The recent global stock market rally rekindled hopes among investors who believe the financial chaos is nearing its end. They assume U.S. measures to stabilize the financial markets will eventually pay off once the toxic assets clogging the system are removed. But Zuo Xiaolei, Chief Economist at China Galaxy Securities Co. Ltd., argues in an article published in China Securities Journal that the effectiveness of the U.S. response remains to be seen, while financial markets will continue to stumble even after they hit bottom. She warns of a second round of crisis. Edited excerpts follow:
In the past two months, global financial markets have rebounded, especially the one on Wall Street. The Dow Jones Industrial Average stood above 8,500 points in May, leaving people wondering if the crisis is over.
For the first step in its Financial Stability Plan, the United States conducted a stress test on 19 banks, the results of which indicated that none were insolvent. U.S. Treasury Secretary Timothy Geithner claimed the U.S. financial system was sound.
The better-than-expected test results were deceiving in that they were made using many illogical hypotheses. These were intended to please investors who had lost faith in the markets in the wake of the financial meltdown.
The United States also planned to set up a public-private investment fund to buy toxic assets. The government and banks hoped those assets could be valued and then sold at a high price so that institutional balance sheets could look prettier. But the pricing regime for the toxic assets is still in doubt, as no sensible buyer would be interested in the culprit that caused the biggest economic recession in half a century.
If no forceful measures are adopted to remove toxic assets, the confidence that has been lifted by optimistic stress-test results will soon fade away.
The recent stock market revival that has been based on expectations instead of actual economic growth is flimsy and unsustainable.
Financial stability is closely tied with economic development and employment. U.S. President Barack Obama warned of rising unemployment even though the April figure was better than expected.
Worsening employment will lead to declining income. The Financial Stability Plan encourages small business lending, student loans, consumer and auto finance and commercial mortgages. However, unemployment will trigger a new round of credit defaults, giving rise to more bad loans for banks. Banks might again be poisoned by a new set of non-performing loans.
Declining income could force people to tighten their belts. If the financial crisis taught them anything, it is to save more and spend less. Wary consumers might not be open to living on credit cards once again unless the economy is pulled out of recession.