Is leverage a problem for the world economy? Is the global "savings glut" at the root of the current credit crisis?
In our view, the answer is no. Saving is good - provided it is well directed - and leverage per se is not a hindrance to economic growth. If capital can be efficiently allocated to the most productive sectors in the global economy, a high savings rate can enable a high investment rate. In turn, a high investment rate can allow for a higher rate of economic growth in the long run. In the five years preceding the current crisis, however, excessive leverage and non-productive investment helped fuel both a credit bubble and an economic boom, with global GDP expanding at the fastest pace since the 1960s. The main question is not whether the world economy was running on too much leverage, but whether the financial sector was able to allocate global capital efficiently. In many countries, misguided government policies favoured investment in housing from the mid-1990s. Meanwhile four of the world's top five largest oil and gas reserves holders, in effect, shut their doors to outside investment from 2000. Financial institutions reacted by channelling excess savings from fast-growing emerging economies into the real estate sector in OECD countries. Attracted by the perceived safety of property markets, capital flows avoided capacity investments in volatile sectors such as commodities. In other words, markets failed and too much money went into real estate, too little into energy. The spike in energy and food prices that followed - primarily the result of under-investment in productive energy capacity and rapid demand growth - crippled fast-growing emerging markets. The financial turmoil is thus coming from a gross global misallocation of capital, not excess indebtedness.
Now, the cyclical downturn in energy prices is pushing investment out of the sector at a time global oil field decline rates are accelerating. In our base case scenario, we estimate global oil production decline rates for mature fields of at least 5 per cent, and see non-OPEC oil output in the current 49-50m barrels a day range over the next seven years. There is a risk, however, that decline rates accelerate to 6 per cent if the investment drops further. This situation could push non-OPEC production down precipitously towards 47m b/d by 2015 from the current levels.
The IMF recently estimated the current global downturn will be the most severe in the post- war period. In the short run, the scarcity of consumer credit will continue to feed into many parts of the global economy from construction to travel and vehicle sales. In the medium term, however, large fiscal and monetary policy stimuli and bank bail-outs could succeed in supporting aggregate OECD demand. Yet, if the energy and credit crises are indeed linked to the same market failure, we could witness a second round of commodity price inflation. With the ongoing upward shift in the cost of credit, investors now require higher rates of return, and investment into marginal energy projects such as oil sands is drying up. Therefore, even if governments are successful in reigniting the global economy, physical energy supply constraints will prevent a return to the high world GDP growth rates of recent years.
The commodity super-cycle is not over, it is just pausing. For the world economy to resume growth of 5 per cent, energy supply must expand by a similar rate. But with lower oil prices and a credit crunch, energy investment is plummeting, suggesting global energy demand will eventually pick up more rapidly than productive energy capacity. Assuming the ongoing global recession does not turn into a multi-year event that pushes energy demand down structurally, steep decline rates could again put upward pressure on oil prices as soon as 2010 or 2011. In particular, if the low oil price/high cost of money environment persists for most of this year and next, our base case scenario for non-OPEC production could prove optimistic, exacerbating the second leg of the commodity super-cycle. If and when the global economy starts to recover, too many dollars chasing too few barrels will only lead to much higher oil prices.
The writer is managing director and global head of commodities research at Banc of America Securities-Merrill Lynch