It’s a Banking Meltdown More Than A Stock Market Collapse!

``The argument that the government is somehow pumping new capital into the market is absurd. Government is actually borrowing the money from the capital markets that it is in turn injecting into the capital markets. There is no additional source of funding; there is only a diversion of funds from more-productive outlets to less-productive outlets, with government acting as the middleman.” -Scott A. Kjar, University of Dallas, Henry Hazlitt on the Bailout

It’s amusing how many people believe that today’s financial crisis is just a “headline” material. They carry this notion that the meltdown seen in the stock market are just confined to within the industry. They believe in media’s assertion that these are all about just banking related losses and perhaps a prospective recession. Yet, importantly governments will successfully come to the rescue. And that banking deposits will be safeguarded by sanctity of government guarantees. We hope that such smugness is correct and don’t turn out to be chimerical.

From our side, the current global stock market meltdown is like utilizing a thermometer to a gauge the body temperature of a patient. From which the mercury’s position indicates of the degree of normality or abnormality in the patient’s temperature than of its cause. Hence, the thermometer signifies as the medium and the mercury’s position the message. In the stock market we see the same message See Figure 1.

Figure 1: Mercury Indicator: Stock Market Meltdown or Banking System Meltdown?

The Performance chart from stockcharts.com shows that since the whole bubble bust cycle episode unraveled, the losses of world equity markets have been far less than the damage suffered by the housing and the entire swath of financial and banking sector.

True, everyone directly or indirectly involved in the financial sector seems to be afflicted. But some are suffering more than the others. This means that like the thermometer, the public’s attention have been on inordinately transfixed to the freefall in global equities but have glossed over the significance of the ongoing risk dynamics in the US financial sector.

From our point of view, the stock market “meltdown” has been a symptom of a deeper underlying disease: the risks of a US banking sector collapse. And this is not just about your typical banking losses, but a representation of the real risks of a total freeze of the entire global banking network system as we discussed in Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

As had been pointed out, the US dollar standard monetary system has been anchored upon a global banking system from which operates on a fractional reserve banking platform from where the entire global banking network revolves or interacts upon. In short, deposits, credit intermediaries, clearing and settlement, maturity transformation, asset markets etc… are all deeply interconnected.

Since the US dollar standard banking system has been at the core of our troubles, all the network of banking nodes connected to such intertwined system have likewise been bearing strains, see Figure 2 from the IMF.

Figure 2: IMF’s GFSR: The Evolution of the US Banking System From Deposits to the Shadow Banking

According to the IMF’s Global Financial Stability Report (emphasis mine), ``Banks have been shifting away from deposits to less reliable market financing. “Core deposits” dominated U.S. banks’ liabilities in the past, but have been gradually replaced by other “managed liabilities”…At the same time, near-banks—which are entirely market financed—have grown sharply. This is related to the “originate-to-distribute” financing model that relies heavily on sound short-term market liquidity management. Euro area and U.K. banks also rely more on market financing than in the past, as in the United States. Similarly, the share of deposits by households (defined roughly the same as U.S. core deposits) has been gradually declining over time, while deposits held by nonfinancial corporations, other financial intermediaries, and nonresidents have steadily increased. In addition to these “managed deposits,” financing through repurchase agreements and issuance of debt securities, both in domestic and foreign markets, have expanded, indicating that European banks are also increasingly exposed to developments in money markets. At the same time, the share of household deposits for Japanese banks has been stable and even increasing over time. This may partly reflect the prolonged low interest environment since the late-1990s.”

In other words, from a depository based banking system the US has evolved into gradual dependency on “near banks” or what is known as the “shadow banking system” (we previously featured a schematic chart from the Bank of International Settlements The Shadow Banking System) which basically relies on short term financing or maturity transformation borrow short and lend or invest long.

Thus, when the collaterals backstopping the entire short term financing channels began to deteriorate, whose chain of events included the Lehman bankruptcy, this resulted to a collapse in the commercial paper market (forbes.com) and the “breaking the buck” in the money markets (edition.cnn.com) as banks refused to deal (borrow and lend) with each other on perceived “rollover risks”.

Consequently, major financial institutions dumped the banking channels and stampeded into US treasuries. This exodus or flight to safety set a record yield of .0203% for 3 months bills last September 17^th (Bloomberg), which we described last week as an “institutional run”. And these strains reverberated throughout the network of banks all over the world which raised credit spreads and resulted to a dearth of US dollars and lack of liquidity in the system as banks and companies hoarded cash. Thus as a result to the credit gridlock the liquidity crunch inspired the sharp selloffs.

So while the defensive mechanism for the global banking system has been designed against isolated instances of retail depositors run via a depositors insurance (e.g. FDIC, PDIC etc…), an institutional run has not been part of such contingencies.

Hence what you have been witnessing is an unprecedented monumental development which has a potential risk of a downside spiral.

To consider, the assets of Shadow Banking system was estimated at some $10 trillion dollars which is almost comparable to the assets of traditional banking system. According to a report from CBS Marketwatch (all highlights mine),

``By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

``Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

``Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007.

``Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

``That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.”

So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.

Besides, risk of a deep and extended recession could imply larger corporate bankruptcies and larger defaults from corporate leveraged loans that could trigger credit events in the CDS market that could give rise to new bouts of forcible liquidations. All these could similarly shrink the capital base of existing banks, even under those buttressed by capital from the US treasury.

In addition, the risks of heavy damages in the asset markets could spread to the insurance and pension funds which risks reinforcing the downside spiral. In short, the shadow banking system poses enough risk to destabilize the entire US banking system.

Global Governments Throws The Kitchen Sink And the House

Governments have virtually thrown not just the proverbial kitchen sink but the entire house to deal with such outsized dilemma. The US government pledged to “deploy all of our tools” as the G7 counterparts have “committed to a global strategy”.

Specifically the US government will earmark some $250 billion for its “capital purchase program” to be infused as capital to the banking system in return for preferred shares of which 9 of the major banks have “agreed” or “coerced” to participate, a temporary guarantee by the FDIC on the “senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing deposit transaction accounts”, the broadening scope Commercial Paper Funding Facility (CPFF) program which will “fund purchases of commercial paper of 3 month maturity from high-quality issuers” (Federal Reserve) and unlimited swap lines or “Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction” with major central banks as the Bank of England (BoE), the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank (SNB) as “necessary to provide sufficient liquidity in short-term funding markets”. (Federal Reserve)

Figure 3: Wall Street Journal: Europe’s Bailout Package

Of course, it’s no different with the European counterparts which have committed aggressively some €1.8 trillion (US $2.4 trillion)-AFP.

So overall, including the US Congress’ contribution of $850 billion plus the Federal Reserves liquidity infusion via US dollar swaps these should amount to over $3 trillion or over 5% of global GDP (2007) of $54.62 trillion based on official exchange rate-CIA.

Such astounding financial theater of operations reminds us of the D-Day 1944 Normandy Landings. Bernanke’s helicopters have not only been operating on round the clock sorties, but they are also flying all over the globe as the Fed has essentially outsourced its printing press functions to international Central banks!

The Illusions of Government Guarantees

If only those unlimited injections of liquidity can translate to REAL capital.

The unfortunate part is that government guarantees depend on the hard currency that backs the system.

For instance, in the case of Iceland which basically guaranteed deposits of its financial system and nationalized its major banks, the lack of hard currency has precipitated a crisis (See our Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?).

As the Icelandic government operated on a huge current account deficit in the face of a paucity of global liquidity, rising risk aversion, global bear markets, global deleveraging and the monumental debt incurred by its banking system, investors withdrew funding and sold the currency aground. Last October 9^th the Iceland Prime Minister even pleaded to the public to restrain from withdrawals (Reuters).

Now goods shortages have emerged and consumer price inflation has soared. If Iceland can’t obtain the sufficient funding from overseas lenders (IMF or Russia or etc.) soon enough, then it would have to resort to the printing press or our developed country equivalent of Zimbabwe.

In a varied strain, Pakistan’s economy and banking system has allegedly been suffering from “some” depositor’s run (thaindian.news) on rumors that the government might impose withdrawal restrictions. Global volatility has exposed Pakistan’s vulnerability to its heavy dependence on short term debt financing and huge current account deficits (see our Increasing Signs of Pakistan's Depression?). Pakistan is now seeking a bailout package from China.

In both examples, government guarantees won’t serve any good if governments can’t support such claims.

Think of it, government revenues basically derive from three channels: taxpayers, borrowing through debt issuance or the printing press.

Even if your government guarantees deposits or other loans, assets etc…, if taxpayer’s can’t pay up, or if the government can’t raise enough borrowings to fund its present expenditure or settle its liabilities seen via fiscal or current account, your government ends up using the printing press to meet its needs.

This means that in the assumption that your government remains functional under a banking system collapse, whatever money guaranteed by the government will surely have its purchasing power evaporated!

If for instance the Philippine government allows deposit guarantees to increase at P 500,000 per depositor (from the present Php 250,000-PDIC) and our doomsday scenario occurs, such an amount which can momentarily buy a second car will eventually (perhaps in just months) buy up only a bottle a beer! That is if government even allows you to withdraw your money. In Argentina’s case during its 1999-2001 crisis, particularly in December of 2001, the Argentine government restricted depositors from withdrawing money to only a specified amount (BBC).

To Austrian economics, such restriction is equivalent to “Confiscatory Deflation”, which according to Joseph Salerno in his Austrian Taxonomy of Deflation, ``There does exist an emphatically malign form of deflation that is coercively imposed by governments and their central banks and that violates property rights, distorts monetary calculation and undermines monetary exchange. It may even catapult an economy back to a primitive state of barter, if applied long and relentlessly enough. This form of deflation involves an outright confiscation of people’s cash balances by the political and bureaucratic elites…

``Confiscatory deflation is generally inflicted on the economy by the political authorities as a means of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound financial system built on fractional-reserve banking. Its essence is an abrogation of bank depositors’ property titles to their cash stored in immediately redeemable checking and savings deposits.” (highlight mine).

Yet when government mandated money loses trust among its constituents people tend to find a substitute, as example see our previous, The Origin of Money and Today's Mackarel and Animal Farm Currencies.

So as shown above, government guarantees do not constitute as an outright safety net. These will all depend on government’s access of available financing at future costs.

Under the same line of thought, the idea that the US dollar as the international foreign currency reserve with unlimited lending capacity is another mirage.

The US economy has been supported by the financing of its current account deficits by foreign exchange surpluses of current account surplus countries mostly found in Asia and Gulf Cooperation Council (GCC). This vendor financing scheme effectively recycles money earned from exports of EM economies by buying into US financial papers to keep their currencies from appreciating.

Hence, the US economy’s ability to provide unlimited finance is moored upon the willingness of foreigners as China, Japan and GCCs to sustain the present system. Said differently, for as long as these financers continue to buy US financial claims, they automatically provide the wherewithal or the “quiet bailout” to the US government.

So China, Japan and others essentially determines the guarantee provisions the US extends to its financial institutions aside from the world’s faith on its printing presses.

Besides, guarantees in the banking system as we previously discussed represent as “beggar-thy-neighbor” policy which keeps at a disadvantage countries offering less amount of guarantees, like the Philippines, since the former tend to attract more capital or savings because of the higher amount of safety.

Hence, guarantees signify as subsidies to those who apply more and a tax to nations who apply less. Thus, the policy regime of surging guarantees on deposits by Europe and the US tend to put into the downside pressures to the Philippine Peso.

Yet, our discussions above are some examples of isolated banking crisis and not of a systemic banking collapse, a domino effect from a prolonged cardiac arrest of the US banking system, the ultimate recipe for a global depression, where guarantees will just be that- a political rhetoric.

US Banking Collapse: You Can Run, But You Can’t Hide; Revival of Bretton Woods?

We proposed last week that this could mark the beginning of the end of the current form of paper money system or even signify as a harbinger to a new paradigm shift from our present monetary system.

Perhaps European Central Bank’s Jean Trichet heard our whispers and began to talk about the revival of a modern version of a “Bretton Woods” (see Did ECB’s Trichet Fire The First Salvo For A Possible Overhaul Of The Global Monetary Standard? and Bretton Woods II: Bringing Back Gold To Our Financial Architecture?)

So aside from the rapid aggressive policy response (bailouts, liquidity injections, nationalization, blanket guarantees), some European leaders have also raised the idea for a shift in the global financial architecture.

As the Reuters report indicates ``Italy's economy minister said a reform of the Bretton Woods institutions should also review trade, foreign exchange and capital markets and questioned whether the dollar should remain the reference currency under a new system.” (highlight mine) So it won’t be a far fetched idea for a movement among nations to address the need to reform the present monetary system.

Yet as the crisis continues to unfold, everything now seems to depend on how the global markets will respond to the massive stimulus applied and how it will measure up to remedy the apparent weakening of the foundations of the US banking system.

Nonetheless the threat remains real.

This means that should the US banking system collapse, there will probably be no escape for almost everyone dependent directly or indirectly on the global banking system, not even for those who aren’t invested in the stock market. While it is true that alternative sources for financing such as microfinancing and trade finance may be picking up on some of the slack, it won’t be enough for it to replace the rapidly mounting losses in the financial system that risks becoming a financial black hole.

We can only guess what implications of a global depression as an offshoot to the US banking collapse could be: pension, insurance, and other money market funds will perhaps evaporate, stock markets will close, a collapse in the international division of labor means each country will have to fend for themselves or dominant “protectionist” policies will prevail (hence some countries will experience hyperinflation and others will suffer from deflation), a run of the US dollar or the present paper money system, rising crime and security risks, civil wars, return of authoritarianism etc…

On the other hand, some sectors would be quite happy- the extreme left will glee with the resultant equality from a depression, as well as bureaucrats and political leadership who will benefit from more government spending. Outside these sectors, everyone will probably be equally poor!

Sorry for the gloom.

Conclusion

Thus, it is an arrant misguided fairy tale to suggest that today’s stock market meltdown is just seen for its “media feed”.

Today’s stock market meltdown is representative of the real risks of a US banking collapse. While I am not betting that this devastation is gonna happen, a US banking collapse would have deep adverse repercussions to our domestic and global banking system, aside from the global economy which practically means the ushering in of the great depression (version 2008) . Why would global central banks have earmarked over $3trillion of bailout money? Why would Bernanke’s Federal Reserve Helicopters be doing simultaneous missions globally to drop “helicopter money”?

So it is equally myopic to suggest that our banking system will be “immune” to such extreme risk scenario. If the issue is only about banking losses and some disruptions in the system then yes the Philippine banking system will escape with some bruises.

Nonetheless if the US banking industry does collapse, not even those out of the stock market will be spared unless their money is stashed under their pillowcase or buried underground.

That is if street muggers don’t figure them out.

Will King Dollar Reign Amidst Global Deflation?

``Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”.- John Stuart Mill (1806-1873) British philosopher, political economist, civil servant and Member of Parliament, was an influential liberal thinker of the 19th century.

Deflation proponents have been confidently increasing their pitch of a global depression or “severe and prolonged” recession cheering about the US dollar’s recent gains as signs of such manifestation.

Since the US credit system has turned disorderly and dysfunctional, it is true that an alternative major flux for global “liquidity” stems from the US current account deficit. And an improving US current account deficit suggests of a further drain of liquidity AWAY from the global financial system, thus amplifying risk towards the financial markets.

Deflation proponents emphatically argue that the strength of the US dollar stems from (factually) the US dollar’s role as the de facto world currency reserve and secondarily from its sophisticated, deep and advanced state of the markets that are likely to attract “limited” capital flows away from the hinges and back to the center or the origin. Hence a global meltdown extrapolates to KING dollar reasserting its hegemonic role in the international monetary sphere.

Global Liquidity Story Isn’t Exclusively A US Dollar Issue

The US dollar’s role as the nonpareil currency reserve of the world is yet incontrovertible, meaning the US still maintains its lead position among the other currencies as the elected currency benchmark (or reserves) for central banks.

BUT its leadership isn’t at all the monopoly it once used to be. And this is the important difference: the Euro has incrementally been expanding a material foothold in the share of the composition of the currency reserve market especially in the context of developing countries or emerging markets.

From the IMF’s September 2007 survey (emphasis mine),

``Data reported to the IMF by industrial and developing (nonindustrial) countries, compiled on an aggregate basis in the IMF's Currency Composition of Official Foreign Exchange Reserves (COFER) database, reveal that more developing countries than industrial countries have switched holdings into euros. Nonindustrial countries hold some 30 percent of their reserve assets in euros and 60 percent in dollars (as of December 2006), compared with 19 percent and 70 percent, respectively, six years earlier.

``Industrial countries' use of the euro has risen to 21 percent from 17 percent in December 2000, while their dollar holdings have remained fairly steady at 72 percent compared with nearly 73 percent six years earlier. Their remaining holdings are in such currencies as the Japanese yen and the pound sterling.”

Figure 1: Brad Setser: Central Banks Still Buying Dollars

Figure 1 from our favorite fund flow analyst Brad Setser of the Council of Foreign Relations shows how the composition of global currency reserves have been growing over the past decade.

So even as currency reserves of global central banks have steadily grown in absolute terms, which also translates to growth in other major currencies aside from the US dollar, the Euro seems to have outpaced the growth in the US dollar. Hence, the growing share of the Euro relative to the US dollar in the universe of currency reserves.

Why is this important? Because if the premise for a severe recession comes from financial links in terms of a liquidity crunch (aside from the trade linkage), then from the angle of asymmetries in the current account distribution-the Euro zone against the emerging markets-also matters.

If hypothetically 65% of global currency reserves are in the US dollars, and 25% comes from the Euro then the trade imbalances also project liquidity flows not only from the US (although it signifies the main channel) but also from the secondary reserve currency in the Euro and also (but insignificantly) in others. Hence the Euro is also a contributor to global liquidity!

In other words, global liquidity flows from the premise of the trade-current account is not solely a US perspective and can’t be the only basis to reckon for liquidity flows, see figure 2.

Figure 2:tradingeconomics.com: China Trade Balance

Figure 2 from tradingeconomics.com illustrates China’s growing surplus from its trade balance with the world despite the present economic growth slowdown, which implies a shift of the weight of its trade from the US to the Eurozone. Thus, these surpluses have “partially” contributed to the amazing $1.81 trillion surge in their forex reserves last July in spite of the sagging global economy.

And this shouldn’t be seen in the context of China alone as much as it should apply to other emerging countries such as the oil exporting nations most especially the Gulf Cooperation Council (GCC).

While it may be true that the Eurozone may now be feeling the pinch of a US led dramatic growth economic slowdown as we pointed out in our recent weekday post Global Recession watch: Japan and Euroland Economic Growth Turns Negative!, this will also translate to a second round leash effect on the US, which means it isn’t clear whether the US current account deficit would improve at all (since both exports and imports are likely to deteriorate in the face of a slowing global economy!).

One thing seems clear is that regardless of the state of the US current account, the case for the taxpayer funded government intervention to ameliorate the woes from the deleveraging plagued stricken Wall Street plus the spillover effects on the Main street are likely to more than offset any improvements in the current account, which means more financing needs by the US public-by either of the following options borrowing abroad, selling assets or printing money-and private sector.

The point is improving current account imbalances should reflect both sides of the ledger and doesn’t automatically translate to a complete or outright drain of liquidity as deflation proponents suggest.

Strength of US Dollar Depends On The Reliability Of US Markets?

Yet if the argument will directed to the premise that the inherent advantage of the US markets due to its depth, sophistication and advance conditions signify as main reasons why the perceived “trust” as a safehaven status, this quote from the Bank of the International Settlements over the fate of the Euro as an alternative foreign currency reserves should serve as an eye opener (highlight mine) `` The euro comes closest to challenging the dollar in its role as a store of value. As a unit of account and medium of exchange, the dollar’s role is not as secure as it once was, but the dollar is still preeminent.”

So what defines a store of value for the BIS?

Again the BIS ``In the strictest sense, this will be a currency whose value is reliable in terms of future purchasing power. This in turn is linked to the maintenance of sustainable macroeconomic policies. Moreover, the store of value function can also depend on the anchoring role of a currency to the extent that the central bank tries to align the currency composition of its country’s assets and liabilities. More generally, the store of value function of an international currency is linked to the breadth and depth of financial markets, in particular to the availability of investments which meet wealth holders’ risk-return objectives.”

So if the Euro’s best chance to compete with the US dollar is seen in the role of a store of value, it implies that the Euro’s “breadth and depth of the financial markets” appears to have nearly assimilated the US markets in order for the BIS to issue such qualifying statement.

Besides, in today’s functioning monetary platform in the fiat “paper” money standard whose system is backed by nothing but promises based on “Full Faith and Credit” of governments then the US dollar as the alleged beneficiary via the “safehaven” asset status from a global meltdown overlooks where the epicenter or source of today’s crisis emanates from.

This comment from Yu Yongding, a former adviser to China's central bank on the cataclysmic repercussions for the global financial system on a failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac as quoted by Bloomberg (HT: Craig McCarty)

``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic, if it is not the end of the world, it is the end of the current international financial system.''

If we go by Mr. Yongding’s statement; the end of the current international financial system is tantamount to the end of the US dollar as the global currency reserve!

So how does one consider the US dollar as today’s “safehaven” when it has been a major source (US housing bust, subprime, Fannie and Freddie Mac) for most of the troubles scourging the financial markets today?

True, global central banks continue to accumulate US dollars have been responsible for their policy decisions, but this is done to maintain the status quo or because of the Nash Equilibrium-(wikipedia.org - a game of two or more players wherein “each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his or her own strategy (i.e., by changing unilaterally). If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium.”)

- or its military doctrine equivalent of the Mutually Assured Destruction (MAD) scenario where once such an event unfolds could prove to be devastating to all involved (once deeply exposed trading partners of the US suddenly decide to quit the game)! So for example, if China decides to quit from the US dollar accumulating game, hell would probably break lose (via a US dollar crisis or hyperinflation on a global scale)!

So it isn’t clear that global central banks will continue supporting the US economy or its financial markets, which will likely to be reflected in the state of the US dollar, if economic or political conditions degenerate further.

Besides, US officials seem very much aware of these conditions, hence quickly signed into a new law to provide for a temporary fix to the ailing GSEs; aside from previous bridge liquidity “alphabet soup” of Fed-US treasury programs, widening the scope of collateral acceptance and direct stimulus to the public.

Another, the seeming “resiliency” of the US economy in the face of a housing and financial sector meltdown has been predicated on mainly its “net” exports and global central bank financing. Thus we read into US Federal Reserve Chair Ben Bernanke’s current policy actions as an indirect stimulus meant for global economies especially for countries tied to the US dollar via currency pegs as previously discussed Global Financial Markets: US Sneezes, World Catches Cold!. The US seems banking on “inflating” on global growth to sustain its economy and keep it out from the clutches of recession.

Thus inflation as a US monetary policy is being transmitted globally and the world has been reciprocating.

Proof?

This from Joachim Fels of Morgan Stanley (emphasis mine),

``In most countries – even in many that have raised interest rates this year – the policy stance is fairly easy. Real short-term interest rates (nominal policy rates minus current CPI inflation) are currently negative in no less than 20 of the 36 countries in our coverage universe. Among others, these include the US, Japan, Canada, Switzerland, Russia, Ukraine, the Czech Republic, Korea, Taiwan, Singapore, Indonesia, the Philippines, Malaysia and Peru. With policy easy to start with, there is thus little scope to cut rates aggressively. By contrast, there are only a few countries that have relatively high real short rates and thus tight monetary polices. Apart from Australia and New Zealand (where real short rates stand at 2.75% and 4%, respectively), these include Brazil and Turkey, where real rates stand at 6.6% and 4.65%, respectively.

``Global real policy rate still negative. Aggregating across all countries in our coverage universe, the weighted global monetary policy rate currently stands at 4.5% in nominal terms. However, current global (weighted) inflation is running at 5.3%, so the global real rate is -0.8%, the lowest in this decade. Thus, global monetary conditions remain very expansionary, limiting the room for a major global monetary easing.

So if global monetary environment remains expansionary how can deflation proponents argue that the world will be engulfed with a meltdown from deflationary forces? The US and the UK, Spain, Ireland, Australia and those suffering a structural “housing bust” does not translate to the same predicament all over the world, especially not in the Philippines.

Besides what is to “deflate” in the Philippines or most of Asia?

Figure 3: BIS: Loan/deposit Ratio of banking systems in Asia and the Pacific

Except for Australia and Korea whose loans are above deposit reserves, loans in most of Asia have not been “leveraged” as shown by the BIS and are below reserves of deposits. In other words, the Asian banking system has more deposits than extended loans.

Yes, a global economic slowdown is in the cards-some will experience recession, some won’t-but definitely not from the garden variety type as seen in the deflation paragon.

Deleveraging Is Not A One Way Street; Short Sales And Market Efficiency

Then there’s the other argument where the whole world will be enveloped by the feedback loop of de-leveraging.

Against the common impression deleveraging isn’t a one way-street though, see figure 4, especially when we deal with advanced or sophisticated markets because of the available facilities to bet on EITHER DIRECTIONS.

Figure 4: stockcharts.com: US-dollar Index-commodity Pair trade

The chart in figure 4 shows how gold (candlestick main window) /oil (lower pane) and the US dollar index (black line behind main window) have had a strong inverse correlation, as demarcated by the blue vertical lines (as US dollar troughs when oil/gold peaks and vice versa). The Dow Jones AIG Grain (lowest pane) seems to have moved ahead of its major commodity bellwether.

The tight correlation suggests of the proliferation of “paired” trades, which means participants who shorted/longed the US dollar also bought/sold oil and gold. Such is why the violent action in one market could have reflected an equally volatile action in the another-but in an opposite direction!

It also means that since every transaction is accounted for by an entity, anyone (represented by an individual or by a company) who is “forced to liquidate or delever” on their market position has to closeout (by taking the opposite position-of either a buy or sell-on the original position taken!). If an entity took up a “short sell” position then one closes by “buying”, and in the same manner if the same entity takes up a “long” position then the consummation of the trade translates to a “sell”.

Thus deleveraging doesn’t automatically mean selling, it can also mean buying!

Proof?

Figure 5: US SEC’s Short Sale curb=Magnified Upside For US Financials!

The US SEC imposed a curb on “naked” (selling without actual possession of borrowed shares) short selling on 19 financial companies last July 16^th. And as we demonstrated above, the huge short position taken by the public was forced to unravel, see figure 5 (see blue arrows). This led to a strong simultaneous upside rebound for the beleaguered Dow US financials (main window), the Broker Dealers (pane below the main window) and Banking indices (lowest pane). Yet this doesn’t account for derivatives.

Maybe one factor why the US equity markets have not entirely collapsed in the face of a prospective or ongoing recession, prompted by the meltdown in the housing and financial domain, is because of the public’s liberal access to “short” the market. To quote Mises.org’s Robert Murphy ``But the basic principle is simple enough: just as a speculator who wants to go long can borrow money to buy stocks, so too a speculator who wants to go short can borrow stocks to "buy money." Short selling is no more mysterious than buying stocks on margin.” Hence, the short selling facilities could have minimized the volatility on the downside by allowing for greater pricing efficiency through expanded liquidity.

Well of course since this isn’t back by any evidence, this is just a guess on my part.

But for the world markets especially in dealing with the deleveraging issue, it could be a different story. Deleveraging means global investors have to sell equity holdings as “short facilities” have not been as deep and widely used as those in the US.

For instance, the Philippines now allows for “borrow and lending”, though I have not read the entire regulation, based on my principal’s opinion, the rules seem quite stringent and rigid as to discourage any actual application because of the costs of compliance. If costs exceeds the benefit who will avail of the trade?

Put differently what good is a facility if it is stifled by suffocating regulations or if it can’t be used?

Finally the penchant of deflation proponents is to compare present occurrence to that of the Great Depression,

This quote from Professor Barry Eichengreen of the University of California, Berkeley in the Financial Times should account for a good retort,

``And since other currencies were linked to the dollar by the fixed exchange rates of the gold standard, US deflation caused foreign deflation. As US demand weakened, other countries saw their currencies become over­valued. They were forced to raise interest rates in the teeth of a deflationary crisis. By raising interest rates, foreign countries transmitted deflation back to the US. Only when they delinked from the dollar and allowed their currencies to depreciate did deflation subside.

``The difference now is that the Fed knows this history. Indeed Ben Bernanke, the Fed chairman, wrote the book on the subject. Seeing the analogy, his Fed has responded to the subprime crisis with aggressive lender-of-last-resort operations. If anything, it may have been too impressed by the analogy. Its mistake was to cut interest rates so dramatically at the same time that it extended its credit facilities. It would have been better to lend freely at a penalty rate. Higher interest rates would have made its emergency credit more costly and led to better-targeted lending and less inflation.

``The Fed’s response has forced other central banks that manage their exchange rates against the dollar, mainly in Asia, to import inflation rather than deflation. Their currencies have become undervalued rather than overvalued. As their real interest rates have fallen, these countries are now exporting inflation back to the US. Where global deflation led to the collapse of commodity prices in the 1930s – devastating those countries dependent on exporting commodities – our current inflation is having the opposite effect. This time, primary producers are the biggest beneficiaries.”

In short, the gold standard of then and today’s paper currency standard aside from the transmission effects of the currency pegs supported by mercantilist policies have been important nuances.

One important thing which was not marked by this observation was that the Great Depression was significantly exacerbated by “Protectionism”.

Summary and Recommendations

A global recession may happen but it isn’t likely to be a depression or alternatively said “severe and prolonged”. Not for most of Asia, especially the Philippines. A global recession may occur because OECD or major developed economies seem to be undergoing recession but is not likely the case for most of the EM economies.

The argument for a US current account improvement as effectively draining the global liquidity picture seems incomplete. The Euro is also a secondary contributor. Although a slowing Eurozone could also mean further test on global liquidity conditions.

Likewise, the second round effect from a global economic slowdown is likely to put a stress on US exports clouding the certainty of the improving path of the US current account balance.

What is clear is that the taxpayer funding of the financial sector and of the main street will offset any improvement in the current account which means more financing requirements through external borrowing, selling of assets to foreigners or monetization.

The argument that the US dollar represents as “safehaven” under a global deflation is unclear if not questionable. First, global deflation seems unlikely; the world’s monetary climate seems still expansionary. Besides most of Asia has less to deflate compared to the overleveraged West. Asia’s “contagion” problems will likely fall on liquidity and not solvency issues.

Second, since the US dollar is the source of the present stress, the argument of its “safehaven” status has been in a test since 2002. Such tests isn’t likely to end soon and may get worst.

Third, the recent rebound by the US dollar and the accompanying fierce selloff in the commodities could be as a result of pair trade deleveraging, aside from a reflection of a global economic growth slowdown. Deleveraging does not equate to outright selling since it can also mean buying especially under markets that are advanced, sophisticated and deep.

Fourth, we don’t buy the argument that the US dollar or the Euro or of any paper currencies as representing any insurance from currency debasement policies by global governments. Inflationary policies assure the loss of purchasing power of paper currencies.

Although the US dollar may rally against the Euro, this may signify an interim or cyclical move instead of a complete turnaround similar to 2005. The US dollar has been in a bear market since 2002 and is likely to remain under pressure given the massive fundamental imbalances it is faced with.

Meanwhile, gold has been on a losing streak. Gold and precious metals represent as our insurance against government’s inflationary actions. The precious metal sector could depart from the performances of its industrial siblings based on the question of health of global economies.

We understand gold to be in a long term bullmarket especially from the fundamental perspective where global governments will work to use their inflationary powers to reduce the impact of any financial or economic dislocation for mostly political ends.

Figure 6: US Global Investors: Gold’s Seasonal Performance

We understand too that added to gold’s present infirmities from delevariging issues is that gold is in a seasonal weakness (see figure 6) and could most likely pick up over the next few months once the deleveraging issues fade.