It is very difficult to see why there will be no stabilization." At a nearby hotel, Richard Fisher, president of Dallas Federal Reserve, told a crowd of international bankers that U.S. authorities "can and will restore order in the credit markets" and "will continue to pursue every avenue and every option." At a press conference at the International Monetary Fund's headquarters, IMF Managing Director Dominique Strauss-Kahn said: "I believe we have an adequate response to the crisis, and the market will reflect it."

Spillover Worldwide

When the markets open on Monday morning, it will be clear whether these verbal assurances and whatever specific measures the U.S. and individual European nations announce will be enough to ease the credit freeze and halt the stock sell-off. But even if the markets breathe a sigh of relief, the question is, how long will the calm last?

Even assuming that actions by the U.S. and Euroland are enough to get the credit markets moving again, attention is likely to shift to fathoming what lies ahead. The economic picture is dark, not only in the U.S. and Europe but also in key emerging markets that not long ago were regarded as bright spots. "As the markets move away from financial fears, they will start looking at what the spillovers will be to the real economy," says Deutsche Bank Group (DB) Chief Economist Norbert Walter.

In business forums and cocktail parties, financiers gathered in Washington mulled long-term implications that few had thought possible not long ago. What makes this financial crisis so different from many of the others faced in the past three decades is that it did not originate with peripheral emerging markets. It struck the core of global capitalism. And unlike previous U.S. recessions, this crisis cannot be fixed with changes in monetary and fiscal policy. It will require years of financial workouts and restructuring. The fallout, therefore, is likely to radiate out across the globe in countless unforeseen ways.

Long, Slow Recovery

One point of consensus is that the U.S. is heading into a very deep recession, perhaps the worst in the post-World War II era. The Institute of International Finance, which just months ago predicted the U.S. would not go into recession, now sees a contraction of at least 2% for several quarters and the jobless rate hitting 7%. And that estimate is based on the premise that the Treasury and Fed rescue efforts will work.

Don't expect the U.S. economy to roar back once recovery begins, either. Fully rebuilding the U.S. credit system and confidence will take time. JP Morgan Chase (JPM) chief economist Bruce Kasman warned that it is far too early to gauge the long-term impact on U.S. consumer behavior. In Japan, consumers held onto their cash for years, which helped delay recovery for a decade.

And don't expect emerging markets to be able to pull the global economy through. Despite falling exports, China's economy is expected to remain robust, thanks to $1.8 trillion in foreign reserves and strong domestic demand. But elsewhere a collapse in demand in the U.S. and Europe will dramatically change the dynamics even in many nations that a few months ago appeared to be in solid shape due to strong trade surpluses and foreign reserves. Emerging markets are going to be hit hard by a triple whammy: plunging manufacturing exports to the U.S., falling commodity prices, and outflows of dollars.

Plunging Oil

Let's start with foreign capital flows: Even though most developing-nation governments have dramatically slashed their dependence on foreign loans, their corporate sectors have been borrowing heavily abroad to finance everything from real estate developments to factories. In the past two months, Russia's foreign reserves have dropped by $40 billion because of capital flight. And several Persian Gulf states have had to tap into their huge sovereign wealth funds to prop up stocks and real estate projects funded by foreign capital. The IIF projects that inflows of foreign private capital to emerging markets, which hit a record $898 billion in 2007, will drop by at least $270 billion by the end of this year and contract further in 2009.

In addition, nations that depend heavily on oil and other commodities could soon be in for more trouble than they anticipated. Oil prices, for example, have already plunged from a peak of $145 a barrel this summer to near $70. That's still in the financial comfort zone of Russia, Venezuela, Iran, and other non-Mideast oil producers. But at the IIF conference, University of Calgary management professor David Mitchell, a leading authority on oil, laid out a scenario in which a sharp contraction in global demand could push crude all the way back down to $25 a barrel—a crisis level for all but Saudi Arabia and a few other Gulf nations.

The debt crash certainly will lead to a rethinking of America's financial system. But the seismic aftershocks will require revision of all assumptions about the global economy.


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