Sunday, December 02, 2007

A Global Depression or Platonicity? II

``Our tendency to mistake the map for territory, to focus on pure and well-defined “forms”, whether objects, like triangles, or social notions, like utopias (societies built according to some blueprint of what “make sense”), even nationalities. When these ideas and crisp constructs inhabit our minds, we privilege them over less elegant objects, those with messier and less tractable structures…Platonicity is what makes us think that we understand more than we actually do.”-Nassim Nicolas Taleb

Projecting past performance into the future is a hazardous strategy. The recent fiasco in the US mortgage markets has been mostly due to such built in expectations of a perpetual boom.

Recalling ex-Citigroup CEO Chuck Prince’s infamous quip, ``When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing". That’s one pitfall which we stridently wish to avoid.

Thus, if a US hard landing scenario emerges where deflation or a severe credit “crunch” takes a firm grip on its markets and the economy, then the attendant monetary measures to be engaged by US authorities are likely to be aggressive (including the much ballyhooed Helicopter strategy by Ben Bernanke), considering their natural inclination to be averse to a Japan-like malaise.

As we earlier pointed out in our September 3 to 9 edition, [see A Global Depression or Platonicity?], the degree of exposure to tainted leveraged instruments in Asia has been limited.

And those advocating for a global meltdown could simply be overestimating on what they know and underestimating on what they don’t, and not giving enough room for randomness to operate, hence our tendency to “mistake the for territories” from which we cited Nassim Taleb definition of Platonicity.

As we also mentioned above, while financial globalization via integration of financial markets has the predisposition to increase correlations, different currency regimes aside from the divergent levels of development of the financial markets are likely to result to different outcomes in the face of such aggressive policy maneuvers.

For instance, considering that major currency reserve holders as China, GCC nations and Hong Kong, have effectively wrapped or surrendered their domestic monetary policies to that of the US by virtue of a US dollar peg, monetary policies are likely to have different impacts to their markets and economy compared to the US.

As Stephen Jen of Morgan Stanley splendidly wrote (highlight ours),

``The credit crunch we are witnessing is really a ‘rich’ countries’ problem. Much of EM (the GCC countries, China or Hong Kong) is unaffected and will not likely be directly infected by it. (We put ‘rich’ in quotes because on some measures some EM countries are richer in cash…) EM may eventually be adversely affected by an economic slowdown in the developed world, through trade, but not in terms of the credit cycle freezing up. In China, for example, the government has intentionally imposed a credit freeze, because it has too much liquidity. The same problem of excess liquidity is still faced by many other countries, such as Hong Kong, the GCC countries and some other EM economies.”

If the recent credit triggered market mayhem should serve as the proverbial canary in the coal mine then figure 4 courtesy of Rating and Investment Information shows how ASEAN Credit Default Swaps performed under the recent duress.

Figure 4: Rating and Investment Information: Narrowing ASEAN Spreads Indicator of Strength?

The cost of Credit-default swaps or contracts designed to protect investors against default has steadily narrowed since 2005 for ASEAN countries including the Philippines and Indonesia, the most vulnerable member countries of the region.

Yes, while there had indeed been a spike in CDS spreads during the August turmoil (encircled), it appears that these spikes can be discerned or construed as more of an “aberration” than of a reversal as the spreads appear to “normalize” or narrow anew.

Figure 5: IMF GFSR Report: Buyers of CDO (In percent, delta-adjusted basis)

As to further examine on the potential impact from the risks of the recent credit crisis turning into a full scale credit seizure, we can further estimate on the portfolio holdings by Asia of infected instruments as previously done.

Collateralized Debt Obligations (CDO) are investment grade structured finance products that are collateralized by asset backed securities, including subprime mortgages. The markets for these credit products have been heavily distressed following the string of losses brought about by the recent credit maelstrom, where estimated losses according to some analysts for the world’s biggest banks are at $77 billion with a potential to reach $260 billion (Bloomberg).

IMF’s latest Global Financial Stability Report as shown in figure 5 estimates that the bulk of the losses or those affected by these “toxic waste” products has been mostly from to the US.

According to the IMF (highlight ours),

``Direct exposure extends beyond the United States, with European and Asian investors active in the ABS and related markets. A handful of European institutions have already reported difficulties or closed owing to their exposure to U.S. mortgage markets and the withdrawal of their short-term funding, and still more are believed to be exposed to indirect mark-to-market losses stemming from their credit lines to conduits and structured investment vehicles. Within the Asia Pacific region, various market analyses suggest that exposure to mortgage-related products is concentrated in Japan, Australia, Taiwan Province of China, and Korea, but their overall exposure has been characterized as manageable and that region appears to be insulated from default risk.”

Figure 6: IMF GFSR :Probability of Multiple Defaults in Select Portfolios (In percent)

Figure 6 from the IMF’s GFSR likewise shows that among financial institutions large complex financial institutions (LCFIs) have been largely prone to losses reflecting extensive exposures to credit derivatives, whereas among emerging markets the estimated default risks remain “benign” with emerging Asia having the least risk.

From the IMF,

``Reflecting a weakening in credit discipline that has emerged along with the growth in credit, private sector borrowers in certain emerging markets are adopting relatively risky strategies to raise financing, often embedding exchange rate risk or options and thus increasing their exposure to volatility. Most noticeably, in some countries in Eastern Europe and Central Asia, banks are increasingly using capital market financing to help finance credit growth. Nevertheless, generally benign emerging market banking system default risk indicators continue to reflect market perceptions of healthy capitalization and profitability, as well as diverse earnings sources and sound asset quality. These trends warrant increased surveillance, as circumstances vary considerably across countries. Authorities in some emerging markets need to ensure that vulnerabilities do not build to more systemic levels. Across all emerging market countries, policies that support continued resilience should help, as global market conditions are likely to remain volatile.”

All of this simply reflects on the divergent exposures of different regions to the recent turmoil.

While we agree with the hard landing camp that trade or economic linkages are likely to affect global markets, where we part is the degree of impact. We don’t share the view of a global financial or economic meltdown.

Monetary policies even if even if they are to be ineffectual in the US are likely to impact the financial markets of different regions at varying degrees.

Given the inflationary tendencies of central banks, under the present Paper money standard, the most likely scenario will be a shift of bubble from one asset class to another, either to commodities or to Asian markets or both.

No comments: