What can be done to alleviate the global economic crisis?

Gonzalo Baranda, Investment Marketing Manager at JPMorgan Asset Management: The recent G20 summit in Washington aimed to confront the many challenges currently facing the global economy. In the short term the main aim is to stabilise the financial system using monetary and fiscal policy tools.

Monetary policy measures

From a monetary policy perspective, this could mean further cuts in interest rates. Now that inflation is of less concern, deflation may become the next big problem and US interest rates could fall close to zero. However, these rate cuts need to be passed in full to the end consumer if they are to have the desired impact and for this to happen a further recapitalisation of the banks has been required.

There have so far been two main approaches to recapitalise the banks - the US TARP, which has been very generous in its terms to the banks with a 5% cost of capital plus warrants for only 15% of the preferred shares, and the UK version, which is a much more punitive plan that will effectively mean a partial nationalisation of large part of the UK banking system.

The UK plan seems to be more "fair" as it makes banks more accountable for their past mistakes and could allow taxpayers to benefit more from any future upside in the value of their equity stakes. However, the UK plan also implies UK government backing for the liability side of the banks' balance sheets too - a fact that effectively could mean a higher future cost of borrowing for the UK government and a likely further depreciation of sterling due to the expected increase in the UK budget deficit.

Fiscal stimulus

From a fiscal standpoint, governments are looking to introduce a more expansive fiscal policy to try to stimulate demand. However, it is difficult to stimulate consumer spending in an environment where unemployment is increasing and house prices are still falling, which is making consumers more inclined to save than consume.

One possible solution is the Keynesian way, which would involve the government stepping in and increasing expenditure. However, with tax collection decreasing as activity slows and general tax increases seemingly ruled out, governments may have to increase debt to increase expenditure. These new debt issues will come at a time when many countries are simultaneously in need of financing, which raises two important questions: Who is going to buy this new debt? And at what price?

The Bank of Japan and China's central bank (the Peoples' Bank of China) are, for instance, the largest holders of US government debt. However, with Japan already in recession (although admittedly the strong yen still provides significant purchasing power) and with China slowing quickly both central banks will now be less willing buyers.

The other obvious option is the Middle East sovereign funds, but with the price of oil down by 65% from its peak, these investors will now almost certainly demand preferential terms.

With a likely rising supply of sovereign debt and with limited demand, the yield offered will have to be substantial. Besides, the increased debt levels may trigger downgrades to some AAA-rated countries, which could increase their cost of debt even further.

Other measures

Longer term, in order to avoid committing similar mistakes again in the future, a large list of problems will have to be addressed. Governments may have to come up with ways to set clear limits on the bank's use of leverage and establish contra-cyclical additional reserves to preserve capital. They may also have to establish clearer accounting rules for the valuation of illiquid assets and put extra controls on the rating agencies, or even make them public agencies to avoid conflict of interests.

Furthermore, governments will need to come up with clear rules in the case of the bankruptcy of financial institutions, both at a national and a global level. More transparency will be needed and a greater disclosure of off-balance vehicles and derivatives instruments. In this respect, the already announced clearing house for credit default swaps may be a very positive way to increase transparency in this over-the-counter market and will allow closer supervision.

A global "lender of last resort" will still have a key role to play in this new world order, especially at times when large capital outflows are provoking very rapid currency depreciation in many emerging market countries and a sharp deflation of their assets. This situation may lead to some countries defaulting on their debt obligations. To try and tackle this issue will effectively mean providing extra resources to the International Monetary Fund.

The G20 have a lot to do, but by working together a framework is being constructed that will help guide the global economy through the current crisis. It will take some time, but confidence should eventually return. When it does, the large levels of liquidity which have been made available will help free up the credit markets so that they can once again provide the fuel to feed growth in the global economy.