The Paradox of the ASEAN, China, Japan and the US Free Trade Agreement Talks

From Japan Times

The Association of Southeast Asian Nations and its six regional partners, including Japan, China and India, declared Tuesday the start of negotiations for a free-trade agreement that could create a huge integrated market compromising more than 3 billion people.

The move toward creating the Regional Comprehensive Economic Partnership comes as the United States is seeking to create another vast free-trade bloc through the Trans-Pacific Partnership initiative.

If the RCEP and TPP, which is currently being negotiated by 11 countries, are created, each could be similar in economic size to the European Union. The 16 countries involved in the RCEP negotiations have a combined nominal gross domestic product of about $19 trillion, or about 30 percent of the world's GDP.

The RCEP negotiations are expected to begin early next year and to be completed by the end of 2015. But it will be a challenge for the 16 countries with their diverse backgrounds to realize a high-quality agreement to liberalize trade in goods, services and investment.

The countries involved are the 10 ASEAN members — Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam — plus China, Japan, South Korea, India, Australia and New Zealand.

Two things here

Any thrust towards the expansion of voluntary trade is always welcome.

Although free trade doesn’t really require FTAs as nations can just unilaterally engage in reducing all forms of trade restrictions (tariffs or non tariff based).

This means that FTAs are not necessarily "free" as they conditional to certain terms and or to specific industries or to particular areas of the economy.

As the great dean of Austrian Economics Murray Rothbard wrote,

If the establishment truly wants free trade, all it has to do is to repeal our numerous tariffs, import quotas, anti-"dumping" laws, and other American-imposed restrictions on trade. No foreign policy or foreign maneuvering is needed.

If authentic free trade evers looms on the policy horizon, there'll be one sure way to tell. The government/media/big-business complex will oppose it tooth and nail. We'll see a string of op-eds "warning" about the imminent return of the 19th century. Media pundits and academics will raise all the old canards against the free market, that it's exploitative and anarchic without government "coordination." The establishment would react to instituting true free trade about as enthusiastically as it would to repealing the income tax.

Yet inflationist policies undertaken by all these nations, especially by the US, Japan and China, which signifies a form of protectionism, essentially offsets any free trade agreement that would be forged.

Nonetheless this leads us to the second point. We have repeatedly been told that frictions over territorial claims have led to political brinkmanship in the region. 

And indeed the open display of mutual animosity has even adversely affected trading output between two major participants, China and Japan, in the FTA.

Tourism between both countries, aside from car sales of Japanese brands have reportedly slumped in September, even after the end of anti-Tokyo protest. 

It has been alleged that China's anti-Tokyo street protests has been orchestrated by the Chinese government that even led to a water cannon shootout between the coast guard patrol boats of Japan and Taiwan, another claimant on the disputed island.

So we are once again seeing the strange case of Dr. Jekyll and Mr. Hyde in terms of regional political and economic relationships between China and Japan (over Senkaku) and China and ASEAN (Scarborough and Spratlys). 

Certainly the conflicting status in trade relations and regional politics means one is a signal and the other is a noise. That’s unless there has been little coordination within their respective governments or that one of the two represents a smokescreen for other veiled agenda.

Quote of the Day: Hubris has its Costs, the Decoupling that Never Was

The lesson from recent economic data and policy moves in Asia (MXAP) is this: Hubris still has its costs.

In recent years, Asia believed its own press a little too much. The way it steered around the financial crisis of 2008, the dizzying stock gains, the migration of bankers from New York to Hong Kong and the region’s mergers-and-acquisitions binge were all interpreted as immutable signs of Asia’s economic arrival.

Decoupling-from-the-West euphoria flooded emerging markets in general. The BRIC economies -- Brazil, Russia, India and China -- thought their rapid growth rates would pick up the slack as America and Europe reeled. Debt markets in developing nations reveled in their new roles as sanctuaries.

Disappointing data and interest-rate cuts in Beijing, Hanoi and Seoul last week show the extent to which Asia got ahead of itself. Asia isn’t re-coupling; it never decoupled much in the first place. That leaves us with two stark realities for the second half of 2012: Emerging markets aren’t ready for prime time globally, and Asian policy makers need to get more aggressive about finding new avenues for growth.

That’s from Bloomberg’s Asian columnist William Pesek.

And this why it is equally dangerous, if not a folly, to believe that ASEAN markets and economies will decouple.

Is ASEAN Resilient from Euro Debt Woes?

A World Bank economist declares ASEAN as "resilient" to the shocks from the Eurozone

Reports the Bloomberg,

Economies in the Association of Southeast Asian Nations are “resilient” to Europe’s sovereign debt woes, with governments having room for monetary and fiscal policy changes, World Bank Managing Director Sri Mulyani Indrawati said.

“For countries, especially Asean countries who are very resilient to the crisis, they still have the ability to maneuver from their own policy space, whether this is on a fiscal side or a monetary side,” Sri Mulyani said in an interview in Tokyo yesterday. “That’s very important.”

Asian policy makers are under renewed pressure to support growth as the world grapples with the threat of a Greek exit from the euro. Greece’s political impasse has deepened the European crisis and sent Asian currencies and stocks tumbling, adding to the uncertain outlook for exports and growth.

Really?

The panic in the Eurozone have partly incited the slump in global equity markets. Europe’s Stox50 has led the recent market rout which spread to ASEAN (ASEA) and other global benchmarks, such as the S&P and Emerging Markets (EEM).

I say “partly” because it would seem misguided to fixate solely at the Eurozone as the key contributing factor in driving the conditions of the global financial markets, as well as, the global economy.

The overall doldrums of global equity markets, possibly includes the China factor and perhaps uncertainty over US monetary policies and or US politics among many others

Yet the transmission from current shocks has likewise become evident in the region’s currencies. The the ringgit, the peso, the baht and the rupiah (left to right) have been conjointly whacked.

Add to this picture, the weakening of global commodity prices.

In short, seen from the actions of financial markets, there hardly has been evidence to support claims of “resiliency” or innuendos of “decoupling”.

Of course, actions in the financial markets may not exhibit the performance of the real economy as had been the case of 2007-2008.

But my point is that it would seem as an appeal to the heuristic and oversimplification of analysis to project on so-called 'resiliency' when the extent of uncertainty have yet to be identified and ascertained in today’s complex and vastly interconnected world.

As the great Professor Ludwig von Mises explained,

Economics does not allow of any breaking up into special branches. It invariably deals with the interconnectedness of all the phenomena of action.

Chart of the Day: France ‘Riskier’ than the Philippines, ASEAN

Insuring 5-year debt against default or credit risk as measured by CDS prices has been more expensive for France than ASEAN countries such as Indonesia, the Philippines and Thailand, according to the Daily Reckoning

Quote of the Day: ASEAN Free Trade Agreement

ASEAN+6 and the Trans Pacific Agreement could serve as starting points and become the basis of a future free trade agreement encompassing all of Asia and the Pacific.

That’s from ADB President Haruhiko Kuroda

Even multilateral institution as the ADB are discovering the importance of free trade.

How Philippine Capital Markets Will Benefit From Free Trade

In this issue:

How Philippine Capital Markets Will Benefit From Free Trade

-Will Lady Luck Probably Smile On The Aquino Regime?

-Explaining Free Trade

-Anti-Free Trade: Political Dynasties and The Maguindanao Massacre

-The Invisible Hand

-How Free Trade Should Benefit The Philippine Capital Markets

At a recent speaking engagement, I was asked of what I thought of the new Aquino administration and his economic policies. My reply, first that I was apolitical, and second, that there are major forces such as globalization, regionalization and the technological revolution that has been and will be driving global policymaking and this includes the Philippines.

Obviously far from being a populist answer, such reply would seem stoic since it didn’t whet the sensationalist craving of the audience.

Will Lady Luck Probably Smile On The Aquino Regime?

As any regular reader would know, in my opinion, the new administration is NO more than representative of the status quo[1], which for me would seem better, compared to activist ‘messianic’ left-leaning leaders, such as Venezuela’s Chavez or even the US president Obama.

And yes, most signs have been validating my perspective, be it on the pronounced policies on jueteng[2], cabinet appointments[3] packed with representatives from big business and even to populist sound bite (or what Mark Twain would refer to as "a minimum of sound to a maximum of sense" or simply “attention generating”) policies such as the “Wang Wang”[4] or the recent administrative action: the censure of PAG-ASA[5] (government weather forecasting) personnel in the wake of the recent widespread brownouts caused by typhoon Basyang.

And based on my analysis I predict that the administration’s performance (success or failure) will likely be aligned with the patterns of “global” if not regional political economic trends.

As previously stated[6], ``the direction of political winds in the Philippines is likely to get influenced more by our deepening interactions with external forces-particularly, the new free trade zone (with ASEAN and China), China's growing role as a major political force as regionalism deepens, a deeper impact from globalization buttressed by technology and OFWs (or migration flows) and deepening financial globalization which includes transmission effects of inflationism, steep yield curves, bubble policies and etc.”

In short, luck or the lack of it, will dominate the Aquino regime.

Well it didn’t take long for more signs to surface which would seem to validate my prognosis.

This from yesterday’s article from the Inquirer.net[7], (all bold emphasis mine)

``In a speech before members of the Philippine Chamber of Commerce and Industry Wednesday evening, Trade Secretary Gregory Domingo said it was now common practice among economies to participate in multilateral trade pacts.

“You have to be part of every trade agreement because to be excluded is a disadvantage for you. We’re not yet part of [the TPP], but at some point, I think it is our desire to join as well,” he said.”

It is unfortunate enough for the Aquino administration’s trade secretary to seem to have little appreciation of the essence of free trade agreements. For Mr. Domingo, and if this should represent the insights of the administration, free trade agreements are simply a fad, take note of “common practice”.

So while I applaud the Aquino administration for supposedly espousing free trade, the essence of the administration’s policymaking, as stated before, is because “everybody else is doing it”. It’s definitely not out of principle, but out of the socio-economic signalling known as “Keeping up with the Joneses”.

This again lends credence to our projection of: one—popularity based policies (in this case globalization) and two—the deepening influence of global political trends which has been influencing local policymaking.

Let me add that while the practice of free trade seem to get more ingrained globally, this remains a virtually unpopular or severely misunderstood concept in the eyes of the domestic populace.

Take for example, this free trade agreement definition from the media; from the same article

``The aim of the free trade agreement is to bring all tariffs down to zero by 2015. The coverage of the deal spans trade in goods and services, rules of origin, trade remedies, sanitary and phytosanitary measures, technical barriers, intellectual property, government procurement and competition policy.”

True, these are mostly technically “legal” definitions, but this hardly dwells on the kernel or the cost-benefits tradeoffs from the said policy.

And in evincing more proof of miscomprehension of free trade, but this time from the officialdom; the same article quotes the incumbent trade secretary anew, (bold highlights mine)

“We will be very vigilant in joining various trade agreements. We’ll try to join as many trade agreements as possible, but still keeping in mind that our interest is really to protect the interest of Philippine businesses and Philippine consumers,” Domingo said.”

But free trade is of the interest of the Filipino consumers and businesses!

Free trade is VOLUNTARY exchange! It allows people to conduct exchanges to satisfy personal and commercial needs.

When we go to a store to ‘freely’ purchase things or services which we deem to need, don’t we achieve immediate satisfaction from the activity?

If people, on their unfettered disposition, buy from me, do I not use the proceeds from the exchange to subsequently also buy from the marketplace, either to fulfil my consumption goals or expand or replenish my business needs or even make contribution to social projects for the betterment of our community/society? Because producers are themselves consumers, then trade is a benefit to all parties involved.

Hence, the fundamental role of the marketplace is to satisfy our sundry needs by means of voluntary, and NOT coercive, exchange. So why does Mr. Domingo express scepticism with “protect the interest of Philippine businesses and Philippine consumers”?

Explaining Free Trade

There are two way to acquire wealth. German sociologist Franz Oppenheimer[8] once said that there is the ‘economic means’ via work and exchange and there is the ‘political means’ by forcible exploitative means either by plunder or by redistribution.

Acquiring wealth through work and exchange is NET beneficial to the society since it fosters the creation of value added products or services.

Figure 1: World Bank[9]: Explosion In Global Mobile Subscribers (left window) and Internet Use (right window)

Think the internet and the mobile phones. Twenty years ago these were non-existent. Yet competition in the marketplace cultivated a sweeping technological innovation, which the introduction of these highly efficient revolutionary tools exponentially expanded access to communication and greatly reduced transaction costs.

Today, I can talk with my mom in Hong Kong everyday at the minimal cost of the bandwith, compared with costly occasional long distance phone calls 20 years back.

Of course there will always be losers anywhere. Creative destruction from free market innovation led to the phasing out or the obsolescence of the pager and the telegraph, the reduced usage of the fax machine, postal mail and even a decline in the newspaper industry[10]. However the gains from innovation have virtually eclipsed the selective losers. In short, by large, society benefited from the new technology.

Moreover, because of the immensely lowered transaction cost, global trade blossomed.

Meanwhile, the obverse side of acquiring wealth from economic means is the political means.

‘Political means’ essentially is parasitic which lives off the work of others. This involves taxation and forcible redistribution, war and corruption. The benefits only accrue to the parties involved in conducting such affairs, primarily government. And such actions signify a ZERO SUM game- where one benefits, as the others losses, which in general do NOT add wealth to the society—since resources is just taken away from someone else.

Furthermore, by allowing people to exchange voluntarily, this furthers the division of labor that creates jobs, and importantly, accumulates capital or wealth.

And increased global trade or globalization, as noted above, has definitely been the prime engine of wealth accumulation (see figure 2).

Figure 2: Google: Deepening Free Trade And Exploding Global Wealth

The correlation of the growth of global merchandise trade relative to the explosion of global per capita income may not be perfect, but it has been strong and rigorously supported by theory and empirical micro evidences as the rapid diffusion of the mobile phone and the web around the world.

Anti-Free Trade: Political Dynasties and The Maguindanao Massacre

In addition, free trade greatly reduces pressures from political redistribution which frequently leads to internecine political conflicts.

Take for instance the Maguindanao massacre[11]. The fundamental reason why such atrocious and barbaric act had been committed was allegedly due to the political insecurity by the incumbent local leadership over the preservation of his regime.

The horrid Maguindanao incident appears to be symptomatic of the latent inherent defects of the Philippine political ‘democratic’ framework, which has cultivated a brood of political dynasties (estimated at about 250) that has used politics to arrogate upon themselves economic opportunities and thus the imperative to remain in power at nearly all cost.

Even this New York Times article of 2007[12] presciently noted of the violent nature from this political arrangement, ``For generations, political dynasties have dominated elections and governments in the Philippines...As these clans protect their reign, they often resort to violence to frustrate any attempt by rivals to unseat them.”

And how do you sustain political dynasties? By systematic redistribution. The above board taxes generated from the local economy are used to pay off voters indirectly by virtue of massive welfare programs [e.g. free movies, free health care, senior citizens discount and etc...] or directly (vote buying) during elections. For instance, local authorities discreetly allow people to squat on empty government and private lands and are given protection from doing so in exchange for votes.

Yet this form of squatting has been provided with a legal cover in the face of the Lina Law (RA 7279)[13], where relocation is required for squatters evicted from their domicile. In short, the law rewards the violation of property rights.

Of course there is also the issue of the undeclared tax payments, which usually ends up in the pockets of the politicians.

Hence, the violence in Maguindanao has been representative of the state of economic deprivation from the operative highly skewed political-legal environment.

According to the Focus on the Global South, Maguindanao remains as one of the poorest provinces in the country. With a population of more than 1 million in 2006, six out of ten people are considered poor in the province, which is almost three times higher than the national average. Maguindanao is also a “mainstay” in the list of ten provinces with the biggest income gap, poverty gap, and severity of poverty[14]

In other words, where politics has been substituted for trade, we get violence as a result of the exploitative grab for resources by the use of political means, as Franz Oppenheimer has postulated.

And this also validates the great Frédéric Bastiat who once said that, “When goods do not cross borders, soldiers will.”

Apparently, in Maguindanao, the order of private armies determined past economic fortunes which had largely been held and distributed by the entrenched political class and which appears as modern day vestiges of a medieval age political structure known as feudalism.

Likewise, history has revealed that the same political means to attain wealth in favour of vested interest groups had been responsible for the mass slaughter of humanity seen in the two horrendous world wars of the 20^th century, where the casualties as estimated by the Wikipedia.org[15] for World War I is anywhere in the range of 10-64 million people while World War II at 40-72 million people.

As historian Michael A. Heilperin poignantly observed[16], Economic nationalism was the real victor of World War I, just as collectivism was to be the real victor of World War II.

So why does the new trade secretary remain fearful of free trade?

The answer is simply because the entrenched political and economic class are concerned and apprehensive that their current economic privileges, which on the other hand signify as economic inefficiencies, brought about by protective walls of legal and political barriers, might not cope with the onslaught of market based competition.

In short, free trade means putting to risks inefficient and uncompetitive firms which has operated on the premises of political concessions such as monopolies, cartels, subsidies, liberal access to state financing, tax shields, various licensing or other state based privileges which has been an enduring trait for Southeast Asian economies, as journalist and author Joe Studwell rightly notes[17], “The lesson of the past decade has been that the relationship between political and economic elites in Southeast Asia is more enduring than almost anyone imagined.”

Thus, by reading in between the lines, the trade secretary appear to signal the administration’s possible intent to enforce gradual change on a regime that thrives on the status quo.

The Invisible Hand

It is likewise foolhardy and mendacious to assert that free trade works to harm consumers as free trade primarily benefits consumers through manifold choices.

Free trade allows consumers to benefit from the various offerings from the producers or service providers, all in competition to satisfy their needs. And the thrust to market products to satisfy consumers comes in many facets such as pricing, quality, utility, aesthetics, self-esteem and etc...

In short, for the consumers, the essence of free trade is choice, the more the array of choices, the greater the value of the exchange.

On the other hand, for the producers, the essence of trade is profits,

As Ludwig von Mises wrote[18],

Profits are the driving force of the market economy. The greater the profits, the better the needs of the consumers are supplied. For profits can only be reaped by removing discrepancies between the demands of the consumers and the previous state of production activities. He who serves the public best, makes the highest profits. In fighting profits governments deliberately sabotage the operation of the market economy.

Thus in connecting the two, free trade gives the consumers the best possible alternative while for producers, the profit incentive from doing so. In short, free trade signifies as the best possible arrangement for achieving satisfaction and profits.

Yet sometimes media gives the illusion that consumers are too dumb that they can’t distinguish between what’s good enough for them and what’s not, and thus require the nanny state via various regulatory interdictions.

Ironically, the same media would pontificate on the virtues of democracy where people get to vote on political leaders, as if people have been bequeathed with intelligence only when they vote for leaders and the lack of it when they spend their own money.

In reality, it works the opposite way.

When people spend for goods and services they expect to get direct benefits from an exchange and thus always exercise the option to choose based on perceived order of needs and of the accompanying value from the available choices.

Isn’t it commonsensical for consumers not to further patronize on what they feel as inferior, inadequate, substandard, or a product or service that is perceived as worth less than the price which they had earlier paid for?

By the pattern of spending, consumers, thus, impose market discipline on producers without the need for state intervention.

The father of modern economics, Adam Smith called this as the Invisible Hand.

In contrast, in elections when people vote for political leaders, what you vote for isn’t what you exactly get. Whether it is Philippine President Joseph Estrada of 1998, Japanese PM Yukio Hatoyama[19] or US President Obama, the point is—populist politics usually ends up with the opposite expectations from which they had been ushered into office.

Of course in any field, one can’t discount that there will always be unscrupulous agents. But such devious entities are likely to fool people ONCE and will be refused further patronage. Thus, any gains will be temporary and by deceiving consumers, they will be penalized by the virtue of monetary and reputational losses, if not lawsuits.

Yet, in the case where physical harm that should emanate from the use of their products or services, then this should also be subjected to legal remediation.

How Free Trade Should Benefit The Philippine Capital Markets

So if the Aquino regime will truly usher the Philippines more as an active participant in free trade engagements this should augur very well for the Philippine economy.

Of course, the Philippines has been a signatory of many free trade[20] accord, even prior to the Aquino regime, which includes including the Asean Trade in Goods Agreement, Asean-Australia-New Zealand Free Trade Agreement, and the Japan Philippines Economic Partnership Agreement, but sustaining and more importantly (and hopefully) expanding the ‘gradualist’ momentum will be a very crucial dynamic.

However, given the administration’s faddish perception of globalization, the consistency of this policy is yet unclear.

Theoretically, increased free trade and/or economic freedom should bode well for the local capital markets, since more investments should translate to the increased access to domestic and global savings which should get intermediated via the banking system or through the capital markets.

Figure 3: McKinsey Global Institute[21]: Share of Financial Assets By Region 2008

In developed economies, except for Japan, bank deposits make up a smaller share of the capital markets as shown by figure 3. The greater part of the distribution of financial assets has been into the private sector debt securities and in the equity markets.

Thus while there are cultural and domestic regulatory dynamics that could also shape the divergences in the distribution of financial assets, we should expect a larger share of private bond and equity markets for mature market economies. This implies Emerging Asia could likely be headed on that path.

Considering that the Philippines, whose primary line of financing has been channelled through the banking sector, where banking penetration level is only 35% of the population, according to McKinsey Quarterly[22] estimates, this means there is a huge amount of unaccounted capital afloat in the system.

And this squares with the estimated 40% share of the informal economy[23] and with 4 of the top 11 largest malls[24] in the world, according to the Forbes Magazine, housed in the Philippines.

In other words, free trade and or economic freedom will compel enterprises and institutions to deal with this enormous untapped savings which should translate to a huge boom for the domestic capital markets.

Part of the early move on this has been the advent of mobile banking.

In terms of bond markets the Philippines accounts for one of the smallest in Asia (see figure 4)

Figure 4: IMF[25]-Size of Corporate Bond Market, ADB[26]-Local Currency Bonds Outstanding

Aside from the untapped savings, which is most likely sourced from the informal economy, the existing bank deposit base is likely to tap into both the bonds and the equity markets.

The factors that are likely to drive these would be amplified relative returns, reforms that would enable the lowering of transaction costs, introduction of derivatives and other more sophisticated financial instruments that allows the public to hedge. Incidentally, if I’m not mistaken only the Philippines among the ASEAN-4 have yet to introduce derivatives in the stock exchanges.

Figure 5: Reuters[27]: Market Capitalization of Emerging Asia

I’d also like to further point out that the Philippine Phisix accounts for as one of the smallest bourse in Asia (not included in Figure 5).

As of Thursday’s close the Phisix free float market cap is estimated at US $66.5 billion (exchange rate of Php 46.5 to a US dollar) compared to $188 billion of Thailand last January 12^th or possibly at $212 billion today adjusted for the 12.7% advance from the aforementioned period.

And it is of no surprise to us that the ASEAN-4, which comprises as the smallest bourses of the region, has accounted for the biggest gains.

The trend of the ASEAN-4 towards freer markets, aided by technological revolution, is just one of the major positive structural long-term factors at play.

Nevertheless, the other major and more influential medium term dynamic is the risks of blowing asset bubbles originating from the current concerted global central banks’ bubble policies, which is likely responsible for today’s buoyant asset markets.

Since the risk for Asia and the ASEAN seem to be a brewing boom-bust cycle, where a boom is a positive and bust is a negative, the larger net effect of a bust which constitutes as capital consumption signifies as a NET NEGATIVE. So we have major two forces counteracting on each other.

But this is a story we have long been talking about.

Anyway, in closing, speaking of bubbles, this news report is just too compelling for me to exclude from this week’s report.

From Bloomberg[28],

``South Korea will ‘soon’ announce plans to stimulate the nation’s property market, Yonhap News reported… The nation’s land ministry is drawing up measures to boost real-estate prices, and the ruling Grand National Party may begin discussions on easing debt-to-income restrictions on homeowners…”

People never seem to learn.

---

[1] See Philippine Election Aftermath: Goodbye Illusion, Welcome Reality!

[2] See Plus Ca Change: President Aquino's Policy On Jueteng

[3] See President Aquino’s Cabinet Appointments: The More Things Change, The More They Remain The Same

[4] See Why The Sell-Offs In Global Markets Are Unlikely Signs Of A Double Dip Recession

[5] See Privatize Pag-Asa or Open Weather Forecasting To Competition

[6] See Philippine Election Myth: New President Will Determine Direction of Economy And Markets

[7] Inquirer.net, RP eyes participation in free trade deal, July 23, 2010

[8] Oppenheimer Franz, The State

[9] World Bank, States and Markets, World Development Index 2009

[10] See Is The Newspaper Industry Dead? Probably Not If It Is For Free

[11] Wikipedia.org, Maguindanao massacre

[12] SFGate.com, Philippine political dynasties stifle democracy, nurture violence / Powerful clans have a stranglehold on system, experts say, New York Times, March 13, 2007

[13] Answers.com, What is the Lina Law?

[14] Manahan, Mary Ann Maguindanao in Focus Focusweb.org

[15] Wikipedia.org, List of wars and disasters by death toll

[16] Heilperin, Michael A. Heilperin Economic Nationalism: From Mercantilism to World War II

[17] Studwell, Joe, Ties That Bind, July 22, 2007

[18] Mises, Ludwig von Confiscatory Taxation, Chapter 32, Section 3

[19] See How Populist Leadership Goes Kaput: Japan Edition

[20] Inquirer.net, loc. cit.

[21] McKinsey Global Institute Global capital markets: Entering a new era, September 2009

[22] See How Free Markets In The Telecom Industry Aids Economic Development

[23] See Does The Government Deserve Credit Over Philippine Economic Growth?

[24] See A Nation Of Shoppers??!!

[25] IMF Regional Economic Outlook Leading the Global Recovery Rebalancing for the Medium Term

[26] Asian Bond Monitor, Asian Development Bank, March 2010

[27] Reuters ANALYSIS-For Singapore bourse, IPOs remain the Achilles heel, January 13, 2010

[28] Prudentbear.com, Trichet Challenges Inflationism, Bloomberg July 19, 2010

Credit Default Risk: From PIIGS To The 4 US States

Four US states, particularly California, Illinois, New Jersey, and New York, has been in a race with the European "PIIGS" in terms of credit risks or default risk as measured by CDS (Credit Default Risk).

As Bespoke Invest notes,

``All four states are closer to the top of the list than the bottom in terms of default risk. As noted earlier, Illinois has the highest default risk at 368.6 bps. The state sits between Dubai and Bulgaria. California ranks second out of the four at 352.9 bps, while New York and New Jersey are both right around the 290 bp level. Illinois and California are both at higher risk than Portugal, while all four are in a worse situation than Spain. In terms of year-to-date change, Illinois default risk is up 117%, New York and New Jersey are both up about 87%, and California is up 35%."

The difference is that the European PIIGS constitute about 18% of EU's GDP while the US contemporary is about 29% of the US GDP. Incidentally, the 4 states are among the biggest (in terms of share of GDP): California (ranked 1st), New York (3rd), Illinois (5th) and New Jersey (8th).

Yet financial markets seem to be singing contrasting tunes which seem inconsistent: jump in the Euro, firming CDS of 4 US states while new lows in 10 year US treasury yields. If there is a shift in concerns towards the 4 US states then treasuries yields are suppose to go higher.

I'd like to add that the gap between the PIIGS and the US-4 relative to the ASEAN-4 led by Indonesia and the Philippines seems to have widened. This partly explains the signs of 'decoupling'.

Why China’s Currency Regime Shift Is Bullish For The Peso

``In essence, China is saying it thinks its currency will do a better job than the US dollar of retaining its value over time. Put another way, China is committed to having lower inflation than the US and China seems willing to deal with the natural consequences of that strategy, which is a currency that gains value. Previously, China was hesitant to allow its currency to gain value versus the dollar. From the early 1990s until mid-2005, despite a combination of rising trade surpluses with the US and growing attractiveness for global capital investors, the yuan-dollar exchange rate was fixed by the Bank of China. In other words, China was willing to import US monetary policy.” Brian S. Wesbury - Chief Economist and Robert Stein, CFA - Senior Economist, China Rising

The gap in the performances of the equity markets between ASEAN and western economies has apparently been widening (see figure 1).

Figure 1 Bloomberg: Signs of ASEAN-US Decoupling?

AS the US markets fumbled (signified by the S&P 500 in green, which was down by 3.65%) this week, ASEAN markets has remained surprisingly resilient, as shown by the Philippine Phisix (orange), Thailand’s SET (red) and Indonesia (yellow). The signs above possibly points to “decoupling”.

Since charting in Bloomberg allows for only four variables, other countries as Malaysia and South Korea had been excluded. Nevertheless, these bourses likewise registered modest gains for the week.

But such buoyancy has not been reflected on the regional currencies. Contrary to my expectations, Asian currencies lost material grounds this week, with the Philippine Peso suffering from the largest decline--down 1.2% to 46.45 against the US dollar. The asymmetric price developments in the marketplace seem to exhibit short term volatility or more “noise” than “signals” from the general trend.

In short, falling Asian currencies and strong stock markets appear in conflict with each other, where one of the two markets will likely be proven wrong.

ASEAN Divergence: Signal Or Noise?

Yet such dissonance is hard to relate to the performance of the euro. The euro declined marginally (-.16%) this week to 1.2371 vis-a-vis a US dollar. This comes in spite of the record surge in the CDS spread of Greece[1], where in the past, an upsurge in default risk translated to an accompanying collapse of the Euro, this time around the Euro appears to be holding ground (see figure 2).

Figure 2: stockcharts.com: Consolidating Euro And Resurgent Commodities

And another part of the picture of mixed actions has also been the advances in the commodity markets particularly, gold, copper and oil.

Seen from a conventional “demand” perspective, rising commodities should exhibit improvements in the global economy. But again, this would be inconsistent with the infirmities manifested by the sagging developed economy equity markets.

Of course, the alternative perspective is the monetary aspect, where rising commodities and weakening major equity benchmark could be exhibiting symptoms of stagflation. Though this would seem consistent with the strength in ASEAN, once known as major commodity producers, this hasn’t been the case today given transformation of the global trade configuration into a supply chain platform (figure 3).

Figure 3: Economist Intelligence Unit[2]: ASEAN Exports

Nevertheless, the significant share of high value (technology based) exports makes ASEAN nations susceptible to the vicissitudes of the global economy. Thus, ASEAN won’t be immune to a recession in the developed world.

Meanwhile, the unexpected picture is that the Philippines had been ranked first among high value exporters. But according to the EIU, what you see isn’t what you get and that’s because internal developments has skewed trade statistics.

Anyway the EIU clarifies, ``In our “high-value exports indicator”, the Philippines ranks first, with about 77% of its total exports made up of high-value goods. This places it well ahead of other individual ASEAN countries, as well as China and India. On the surface, this result might seem surprising, given that the Philippines is by no means a technology leader. However, one explanation for this ranking mined or exported. The industry desperately needs foreign capital and technology, but government policy for many years has kept out foreign investors. As a result, low-value exports from the Philippines have been depressed. It was only in December 2004 that the Supreme Court ruled that foreigners could again get involved in the mining sector. As the consequences of that ruling start to filter through, and as low-value exports pick up, so the Philippines may well slip down the high-value exports ranking.” (emphasis added)

From the above we learn that statistics are not reliable indicators of actual events because many factors influence an outcome, and second, the Philippines made it to the top of the list because the government has suppressed trade activities which pumped up the share of high value exports.

Alternatively, while the increased participation of the low value share is likely to erode the Philippines’ standings as measured by the above statistics, more trade should equate to more output and economic benefit.

Bottom line: Strong performances of ASEAN stocks and commodities defy the bearish outlook suggesting of a double dip recession in the world economy.

The Yuan Factor In The ASEAN’s Divergence

This brings us to the next factor which is likely to influence the ASEAN trade and market dynamics.

It’s the Chinese Yuan.

China’s government has announced last weekend that the Yuan will return to a managed float from the de facto US dollar peg[3].

In 2005, China went into a managed float but the recent financial crisis had forced China to re-peg the Yuan back to the US dollar[4] as a defensive move.

While a parcel of China’s action may have been in response to ease global political pressures aimed at pressuring the Yuan to revalue out of the perceived “overvaluation” and to “rebalance” the global economy, the geopolitical aspect seems to overstate the case. Instead, for me, China’s response has been due to its serial failure to combat internal inflation which continually flies in the face of government’s tightening policies.

As we wrote in March of this year[5],

``China has attempted several times since last late year to arm twist several industries to stem credit expansion which has led to inflation. Lately she has threatened to nullify loans granted to local governments and has similarly instructed 78 state owned enterprises (SOE) to quit the real estate market leaving 16 SOE property developers.

``And economic overheating presents as a real risk. There has been an acute shortage of labor where factory wages haverisen by as much 20% as the inland now competes with the coastal areas and reduced migration in search of jobs.

``We are now witnessing a classic adjustment in trade balances as taught in classical economics. As Adam Smith once wrote, ``When the quantity of gold and silver imported into any country exceeds the effectual demand, no vigilance of government can prevent their exportation.” (emphasis added)

``In short, this leaves the Chinese government little or no option but to allow its currency to rise as a safety valve against a runaway inflation.”

And faced with the predicament of recession risks from further credit rollbacks and the intensifying inflation, China has indeed resorted to the currency safety valve.

A stronger yuan allows relatively cheaper imports, which many in the mainstream mistakenly thinks that this will translate to economic “rebalancing”.

Yet in a world of paper money system, the international currency reserve, which essentially expedites the global trading activities, has NO automatic mechanism for adjustments. This implies that aside from adjustments mostly due to political preferences, the higher costs from the attendant currency adjustments simply mean that investments get shifted to the trading partners (see figure 4).

Figure 4: IMF[6]: Savings-Investment, WEF[7]: ASEAN Exports By Destination/

Alternatively, this means that “rebalancing” concept is an illusion, which fundamentally disregards the function of money as a medium of exchange and where an international currency reserve is the politically preferred “medium of exchange.”

The upshot to this is that a firmer yuan would induce the growing number of wealthy Chinese to buy more stuff abroad [provided the government allows for this]. And this should extrapolate to a boon to the major trading partners.

Considering that the share of the China-ASEAN trade has been ballooning (lower window of the ASEAN Export Destinations) at the expense of Japan and the US, the underinvestment seen in Emerging Asia (upper window) exhibited by yawning gap between savings and investment is likely to see significant improvements as a consequence to both a rising yuan and the deepening of intra-region trade. [Note: the Asian Crisis was clearly a result of malinvestments as shown by investments overtaking savings, which obviously was funded by inflated money from domestic and foreign sources.]

Of course, currency valuation is just one of the many factors that influence trading dynamics, yet one of the most important forces is the political desire to accommodate free trade.

Apparently, the process to integrate economically by regionalization has already been set into motion by the China-ASEAN Free Trade Agreement (FTA)[8] in late 2009 and secondarily, by China’s attempt to introduce the yuan as the region’s reserve currency[9].

The negative facet is that the use of the currency valve triggers more political rather than consumer based distribution which leads to accretion of internal imbalances and an eventual bust.

We are reminded that China’s 9.8% appreciation in 2005 did little to make any dent in the so-called “rebalancing” of trade and that the revaluation of the Japanese Yen through the Plaza Accord[10] in 1985 (15 years ago), had also little impact on Japan’s trade surpluses (Japan remains mostly in the trade surplus position).

Instead, the corollary of the Plaza Accord was that it fueled a massive real estate bubble in Japan which culminated with a colossal bust that lasted for more than ten years, popularly known as the Lost Decade[11].

However, if China is indeed truly determined to make the avowed currency regime shift, then one can’t help but put into picture how the Philippine Peso has responded to China’s revaluation via the shift to a managed float in July of 2005 (see figure 5).

Figure 5: yahoo finance[12]: USD-China Yuan (top), USD-Philippine Peso (down)

The Peso has strengthened in near conjunction with China’s yuan!

Although China ranks fourth among the largest trading partner for the Philippines, in terms of exports, and ranks third in terms of imports in 2009[13], China projects that the recent FTA will pole-vault China’s position as the Philippines’ 2^nd largest trade partner[14].

Thus, China’s ascendant “free trade” dynamics combined with the Yuan’s appreciation should lead to a shift in the current trading framework which will likewise be reflected on her trading partners as the Philippines.

Of course, the growing role of China’s trade relations will also redound to the political spectrum. So we should expect to see more of Chinese representation in local politics overtime.

And we should expect all these to be eventually reflected on the region’s financial markets. (see figure 6)

Figure 6: US Global Funds: Indonesia As Prime Beneficiary

The last time the Yuan was revalued in 2005, Indonesia massively outperformed.

However, as noted above, almost every Asian currency profited from this, including the Peso.

According to US Global Funds[15], ``Indonesia remains one of the major beneficiaries of an appreciating Chinese currency, thanks to the commodity-heavy nature of its exports to China. Coal and palm oil are key categories. During the three years from mid-2005 to mid-2008, when the yuan was unpegged from the U.S. dollar and saw appreciation, Indonesian equities more than doubled in U.S. dollar terms, making them the second-best performer in Asia after Chinese equities. In addition, the government’s improving fiscal status highlights a prudent Indonesia where public sector debt declined to 31 percent of GDP in 2009 from 102 percent in 1999, a confidence booster in a world of apprehensions over sovereign indebtedness.”

Today, Indonesia is once again at the top in terms of equity performance on a year to date basis.

Ingredients Of A Bubble: Pegged Currency And Lack Of Convertibility

None the less, this isn’t 2005.

Then, the US dollar weakened as global growth surged behind the US centric housing mortgage bubble. This means the Yuan appreciated on the back of weak dollar.

Today, the US dollar has emerged as safehaven from ongoing credit prompted woes in Europe, hence, the Yuan’s appreciation arises out of the US dollar strength. Besides, in contrast to 2005 where global economy was running on full throttle based on a US bubble, today, emerging markets and Asia has reportedly done most of the weightlifting of the global economy out of the recession[16].

In my view, the attendant underperformance of developed economies is likely to attract even more of hot money flows into China, Asia and the Emerging Markets.

In addition, the gradual appreciation of the yuan amidst the lack of convertibility is likely to prompt for more the same bubble predicament.

The problem isn’t China’s alleged “currency manipulation”, instead it is the lack of convertibility or the freedom to convert local currency to foreign currency and vice versa. The lack of convertibility means that the pricing mechanism via concurrent exchange rate or monetary policies (e.g. monetary base) has been severely distorted from which creates arbitrage opportunities. Speculative money sees this and gets “smuggled in” through unofficial channels, which causes “huge surpluses”. Naturally, such policy contortions lead to malinvestments throughout the country’s economic structure.

In addition, having both the exchange rate and monetary targets, likewise create mismatches from which imbalances will ultimately be expressed via a crisis. This characterises the pegged currency regime. Contrary to public wisdom, a pegged currency and fixed currency framework are different.

A fixed currency, according to economist Steve Hanke[17] is either established by a currency board which “sets the exchange rate, but has no monetary policy — the money supply is on autopilot — or a country is "dollarized" and uses a foreign currency as its own. Under a fixed-rate regime, a country's monetary base is determined by the balance of payments, moving in a one-to-one correspondence with changes in its foreign reserves.”

An example of the symptoms from imbalances of a pegged currency is China’s battle to control inflation and the subsequent reaction to appreciate the yuan following the failed attempts to arrest inflation.

Hence the lack of convertibility and the ramifications from conflicting goals of a pegged currency framework are likewise recipes to bubbles.

And one way to alleviate this dilemma is to engage in free market mechanism and to eliminate controls again, Mr. Hanke, ``Beijing should adopt a fixed exchange rate regime. This would force Beijing to dump exchange controls and make the yuan fully convertible. Such a "Big Bang" would muzzle the China-bashers and put Beijing in the driver's seat. After all, China would then have a stable, freemarket exchange-rate regime.”

Considering the earlier or previous bubble policies, this is not going to be a painless solution.

But the point is, free markets operating under a under currency regime with free market mechanisms and without exchange controls will reduce, if not eliminate, incidences of bubbles.

But this isn’t likely to happen under a central banking system.

Therefore, China’s regime shift isn’t likely to do away with the formative bubble in process.

Conclusion

To conclude, China’s purported regime change is likely to result in an appreciation of Asian currencies, including the Philippine Peso.

This would be further amplified by the ongoing region’s trade integration. And the possible decoupling signs we seem to be witnessing today could likely be the evolving repercussions from China’s currency shift.

So unless we see further deterioration in the economic conditions of developed markets which would result to a liquidity squeeze, the effects of the China’s actions will likely be evinced positively in the region’s financial markets.

Therefore, like in our previous outlooks, the case of the China’s currency regime shift adds to why the Philippine Peso, Asian currencies and equity markets should a buy.

Nevertheless, China’s currency makeover doesn’t eliminate the ongoing bubble process.

Perhaps in the future we will deal with “buy what the Chinese buys, and sell what the Chinese sells” story.

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[1] Businessweek, Greece Swaps Surge to Record, Signaling 68.5% Chance of Default, June 25 2010

[2] Economist Intelligence Unit ASEAN Exports Today, tomorrow and the high value challenge

[3] Wall Street Journal Blog, China Issues Statement on Yuan Exchange Rate Flexibility, June 19, 2010

[4] See Currency Values Hardly Impacts Merchandise Trade

[5] See Spurious Mercantilist Claims And Repercussions Of A Strong Chinese Yuan

[6] IMF, The Regional Economic Outlook, April 2010

[7] World Economic Forum, Enabling Trade in the Greater ASEAN Region

[8] See Asian Regional Integration Deepens With The Advent Of China ASEAN Free Trade Zone

[9] See The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency

[10] Wikipedia.org, Plaza Accord

[11] Wikipedia.org, Lost Decade (Japan)

[12] Yahoo Finance, Currency Converter

[13] Economywatch.com, Philippines Trade, Exports and Imports

[14] Xinhuanet.com China to become 2nd largest trade partner of Philippines as recovery takes hold, December 30, 2009

[15] US Global Investors, Investor Alert, June 25, 2010

[16] See Another Reason Not To Bet On A 2010 'Double Dip Recession’

[17] Hanke, Steve H. The Dead Hand of Exchange Controls