George Soros believes that we are in the midst of the worst crisis since the Great Depression of the 1930s in the United States. This time the depression is global.

Back in early 2008, in his book A New Paradigm for Financial Markets, Soros made a number of predictions. Looks like they’re starting to come true.

Forewarned is forearmed. Read Soros’s predictions in the book and our blog.

To learn all the details of the opinion of George Soros, buy his book

The theory of reflexivity does not allow any precise predictions. However, it allows us to formulate assumptions about the ways of future development.

A 60-year period of credit expansion based on the ability of the United States to enjoy its position at the center of the global financial system and control of the world’s reserve currency is coming to an end. The current financial crisis will have a more severe and longer-term impact than any similar crisis in the past. Central banks, as before, will be able to temporarily increase the level of liquidity, so the acute phase of the crisis will be overcome; the world banking system will not collapse as it did in the 1930s. However, in all previous cases, the crisis was followed by a new period of economic growth, stimulated by easily accessible money and the growth of new forms of credit. This time growth will resume much later. The ability of the Federal Reserve to cut interest rates will be limited by the reluctance of the rest of the world to hold dollars and long-term bonds denominated in them. Some of the new financial instruments have failed and will cease to be used. Some large financial institutions will go bankrupt and getting loans will become more difficult. The size of the loan relative to the amount of collateral will certainly decrease, while the cost of lending will increase. The desire to borrow money and take risks will decrease. One of the main sources of credit expansion – the US current trade deficit – is now at its maximum level. All this will lead to negative consequences for the American economy.
We can expect long-term changes in the principle of functioning of banks, in particular investment banks. These industries have developed with little regulation since 1972, allowing them to bring some more modern products to market. I assume that this trend will change its direction. Regulators will try to regain control over the activities of the financial industry. How far they can go depends on the severity of the crisis. When it comes to American taxpayer money, the US Congress will be involved in the process. In the late 1980s, financial stocks accounted for 14% of the total US stock market capitalization, in the late 1990s this figure was 15%, and peaked at 23% in 2006. I expect that this percentage will decrease significantly over the next ten years. (As of March 14, 2008, it was 18.2%.)

However, there is no reason to predict a prolonged period of credit contraction or an economic downturn in the world as a whole due to the active work of opposing forces. China, India, and some oil-producing countries are in a period of dynamic development, which is unlikely to be significantly slowed down by the financial crisis and recession in the United States. The US recession will soften on its own as the country’s current account deficit decreases.

The United States during the Bush administration failed to maintain proper political leadership and as a result suffered a significant decline in power and influence in the world. The invasion of Iraq is closely linked to rising oil prices and the refusal of the entire world to keep its foreign exchange reserves in dollars. A recession in the US, coupled with growth in China, India and the oil-producing countries, will further reduce the influence and power of the United States. A substantial portion of the cash reserves currently held as US government liabilities will be converted into physical assets. This will lead to a continuation of the boom in commodity markets and create inflationary pressure. The declining role of the dollar as the accepted reserve currency will have long-term political implications and will awaken the specter of a breakdown in the existing world order: we will be forced to go through a period of high uncertainty and destruction of financial wealth until the new system is established.

Of course, I’m theorizing. But theory by itself, even if supported by facts, does not lead us forward. We have to cross its borders. In other words, it’s time for conjecture.

Now, at the beginning of 2008, I notice that the financial market is too preoccupied with the liquidity crisis and not sufficiently aware of the long-term consequences of the situation.

Central banks will do everything to provide markets with liquidity. They have already lent large sums to the markets against a wider range of collateral than ever before. Therefore, we can assume that the acute stage of the crisis will end soon, but the decline will continue. Both investors and the general public misunderstand the situation, believing that the financial authorities – the Federal Reserve and the government – will do everything possible to prevent a recession. It seems to me that they have no such intention: partly because of the boom in the commodity markets, partly because of the vulnerability of the dollar (and both of these factors mutually reinforce each other). Today, few people want to save in dollars; their holders are ready to diversify their assets. Demand for the main alternative currency, the euro, has already risen to unprecedented heights, and there is good reason to continue this growth. The appreciation of the Chinese renminbi (also called the yuan) against the euro has created huge trade tensions between China and Europe, and the process is not over yet. I believe that the renminbi will continue to rise, and perhaps even faster. The actions of Chinese leaders are difficult to calculate, but there are a number of reasons why they should move in this direction. The most important is the threat of protectionism from the United States, and now also from Europe. The appreciation of the currency helps to reduce the tension associated with the excess positive trade balance. It also helps reduce price inflation, which is becoming a real problem for China. Since inflation depends mainly on the price of imported oil and food, the appreciation of the national currency is a direct antidote to this. In the past, there has been strong opposition to the high renminbi from the agricultural sector; but with rising food prices, it will no longer be significant. And this is for the best. However, the growth of the renminbi leads to problems, the meaning of which many do not fully understand.

China’s problem is that the real value of money is already almost negative, and the accelerated appreciation of the currency is only worsening the situation. This leads to the creation of an asset bubble. The process has already begun. Real estate is on the rise, with the Shanghai Stock Exchange rising 97% in 2007 and up 420% since July 2005 (when the four-year bear market ended). For reasons that I will detail below, this bubble is only in its infancy, but it will be extremely difficult to avoid a financial crisis in the future.

The problem in the US is that a rise in the renminbi will drive up prices at retail chains like Wal -Mart. A little inflation in a recession can be helpful, but the Federal Reserve should be concerned about the stability of the currency. I think that the Fed will gradually reduce the discount rate (perhaps by 0.25% at the end of each meeting of the Open Market Committee), but at some point the rates on long-term loans will not go down as expected, but will start to rise. At this point, the Fed will reach the limits of its ability to stimulate the economy. Again, I do not know exactly when this moment will come, but I assume that everything will start sooner rather than later.

Most economic forecasts indicate that the possibility of a recession is less than 50%. I don’t understand this kind of logic. In five years, housing will cost at least 20% cheaper than it is now – that is, prices will correspond to the incomes of American families. And at first, prices will fall even below the norm, which will clear the market. So far, as statistics show, there is no improvement in the market. Falls of this magnitude necessarily affect consumer spending, employment, and overall business activity.

Strong exports could be the only counter to this, but with a general slowdown in growth around the world, exports will also decline. Consumer spending has proven remarkably resilient, and there’s a noticeable shift in the positive outlook for the future, with 65% of homeowners expecting a modest increase in their value. According to my boom-bust theory , going forward , market participants will evaluate the situation negatively (also delusional about this) until the economy returns to normal. It is not clear if we are in the process of a recession now, but I have no doubt that we will slide into one in 2008.

It is not yet entirely clear what will happen to financial institutions. At the end of the year, a number of unpleasant surprises will be revealed, and the recession will lead to further collapse. Institutions have something to lose. CDOs tied to commercial real estate (especially large retail malls) can easily collapse. Banks traded credit default swaps ( credit default swaps ) linked to their balance sheets, so that a number of defaults cannot be ruled out as the recession progresses. Markets won’t be completely sure if they are aware of all the implicit commitments. The major investment banks have so far diligently replenished their balance sheets by increasing capital (mainly from sovereign funds), and this suggested that the banking industry could be saved. But the appetites of investment banks may soon be satisfied. And then the risks will be transferred to those who are not fully aware of them, and the price paid by the first investors may be too high.

Most likely, Europe will suffer as hard as the United States. Spain, which has its own real estate bubble, and the UK, given London’s importance as a financial center, are particularly vulnerable. European banks and pension funds, even more than American ones, are overloaded with doubtful assets, and an overvalued euro and pound sterling will negatively affect the European economy. The Japanese economy is also not doing very well. Together, developed countries make up 70% of the entire world economy. However, I am not sure that the entire world economy will fall into a recession. Positive dynamics prevails in oil-producing countries and a number of developing economies. It is commonly believed that when America sneezes, the whole world catches a cold. It was true before, but not now.

China is undergoing a period of radical structural transformation, which is being exacerbated by an asset bubble along with negative real interest rates. State-owned enterprises are transferred to private ownership, as a result, large blocks of shares of enterprises often fall into the hands of their leaders. Intelligent heads of state-owned enterprises were previously forced to earn extra money on the side; now it is much more profitable for them to earn money for companies that are beginning to pass into their ownership. Shares of companies listed on the Shanghai Stock Exchange may seem overvalued (the price of a share may be forty times higher than the expected earnings of the next year), but such a value may well become justified if the motivation of the management of these companies changes. Undoubtedly, the bubble is already forming, but it is still at an early stage, and its development is supported by quite powerful forces. The economic elite is ready to gladly exchange the current earnings for the ownership of property that can be passed on to their heirs. Managers of a huge number of companies yearn for liberation from state ownership and are doing everything to ensure that this process is not interrupted. There is nothing more profitable than investing in a bubble in the early stages of its development.

I visited China in October 2005 and, although I was no longer actively investing, I noticed huge investment opportunities, perhaps the best I have seen in my career. The Chinese economy has grown over the past decade by more than 10% annually, but corporate earnings have grown at a slower pace. After a short period of euphoria, typical of all emerging markets, the stock market began to move in a “bear” trend that has persisted for the past four years. It was only recently that the government announced a scheme under which state-owned blocks of shares would be brought to market within two years. It may have been the chance of a lifetime, but I did not want to go back to active money management, and besides, I could not find a reliable Chinese partner. We have made some investments in China, but, as always, not enough. Since then, the Shanghai Exchange Index has risen more than 400%.

China has a significant impact on the economies of other developing countries. Its raw material appetite is huge, and the development of the Chinese economy has been the main reason for the boom in the raw materials and dry cargo transportation industry. Despite the expected slowdown in global economic growth, the price of iron ore (of which China is the main consumer) could rise by at least 30% next year. China began to actively buy mining, processing and oil companies. He is also ready to prolong a long-term loan on favorable terms for African countries. China entered into a struggle with the West for the right to direct financial flows to Africa and became the main trading partner of many states of this continent. (It also gradually becomes the main culprit in the development of the greenhouse effect, but this does not directly apply to the issue we are discussing.)

Undoubtedly, a recession in the developed world will negatively affect the volume of Chinese exports, but the Chinese economy itself, its investments and exports to third countries will be able to compensate for this effect. Growth will slow down, but the bubble, fueled by negative real interest rates, will continue to grow. The stock index will not grow as fast as last year (it is possible that it will not grow at all), but new issues and the growth of the market itself will continue. The structural transformation of the economy will become more pronounced. Unprofitable state-owned enterprises will begin to disappear, and so-called “ super -state enterprises” will begin to dominate – companies created on the basis of former state-owned enterprises, well-managed and with real support for the high price of their shares in the form of assets received from the parent company. The process will be somewhat similar to what I called the merger mania in the chapter on Oligopolization of America in The Alchemy of Finance, but much more dramatic. It will definitely end in the coming years, and not the fact that it is bad. In my opinion, China will be able to overcome the current financial crisis and the subsequent recession and gain significant strength.

The long-term outlook for China looks uncertain. It would not be surprising if the currently developing bubble leads to a financial crisis in a few years. I said a long time ago that communism in China would come to an end as a result of the capitalist crisis. Conversely, China’s transformation into a country with a capitalist economy can take place without a financial crisis. Either way, China will challenge US dominance much sooner than expected when George W. Bush was elected president. This will be a real blow to Project for a New American Century! One of the most important tasks of the new administration will be to reconcile the interests of a rising China with the established world order.

At Christmas 2006, I visited India and was impressed by the potential for investment in this country – even more so than in China. India is a democratic country with the rule of law. In addition, investing in India is easier from a technical point of view. The main market indicators have increased significantly since that time. For example, India’s growth rate then was 3.5% per year (slightly higher than the population growth rate), but now it has almost doubled. The foundations for economic reform were laid by the current prime minister, Manmohan Singh, in his tenure as finance minister nearly a decade ago. It took some time to change the dynamics of the economy in the country, which was catalyzed by the successful outsourcing of information technology services. Last year, India provided about half of the newly created jobs in this industry globally, but even now, the number of people in this industry is less than 1% of the country’s total employed population. The industry has already passed the peak of its profitability. There is a shortage of skilled labor, and the rate of return is declining due to the appreciation of the national currency. Nevertheless, the positive dynamics spread to the entire economy.

The most notable example is the growth of the Ambani brothers’ business . When their father, the founder of Reliance Industries, died, the brothers divided his empire among themselves and are now trying to outdo each other. Their activities extend to many areas: oil refining, petrochemicals, natural gas production offshore India, financial services, even the production of mobile phones. Gas production will allow India to remain independent in terms of energy supplies over the next few years. Mukesh Ambani is using money from the oil and gas business to develop the Reliance Retail chain, which supplies food directly from producers to end consumers; this project allows to reduce the margin for the final consumer by more than half.

And although India’s infrastructure lags behind that of China, investment in the country’s economy is starting to grow, both through increased savings at home and through capital inflows from the oil-producing countries of the Persian Gulf, which employ many Indians. Therefore, I expect the Indian economy to develop normally, although a correction in the stock markets cannot be ruled out, due to the fact that the results are no longer as outstanding as before.

Another source of strength for the global economy lies in some of the oil-producing countries of the Middle East (I do not include the Russian market in this book). They are accumulating reserves at an astounding rate: in 2006 their growth was $122 billion, the estimated growth in 2007 is estimated at about $114 billion, and the total level is about $545 billion. These countries are willing to invest in various assets (not just bonds denominated in US dollars), each of them has sovereign funds, the size of which is growing rapidly. The Gulf countries decided to invest in their own economy in order to develop access to cheap energy sources, build oil refineries and petrochemical plants, expand aluminum production, and so on. The only factor holding back this development is the lack of labor and equipment. By solving these problems through their competitive advantages, countries may well become the dominant force in these industries. The authorities of the emirate of Abu Dhabi decided to create a metropolis that can compete with Dubai. With reserves in excess of a trillion dollars and a population of 1.6 million people (80% of which are foreigners), they can afford it. Accelerated development has created inflationary tensions and, consequently, grounds for not pegging currencies to the dollar. Kuwait has already done so, but other countries, notably Saudi Arabia, have refused to follow suit, in large part because of strong political pressure from Washington. The dollar peg, coupled with domestic inflation, led to negative real interest rates. Gulf stock markets are recovering from the severe crash that followed the initial euphoria, and negative real interest rates are attracting capital from abroad, just like in China.

This is the negative effect of the dollar peg, although the Gulf countries (not including Kuwait in this case) do not have a currency band system. I believe that the dynamics of their development is strong enough – despite the political risks caused by the position of Iran – and will be able to withstand the global slowdown. Any reduction in interest rates in the United States will increase the desire of the East to abandon the dollar peg.

Sovereign funds are becoming important players in the international financial system. They currently stand at around $2.5 trillion, according to some estimates, and are growing rapidly. They have already invested $28.65 billion in weakened financial institutions. (By comparison, China invested $5 billion in Africa.) Sovereign funds can be expected to become lenders and investors of last resort, somewhat reminiscent of the role Japan played after the stock market crash of 1987. However, sovereign wealth funds are more diversified than the then Japanese financial institutions; Apparently, the paths of their further development will diverge. Most likely, the financial crisis will increase the degree of interest of Western countries in such structures. Do not forget about the political opposition faced by the Chinese state corporation China National Off shore Oil Corporation, which was trying to acquire Unocal , or DP World, a Dubai-based company that wanted control of American ports. One can imagine how willingly sovereign wealth funds would prefer to invest in developing countries, the only limit being the ability of these countries to accept any amount of capital. In all likelihood, this will lead to positive dynamics in the development of the economies of countries receiving capital. Sovereign funds are likely to become the most important stakeholders in the US economy, too, if they do not face serious protectionist measures.

The question remains at what point the global slowdown will turn into a global recession. Apparently, developing countries will survive it better than developed ones. In some cases, periodic reversals of the trend can be expected, when investments in the extractive industries can lead to the formation of excess production capacity.

The best strategy in 2007 was to go long in emerging markets and short in developed markets. I expected a similar development in 2008, with one exception: I expected to shift the focus of my strategy to short positions. Due to the fact that my fund, formerly a purely hedge fund, has become an endowment fund, and my role in its management has decreased, I do not feel it possible to go into detail about the structure of our investment portfolio, as I did in the book “The Alchemy of Finance”. However, I can summarize my investment strategy for 2008 in one sentence: shorting US and European equities, 10-year US government bonds, and the US dollar; long positions in shares of China, India and the Gulf countries, as well as currencies not pegged to the dollar.