Monday, May 26, 2008

If Oil Is A Bubble, Then It Is A Government Sponsored Bubble!

``The economic hardship, of which we had a taste in 1981 and 1982, will be much worse. That in itself is bad enough news, but historically, when a nation debauches its currency international trade breaks down — today 40 percent of international trade is carried out through barter — protectionist sentiments rise — as they have in Congress already — eliciting hostile feelings with our friends. Free-trade alliances break down, breeding strong feelings of nationalism — all conditions that traditionally lead to war; a likely scenario for the 1990s, unless our economic policies and attitudes regarding government are quickly changed.”- Congressman Ron Paul, The Economics of a Free Society

Are Oil and Commodities In A Bubble?

Oil prices dashed to a phenomenal record at $135 per barrel and many have screamed “BUBBLE”!

By definition a bubble means assets or securities priced far from its perceived “fundamentals” or irrationally and impulsively driven by excessive speculation.

The stated reasons for the commodity “bubble”: forced short covering from miscalculated bets, frenetic inventory accumulation by big oil consumers (e.g. airlines) or by nations- such as China use of diesel generation for rescue efforts and for stock piling ahead of the Olympics and worst, alleged collusion to manipulate oil prices such as evidences of government contracted oil tankers holding inventories at seas, rerouting of speculative trades from regulated markets to unregulated markets such as OTC and International Exchange (ICE) and massive jump of investments from pension funds and banks via “Indexed” Speculation.

Any markets always contain certain degrees of speculative element simply because of varying expectations and interests by market participants which are essentially reflected on prices. Some are there to hedge their produce, some are there to profit from short term/momentum trades or take advantage of arbitrage spreads, some are there to profit from long term investments and in cases of a bubble, most will be there simply to be a part of the crowd!

As for the supposed commodity bubble, as we noted previously, while there have been some signs of an emergent bubble, they seem far away from being a Bubble “bubble” as we know of.

Mainstream analysts continue to cavil as they did in early 2006. For us, this represents signs of denial. They think of the financials (with all its present hurdles) and the tech industry as still the vogue place to be and such represents as high quality investments, while the commodity industry has always been condemned and is still relegated to account of low grade cyclical driven speculation. They think past performance will produce the same distribution outcomes.

Under the framework of the psychological cycle operating under a boom-bust or bubble cycle, until the mainstream thinking capitulates, the commodity boom has an enormous room to run.

Yes, we don’t deny that sharp movements of prices assets in one direction should equate to equally dramatic movements to the downside, but what concerns us is the long term trend because trying to time markets for us is a vanity play.

In May of 2005 The Cure Is Worse Than The Disease, we outlined our case for the bullmarket in oil…

``1. US Federal Reserve for expanding credit to an unprecedented scale and its negative real interest rate policy which fueled massive speculative positions globally,

``2. The excess printing of paper monies by the collective governments stoking an inflationary environment,

``3. The OPEC members for nationalizing their respective oil industries thereby misallocating capital investments that led to the present underinvestments,

``4. The Chinese government for adapting a market-based economy (from less than 100,000 cars in 1994 to over 2 million cars 2004),

``5. The US dollar-remimbi peg that accelerated an infrastructure and real estate boom thereby increasing demand for oil,

``6. The war on terror that has disrupted oil supplies,

``7. The Bush administration for the continually loading up the Strategic Petroleum Reserve, and…

``8. The lawyers and environmentalists for increased regulations on explorations and oil refinery requirements.

Have any of the above factors changed? Except for the recent suspension of the stockpiling of the US Strategic Petroleum Reserves, generally all of these fundamentals remain in place.

But we’d like to make some modifications if not additions; for the demand side it’s not only about China but of emerging markets (we are talking about India, Brazil, Russia, Southeast Asia and others representing about 80% of the world’s 6.6 billion population).

Most importantly, we missed one very important variable which ensures the longevity of the commodity cycle….PRICE CONTROLS.

Nonetheless, have oil prices risen enough to impact demand? We doubt so, simply because the market price of oil has not been reflected equally in different countries because of the varying extent of PRICE CONTROLS and if not tax structures encompassing the industry.

Politicization Of The “Oil Bubble”

The recent “bubble” perspective arises from mostly the arguments of the “DEMAND” side.

Just because investments in commodity indices (of which oil makes up a significant share) allegedly surged from $13 billion to $260 billion doesn’t imply that it is in a bubble. Not everything that attracts investments automatically equates to a bubble. Not everything that goes up is a bubble.

Media’s “framing” of information based on relative figures depicts of a bias. And this cognitive bias is known as the Contrast Principle where-we notice difference between things, not absolute measures (changing In contrast, the market for derivatives exploded by 44% to $596 TRILLION (and not billions) or to over TEN times the global GDP, yet mainstream seems quiescent about such development. Derivatives are financial instruments or contracts based on the underlying assets such as foreign exchange, interest rates, equities, commodities, inflation indices or even weather predictions.

Why? Because commodity prices impact the real world. And in the real world, people’s lifestyles are affected by commodity price movements, thus have the tendency to be politicized.

And because people refuse to understand the underlying issues, instead they seek for emotionally satisfying terse explanations via melodramatic narratives as seen through heroes and villains. To quote Thomas Sowell ``Voters don't want to hear about impersonal things like supply and demand. They want to hear about how their political heroes will stop the villains from "gouging" them or "exploiting" them with high prices. Moral melodrama is where it's at, politically.”

Nonetheless, when measured relative to its exposure as financial derivatives, according to the Bank of International Settlements, commodities account for only 1.5% (26.5% growth year on year) of the outstanding derivatives in 2007 compared to interest rates 65% (34.83% growth year on year), foreign exchange 9.4% (39.65%), credit default swaps 9.7% (102%), equities 1.4% (13.6%) and others. So as a function of the derivatives markets in relative terms, we don’t see any signs of bubble like performances from commodities.

Yet, commodities cannot be qualified in the same way we evaluate stocks or housing assets, as Ms. Caroline Baum of Bloomberg rightly argues (highlight mine),

``With other asset classes, there are metrics that allow us to quantify the degree to which prices have strayed from their fundamental moorings. Stock prices have an historical relationship with underlying earnings. House prices don't stray too far from their ``earnings'' stream, or rental value.

``With commodities, no such quantifiable ratio exits. Instead, analysts point to verticality, or the rate of price increases in a short period of time; to the fact that open interest in futures contracts dwarfs actual supply; or to the sheer volume of trading.”

In other words, in the absence of any valid metrics to assess if commodities prices have meaningfully careened away from fundamentals, market price actions have been the principal criteria for labeling the activities of oil and commodity prices as a bubble. And market price actions do not tell the whole picture.

This leads us to politicization.

Some have argued to regulators to restrict or limit the participation and speculative positions of institutional investors (pension funds, hedge funds and etc.) into investing in oil and commodity space since they have accounted for a substantial increase in the market capitalization of commodity based index funds.

Backed by circumstantial evidence, the claim is that additional demand from institutional investors represents a form of “hoarding” in the futures market unduly driving up prices. Investors have been able to go around Commodity Futures Trading Commission (CFTC) market position limits on commodity acquisitions by swapping with investment banks, who in turn hedges the (total return) swap by buying futures contract. This loophole of allowing swap for hedges has paved way for the unlimited size positioning which concurrently drives up the market caps of commodity index funds.

But cash and futures market signify two distinct functions which essentially refutes such argument, according to the Economist (emphasis mine),

``Yet few bankers agree that speculation has much to do with price rises. For one thing, indexed funds do not actually buy any physical oil, since it is bulky and expensive to store. Instead they buy contracts for future delivery, a few months hence. When the delivery date approaches, they sell their contract to someone who actually needs the oil right away, and then invest the proceeds in more futures. So far from holding oil back from the market, they tend to be big sellers of oil for immediate delivery.

``That is important because it means that there is no hoarding, typically a prerequisite for a speculative bubble. Indeed, as discussed, America’s stocks and those of most other countries are at normal levels. If the indexed funds were indeed pushing the price of oil beyond the level justified by supply and demand, then they would be having trouble selling their futures contracts at such high prices before they matured. But there is no sign of that. In fact, until recently, oil for immediate delivery was more expensive than futures contracts.

This is especially elaborate in the non-storable commodities (livestock and meats). The point is cash markets represents the actual balance of demand and supply and is unlikely to be subjected to massive speculations as alleged to be in contrast to houses or stocks.

Governments Controls The Supply Side Of The Oil Market

This brings us to the arguments vastly overlooked by Keynesian populists, the supply side.

Given today’s highly anticipated global economic slowdown, reduced economic activities should have translated to lower demand, thereby pulling down prices. Yet with oil prices having doubled over the past year, pricing signals should have dictated for more supplies, as shown in figure 1.

Figure 1 courtesy of US Global Investors: Oil Supplies remain Stagnant

But conventional supplies have hardly made a dent to the oil pricing market possibly due to the stagnant production by both OPEC (green line) and Non-OPEC (blue line) even amidst a global economic growth slowdown. With a slim spread between supply and demand, any drop in demand could easily be offset by an equivalent drop in supplies, and if supply falls faster than demand prices then prices will continue to rise!

And importantly, we must not forget that the supply side of the oil market is basically controlled (about 80% of reserves) by governments through national oil companies. Hence, the oil market is NOT a laissez faire or free market, but like rice or food markets, they account as political commodity market functioning under the auspices of nation states.

If oil is indeed in a “bubble” and government intends to pop the “bubble”, then common sense tell us that oil producing governments can simply deliver the coup de grace by offloading its “surplus” oil into the market! No amount of “speculative futures” can withstand the forces of actual supplies crammed into the markets. But has this happened? No.

If the oil markets have NOT been responding to the price signals, it is because the national oil companies, aside from governments themselves, have been responsible for the supply constraints and nobody else.

Underinvestments arising from misallocation of resources, geological restrictions emanating from environmental concerns, legal proscriptions to allow private and or foreign capital for domestic oil explorations and development of the industry (as in Mexico), nationalization of the oil industry (see Figure 2) and capital and technological inhibitions from national governments have all contributed to these imbalances.

Figure 2 Resource Investor/ Guriev, Sergei, Anton Kolotilin, and Konstantin Sonin: High Oil Prices lead to Expropriation or Resource Nationalism

Resource nationalism or nationalization or expropriation happens during high oil prices as the Resource quotes Sergei Guriev, Anton Kolotilin, Konstantin Sonin’s paper (highlight mine),

``On the one hand, it seems natural that the higher the oil price, the more valuable the oil assets and the stronger the incentive to expropriate. On the other hand, given the costs of expropriation, it is not immediately clear why a government of an oil-producing country would respond to a positive oil price shock with expropriation rather than just with imposing higher taxes. Using taxes contingent on (observable and verifiable) oil prices, the government can preserve oil companies' incentives for investment in new fields and cost-reducing technologies. This straightforward solution, however, relies on the external enforcement of contracts, which is not the case: the government is both an enforcer and a contracting party. Therefore, this contract can only be self-enforced. As BP’s then-CEO recently said, “There is no such thing in the [Petroleum] E[xploration] & P[roduction] business as a contract that is not renegotiated” (Weiner and Click, 2007). The only protection for a private company is the government's desire to benefit from more efficient production in the future and checks and balances that assure that the government in office pursues the long-term national interest…We show that expropriations are indeed more likely to take place when oil price (controlling for its long-term trend) is high and in countries where political institutions are weak. The results hold for both measures of institutions that we use (constraints on the executive and the level of democracy from the Polity IV dataset). Most importantly, the results hold even if we control for country fixed effects; in other words, in a given country, expropriation is likelier in periods of weakened institutions.”

With due respect to Mssrs. Guriev et. al., the main difference between nationalization and higher taxes essentially boils down to control.

Private companies operating under high tax regime may use accounting ruses to go around taxes or resort to technical smuggling. In contrast, nationalization denotes of complete control over oil revenues.

Further, countries with politically weak institutions only underscore such dilemma. Companies can bribe their way out of taxes and unevenly distribute pelf to the bureaucracy. On the other hand, under nationalized industries bribes or corruption are most likely systemically organized.

Besides, the main incentive why countries engage in resource nationalism is almost entirely about politics. Oil companies can be a source of rewarding political affiliates or dispensing of political favors. Oil revenues can also be meant for expanding bureaucratic spending such as popular social welfare programs in order to preserve the incumbent’s grip on to power.

This is of course aside from what we mentioned earlier, accrued material personal benefits by those in power. Like cows, national governments find a way to milk these oil companies until they dry.

Besides, future development is only a catchword for vote generation applicable mostly during election seasons.

Governments Also Influence Demand Side Of The Oil Market

Governments have likewise been directly and indirectly responsible for pumping up demand.

This by inordinately expanding money and credit intermediation via a loose monetary, price caps and subsidies that has led to widespread smuggling across borders and expanded demand because of profit incentives through price arbitrage and “hoarding” and the amassing of strategic reserves by oil importing countries.

Figure 3: Whiskey and Gunpowder: Money Supply and Oil Prices

Chris Mayer of Whiskey and Gunpowder opines that US money supply and oil prices has an unusually powerful correlation as shown in Figure 3.

Quoting Mr. Mayer (emphasis mine), ``Since January 2001, you can explain the move in the price of oil largely as a function of increasing money supply. As the amount of money grows, the price of oil rises. In fact, almost 87% of the move in the price of oil can be explained by the increase in money supply.

``Basically, $100 per barrel oil is what we would expect to see, given this relationship between the oil price and money supply. Given that we are still in the midst of a credit crisis of sorts, it seems unlikely the Fed will tighten money in any way at all. That leaves a clear path for the price of oil and commodities to continue to rally in nominal terms.”

Since the US is presently engaged in a currency debasing policy as seen with its ongoing “nationalization” of mortgage related losses or whose financial sector have been undergoing a “liquidity” transfusion from the US Federal Reserve, such loose policies have been weighing enormously on the US dollar. The softening economy likewise has contributed to these dollar infirmities.

And since oil prices have been traded mostly in US dollars, the weakening of the US dollar has similarly accounted for a strong inverse correlation with oil prices. In short, a weak dollar-strong oil phenomenon as seen in figure 4.

Figure 4: Stock US dollar Index, Euro and Oil

From the Sydney Morning Herald: ``The correlation coefficient between oil and the euro-dollar exchange rate has been 0.95 for the past year, indicating they have moved in the same direction 95% of the time. The correlation is calculated based on the price changes of oil and the currencies.”

This simply means that given the same rate of a near lockstep association, if the US dollar index (whose basket comprise over 50% weightings by the Euro) continues to weaken, oil prices will most likely continue with its advance or vice versa.

The blue vertical lines, in Figure 4, shows of some notable congruence (interim inflection points) in the prices activities of the US dollar and Oil or Euro.

In addition to US money supplies and the inverse correlation of the US dollar Index and Oil, we have long argued that the US policy of “reflation” are being transmitted to emerging countries via monetary pegs which results to even looser policies leading to a more intense “goods and services” inflation on a globalized scale, see Figure 5.

Figure 5: Economist: Negative Real Rates and A Boom in Global Money Supplies

We have always emphasized on the importance of interest rates because it determines the saving, spending and consumption patterns of individuals, industries or economies and thus shape economic growth, direction of asset domestic asset prices and “inflation” expectations. Meanwhile, the yield spread is one of the many major contributory factors that generate investor incentives or disincentives for allocating scarce resources.

The chart shows how the world has embarked on a loose monetary policy characterized by a booming money supply (right) mostly in emerging markets and negative real interest rates (left) as measured by short-term yields over nominal GDP growth, where the Economist notes ``So it is worrying that global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative.”

Loose monetary policies threaten economic growth by price instability or the acceleration of “goods and services” inflation. Again from the Economist (emphasis mine),

``Even if the Fed's interest rate suits the American economy, global interest rates are too low. In turn, the unwarranted stimulus to demand in emerging economies is further pushing up commodity prices; so too is speculative buying by investors seeking higher returns than from bond yields, which are still being depressed by the emerging economies' build-up of reserves. This stokes inflationary pressures in America and Europe and makes life difficult for rich-country central banks.

``Loose money in America and rigid exchange rates in emerging economies are a perilous mix. The longer emerging economies hold down their exchange rates, the greater the risk of rising global inflation. Admittedly, exchange-rate appreciation is not as simple a remedy for emerging economies as some claim: a rise in interest rates and the expectation of a further appreciation in the exchange rate could, perversely, exacerbate inflation by sucking in more capital; and setting the exchange rate free risks massive overvaluation. But with an economic serial killer on the loose, one way or another monetary policy will have to tighten and exchange rates rise.”

So those worried about the pockets of “deflation” in some parts of the world should likewise reckon with how in a global economy, the US Federal Reserve policies as the de facto international currency reserve, has diffused into the emerging markets and how these policies have affected the investing and consumption patterns which has been affecting commodity prices now spreading over to a more pronounced politically sensitive “goods and services” inflation.

Moreover, the investing pattern arising from the growth stories of commodity backed emerging countries have provided further backstop to commodity and commodity based investments.

Next we have price controls.

In an effort to control goods and prices inflation many countries have used price controls or subsidies to buy political stability. Price controls have created arbitrage opportunities within borders, escalating demand for oil to profit from spreads. Such arbitrage opportunities have prompted for incidences of fuel smuggling even within China or in parts of the Asian region and elsewhere.

I even read an account somewhere where some Hong Kong residents have been said to transit to nearby China in order to have their gas tank filled, since gas prices in China is said to be a third of the world market.

These price distorting schemes have helped in the expansion of outsized demand for fuel around the world which has led to elevated oil prices at these levels.

Since rising commodity prices affect the real economy, the clamor for political subsidies will continue to mount.

Commodity bears argue that emerging markets can’t afford such subsidies because it will impair their fiscal positions, thus by lifting subsidies demand will slow.

If political survival is at stake, it is highly questionable if the present set of leaders will undertake unpopular measures that would compromise their positions.

Besides, the other factors possibly influencing the demand supply imbalances in the oil market could due to geopolitical considerations, the structural decline of conventional global oil production (otherwise known as “peak-oil”) or as an unintended consequence from stringent regulations.

If it is also true that government tankers were reportedly kept at seas or seemed to have withheld inventories on the account of expectations for higher prices then it all also goes to show that governments themselves have been engaged in speculations over oil prices.

Needless to say, if oil is in a bubble, then it is obviously a government sponsored bubble!

Sunday, May 25, 2008

Commodity Boom Driver of Emerging Market Powered Global Decoupling?

``Commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. Developing, BRIC-like economies are obvious choices for investment dollars.”-William Gross, Pimco, Hmmmmm?

Faced with oil at $135, global equity markets fumbled over the week over the prospects of “inflation” according to mainstream media.

We doubt such premise. As we have earlier pointed out in Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?, our view is that a recessionary risk in the US has been more of a force to reckon with. Higher oil or food prices simply compounds the economic woes of the US.

Major US benchmarks fell hard this week with the Dow Jones Industrials losing 3.91%, the S & P 500 down 3.47% and the Nasdaq down 3.33%. Surprisingly, global markets had been least affected compared to the past.

In fact, a key emerging market benchmark, the MSCI Emerging Market index earlier in the week managed to recoup the year’s losses (Bloomberg) but fell back following this week’s correction. As of Friday’s close, the MSCI EM is down 3% after falling as much as 16% in March.

Figure 6: Soaring Commodity based Benchmarks!

Yes, despite record oil and food prices, major commodity bellwethers as in Brazil’s Bovespa (upper window), Canada (Dow Jones Canada-main window), South Africa (Dow Jones South Africa-pane below center window) and Russia’s RTS (lowest pane) have all been drifting at fresh record highs as shown in figure 6.

While one may argue that three of the four indices are major oil exporters, this hasn’t been entirely the case for all major oil exporters if one considers the performances of the GCC countries. Among GCC states, Oman, Bahrain and Qatar are now at record high levels, while UAE, Saudi Arabia and Kuwait have been drifting sideways. In Asia, only Thailand, a non oil exporter, among all Asian countries seems to be fast closing in on its previously set record.

The point is that the commodity boom has managed to keep emerging market indices afloat despite the ongoing travails of the US and some European countries. The trend is likely to continue over the long term.

For the Phisix, as a former major commodity exporting nation, the bullish sentiment on commodity exporting countries should spillover to our equity assets. Maybe not all, but on select commodity related issues.

Yes, goods and price inflation poses as a threat to the economy but it does not necessarily mean equity markets cannot survive as previously discussed in Phisix, Inflation and the Available Bias and Inflation Data Brings Philippines Into Deeper Negative Real Rates; NOT A Likely Cause of Today’s Decline. Essentially there will be assets that would still benefit from such environment.

If we are to see a reprise of the real asset boom of the 70s to the 80s then as the table 1 shows (courtesy of Dr. Marc Faber) and as previously discussed in September 2005’s Gold At Fresh 17 Year Highs; Currency-wide bullmarket begins!, a similar pattern of return distribution could emerge where commodity related investments are likely to outperform the market.

Risk Of A US Dollar Crisis: Benign or The Austrian Endgame?

``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”-Ludwig von Mises, Human Action, The Monetary or Circulation Credit Theory of the Trade Cycle

As a final thought, many people ignore the risks of a US dollar crisis.

Crisis happens because they are an unexpected. It is a black swan or statistical fat tail. The US housing crisis was a much anticipated outcome yet many got caught owing to the belief that they would be able to get out on time. They never expected a buyer’s boycott.

Another, the repercussions from the US housing bust was largely unforeseen. Nobody saw that the investment grade AAA papers would lose sizably in value. Nobody predicted the extent of the contagion from the mortgage bust which would lead to a seizure of global credit markets.

Today, the US dollar continues to fall. The conventional expectation is that the declining trend of the dollar will be orderly. The culmination of the US dollar crisis is presumed to be a benign “overshoot” of the currency’s valuation which would fall low enough to attract enough foreign buyers and reverse the decline. We hope this is the right scenario.

However, the Austrian school’s endgame outcome is different. The risk from a US dollar crisis probably suggests of the collapse of the global currency standard and the end of the US dollar as the world’s de facto foreign exchange reserve. It also suggests that the world may experience a bout of hyperinflation, as the entire chain structure of paper money collapses. To quote Anthony Mueller, The End of Dollar Supremacy, ``Losing trust does not mean that there must be a ready substitute. On the contrary: when distrust will emerge towards the US dollar this would affect the attitude towards all paper currencies. In the final stages of the currency crisis, the dollar will most likely devalue not so much against the euro and the yen, but all of these currencies and most of the rest will devalue drastically against gold.”

Yet the common denominator of countries that experienced hyperinflation had war related expenditures, protectionist walls and uncompromising leadership which pursued onerous welfare policies that eventually resulted to a lose of faith in the country’s currency. These ingredients have been not absent from today’s landscape. The difference is at least we remain globalized.

I came across a sober article from a blogger Steve Waldman who suggests that today’s commodity boom could be seen as “a run on central banks”.

To quote Mr. Waldman (highlight mine) ``Capital devoted to precautionary storage would be better employed building new enterprises, laying a foundation for tomorrow's prosperity. But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban "hoarding, profiteering, and price-gouging". People will hoard anyway if they don't believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won't suffice. Nor will yet another drink from the punch bowl.

Since the pillar of the world’s Paper money standard depends solely on faith on the credibility of the issuer of money, all it needs to topple the entire system is to lose such binding faith. I hope we don’t lose it.

Friday, May 23, 2008

Driver Of The Philippine Peso: Available Bias, Oil or the China’s Yuan? Part II

We are told today told that rising food and energy prices have been wreaking havoc to some emerging market balance sheets and thus have "caused" the fall in the respective currencies.

Korean Won, Philippine Peso and Indonesia’s Rupiah
Courtesy of Danske Bank

As we commented earlier, we are not persuaded with this argument because it seems to gloss over the other side of the trade-if emerging markets are expanding liabilities for social safety nets in face of “higher inflation”, have not the US likewise been throwing money at its financial markets in order to “reflate” the economy?

USD/Yuan courtesy of yahoo

We might be charged with the cognitive bias of “clustering illusions” or looking for pattern where there is none, BUT it does seem that the price actions of the Korean Won, Indonesia’s Rupiah and the Philippine Peso appears to have coincided with the movements of the Chinese Yuan, as we earlier argued at Driver Of The Philippine Peso: Available Bias, Oil or the China’s Yuan?.

The chart above shows that last September’s speed bump of the Yuan was nearly in consonance with the spike in the USD/WON, USD/PHP and USD/INR.

Today as the Yuan seemed to have paused from advancing against the US dollar, the aforementioned currencies lost meaningful ground.

USD Index courtesy of

Now seen from the lens of the US dollar index, we uncannily observe of a pattern resemblance with the Yuan; the US dollar index paused from its recent downtrend and attempted a rally which appears to have fizzled out.

Could it be that once the US dollar index resumes its downdraft, the Chinese Yuan would recommence with its appreciation? And if the Chinese Yuan plays a more significant role than energy or food prices, as we suspect it to be, perhaps we might see these Emerging Asian currencies strengthen anew, despite higher oil or food prices?

Thursday, May 22, 2008

World Bank’s Prescription for Sustained Economic Growth: Governance Committed To A Market Economy

The World Bank recently made a prescription for an ideal sustained growth; notes the Economist (highlight mine)...

“SINCE 1950 13 countries have grown at an average rate of 7% a year, or more, for 25 years or longer. Were these exceptional “economic miracles”, or models for others to follow? On Wednesday May 21st a new study on the subject, “The Growth Report: Strategies for Sustained Growth and Inclusive Development”, was published by a body of thinkers and policymakers brought together by the World Bank (one of our Delhi correspondents was involved in editing the final report). The report notes that the causes of breakneck growth varied significantly between countries, but it identifies five points of broad resemblance:

1. FULL EXPLOITATION of the world economy (importing bright ideas and technology; producing exports that others want);


3. HIGH RATES of saving and investment;



courtesy of the World Bank

“Given their steady years of growth, India and Vietnam may be on their way to joining this select group.

The 13 economies as listed by the World Bank…

courtesy of the Economist

The common characteristics of these high growth countries, to quote the World Bank,

``The high-growth countries benefited in two ways. One, they imported ideas, technology, and knowhow from the rest of the world. Two, they exploited global demand, which provided a deep, elastic market for their goods. The inflow of knowledge dramatically increased the economy’s productive potential; the global market provided the demand necessary to fulfill it. To put it very simply, they imported what the rest of the world knew, and exported what it wanted.”

In short, governance committed to the Market Economy which benefits from a global division of labor buttressed by exchanges of ideas, technology and optimum resource allocation as dictated by the market forces.

Monday, May 19, 2008

Foreign Money on Domestic Mining Industry

Why we think foreign money has been flowing into Mining stocks and why we think they will continue to pump them up…

Here are some clues.

First clue: benchmark indices of several key commodity countries are at record highs.

Courtesy of Bloomberg: Brazil’s Bovespa

Courtesy of Bloomberg: Canada’s S&P/TSX

Courtesy of Bloomberg: Russia’s Russian Traded Index

Second clue: global mining indices likewise are on the ramp!

Courtesy of Dow Jones US mining

Courtesy of S&P Metals and Mining Index

Courtesy of S&P Global Mining Index

Third clue: Best and Dominant Performers during the Past 3 months (as of Friday’s close)

Courtesy of Big


Sunday, May 18, 2008

Driver Of The Philippine Peso: Available Bias, Oil or the China’s Yuan?

``The problem is not that supply and demand is such a complex explanation. The problem is that supply and demand is not an emotionally satisfying explanation. For that, you need melodrama, heroes and villains.” - Thomas Sowell, Too "Complex"?
The Philippine Peso has lost 5.78% since it peaked at Php 40.33 (closing quote) against a US dollar in February 28th of this year. Year to date the Peso is down 3.55%.
Falling Peso and Media’s Available Bias, What Happened To Remittances?
Yet mainstream analysis seems lost with what has been going on. We’ve heard all sorts of oversimplified explanations or narrative causations covering the rice crisis to fiscal imprudence to surging oil prices to high “inflation” to risk aversion or to political maelstrom. But these factors do not seem to add up.
Previously, the popular explanation was that the strength of the Peso has been driven primarily by remittances, with subsidiary (and belated) attributions to portfolio flows. We argued against this remittance prompted Peso-appreciation in Philippine Peso And Remittances: The Unsecured Knot and What Media Didn’t Tell About the Peso.
Nonetheless, growth from remittance inflows from OFWs continue to hit record breaking levels and remains as vigorous as ever- 16% February, 9.4% in March or 13.2% for the first quarter…yet the Peso fumbled! Overtime, false premises are eventually unmasked.
Today, high inflation or levitated oil prices appear to dominate the airspace look equally tenuous.
Way up until the end of February of 2008, oil-based on West Texas Intermediate Crude benchmark-had been drifting upwards at the $100 levels where simultaneously the Peso continued to firm. Does this imply that oil above $100 signifies as the “critical point” where the economy folds?
Such arguments have NOT been consistent with present economic data.
The country’s current account recorded a 1st quarter surplus of $8.6 billion (manila standard) and $499 million in April ( despite the 106% year on year growth of crude oil imports or 960% leap of rice imports y-o-y based on February figures which led to a $379 million trade deficit (manila times).
The country’s foreign exchange reserves also reached a fresh record at $36.7 billion ( despite “suspicions” of the Philippine Central Bank, Bangko Sentral ng Pilipinas (BSP) intervening in the currency market (seller of US dollars) to “contain” the Peso’s depreciation.
Moreover, the nation’s economic growth should remain robust. The Agriculture sector remains buoyant higher by 4% (Reuters) while tourism growth jumped 8.5% ( both for the 1st quarter.
True enough, while a global economic slowdown may have SOME impact to the Philippine economy, especially in today’s highly interconnected world (relative to the past), as we argued Is the Philippines Resilient Enough to Withstand A US Recession?, where remittances represents about 10% of GDP and foreign trade (exports and imports) accounts for about 40%, we have other highly unappreciated-underinvestment themes-that has tremendous growth potentials (which ironically constitutes as the majority of the economy) enough to offset a global slowdown such as agriculture, mining, tourism, infrastructure, business process outsourcing, real estate, finance (banking and non-banking) and other service sectors.
We presented this in many of our articles including The Philippine Mining Index Lags the World (featured at in September 2003 and blog posts as A Prospective Boom in Philippine Agriculture!, Want a Stock Market tip? PGMA’s SONA was a Mouthful and Phisix: “Fear Is A Foe Of The Faddist, But The Friend Of The Fundamentalist.
Has Outcomes Started to Impact Expectations?
Our belief is that the advancing phase of the global commodity cycle compounded by a deepening process of regionalization (economic, trade and financial integration) will benefit the Philippine economy and its financial markets despite the present exogenous (global credit crisis, US recession, global economic slowdown, high “inflation”) and endogenous (political, cultural and national balance sheet or fiscal) risks.
Remember there is NO such thing as a “perfect decoupling” or a “perfect integration”. Amidst today’s globalization trends, where integration and interrelation among economies has been increasing, there will always be some idiosyncrasies within a political economy relative to the world based on culture, population (demographic) construct, intrinsic policies, willingness to open for international or global interaction, political, economic and financial market framework and others. Said differently, there is no such thing as a “one-size-fits-all” paradigm. The distinction of the impact from globalization trends depends on the degree of the country’s exposure.
Take for instance proponents of the deflationary depression scenario have been forecasting of a global recession (if not a depression) arising from the global credit crisis, as we discussed in Global Depression: A Theory Similar To A Horror Movie?, yet 10 months into the credit crisis, global economies appears to remain unexpectedly strong!
Japan’s economy stunned the consensus with a 3.3% growth on “exports on to Asia and emerging markets” (Bloomberg) equally buttressed by resilient domestic demand. It’s the same story in Europe which grew by .7% in the 1st quarter or 2.2% from a year earlier (Bloomberg), where the Germany (the “strongest growth in 12 years”) and France surprisingly compensated for the slowdowns of some countries (e.g. Spain, and Italy) within region coming in the face of a strong “euro”, rising “inflation”, US economic slowdown and other risk variables.
Assuming a lag period for the transmission of the Credit Crisis or a US economic slowdown, this suggests that economic data should begin to reflect on such slowdown. But this has yet to surface. Of course, we don’t discount that such lag period may take longer and might eventually weigh on Japan or Europe’s economic growth.
But the all important lesson here is that forecasting based on inductions similar to Dry Bone song (toe bone is connected to the ankle bone is connected to the knee bone, etc…) overestimates what is known, and at the same time, underestimates on what is unknown. That is why projections based on the extremes are likely to be exaggerated or highly erroneous and so with the self-righteous rigid convictions which underpin such views.
The Other Side of Oil
In the interim, claims that “decoupling is a myth” based on the initial reaction of forced liquidations seem to be vacillating. Some deflation proponents have now been arguing about the dissociation of stock markets and the economy.
As you know, we have long argued that the stock market performance doesn’t always account for the activities of economies or corporate earnings simply because the stock market (or other aspects of the financial markets) can also account for the function of money as a “store of value” or the opportunity cost of holding cash. (I have to keep repeating this because many people don’t seem to get it).
As a reminder, Zimbabwe has long been in a serial recession but whose stock market has continually soared amidst declining purchasing power (hyperinflation) manifested by its currency (massive devaluation). Economic health-unemployment (80%), manufacturing capacity (5%)-and corporate earnings have not been a factor for stock market performance, but the currency’s (Zimbabwe Dollar) purchasing power has.
When people fear the value of their currency is eroding, as seen through sharply higher prices of goods and services, they tend to seek refuge in asset prices which are scarce, liquid and represents “store of value” or whose value is expected to remain against a massively devaluing currency. Yes, central banks can simply print money for myriad political purposes and accrete humongous financial claims against a dearth of hard assets.
While the others see the rise of commodity prices as a relative shift from the absorption of credit creation and intermediation to financial assets into commodities or in short- NO problem of inflation, our view is that today’s rising markets could be a symptom of a Zimbabwe like disease in the markets.
The world’s current account imbalances, whose enormous surpluses are held by non-democratic emerging markets with underdeveloped financial markets, have equally been generating massive domestic liquidity through amassing foreign currency reserves transmitted by the monetary pegs to the US dollar. In effect, US dollar policies (such as today’s negative real yields) are being diffused to emerging markets via monetary mechanism where the latter’s surpluses are recycled into democratic industrialized economies with mature financial markets which may continue to incur current account deficits.
For instance, with Oil at $126; this means intensifying wealth transfer from oil exporters to oil importers, it also means higher surpluses for oil exporting countries, aside from more money for alternative non US dollar investments via Sovereign Wealth Funds by oil exporters and other surplus generating countries and structural adjustments in the balances of the current account surplus-deficit nations based on the changing dynamics of spending, investing and trading patterns.
A very perceptive commentary from Brad Setser (highlight mine),
``It would lead to something like a $650-700 billion transfer of wealth from the oil-importing economies to the major oil-exporting economies
``Assuming that the oil exporters don’t spend and invest all that much more than they already were planning to do in 2008, the rise in the oil export revenues will translate into a comparable increase in the oil exporters' current account surplus – and a comparable rise in the oil importers deficit. Of course, there will be some adjustment in the imports of the oil-exporting economies. But spending and investment in the oil-exporting economies tends to adjust with a lag to rises in the price of oil. And both are already on a sharply upward trajectory. Governments are spending more - and the oil-exporting economies are investing more, in part real interest rates in many oil-exporting economies are incredible low. Those crazy and wildly pro-cyclical dollar pegs. If oil had stayed at its 2007 level, it is safe to assume that the oil exporters surplus – roughly $425 billion in 2007 according to the IMF – would have fallen by $100 billion, if not more.
``The Spring IMF World Economic Outlook assumed that oil would average $95 a barrel -- pushing the oil exporters current account surplus up to $620 billion. If oil says at $125 a barrel for the rest of the year and oil averages $115 a barrel for the year, the oil exporters' current account surplus could approach $900 billion range.”
So with huge surpluses from emerging market oil exporters (GCC), aside from countries with surpluses from goods and services (Japan) and countries with surpluses from capital inflows (Brazil), which maybe finding their way into global financial (possibly through equity-via the Sovereign Wealth Fund route) markets coupled with excess liquidity arising from the lack of sterilization (mopping up of excess liquidity) due to the underdeveloped financial markets could have accounted for the spillage of such liquidity excesses over to the commodity markets, could have accounted for the rising price of goods and services around the world and the appearance of recovery in the global equity markets.
The point which requires emphasis is that the spending, investing and trading patterns by these current account surplus countries are likely to determine the asset or currency values of where these spare funds will eventually be parked.
Another aspect to stress is that these surpluses amount to an ocean of money being pumped into the system, aside from the equivalent strains being produced by such surplus-deficit asymmetries.
Baltic Dry Index, Commodity Cycle and the Flawed Populism Concepts

Figure 1: Soaring Baltic Dry Index Amidst Recovering US S&P 500
Figure 1 from shows of the near record highs of the Baltic Dry Index overlapped by the main US equity benchmark the S & P 500.
The Baltic Dry Index an index which is representative of dry bulk shipping rates covering a range of raw materials or commodities including coal, iron ore and grain indicates that there is an ongoing shortage of shipping carriers which has prompted for shipping rates to climb back to its recent record highs.
While the correlation between the S&P and Baltic Index has not been entirely strong, we do see some firming interaction since the second round implosion of the credit crisis last October. This paved way for the fall in the Baltic rates coincident to the S&P. Recently the Baltic rates appears to have led the S&P.
This posits the scenario where Baltic shipping rates could have reacted to the supposition of a marked slowdown in commodity shipments (possibly expectations of a US recession), whereas today, the Baltic Index could be sounding off a “limited impact” scenario of an economic growth slowdown relative to the commodity markets.
Further, the fresh record high of the CRB Index supports the assumption of vigorous demand for commodities. But there is also another possible factor responsible for such upsurge-supply bottlenecks brought about by high financing charges and tight lending standards-have caused cancellation of orders for additional ships.
From Bloomberg’ Todd Zeranski, ``As much as $14 billion in ship orders is threatened by cancellations and delays, equal to 94 percent of annual revenue at Hyundai Heavy Industries Co., the largest shipbuilder. Tightening credit markets mean lenders demand a bigger deposit and shorter terms for financing, said Tobias Backer, the head of shipping for the Americas at Fortis, a merchant banker.
``The loss or delay in deliveries of about 250 cargo ships, or 10 percent of orders, will tighten the supply of vessels and support rates when demand from China and India for everything from soybeans to coal has never been greater. Based on the current orders for 2,561 new cargo ships, shipping rates are expected to decline 56 percent during the next three years, futures markets show.”
So even amidst a threat of a potential slowdown in demand for commodities for whatever reasons, the restricted access to financing extrapolates to diminished output for shipping, which means supply constrains or elevated prices for commodities and the Baltic Index.
Demand is a populist Keynesian framework peddled by mainstream media, however supply is another important variable frequently ignored.
The point being, a global economic slowdown isn’t a clear cut certainty that will cause a fall commodity prices, if supply falls faster than the decrease in demand then obviously prices will continue to rise.
Currency Basics
What has this got to do with the Peso?
A lot.
First things first, when we deal with currency markets, we deal with currency pairs or currency values measured against another currency. For instance when we quote the US dollar relative to the Philippine Peso USD/Php, the US dollar serves as the base currency while the Peso is the quoted or the secondary currency.
Second currency values are fundamentally driven by fund flows (capital and trading account), expected policy actions (monetary and fiscal), prospective interest rates and or yields, economic activities, political conditions, purchasing power and others. Traders and punters likewise apply sentiment and technical measures like in the stock market.
Third, since currency values are measured against another then it is a zero sum game, when one currency rise, the other declines. Hence, valuation of currencies shouldn’t be seen from a singular perspective but from dual ends. In other words, valuation is measured by relativity.
For example when one argues that rising oil prices hurt the Peso, it misses the perspective the US is likewise an oil importer, hence oil imports are likewise potentially harmful to the US dollar, so the question should be- higher oil prices should essentially impact which currency more?
Widening Our Perspective On The Peso
Let’s us examine the Philippine Peso. As noted above the Peso continues to amass foreign exchange surpluses aside from recording current account surpluses mostly from remittances.
At the margins, the Peso’s prices have somewhat been set by foreign portfolio flows, aside from other additional minor factors as investment income or central bank forex operations. On the other hand, the US dollar is a net current account deficit currency despite its privilege as the world’s de facto currency reserve.

Figure 2: PSE: Foreign Activities: Declining Trend of Outflows?
Figure 2 exhibits the daily activities of foreign money in the Philippine Stock Exchange. It shows that foreign selling in the PSE has peaked sometime in December 2007, but seems to be gradually declining as shown by the red arrow.
By implication if the trends of foreign funds continue to improve then the Peso should strengthen. It could. But such analysis isn’t straightforward.

Figure 3: USD/Peso-Phisix relationship
Look at figure 3, the USD/Peso (black line chart), since the Peso began to appreciate in 2005 the Phisix seemed to track the USD/Peso’s performance on an inverse scale.
When the US Dollar rose, the Phisix declined, conversely when the Phisix peaked, the US dollar was in a trough (blue arrows). This relationship held until August of last year from where such correlation broke down. Bizarrely the Peso continued to appreciate even while the Phisix had been encountering a net outflow.
China’s Yuan Possible Influence On The Peso
Figure 4: Chinese Remimbi Resembles the Peso’s path
Figure 4 from shows of the uncanny resemblance between the movements of the Peso and the Chinese remimbi.
Notice when the Remimbi spiked in August, the USD/Php bottomed. Over in August to September as the Remimbi weakened, the USD/PHP firmed. Next, as the remimbi soared from September until early March, so did the Peso until the last day of February.
So while correlation may not imply absolute causation, we think that the ongoing dynamics of increasing regionalization has had a hand in these. We have argued how trading structure of the region has been reconfigured into what Asian Development Bank describes as “vertical integration of production chains” or a regional outsourcing platform with China as the final assembly point.
The point is that since Asian countries have been engaged in some form of competitive devaluation or have manipulated their currencies to keep prices competitive, and since most of their exports have now shifted to within the region or to China, most of Asia’s emerging markets seem to have kept the dynamics of currency values within the parameters of Chinese remimbi as a bellwether.
And if we are correct with the analysis that the remimbi as the region’s leading benchmark, then it is likely that today’s correction will not last.
This excerpt from a speech of University of California, Berkeley’s Professor Barry Eichengreen, courtesy of RGE Global (highlight mine),
``If the U.S. is in for a long recession and serious credit problems are not over, then betting on dollar recovery would be premature. The problem is that the dollar has fallen dramatically against the euro but much less against the Asian currencies, because of the reluctance of governments and central banks there to let their currencies move against the greenback. It would be nice if those Asian governments and central banks let their currencies strengthen more against the dollar – both to make up lost ground and because Asia is the one part of the world that is growing strongly. The dollar could then recover a bit against the euro, which would take some pressure off of Europe, without appreciating on an effective basis. Indeed, if exchange rates were simply left to the markets, I would not be surprised to see the dollar fall further on an effective basis, given the weakness of the U.S. economy. That is, any recovery against the euro could be dominated by further depreciation against Asian currencies.
``But the reality is that exchange rates are not left to the markets. With inflation accelerating, Asian central banks are likely to countenance a bit more local-currency appreciation against the dollar, but only a bit. And if they limit the depreciation of the dollar against their currencies, there is not going to be much recovery of the dollar against the euro.”
So what can we learn from Prof. Eichengreen?
One growth differentials are likely to allow Asian currencies to appreciate. Two, faced with inflation pressures, given enough lever arising from strong economic growth (aside from the wide gaps of purchasing power) monetary policies will most likely adjust to present conditions. Either our BSP increase interest rates or allow for currency appreciation or a combination of both. If the BSP increases rates then yield differentials against the US dollar should widen which could attract back foreign capital.
This basically debunks arguments floated by mainstream analysts where rising oil prices or inflation is said to inhibit the Peso’s advance. This overlooks the perspective of policy maneuvers.
Next, considering that global risk taking conditions have been picking up of late, (yes we are seeing some major indices crossover the threshold away from bear markets territories) we are likely to see a reversal of portfolio outflows.
Lastly pricing in the foreign exchange markets are not entirely market-determined, hence the imbalances in the global monetary system will continue to mount.
We would further add that based on a probable shift in trade composition where eventually we should see commodity based exports (mining and agriculture) heftily contribute to our trade and current account surpluses (aside from investments and revenues from Tourism, energy and infrastructure) to compliment remittances and portfolio flows, provided the leadership maintain their fiscal discipline, the Peso’s long term path alongside its neighboring currencies is most likely to the upside! All these are also anchored on the underlying policies by the BSP (or the BSP’s tolerance for a market determined outcome).
For the meantime, while I can’t say when the USD/Php is likely to top, I would recommend using today’s rallying dollar as an opportunity for exit or to diversify.