By Lee Boon Keng

CALM is the most expensive commodity in the market nowadays. The way to afford it is to seriously think about where we go from here, so we can decide sensibly what to do next.

So, where do we go from here? That depends on your answers to the following two questions:

• Will the financial crisis in the US result in a systemic breakdown?
• In the absence of a systemic breakdown, are emerging economies, led by China, able to drive global growth?

If you believe the financial crisis in the US will end with a systemic breakdown, then all bets are off and the best thing to do is to hold cash and/or gold.

However, we do not believe we are at the doorstep of a systemic breakdown - more on why later - and so when the dust settles, holding cash and/or gold will not be the best strategy.

To be sure, we did come close to a systemic failure in mid-September when the anticipated bailout of Lehman Brothers failed to materialise. Lehman's bankruptcy was followed swiftly by the near failure of AIG and attacks on the remaining two pillars of investment banking - Morgan Stanley and Goldman Sachs. All of a sudden, no one was too big to fail.

The overnight cost of funds spiked to almost 6.5 per cent, a good 4.5 per cent above the Fed Funds target rate, which is the overnight interbank interest rate set by the US Federal Reserve. The flight to safety, meanwhile, sent yield for Treasury bills briefly into the negative territory. Worse, the commercial paper market imploded as money market funds, the typical buyers of this paper used to fund day-to-day working capital of corporate America, started to liquidate. The system was seizing up.

A ban on short-selling, with a proposal by the US Treasury and the Fed for a US$700 billion bailout package, called the Troubled Asset Relief Programme (Tarp), helped put a floor under the system.

In the week that followed, while Congress deliberated on Tarp, the US financial system was hard at work consolidating. JP Morgan bought Washington Mutual; Goldman Sachs and Morgan Stanley applied to become bank holding companies; and Wells Fargo is battling Citigroup for Wachovia - suddenly there is a bank worth fighting over.

Tarp was passed by the House of Representatives on Oct 3, just two days after the Senate's approval.Ironically, while Tarp is different in form from what the Fed was doing prior to the crisis reaching its post-Lehman height, it is similar in essence. Just as the Fed could provide liquidity through its discount window and expand its term auction facility to include a wider range of collateral, Tarp was set up to supply the necessary liquidity to absorb the troubled assets from financial institutions.

In essence, it is about liquidity and the willingness, plus the ability, to provide whatever it takes.

The ability has always been there. After all, the Fed can always print - which incidentally is how the Fed chairman got the nickname 'helicopter Ben'. The willingness, however, has been restrained not so much by the fear of moral hazard as what happened after the Bear Stearns bailout.

So, what happened after the Bear's bailout that made the Fed's rescue programme so difficult to implement? The short answer is that light crude oil futures jumped from about US$100 to almost US$150 a barrel within just four months after the bailout.

Speculators peddled the myth that a weaker US dollar necessarily meant higher oil prices. The market bought it, oblivious to the fact that there were many occasions in the past where the US dollar did not move in the opposite direction from oil prices. The fact is, oil prices are determined by demand and supply. In the absence of any supply disruption and in the presence of demand destruction, prices should fall, not rise - Economics 101. And that was what we had in the oil market at the time of the Bear's bailout.

But the oil 'shock' between March and July sent the world into a stagflationary panic that forced the Fed to sound hawkish when what it really needed to do was to provide ample liquidity to stabilise the financial system. The hawkish-sounding Fed put upward pressures on mortgage rates that exacerbated the housing crisis. The Fed's Bear bailout plan, similar in essence to Tarp, was hijacked by oil speculation.

Why do we believe there will not be a systemic breakdown? Because the financial crisis in the US is a problem that money can solve, provided there is the commitment and the means to do whatever it takes.

We know the means have always been there. We now know that as long as the recent oil shock is recognised as a product of speculation, and appropriate measures are introduced to prevent it from repeating, the commitment can be sustained.

On Sept 18, the House of Representatives approved measures to curb oil speculation. Within just two months of this, light crude futures have tumbled from their mid-July peak of about US$150 a barrel to below US$90 a barrel.

This brings us to the second question: In the absence of a systemic breakdown, are emerging economies, led by China, able to drive global growth? The short answer is: Yes, provided there is no inflationary shock similar to one in the first half of this year.

If the global economy is going to slow as the US enters a recession, then demand destruction without any sustained supply disruption would bring oil and commodity prices down - again, Economics 101. This is the most probable medium-term outcome for the oil and commodity markets.

But will a recession in the US sink the economies of emerging countries, particularly China, despite lower oil prices?

We have our doubts.

First, over the past five years or so, the world has been increasingly less dependent on US consumption. In fact, the opposite is true - the US has become more dependent on consumption in other economies. Since 2000, exports from the US to China have increased almost 500 per cent, and have more than doubled to South and Central America. Hence, a US economic recession will shave some growth from emerging markets but no longer necessarily cause a recession in these countries.

Second, and more important, consider what the Chinese government recognises as the state of the global economy and what it has to do going forward. Since July 2005 when the Chinese government made the decision to de-peg the reminbi from the US dollar, it knew that its export competitiveness would deteriorate over time.

Now that consumption in the US will slow precipitously in the coming year, the Chinese authorities must recognise that exports can no longer be China's main engine of growth. If China wants to sustain a growth rate of 8 to 10 per cent a year, domestic spending must replace exports as its main engine of growth. But that cannot be achieved if there is steady wealth destruction in China. People getting poorer by the day do not spend more, they spend less. Clearly, with the plunge in Chinese equity and real estate prices in some parts of the country over the past nine months, wealth has been destroyed.

Should the Chinese authorities fail to stem this erosion in wealth, the transformation into a domestically driven economy will fail. Add to this a US recession and the Chinese economy could sink into a recession, an outcome the Chinese government would very much like to avoid after the recent Sichuan earthquake and a successful Beijing Olympics.

In time, wealth creation must become a policy imperative for the Chinese government. That is the will. We also know that China has the means to do so - a twin surplus, almost US$2 trillion in foreign reserves and plenty of room to loosen a very tight monetary policy.

So, where do we go from here?

We believe the US financial crisis will not end with a systemic failure provided oil prices are relatively well-contained. While some level of stability will emerge in the US financial system, mired by a housing crisis, its economy will remain weak for several years. However, this is unlikely to plunge emerging economies into a recession because the world has grown dramatically less dependent on US consumers.

To transform China into a domestically driven economy, wealth creation will ultimately become the Chinese government's policy imperative. We believe it has the will and the means to carry this out successfully.

Financial institutions in Asia have been a pillar of relative stability throughout this US-led credit crisis. They have benefited from a flight to safety and will play a more prominent role in a globally rebalanced portfolio of capital.

So, when the dust settles, global capital will converge into emerging Asia - through its financial intermediaries first and then to its real economies. We want to be there, if not ahead, at least on time.

The writer is senior investment strategist, private banking, DBS Bank.

This article was first published in The Business Times on October 08, 2008.