How Political Tea Leaves Will Shape The Investment Landscape

``One key attribute that gives money value is scarcity. If something that is used as money becomes too plentiful, it loses value. That is how inflation and hyperinflation happens. Giving a central bank the power to create fiat money out of thin air creates the tremendous risk of eventual hyperinflation. Most of the founding fathers did not want a central bank. Having just experienced the hyperinflation of the Continental dollar, they understood the power and the temptations inherent in that type of system. It gives one entity far too much power to control and destabilize the economy.” Dr. Ron Paul, The Neo-Alchemy of the Federal Reserve

Never has ascertaining the probabilities of the rapidly evolving highly fluid macro environment been as critical today in shaping one’s portfolio or even in anticipation of the how to allocate resources in the coming business environment.

Why? Because future revenue streams, productivity levels, earnings and all other micro metrics, aside from market or business cycles, will all depend on the outcome from the present set of policy choices.

While the investment field shudders at the thought mentioning such ominous phrase; ``it’s different this time”, well, it hard to say it but it does seem different this time.

As we noted in last week’s Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?,

``Even as global governments have been rapidly anteing up on claims to taxpayers’ future income stream by a concoction of “inflationary” actions such as lender of last resort, market maker of last resort, guarantor of last resort, investor of last resort, spender of last resort and ultimately buyer of last resort, a credit driven US economic recovery isn’t likely to happen; not when governments are tightening supervision or regulatory framework, not when banks are hoarding money to recapitalize, not when borrowers are tightening belts and suffering from capital losses on declining assets and certainly not when income is shrinking as unemployment and business bankruptcies rise on falling profits, and most importantly not when the collective psychology has been transitioning from one of overconfidence to one of morbid risk aversion.

``Thus the best case scenario for the credit driven “economic growth” will be a back to basics template-the traditional mechanisms of collateralized backed lending based on borrower’s capacity to pay. But these won’t be enough to reignite the Moneyness of credit. Not even under the US government’s directive.”

We found our assertions pleasantly echoed by the world’s Bond King in his latest outlook; from PIMCO’s Mr. William Gross (who confirms our cognitive biases-emphasis ours)

``My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”

So as global governments take up the shoes from the private sector, the outcomes as reflected by market conditions and on the economic landscape will obviously be different, see Figure 1.

Figure 1 Gavekal: Portfolio Distribution In Different Environments

From Gavekal’s Brave New World is a simplified template where we see basically four economic environments; from which a long term theme, at the moment, has been struggling to emerge, albeit under a current, possibly temporary, dominant theme which are being battled out by government forces.

But nonetheless, we can identify whence our recent past, posit on the present environment and identify possible outcomes.

From the privilege of hindsight the most obvious is the inflationary boom, which was characterized by a credit inspired boom in almost every asset classes across the world, but in contrast to the template, this includes a boom in government bonds!

Today we are seeing the opposite- a market driven deflationary bust, where the unwinding debt burden has prompted for a reversal of the former order or an across the board selling except for US treasuries and the US dollar. Thus the characteristics as described in the template are presently still being perfected.

Yet, given the observable actions of governments, one may infer that the current deflationary bust phase is being engaged in with a tremendous surge of inflationary forces (bailouts, guarantees, lending, capital provision, etc.) in the hope to restore the former order.

And this has been the source of the fierce debates encapsulating the investment industry; will today’s deflationary bust outrun inflationary forces and transit into a modern day global depression? Will the unintended consequences of the concerted inflationary injections by global central banks result to a US dollar crisis or inflationary bust or hyperinflationary depression? Or will Goldilocks be resurrected with government stilts?

Deflation and Endowment Effects

The basic problem is the house of cards built upon by an unsustainable credit structure from which the world’s economy has been anchored upon, see figure 2.

Figure 2: courtesy of contraryinvestor.com: Unsustainable Credit Market

As we previously noted there are basically two ways to preside over such predicament. One is to allow market forces to reduce debt to levels where the afflicted economy could pay these off. Two, is to reduce the real value of debt via inflation. Of course, there is always the third way: the default option.

But since we believe that the US government and the other debt laden economies are likely to avoid the third option, as their taxpayers have been aggressively absorbing the losses, these relegate us to the first two options.

Deflation proponents (mostly Keynesians) argue that the central bank measures are proving to be impotent when dealing with the tsunami of debt because losses have simply been staggering to drain “capital” than can be replaced and which has similarly devastated the credit system beyond immediate repair. Hence, the global central bank actions are unlikely to rekindle a credit driven (inflationary boom) economic recovery.

In addition, they argue that because of the credit prompted seizure in the banking system its spillover effects to the real economy will lead to a much further decline in aggregate demand which accentuates the overcapacity in the global trade network which will further transmit deflationary forces worldwide.

Moreover, they’ve boisterously indulged in a public blame game in the context of trade balances. They accuse the current account surplus economies, who still seem reluctant to abide by their behest of absorbing declining world aggregate demand via their prescribed policies of increasing domestic consumption, of being ‘beggar thy neighbor’. Some of them have even implied that the continued thrust towards mercantilism in today’s recessionary as “Protectionism In Disguise” (PID).

This of course, according to our self-righteous omnipotent camp will lead to further deflation as excess capacity will forcibly be dumped into the markets and may result to countervailing protectionist actions.

Grim indeed.

The bizarre thing is that Keynesians have been fighting among themselves: the insiders or policymakers believe that eventually their actions will triumph, while the outsiders believe that their sanctimonious wisdoms represent as the much needed elixir to the present predicament.

Yet all of these exhibits nothing more than the cognitive bias of the “endowment effect” or placing a higher value on opinions they own than opinions that they do not.

The rest is speculation.

End Justifies The Means: The Gathering Inflation Storm?

There are two ways one can categorize all these competing analysis.

One, means to an end- (free dictionary) something that you are not interested in but that you do because it will help you to achieve something else; or applied to the recent events, the analysis that “my way has to be followed” regardless of the outcome.

Yes, the US and many European governments have practically followed nearly all Keynesian prescriptions short of outright nationalizations of the affected industries, yet NO definitive progress.

In short, we see many analysis based on the strict adherence to ideological methodologies than the actual pursuit of economic goals.

Of course, this will have to be wrapped with technical gobbledygook, such as liquidity trap, debt trap, and assorted claptraps (possibly even crab traps), to entertain and wow their audience, especially catered to those seeking easy answers or explanations to the performance of today’s market as the trajectory for the future.

Two, end justifies the means- (free dictionary) in order to achieve an important aim, it as acceptable to do something bad or the end result determines the course of action.

As we have earlier said the major alternative recourse to deal with an unsustainable debt structure is to ultimately inflate the real value of debt, which essentially shifts the burden from the debtor to the creditor.

And there have been rising incidences of voices expressing such direction:

This from Atlanta Federal Reserve President Dennis Lockhart (Wall Street Journal) ``A direct path to recovery is unlikely, as we have seen, events arise that knock us off the path to a stable credit environment…the Fed retains a number of options to help the economy.” (highlight ours)

This from former IMF Chief Economist Kenneth Rogoff whom we earlier quoted in Kenneth Rogoff: Inflate Our Debts Away!

``Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitisation, structured finance and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed….

``Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20% or 30% instead of 5-6%. Indeed, fear of overshooting paralysed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.

This from a commentary entitled “Central banks need a helicopter” by Eric Lonergan a macro hedge fund manager at the Financial Times (highlight mine),

``What is lacking is a legal and institutional framework to do this. The helicopter model is right, but we don’t have any helicopters…Central banks, and not the fiscal authorities, are best placed to make these cash transfers. The government should determine a rule for the transfer. It is the government’s remit to decide if transfers should be equal, or skewed to lower income groups….The reasons for granting this authority to the central bank are clear: it requires use of the monetary base. Granting government such powers would be vulnerable to political manipulation and misuse. These are the same reasons for giving central banks independent authority over interest rates.”

Let’s go back to basics, the reason governments are inflating the system away (albeit in rapid phases) is because of the perceived risks of destabilizing debt deflation. Yet you can’t have market driven deflation process without preceding government stimulated inflation. Thereby deflation is a consequence of prior inflation. It is a function of action-reaction, cause and effect and a feedback loop- where government tries to manipulate the market and market eventually unwinds the unsustainable structure.

Our point is simple; if authorities today see the continuing defenselessness of the present economic and market conditions against deflationary forces, ultimately the only way to reduce the monstrous debt levels would be to activate the nuclear option or the Zimbabwe model.

And as repeatedly argued, the Zimbabwe model doesn’t need a functioning credit system because it can bypass the commercial system and print away its liabilities by expanding government bureaucracy explicitly designed to attain such political goal.

As Steve Hanke in the Forbes magazine wrote, ``The cause of the hyperinflation is a government that forces the Reserve Bank of Zimbabwe to print money. The government finances its spending by issuing debt that the RBZ must purchase with new Zimbabwe dollars. The bank also produces jobs, at the expense of every Zimbabwean who uses money. Between 2001 and 2007 its staff grew by 120%, from 618 to 1,360 employees, the largest increase in any central bank in the world. Still, the bank doesn't produce accurate, timely data.”

In other words, the Rogoff solution simply qualifies the ‘end justifying the means’ approach, where the ultimate goal is political -to reduce debt in order for the economy to recover eventually or over the long term for political survival, than an outright economic end. Yet because of the vagueness of such measures, there will likely be huge risks of unintended painful consequences. But nonetheless, if present measures continue to be proven futile, then path of the policy directives could likely to lead to such endgame measures-our Mises moment.

Yet, the Rogoff solution simply cuts through the long chase of the farcical rigmarole advanced by deflation proponents who use their repertoire of technical vernaculars of assorted “traps” to convey a deflation scenario. When worst comes to worst all these technical gibberish will simply evaporate.

Moreover, deflation proponents seem to forget that the Japan’s lost decade or the Great Depression from which Keynesians have modeled their paradigms had one common denominator: “isolationism”.

Japan’s debacle looks significantly political and culturally (pathological savers) induced, while the Smoot Hawley Act in the 1930s erected a firewall among nations which essentially choked off trade and capital flows and deepened the crisis into a Depression.

This clearly hasn’t been the case today, YET, see Figure 3.

Figure 3: US global: Global Central Banks Concertedly Cutting Rates

There had been nearly coordinated massive interest rate cuts this week by several key central banks; the Swedish Riksbank slashed its rates by nearly half, cutting 175 bp to 2%, followed by the Bank of England, which slashed rates by 100bp (last month it cut by 150 bp), while the ECB was the most conservative and cut of 75bp. Indonesia followed with 25 bp while New Zealand cut a record 150bp to 5% (guardian.co.uk).

And as we quoted Arthur Middleton Hughes in our Global Market Crash: Accelerating The Mises Moment!, ``the market rate of interest means different things to different segments of the structure of production.”

If the all important tie that binds the world has been forcible selling out of the debt deflation process, then as these phenomenon subsides we can expect these interest rate policies to eventually gain traction.

And it is not merely interest rates, but a panoply of distinct national fiscal and monetary policies targeted at cushioning such transmission.

Remember, even in today’s globalization framework, the integration of economies hasn’t been perfect and that is why we can see select bourses as Tunisia, Ghana, Iraq or Ecuador defying global trends, perhaps due to such leakages.

The point is there is no 100% correlation among markets and economies. And when the forcible selling (capital flow) fades, the transmission linkages will focus on other aspects as trade or remittances which have varying degrees of external connections relative to their national GDP.

Thus, considering the compounded effects of individual economies and their respective national policy actions, market or economic performances should vary significantly.

The idea that global deflation will engulf every nation seems likely a fallacy of composition if not a chimera.

Reviving Smoot-Hawley Version 2008?

Next, there is this camp agitating for a revised form of protectionism.

They accuse nations with huge current account surplus, particularly China, for nurturing trade frictions amidst a recessionary environment-by obstinately opting to sustain the present trade configuration which is heavily modeled after an export led capital intensive investment growth.

The recent surge of the US dollar against the Chinese Yuan and China’s recent policies of providing for higher rebate and removal of bank credit caps have been interpreted to as being implicitly protectionist.

The alleged risks is that given the slackening of aggregate demand, China’s export oriented growth model could pose as furthering the deflationary environment by dumping excess capacity to the world.

Echoing former accusations of currency manipulation, but in a variant form, the adamant refusal by China to reduce its export subsidies (via Currency controls etc.) at the expense of domestic consumption, is seen by critics as tantamount to fostering protectionism and thus, should require equivalent punitive sanctions.

Recessions are, as seen from the mainstream, defined as a broad based decline in economic activity, which covers falling industrial production, payroll employment, real disposable income excluding transfer payments and real business sales.

But recessions or bubble bust cycles are mainly ``a process whereby business errors brought about by past easy monetary policies are revealed and liquidated once the central bank tightens its monetary stance,” as noted by Frank Shostak.

In other words, when China gets implicitly or explicitly blamed for “currency manipulation” or for failing to adopt policies that “OUGHT TO” balance the world trade, it assumes that the US, doesn’t carry the same burden.

But what seems thoroughly missed by such critics is that the extreme ends of the current account or trade imbalances reflect the ramifications of the Paper-US dollar standard system. You can’t have sustained and or even extreme junctures of imbalances under a pure gold standard!

Besides, since the supply or issuance of currencies is solely under the jurisdiction of the monopolistic central banks, which equally manages short term interest rate policies or the amount of bank reserves required, then the entire currency market operating under the Paper money platform accounts for as pseudo-market or a manipulated market.

To quote Mises.org’s Stefan Karlsson, ``Any currency created by a central bank is bound to be manipulated. In fact, manipulating the currency is the task for which central banks were created for. If they didn't manipulate the currency, there would be no reason to have a central bank.” (underscore mine)

In addition, the fact that the US functions as the world’s reserve currency makes it the premier manipulator- for having the unmatched privilege to extend paper IOUs as payment or settlement or in exchange for goods and services.

We don’t absolve the Chinese for their policies, but perhaps, by learning from the harsh experience of its neighbors during the Asian crisis, the Chinese have opted to adopt similar mercantilist nature to protect its interest but on a declining intensity as it globalizes.

The point that Chinese authorities are considering full convertibility of the yuan, as per Finance Asia (emphasis mine), ``The Chinese authorities should raise the profile of the renminbi during the global financial turmoil and get ready for the currency’s full convertibility, according to Wu Xiaoling, deputy director with the finance and economic committee of the National People’s Congress”, or this ``Wu, who was a deputy governor of the People’s Bank of China (PBOC) until earlier this year, told a seminar in Beijing in November that the renminbi should become an international reserve currency in tandem with its full convertibility, reflecting a renewed interest in loosening control of the currency as the country becomes more deeply integrated in the world financial system. She said it was difficult to find an alternative reserve currency but added that the renminbi was ready to become an international currency to replace the dollar,” equally demonstrates the political thrust to gain superiority by becoming more integrated with the world via reducing mercantilist policies and adopting international currency standards.

But, unlike the expectations of our magic wand wielding experts, you don’t expect them to do this overnight.

Figure 4 Gavekal: China Reserves Outgrow China’s Trade Surplus & FDI

Also during the past years, China’s currency reserves didn’t account for only trade surpluses or FDI flows, but as figure 4 courtesy of Gavekal Capital shows, a significant part of these reserves could have emanated from portfolio or speculative flows even in a heavily regulated environment.

Thus, the recent surge of US dollar relative to the Yuan may not entirely be a policy choice but also representative of these outflows given the current conditions. The fact that China’s real estate has been decelerating and may have absorbed most of these speculative flows could reflect such dynamics.

Nonetheless Keynesians always focus on the aggregate demand when recessions or a busting cycle also means a contraction of aggregate supply.

Malinvestments as seen in jobs, industries or companies or likewise seen in supply or demand created by the illusory capital or “money from thin air” which would need to be cleared. Or when the excesses in demand and in supply are sufficiently reduced or eliminated, and losses are taken over by new investors funded by fresh capital, then the economy will start to recover.

Again Frank Shostak (highlight mine), ``Contrary to the Keynesian framework, recessions are not about insufficient demand. In fact Austrians maintain that people's demand is unlimited. The key in Austrian thinking is how to fund the demand. We argue that every unit of money must be earned. This in turn means that before a demand could be exercised, something must be produced. Every increase in the demand must be preceded by an increase in the production of real wealth, i.e. goods and services that are on the highest priority list of consumers (we don't believe in indifference curves).”

The point is whatever decline in aggregate demand also translates to a decline in capacity as losses squeezes these excesses out. Today’s falling prices may already reflect such oversupply-declining demand adjustments.

Said differently the calls to maintain or support “demand” by means of more government intervention aimed at propping up of institutions, which are not viable and can’t survive the market process on its own, isn’t a convincing answer. The pain from the adjustments in debt laden Western economies is also felt but to a lesser degree in Asian economies.

Likewise, imposing undue protectionist sanctions to suit the whims of such pious and all knowing experts, will likely have more unintended consequences, foster even more imbalances and or risks further deterioration of the present conditions.

Forcing China to radically reform, without dealing with the structural asymmetries from today’s fractional reserve banking US dollar standard, won’t resolve the recurring boom-bust cycles. This simply deals with the symptoms and not the cause.

China Slashes Rates, Shanghai Composite At Critical Juncture

Faced with grim prospects of dramatically decelerating economic growth (World Bank Projections have cut growth forecast from 9.2% to 7.5% for 2009), an alarmed China has opted to aggressively use its monetary policy.

According to a report from Bloomberg (highlight mine), ``China lowered its key lending rate by the most in 11 years, extending efforts to prevent an economic slump less than three weeks after unveiling a 4 trillion yuan ($586 billion) stimulus plan.

``The key one-year lending rate will drop 108 basis points to 5.58 percent, the People's Bank of China said on its Web site today. The deposit rate will fall by the same amount to 2.52 percent. The changes are effective tomorrow…

``The bank lowered the reserve requirement for the biggest banks to 16 percent from 17 percent, effective Dec. 5. The requirement for smaller banks will fall to 14 percent from 16 percent. The central bank also reduced the interest rate that it pays on reserves deposited by commercial banks to encourage lending.

chart courtesy of Dankse Bank: Lending and deposit rate (left), reserve requirement (right)

Yet additional measures are being considered, from the same Bloomberg report,

``Two hours after the rate cut, China's cabinet said it was studying extra measures to help struggling companies in the steel, auto, petrochemical and textile industries; to increase key commodity reserves; and to expand insurance for the jobless.

``The government will also push ahead with fuel-price and tax reforms to help boost consumption, the cabinet said. A fuel-price cut would be the first in two almost years. The government regulates energy prices to contain inflation, which fell to a 17- month low in October.”

Fundamentally, the global contagion is expected to impact China via the export channel (and via portfolio flows), albeit exports still managed to grow robustly by 19.2% last October, but down from last September’s 21% with trade surplus swelling to a record $35.2 billion on declining import growth. A CLSA survey recently showed that export orders have dropped to its lowest since 2004, which possibly indicates that exports have yet to reflect on the substantial decline with a time lag.

But the continuing slump in the real estate industry seems likely a bigger concern considering that many loans from the informal sector could surface or find its way into the balance sheets of the formal banking sector, and increase incidences of Non Performing Loans. This should translate to a significant weakening domestic investment as we previously discussed in China’s Bailout Package; Shanghai Index At Possible Bottom?, which the Chinese government aims to offset with a massive stimulus package.

But, it is our hunch that perhaps China’s markets have already priced in or have discounted much of these somber expectations considering the harrowing bear market losses of 72% (from peak to trough).

Unless, the world will yield to a depression, the recent lows could possibly mark a cyclical transition from a declining phase to a “bottom” phase.

China’s Shanghai index appears to be testing the 50-day ma resistance.

A successful breakout from this resistance level could serve as one of our confirmation metrics. Otherwise a failed breakout means a test of the recent lows.

Panics: Die of Exhaustion Or From Policy Overdose?

``Word to the wise - don't accept advice or analysis about this crisis from anyone who failed to anticipate it in the first place! The people warning about Depression now are the same reckless jackasses who told investors that stocks were cheap and “resilient” at the highs.”- John P. Hussman, Ph.D. Four Magic Words: "We Are Providing Capital"

Let me offer a non-sequitur argument: Because we could be destined for doom, we might as well bet on hope.

In other words, with so much of the prevailing gloom in the atmosphere this could, by in itself, possibly signify an end to the panic.

As Morgan Stanley’s Stephen Roach eloquently articulated in the International Herald Tribune (hightlight mine), ``The most important thing about financial panics is that they are all temporary. They either die of exhaustion or are overwhelmed by the heavy artillery of government policies.”

True enough, as we have always pointed out, doom or boom or market extremes have simply been accounted psychological phases of the market cycles.

Nevertheless, Mr. Roach uses the Professor Charles Kindleberger’s “revulsion stage” as a paragon for the possible panic endgame.

Professor Charles Kindleberger in Manias Panics, and Crashes A History of Financial Crisis identifies the phase as [p.15] ``Revulsion and discredit may go so far as to lead to panic (or as the Germans put it, Torschlusspanik, “door-shut-panic”) with people overcrowding to get through the door before it slams shut. The panic feeds on itself, as did speculation, until one or more of the three things happen: (1) prices fall so low that people are tempted to move back into less liquid assets: (2) trade is cut off by setting limits on price declines, shutting down exchanges or otherwise closing trading, or (3) a lender of last resort succeeds in convincing the market that money will be made available in sufficient volume to meet demand for cash.” (highlight mine)

While low prices and lender of last resort could likely be more pragmatic solutions, it is doubtful if the cutting of trades or closing exchanges will succeed in limiting the panic phase. As the recent examples of Indonesia and Russia manifested, temporary suspensions of bourse activities have not deterred the onslaught of a rampaging bear.

It would be more suitable for the markets to discover the price clearing levels required to set a floor than to applying stop gap solutions that only delays the imminent or worsens the scenario. Price controls rarely work especially over the long term and could lead to extreme volatility.

Nonetheless, with the successive coordinated barrage of heavy systemic stimulus by global central banks, possibly attempting to err on the side of a policy overkill, we might as well hope that 1) these efforts could somehow jumpstart parts of the global markets and or economies that have not been tainted by the US credit bubble dynamics or 2) that market levels could be low enough to attract distressed asset buyers which could provide the necessary support to the present levels.

While it likely true that the credit system in the US and parts of Europe have been severely impaired and will unlikely restore the Ponzi dynamics to its previous levels that has driven the massive buildup of such bubble, the most the US can afford is probably to buy enough time for the world economies to recover and pick up on its slack and hope that they can the recovery would be strong enough to lift the US out of the rut.

Divergences of Policy Approaches: Asia’s Market Oriented Response

One thing that has yet kept the world out of pangs of the 1930s global depression is that global economies have remained opened and that actions of policymakers have been constructively collaborative instead of protectionist.

Put differently, the world has been using most of its combined resources to deal with such a systemic problem. While such grand collaborative efforts may lead to the risks of huge inflation in the future, the scale of cooperation should likely diminish the menace of “deflationary meltdown”.

So while the US and Europe have closed ranks and concertedly used governments to assume the multifarious roles of “lenders of last resort”, “market makers of last resort”, “guarantors of last resort” or “investors of last resort” to shield its financial system from a downright collapse, Asia’s approach has been mostly “market-oriented”.

Some of the recent developments:

1) Taiwan removed foreign ownership restrictions or opened its doors to the global marketplace (Businessweek) encouraging overseas companies to list, aside from attracting potential foreign investors (particularly China’s resident investors) to participate in Taiwan’s financial markets.

2) Taiwan slashed estate and gift taxes from 50% to 10% (Taipei Times)

3) The Indian response: From the Economist ``On October 6th the Securities and Exchange Board of India removed its year-old restrictions on participatory notes (offshore derivative instruments that allow unregistered foreign investors to invest in Indian stockmarkets). The next day, external commercial borrowing rules were liberalised to include the mining, exploration and refining sectors in the definition of infrastructure. That raised the cap on overseas borrowing for companies in these sectors from US$50m to US$500m—although there may be little international money to borrow.” (highlight mine)

4) To cushion the effects of a global growth slowdown, China’s leaders are presently deliberating to allow its rural farmers to sell or trade state owned land rights and possibly also extending the tenure of land rights ownership from 30 to 70 years.

According to the New York Times, ``The new policy, which is being discussed this weekend by Communist Party leaders and could be announced within days, would be the biggest economic reform in many years and would mark another significant departure from the system of collective ownership and state control that China built after the 1949 revolution….Chinese leaders are alarmed by the prospect of a deep recession in leading export markets at a time when their own economy, after a long streak of double-digit growth, is slowing. Officials are eager to stoke new consumer activity at home, and one potentially enormous but barely tapped source of demand is the peasant population, which has been largely excluded from the raging growth in cities.”

So what could be the potential impact for such a major reforms to China’s rural population? See figure 4.Figure 4: Matthews Asia: China’s Rural and Urban Incomes

According to Matthews Asia, ``This reform is timely as a growing wealth disparity between China’s rich and poor is becoming a concern. China’s rural economy, despite representing over half of China’s population, has lagged behind urban economic development. The agriculture sector currently accounts for less than 12% of the nation’s GDP compared to 25% two decades ago. The top 10% of wealthy individuals command more than 40% of total private assets in the country. The impact of this reform is likely to benefit both the agricultural sector and rural areas by increasing agricultural investment and rural consumption. Enhanced rural standards of living should also help improve farm productivity and yields, important aspects for China to continue its self-sufficiency in grain production.” (highlight mine)

In other words, we shouldn’t underestimate the reforms undertaken by Asian governments out to achieve productivity advantages by tapping into market oriented policies while their western counterparts are presently burdened with restoring credit flows and in the future paying for the cost of such rescue missions.

Inflation As The Next Crisis?

So while the risks are real that the US banking sector could collapse and ripple to the world as global depression, the lessons from Professor Kindleberger shows that panics either exhaust itself to death or will likely get overwhelmed by an overdose of inflationary policies.

Basically all we have to watch for in the interim are the actions in the credit markets. So far we have seen some marginal signs of improvement, but not material enough to declare an outright recovery, see figure 5

Figure 5: Bloomberg: Overnight Libor (left), and TED spread (right)

Yes, markets almost always tend to overshoot, especially when driven to the extreme ends by psychology spasms, but ultimately credit flows are likely to determine the transitional shifts.

If credit markets do recover, market concerns will likely move from threats of a systemic meltdown brought about by “institutional or silent bank runs” to one of the economic impact emanating from the recent crisis.

Besides, the policymakers are likely to keep up with such aggressive pressures to reinflate the system and possibly engage the present crisis with a zero bound interest rate policy which basically adds more firepower to its various arsenals to combat deflation.

It isn’t that we agree to such today’s policy actions but it is what they have been doing and what they will probably do more under present operating conditions. This means that if they succeed in reinflating the system the next crisis would likely be oil at $200!

Figure 7: iTulip: Inflation Is The Menace

According to Eric Janzen of iTulip ``Since the international gold standard was abrogated by the US in 1971, ushering in the second era of floating exchange rates in 100 years – the last one ended badly as well – no deflation has occurred. Japan's experience with "deflation" would not show up on this graph because in no year since 1990 has deflation in Japan exceeded 2%.

“We continue to expect that the actions of central banks to halt deflation will, as usual, in the long run work too well.”

So hang on tight as the next few weeks will possibly determine if our doomsday emerges (and I thought they said that the scientific experiment of the Large Hardon Collider risks a true to life Armageddon) or if the impact from the inflationary overdrive of the collective powers of global central banks materializes.

Phisix: Back To The Global Divergence Mode

``In the short run, the stock market is a voting machine and long run is a weighing machine. Five years from now and 10 years from now we will see that we could have made some extraordinary buys. I do know that the American economy will do well, and that people that own a piece of it will do well. But they shouldn't do it on leverage, and that's what people have learned in this period. "-Warren Buffett (at a CNBC interview with Becky Quick)

Following the bloody carnage in the global equity markets during the previous week, the Phisix reverted to its “divergent” mode by recovering most of its losses. The Philippine benchmark was up by 5.46% over the week, even amidst a mostly dreary global outlook and was one of rare bright spots in the Asian market alongside Vietnam (+10.19%) and China’s Shanghai (10.54%).

What seems to have driven the Phisix to stoically climb to the upside, amidst the interim weakness in most of the global markets, has been an erosion of foreign selling. Curiously enough, we even saw select blue chip buying by foreign money, albeit they were seen sporadically selling over the broad market to account for a minor net inflow of Php 188 million over the week.

Of course one week does not a trend make. But as what we have been saying before, if the estimates of foreign liquidation relative to the previous years of inflows have been accurate, then the pressure from another round of AIG-type of forcible liquidation has probably peaked and should be declining. And if we continue to see this trend reinforced, then the threat from any future selling pressures is likely to emanate from local retail investors who are the easiest to be swayed or spooked by media reports. Thus, perhaps the diminishing trend of foreign selling plus future risks of “contagion dynamic” from local retail investors are likely to be indicative of the bottoming process we have long talking about. And a bottom process entails rangebound trading or gradual confidence building recovery.

As we have repeatedly argued, the Phisix doesn’t share the same problem with most of the world. In fact, the Phisix sorely missed out (or is it serendipitously?) the real estate boom during the last few years. The contagion linkage the Philippine has with the world is through the trade, remittances, the booby traps from toxic US instruments held by some financial institutions and financial flows.

One year into the crisis we have yet to see any material deterioration from these external channels. Ironically, what has sharply impacted the local economic growth data has been the “rising food and fuel” component or imported “cost push” inflation. With food and fuel prices down, the risk towards the extended impact from the latter influences could be seen as likely to diminish which in essence should support “growth”.

Albeit, with the recent jump of oil to above $100 ($106 as of Friday) had been mainly on the account of the weakness of the US dollar rather than from demand recovery as industrial metals and the Baltic Index continue to soften see figure 3. In other words, oil and gold have been the beneficiaries (safe haven?) of the growing anxiety over a massive scale of US intervention to rescue its financial system.

As this Bloomberg report avers (highlight mine), ``Domestic banks are cutting trading with international firms in the interbank market, according to Zhuang Zhiqiang, a trader at Xiamen International Bank Co., which is partially owned by the Asian Development Bank. The move aims to control risks after the bankruptcy of Lehman Brothers Holdings Inc. stunned domestic investors, said Zhao Qingming, an analyst in Beijing at China Construction Bank Corp., the nation's second-largest lender. We've turned more cautious,'' said Zhuang, who is based in the southern Chinese city of Xiamen. ``Bank officials are worried about settlement risks as the ongoing crisis has weakened people's trust in U.S. banks.''

Figure 3: stockcharts.com: US Dollar Driven Oil Rebound!

Now with some Asian countries beginning to tow the line of monetary policies directed at resuscitating growth, where according to a Bloomberg report, ``Taiwan cut borrowing costs on Sept. 25, joining China, Australia and New Zealand in easing the price of money this month,” we are likely to see some of these effects via a recovery in the second quarter of 2009 barring a crash of the US economy.

We just hope that our central bank will not get cowed by pressures from our politicians and to remain focused on fighting the “ravages of residual inflation” by continuing to tighten.

Fannie And Freddie Bailout Designed To Save The US Dollar Standard System

``Over the past few years, the Agencies were central to the process that brought the emerging world’s savings to the US housing market. And governments were involved every step of the way. When the world’s central banks (and other big bond investors) decided that the implicit US government backing for the Agencies wasn’t enough, the US government had to make the backing explicit.”-Brad Setser, Council of Foreign Relations, So true …

 

It was a highly volatile market out there this week.

 

The initial salvo was wild cheering from global equity markets on the recent action by the US Treasury to take its Government Sponsored Enterprise (GSE)-Fannie Mae and Freddie Mac- into “convervatorship” (quasi-nationalization). However, the festiveness quickly dissipated when the realities of “a weakening global economy”, the ramifications from the credit event of the F&F takeover on the Credit Default Swap Market and concerns over the persistent deterioration of US financial conditions as manifested by the lackluster capital raising quandary by Lehman Bros, which until recently, was the 4^th largest investment bank in the US, sunk into the consciousness of global investors which resulted to a retreat from most of the earlier gains.

 

The conservatorship program includes the taking over of management control of Fannie and Freddie (F&F) by its regulator the Federal Housing Finance Agency (FHFA), where common and preferred stock would be diluted and not eliminated. The takeover now alters the corporate objective of the GSEs to “improving mortgage financing conditions” from “maximizing common shareholder returns”.

 

The program also includes capital injection into the GSEs by US Treasury and FHFA to maintain the positive net worth of these agencies in order to fulfill its financial obligations, where in exchange the US Treasury receives “senior” preferred equity shares and warrants aimed at securing solvency.

 

Aside, a new credit facility designed to secure liquidity concerns will be introduced to backstop F&F and Federal Home Loan Banks, and which is set to expire on December 2009. Lastly, a temporary program will also be put in place to acquire GSE Mortgages in order to secure market liquidity of mortgage securities also slated to expire on December of 2009.

 

For starters, Agency securities are one of the world’s most widely held securities by both private and the public sectors (Sovereign Wealth Funds and Central banks).

 

Morgan Stanley’s Stephen Jen has a great breakdown on these (highlight mine),

 

`` Total foreign holdings of long-term USD securities increased from US$7.8 trillion in 2006 to US$9.8 trillion in 2007, with US$1.3 trillion of this annual increase from increased foreign holdings of US long-term debt securities, including US Treasuries, agencies, agency ABS and corporate bonds.  Foreigners are dominant in some of these markets.  For example, some 57% of the marketable Treasury securities are held by foreign investors. 

 

``Foreign investors’ appetite for US agencies – both straight agency debt and agency-backed ABS (also called agency pass-throughs) – has risen sharply.  (Fannie Mae and Freddie Mac (F&F) are government-sponsored enterprises (GSEs) with two main activities.  First, they securitise mortgages by converting conforming mortgage loans into tradable mortgage-backed securities (MBS).  Second, they have an ‘investment portfolio’ business, whereby they issue AAA rated agency debt to finance the holding of MBS or other assets.  The latter is a ‘carry trade’, capitalising on the then-implicit government guarantee.  One key part of the policy discussion regarding F&F is whether their second activity is justified.)   Of close to US$7.5 trillion in outstanding US agency debt and agency-backed ABS, some US$1.54 trillion (according to Fed flow of funds data, June 2008) is held outside the US, with China, Japan and AXJ being the largest holders of these securities, with US$985 billion of this latter figure held by foreign central banks. (The share of total US long-term securities held by foreign investors has more than doubled since 1994 (from 7.9% of the US$16 trillion in securities back then to 18.8% of the US$49 trillion outstanding as of 2007).” 

 

We featured a chart on the composition of foreign holdings of the F&F in Inflation: Myths And Beneficiaries. Nonetheless, private ownership of Agency backed papers appears to have stagnated since 2005 while foreign public ownership has steadily increased as shown in Figure 2.

Figure 2: Northern Trust: Foreign Public-Private Exposure On F&F

 

In perspective, aside from foreign holdings GSE debt securities are likewise owned by US households and institutions or financial entities as commercial banks, savings banks, credit unions, pension funds, life insurance companies mutual funds, brokers, ABS issuers and REITs.

 

However, as % of total outstanding debt, in 2007 ownership of GSE debt in pecking order: foreigners comprise 19.92%, followed by commercial banks 13.87%, households 12.06%, mutual funds 7.67% and ABS 5.13% (Northern Trust).

 

So when US Secretary Paulson was asked of the US government’s takeover of F&F, his reply as quoted by the Washington Post,

 

``"The U.S. government had no choice," he said.

 

``Mr. Paulson, in an interview with CNBC on Monday, said foreign pressure was not the "major driver" of the takeover, but acknowledged that "there's no doubt that there's fragility in the capital markets."

 

``"These companies are so big, and they are owned by investors all around the world. You are obviously going to get concerns," Mr. Paulson said. "It was definitely concerning overseas, but there was concern in this country. I tell you, my phone is ringing the most from investors here." 

 

This means the US financial system have reached a near calamity. 

 

However many had been quick to lash at the “conservatorship” program as virtually a bailout of foreign owners of agency securities.

 

While this perception seems partly correct, I think most of these critics ignore the fact that these actions basically signify a remedial patchwork to the emerging cracks at the Fiat Paper Money “US Dollar” standard system. The massive current account imbalances a common feature in today’s world tends to amplify on the systemic flaws especially amidst today’s heightened volatility.

 

At present, countries with current account surpluses at one side of the ledger need to be offset by countries with current account deficits at the opposite side. As an example, deficits of the US have been more than sufficiently covered for by capital flows from mostly emerging markets paving way for the unorthodox pattern of “Poor countries Financing The Rich”.

 

Yes, while various politicians and experts from around the world have boisterously decried about “social inequality”, unknowing to most is that such inflationary “inequality” mechanism appears to be the imbedded on the US dollar standard platform. Think of it, while profits are privatized, losses are socialized! Wall Street’s politically connected gets rescued, while the masses pay for the mess created by the former. The failed F&F model was demonstrative of the Keynesian brand of capitalism and not of the laissez faire genre. (Please don’t associate the fiat paper money standard as epitomizing laissez faire or free markets too. Same with currency markets, interest rate markets or even oil markets! These markets are controlled heavily by governments notably on the supply side. As an aside, the “anarchy” in the Shadow Banking System wasn’t symptomatic of a free market mess, but one of going around banking regulations or taking advantage of “regulatory loopholes” in order to take on added leverage by assuming more risk to magnify returns by the establishment of off-balance sheet Structured Investment Vehicles (SIV). Going around loopholes do not signify free market paradigms).

 

Going back to the unorthodox pattern of “Poor countries Financing The Rich”, during the gold standard, current account imbalances had effectively been curtailed by the shifts in the gold reserves by nation states engaged in trade. This essentially accounted for as an automatic adjustment mechanism, which is absent today under the digitalized and unlimited printing capabilities of central banks to churn out money “from thin air”.

 

And as we noted above, current account imbalances today need to be offset. During the recent past, the nations with current account surpluses signified as subsidies to domestic export-oriented industries but came at the expense of domestic consumers, i.e. China, Asia and other emerging markets. On the other hand, current account deficit nations run subsidies on domestic consumers via expanding domestic debt (financed by current account surplus countries) at the expense of domestic production. From which the transmission mechanism had been mainly via currency pegs or dollar links.

 

The foreign buying of agency papers or US debts were meant to sustain mercantilists’ policies by frontloading currency and interest rate risks in order to keep the exchange rate undervalued and thus promote domestic export oriented industries in order to expand employment. Hence, the currency manipulation policies that led to the current account imbalances had primarily been meant as a tool to manage domestic political risks.

 

In other words, the US dollar standard system paved way for political imperatives over economic goals, see figure 3.

Figure 3: Asianbondsonline.com: China-US yield curve

 

What sense would it make for a current account surplus country as China to buy or load up on assets of a depreciating currency, thereby suffer from currency loss? What sense too for current account country as China to buy assets whose yield is less than what is offered domestically, thereby suffer from opportunity cost of low interest rate spreads (assuming holding bonds until maturity)? And this has been going on for years!

 

The same for deficit countries, domestic consumers had been financed to go into a debt driven asset buying binge which resulted to overleveraged driven massive speculation, again for political goal of sustaining finance driven economic booms, where the demand from domestic consumption boom has greased the industries of current account surplus countries as China and emerging countries.

 

The US dollar, functioning as the world’s de facto currency reserve currency, has fundamentally been used by the US government to freely load up on debt, given its special privilege to underwrite from its own currency, by selling almost unlimited financial claims to international investors to finance such speculative unsustainable booms.

 

And as the US real estate and financial boom has basically unraveled, all these seem to be in a transition.

 

Recently there had been some signs of reluctance of nations with current account surpluses to stack up into agency papers. Of course, the recent actions by the US Treasury may seem to have assuaged the concerns of repayment by buying more into US treasuries instead of agency papers.

 

So what can we see from all these?

 

One, current account surpluses nations or foreign central banks seem to have the tolerance bandwidth, given their accrued currency reserves, to suffer from the risks of currency and interest rate losses provided they get repaid for holding these securities until maturity. I guess the actions by the US treasury may have answered such “repayment” concerns.

 

Two, foreigners which have been formerly financing the US real estate securitization boom appears to be bailing out, if not help tacitly ‘nationalize’ the structurally beleaguered industries by buying into agency papers until recently.

 

It also reveals of the extent of overdependence or vulnerability of the US on relying on foreign financing. The risk seems such that if foreign central banks or state owned Sovereign Wealth Funds or affiliated institutions would deem to have accumulated more US dollar reserves than what they might think is required, and change their priorities by reducing finance exposure to the US, which can even lead to more volatility in the US. Political factors can also hold sway to the appetite of foreign financing of US deficits.

 

In addition, understanding its present predicament and limitations, the “capital short” US government seems to be working feverishly to attract or to intermediate for foreign capital participation into buying out its besieged financial institutions. Example, a syndicate led by UK’s 3^rd largest bank, Barclay’s along with a “club rescue” team of “Temasek of Singapore and China Development Bank, was reportedly have shown willingness to back a deal that would put Barclays in the top tier of financial institutions.” (timesonline.co.uk)

 

Three, it’s all about the increasing integration of geopolitics or the decreasing hegemony of the US, as seen in the “Poor financing the Rich” aside from “Autocratic and non-democratic states financing democratic countries”!

 

Some Poor but Autocratic/non democratic nations that have been a beneficiary to the ongoing wealth transfer appear to have accumulated enough political clout as to weigh on the internal political policymaking of the US. 

 

Remember this quote from Yu Yongding, a former adviser to China's central bank quoted last in our Will King Dollar Reign Amidst Global Deflation? ``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic, if it is not the end of the world, it is the end of the current international financial system.” The recent political actions employed by the US government appeared to underscore such circumstances and Mr. Yu’s prayers seems to have been answered.

 

Or how about Russia’s recent military offensive against Georgia (as discussed in Toynbee’s Generational War Cycle: In Mindanao or In Georgia/South Ossetia?) which has practically left the US as a political nonparticipant to a besieged ally?

 

This only goes to show how the US looks to be losing its imperial edge over the global geopolitical economy and how the US dollar standard system appears to be in greater jeopardy.