How to Avert a Global Downturn

The subprime mortgage mess is rattling nerves this week, even in the place once deemed a safe haven in the global economy: Asia. David K. P. Li, chairman of the Hong Kong-based Bank of East Asia, says the turmoil in financial markets won't abate until the true scope of the mortgage-linked debt crisis is revealed early next year, and he is convinced that leading central banks must act now to avert a global downturn. Li also says a significant slowdown in China's growth rate has begun, and he fears that a stock market bust there could cost millions of small investors their savings. On Thursday he spoke with NEWSWEEK's George Wehrfritz at the Horasis China Europe Business Meeting in Frankfurt. Excerpts:

NEWSWEEK: Financial markets are in turmoil this week. What do you think is happening?
David K. P. Li:
It all started two or three years ago, when investment banks in Europe and America began to pass on more risk to customers. They packaged [home mortgage loans] up nicely so they could earn income while escaping liability. Purchasers loved them for the simple reason that they earned a high interest rate, but they didn't realize the risks involved. The banks said [these products] were very safe, and the credit rating agencies were not doing their homework, [so] they rated these vehicles as [investment-grade] debt. They did so based on the reputations of the participants, not on what was inside each package of loans.

Leading banks have already declared losses in the billions. How long do you expect the crisis to persist?
Bigger problems could come out over the next few months. But [the situation] will settle down once the auditors agree on a way of valuing the market risk. By the first quarter of next year we should have a clear picture of the liability each bank has and what has actually happened.

What should the U.S. Federal Reserve Board and the European Central Bank be doing today?
The central banks have to come to the rescue. Basically, they should create something similar to the Resolution Trust Corp., which was established to deal with the savings and loan crisis in America [in the 1980s]. Today's problem is bigger. If they structure it nicely, then the recession in America isn't going to be that bad.

So the U.S. economy is headed for a recession.
At the moment it is highly likely, but how deep the recession will be one never knows. Next year is an election year, so the recession won't likely be felt until after the election because so much money will be spent to prop up the economy. I reckon there will be hard times after the election.

How would an American slowdown affect Asian growth?
The American economy still affects Asia a great deal. The two economies can't be decoupled from each other. If would help if the consumer market in China takes off, but today China is still so dependent on the U.S. and European markets that a recession in America would have an impact in Europe and across Asia.

What do you forecast the Chinese growth rate to be in a year?
The third quarter figure was 11.6 percent. But in the fourth quarter they'll be lucky if they hit 10 percent. Hopefully, it will be around 8 percent next year. China needs 7 to 8 percent to sustain its employment rate, so I hope they can sustain at least that much. It all depends on how quickly the American economy slows down.

How concerned are you about asset valuations in China? Is it fair to say that a stock bubble exists?
The bubble is indeed there, but whether it bursts or not is another matter. The Chinese government is trying its best to let the air out gradually if they can, but it takes time for their policies to work.

What are your best- and worst-case scenarios for China over the next year to 18 months?
My best-case scenario is that the so-called financial through-train [which would allow mainland Chinese to invest more in Hong Kong] will arrive, thereby harmonizing the two stock markets. Then Hong Kong will become the financial center of China. My worst-case scenario is that the bubble bursts and a lot of people in China lose most of their savings. It will be a hard lesson, but I don't think there will be riots in the streets.