Monetary Conditions Remain Supportive of Emerging Market Assets

``Inflation is a societal evil. It redistributes real wealth from creditors to debtors. It impairs the role of money as a means of exchange. The efficiency of the market's price mechanism is greatly reduced, encouraging bad decisions, which in turn harm peoples' economic well-being. At the end of the day, inflation is a serious threat to freedom. The majority of the people, suffering badly from inflation, would most likely blame the free market for their plight, rather than blame the central bank for the debasing of the currency.”- Dr. Thorsten Polleit, Honorary Professor at the Frankfurt School of Finance & Management

Last week I presented the idea that the Phisix would likely be cushioned by negative real interest rates. Negative real interest rates are essentially consequences of policy actions which is either deliberate (government taking up “pro-growth” stance to induce borrowing) or unintentional (outcomes from policies directed at a different agenda).

Since the Consumer Price Indices (note: I don’t use inflation) have been at record low levels in 2007, Philippine authorities have utilized such environment to slash interest rates in order to cut interest rate differentials between the US dollar to stem portfolio flows into the country, whose implicit aim is to curb the pace of the rising Peso. In short, the country’s central bank, the Bangko Sentral ng Pilipinas (BSP) has been acting to control the Peso’s appreciation by manipulating interest rates, among other policy tools.

And as we also noted last week, the BSP had been surprised by the sudden upsurge in the local CPI which appears to have limited its policy options in following the US Federal Reserves into similar policy measures aimed at providing stimulus to the economy in order to shield the economy from a potentially sharp downturn.

While the projections for domestic CPI remains moderate, my take is that the BSP will likely be “surprised” anew by the continued surge in commodity prices globally (this week: record high soybean, soybean oil, platinum).

This means that if the BSP opts to maintain rates at present levels despite a resurgent “sticky” CPI, then it is thus adopting a “pro-growth” stance, or attempting to expand credit to drive domestic consumption and investment. On the other hand, the BSP may move to increase rates as now reflected in the bond market (both dollar and peso denominated).

As we have said before, negative interest real rates relates to the function of money as a “store of value”. When inflation is higher than the income stream received via coupon yields of fixed income “risk free” investments then effectively the purchasing power of a currency erodes, thus the populace would find alternative means of maintaining the “store of value” in a currency by buying into other assets or by speculating in the expectations of returns above inflation rates.

If the BSP elects to maintain at these levels then we are likely to see expanded borrowings from domestic investors from which some assets may benefit. On the other hand, if the BSP raises policy rates, foreign portfolio inflows could be magnified.

As Ludwig von Mises wrote in Man, Economy, and State: A Treatise on Economic Principles,

``Credit expansion is the governments' foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.”

Again boom bust cycles are essentially driven by incorrect signals sent by policy makers to the capital markets. If a boom will be triggered by a prolonged negative interest rate environment, then a bust in the future should likewise be expected.

Such is the dilemma facing the BSP, as the credit squeeze in the US and Europe continues to unfold (see figure 2), attendant policy measures by the US or Europe could be expected to target or address the ongoing tightness in these markets.

Figure 2: Danske Bank: Widening Spreads Indicate Monetary Tightness

Doug Noland from the Credit Bubble Bulletin (highlight mine) identifies the broad market tensions, ``In the markets, various indices of investment grade Credits widened sharply to record levels. The key “dollar swap” (interest-rate derivative hedging) market saw spreads widen sharply. Agency spreads also widened significantly. Benchmark Fannie Mae MBS spreads widened a remarkable 20 bps against 10-year Treasuries, while agency debt spreads widened a noteworthy 12.5 basis points to 69.5 bps (high since November).”

This means that as policy rates in the US become accommodative, the interest rate spread or differentials or “carry” widens in favor of the peso, coupled with stronger economic growth, these factors are likely to signify as strong incentives for foreign money to bid up on Philippine assets.

On the other hand, if the BSP moves to increase rates in the face of rising CPI, it would only add fuel to such motivations. So PSE President Francis Lim shouldn’t be “unhappy” because the evolving events are likely to turn the tide in his favor (a return to portfolio inflows) overtime. All he has to do is to wait for Chairman Bernanke to deliver his gift.

Again as a reminder, the problem of the Philippine markets is not due directly to the worldwide credit crunch or our banking system “infected” with toxic papers (according to BSP Governor Armando Tetangco and Fitch Ratings- Philippine bank exposure to the CDO market is only .2% to total banking assets or $180 million) or seizure in the Philippine credit system but one of forcible liquidations by foreign funds or institutions impacted by the mortgage securities crisis to raise capital, and subordinately, readjustments on economic growth expectations following a considerable downshift in the US.

Experiences of Negative Real Yields

So how powerful does a negative interest rate impact asset prices?

According to Barry Ritholtz, ``In the United States, real interest rates were negative between 2002-03. The crisis hit five years later. (Real Interest rates just flipped negative again in 2008).” Ergo, negative interest rates have basically been a crucial variable in shaping the US real estate boom bust cycle.

Negative interest rates have also accelerated a boom in the Hong Kong property markets despite the swoon in the equity counterparts.

According to the Australiannews.com (highlight mine), ``The unintended result is that home loan rates are so cheap that they are throwing more fuel on a hot property market that looks set to get even hotter.

``A typical mortgage here now carries interest of about 3.1 per cent. But compared with Hong Kong's inflation rate of about 3.8per cent, which now hovers at a more than nine-year high, that looks inviting, creating a so-called negative real interest rate.

``For many potential home buyers in Hong Kong, mortgage payments are now effectively cheaper than rents, which are slower to adjust to rate changes.”

So if the Hong Kong property markets are the assets directly boosted by negative rates, we earlier said that Zimbabwe (hyperinflation-66,000% last December!) found its “store of value” in stocks and in Venezuela via “Cars”.

And so with China, see figure 3.

Figure 3, World Bank China Quarterly: Interest rate differential with the US has reversed (left), Interest rate increases lagged behind the rise in inflation (right)

This from the World Bank, ``With monetary policy remaining constrained by the exchange rate policy, administrative measures continue to play a role in monetary policy. High balance of payment surpluses put upward pressure on the RMB. Much of the surpluses are sterilized using open market operations and reserve rate increases. With the interest differential between China and the US having turned positive, policy makers are concerned that high interest rates would attract more portfolio flows (although it is not clear how high interest rate sensitive capital inflows are). This external constraint has kept domestic interest rates lower than they otherwise would be. Interest rates were increased during 2007, but these increases lagged behind the rise in inflation. Thus, on the metric of real interest rates (deflated by current inflation) there was no monetary tightening in 2007. As a result, administrative measures and window guidance are used to affect bank lending. The tightening of window guidance at the end of 2007 have been relatively successful in reducing credit expansion, although the success of such measures is difficult to maintain for long periods without economic costs.”

Monetary Policies As Leading Indicator

For us, monetary policies have served as marvelous reliable leading indicators in determining performances of asset classes, more than “micro” fundamentals or technicals.

In my January 21 to 25 outlook [see Bernanke’s Financial Accelerator At Work, US Dollar As Lifeblood of Globalization], I wrote,

``If there is any one-single most important link to globalization, it is not exports, reserves, capital flows or remittances, it is the US dollar standard system. Since most of the trade or capital flows, which shapes trading patterns and cross border flows influences a nation's economic and monetary structure, are conducted still in the US dollar, US policies (fiscal and monetary) will continue to be asymmetrically transmitted to the rest of the world. As to its unintended effects is one matter to reckon with and speculate on.”

Well, David Kotok of the Cumberland Advisors (highlight mine) appears to corroborate our view, ``The power of the Fed projects globally because there are many jurisdictions which peg or manage their currency exchange rate against the dollar. China manages its currency and does not allow the market place to set the exchange rate. China was 31% of our trade deficit in 2007 and is 7.5% of the world’s non-US GDP. Saudi Arabia pegs its currency. It is 3% of the US trade deficit and 1% of the world’s non-US GDP. Tom Russo of the Group of Thirty estimated the world’s cumulative numbers on this issue…He sees more than half of the US trade deficit to countries that are either managed or pegged. They collectively represent about 16% of the world’s non-US GDP. The US is about 27% of world GDP.

``We must understand that a stimulative monetary policy in the US transfers stimulus to those countries as well as applying it here. That is why we are optimistic that the Fed’s power will reach beyond our borders and that the outlook for the growth of world economies is looking better because of it.”

Again, what we are trying to say is that policy responses from a financial architecture built around the US dollar standard system will likely be distinct across geography depending on the currency regime, the economic and capital structures aside from present policies and the prospective policies adopted in the face of changing conditions.

Because the linkages from the interest rate channel commands a significant heft, it has the potential to impact markets materially or offset the liquidity contraction experienced in some other parts of the world. Thus, the assumption of a “one-size-fits-all” argument is for us a logical fallacy of composition.

So like the BSP, China as shown above has been living through a negative interest rate environment, which has been an important contributor to the ongoing boom in its real estate industry, aside from the previous boom in stocks in 2007 (The Shanghai composite is down 14.5% year to date and down 26% from its peak in October 2007). Nonetheless, like all cycles greased by credit expansion, a bust in China is likely to follow its boom-at a yet to be defined timeframe-2010 or 2011, perhaps?

And importantly, as rate adjustments in the US have brought upon a “negative carry” this should reinforce the case of additional weakening of the US dollar relative to Asian currencies.

Respected fund manager John Hussman of the Hussman Funds, expects a dollar crisis arising out of the US-China negative carry (emphasis mine), ``Presently, the U.S. economy is running the deepest current account deficit in history, even as the Federal government has promised to run up another $150 billion in debt to run a “stimulus package.” At the same time, the carry between Chinese interest rates and U.S. Treasury yields has now turned negative, meaning that there is no longer a favorable interest rate differential to encourage Chinese investment in U.S. government debt. Moreover, the gradual appreciation of the yuan continues, meaning that the Chinese are also taking losses on their holdings of U.S. Treasuries due to dollar devaluation. The only remaining allure of Treasuries has been for capital gains due to investors' flight to safety, but with yields already compressed, it is increasingly risky to expect continued downward pressure on long-maturity interest rates. This places the U.S. in the difficult position of having to finance an enormous volume of capital needs from foreigners, particularly for Treasury debt, yet without being able to offer competitive yields or strong prospects for additional capital gains.

``My impression is that the markets will respond to this difficulty with what economist Rudiger Dornbusch referred to as “exchange rate overshooting.” In the present context, that means a dollar crisis.”

``Specifically, if there is a weak prospect that foreign lenders will achieve a total return on U.S. Treasuries competitive with what they can earn in their own country, and every prospect that short-term interest rates in the U.S. will remain depressed or fall even further, the only way to attract capital is to immediately drive the value of the U.S. dollar to such a sharply depressed level that it will be expected to appreciate over time.”

Proof of Liquidity: Soaring Emerging Market Reserves

So based on a returns perspective, such prospects may not be attractive for the Chinese (as losses on reserve holdings mount) as they could restrain their accumulation of US assets. But an important point to consider is that the Chinese buying of US assets have not been due to return basis but more for economic and political consideration, hence the “competitive depreciation” of currency.

The perceptive and very meticulous analyst Brad Setser makes a very important point (highlight mine), ``Central banks aren't building up dollar reserves because they want dollars. They are building up dollar reserves because they don't want their currencies to appreciate against the dollar. The dollar's fall against the euro and the growth in emerging economies dollar reserves are thus both manifestations of the same basic trend -- a lack of private demand for dollars, relative to the US current account deficit, and the resulting pressure for the dollar to fall.”

Yes, private sector investments could likely to veer away from US assets, as they have been. But it is unclear whether this should impact the emerging market governments from accruing US assets in order to control or manage their currency values. Based on recent performances this has not been the case.

Figure 4: Brad Setser: Surging Dollar and Total Reserves Amidst A Slowdown in US Current Accounts

Figure 4 courtesy of Brad Setser shows how Emerging markets continue to aggressively accumulate reserves in both US dollar (yellow) and total reserves (blue line) even in the light of an improvement in the US current account deficit (red line).

And for 2008, the pace of accumulation is likely to pick up. According to Brad Setser, ``And 2008? Well, the early data for January suggests that global reserve growth remains very, very strong. India, Singapore, Malaysia and Thailand combined to add over $30b to their reserves (counting the increase in Thailand's forward book). Japan chalked in another $20b, though its total was inflated by the impact of falling long-term rates on its long-term dollar portfolio (Japan marks its bond portfolio to market). Brazil is still intervening as well.

``Then throw in China. Or really through in China's reserves, the CIC and the state banks, as not all of China's foreign exchange is now showing up at the central bank.

``Then add in the oil exporters ...

``There is a reason why the Fed's custodial holdings rose so strongly in January.

``The scale of the increase in emerging market government assets right now is truly mind-blowing.”

This simply shows that even if the US current account has been improving substantially enough to raise the alarm bells from the depression advocates of a global liquidity crunch, the continued “massive” accumulation of surpluses evidenced by the rapid surge of emerging market (dollar and total) reserves spotlights on the liquidity dynamics generated elsewhere (euro zone, intraregion Asia?).

The surge of China’s January bank lending and money supply growth appears to validate this view. In short, some parts of the world have been experiencing credit deflation while in other parts of the world, liquidity remains abundant. Inflationary dynamics are likely to end up in assets or channels unspecified by the authorities.

Is it a wonder why commodities (agriculture, energy, precious metals) continue to surge in face of the gloom and doom scenario parlayed by depression advocates? This comes in stark contrast to the scenario where US money contraction is said to feed in through world prices (some of them hit mainstream press saying that the depression risks would prompt the US government to buy a broad range of assets to support the economy).

Projecting Oil Prices is Not All About Demand

Mainstream analysis also declares that as the US segues into a recession, world demand for oil would crimp and thus be reflected in its prices. Some have even argued for $70 oil by mid year. They could be right. But this has not yet been apparent.

Figure 6: Simmons and Company: Contracting World Oil Supplies

The problem with this view is that many high profile experts seem to focus on one side, the demand side (shows of their economic ideology-the Keynesian school). Rarely has there been an objective perspective dealing with the balance-such as ascertaining the actual state of the supply side as shown in Figure 6, courtesy of Matthew Simmons of Simmons and Company International.

The theory is if demand slows more than the supply then prices should go down. However what is greatly overlooked is that if supply declines faster than the decline in demand then prices will remain levitated. Now supply appears to be rapidly “peaking out” even when demand seems to stall (IEA-Forbes).

Moreover, if speculation is indeed responsible for oil at its current levels then depressionists will be proven right. However, we have read this oversimplified “speculation-driven” rationalization ever since oil prices hit $30, $40, $50, $60, $70, $80 and now $90 oil. Even at today’s seizure in auction rated securities as evidence of a spreading credit crisis we are seeing continued elevated oil prices.

In addition, global oil supply forecasts won’t be reliable for as long as there is a lack of transparency in terms of field audit, or checking on the validity of claims of real proven reserves by oil producers or exporters, aside from some government’s move to nationalize the industry, limit exploration access, increase tax revenues by arbitrary contract changes and containing private sector participation. In short, government’s restrictions to access oil have been contributing to the inefficient allocation of resources, distorting the marketplace and subsequently today’s high prices.

Besides it has been reported by U.K.-based Oil Depletion Analysis Centre that 60 of the world’s 98 oil producing countries have already hit peak oil production according to energy analyst Sean Brodrick. So as recent discoveries have not been enough to replace declining production wells, supply pressures will remain.

WTIC crude soared by 4% over the week to $95.5 per barrel, only $4.5 away from the psychological threshold high of $100. Rising crude oil adds to the pockets of OPEC and other oil producers, even as interest rates are likely to head lower especially for countries with its currency regime tied to the US dollar, as the US Federal Reserves adjusts its policies in order to provide enough cushion to its downshifting economy. In addition, a decline in the US dollar (prompted by China’s negative carry or as an offshoot to ‘stimulative’ policies) is negatively correlated to the price of oil or ensures higher oil prices.

Rising oil and commodity prices translate to more foreign exchange reserves for emerging markets central banks. This also means more money for placements by government owned sovereign wealth funds. This also suggests of abundant liquidity for the emerging economies marketplace. As well, negative interest rate environment could foster an environment that could absorb some of the excess liquidity. Or if Dr. Hussman is right, where China slows on buying US assets then a realignment of capital flows to within the region is a likely alternative.

Bottom line: Negative real yields, widening spreads between US dollar and Philippine Peso, negative carry between China and the US, growing foreign currency reserves in emerging countries and higher commodity prices should underpin emerging market assets as the Phisix.