Chart of the Day: Is China Suffering from a Credit Crunch?

The Pragmatic Capitalist quotes a Nomura Study of what seems to be a simmering volcano waiting to explode

In order to understand better how serious the problem is, we monitor the bill discount rate, which is the financing cost for firms when they sell commercial acceptance bills to banks for cash. A higher bill discount rate is a signal that the imbalance between supply and demand for credit has worsened. The 6-month bill discount rate has worsened at alarming pace since 2011, rising to above 10%.

The gap between the bill discount rate and the interbank rate has widened to 5.7 percentage points, the highest level since the data was made available. China’s credit market is becoming more fragmented. Financing costs for firms without access to bank loans have risen much more than those for large state owned enterprises. The sharp rise in the bill discount rate may be partly driven by property developers who are facing worsening financing conditions given the lackluster sales.”

These indicators: China’s Bill discount rate and the Shanghai Interbank Offered Rate (SHIBOR) should be one very important indicator to watch

Interest Rates As Key To Stock Market Trends

``Credit expansion can bring about a temporary boom. But such a fictitious prosperity must end in a general depression of trade, a slump.” Ludwig von Mises

As we have long reiterated, the main driver of the financial assets isn’t economic growth nor is it about earnings but mainly about monetary inflation and credit.

Well it appears that the prominent mainstream research company McKinsey Quarterly somewhat shares our view (see figure 3)

Figure 3 McKinsey Quarterly[1]: Watch For Credit Conditions

Tim Koller of McKinsey writes that the stock markets are not reliable economic indicators of the economy (left window), ``While the equity markets may not predict economic trends well, their depth does provide investors with liquidity, so they generally continue to function smoothly even in difficult times.”

And importantly, Mr. Koller identifies credit conditions as the chief mover of the economy and of the financial markets: ``The credit markets are where crises develop—and then filter through to the real economy and drive downturns in the equity markets. Indeed, some sort of credit crisis has driven most major downturns over the past to 40 years.” (see right window of chart)

And four common patterns of credit crisis cycles can be observed: yield curve inversion and the freezing up of the debt markets, marketplace illiquidity, bandwagon effect on the industry participants and enlarged risk appetite out of the expectations that governments will provide support (moral hazard problem).

And naturally the common symptoms of a blossoming bubble would be loose lending standards, unusually high leverage and what Mr. Koller calls as “transactions without value” or euphemism for outrageous valuations, which are rationalized as the new paradigm.

Interest Rate Manipulation Fuels Imbalances

In reality, credit conditions are hardly shaped by free markets, otherwise boom bust conditions would largely be limited in scale and in duration. Instead, as a major policy tool used by central banks, interest rates are mainly used to perpetuate boom conditions, mostly based on political considerations.

As the great Professor Ludwig von Mises described of the Business or Trade cycle fostered by central bank manipulation of interest rates[2],

``The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as "suppliers" of additional credit, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention. The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought "profitable" if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found "profitable" and can be initiated.”

In short, artificially tampering of interest rates leads to an unnecessary pile up in systemic leverage along with massive malinvestments which also drives up valuations of securities or assets to extreme levels.

Of course the market psychology here is to rationalize such actions as being warranted to the prevailing conditions, when they genuinely account for “flaws in perception” as billionaire George Soros rightly identifies[3], or a false sense of reality brought about by distorted incentives.

Yet in order to maintain these lofty levels would require constant infusion of fresh credit at far larger scale than the former.

Figure 4: Economic Slowdown and Quantitative Easing (chart from Danske Bank[4])

We seem to be seeing this episode playout today with renewed clamor[5] and the growing expectations by the mainstream for the US Federal Reserve to implement Quantitative Easing 2.0 on escalating fears of a global economic relapse (see figure 4 right window) by further pushing down interest rates.

Market expectations of the realization of the Federal Reserve’s QE 2.0 have thrashed the US dollar (left window), even as US treasury yields fall!

Even the resurgence of Ireland’s debt woes have failed to bolster the US dollar relative to the Euro. The rising Euro seems to validate our earlier prediction in contrast to mainstream expectations, but appears to have overshot our target[6].

So we have now a phenomenon outside or opposite to what had occurred in 2008, where a rally in US treasuries coincided with a rally in the US dollar.

And this should be a prime example of how past performances or patterns do NOT repeat.

Unravelling Of The Business Cycle

However, artificial suppressed rates can last only for so long.

Since resources are scarce and where interest rate manipulation essentially diverts massive amount of resources and labor into unproductive speculative activities, the increased demand for resources are eventually reflected on the price levels.

The current run-up in most prices of commodities[7] seem to be manifesting symptoms of the Austrian business cycle theory at work.

Eventually the whole artifice unravels with a bubble bust or with a destruction of the currency system if central banks persist to inflate.

Again Professor von Mises,

``This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in. No one wants to keep his money, because its possession implies greater and greater losses from one day to the next; everyone rushes to exchange money for goods, people buy things they have no considerable use for without even considering the price, just in order to get rid of the money....

``If, on the contrary, the banks decided to halt the expansion of credit in time to prevent the collapse of the currency and if a brake is thus put on the boom, it will quickly be seen that the false impression of "profitability" created by the credit expansion has led to unjustified investments. Many enterprises or business endeavors which had been launched thanks to the artificial lowering of the interest rate, and which had been sustained thanks to the equally artificial increase of prices, no longer appear profitable. Some enterprises cut back their scale of operation, others close down or fail. Prices collapse; crisis and depression follow the boom. The crisis and the ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit.

Therefore, it has been long contention of mine that the interest rates and market psychology working as a feedback loop mechanism ultimately sorts out the phases of the business cycle.

---

[1] Koller, Tim A better way to anticipate downturns, McKinsey Quarterly

[2] Mises, Ludwig von The Austrian Theory of the Trade Cycle

[3] Soros George, The Alchemy of Finance p.58

[4] Danske Bank, Currency Debate Heats Up, October 8, 2010

[5] Los Angeles Times Blog More Fed help for economy now just a matter of time October 8, 2010

[6] See Buy The Peso And The Phisix On Prospects Of A Euro Rally, June 14, 2010

[7] See Commodity Inflation, October 8, 2010

Video: Crisis of Credit Visualized

Nice presentation of the credit crisis. HT: Justin Ptak Mises Blog

The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

Credit Spreads: Some Improvements But Not Enough

The global banking credit crunch has triggered many liquidity problems, aside from unmasking some insolvency and balance sheet vulnerabilities across countries and companies or in both the public and private sector around the world.

Notably we see some improvements, although still far from the norm.

All charts from Bloomberg.

Euribor 3 months...

TED Spread...
Hong Kong dollar Hibor...

3 month Libor-OIS Spread...

BBA Libor USD 3 months...

Federal Reserve Bank of Minneapolis: What Credit Crisis?

This financial crisis has painted a popular view that our economic and financial world seems careened towards perdition; largely underpinned by the blowup in the securitization markets and a freeze in the credit markets. And such is the reason why global governments have united to supposedly provide the intensive care treatment needed to avert a systemic meltdown.

Ironically, what the US Federal Reserve and the US Treasury have been saying runs counter to the insights of the Federal Reserve Bank of Minneapolis. The US government says the system is in danger which requires massive intervention while the Minneapolis implies that there is no systemic threat.

V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe in a recent working paper “Myths about the Financial Crisis of 2008” (HT: Mike Moffatt About.com) disputes much of the woes aired by the experts and the financial press.

From Chari, Christiano and Kehoe,

``Clearly, the United States and the world economy are undergoing a major financial crisis. Interbank borrowing and lending rates have risen to unprecedented levels relative to U.S. Treasury Bills. Several major financial institutions have failed. These real problems have also been associated with four widely-held myths about the nature of the financial crisis and the associated spillovers to the rest of the economy. The financial press and policymakers have made four claims about the nature of the crisis.

1. Bank lending to non financial corporations and individuals has declined sharply.

2. Interbank lending is essentially nonexistent.

3. Commercial paper issuance by non.nancial corporations has declined sharply and rates have risen to unprecedented levels.

4. Banks play a large role in channeling funds from savers to borrowers.”

The Federal Reserve Bank of Minneapolis presents the following charts…

While volume transactions of commercial paper fell dramatically, the non financial market seems to remain buoyant.

Meanwhile 90 day commercial paper rates have zoomed.

Our comment:

On the surface it would appear there hasn’t been much of the dislocation in the credit markets. But if one takes into account the spikes of Interbank 5A, commercial and Industrial loans 3A, Bank Credit 1A and Loans and Leases 2A, they seem coincidental with the US Federal Actions. Perhaps much of the recent gains in these credit activities could have been influenced by Fed policies.

Another possible factor for a spike in the loans is that the compressed activities in the commercial paper market could have prompted corporations to tap their revolving credit lines instead. Or perhaps consumers have used more of the credit card to sustain consumption patterns.

Nonetheless, if the present crisis is viewed from the angle of the US Federal Reserve’s Balance Sheet, the change of its composition and its rapid expansion implies that the crisis isn’t a myth. Chart courtesy of by Federal Bank of Atlanta.

Such dissonance could imply of the concentration of risks in the US banking system to a few but large heavily affected institutions.

As Christopher Whalen (HT: Craig McCarty) of the Institutional Risk Analytics observes, ``Despite grim macro outlook for US economy, most smaller banks in the US are in good shape. While losses will rise for the banking industry as a whole, smaller banks up through large regional institutions have the capital to absorb losses and continue during business. Top five institutions are where the assets are concentrated and the loss rates will be higher as the credit cycle peaks in Q1-2 of 2009.”

Lastly if it is true that today's crisis is a myth then why the need for all these coordinated and intensive intervention? Perhaps to save Wall Street?

News from The 1990s Foretold of this Crisis

Debating who had been responsible for this crisis can take lots of academic vernacular to support or debunk the premises.

But we don’t need it.

By looking at the past, we can note that some news reports during the ‘90s appear to have actually “sensed” or predicted today’s fateful occurrence.

This excerpt from an LA TIMES article…

Minorities’ Home Ownership Booms Under Clinton but Still Lags Whites’

By Ronald Brownstein May 31, 1999

``All of this suggests that Clinton’s efforts to increase minority access to loans and capital also have spurred this decade’s gains. Under Clinton, bank regulators have breathed the first real life into enforcement of the Community Reinvestment Act, a 20-year-old statute meant to combat “redlining” by requiring banks to serve their low-income communities. The administration also has sent a clear message by stiffening enforcement of the fair housing and fair lending laws. The bottom line: Between 1993 and 1997, home loans grew by 72% to blacks and by 45% to Latinos, far faster than the total growth rate.

``Lenders also have opened the door wider to minorities because of new initiatives at Fannie Mae and Freddie Mac–the giant federally chartered corporations that play critical, if obscure, roles in the home finance system. Fannie Mae and Freddie Mac buy mortgages from lenders and bundle them into securities; that provides lenders the funds to lend more.

``In 1992, Congress mandated that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers. Operating under that requirement, Fannie Mae, in particular, has been aggressive and creative in stimulating minority gains. It has aimed extensive advertising campaigns at minorities that explain how to buy a home and opened three dozen local offices to encourage lenders to serve these markets.

``Most importantly, Fannie Mae has agreed to buy more loans with very low down payments–or with mortgage payments that represent an unusually high percentage of a buyer’s income. That’s made banks willing to lend to lower-income families they once might have rejected…

``The top priority may be to ask more of Fannie Mae and Freddie Mac. The two companies are now required to devote 42% of their portfolios to loans for low- and moderate-income borrowers; HUD, which has the authority to set the targets, is poised to propose an increase this summer. Although Fannie Mae actually has exceeded its target since 1994, it is resisting any hike. It argues that a higher target would only produce more loan defaults by pressuring banks to accept unsafe borrowers. HUD says Fannie Mae is resisting more low-income loans because they are less profitable."

From the New York Times article by Steven Holmes Fannie Mae Eases Credit To Aid Mortgage Lending, September 30, 1999

``Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

“In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the saving and loan industry in the 1980’s.

“‘From the perspective of many people, including me, this is another thrift industry growing up around us,’ said Peter Wallison a resident fellow at the American Enterprise Institute. ‘If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.’”

Hat tip Prieur Du Plessis

As author Steven Landsburg reminds us, ``Most of economics can be summarized in just four words: People respond to incentives. The rest is commentary." (Hat tip Mark Perry )

Wall Street's Agenda Seem to Dictate on US and Global Policies!

When faced with strong political pressures from the ongoing disorders of social, economic or financial nature, as we said, it is NEVER a question about governments NOT doing anything, but a question public expectations on the outcome of such actions.

Despite the passage of the $850 billion Emergency Economic Stabilization Act (yes Virginia, additional $150 billion on added porks! From Congressman Ron Paul ``In fact, it wasn't until the Senate had a chance to load it up with even MORE spending, when it was finally inflationary and horrible enough, at $850 billion instead of a mere $700 billion, that it passed – and with a comfortable margin, in spite of constituent calls still coming in overwhelmingly against it. 57 members switched their vote!” How Pork Barrels can easily switch votes is not only a Philippine phenomenon but elsewhere like in the US too!), markets continued to display brutal rioting yesterday and today.

So the Fed came up with even more actions; it doubled its auctions of cash lending to banks to as much as $900 billion, announced the changes in debt issuance which reintroduced 3 year notes and began implementing the paying of interest in bank reserves (Bloomberg).

Nonetheless pressures from various influential quarters of Wall Street “suggesting” to them on how to solve the problem. Example, William Gross of Pimco recently wrote, ``We believe that the Federal Reserve must now act as a clearing house, guaranteeing that institutional transactions clear (and investors receive) their Big Macs at the second window. They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past.”

From the New York Times today (emphasis mine), ``Under a proposal being discussed with the Treasury Department, the Fed could buy vast amounts of the unsecured short-term debt that companies rely on to finance their day-to-day activities, according to officials familiar with the discussions. If this were to happen, the central bank would come closer than ever to lending directly to businesses.

``While the move would put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has virtually dried up.”

Nonetheless as the Bernanke's FED and Paulson's US Treasury deliberate on agreeing into Wall Street's formula to further use taxpayer money to thaw the frozen credit markets, Australia's central bank cut its interest rate benchmark by one percentage point to 6 percent from 7 percent signifying ``the biggest reduction since a recession in 1992, to cushion the nation's economy against fallout from a global credit freeze." (Bloomberg).

Most likely both the "suggestions" of lowering interest rates and FED buying of commercial paper will be effected with the former being a "common policy" adopted by most embattled OECD economies.

It's funny how global policymakers seem to tow the line of Wall Street's elixirs when the latter haven't been able to resolve their own problems, to borrow Kenneth Rogoff's quote on the bailout enactment, ``the central conceit is that government ingenuity can disentangle the trillion-dollar “sub-prime” mortgage loan market, even though Wall Street’s own rocket scientists have utterly failed to do so."

This basically serves as an example of regulatory capture where "a government regulatory agency created to act in the public interest instead acts in favor of the commercial or special interests that dominate in the industry or sector it is charged with regulating." (wikipedia.org )

Hopefully if the US government decides to abide by the recommendations of Wall Street despite the conflict of interest issues, global markets will finally embrace this for good.

Media Sentiment: The US is in a Depression! Warren Buffett Buys!

The US is in a DEPRESSION! That’s if we are to measure depression in the context of FEAR than the actual economic depression itself!

According to the Economist, ``MANY comparisons may be made between the devastation being wrought on America's financial system today and the Wall Street crash of 1929. One similarity that the world is desperate to avoid is a repeat of the depression of the 1930s. Hopes are pinned on the American bail-out plan that the House of Representatives is set to reconsider on Friday October 3rd. If the fear of depression is anything to go by, the future looks bleak. A survey of newspaper articles over the past two decades shows a sharp spike in mentions of the dreaded D-word, as commentators have started to think the worst. The prognostications may possibly turn out to be true, or perhaps the only thing we have to fear are the fears of journalists themselves.” (underscore mine)

Courtesy of the Economist

Growing fears of “A Mother of All Banking System Run” or its downright collapse emanating from the unresolved gridlocked in the global credit markets have aggravated such an outlook, compounded with the rapidly deteriorating economic environment.

Even Warren Buffett, the world’s most successful stock market investor, acknowledges part of this anxiety and analogizes the present conditions to one of the US Economy lying "flat on the floor” and undergoing a “Cardiac Arrest”.

In a recent CNBC interview with Charles Rose, Mr. Buffett said,

``Paramedics have arrived…and they shouldn't argue about whether to put the resuscitation equipment a quarter of an inch this way or a quarter of an inch that way, or they shouldn't start criticizing the patient because he didn't have blood-pressure tests.” In reference to his advancement of the bailout package, which was recently approved by the US Congress.

He relates the impact of the credit crunch as ``sucking the blood out of the economic body of the United States”.

Anyway, the Mr. Buffett in apparent empathy with the US, ``In my adult lifetime, I don't think I've ever seen people as fearful, economically, as they are right now….They are not wrong to be worried.''(highlight mine)

Plainly said, the fear the US faces from the present risks environment seems justified, although Mr. Buffett believes that these presents itself as opportunities from which to profit over the long term, ``The prices make a lot more sense now…You want to be greedy when others are fearful and you want to be fearful when others are greedy.''

A classical Mr. Buffett act.

From our end, we understand this as nothing really new.

Boom and Bust always bring about attitudinal change. Inflation is followed by deflation. Greed turns to Fear, Panic and ultimately to depression. Aggressive risk taking morphs into morbid aversion to risk. Generosity turns into frugality. Profits segue into losses. Debt level falls. Collateral values fall. The negative feedback loop of margin calls from reduced collateral values reinforces downward price spirals on asset values. Company Balance sheet shrinks. Unemployment rises. Conspicuous consumption shifts into consumption based on necessities. People’s time references are lowered. Real currency values rises as people and corporations hoard cash. Government fiscal deficits rise as rescue efforts mount or as contingent liabilities are realized as losses. Zero savings can mean more savings. Current account deficits could become surpluses. So what else is different?

Eventually most of the malinvestments and excess levels of gearing or leverage will be reduced to the point where the economy affords them. All these take time. But the adjustments won't be painless.

It’s what history has repeatedly shown. It’s what all cycles are all about. It’s the nature of human beings, especially when misdirected decisions have been impelled by policy incentives that lead to such behavior.

Besides, is this not the essence of capitalism: Profits and losses? We can't say capitalism is purely a one way street of profits, while loses need be socialized. That's the Keynesian brand of capitalism. And that's what has got us into this in the first place.

As US President Franklin D. Roosevelt in his First Inaugural Address on a Saturday of March 4, 1933 ``So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”

While there is nothing to fear but fear itself, eventually there will be a resolution to the crisis as it always had been. It's not the end of the world as we know it. Although we are hopeful that in learning from history we could avoid taking on the similar paths that would risk actualizing these fears.

Testing the Banking System’s Resilience: Deposit Insurance Coverage

Previously the conventional thinking was that the banking system signified as the ultimate bulwark of money. While people basically trusted banks because of their faith over governments (implied guarantees), many fail to realize that such government authored cartelized system, which centered on the powers emanating from central banks, are not foolproof and are likewise subject to incompetence or abuse-whose constant manipulations of the market can be equally disruptive-and thus, lead to a loss of faith or specifically a RUN.

BCA Research: Credit Markets Remain Jittery

The continuing tremors in the banking system, as indicated by the intensified stress in the credit markets (see BCA Research chart above), which has fundamentally emanated from the bubble bust in the US, has rippled almost internationally and has most importantly began to raise questions about the sanctity and integrity of the current operating monetary platform-the Paper money standard.

As the system remains besieged from its self-inflicted ordeal, it is everyone’s task to ensure of the security of their deposits via the institutionalized deposit insurance coverage or a safety net (guarantee) provided by government institutions to depositors in order to promote financial stability.

From the Economist

According to the Economist, ``AS BANKS tumble like skittles, customers across the world are eyeing their cash nervously. Savings are protected in around 100 countries, with varying degrees of generosity. Those spooked by a run on a bank in Hong Kong this month may have been particularly nervous because only HK$100,000 ($12,860) of their cash is protected, including interest. Ireland has recently extended its limit from €20,000 ($29,337) to €100,000, to reassure savers. In America the first $100,000 is guaranteed for each depositor at each bank, while Britain's savers are limited to £35,000 ($64,650) in one institution, although an increase is expected soon. It is not only a matter of how much is protected, of course, but also of how quickly and easily the savers would get it back.” (highlight mine)

Of course, the other alternative is to own precious metals.

Incredible Pictures: The World In A State of Panic!

September 17-18 should be a milestone of sorts as world markets freezes in panic.

This From Bloomberg,

``U.S. Treasury three-month bill rates dropped to the lowest since at least 1954 on concern that credit market losses will widen after the bankruptcy of Lehman Brothers Holdings Inc. and the federal takeover of American International Group Inc.

``Investors pushed the rate as low as 0.233 percent as the loss of confidence in credit markets deepened. Reserve Primary Fund, the oldest U.S. money-market fund, became the first in 14 years to expose investors to losses after writing off $785 million of debt issued by Lehman.

3 month US Treasury Bill

Everyone (public and private entities) seem to be scampering for the exit doors to the point of buying short term treasuries that almost yield nothing.

Yet, one sided trades like this are vulnerable to sudden sharp reversals.

London-Interbank Offered Rate - British Bankers Association Fixing for US Dollar.

Bank Lending in terms of Libor. Again from Bloomberg, ``Money-market rates jumped this week as lending between banks seized up. The London interbank offered rate, or Libor, that banks charge each for three-month loans rose the most since 1999, to 3.06 percent, the British Bankers' Association said.”TED Spread

Seen from spread of Treasuries relative to bank lending rates, another quote from Bloomberg, ``The difference between what the U.S. government and banks pay to borrow in dollars for three months, the so-called TED spread, widened to the most since the October 1987 stock-market crash as bill yields tumbled. The spread widened as much as 64 basis points to 283 basis points. It was as low as 75 basis points on May 27.” Awesome.

This credit seizure episode has now spilled over to Asia!

Again from Bloomberg,

``Credit-default swap indexes in Australia and Asia outside Japan traded at all-time highs after the cost to protect against a default by Morgan Stanley and Goldman Sachs Group Inc. rose to records in New York yesterday. Default swaps rise as perceptions of credit quality deteriorate…

``The Markit iTraxx Australia Series 9 credit-default swap index traded 40 basis points higher at a record 235 basis points today and was at 225 basis points at 12:15 in Sydney, JPMorgan Chase & Co. prices show…

``The Asian benchmark that tracks 50 investment-grade borrowers outside Japan jumped as much as 30 basis points to a record 240, ICAP Plc prices show. The Markit iTraxx Japan index increased 31 basis points to 200 according to prices from Morgan Stanley…

MSCI Asia Pacific Index

So it does not put a doubt that credit woes have likewise tainted other assets as Asian equities seen above.

The MSCI Asia Pacific Index have fallen to a three year low!

Relative Economic Growth, Lack of Access to Capital and Global Depression

``With greater wealth comes greater responsibility. This is inescapable. Wealth has a social function. If you own something, you must make decisions about how to use it. Consumers are always bidding for either ownership or the use of your assets. Ownership therefore has a price. If you do not respond to the offer, you are paying this price. You are paying the price in the form of forfeited opportunities. Whatever you do with the wealth, you could be doing something else with it. You cannot escape the responsibility of not doing something else with whatever you own.”-Professor Gary North, Honeymooner Politics

It can’t be an argument from the economic growth perspective too…

Figure 6: IMF: WEO Presentation: Economic growth decelerates Around the Globe

Even as global economic growth has moderated to 4 ½ in the first quarter of 2008 down from 5%, such growth clip is expected to decline further to 4.1% in 2008 and 3.9% in 2009, according to the IMF.

From the IMF’s World Economic Outlook update (emphasis mine),

``Growth for the United States in 2008 would moderate to 1.3 percent on an annual-average basis, an upward revision to reflect incoming data for the first half of the year. Nevertheless, the economy is projected to contract moderately during the second half of the year, as consumption would be dampened by rising oil and food prices and tight credit conditions, before starting to gradually recover in 2009. Growth projections for the euro area and Japan also show a slowdown in activity in the second half of 2008.

``Expansions in emerging and developing economies are also expected to lose steam. Growth in these economies is projected to ease to around 7 percent in 2008–09, from 8 percent in 2007. In China, growth is now projected to moderate from near 12 percent in 2007 to around 10 percent in 2008–09.”

In short, despite the moderating pace, the economic growth differentials are still tilted towards in favor of emerging market economies (see left pane in Figure 6).

Moreover, we can hardly buy the arguments from the deflationist proponents of a world depression or near depression see figure 7.

Figure 7: ADB: Asia’s Household Indebtedness

ADB’s data shows of the dearth of leverage or indebtedness of the household sector, which reinforces our supposition of the insufficient access to the banking system by a large segment of the Philippine economy. Similarly this represents both as a shortcoming and as an opportunity (huge growth area).

If the banking system, the main conduit for finance intermediation, has relatively low exposure, it explains why the Philippine capital market likewise lags the region or for most of the world.

It also gives credence to the outlook that a large section of the economy is levered to informal financing channels.

Basically Indonesia and the Philippines could be deemed as primeval cash based society. It also demonstrates why both countries have lagged in the aspects of developments simply because of the lack of access to capital and to paucity of sophistication to lever and recycle capital.

Figure 8: ADB: Public Sector and External Debt as % of GDP

External and Public sector Debt for most of Asia has likewise been materially improving. But the Philippines has the worst position among the peers but has likewise shown significant progress.

Of course past performance may not repeat in the future given the deteriorating conditions abroad, but given the composite framework of the Philippine economy or financials, we need to be substantially convinced of how a depression in the US will result to a depression in the Philippine economy or in Asia. We have discussed in details such linkages in ‘Is the Philippines Resilient Enough to Withstand A US Recession?’.

We also don’t share the view that advanced economies will RECOVER first given the so-called belated effects of an economic growth slowdown contagion to Asia or to emerging markets.

The reason is that the US or UK or countries presently scourged with the deleveraging process is a systemic impairment which will take a longer period for convalescence or for market clearing. Whereas Asia or emerging market’s bear market comes about from the trade and financial nexus with these economies and has not yet been a structural problem (YET).

As a reminder, from every cycle emerges a new market leader, e.g. in the US, the technology sector 1990s-2000 and financials and housing in 2003-2007 (today the energy sector appears to be at the helm) and it is likely that once a recovery phases there will likewise be a new market leader (perhaps the next bubble). And our likely candidate emanates from Asia or emerging markets.

To elaborate further, monetary inflation has been a process INTRINSIC to the fiat paper money/currency standard. Since the impact of inflation is always never equal, it gets to be absorbed in different points of the economy at different times.

For instance in 2003-2007, most of the inflationary actions by global monetary authorities got absorbed in the real estate sector backed by financial securities (structured finance, derivatives, mortgages backed securities, etc…).

Aside, the spillover from these actions led to global arbitrages which spurred a phenomenon of price values of stocks, emerging market debts and commodities.

But since the advent of the global credit crunch, much of the real estate financed securities have been deflating, thus, the inflation absorption has shifted towards hard assets. Hence, the accentuated surges in food, energy and commodity prices (which is why it gets political mileage). Now that commodity and oil prices are in a respite, our suspicion is that some asset classes are likely to takeover or benefit from these relative price adjustments or the rotating inflation.

Remember, these processes won’t come to a halt, especially under political imperatives to save the system or the poor or the society or the economy. There will always be some justifications (cloaked by technical jargons-or ‘intelligent nonsense’ as Black Swan savant Mr. Nassim Taleb would say) for such politically based actions.

Overall, if the popularly held inflation menace will be less of a threat to the global economy, aside from global markets having priced in MOST of the decline in economic growth aspects as reflected in the financial markets (markets indeed serve as great discounting mechanism) then it is likely that we should see the rotation of this inflationary assimilation into new conduits; let me guess-Asia.

Global Financial Markets: US Sneezes, World Catches Cold!

``So there is a connection between the ultra-expansionary monetary policies of Mr. Bernanke – I might add, an economist that is an academic and that has studied the Depression but doesn’t understand anything about international macroeconomic conditions. And the conditions that led to the Depression in 1929-32 are very different from what we are facing today because commodity prices at that time had been in an upward trend from 1890 to 1921, but throughout the 1920s, essentially in a downtrend. We are now in an uptrend, so the more money he prints, the higher commodity prices will go, and the lower the dollar will go and the more inflationary pressures the U.S. will face.”-Dr. Marc Faber on Global Inflation

The Dam finally broke.

The three major equity market bellwethers of the US are now knocking at the bear’s lair in the wake of the market’s carnage last week. Following the breakdown of Dow Jones Industrials, the 30 company price weighted average benchmark is now at the brink from the official technical description of a bear market or a loss of 20% from the peak.

The Industrials is down 19.89% from its zenith in October (based on closing prices), while the contemporary benchmarks of the S & P 500 and the Nasdaq are likewise nearing the technical breakdown and are down 18.32% and 19.01% from October, respectively.

And when the US sneezes, the world catches cold, as shown in Figure 1.

Figure 1: courtesy of stockcharts.com: The US Sneezes, The World Catches Cold

Like its US counterpart, the Euro Stoxx 50, a free float market cap weighted index of the 50 European blue chips is seen likewise attempting a technical breakdown (pane below main window) now perched at the critical support levels, while Asia and Emerging markets (center and lowest pane) have also been feeling the heat.

$140 Oil: The Last Nail In The Coffin

Again, mainstream media and their coterie of experts has fingered $140 oil as the culprit, but as we have been saying all along, $140 oil represents as only a contributory factor or the proverbial last “nail” in the coffin.

The recessionary pressures-from the ongoing credit turmoil, the housing meltdown, the market tightening of access to financing, the grand “deleveraging” in the financial sector, growing statistics of bankruptcies and foreclosures, mounting job losses, falling corporate profits, worsening balance sheets, consumer spending retrenchment, slowing capital investments and others, aside from higher “inflation” (high energy and food costs, rising prices of imports, rising costs of raw materials et. al.)-have combined to impact the real economy, which is now being reflected in the revaluation of the US equity markets.

Figure 2: courtesy of Bloomberg: Rising TED Spread: Credit Woes Not over!

Figure 2 from Bloomberg is just an example of the prevailing abnormalities and disruptions in the credit markets affecting both the financial sector and the real economy.

The TED spread-or “the difference between the interest rate for the three month US Treasuries contract and the three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped the T-bill futures, the TED spread is now calculated as the difference between the three month T-bill interest rate and three month LIBOR. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another” (wikipedia.org)-continue to remain under severe strain and appears reaccelerating.

So as financial institutions remain reluctant to lend to each other, this suggests of the dearth of access to finance by many economic agents in the real economy, which essentially leads to an economic growth slowdown.

Figure 3: courtesy of Northern Trust: Falling Corporate Profits From the US

Such impact is becoming more evident in the performance of corporate profitability. This from Chief economist Paul Kasriel of Northern Trust (underscore mine),

``Along with its “final” estimate of first-quarter GDP, the BEA also reported its revised estimate of first-quarter corporate profits. Compared with the fourth quarter of 2007, corporate profits from current operations were estimated to have declined 0.3% in the first quarter of 2008 rather than the 0.3% increase originally reported. Looking at total profits on a year-over-year basis, they were up 1.0% in the first quarter. But, as shown in Chart 1, profits generated from domestic operations contracted 4.8% -- the third consecutive quarter in which year-over-year domestically-generated corporate profits contracted. If total profits are increasing year-over-year, but domestically-generated profits are contracting, then it must be that profits generated from overseas operations are increasing.”

So as shown above, this is not all about oil.

In Eyes Of Ben Bernanke: Systemic Deflation, Interest Rates and Petrol Deficits

There is an idea being floated that “frustrated expectations” over the policy actions of Fed controlled interest rates had been answerable for this week’s rout.

Since the prevailing belief is that oil prices have been “causing” the stress in the US economy and the financial markets, the expectations was for the Fed Chairman Bernanke to “raise rates” in order to combat rising oil prices. Since the Fed stayed on with the present rates, market’s expectations was unfulfilled, thus the attendant mayhem. How I wish it were so simple.

We don’t want to moralize about the principles of money “tightening” although it is a premise which we basically agree with. Yet it is one of the many things the world can do to ease the present strains but comes with a political cost.

The role of market participants is to anticipate on the prospective developments in the marketplace in order to profit from it. So we should instead attempt to understand the mindset of the leadership or those at the helm of the US Federal Reserve, particularly of Fed Chair Bernanke.

Second, it should be understood that the cyclical counterpart of a boom derived from credit inflation is an ensuing bust from debt deflation, which is what we are seeing in the US and parts of Europe today.

Indeed, the US government has reacted with a cocktail of countermeasures to cushion the aftermath of the housing, mortgage and structured finance bubble (deflation) bust with tax rebates, expanding the role of (Government Sponsored Enterprises) GSEs of Federal Home Loan Banks, Fannie Mae and Freddie Mac as mortgage “buyer of last resort”, sharp interest rates cuts, bridge financing via direct access by financial intermediaries to the Fed, currency swap with foreign central banks, the Fed engineered acquisition of investment bank Bear Stearns and the partial overhaul of the asset side of the Federal Reserve balance sheet replaced with collateral from various financial institutions that had been frozen or illiquid in the marketplace. But apparently, these actions have not resolved the liquidity or the solvency issues plaguing the financial sector-the epicenter of today’s debacle.

Thus, as stated in our latest blog post, Chairman Bernanke The Ideologue Probably Won’t Raise Anytime Soon, Mr. Bernanke’s premier concern is one of a systemic debt deflation (or a repeat of the Great Depression or Japan’s lost decade) and perhaps views the current inflation menace as a temporary phenomenon despite the recent verbal signaling to the opposite effect-“the upside risks to inflation and inflation expectations have increased” (Federal Reserves).

When action is measured against words, the point is, with nominal interest rates far below the official rate of “inflation”, which signifies a policy decision, this opines that Mr. Bernanke is indubitably concerned with the impact from the overleverage in the system- yes, as an example trading of enigmatic derivative instruments have now ballooned to $692 trillion (Bloomberg) or more than 10x the GDP of the global economy!

On the other hand, the issue of rising oil prices equals a US recession has been a causality embraced by mainstream thinking.

This quote from Stephen Leeb (Hat Tip Barry Ritholtz), ``Nothing has been a more reliable indicator for an upcoming recession as the price of Oil. Every major bear market, every major economic decline has been preceded by a large spike in oil prices. The 73-74 recession, recession of beginning 80's and the recession of 2000. Oil prices jumped 80% between 1999 and 2000. Oil prices have been the most important indicator of major economic disasters. Whenever Oil prices rise about 80% from year ago levels, a fair chance does exist that a recession/bear market will follow."

Figure 4: Courtesy of St. Louis Fed: Oil Is Not The Only Driver of Recession; Interest Rates too!

Figure 4 from the Federal Bank of St. Louis shows that rising oil prices and a US recession has not solely been the coincidental variables but interest rates too!

Rising interest rates (red line) preceded ALL recession periods (gray area) in the US since 1954. Nonetheless, when oil prices came into the picture in about 1965 (blue line), all instances where oil price rose significantly and was met with an attendant recession, the interest rate cycles were seen either peaking out or rolling over.

What this could suggest is that policy measures (mostly in response to the bond market via rising treasury yields) to wring out “inflation” in the system as signified by high oil prices could have led to the “recession or bear market” indicated by Mr. Leeb.

Put bluntly, it is not oil prices but a tightening environment to squeeze out “inflation” that resulted to these periods of recession. Oil prices again, served as the most convenient scapegoat.

And Mr. Bernanke, whom have exhaustively been trying to avert a recession, could have probably seen this picture and has purposely moved against such tightening in the belief that economic growth guided by the Fed’s monetary and fiscal policies, could help patch up these deflationary bottlenecks overtime while “inflation” symptoms of high oil prices could perhaps bow or vanish amidst these deflationary headwinds.

Another factor perhaps, is that the realization by Mr. Bernanke & co. of the nature of today’s monetary inflation as being transmitted through mainly the US current account deficit and secondarily monetary pegs or dollar linked currency framework adopted by about 45 countries.

Figure 5: courtesy of Brad Sester: US Petroleum Deficit Already Exceeds the Non-Petroleum Deficits

The idea is that since US monetary aggregates and bank credit (loans or investments of commercial banks) have NOT been expanding, petroleum imports- to quote our favorite keen eyed fund flow analyst Council on Foreign Relation’s Brad Setser, ``The petroleum deficit – over the last three months – already exceeds the non-petroleum deficit” -has now become the dominant variable of the US current account deficit which effectively becomes the primary source of monetary lubricant for the economic growth engines of emerging markets economies.

In figure 5 courtesy of Brad Setser, Petroleum imports have been expanding to the degree more than enough to offset the decline in non petrol imports. Said differently, US consumers have been materially buying less of foreign goods and have been paying more for oil products!

Remember, US export growth has been relatively strong in the face of today’s tribulations and has cushioned its economy from massive deterioration. And the continuity of such conditions requires a robust pace of export growth which emanates from a vigorous clip of external demand expansion.

Perhaps Mr. Bernanke thinks that if a decline in the Petrol deficits without the accompanying improvement in non-petroleum deficits translates to a slowdown of global demand for US products then the US economy faces the risks of a deflationary collapse! Put differently the US is in a life support system presently sustained by its monetary policy induced externally generated inflation process!

And this could be the reason why US Treasury Secretary Henry Paulson recently made rounds to the Gulf states telling them that abandoning the (currency) pegs “will not solve their inflation problems” (CBSMarketwatch).

Of course, the mirror view is that a US deflationary bust will extrapolate to a global depression (as repeatedly advocated by some)!

In effect, the implicit impact from the policies assumed (or of keeping rates on hold) by Mr. Bernanke & co. is to maintain a weak dollar, high oil price, and continued monetary inflation from the world feeding into the US economy by shoring up its exports in the hope that the latter will offset it from a deflationary collapse.

Maybe if all the above measures cease to work then the last ace for Mr. Bernanke would be to expand the Fed’s balance sheets by printing money or otherwise the US economy could succumb to deflationary recession!

Bernanke In Hot Seat, Imbalances As An Offshoot To Consenting Nations

Yes, Mr. Bernanke is in hot seat as the Federal Reserve for the first time in US history is due to undergo scrutiny from the IMF. According to Der Spiegel’s Gabor Steingart (highlight ours),

``Officials with the International Monetary Fund (IMF) have informed Bernanke about a plan that would have been unheard-of in the past: a general examination of the US financial system. The IMF's board of directors has ruled that a so-called Financial Sector Assessment Program (FSAP) is to be carried out in the United States. It is nothing less than an X-ray of the entire US financial system.

``As part of the assessment, the Fed, the Securities and Exchange Commission (SEC), the major investment banks, mortgage banks and hedge funds will be asked to hand over confidential documents to the IMF team. They will be required to answer the questions they are asked during interviews. Their databases will be subjected to so-called stress tests -- worst-case scenarios designed to simulate the broader effects of failures of other major financial institutions or a continuing decline of the dollar.

``Under its bylaws, the IMF is charged with the supervision of the international monetary system. Roughly two-thirds of IMF members -- but never the United States -- have already endured this painful procedure.”

It is likely that many countries have seen how US policies have unduly been impacting the world (through higher consumer goods and services inflation), thus the IMF could be applying pressures to the US to adopt a more global centric policies (speculation for me here). Of course, adopting currency pegs is a national determined policy, which means today’s imbalances is a product of “consenting states” or playing within the unwritten guidelines of the US dollar standard.

In finality, Mr. Bernanke’s recent policies have resulted to a general market tumult: a big decline in global equity markets, a rally in US Treasuries, a fall in global sovereign bonds, a retreat in US dollar index, and a massive rally in major commodities. Mixed signal in all.

No, this week’s decline isn’t all deflationary...

Table 1: Bigcharts.com: Commodity Indices Outperforms!

Not for the moment in the US anyway…