China Takes Steps to Push for the Convertibility of the Yuan

China takes a step further to push for the convertibility of her currency, the yuan.

From Marketwatch.com: (bold emphasis mine)

China will widen channels for capital outflows and push for a bigger role for its own currency in cross-border trade, the country's central bank said Saturday.

The People's Bank of China also repeated past pledges to continue efforts to promote convertibility of the yuan under the capital account.

"As foreign capital takes an active role in China's financial markets we will continue to allow domestic capital to participate in global financial markets," the People's Bank of China said in a summary of its China 2011 Global Financial Market Report posted on the website of its Shanghai office.

"China will further expand the use of the yuan in cross-border trade and investment, and create a virtuous circle for cross-border flows of the currency," the bank said.

The summary didn't give any details of the central bank's plans though it said the full report will be issued Saturday.

The People's Bank of China has repeatedly stated it wants to ease restrictions on converting the yuan under the capital account though it has avoided giving any timetable.

China has been encouraging its companies to take a bigger role in the global economy, and one of the key requirements for this has been to let them move foreign exchange offshore.

Beijing has also been trying to promote the use of its own currency in trade settlement, and the central bank's statements on this issue are in line with previously stated policy goals.

So based on the economy, China has been pushing for trade, integration (regionalism) and the yuan as the region's reserve currency.

But based on geopolitics, China does the “gunboat diplomacy”.

These two simply don’t add up.

Go figure.

A US-Philippines Bases Treaty (2012 Edition) in the Making?

From the Washington Post,

Two decades after evicting U.S. forces from their biggest base in the Pacific, the Philippines is in talks with the Obama administration about expanding the American military presence in the island nation, the latest in a series of strategic moves aimed at China.

Although negotiations are in the early stages, officials from both governments said they are favorably inclined toward a deal. They are scheduled to intensify the discussions Thursday and Friday in Washington before higher-level meetings in March. If an arrangement is reached, it would follow other recent agreements to base thousands of U.S. Marines in northern Australia and to station Navy warships in Singapore.

Among the options under consideration are operating Navy ships from the Philippines, deploying troops on a rotational basis and staging more frequent joint exercises. Under each scenario, U.S. forces would effectively be guests at existing foreign bases.

The sudden rush by many in the Asia-Pacific region to embrace Washington is a direct reaction to China’s rise as a military power and its assertiveness in staking claims to disputed territories, such as the energy-rich South China Sea.

“We can point to other countries: Australia, Japan, Singapore,” said a senior Philippine official involved in the talks, speaking on the condition of anonymity because of the confidentiality of the deliberations. “We’re not the only one doing this, and for good reason. We all want to see a peaceful and stable region. Nobody wants to have to face China or confront China.”

The strategic talks with the Philippines are in addition to feelers that the Obama administration has put out to other Southeast Asian countries, including Vietnam and Thailand, about possibly bolstering military partnerships.

What seems to be the common denominator between now and two decades ago when the Bases Extension Treaty was rejected by the Philippine Senate?

Well both has the Aquino administration (mother and son) taking on the side of—or has fought for an extension of—US foreign policy in the country.

Not that this about the Aquino administration being an American stooge, although they may well be, but about the developing trend in US foreign policy and the possible implications here.

Obama’s foreign policy has increasingly been militant just as the Presidential election approaches.

Last night at the State of the Union address President Obama threatened Iran with ‘no options off the table’ rhetoric. In addition, President Obama seems to having an on-off or love-hate affair with China with the latter being painted as a potential adversary.

Military aggression as China’s foreign policy path is unlikely, despite some caustic international incidences at the Spratlys Island.

As pointed out before, such incidences could be indicative of China’s reaction to what seems to be an encirclement strategy being applied by the US and or the heated rhetoric by President Obama of charging China as a currency manipulator.

Also China could testing the responses of her neighbors to see where their loyalty lies and to what degree they have been, which could be part of 37 war strategies of “beating the grass to startle the snake strategy”, or that China could be flaunting her new weapons to signal her newfound geopolitical muscle.

But most importantly, I think China could be using the Spratlys to gain negotiation leverage.

In politics, what you see is hardly what you get.

Nevertheless, actions serve as best indicators of intent or what Austrian economists calls as the demonstrated preference.

China won’t likely kill the proverbial goose that lays the golden eggs for the simple reason that China’s trade with the region has been burgeoning substantially. (charts above from ADB)

To add, China has even taken further steps to increase the usage of her country’s currency as the region’s medium of exchange in the path towards regional integration.

China will surely not attain integration by invading her neighbors. Two major World Wars of the 20^th century should serve as painful lessons.

Integration can only be achieved through social cooperation via the division of labor or free trade.

And unless China’s leaders have lost their senses, perhaps out of desperation or becomes mentally deranged, a bellicose foreign policy would translate to their political suicide considering that today’s state of warfare. So this isn’t a rational or even a viable option.

In addition, the thought of foreign bases as functional deterrent to military aggression is essentially obsolete in a nuclear war.

In reality, military bases have mostly been used as a staging point for political interventions in local affairs and for justifying the maintenance and or growth of the defense budget for the US federal government.

And importantly, encirclement strategies to contain China’s so-called growing military capability are not helpful, they signify signs of (US) insecurity that only promotes antagonism that could lead to genuine confrontation.

The point is, any military base agreements will serve as a magnet for any prospective war or military hostility, incentivize more foreign interventions in local (Philippine) affairs and would create social friction between the average Filipinos and US military.

Military bases for whose benefit?

Again as stated earlier, wars benefit the military industrial complex who as rent seekers, needs politics induced wars to sell their products and services to generate profit. Peace is an anathema to them.

War and imperialist policies also benefit the (local and foreign) political class who use wars (or the threat of wars) to expand to control over society through various interventions and taxation, to curb civil liberties, and to justify the budgets extracted from society for their personal benefits.

As Murray N. Rothbard once wrote,

Imperialism will ensure for the United States the existence of perpetual "enemies," of waging what Charles A. Beard was later to call "perpetual war for perpetual peace." For, Flynn pointed out, "we have managed to acquire bases all over the world…. There is no part of the world where trouble can break out where… we cannot claim that our interests are menaced. Thus menaced there must remain when the war is over a continuing argument in the hands of the imperialists for a vast naval establishment and a huge army ready to attack anywhere or to resist an attack from all the enemies we shall be obliged to have

Fruits From Creative Destruction: An Asian and Emerging Market Decoupling?

``But innovation, in Schumpeter’s famous phrase, is also “creative destruction”. It makes obsolete yesterday’s capital equipment and capital investment. The more the economy progresses, the more capital formation will it therefore need. Thus, the classical economist-or the accountant or the stock exchange-considers “profit” is a genuine cost, the cost of staying in business, the cost of a future in which nothing is predictable except that today’s profitable business will become tomorrow’s white elephant.”- Peter F. Drucker, Profit’s Function, The Daily Drucker.

We read from creditwritedowns.com that Morgan Stanley Asia Chairman Stephen Roach made some predictions, namely:

1 “Asia will have a less acute impact from the global financial and economic crisis”

2. “Export-led regions are followers, not leaders.” Hence would recover after their main export markets, the US and Europe, recovered.

3. “The only possibility (to recover earlier) is China, as it has large infrastructure spending in place that could provide support for economic growth.”

Dr. Roach has been one of the unassuming well respected contrarian voices, whom I have followed, who sternly warned of this crisis.

Nonetheless while we agree with some of his prognosis, where we depart with Dr. Roach is on the aspect of a ‘belated recovery’ of Asia because of its “export dependence” on US and Europe.

Creative Destruction: The Telephone Destroyed The Telegraph

While it is true that the Asian model had functioned as an export-led region over the past years, our favorite cliché, ``Past performance does not guarantee future results” would possibly come into play in the transformation of the playing field.

Let us simplify, if a business paradigm doesn’t work do you insist on pursuing the same model or do you attempt a shift?

Marketing Guru Seth Godin has a terse but poignant depiction of “solving a different problem” response to our question. We quote the terrific guru Mr. Godin,

``The telephone destroyed the telegraph.

``Here's why people liked the telegraph: It was universal, inexpensive, asynchronous and it left a paper trail.

``The telephone offered not one of these four attributes. It was far from universal, and if someone didn't have a phone, you couldn't call them. It was expensive, even before someone called you. It was synchronous--if you weren't home, no call got made. And of course, there was no paper trail.

``If the telephone guys had set out to make something that did what the telegraph does, but better, they probably would have failed. Instead, they solved a different problem, in such an overwhelmingly useful way that they eliminated the feature set of the competition.” (bold highlight mine)

In short, we see human action basically at work. To quote Ludwig von Mises, ``Action is an attempt to substitute a more satisfactory state of affairs for a less satisfactory one. We call such a willfully induced alteration an exchange.”

People who relied on old models didn’t see this coming. They would have resisted until they were overwhelmed.

The fact is the telephone replaced an entrenched system. Joseph Schumpeter, in economic vernacular coined this as “creative destruction”. And creative destruction essentially leads to new operating environments: the rise of the telephone.

Similarly, the Asian export model has been built upon the US credit bubble structure. That bubble is presently deflating and would most possibly dissipate. So is it with Europe’s model.

In other words, the global economy’s trade and investment framework will probably reconfigure based on the present operating economic realities. Countries and regions would probably operate under a set of redefined roles.

Here are three clues of the possible creative destruction transformation.

Deepening Regionalism

Figure 3: ADB: Emerging Asian Regionalism

This from the ADB’s Emerging Asian Regionalism, ``In large part due to the growth of production networks just discussed, trade within Asia has increased from 37% of its total trade in 1986 to 52% in 2006 (Figure 3.3). The share of trade with Europe has risen somewhat, while that with the US and the rest of the world has fallen. As set out in Chapter 2, Asia’s intraregional trade share is now midway between Europe’s and North America’s. It is also higher than Europe’s was at the outset of its integration process in the early 1960s.

``But trade has not been diverted from the rest of the world. On the contrary, trade with each of Asia’s four main partner groups has increased in the last two decades—not just absolutely, but also relative to Asia’s GDP (Figure 3.4). For example, Asia’s trade with the EU has more than doubled as a share of its GDP, from 2.6% in 1986 to 6.0% in 2006. The increase is even larger as a share of the EU’s GDP. The aggregate trade data thus suggests that Asia is steadily integrating both regionally and globally.”

The fact is that Asia has steadily been regionalizing or developing its intraregional dynamics even when the bubble structure had been functional. Today’s imploding bubble isn’t likely to alter such deepening trend.

Moreover, the current unwinding bubble structure is emblematic of a discoordination process from a ‘market clearing’ environment.

Under this phase, spare capacities are being shut or sold, excess labor are being laid off, surplus inventories are being liquidated and losses are being realized. Essentially new players are taking over the affected industries. And new players will be coming in with fresh capital to replace those whom have lost. Fresh capital will come from those economies with large savings or unimpaired banking system (see Will Deglobalization Lead To Decoupling?)

And like any economic cycles, this adjustment process will lead to equilibrium. Eventually a trough will be reached, where demand and supply should balance out and a transition to recovery follows.

The post bubble structure is likely to reinforce and not reduce this intraregional dynamic.

So in contrast to the notion of a belated recovery in Asia hinged on the old decrepit model, a China recovery should lift the rest of Asia out of the doldrums.

Asia and not the old stewards should lead the recovery based on the new paradigm.

And in every new bullmarket there always has been a change in market leadership. We are probably witnessing the incipience of such change today.

Real Savings Function As Basic Consumption

The assumption of the intransigence of Asia as an export led model is predicated on Keynesian theory of aggregate demand. In essence, for as long as borrowing and lending won’t recover in the traditional ‘aggregate demand’ economies, there won’t be a recovery in export led economies.

But in contrast to such consensus view, demand is not our problem, production from savings is.

According to quote Dr. Frank Shostak, ``At any point in time, the amount of goods and services available are finite. This is not so with regard to people’s demand, which tends to be unlimited. Most people want as many things as they can think of. What thwarts their demand is the availability of means. Hence, there can never be a problem with demand as such, but with the means to accommodate demand.

``Moreover, no producer is preoccupied with demand in general, but rather with the demand for his particular goods.”

``In the real world, one has to become a producer before one can demand goods and services. It is necessary to produce some useful goods that can be exchanged for other goods.”

A sole shipwrecked survivor in an island will need to scour for food and water in order to consume. This means he/she can only consume from what can be produced (catch or harvest). It goes the same in a barter economy; a baker can only have his pair of shoes if he trades his spare breads with surplus of shoes made by the shoemaker.

Surplus bread or shoes or produce, thus, constitute as real savings. And to expand production, the shoemaker, the baker or even the shipwrecked survivor would need to invest their surpluses or savings to achieve more output which enables them to spend more in the future.

Instead of getting x amounts of coconuts required for daily nourishment, the shipwrecked survivor will acquire a week’s harvest and use his spare time to make a knife so he can either make ladder (to improve output), build a boat (to catch fish or to go home) or to hunt animals (to alter diet) or to make a shelter (for convenience). Essentially savings allows the survivor to improve on his/her living conditions.

To increase production for the goal of increasing future consumption, the savings of both the shoemaker and the baker would likely be invested in new equipment (capital goods).

Again to quote Dr. Shostak (bold highlight mine), ``What limits the production growth of goods and services is the introduction of better tools and machinery (i.e., capital goods), which raises worker productivity. Tools and machinery are not readily available; they must be made. In order to make them, people must allocate consumer goods and services that will sustain those individuals engaged in the production of tools and machinery.

``This allocation of consumer goods and services is what savings is all about. Note that savings become possible once some individuals have agreed to transfer some of their present goods to individuals that are engaged in the production of tools and machinery. Obviously, they do not transfer these goods for free, but in return for a greater quantity of goods in the future. According to Mises, "Production of goods ready for consumption requires the use of capital goods, that is, of tools and of half-finished material. Capital comes into existence by saving, i.e., temporary abstention from consumption.”

``Since saving enables the production of capital goods, saving is obviously at the heart of the economic growth that raises people's living standards. On this Mises wrote, “Saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material condition of man; they are the foundation of human civilization.”

So what changes this primitive way of production-consumption to mainstream’s consumption-production framework?

The answer is debt. Debt can be used in productive or non-productive spending. But debt today is structured based on the modern central banking.

Think credit card. Credit card allows everyone to extend present consumption patterns by charging to future income. If debt is continually spent on non-productive items, it eventually chafes on one’s capacity to pay. It consumes equity. Eventually, overindulgence in non productive debt leads bankruptcy. And this epitomizes today’s crisis.

But debt issued from real savings can’t lead to massive clustering of errors (bubble burst) because they are limited and based on production surpluses. It is non productive debt issued from ‘something out of nothing’ or the fractional banking system combined with loose monetary policies from interest manipulations that skews the lending incentives and enables massive malinvestments.

To aptly quote Mr. Peter Schiff’s analysis of today’s crisis, ``Credit, whether securitized or not, cannot be created out of thin air. It only comes into existence though savings, which must be preceded by under-consumption. Since savings are scarce, any government guarantees toward consumer credit merely crowd out credit that might otherwise have been available to business. During the previous decade too much credit was extended to consumers and not enough to producers (securitization focused almost exclusively on consumer debt). The market is trying to correct this misallocation, but government policy is standing in the way. When consumers borrow and spend, society gains nothing. When producers borrow and invest, our capital stock is improved, and we all benefit from the increased productivity.”

Now if capital comes into existence by virtue of savings, we should ask where most of the savings are located?

The answer is in Asia and emerging markets.

Figure 4: Matthews Asian Fund: Asia Insight

According to Winnie Puah of Matthews Asia, ``The economic potential and impact of Asian savings have yet to be fully unleashed at home. Indeed, Asia’s excess savings fuelled the recent boom in U.S. consumption and housing markets. Creating a consumption boom in Asia would mean that Asia needs to borrow and spend more. To date, governments are supporting domestic demand with fiscal stimulus packages—but it is household balance sheets that hold the key to developing a consumer culture. Overall, Asian households are well-positioned to increase spending—most have low debt levels and high rates of savings… there is a noticeable divergence in saving patterns between emerging and mature economies over the past decade, particularly since Asia learned a hard lesson from being overleveraged during the Asian financial crisis. Today, most Asian households save 10%—30% of their disposable incomes. China’s households, for example, have over US$3 trillion in savings deposits but have borrowed only US$500 billion.”

Thus I wouldn’t underestimate the power of Asia’s savings that could be converted or transformed into spending.

Asia’s Tsunami of Middle Class Consumers

In my August 2008 article Decoupling Recoupling Debate As A Religion, we noted of the theory called as the “Acceleration Phenomenon” developed by French economist Aftalion, who propounded that a marginal increase in the income distribution of heavily populated countries as China, based on a Gaussian pattern, can potentially unleash a torrent of middle class consumers.

Apparently, the Economist recently published a similar but improvised version of the Acceleration Phenomenon model. And based on this, the Economist says that 57% of the world population is now living in middle class standards (see figure 5)!

Figure 5: The Economist: The Rise of the Middle Class?

From The Economist (bold highlights mine), ``In practice, emerging markets may be said to have two middle classes. One consists of those who are middle class by any standard—ie, with an income between the average Brazilian and Italian. This group has the makings of a global class whose members have as much in common with each other as with the poor in their own countries. It is growing fast, but still makes up only a tenth of the developing world. You could call it the global middle class.

``The other, more numerous, group consists of those who are middle-class by the standards of the developing world but not the rich one. Some time in the past year or two, for the first time in history, they became a majority of the developing world’s population: their share of the total rose from one-third in 1990 to 49% in 2005. Call it the developing middle class.

``Using a somewhat different definition—those earning $10-100 a day, including in rich countries—an Indian economist, Surjit Bhalla, also found that the middle class’s share of the whole world’s population rose from one-third to over half (57%) between 1990 and 2006. He argues that this is the third middle-class surge since 1800. The first occurred in the 19th century with the creation of the first mass middle class in western Europe. The second, mainly in Western countries, occurred during the baby boom (1950-1980). The current, third one is happening almost entirely in emerging countries. According to Mr Bhalla’s calculations, the number of middle-class people in Asia has overtaken the number in the West for the first time since 1700.”

So apparently, today’s phenomenon seems strikingly similar to Seth Godin’s description of the creative destruction of the telegraph.

The seeds of the rising middle class appear to emanate from the wealth transfer from the developed Western economies to Asia and emerging markets. Put differently, Asia and EM economies could be the fruits from the recent ‘creative destruction’.

Some Emerging Signs?

However, there are always two sides to a coin.

For some, the present crisis signify as a potential regression of these resurgent middle class to their poverty stricken state, as the major economies slumps and drag the entire world into a vortex.

For us, substantial savings or capital (the key to consumption), deepening regionalism, underutilized or untapped credit facilities, rapidly developing financial markets, a huge middle class, unimpaired banking system, and most importantly policies dedicated to economic freedom serve as the proverbial line etched in the sand.

One might add that the negative interest rates or low interest policies and the spillage effect from stimulus programs from developed economies appear to percolate into the financial systems of Asia and emerging markets.

Although these are inherently long term trends, we sense some emergent short term signs which may corroborate this view:

1. Despite the 30% slump in the global Mergers and Acquisitions in 2008, China recorded a 44% jump to $159 billion mostly to foreign telecommunication and foreign parts makers (Korea Times). Japan M&A soared last year to a record $165 billion in 2008 a 13% increase (Bloomberg).

2. Credit environment seems to be easing substantially.

According to FinanceAsia (Bold highlights), ``The fallout from Japan's banking crisis offers clues to how the current situation may resolve itself. Back then, healing started first in the areas that had been most affected -- interbank lending recovered earliest, followed by credit markets, volatility markets and finally, many years later, equity markets.

``In today's crisis, interbank lending is already starting to recover. The spread between three-month interbank lending rates and overnight rates, which provides a key measure of the health of credit markets, has dropped significantly from its peak of 364bp in early 2008 down to less than 100bp today. As the interbank market recovers, credit should be next to heal.

``However, at the moment, triple-B spreads are at their highest levels in more than 100 years, which makes credit look like an extremely attractive investment opportunity. And there is every reason to expect that Asian corporates will participate in the healing, perhaps even as quickly as their counterparts in the US. (Oops and I thought everyone said divergence wasn’t possible or decoupling is a myth)

3. Asian companies have begun to engage in debt buyback. Again from FinanceAsia, ``Asian companies are buying back their debt with gusto and this could be a sign that credit markets are on the mend, according to Morgan Stanley.

``Asian companies are betting that credit will offer the best returns in 2009 and, like the smart traders they are, executives in the region are busy buying back their debt with gusto.

4. A picture speaks a thousand words…

Figure 6: A BRIC Decoupling?

China and Brazil appear to be leading the BRIC recovery while India (BSE) and Russia (RTS) seem to initiating their own.

For financial markets of developed economies, don’t speak of bad words.

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.”

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

``The problem is not that supply and demand is such a complex explanation. The problem is that supply and demand is not an emotionally satisfying explanation. For that, you need melodrama, heroes and villains.” - Thomas Sowell, Too "Complex"?
The Philippine Peso has lost 5.78% since it peaked at Php 40.33 (closing quote) against a US dollar in February 28^th of this year. Year to date the Peso is down 3.55%.

Falling Peso and Media’s Available Bias, What Happened To Remittances?

Yet mainstream analysis seems lost with what has been going on. We’ve heard all sorts of oversimplified explanations or narrative causations covering the rice crisis to fiscal imprudence to surging oil prices to high “inflation” to risk aversion or to political maelstrom. But these factors do not seem to add up.

Previously, the popular explanation was that the strength of the Peso has been driven primarily by remittances, with subsidiary (and belated) attributions to portfolio flows. We argued against this remittance prompted Peso-appreciation in Philippine Peso And Remittances: The Unsecured Knot and What Media Didn’t Tell About the Peso.

Nonetheless, growth from remittance inflows from OFWs continue to hit record breaking levels and remains as vigorous as ever- 16% February, 9.4% in March or 13.2% for the first quarter…yet the Peso fumbled! Overtime, false premises are eventually unmasked.

Today, high inflation or levitated oil prices appear to dominate the airspace look equally tenuous.

Way up until the end of February of 2008, oil-based on West Texas Intermediate Crude benchmark-had been drifting upwards at the $100 levels where simultaneously the Peso continued to firm. Does this imply that oil above $100 signifies as the “critical point” where the economy folds?

Such arguments have NOT been consistent with present economic data.

The country’s current account recorded a 1^st quarter surplus of $8.6 billion (manila standard) and $499 million in April (inquirer.net) despite the 106% year on year growth of crude oil imports or 960% leap of rice imports y-o-y based on February figures which led to a $379 million trade deficit (manila times).

The country’s foreign exchange reserves also reached a fresh record at $36.7 billion (inquirer.net) despite “suspicions” of the Philippine Central Bank, Bangko Sentral ng Pilipinas (BSP) intervening in the currency market (seller of US dollars) to “contain” the Peso’s depreciation.

Moreover, the nation’s economic growth should remain robust. The Agriculture sector remains buoyant higher by 4% (Reuters) while tourism growth jumped 8.5% (inquirer.net) both for the 1^st quarter.

True enough, while a global economic slowdown may have SOME impact to the Philippine economy, especially in today’s highly interconnected world (relative to the past), as we argued Is the Philippines Resilient Enough to Withstand A US Recession?, where remittances represents about 10% of GDP and foreign trade (exports and imports) accounts for about 40%, we have other highly unappreciated-underinvestment themes-that has tremendous growth potentials (which ironically constitutes as the majority of the economy) enough to offset a global slowdown such as agriculture, mining, tourism, infrastructure, business process outsourcing, real estate, finance (banking and non-banking) and other service sectors.

We presented this in many of our articles including The Philippine Mining Index Lags the World (featured at safehaven.com) in September 2003 and blog posts as A Prospective Boom in Philippine Agriculture!, Want a Stock Market tip? PGMA’s SONA was a Mouthful and Phisix: “Fear Is A Foe Of The Faddist, But The Friend Of The Fundamentalist.

Has Outcomes Started to Impact Expectations?

Our belief is that the advancing phase of the global commodity cycle compounded by a deepening process of regionalization (economic, trade and financial integration) will benefit the Philippine economy and its financial markets despite the present exogenous (global credit crisis, US recession, global economic slowdown, high “inflation”) and endogenous (political, cultural and national balance sheet or fiscal) risks.

Remember there is NO such thing as a “perfect decoupling” or a “perfect integration”. Amidst today’s globalization trends, where integration and interrelation among economies has been increasing, there will always be some idiosyncrasies within a political economy relative to the world based on culture, population (demographic) construct, intrinsic policies, willingness to open for international or global interaction, political, economic and financial market framework and others. Said differently, there is no such thing as a “one-size-fits-all” paradigm. The distinction of the impact from globalization trends depends on the degree of the country’s exposure.

Take for instance proponents of the deflationary depression scenario have been forecasting of a global recession (if not a depression) arising from the global credit crisis, as we discussed in Global Depression: A Theory Similar To A Horror Movie?, yet 10 months into the credit crisis, global economies appears to remain unexpectedly strong!

Japan’s economy stunned the consensus with a 3.3% growth on “exports on to Asia and emerging markets” (Bloomberg) equally buttressed by resilient domestic demand. It’s the same story in Europe which grew by .7% in the 1^st quarter or 2.2% from a year earlier (Bloomberg), where the Germany (the “strongest growth in 12 years”) and France surprisingly compensated for the slowdowns of some countries (e.g. Spain, and Italy) within region coming in the face of a strong “euro”, rising “inflation”, US economic slowdown and other risk variables.

Assuming a lag period for the transmission of the Credit Crisis or a US economic slowdown, this suggests that economic data should begin to reflect on such slowdown. But this has yet to surface. Of course, we don’t discount that such lag period may take longer and might eventually weigh on Japan or Europe’s economic growth.

But the all important lesson here is that forecasting based on inductions similar to Dry Bone song (toe bone is connected to the ankle bone is connected to the knee bone, etc…) overestimates what is known, and at the same time, underestimates on what is unknown. That is why projections based on the extremes are likely to be exaggerated or highly erroneous and so with the self-righteous rigid convictions which underpin such views.

The Other Side of Oil

In the interim, claims that “decoupling is a myth” based on the initial reaction of forced liquidations seem to be vacillating. Some deflation proponents have now been arguing about the dissociation of stock markets and the economy.

As you know, we have long argued that the stock market performance doesn’t always account for the activities of economies or corporate earnings simply because the stock market (or other aspects of the financial markets) can also account for the function of money as a “store of value” or the opportunity cost of holding cash. (I have to keep repeating this because many people don’t seem to get it).

As a reminder, Zimbabwe has long been in a serial recession but whose stock market has continually soared amidst declining purchasing power (hyperinflation) manifested by its currency (massive devaluation). Economic health-unemployment (80%), manufacturing capacity (5%)-and corporate earnings have not been a factor for stock market performance, but the currency’s (Zimbabwe Dollar) purchasing power has.

When people fear the value of their currency is eroding, as seen through sharply higher prices of goods and services, they tend to seek refuge in asset prices which are scarce, liquid and represents “store of value” or whose value is expected to remain against a massively devaluing currency. Yes, central banks can simply print money for myriad political purposes and accrete humongous financial claims against a dearth of hard assets.

While the others see the rise of commodity prices as a relative shift from the absorption of credit creation and intermediation to financial assets into commodities or in short- NO problem of inflation, our view is that today’s rising markets could be a symptom of a Zimbabwe like disease in the markets.

The world’s current account imbalances, whose enormous surpluses are held by non-democratic emerging markets with underdeveloped financial markets, have equally been generating massive domestic liquidity through amassing foreign currency reserves transmitted by the monetary pegs to the US dollar. In effect, US dollar policies (such as today’s negative real yields) are being diffused to emerging markets via monetary mechanism where the latter’s surpluses are recycled into democratic industrialized economies with mature financial markets which may continue to incur current account deficits.

For instance, with Oil at $126; this means intensifying wealth transfer from oil exporters to oil importers, it also means higher surpluses for oil exporting countries, aside from more money for alternative non US dollar investments via Sovereign Wealth Funds by oil exporters and other surplus generating countries and structural adjustments in the balances of the current account surplus-deficit nations based on the changing dynamics of spending, investing and trading patterns.

A very perceptive commentary from Brad Setser (highlight mine),

``It would lead to something like a $650-700 billion transfer of wealth from the oil-importing economies to the major oil-exporting economies

``Assuming that the oil exporters don’t spend and invest all that much more than they already were planning to do in 2008, the rise in the oil export revenues will translate into a comparable increase in the oil exporters' current account surplus – and a comparable rise in the oil importers deficit. Of course, there will be some adjustment in the imports of the oil-exporting economies. But spending and investment in the oil-exporting economies tends to adjust with a lag to rises in the price of oil. And both are already on a sharply upward trajectory. Governments are spending more - and the oil-exporting economies are investing more, in part real interest rates in many oil-exporting economies are incredible low. Those crazy and wildly pro-cyclical dollar pegs. If oil had stayed at its 2007 level, it is safe to assume that the oil exporters surplus – roughly $425 billion in 2007 according to the IMF – would have fallen by $100 billion, if not more.

``The Spring IMF World Economic Outlook assumed that oil would average $95 a barrel -- pushing the oil exporters current account surplus up to $620 billion. If oil says at $125 a barrel for the rest of the year and oil averages $115 a barrel for the year, the oil exporters' current account surplus could approach $900 billion range.”

So with huge surpluses from emerging market oil exporters (GCC), aside from countries with surpluses from goods and services (Japan) and countries with surpluses from capital inflows (Brazil), which maybe finding their way into global financial (possibly through equity-via the Sovereign Wealth Fund route) markets coupled with excess liquidity arising from the lack of sterilization (mopping up of excess liquidity) due to the underdeveloped financial markets could have accounted for the spillage of such liquidity excesses over to the commodity markets, could have accounted for the rising price of goods and services around the world and the appearance of recovery in the global equity markets.

The point which requires emphasis is that the spending, investing and trading patterns by these current account surplus countries are likely to determine the asset or currency values of where these spare funds will eventually be parked.

Another aspect to stress is that these surpluses amount to an ocean of money being pumped into the system, aside from the equivalent strains being produced by such surplus-deficit asymmetries.

Baltic Dry Index, Commodity Cycle and the Flawed Populism Concepts

Figure 1: Investmenttools.com: Soaring Baltic Dry Index Amidst Recovering US S&P 500

Figure 1 from Investmenttools.com shows of the near record highs of the Baltic Dry Index overlapped by the main US equity benchmark the S & P 500.

The Baltic Dry Index an index which is representative of dry bulk shipping rates covering a range of raw materials or commodities including coal, iron ore and grain indicates that there is an ongoing shortage of shipping carriers which has prompted for shipping rates to climb back to its recent record highs.

While the correlation between the S&P and Baltic Index has not been entirely strong, we do see some firming interaction since the second round implosion of the credit crisis last October. This paved way for the fall in the Baltic rates coincident to the S&P. Recently the Baltic rates appears to have led the S&P.

This posits the scenario where Baltic shipping rates could have reacted to the supposition of a marked slowdown in commodity shipments (possibly expectations of a US recession), whereas today, the Baltic Index could be sounding off a “limited impact” scenario of an economic growth slowdown relative to the commodity markets.

Further, the fresh record high of the CRB Index supports the assumption of vigorous demand for commodities. But there is also another possible factor responsible for such upsurge-supply bottlenecks brought about by high financing charges and tight lending standards-have caused cancellation of orders for additional ships.

From Bloomberg’ Todd Zeranski, ``As much as $14 billion in ship orders is threatened by cancellations and delays, equal to 94 percent of annual revenue at Hyundai Heavy Industries Co., the largest shipbuilder. Tightening credit markets mean lenders demand a bigger deposit and shorter terms for financing, said Tobias Backer, the head of shipping for the Americas at Fortis, a merchant banker.

``The loss or delay in deliveries of about 250 cargo ships, or 10 percent of orders, will tighten the supply of vessels and support rates when demand from China and India for everything from soybeans to coal has never been greater. Based on the current orders for 2,561 new cargo ships, shipping rates are expected to decline 56 percent during the next three years, futures markets show.”

So even amidst a threat of a potential slowdown in demand for commodities for whatever reasons, the restricted access to financing extrapolates to diminished output for shipping, which means supply constrains or elevated prices for commodities and the Baltic Index.

Demand is a populist Keynesian framework peddled by mainstream media, however supply is another important variable frequently ignored.

The point being, a global economic slowdown isn’t a clear cut certainty that will cause a fall commodity prices, if supply falls faster than the decrease in demand then obviously prices will continue to rise.

Currency Basics

What has this got to do with the Peso?

A lot.

First things first, when we deal with currency markets, we deal with currency pairs or currency values measured against another currency. For instance when we quote the US dollar relative to the Philippine Peso USD/Php, the US dollar serves as the base currency while the Peso is the quoted or the secondary currency.

Second currency values are fundamentally driven by fund flows (capital and trading account), expected policy actions (monetary and fiscal), prospective interest rates and or yields, economic activities, political conditions, purchasing power and others. Traders and punters likewise apply sentiment and technical measures like in the stock market.

Third, since currency values are measured against another then it is a zero sum game, when one currency rise, the other declines. Hence, valuation of currencies shouldn’t be seen from a singular perspective but from dual ends. In other words, valuation is measured by relativity.

For example when one argues that rising oil prices hurt the Peso, it misses the perspective the US is likewise an oil importer, hence oil imports are likewise potentially harmful to the US dollar, so the question should be- higher oil prices should essentially impact which currency more?

Widening Our Perspective On The Peso

Let’s us examine the Philippine Peso. As noted above the Peso continues to amass foreign exchange surpluses aside from recording current account surpluses mostly from remittances.

At the margins, the Peso’s prices have somewhat been set by foreign portfolio flows, aside from other additional minor factors as investment income or central bank forex operations. On the other hand, the US dollar is a net current account deficit currency despite its privilege as the world’s de facto currency reserve.

Figure 2: PSE: Foreign Activities: Declining Trend of Outflows?

Figure 2 exhibits the daily activities of foreign money in the Philippine Stock Exchange. It shows that foreign selling in the PSE has peaked sometime in December 2007, but seems to be gradually declining as shown by the red arrow.

By implication if the trends of foreign funds continue to improve then the Peso should strengthen. It could. But such analysis isn’t straightforward.

Figure 3: USD/Peso-Phisix relationship

Look at figure 3, the USD/Peso (black line chart), since the Peso began to appreciate in 2005 the Phisix seemed to track the USD/Peso’s performance on an inverse scale.

When the US Dollar rose, the Phisix declined, conversely when the Phisix peaked, the US dollar was in a trough (blue arrows). This relationship held until August of last year from where such correlation broke down. Bizarrely the Peso continued to appreciate even while the Phisix had been encountering a net outflow.

China’s Yuan Possible Influence On The Peso

Figure 4: Ino.com: Chinese Remimbi Resembles the Peso’s path

Figure 4 from Ino.com shows of the uncanny resemblance between the movements of the Peso and the Chinese remimbi.

Notice when the Remimbi spiked in August, the USD/Php bottomed. Over in August to September as the Remimbi weakened, the USD/PHP firmed. Next, as the remimbi soared from September until early March, so did the Peso until the last day of February.

So while correlation may not imply absolute causation, we think that the ongoing dynamics of increasing regionalization has had a hand in these. We have argued how trading structure of the region has been reconfigured into what Asian Development Bank describes as “vertical integration of production chains” or a regional outsourcing platform with China as the final assembly point.

The point is that since Asian countries have been engaged in some form of competitive devaluation or have manipulated their currencies to keep prices competitive, and since most of their exports have now shifted to within the region or to China, most of Asia’s emerging markets seem to have kept the dynamics of currency values within the parameters of Chinese remimbi as a bellwether.

And if we are correct with the analysis that the remimbi as the region’s leading benchmark, then it is likely that today’s correction will not last.

This excerpt from a speech of University of California, Berkeley’s Professor Barry Eichengreen, courtesy of RGE Global (highlight mine),

``If the U.S. is in for a long recession and serious credit problems are not over, then betting on dollar recovery would be premature. The problem is that the dollar has fallen dramatically against the euro but much less against the Asian currencies, because of the reluctance of governments and central banks there to let their currencies move against the greenback. It would be nice if those Asian governments and central banks let their currencies strengthen more against the dollar – both to make up lost ground and because Asia is the one part of the world that is growing strongly. The dollar could then recover a bit against the euro, which would take some pressure off of Europe, without appreciating on an effective basis. Indeed, if exchange rates were simply left to the markets, I would not be surprised to see the dollar fall further on an effective basis, given the weakness of the U.S. economy. That is, any recovery against the euro could be dominated by further depreciation against Asian currencies.

``But the reality is that exchange rates are not left to the markets. With inflation accelerating, Asian central banks are likely to countenance a bit more local-currency appreciation against the dollar, but only a bit. And if they limit the depreciation of the dollar against their currencies, there is not going to be much recovery of the dollar against the euro.”

So what can we learn from Prof. Eichengreen?

One growth differentials are likely to allow Asian currencies to appreciate. Two, faced with inflation pressures, given enough lever arising from strong economic growth (aside from the wide gaps of purchasing power) monetary policies will most likely adjust to present conditions. Either our BSP increase interest rates or allow for currency appreciation or a combination of both. If the BSP increases rates then yield differentials against the US dollar should widen which could attract back foreign capital.

This basically debunks arguments floated by mainstream analysts where rising oil prices or inflation is said to inhibit the Peso’s advance. This overlooks the perspective of policy maneuvers.

Next, considering that global risk taking conditions have been picking up of late, (yes we are seeing some major indices crossover the threshold away from bear markets territories) we are likely to see a reversal of portfolio outflows.

Lastly pricing in the foreign exchange markets are not entirely market-determined, hence the imbalances in the global monetary system will continue to mount.

We would further add that based on a probable shift in trade composition where eventually we should see commodity based exports (mining and agriculture) heftily contribute to our trade and current account surpluses (aside from investments and revenues from Tourism, energy and infrastructure) to compliment remittances and portfolio flows, provided the leadership maintain their fiscal discipline, the Peso’s long term path alongside its neighboring currencies is most likely to the upside! All these are also anchored on the underlying policies by the BSP (or the BSP’s tolerance for a market determined outcome).

For the meantime, while I can’t say when the USD/Php is likely to top, I would recommend using today’s rallying dollar as an opportunity for exit or to diversify.