from their mutual funds. This triggers a second round of selling by institutional fund managers who have to sell to cover redemptions. Hedge funds have been made scapegoats for short selling, but the reality is that they have not played a major part in the fall of bank shares. The banks’ shares dropped far more during the ban on short selling than before it. Hedge funds are playing their part in the share price drop however; they have borrowed money to invest and as share prices and commodity prices have dropped, the banks have called in loans which necessitated the hedge funds selling some of their holdings in shares and commodities. We saw oil and gold prices drop as well as shares.

The mini crash of 1998 was caused by the collapse of LTCM (the world's largest hedge fund at the time) following Russia's default on foreign debt and recovered quickly. This time, the hedge funds have held up well. The main reason being that the owners invariably invest their own money and control what the fund invests in. Bank senior executives often have little understanding or control of their dealing desks. We saw that with the collapse of Baring years ago and the rogue trader at Societie General earlier this year.

What now?

Well, this is difficult to predict as we are in uncharted territory. It has taken time for the severity of the situation to sink in with most governments. If they have been to slow to react, the IMF has given them a shake up this weekend by saying that we could see a major melt down in the world financial system if governments do not take strong action. As I write, more and more governments are coming out to support their banks.

We can be sure we are not at the end yet. There is more bad debt on the books of the banks that has not been fully written off yet. A change in accounting rules may stave off some of this, but there is still a problem. The equity markets are badly shaken and will undoubtedly be very volatile for some time to come.

The shock of it all has triggered a lack of confidence which takes time to be restored and will affect us all. The removal of the credit mountain will cause an economic slowdown, but the worry that ensues will filter down to the consumer, who will stop spending - even if he has the money to spend - and this will push the slowdown into recession. There is much pessimism around and many comparisons to the great depression of the 1930s. You have to remember when assimilating the news that bad news sells papers and keeps people glued to the news channels, far more than good news. Gloomy predictions sell better than optimistic ones. The news channels know this.

America is likely to bear the worst brunt of this, with UK close behind and then Europe. It is harder to predict the effect on the emerging markets. They will undoubtedly slow down as their export markets dry up, but the larger emerging countries have started to develop a domestic market and a new middle class and they do not carry the bad debt of the western banks. China is sitting on over $500 billion of US Treasury Bills. However, China has already started to feel the impact of a slow down with some 20 million jobs being lost already this year, according to the Sunday Times. This sounds a lot, but you have to remember they have population of over 1.3 billion, - more than 4.3 times that of USA.

Not another "great depression"

The IMF said on Wednesday that despite this being the greatest shock to the financial system since 1929, the chances of a 1930s style depression are "nearly nil" They predict that global growth will slow to 3.9% this year, down from 5% last year, and drop to 3% next year. This does assume that western governments will respond n the right way to the crisis. They predict that emerging markets will fare better in 2009 than the G7 countries, with China growing at 9.3%, India at 6.9%, Russia at 5.5%, Middle East at 5.9% and USA and Europe at zero. Given the time between the research and publication, these figures could be a little on the high side now, but it serves to demonstrate that the emerging markets are likely to be more robust in the coming years than those of the G7 countries. I

t is unlikely that the Middle East property boom will continue as it has. Confidence will be affected and international buyers from outside the Gulf may be forced to sell if they have bought on credit.

Political change

On the political side we are likely to see major changes. Gordon Brown will no longer be able to proclaim "the end of boom and bust". However to be fair, he has acted decisively and led the world out of the banking crisis, creating a better rescue package than Hank Paulson created for the USA.

Western governments will end up holding major stakes in their big banks and insurance companies to restore confidence. In some cases, they will be nationalised. This will lead to a return of solid banking principles and rein in the wilder activities of the bank dealing rooms. It could also lead to political interference and inefficiency in banking as politicians are rarely qualified bankers. Undoubtedly, we will see more financial regulation and this will have a restrictive effect on financial services, much of which is already sinking under a weight of heavy handed legislation since 9/11.

Part 1: INFLATING THE BUBBLE

Part 2: BURSTING THE BUBBLE

Part 3: CONFIDENCE

Clive Ward, Guest Contributor for EconomyWatch.com

Sources: Financial Times, The Times, Steve Sjuggerud Daily Wealth, International Monetary Fund website, Time Magazine

Clive Ward is a director of Affinity Consulting Group Ltd (ACG) and of Ganoz Asset Managment Ltd (GAM).  ACG provides investment advice, financial planning and portfolio management services and has offices in Singapore, Dubai and Shanghai.  www.affinity-consulting.com

GAM manages a range of high yield, automated, technical trading forex

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