Beware the New Government Money Grab via Banks: Dormant Accounts

Governments are also very innovative. Since they have all been so desperate to corral people’s money, they find new ways and means to do so. So here is the latest government money grab enforced through banks: Dormant accounts.

Writes Sovereign Man’s Simon Black

And over the last few years, one of the most creative ways that bankrupt governments have come up with is to confiscate what they consider “dormant” bank accounts—this would be an account without any transactions over a specified period of time.

The UK was the first on the scene with this idea with the 2008 Dormant Bank and Building Society Act. It was passed just in the knick of time right as the entire financial system was collapsing.

Within two years, the British Banker’s Association estimated that the law could raise as much as $600 million for the government… no small sum in the UK.

Earlier this year, Japan launched a similar initiative aimed at grabbing dormant bank accounts; they expect the move will raise approximately $500 million annually.

Both at least Japan and the UK have long-term thresholds. In Japan, they’ll seize an account if it has been dormant for more than 10 years. In the UK, it’s 15 years.

But there are a number of things wrong with this approach.

First, it calls into question the fundamental principle of private property. How can something be yours if the state can legislate its authority to seize it?

And even if the account holder has long since passed, shouldn’t the funds, by default, be awarded to the survivors nominated in accordance with the instructions in his/her last will and testament?

It is a rather ignoble act indeed to set aside the wishes of the dead so that the state can have yet another resource to plunder.

More concerning, though, is that if the state can simply legislate its authority to seize dormant bank accounts, then they can just as easily lower the bar.

Australia (which actually has a well-capitalized banking system and is not even a bankrupt government) passed legislation last year to reduce the threshold on seizing dormant accounts from seven years down to just THREE.

And in the last 12-months since the legislation was passed, the Australian government has seized a whopping 80,000 accounts totaling A$360 million… more than has been seized in the previous five decades COMBINED.

In case you’re wondering, yes of course, the Land of the Free has similar rules.

Read the rest here

Oh expect these dynamic to be adapted globally. 

The Religion Called Central Banking: Swiss National Bank Edition

The worship of central banking as superheroes continues

From today’s Bloomberg headline: Swiss Seen Immune From Euro Recession as SNB Holds Firm

The Swiss National Bank (SNBN) has shielded the economy from the effects of the slump in the euro region with its currency ceiling of 1.20 francs per euro. Such a policy has helped ensure Switzerland suffered only one quarter of contraction since the cap was imposed in September 2011, and an unemployment rate about a quarter of that in the 17-nation bloc.

So far yes.

But what will be the long term costs of shielding the economy by massively expanding the SNB’s balance sheets? 

Media believes in the philosopher's stone or of attaining something from nothing or that there are no costs from money printing.

But the Swiss government and the SNB’s policies has prompted for a ballooning of external debt.

Likewise domestic credit to the Private sector continues to swell

Moreover the growth of domestic credit Provided by the Banking sector has been accelerating.

Swiss stock market measured by the SMI has been making a run but still short of the 2007 high. Above charts courtesy of tradingeconomics.com

Swiss housing prices continues to spiral higher. The reflexive feedback loop in play Higher prices, more debt.  More debt. Higher prices

And the Swiss banking sector as % of GDP is about to 400% which ranks third only to France and Netherland.

Unless one comes to believe that interest rates will stay low forever, the crux of the question is how will all these measure up when interest rates rise?

Turkish Banks offer Gold Deposit Accounts

Speaking of a reset in the global order monetary, one possible step towards the reintroduction of gold as money is for the banking system not only to accept gold as loan collateral but for people to be able to have gold deposit accounts which could pave way for payments and settlements services in gold.

Banks in Turkey seems to have lunged into this path.

From Mineweb.com

For centuries, Turks have flocked to the jewellery shops of Istanbul's labyrinthine Grand Bazaar to trade their gold - ornaments handed down through their families over generations, or bars stashed under mattresses as savings. But in recent months the shops have a new and unexpected competitor: banks.

The country's commercial banks are pouring their technical expertise and marketing resources into offering their customers gold deposit accounts. Customers hand their gold to a bank and can make withdrawals from their accounts in gold bars or the lira currency; the accounts offer interest rates that are substantially lower than those on normal time deposits.

Gold deposit accounts have been growing around the world, but Turkey's boom has made it a leader in the trend. This appears to have cut the amount of gold flowing to jewellers in the Grand Bazaar and elsewhere in the country, a trend which dismays the shop owners. In the long run, it could threaten their business model, which relies partly on turning scrap gold they buy into jewellery and selling it back to retail customers…

Gold is big business in Turkey, for cultural reasons and also because of the country's experience with bouts of high inflation over the past century. The metal is traditionally given as a gift at weddings and circumcision ceremonies, and demand for imports tends to surge during the summer months.

Turks are believed to have accumulated about 5,000 tonnes of gold in their homes, worth around $250 billion at current international prices, according to the World Gold Council, an industry lobby. It ranks Turkey's gold demand as fifth in the world for jewellery and eighth for retail investment, mostly behind countries with much bigger populations such as India, China and the United States.

I hope that Philippine banking system does the same.

Quote of the Day: Banking Stress Test

From Vern McKinley at the Freebanking.org

Another interesting issue about Dexia is that just this past summer it went through the so-called “stress tests” by the European Banking Authority. Dexia passed with flying colors with an 11% capital ratio intact, well above the 10% ratio that its regulators had hoped for. This was the procedure that 91 of Europe’s largest banks went through to see how they could withstand the stress of a downturn. Seems the stress test was not so stressful, as it just assumed that sovereign debt would not cause any problems for Dexia. So the post-crisis panacea for addressing future stress of having banking agencies worldwide demand higher capital ratios and then intervene early to avoid bailouts seems to be coming apart before it was even fully implemented.

Is Mainstream Banking Bringing Gold Back as Money?

At the Huffington Post, structured securities expert Janet Tavakoli notes that US mainstream banking has began accepting gold as a collateral, she writes,

J.P. Morgan Chase & Co. announced on February 7, 2011 that it will accept physical gold as collateral for investors that want to make short-term borrowings of cash or securities.

Presenting gold to satisfy demands for performance bond collateral has been allowed on the London CME in a limited way since October 2009. As of November 22, 2010, the Intercontinental Exchange Inc. (ICE) has accepted gold bullion as collateral on all credit default swaps and energy transactions.

I don't recall the G-20 declaring gold a new currency. Yet JPMorgan Chase and a couple of financial market exchanges have effectively declared that gold is an alternative currency.

In other words, gold is money.

The market appears to be driving gold back to reassume its lost function—a role stripped away by ideological statists to advance their political agenda which has led to the grandest experiment of nearly 40 years: paper money via the US dollar standard.

And perhaps, such illusion—turning stones into bread—maybe coming home to roost.

As Professor Ludwig von Mises once wrote,

The return to gold does not depend on the fulfillment of some material condition. It is an ideological problem. It presupposes only one thing: the abandonment of the illusion that increasing the quantity of money creates prosperity.

Why The Slack In Credit To Small Business In The US? Because Regulators Won't Allow Them

Politics can be characterized as a stratagem of saying one thing and doing another.

Here is a good example. US policymakers say that credit is vital to the economy and that all their efforts have been targeted at restoring the credit process.

But based on a report, what the left hand is doing seems being undone by the right hand.

From the USA Today, [hat tip: Douglas French Mises Blog] (all bold emphasis mine)

``Across the USA, banks say there's a big reason they aren't lending more: Regulators won't let them. Even as the White House exhorts banks to open the lending spigots, particularly for small-business borrowers who are key to job growth, banks say government field examiners are toughening their reviews in ways that discourage sound loans.

``Rep. Blaine Luetkemeyer, R-Mo., a former bank examiner, recently laced into top banking regulators. "We have this huge disconnect between what's going on here in D.C. (and) what's actually been going on out in the field," he told them at a joint hearing of the House Financial Services and Small Business committees. "Quite frankly, you guys are part of the problem."

``Bank examiners — including those at the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency — don't approve or deny loans. However, bank executives say examiners are downgrading the ratings of performing loanssimply because the collateral — typically, commercial real estate — has fallen in value or the borrower is located in an economically distressed state. And they're making banks exceed the minimum levels for capital and bad-loan reserves. Those practices, they say, fail to consider banks' familiarity with their communities and borrowers. And they constrict lending."

So much for lack of demand.

It makes me wonder, are these being done deliberately so as to justify more intervention and inflationism?

CDS Market/Default Risk Ranking: Philippines Maintains 12th Place, Europe Dominates Monthly Laggards

Bespoke Investment gives us a colorful snapshot of the pecking order of the cost of insuring debts of various nations, as measured by changes in Credit Default Swaps.

Based on month to month changes, according to Bespoke, ``Ireland, Austria, Greece, and the UK have seen default risk rise the most over the last month. All have risen close to or more than 100%. US default risk has risen the 8th most at 68%.”

Among the 10 worst monthly performers, notice that except for the US which ranks 8^th, European countries have dominated the field.

While we may not have the sufficient explanation on why the markets have priced in serious jitters to many European sovereign debts, we suspect that this has been related to

1) credit risks concerns via banking exposures to the Balkan States, which had overheated and whose internal bubbles has imploded, and possibly combined with

2) the recent deleveraging which has heightened liquidity strains in economies with accentuated budget deficits as below courtesy of Danske …

We also understand that Europe’s economy has been more dependent on the banking sector than the capital markets relative to the US. And when the cardiac arrest engulfed the global banking industry last October, the region’s banks, which carried substantial toxic instruments, saw its lending flows to the real economy critically impaired.

Thus, credit driven economic slowdown plus accentuated budget deficits compounded with credit risk exposure to the Balkans may have raised the market’s concern over many of the European nation’s default risk.

National CDS Ranking according to prices.

More from Bespoke, ``Since then, default risk has risen for all but two of these countries (Lebanon and Argentina). Below we provide the current credit default swap prices for these countries, along with where they were trading one month ago and at the start of the year. As shown, Argentina, Venezuela, and Iceland have the highest default risk, with Russia not far behind. Germany, Japan, and France all have lower default risk than the US at the moment. It now costs $60 per year to insure against US default for the next five years. While this may not seem high, it was at $8 earlier in the year, and $36 one month ago.”

Nonetheless, the CDS market shows how exposures to toxic papers, credit bubbles or failed government policies have largely impacted national credit ratings.

Hence, to engage in the narrative generalization that emerging markets reflect a similar state to toxic waste papers that prompted this crisis is to engage in a fallacy of division.

What we should watch is how the markets will price US CDS, as the world's reserve currency, to reflect on the market's approval or disapproval of present policy actions. A continued march upward could signify strains in its privileged status.

Meanwhile, the Philippines maintained its 12^th ranking with minor changes relative to the rest, on a month to month basis. That should be a relief.

Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

``The business cycle is brought about, not by any mysterious failings of the free market economy, but quite the opposite: By systematic intervention by government in the market process. Government intervention brings about bank expansion and inflation, and, when the inflation comes to an end, the subsequent depression-adjustment comes into play.” Murray N. Rothbard, Economic Depressions: Their Cause and Cure

While blood on the streets could essentially represent a once in a lifetime opportunity, one must understand too why it requires additional contemplation of the operational dynamics that lead markets to be consumed by fear.

Riots From Lehman’s CDS Settlement?

One of the stated reasons behind last week’s bloodbath has been attributed to the settlement of Credit Default Swaps contracts from the bankrupted Lehman Bros.

According to Wikipedia.org ``A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" makes periodic payments to the "seller" in exchange for the right to a payoff if there is a default or credit event in respect of a third party or "reference entity"” In essence, CDS contracts function like an insurance where bond or loans are insured by the underwriters “sellers” and paid for by those seeking shelter from potential defaults “the buyers”.

In Lehman’s case its $128 million bonds (Bloomberg) was reportedly priced at 8.625 cents to a dollar which meant that insurance sellers had to pay its counterparties or buyers at 91.375 on a US dollar or cough up an estimated $365 billion (washingtonpost.com) to settle for each of the contracts which covered more than 350 banks and investors worldwide.

Generally this won’t be a problem for banks that has direct access to the US Federal Reserve, except for its booking additional accounting losses. But for institutions without direct channels to the US Fed this implies raising cash by means liquidating assets, hence the consequent selloffs.

Figure 4: New York Times: CDS Market Shrinking But Still Gargantuan

Although the CDS market has been said to decline from more than $60 TRILLION to $54 TRILLION, the sum is staggering.

According to the New York Times, ``The 12 percent decline, to $54.6 trillion, still left the market vastly larger than the total amount of debt that can be insured. The huge total reflects the way the market is structured, as well as the fact that someone does not need to actually be owed money by a company to be able to buy a credit-default swap. In that case, the buyer is betting that the company will go broke.

``Within that huge market, many contracts offset one another — assuming that all parties honor their commitments. But if one major firm goes broke, the effect could snowball as others are unable to meet their commitments.”

In other words if the present crisis could worsen and lead to more bankruptcies of major institutions this could put the viability of CDS counterparties at risk. Hence, it’s not the issue of settlement but the issue of sellers of CDS of defaulted bonds having enough resources to pay for their liabilities.

For instance, while news focused on politicians bickering over $700 billion bailout, the US Congress passed $25 billion loan package (USA Today) to the US automakers. Yet despite this, the S&P raised the risks potential of bankruptcies for the big three; General Motors, Ford and Chrysler (Bloomberg). Presently these automakers have been pressuring the government to release the funds recently appropriated for by the US Congress (money.cnn.com).

Some analysts warn that CDS exposures to GM bonds are worth some $ 1 trillion even when GM’s market capitalization is today less than $3 billion. They suggest that a bankruptcy could entail another bout of market upheaval. Maybe.

While this week’s market riots can’t be directly attributed as having been caused by the Lehman CDS settlement, they may have contributed to it.

Spreading Credit Paralysis

What seems to be more convincing is what has been happening at the world credit markets. Remember this crisis began with the advent of the credit crunch in July of 2007. And after the Lehman bankruptcy, events seem to have rapidly deteriorated.

Credit stress indicators as seen in likes of LIBOR (London Interbank Offered Rate) and TED spread have sizably widened even as the US Federal Reserve introduced a new program aimed at surgically bypassing the commercial market by providing direct funding to affected financial companies by directly acquiring unsecured commercial papers and asset backed securities, called the Commercial Paper Funding Facility (CPFF)

Figure 5: Danske Bank: Commercial Paper and Asset Backed Securities Plunges

As you can see in Figure 5, the commercial paper (CP) market for financial institutions have effectively dried up (see redline) just recently. Aside from the Asset Backed Commercial paper (ABSP) which continues to fall from last year, the CP market’s decline has coincided with the recent crash in global equity markets.

Remember, the commercial paper market is a fundamental source of funding for working capital by corporations. Hence with the apparent difficulties to access capital, the alternative option for companies with no direct access to the Federal Reserve or for companies that have exhausted their revolving capital, is to sell into the markets their most liquid instrument regardless of the price.

This could be the reason why the VIX index has soared to UNPRECENDENTED levels simply because financial companies had NO CHOICE but to monetize all assets at whatever price to keep their businesses afloat!

And this has spread about to every financial center from Hong Kong, Singapore, Japan and others, including the Philippines. According to a report from Bloomberg, ``Rising Libor, set each day in the center of international finance, means higher payments on financial contracts valued at $360 trillion -- or $53,500 for each person worldwide --including mortgages in Britain, student loans in the U.S. and the debt of companies like CIIF in Makati City, the Philippines.”

And this difficulty of raising money today has equally led to hedge funds redemptions especially by institutional investors which may have contributed to the carnage, from Wall Street Journal,

``Larger investors, like pension funds, which had in some instances borrowed money to invest in hedge funds, are pulling out because the credit crunch makes it difficult to raise money.

``Investors can't redeem their money from hedge funds at will; often they have quarterly windows when they can do so. Many investors had until Sept. 30 to tell hedge funds they wanted out. While the funds are typically not required to redeem the money until the end of the year, the redemptions were greater than some funds expected. That caused a scramble to raise cash to pay the investors back. And one quick way to raise cash is often to sell holdings of stock.

Some of these hedge fund liquidations have been even traced to the collapse in Hong Kong’s market (the Hang Seng Index lost 16% week on week), according to Xinhua.net, ``In a sign of redemption pressures on the investment funds, the Hong Kong unit of Atlantis Investment Management said it has suspended redemptions in its Atlantis China Fortune Fund -- a hedge fund with outstanding performance -- due to market volatility.”

Institutional Bank Run

As you can see banks refusing to lend to each other, deterioration in money market, collapse in the commercial paper market, massive hedge fund redemptions and fears of credit derivative counterparty viability could be diagnosed as an institutional bank run.

Honorary Professor at the Frankfurt School of Finance & Management Thorsten Polleit makes our day to come up with a lucid explanation at the Mises.org,

``What spells trouble, however, is an institutional bank run: banks lose confidence in each other. Most banks rely heavily on interbank refinancing. And if interbank lending dries up, banks find it increasingly difficult, if not impossible, to obtain refinancing (at an acceptable level of interest rates).

``An institutional bank run is particularly painful for banks involved in maturity transformation. Most banks borrow funds with short- and medium-term maturities and invest them longer-term. As short- and medium-term interest rates are typically lower than longer-term yields, maturity transformation is a profitable.

``However, in such a business, banks are exposed to rollover risk. If short- and medium-term interest rates rise relative to (fixed) longer-term yields, maturity transformation leads to losses — and in the extreme case, banks can go bankrupt if they fail to obtain refinancing funds for liabilities falling due.

``Growing investor concern about rollover risks has the potential to make a bank default on its payment obligations: interest rates for bank refinancing go up, so that loans falling due would have to be refinanced at (considerably) higher interest rates.

While banks are protected from depositors run by deposit insurance, what protects banks from an institutional run?

The European Experience

Ireland broke the proverbial ice in declaring a blanket guarantee on a wide-ranging arrangement that covered deposits and debts of its six financial institutions aimed at ``easing the banks’ short-term funding’ (Financial Times) among European countries.

This created a furor among its neighbors which contended that the ‘Beggar-thy-neighbor’ policies risks fomenting destabilization of capital flows. The reason is that the public would naturally tend to gravitate on the countries or institutions that issue a guarantee on their deposits, hence lost business opportunities for those that don’t do so.

Instinctively the radical policy adopted by Ireland evolved into a domino effect; despite the protests, every EU nations followed to jointly increase their savers to €50,000 (breakingnews.ie).

The problem is according to the Economist (with reference to Ireland or to those who initially went on a blanket deposit guarantee), ``it is not entirely clear how governments would pay these bills, if they ever came due. The chances of governments having to make good on all deposits seems remote, but the figures involved are eye-popping. In Ireland, for instance, national debt would jump from about 25% of GDP to about 325% if the value of its banks’ deposits and debts were taken on to the government’s books, according to analysts at Morgan Stanley, an investment bank. Similarly in Germany, national debt would jump to almost 200% of GDP if it included bank deposits (and about 250% if it included all the debts of its banking system). This may explain why interest rates on Irish government bonds have been rising in recent days.” (emphasis mine)

In other words, should losses consume a substantial portion of the resources of Ireland’s banking system, taxpayers will be on the hook and bear the onus for such unwarranted policy actions. As you can see, desperate times call for desperate measures regardless of the consequences. Nonetheless, Ireland expanded its deposit guarantees to cover 5 foreign owned banks (Economic Times India) presumably to avoid the Iceland experience, again despite the objection of most its neighbors.

Yet, strong pressures to guarantee the domestic banking system at all costs have taken a strain on the solvency of its neighbor Iceland.

From the same Economist magazine article, ``While governments on mainland Europe were trying to save their banks, Iceland was trying to save the country after it had overextended itself trying to bail-out its banking system. Its economy had been doing well, but its banks had expanded rapidly abroad, amassing foreign liabilities some ten times larger than the country’s economy, many funded in fickle money markets. Since the country nationalised Glitnir, its third-largest bank, last week the whole Icelandic economy has come under threat. Its currency is tumbling and the cost of insuring its national debt against default is soaring. As of Monday it was desperately calling for help from other central banks and was considering radical actions including using the foreign assets of pension funds to bolster the central bank’s reserves. These stand at a meagre €4 billion or so, according to Fitch, a rating agency, and in effect are now pledged to back more than a €100 billion in foreign liabilities owed by its banks.”

Iceland, a country of about 300,000 population and the 6^th richest in per capita GDP (nationmaster.com), behaved like a hedge fund whose banking system immersed on the carry trade during the boom days. They borrowed short and invested long (overseas) or the maturity transformation (see Polleit) and additionally took on currency risk. In fact many of their home mortgages have been pegged to foreign currencies which has aggravated both the conditions of bankers and borrowers, from the New York Times,

``Some Icelanders with recently acquired mortgages face a double threat. Home prices have been falling, and analysts expect them to decline further. But many of these mortgages were taken out in foreign currencies — marketed by the banks as a way to benefit from lower interest rates abroad, as rates in Iceland rose into the double digits over the last year.

``Now, with the Icelandic krona plunging, homeowners have to pay back suddenly far more expensive euro- or dollar-value of their mortgages — a kind of negative equity, squared.”

Figure 6: Ino.com: Iceland’s Krona Plunge Against the US dollar (left) and the Euro (right)

In addition, Iceland’s guarantees initially extended to only local depositors and did not to cover overseas investors many of which came from UK, hence ensuing threats of lawsuits. But as of this writing Iceland seems to have reached a deposit accord with UK and Netherlands (Bloomberg).

Moreover, another critical problem is that Iceland found no aid from its Western allies even as a NATO member and had to rush into the arms of political rival Russia which promised a loan for €4 billion (US $5.43 billion)! This is a dangerous precedent for central banks. Of course while this might seem like isolated case- in Asia Japan earlier rushed to offer loans to South Korea when the latter’s currency got pounded, aside from eyeing to create a scheme under the IMF to assist EM countries (Japan Times) and the urgency to revive the Asian counterpart of IMF (AFP)- such risks could worsen if the crisis deepens.

With the nationalization of Iceland’s top banks, taxpayers will also be responsible for the realized losses from the outsized liabilities, from which we agree with London School of Economics Professor Willem Buiter who says, ``The acquisition by the government of a 75 percent stake in Glitnir and the recent nationalisation of Landsbanki were therefore a mistake. Rather than hammering its tax payers and the beneficiaries of its public spending programmes, rather than squeezing the living standards of its households through a sustained masstive real exchange rate depreciation and terms of trade deterioration, and rather than creating a massive domestic recession/depression to try and keep its banks afloat, it should now let Glitnir, Landsbanki and Kaupthing float or swim on their own. The interests of domestic tax payers and workers should weigh more heavily than the interests of the creditors of these banks.”

Here are some lessons:

-Iceland through its nationalization of banks now suffers from the risks of currency, market, rollover and payment losses having to overextend themselves overseas and whose policies will eventually take a heavy toll on its citizenry.

-It’s not about the interest of taxpayers but of the interest of a few who control and become too entrenched into the system and whose risks has now become systemic.

-The Iceland experience of isolation in times of need reveals that central banks can’t always guarantee assistance to one another.

-In times of turmoil, national policies such as the action taken by Ireland can have negative externality effects- incur immediate political and future economic and financial costs.

-The risks of an institutional bank run which threatens the entire global banking system is clearly a top concern for European banks who seem to be acting out of desperation.

-Blanket guarantees (which had been limited to some countries so far) and nationalization of the banking industry will most likely be the ultimate tool used by central banks when pushed to the wall.

Global Liquidity Shortages and Falling Forex Reserves

In today’s turmoil, foreign currency reserves held by emerging markets appear to have been used as defense mechanism against a shortage of US dollar in the present environment in order to defend local currencies.

As affected US and European banks continue to raise capital and shrink balance sheets by selling assets and hoarding and conserving cash resulting to a lack of liquidity into the system, despite the massive infusion in the system by the global central banks led by the US Federal Reserve, this may also be construed as a symptom of the ongoing ‘institutional bank run’.

Figure 7: yardeni.com: Falling reserve growth

The chart courtesy of yardeni.com shows the declining growth rate of forex accumulation from developing and industrial countries. Since September, the growth rate is likely to have turned negative as more economies use their spare reserves to cushion the fall of their currencies.

From Bloomberg, ``Latin American central banks are being forced to draw on record foreign reserves built up during the six-year commodities rally to stop their currencies from sinking in the worst financial crisis since the Great Depression..

``The worst currency meltdown in Latin America since the emerging-market economic crises of the 1990s is causing companies' dollar debts to swell as well as sparking derivatives losses, and may stoke inflation. The decision to intervene came after central banks in the U.S., Europe and Canada cut interest rates in a coordinated effort to boost confidence…

``Brazil and Mexico join Argentina and Peru in selling dollars. Central banks in Chile and Colombia have so far used derivatives contracts to arrest the decline of their currencies, without touching reserves.

So it’s not just Latin Americans selling their US dollar surpluses but likewise in India ($8 billion in one week-hindubusinessline.com) and South Korea (estimated $25 billion since March).

Moreover current deficit economies including the US are likely to be at greater risks since it would need surpluses from foreign investors to fund the imbalances.

While the US continues to see strong inflows from central banks into US treasuries, our favorite fund flow analyst Brad Setser says that Central banks have either been shifting into US dollars from the euro or their reserve managers have also lost confidence in the international banking system or is moving into the safest and most liquid assets via the treasuries.

As per Mr. Setser. ``I would bet that this is more a flight away from risky dollar assets toward Treasuries than a flight into the dollar.”

Conclusion

I don’t like to sound alarmist, but all the present actions seem to indicate of the genuine risk of a failure in the global banking system. And this probably could be the reason behind why the recent turmoil in the financial markets has been quite intensive and amplified.

So the most likely steps being undertaken by global regulators in the realization of such risks (why do you think global central banks cut rates together?) will be to rapidly absorb or nationalize troubled banks (if not the entire industry) and continue to inject massive liquidity and lower interest rates aside from outright guarantees on deposits and loans in the hope to restore confidence to a faltering Paper Money system. In short, they intend to reinflate the impaired banking system.

Yet even under such conditions we can’t be sure if governments can provide sufficient shelter for the depositors and users of the system if conditions should deteriorate further. Present capital in the domestic system won’t probably be enough when the economic functions (clearing and settlement, payment processing, credit intermediation, currency exchange, etc.) of external banking system becomes dysfunctional, even under the context of our government guarantees (which will largely depend on its balance sheet and the ability for the citizenry to carry more public liabilities). Moreover, the international division of labor will likely be curtailed, leading to societal hardships and risks of political destabilization.

The key is to watch the conditions of the credit spreads, commercial paper and money market. Any material improvement in the major credit spread indicators will likely ease the pressure on regulators and relieve the pressure on most markets. Thus, while the potential for a rebound in the stockmarket seems likely given the severely oversold conditions, the vigor and sustainability will greatly depend on the clearing of the flow of global credit.

But on the optimistic part, the markets have already painfully reflected on the necessary adjustments of prices. While it is doubtful if we have reached the level of market clearing enough for the economic system to be able to pay for its outstanding liabilities given the amount of leverage embedded, it may have relieved additional pressures for a repeat performance of this week’s gore.

Of course, any action that government does which may coincide with a recovery is likely to be deemed as government’s success by liberals, it is not. The markets have already violently reacted.

Next, global depressions are aggravated by protectionism. This means that for as long as globalization in trade and finance can be given the opportunity to work, it may be able to accrue real savings to enough to recuperate the system. Besides, technology can vastly aid such process.

Another, this crisis episode is likely to generate a massive shift in productivity and wealth. The losses absorbed by crisis affected nations will impact their economies by reduced productivity on greater tax obligations. Thus, we are likely to see a faster recovery on economies that survived the ordeal with less baggage from government intervention. That is why we believe that some emerging markets including most of Asia should recover faster.

Moreover it isn’t true that if the banking industry goes the entire economy goes. As example, the Philippines has a large informal economy which is largely a cash economy. True, a dysfunctional international banking system abroad can create economic dislocations which may result to hardships but markets can be innovative.

As a final note, don’t forget that historical experiments over paper money have repeatedly flunked. We don’t know if this is signifies as 1) a mere jolt to the system or 2) the start of the end of the Paper money system or 3) the critical mass that would spur a major shift in the present form of monetary standard.

Significance of the Prospective Sale of AIG’s Philippine Unit Philamlife

John F Kennedy once said, “When written in Chinese, the word "crisis" is composed of two characters-one represents danger, and the other represents opportunity.”

AIG’s predicament of shoring up its balance sheet will come into full test for the global markets as it is reportedly negotiating for sale 15 to 20 of its business units (thedeal.com)

One of which is its Philippine exposure…Philamlife.

According to the Reuters,

``The Philippine unit of American International Group (AIG), the country's biggest insurance company, has received takeover offers from several groups, including the Yuchengco business clan, a top company official said on Monday.

``…AIG had not finalised any decision on what it would do with its Philippine unit, which has total assets of 170 billion pesos ($3.6 billion). Philamlife also has interests in banking, asset management and outsourcing.”

What’s the significance?

1) If the buyers should come from the Philippines, this could reflect on the strength of the nation’s real pool of savings.

2) In a world seemingly starving for capital, this should also reflect the Philippine market’s ability to expedite and raise capital which could also translate to a test of the health conditions of our economy’s liquidity and the stability of our overall financial system.

Phisix: Throwing The Baby Out of the Water

``An optimist sees an opportunity in every calamity; a pessimist sees a calamity in every opportunity.”-Winston Churchill

The recent selloff in most of the global equity markets has led some doomsday proponents to pronounce the toxicity of the emerging asset class as evidence by a drop in global forex reserves. They believe that a paucity of liquidity compounded by a US recession would lead to collapsing asset classes or some form of a crisis in emerging markets.

Unfortunately we can’t be convinced by such deflationary recoupling scenario promoted by perma bears simply because such argument has been predicated on the “fallacy of composition” or the generalization of the whole when it is only true for some its parts.

For instance, in the case of Russia which had been used as an example, which we recently also posted in An Epitome of A Full Scale Bear Market:: Russia, the country’s problem has been mostly from the political imbroglio where it got into a military engagement with neighboring Georgia. A compounding factor had been the liquidity crunch and falling commodity prices.

We aren’t seeing the same dynamics here in the Philippines.

Emerging Markets Are Not The Same

As we have repeatedly been arguing, for the Philippines it has not been about the question of risks from a recession, overleverage, oversupply, overvaluation, excessive speculation, stifling new government regulations or taxes, war, or even insolvency as seen in the case of the US or other developed economies.

Nor is it in Brazil whose housing or property industry remains sizzling hot according to the Business.view of the Economist.

For the Philippines despite the announcement of several banks with exposures to the Lehman bankruptcy, we had been right to say that the potential loses from these ‘toxic’ US instruments had been inconsequential relative to the banking industry’s capitalization or assets.

This from the inquirer.net (highlight mine),

``Seven banks in the Philippines have a total of $386 million in exposure to bankrupt US investment banking giant Lehman Brothers, according to the central bank’s estimates, but the banking system is widely believed to be in a good position to withstand the world’s worst financial shake-out.

``Even assuming zero recovery of their exposure to Lehman, the fallout for the seven banks is not expected to exceed one percent of their total assets.

``According to estimates by the central bank, Bangko Sentral ng Pilipinas (BSP), obtained by the Philippine Daily Inquirer, the retail tycoon Henry Sy’s Banco de Oro Unibank has the biggest exposure to Lehman at $134 million, followed by state-owned Development Bank of the Philippines (DBP) at $90 million.

``The BSP data show Metropolitan Bank and Trust Co. (Metrobank) has an exposure of $71 million, Rizal Commercial Banking Corp. (RCBC) $40 million, Standard Chartered Bank’s Manila branch $26 million, Bank of Commerce $15 million, and United Coconut Planters Bank (UCPB) $10 million.

``As a percentage of total assets of the individual banks, the exposures are as low as 0.5 percent and as high as 1.7 percent, according to the estimates, which were discussed at a meeting of the BSP policymaking body, the Monetary Board, on Thursday.”

As we have pointed out the main risk from the external link would come from the extent of foreign selling of domestic assets on the account of today’s mostly US based ‘deleveraging’ process. While there could still be some exposures to ‘tainted’ US financial instruments that may implode in the future, our idea is that this is likely to be material to impact normal business operations of the local banking industry.

Moreover, if some of the estimates are correct that over 50% of portfolio flows to Asia has been redeemed (as pointed out last week) then we are most likely to have seen the worst of the depressed foreign sentiment which leaves us with sympathy selling.

Figure 5: PSE Net Foreign Selling

The Phisix suffered its second worst week of the year which lost 6.93% compared to the week that ended January 18^th which accounted for a 9.57% loss. But relative to the degree of foreign selling, (see figure 5 orange arrows) the amount has been less intense compared to the similar circumstances when the Phisix had been subjected to the same fate.

In fact, last Thursday, which likewise accounted for a 4% drop following a similar decline in the US markets, the Phisix saw significant reduction of foreign selling to the tune of only Php 256 million compared to the daily range of Php 500-950 million a day during the past 2 weeks. This leaves us to hypothesize that mostly momentum driven domestic retail investors “threw out the baby with the bath water” in panic!

Of course, we are not saying the Phisix is riskfree or immune. Any risk from the Phisix would likely come from the political spectrum, if not from inflation or higher food prices, which so far have begun to decline. Of course, the recent concerted central bank pumping of liquidity into the global markets may reverse this decline. But if the global equity asset classes manage to absorb these injections, then the increase in consumer inflation could likely be gradual.

Debating Keynesian Concepts

Besides, we don’t buy into the Keynesian connection that consumer spending drives the economy which leads to the myth that the wilting US consumers will automatically lead to a bust in the emerging markets. As Gerard Jackson of Brookesnews explains, ``consumer demand springs from production, meaning you cannot consume what has not been produced. Therefore when consumers demand goods they are in effect exchanging what they produced for the products of other consumers. This is why the classical school considered money to be a veil that concealed the process of production and exchange from the public eye.”

The notion of a consumer driven economy actually stems from monetary inflation which has a detrimental effect in shaping an economy’s capital structure, to quote Gerard Jackson anew, ``Monetary manipulation not only severely distorts a country’s capital structure by misdirecting production it can also lead to the currency being overvalued which in turn could induce some manufacturers to shift operations offshore when undistorted marketed conditions would have persuaded them to remain in the US”.

And if trade or current account balances signified of the symptom of inflationary monetary policies, then the Phisix hasn’t been in the same shape or conditions as the US enough to unjustly merit a “toxic” grade. Moreover, based on the account of real savings or savings from the actual stuff we produce, the Philippines with its large informal economy equates to a cash based society with minuscule leverage applied, meaning much of our economy has been based real output than from the influences of distortive monetary policies.

Besides, much of the angst from the past Asian financial crisis still lingers, as evidenced by the minimal exposure of the banking system to rubbish US papers and conservative lending schemes by the banking system.

Moreover, valuations in Asia ex-Japan have nearly fallen to its multi-year “floor levels” which may translate to a looming bottom, see figure 6.

Figure 6: Matthews Asia: Asia’s Valuations Near Extreme Lows

To quote Robert J. Horrocks, PhD of Matthews Asia, ``the “decoupling” term has done a disservice to the entire economic debate. It has given the impression that economies must sever their links, and has denied the possibility that countries might simply transform their relationships whilst remaining close. The failure then of the world to decouple has lead to an overemphasis on the short-term decline in earnings and the worry that Asia will follow the U.S. into recession. Valuations in Asia have collapsed from the overexcited levels of late last year to far more sober levels that capture little of the exciting prospects for Asian growth. As such, they provide a long-term investor with a decent margin of safety. Framing the argument properly, I believe, helps to see the opportunities more clearly.” (highlight mine)

Like Mr Robert J. Horrocks, we have often stated that the decoupling recoupling debate is nothing but an invalid abstraction detached from the reality of the globalization process. And that from a valuations viewpoint, Asia has reached extreme lows and apparently has become detached from the real economy.

So while there might be additional sympathy selling pressures arising from the impact of the US financial crisis, this could be seen as opportunities from the facets of margin of safety to accumulate than to join the bandwagon of running for cover. Because markets are emotionally driven over the short term, they can always overshoot to the upside or the downside.

Recommendation: A Tradeable Rally Ahead?

Finally, some indicators suggest that we could have likewise bottomed out over the interim and a tradeable rally could be in the offing.

One, the restrictions on short selling of 799 financial stocks in the US and also adopted in the UK has moved the equity markets in seismic proportions last Friday. This should translate to a strong open in the PSE at the start of the week. However the effects from restriction curbs tend to be short term.

Two, as pointed out in my recent blog, Fear Index Pointing To Tradeable Rally Ahead?, each time the VIX or Fear Index peaks at above 30 it is usually followed by a bearmarket rally. The VIX or fear index hit a record high last week signifying outsized fear.

Three, the Phisix is coming from an oversold level, which means there could be more room for more upside traction.

So far, the recent lows have held its ground, giving us a clue of the possible strength of the aforementioned support level. The longer the Phisix maintains such support level the stronger it becomes.

Fourth, massive injections of bridge financing by global central banks tend to induce a period of lull following the recent turbulence. In addition, the proposed resurrection of the Resolution Trust Company RTC type of rescue package will entail a huge cost to US taxpayers. Over the longer perspective, this could lead to some capital reallocation of Asian capital to within the region and,

Lastly, any forthcoming rally, which would probably coincide with the closing of the seasonally weak September, may strengthen our case for a yearend rally.

Global Markets: The End Of The World? Or Overestimating Global Consequences?

``I cannot find a single convincing argument that tells me that astrologers won’t do better than economists…The problem is the arrogance of these economists, they’re making people rely on theories that have not worked, do not work, and are really dangerous.” Nassim Nicholas Taleb

If you look at today’s prevailing sentiment, especially from those within the US, the perception is that the global financial realm looks likely headed for a meltdown. This leaves investors the Hobson’s choice of running to the hills for cover or burying one’s money under the ground.

Of course, such sentiment has been bolstered by falling asset prices, which if we borrow George Soro’s “reflexivity theory” basically means irrational beliefs or convictions reinforced by market actions can help shape reality- or that market trends have the tendency of molding fundamentals than the other way around.

In the US signs of a deepening economic slowdown, tighter access to credit, rising cost of money, declining collateral prices, forcible liquidations, rising bankruptcies and foreclosures, the seeming paucity of capital, diminishing consumer spending, decreasing business spending, falling corporate profits and a continuing gridlock in the global financial system compounded by high food and energy costs have combined to impinge on the country’s socio-ecosystem.

And the inference is that trade, finance, credit and labor linkages, aside from unpredictable tide of capital flows, effects from intertwined currency regimes and consumer sentiment channels in a more intensified and interlinked world raises the risks of a contagion-a global recession or even a world depression. (The latter has been a popular topic searched at my blog. Besides, google search shows 3,020,000 links, compared to world recession of 546,000-meaning a surge of topical resource materials)

Meanwhile, emerging markets former darlings of global investors predicated on economic growth outperformance appears to have now been consumed by the conflagration of soaring food and fuel prices or mainstream’s definition of “inflation”.

So, from the chain of linkages shown above, the world “recouples”.

Add to this dimension is that since globalization has so far bolstered the faltering US economy via the underlying strength of the global economy fed by the transmission link of dollar links and currency pegs, manifested through via the export and financial assets channels; thus, a softening of the ex-US economic growth tends ricochet back to the US economy, reinforcing a vicious countercyclical trends around the world.

Shrinking US Deficits Mean Lower Liquidity and Higher Risks

Figure 1: Gavekal: Shrinking Global Liquidity via US Trade Deficit (HT: John Maudlin)

As we have pointed out previously pointed out in Global Financial Markets: US Sneezes, World Catches Cold!, the slackening of the non-petroleum trade deficits (largely indicative of slowing demand growth in the US) have been replaced by a surge in petroleum imports (oil imports now comprises almost 50% of total), which makes the overall deficit marginally lower but still significant see figure 1.

However, the recent decline in Oil and commodity prices seem indicative of two important dynamics: one global economic growth could be in decline (see Philippine Economy: World Financial Markets Allude To Diminishing Risks of Inflation) and second, diminishing trade or current account deficits have translated to reduced US dollar based liquidity circulating throughout the world financial system.

Since most of the world transactions remain anchored to the US dollar the US current account deficit functions as the world’s working capital. Hence the decline in the trade or current account deficits leads a contraction of liquidity in the global marketplace and a potential dollar squeeze that leads to a financial crisis somewhere.

Figure 2: Economagic: US Current Account, S&P 500 and US Dollar Index

Figure 2 from the Economagic shows that in the past, significant improvements in the US current account (see blue circles) have coincided with a recession, weakening equity price values and a rallying US dollar trade weighted index.

We have been seeing many of these factors in motion-recession still unofficial, faltering US equity benchmarks, global credit crunch, and consolidation of trade weighted US dollar index-as the current account balance deficits have markedly improved.

So the point is global liquidity have been greatly impacted by the ongoing deleveraging process in some of the major developed economies and the pronounced transfer of wealth from oil consumers and oil producers which can equally be seen as a transfer of wealth from the private sector to the public sector (which likewise adds to the tightening). Thus, the risk environment remains elevated for MOST of the world’s financial markets.

But When The Parasite Is Removed, The Host Will Thrive.

It can also be said that we can’t disagree with the analysis that the world risks transiting into a recession, considering that OECD economies constitute nearly 2/3 of GDP (nzherald.co.nz).

But then again, given the high levels of risk aversion and the impact from contracting liquidity, we can’t also read too much of the aggregate as representative of all the parts, lest be engaged in the fallacy of division- what must be true of a whole must also be true of its constituents, because of the following:

1. There are inherent nuances in the risks profiles of every nation due to the idiosyncratic political, economic and financial/capital markets structure or in the policy directions by respective authorities, see table 1.

Table 1 Economist: Country Risks Scores

This from the Economist (underscore mine),

``The credit crunch continues to depress ratings in the developed world. While the emerging world largely dodged the subprime bullet, it is beginning to feel the impact of the credit crunch and the slowdown in the OECD. Inflation is also having an adverse effect on emerging market risk scores. Inflationary pressures are in part due to high fuel and food costs, but also sometimes reflect overheating and capacity constraints. Central banks are generally behind the curve in tightening monetary policy and will have to raise interest rates aggressively to rein in inflation. This will create strains for companies and households which have borrowed heavily in the boom years, particularly if output growth slows.”

Whether the problem is inflation or from spillover effects from credit crunch or a combo thereof, the different configurations and policy directions determines the disparate risk profiles of each nation. So it would be ridiculous to lump the Philippines in the same category with Zimbabwe or Iraq in as much as it would be ludicrous to classify the Philippines with that of Switzerland or Finland.

Thus, the different risk profiles will result to diverse outcomes relative to economic wellbeing or financial market performance.

2. Doomsayers could be overestimating the risks associated with the chain effects from global linkages while underestimating other variables such as domestic investment and consumption patterns aside from regionalization trends or policy levers available to authorities.

Figure 3: ADB: Emerging Asian Regionalism

For instance, while it is true that Asia remains sensitive to world trade, where 67.5% of exports represent final demand OUTSIDE of the integrated Asia, regionalization has not been CONFINED to simply trading channels but to other aspects such as tourism, equity markets and bond markets (e.g. Asian Bond Market Initiative), foreign direct investments, trade policy cooperation and macroeconomic links as shown in Figure 3.

In addition, learning from the Asian Financial Crisis of 1997, it is noteworthy to cite the region’s attempt to undertake insurance measures such as monetary cooperation like the Chiang Mai Initiative (CMI), or a resource pooling strategy consisting of bilateral currency swap arrangements to cushion potential recurrence of external shocks. Another is the Manila framework, “a regional surveillance mechanism to monitor economic development and issues that deserve attention by the participating members.” (ADB)

Next, in the perspective of policy leverage, the humongous currency reserves of China ($1.81 trillion as of June 2008- Bloomberg) and the rest of the emerging market rubric which accounts for 76% of the $4.9 trillion global reserves in 2007 (Michael Sesit-Bloomberg) allows for much leg room for domestic investment spending or stimulus.

Investment bank Merrill Lynch estimates that Emerging Markets are expected to pour a huge amount of these reserves into infrastructure expenditures as shown in Figure 4.

Figure 4: US Global Investors: Expected Share of EM Infrastructure expenditures

According to khl.com, ``Annual infrastructure spending in emerging markets (EM) - Africa, Middle East, Latin America, Eastern Europe and Asia - is expected to jump +80% over the next three years, according to financial management and advisory company Merrill Lynch.

``The company's latest forecast said EM infrastructure spending would rise from US$ 1.25 trillion to US$ 2.25 trillion annually over the next three years, thanks to more aggressive government spending programmes, fuelled by decades of under-investment in power, transportation, and water, and higher analyst estimates.” (highlight mine).

So while the much dreaded consumer goods and services inflation wanes in the following months, we can expect EM governments to address its policy leverage by renewing its focus to build internal productive capacity.

Here in the Philippines, infrastructure expenditures are expected to climb to $50 billion from 2007-2010 (chinapost.com).

From the investor's point of view, areas where such huge investment undertaking will take place should translate to massive growth potentials and outsized prospective returns.

3. As we have repeatedly been saying, the problem of systemic overleveraging and the attendant market prompted deleveraging process has been mostly an Anglo Saxon or US-Europe affair with very little or minimal exposure in Asia or in the Emerging Market economies see figure 5.

Figure 5: IMF Global Financial Stability Report Update: Bank Writedowns and Capital Raised

Figure 5 from IMF shows that writedowns far exceed capital raising activities mainly seen in the US. From the IMF, ``However, disclosed losses have thus far exceeded capital raised and banks face difficulties in maintaining earnings due to falling credit quality, declining fee income, high funding costs, and exposures to “monoline” and mortgage insurers.” (highlight mine)

Thus, it is essential to understand the distinction among countries baggaged by cyclical or by structural variables. This also means countries affected by countercyclical factors are likely to experience shorter term pain compared to the structurally impaired markets whose recovery are likely to be protracted due to the sizable market clearing process coming out of severe malinvestments.

So we can’t buy on the notion that the world will evolve towards absolute “convergence” based on financial market performance and or in the economic outlook in as much as we can’t expect total “divergence”.

Under today’s environment, economic and financial market performances will likely be discriminatory than a holistic episode as seen during the recent past.

To quote Peter Schiff of Euro Pacific Capital (emphasis mine), ``The world is over-reacting to our problems, almost to the extent that we are under-reacting. Investors are over-estimating the global consequences of the collapse of the American consumer. I have long argued that American consumers have been functioning as global economic parasites, feeding off the productivity of the rest of the world. When the parasite is removed, the host will thrive. While those who have loaned us money will finally recognize their losses, the truth (belatedly recognized) will set them free. Once they move on, the world will enjoy enhanced growth, as it reclaims the savings, resources and consumer goods previously sent to America on credit.”