Sequel To Asian Financial Crisis?, Costly Bailouts and Bernanke Buys Time

``So the lesson we can take away from all this is to respect what the market tells us, listen to it and ignore the nonsense in the news. More recent incongruous market action should be respected because it may be indicating something important.”-George Kleinman, Commodity Trends, What I Learned This Year Trading Commodities

 

Since I read voluminous reports, articles and research papers daily, I get the privilege of having to access a diversity of opinions and insights of which ranges from the extreme ends of optimism and pessimism. Thus, I realized that my personal biases have been frequently challenged or tempered by the influences of contrasting outlooks. Instead of having extreme convictions which are usually swayed by emotions my views have been redirected to the moderation.

 

Over the years we have pointed on the perils of systemic overleveraging via the US housing bubble and how it poses as a challenge to the global market and the economies. Now that it has become a reality and whose dynamics has been providing us with a suspense thriller, I have been arguing today that the “US is not the Philippines and vice versa” such that while there are transmission linkages that could impact the local economy via trade, labor and financing, there are domestic factors to reckon with that could help cushion on the negative effects from the present systemic deleveraging seen in developed economies.

 

Besides, if I had to take the view of the extreme pessimist, I would have to move to the countryside, stockpile upon years of food (aside from raising them by ourselves) and medicine, accumulate precious metals, and load up on ammunition, energize our homes with solar panels and erect my “mini” fortress in anticipation of the holocaust. Think medieval times applied to present circumstances. That is what the extremes see. Great Depression, a world at war, grand anarchy, massive famine and hunger, breakdown of the financial and monetary system and the society’s division of labor and etc.-arising out of the sudden arrival of “peak oil” or from the ravages of a global economic depression.

 

However, I learned from the Austrian School of Economics that people are rational beings which when confronted with even similar circumstances react distinctly as we discussed last week in Global Recession: Reading From Individual Actions Than From The Collective. Because of such divergence in the actions of individuals there is the tendency that the perceived outcome could be different from what many analysts expect.

 

If it were as simple for people to react in a “common” manner, as seen via the lens of “omniscient” experts, perhaps in the model of the “Gaussian curve”, then our problems would be easily solved. Governments through these experts can simply legislate away on how we should act. But the reality is that we are not robots, our rationalities cannot legislated, and governments only react to circumstances brought upon by the compounded actions of the marketplace. Why do you think we have this “deleveraging” problem in the first place?

 

Not wanting to stop the boom which the US authorities fostered (negative real rates, current account deficits, Fannie and Freddie Mac’s privileged status-which impelled them to take upon greater risk in their portfolios and prompted for a model from which was assimilated by private label mortgages, former Federal Reserve Chair Greenspan’s promotion of ARM, tight regulation in the banking system which led to creation of the “shadow banking system”, etc.) in the first place, now the same authorities have been applying cushion to the impact of an unwinding market dynamic emanating from a grand malinvestment edifice. Yet, if circumstances have been as predictable and politicians react accordingly, we wouldn’t be in these shoes today.

 

Sequel To Asian Financial Crisis? Not So Fast!

 

Even from the Philippine perspective we see the same unpredictability. Because of the interconnectedness brought upon by globalization trends, we have been saying that perhaps the Philippine economy will probably experience slower growth because of the adverse development abroad which are likely to negatively impact our “external linkages”. None of this has happened yet. Export growth trends (up 8.3% in June) and (remittances up 30% in June) have remained vigorous. Maybe it will be a matter of lagged effects.

 

It has been the same with our bullishness of the Peso relative to the US dollar. Where fundamentals favor many ex-US dollar currencies, especially relative to Asia, the sheer vigor in the momentum of the US dollar’s ACROSS THE BOARD advances have spawned many “rationalizations” from “high inflation” to “relative economic growth” to “shrinking liquidity due to current account improvement” and now to Fannie and Freddie Mac inspired risk of a currency crisis. Much of them I believe as unfounded.

 

Look at the following horrid news items:

 

This from the Bloomberg (emphasis mine),

 

Asia Currencies to Fall 12% on Capital Flight, ABN Amro Says

 

``There is more downside to Asian currencies from a reflow of capital out of Asia,'' Irene Cheung, a Singapore-based strategist at ABN Amro Bank, said in a phone interview. ``The decline could accelerate in the next two months because banks in the U.S. and Europe are pulling out. They are short of cash and need to recapitalize toward year-end.''….

 

``As much as $1 trillion flowed into Asia since 2001, of which two-fifths went to China, slightly more than a third to Korea and the rest went mostly to India and Taiwan, according to ABN's estimate.

 

Or this Korea’s Chosun.com (highlight mine)

 

``The main reason behind Monday’s panic was the September crisis rumor, which refused to go away despite government efforts to calm jitters.Stoking them was a scenario where W8 trillion (US$1=W1,118) worth of foreign investment in bonds maturing in September would exit the Korean market at once, further undermining the won and leading to a string of bankruptcies in financial institutions.”

 

Or this from UK Timesonline.co.uk

``Heavy investment by the Korean Government in Fannie, Freddie and other US-related agency bonds has left a potentially huge liquidity problem - perhaps $50 billion (£27.4 billion) - in the foreign reserve portfolio. Some believe that Seoul might have no ammunition left to prevent a significant flight from the won. Fruitless currency intervention by South Korea - increasingly desperate-looking verbal and financial measures to fight the market trend - cost about $20 billion in July alone.”

 

I don’t know why the seeming emphasis on the South Korean won’s 3.3% decline (see figure 1) when the Australian dollar and the New Zealand dollar even took heavier blows, down 5.08% and 4.46% respectively. Although I suspect that the latter two can be easily attributed to sharp decline in commodity prices.

Figure 1: yahoo.com: The Skyrocketing US dollar-Korean Won

 

Except for the Chinese remimbi (down .04%) and the Japanese yen (up 1.14%), based on Bloomberg’s data, ALL Asian currencies took it to the chin with the biggest casualties including the once mighty Singapore Dollar (down 1.43%). The Peso was down nearly 2% to 46.82 to a US dollar. Such dramatic cascading actions in the currency markets have led to creepy claims of market disaster.

 

Patching up all these we understand that stuffed with outsized holdings of US Fannie and Freddie Mac papers have basically rendered South Korea’s central bank as illiquid. Faced with maturing bonds in the face of a central bank liquidity crunch aggravated by current account deficit and portfolio liquidations from the deleveraging US and European institutions translates to a currency run. Thus, the currency crisis of South Korea and the rest of Asia!

 

Run for your lives…Its Asian crisis all over again! Or is it?

 

Of course we understand too that the global credit crunch has adversely impacted many companies that rely on global trade like Daewoo Shipping, some of whose international customers have withdrawn due to the lack of access to credit, aside from the anticipation of slowing business due to economic growth deceleration. And state owned Korean institutions, the Korea Development Bank and Korea Asset Management Corp, which controls 50.4% (Bloomberg, Hat Tip Craig McCarty) have reportedly been selling their stake in the company, possibly reinforcing the view of the state’s liquidity predicament.

 

But wait, what seems grossly inconsistent is that if South Korea’s central banks are truly in liquidity crunch, the same institutions cited above have played separate roles in NEGOTIATING TO ACQUIRE stakes at the beleaguered US financial institutions of the LEHMAN Brothers and Merrill Lynch!

 

So what could also be seen as selling by state owned Korean financial institutions of Daewoo shipping could also be interpreted not as raising liquidity for financing obligations but as an arbitrage, buying US assets! If the latter view is correct then, where’s the currency crisis?

 

Horror Stories Deserve A Second Look

 

Of course we can’t deny that with heightened incidences of liquidations from hedge funds on every asset class would “hurt” somewhat ex-US currencies due to a gush of outflows.

 

But to assume that MOST of the money which had flowed into Asia WILL EQUALLY stampede out seems one dimensional if not downrightridiculous or absurd. Such assumption ignores the fact that Asia has also been a source of liquidity growth and not just in the US.

 

Proof?  This from India’s Daily News Analysis (emphasis mine), ``Wealth is growing at much faster rates among the rest of the world.Households in Asia, the Pacific Rim excluding Japan and Latin America saw the greatest growth, with wealth rising 14%. That growth was fuelled by manufacturing in Asia and commodities in Latin America and the Middle East, as well as more currency and political stability.”

 

Besides, such analysis ignores that the fact that Asia has been impacted by trade and financial linkages and have NOT been the source of the financial disaster. In short there is a stark difference between structural and cyclical factors.

 

Another proof?

 

While, many OECD economies have been undergoing the paroxysm of deleveraging which essentially raises the cost of capital aside from the paucity of access to capital seen via contracting bank lending, figure 2 shows how the Philippine Banking system continues to experience robust growth!

Figure 2: ATR Kim Eng: Philippine Banking System Continues to Expand!

 

This from ATR Kim Eng (Hat Tip: Ton Garriz), ``The growth in outstanding loans of commercial banks accelerated to 18.1% Y/Y in June from 15.8% in May. The trend is consistent with the numbers reported separately by banks in their Q2 financial results. Credit expansion was driven by wholesale and retail trade (+38.5%), electricity, gas and water (+43.8%), and transportation, storage and communications (+57%). The growth in loans to the manufacturing sector grew at a slower pace of 7% although an improvement from 5.2% in the previous month. Manufacturing accounts for the 22% of total loans, the largest among categories. Auto loans also reversed course, growing 15.3% in June from a 6.9% contraction in the previous month.”

 

So aside from growth seen in the general industry we are seeing also credit growth in the consumer segment as seen in Auto Loans. This also suggests that sales of cars despite “high” oil prices can be expected to remain firm.

 

Additional information from the Inquirer.net,

 

``Consumer-related loans, which made up of about 8.0 percent of total bank lending, climbed 22 percent in June against a revised 19.9 percent in May, the central bank data showed. Consumption loan growth came mostly from credit card receivables which grew 27.3 percent in June, the central bank said.”

 

So the credit contraction or a liquidity crunch hasn’t infringed (yet. Though I don’t expect it to impact us materially) on the premises of the Philippine economy. Also all these suggest that the Philippine economy remains vibrant.

 

And the financial markets except the Peso have been bearing us out.

 

While Korean bonds have fallen (rising yields) reflecting the anxiety of deficit-global deleveraging process, Philippine bonds continue to rallymarkedly (falling yields).

 

This implies two possible developments, one, “lower” expectations of future consumer price inflation and two, diminished symptoms of “liquidity” crunch or contagion from the world’s develeraging process.

 

As we have written in many times during the past, market internals of the Phisix have shown decreasing depth of foreign selling. This has recently supported the Phisix’s “divergence” from most of the global markets, see figure 3.

Figure 3: PSE: Once Again, Diminishing Foreign outflows

 

As you can see, the foreign selling since the credit crunch unraveled last year has been the dominant theme in the Phisix. But once again the scale of selling activities (exhibited by the red arrow) seems to be diminishing and NOT increasing in contrast to the gloom and doom citations by freaked out analysts!

 

And yes, while the markets may not agree with me yet on the Peso which I believe reflects mainly a function of the unwinding short US dollar Carry trade, the deleveraging process, government intervention and momentum, this perhaps could last longer than my expectations.

 

Besides as we pointed in our July 20 issue Philippine Peso: Technical Pattern, BSP Actions and Diminished Inflation Points To A Rally, previous patterns have shown the Peso to correct by 45-50% before resuming its upward path which means the Peso could go over 47 before appreciating.

 

And if falling Asian currencies have been associated with the illiquidity from Asian central bank portfolio holdings of Fannie and Freddie Mac securities then the latest proposed emergency actions by the US Treasury (which is set to be announced before Asian markets open on Monday) suggest that “implicit guarantees will become explicit” as the US nationalizes the two behemoth widely owned mortgage institutions.

 

This from Bloomberg, ``The Treasury plans to put Fannie and Freddie into a so- called conservatorship and pump capital into the companies, House Financial Services Committee Chairman Barney Frank said in an interview yesterday. The government would make periodic capital injections by buying convertible preferred shares or warrants, according to a person briefed on the plan. Paulson is seeking to end a crisis of confidence in the companies sparked by concern the companies didn't have enough capital to weather the biggest housing slump since the Great Depression.”

 

US Dollar Weighed By Heavy Cost of Bailout, Bernanke Buying Time

 

It’s simply amazing how we can be bullish the US dollar when the US government will be throwing so much money to salvage its financial system from a complete meltdown at a heavy cost to its taxpayers.

 

Don A. Rich in Mises.org wrote about the estimated full cost to taxpayers in rescuing Fannie and Freddie Mac alone, ``the real cost of the bailouts will easily exceed $1.3 trillion. In fact, the real cost is likely to range between $1.3 trillion to $1.6 trillion, and is not unlikely to reach $2.5 trillion.”

 

In perspective, US $1.3 trillion is almost equivalent to 10% of the US GDP! That’s for the GSEs alone, how about the others (FDIC and the rising bank foreclosures)?

 

Furthermore, just look at these comments from the news wires:

 

The Bloomberg quotes PIMCOs top honcho and bond market wizard Bill Gross (highlight mine),

 

``Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami,'' Gross said. ``If we are to prevent a continuing asset and debt liquidation of near historic proportions, we will require policies that open up the balance sheet of the U.S. Treasury.''

 

Former Federal Reserve Chairman Paul Volker says of the same thing (Bloomberg)

 

``This bright new system, this practice in the United States, this practice in the United Kingdom and elsewhere, has broken down,'' Volcker said today at a banking conference in Calgary. ``Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation.''

 

No, the US dollar’s rally can’t be about economic growth or earlier recovery relative to its peers. The remaining pillar that keeps the US economy afloat has been exports, if the actions in the international financial markets are any indications, as seen in collapsing commodity prices and falling equity values in the BRIC zone (except India!), these suggest that US exports will likewise founder perhaps ushering its economy to a full blown recession perhaps from here going forward.

 

It can’t be about compression of liquidity out of the improvement in the US current account deficits too, if US exports fall in tandem with imports then the deficit standings will remain the same. Besides, the strength of the US exports implies the strength of the global economy; meaning in order for the US economy to keep from falling into a recession it needs a stronger global economy. So relativity-wise, the US can’t outgrow the world economy, especially against emerging markets which has supplied most of its financing requirements.

 

Yet any supposed improvement in the current account deficits will likely be offset by a sharp widening of fiscal deficits where government spending can’t be curbed at the same rate as the slowdown in tax revenues. And these deficits entail the need for foreign capital to plug or fill such yawning gap.

 

It can’t be about the rush to secure US dollars to pay off debt as deflation proponents argue. The liquidity crunch has been mainly a US and partly a Europe phenomenon. Besides, liquidity hasn’t been a monopoly of the US dollar and its financial system.

Figure 4: PIMCO: World Real Policy Rates Remain Negative!

 

Figure 4 from Pimco demonstrates that the world remains essentially “accommodative”.

 

My interpretation is that by keeping the US Fed policy rates down, Chairman Bernanke aims to transmit its inflationary policies via dollar links and currency pegs to Emerging Economies in order for latter to recover earlier-if not to remain vibrant-in order to buoy (via exports) and finance (plug deficits) the US economy, aside from inflating away the relative values of foreign owned US financial liabilities. (Korea’s plan to buy into Lehman and or Merrill Lynch exhibits such patterns).

 

You see the probable strategy employed by the global central banks led by Chairman Bernanke’s US Federal reserve seems to be to buy enough time for the world to recover and eventually write off all the losses in the affected financial sectors (once enough capital has been raised and when markets stabilize) similar to what the US Federal Reserve did in the early 1980s when every major American bank was technically bankrupt.

 

This apropos excerpt from one of our favorite analyst John Maudlin (underscore mine),

 

``They had made massive loans all over Latin America because the loans were so profitable. And everyone knows that governments pay their loans. Where was the risk? This stuff was rated AAA. Except that the borrowers decided they could not afford to make the payments and defaulted on the loans. Argentina, Brazil and all the rest put the US banking system in jeopardy of grinding to a halt. The amount of the loans exceeded the required capitalization of the US banks.

 

``Not all that different from today, expect the problem is defaulting US homeowners. So what did they do then? The Fed allowed the banks to carry the Latin American loans at face value rather than at market value. Over the course of the next six years, the banks increased their capital ratios by a combination of earnings and selling stock. Then when they were adequately capitalized, one by one they wrote off their Latin American loans, beginning with Citibank in 1986.”

 

Conclusion

 

The important thing to differentiate from our standpoint to that of horror stories is that the world is much integrated, more sophisticated and collaborative or more flexible as to diffuse these shocks to perhaps minimize stress levels. That’s why I try to always keep my mind open than simply fall for emotionally stirred hypes.

 

Applied to the investing world, such scenario translates to the same theme: gradual accumulation of EM and Asian assets and/or currencies as the opportunities arise, because the world likely to grow or recover in support of the US economy and not the other way around.