Global Stock Markets: Will the Recent Rise in Interest Rates Pop the Bubble?

The natural tendency of government, once in charge of money, is to inflate and to destroy the value of the currency. To understand this truth, we must examine the nature of government and of the creation of money. Throughout history, governments have been chronically short of revenue. The reason should be clear: unlike you and me, governments do not produce useful goods and services that they can sell on the market; governments, rather than producing and selling services, live parasitically off the market and off society. Unlike every other person and institution in society, government obtains its revenue from coercion, from taxation. In older and saner times, indeed, the king was able to obtain sufficient revenue from the products of his own private lands and forests, as well as through highway tolls. For the State to achieve regularized, peacetime taxation was a struggle of centuries. And even after taxation was established, the kings realized that they could not easily impose new taxes or higher rates on old levies; if they did so, revolution was very apt to break out.-Murray N. Rothbard

The rampaging bullmarket here and abroad has raised concerns that recent increases in nominal interest rates could put a kibosh to the current run.

As I pointed out before, the actions in the interest rates markets will be shaped by different circumstances[1] which means it is not helpful to apply one size fits all analysis to potentially variable scenarios that may arise.

Interest rates may reflect on changes in consumer price inflation, they may also reflect on the perception of credit quality and they may reflect also on the state of demand for credit relative to the scarcity or availability of savings or capital[2].

Since the current interest rate environment has been mostly manipulated by political actions, where the political goal has supposedly been to whet aggregate demand by bringing interest rates towards zero, then we are dealing with a policy based negative real rates economic environment.

So the crucial issue is, has the recent selloff in treasury bonds neutralized the negative real rates regime? The answer is no.

First of all, current environment has not been reflecting concerns over deterioration of credit quality as measured through credit spreads[3], which seem to have eased.

Also, milestone highs reached by global stock markets, led by the US, have encouraged complacency through a reduction of volatility[4].

Second, the yield curve of US treasuries despite having flattened (perhaps due to policy manipulations) still manifests opportunities for maturity transformation trade or lending activities.

Thus, we are seeing signs of recovery in business and commercial lending in the US.

Some of the banking system’s excess reserves held at the US Federal Reserve seem to be finding its way into the economy.

Lastly, many are still in denial that inflation poses a risk, despite rising Treasury Inflation Protected Securities (TIPS).

TIPs are government issued treasury securities indexed to the consumer price index (CPI) with maturity ranging from 5 to 30 years which are usually considered as inflation hedges. (That’s if you believe on the accuracy of the CPI index. I don’t)

TIPs seem to have converged with the S&P 500.

Financial markets could be pricing in a risk ON environment and real economic activities, calibrated by the current negative real rates regime, combined with signs of escalating consumer price inflation.

The reality is that mainstream and the political establishment will continue to deny that inflation exists, when the US Federal Reserve has already been rampantly inflating.

Monetary inflation is inflation. However the public is being misled by semantics of inflation by pointing to consumer price inflation.

As Professor Ludwig von Mises wrote[5],

To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase

They put the responsibility for the rising cost of living on business, This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices. While the Office of Stabilization and Price Control is busy annoying sellers as well as consumers by a flood of decrees and regulations, the only effect of which is scarcity, the Treasury goes on with inflation.

That’s because any acknowledgement of inflation would put to a stop or would prompt for a reversal of the Fed’s accommodative policies. And considering that the banking system has been laden with bad loans, and that welfare based governments have unsustainable Ponzi financing liabilities, then tightening money conditions, expressed through higher interest rates, means the collapse of the system.

Underneath the seeming placid signs of today’s marketplace have been central banking steroids at work as the balance sheets of major economies have soared to uncharted territories[6].

The US Fed and the ECB, as well as other central banks, including the local BSP, will work to sustain negative interest rates environment, no matter any publicized rhetoric to the contrary. There may be some internal objections by a few policy makers, but all these have signified as noises more than actual actions. The politics of the establishment has drowned out any resistance as shown by central banks balance sheets.

One must remember that the US Federal Reserve was created out of politics[7], exists or survives through political money and will die through politics. And so with the rest of central banks.

Thus there is NO way that central bankers will not be influenced[8] by political leaders, their networks and by the regulated. Political power always has corrupting influences.

A good example can be gleaned from Independent Institute research fellow Vern McKinley’s comments[9] on U.S. Treasury secretary Mr. Timothy Geithner’s recent Op Ed[10]

He recounts how the CEO of Bear, with his firm on the brink of bankruptcy, came to him looking for a shoulder to cry on. From his then leadership perch as president of the New York Fed, the bank ultimately extended nearly $30 billion for a bailout, the first in a series of such interventions.

Central bankers are human beings. Only people deprived of reason fail to see the realities of government’s role.

And since the FED has unleashed what used to be a nuclear option, other central banks have learned to assimilate the FED’s policy. This essentially transforms what used to be a contingency measure into conventional policymaking.

As been said before, inflationism has produced an unprecedented state of dependency

And that such state of dependency can be seen through the dramatically expanding role of non-market forces or the government.

As Harvard’s Carmen Reinhart observed in her Bloomberg column[11],

In the U.S. Treasury market, the increasing role of official players (or conversely the shrinking role of “outside market players”) is made plain in Figure 3, which shows the evolution from 1945 through 2010 of the share of “outside” marketable U.S. Treasury securities plus those of so-called government-sponsored enterprises, such as the mortgage companies Fannie Mae and Freddie Mac.

The combination of the Federal Reserve’s two rounds of quantitative easing and, more importantly, record purchases of U.S. Treasuries (and quasi-Treasuries, the government-sponsored enterprises, or GSEs) by foreign central banks (notably China) has left the share of outside marketable Treasury securities at almost 50 percent, and when GSEs are included, below 65 percent.

These are the lowest shares since the expansive monetary policy stance of the U.S. regularly associated with the breakdown of Bretton Woods in the early 1970s. That, too, was a period of rising oil, gold and commodity prices, negative real interest rates, currency turmoil and, eventually, higher inflation.

This is not an issue involving economics alone. This is an issue involving the survival of the current state of the political institutions.

Bottom line: Rising interest rates will pop the bubble one day. But we have not reached this point yet.

Again, the raft of credit easing measures announced last month will likely push equity market higher perhaps until the first semester or somewhere at near the end of these programs. Of course there will be sporadic shallow short term corrections amidst the current surge.

However, the next downside volatility will only serve as pretext for more injections until the market will upend such policies most likely through intensified price inflation.

---

[1] See Global Equity Market’s Inflationary Boom: Divergent Returns On Convergent Actions, February 13, 2011

[2] See I Told You Moment: Philippine Phisix At Historic Highs! January 15, 2012

[3] Danske Bank, The US bond market finally surrendered, Weekly Focus March 16, 2012

[4] See Graphics: The Risk On Environment March 14, 2012

[5] Mises, Ludwig von 19 Inflation Economic Freedom and Interventionism Mises.org

[6] Zero Hedge, Is This The Chart Of A Broken Inflation Transmission Mechanism? March 13, 2012

[7] See The US Federal Reserve: The Creature From Jekyll Island, July 3, 2009

[8] See Paul Volcker Warns Ben Bernanke: A Little Extra Inflation Would Backfire, March 16, 2012

[9] McKinley Vern Timothy Geithner's Bailout Legacy Not One To Be Proud Of, Investor’s Business Daily March 15, 2012

[10] Geithner Timothy Op-Ed: ‘Financial Crisis Amnesia’ Treasury.gov March 1, 2012

[11] Reinhart Carmen Financial Repression Has Come Back to Stay, Bloomberg.com March 12, 2012

Central And Eastern Europe’s “Sudden Stop” Fuels US Dollar Rally

``Big government reforms, bailouts, stimulus, and “change" in general create negative expectations of the future along with a great deal of uncertainty. This leads to inaction and fear — the preconditions for a crash in the stock market. All it needs now is the appropriate trigger.” Mark Thornton, Unhinged

Except for some currencies such as the Norwegian Krone, British Pound or the Swiss Franc, the US dollar surged against almost every major currency including those in Asia…the Philippine Peso included. (Be reminded this has nothing do with remittances)

Since the forex market is a huge liquid market, with daily turnover of nearly $ 4 trillion dollars, this means there has been an intense wave of ex-US dollar liquidation. And to see such a coordinated move suggests that the global financial system could be faced with renewed dislocations in a disturbing scale. So the likely suspects could be either major bank/s in distress, or a country or some countries could be at a verge of default.

Central an dEastern Europe’s “Sudden Stop”

With no major spike in the major indicators which we monitor, such as the Libor-OIS, TED Spread, EURIBOR 3 month, Hong Kong Hibor, BBA LIBOR 3 months and 3 MO LIBOR - OIS SPREAD, the epicenter of last week’s pressure appears to emanate from the Central and Eastern European (CEE) region.

Regional credit spreads and Credit Default Swap (CDS) prices soared, as credit ratings agency the Moody’s issued a warning last week of the possibility of credit ratings downgrades in the region’s debt amidst a deteriorating global economic environment, See figure 1.

Figure 1: Danske Bank: CEE Under Pressure

According to the Danske Bank, ``Credit spreads have had a hard time during the week – especially for banks. The investment grade CDS index, iTraxx Europe, currently trades at 174bp up from 154bp last Friday. The high yield index iTraxx Crossover currently trades at 1085bp up from 1070bp last week. The senior financial index has also widened considerably and now trades at 152bp. As long as sovereign CDS prices are under pressure CDSs on senior bank debt are also likely to suffer as the two are heavily interlinked due to the various state guarantees on bank debt.”

The turbulence affected every financial market in the region; the CEE currencies crumbled, regional bond markets sovereign spreads widened, and regional equity markets tanked see figure 2.

Figure 2: Danske Bank: Emerging Europe currencies slump, Euro bonds

All these resemble what is known as the “sudden stop” or capital stampeding out of the region.

Somehow the CEE crisis approximates what had happened in Asia 12 years ago or what was labeled as the 1997 Asian Financial Crisis.

Central and Eastern European Crisis A Shadow of the Asian Financial Crisis?

So what ails the CEE?

As in all bubble cycles, the common denominator have always been unsustainable debt. And unmanageable debt acquired by the banking system and Eastern European households during the boom days had been manifested through burgeoning current account or external deficits. And these deficits had been balanced or offset by a flux in capital flows, mostly bank loans see figure 3.

Figure 3: Emerging Europe Crisis versus the Asian Crisis

The Bank of International Settlements (BIS) makes a comparison between the present developments in Emerging Europe with of Asia 12 years ago.

From the BIS, ``The crisis was preceded by rapid growth in credit to the private sector, with a significant share of loans denominated in foreign currency. East Asian economies also recorded large current account deficits, mainly induced by the private sector. These deficits were financed by strong debt inflows, which reversed sharply following the crisis. A further similarity lies in exchange rate policies. Prior to the crisis, East Asian economies had fixed nominal exchange rates (in their case against the US dollar). Moreover, the economies relied heavily on a single foreign creditor – Japanese banks. Emerging European countries currently show a similar level of dependence on a few European banking system creditors. For example, claims by Austrian-owned banks are equivalent to 20% of annual GDP in the Czech Republic, Hungary and Slovakia, while claims of Swedish-owned banks on the Baltic states are equivalent to 90% of their combined GDP. An adverse shock to one or more of these foreign banks could result in them withdrawing funds from emerging European countries.”

So the emerging similarities seen in both crises have been strong debt inflows, fixed nominal exchange rates and the concentration of source financing.

As the above chart shows, FDIs (red line) and Bank loans/Debt (blue line) composed most of the inflows in Emerging Europe (left window) whereas the Asian crisis bubble (right window) was almost entirely financed by debt from bank loans.

According to BIS, one marked difference for the strong capital flows in Emerging Europe had been due to the “strengthening in GDP growth and policy frameworks due to closer EU integration.” Plainly put, the integration of many of these countries into the Eurozone facilitated capital flows movement in the region, which may have abetted the bubble formation.

Moreover, another important difference was that Asian debt was principally channeled into the corporate sector while the liabilities in Emerging Europe have been foreign currency related.

Like the recent debacle in Iceland, Emerging Europe’s households incurred vast mortgage liabilities through their banking system in unhedged foreign currency contracts (mostly in Euro and Swiss Francs), which was meant to take advantage of low interest rates while neglectfully assuming the currency risk. In short, Emerging European households engaged in the currency arbitrages or otherwise known as the CARRY TRADE.

So when the sharp downturn in economic growth occurred, these capital starved economies failed to attract external capital, hence, the net effect was a drastic adjustment in their currencies which prompted for a capital flight.

Households which took on massive doses of foreign currency liabilities or loans saw their debts balloon as their domestic currency depreciated.

And it is not just in the households, but foreign investors too which incurred substantial exposure through local currency instruments. Morgan Stanley estimates Turkey, Hungary, Poland and Czech having non-resident exposures to equities and bonds at 30%, 18%, 17% and 10%, respectively.

Thus, the sharp gyrations in the currency markets have accentuated the pressures on the underlying foreign currency mismatches in the region’s financial system.

Another source of distinction has been the degree of exposure of the Emerging Europe’s debt to the European banking system. As noted by the BIS above, the Asian crisis further undermined Japan’s banking system, which provided the most of the loans, at the time when its domestic economy had been enduring the first leg of its decade long recession. On the hand, over 90% of the distribution of loans $1.64 trillion loans held by Emerging Europe have been scattered between the European and Swedish banks.

Doom Mongering: Will Eastern Europe Collapse the World?

Nonetheless this has been the key source of pessimism in media, especially by doom mongers whom have alleged that the failure to salvage East Europe will either lead to a worldwide economic catastrophe or to the disintegration of the Euro, as major European economies as Germany and France may opt NOT to bailout the crisis affected union members or union members whose banking system are heavily exposed to Eastern Europe of which may lead to cross defaults and culminate with a collapse in the monetary union.

In addition, they further assert that due to the huge extent of financing requirements, the IMF would deplete its funds and may be compelled to sell its gold hoard in order to raise cash. And to prim their narrative, they’ve made use of the historical parallelism to bolster their views or as possible precedent; the Austrian bank collapse in 1931 triggered a chain reaction which ushered in an economic crisis in Europe during the Great Depression years.

We are no experts in the Euro zone and Emerging Europe markets, but what we understand is that these doomsayers appear to be inherently biased against the Euro (on its very existence, even prior to these crisis), or alternatively, have been staunch defenders of the US dollar as-the-world’s-international-currency-standard, and have used the recent opportunities to promote their agenda.

Moreover, these doom mongers appear to be interventionists who peddle fear to advocate increased government presence and interference, which ironically has been the primary cause of the present predicament.

Be reminded that the fiat paper money system exists on the basis of trust by the public on the issuing government. Conversely, a lost of faith or trust, for whatever reason, may indeed undermine the existence of a monetary framework, such as the US dollar or the Euro. Thus rising gold prices are emblematic of these monetary disorders and we can’t disregard any of these assertions.

Although, for us, the claims of the tragic collapse from the ongoing CEE crisis could be discerned as somewhat superfluous.

One, the argument looks like a fallacy of composition- as defined by wikipedia.org-something is true of the whole from the fact that it is true of some part of the whole (or even of every proper part).

Figure 4: BIS: Foreign Liabilities Varies Across EM Regions

The CEE debt problem has been interpreted as something with homogeneous like dynamics, where the assumption is that every country appears to be suffering from the same degree of difficulties even when the economic structures (leverage, deficits etc.) are different.

They even apply the same logic to the rest of the world including Asia, where, as can be seen in Figure 4, have different scale of foreign liabilities exposure.

Two, because a large part of the Emerging Europe’s banking system is owned by European banks (see Figure 5) some have alleged that European governments have been indiscriminately pressuring their domestic banks with exposures to Eastern Europe to abruptly reduce or pullback their exposure to these countries, such as Greek banks in Balkans. There may be some cases, but a wholesale withdrawal would seem unlikely.

Figure 5 BIS: Foreign Bank Ownership in Emerging Markets

Yet according to the BIS, ``a large part of most emerging European banking systems is foreign owned. These banking groups appear to be financially strong currently, as reflected in standard –albeit backward-looking – measures of financial strength such as capital adequacy ratios and profitability. The foreign subsidiaries should have better risk management techniques in place, more geographically dispersed assets and, in principle, good supervision (from the home country on the consolidated entity).” [bold highlight mine]

Three, emerging markets have been reckoned as “more inferior and risk prone” asset class compared to the securitized instruments sold by the US.

As the Europe.view in the Economist magazine aptly remarked, ``Foreign-currency borrowing by east European households was seriously unwise. But it does not compare with the wild selling of sub-prime mortgages in America that turned balance sheets there to toxic waste. It may be necessary to restructure some of these loans, or convert them into local currency (perhaps with statutory intervention). That will hurt bank profits. But it will not mean American-style write-offs. Bank lending to foreign companies based in eastern Europe is still a good business.”

Divergences Even Among Emerging Markets?

While it could be true that some European banks could be heavily levered compared to their US counterparts and has significant exposure to the CEE region- where the latter seem to be encountering an Asian Crisis like unraveling due to outsized external deficits, large internal leverage and foreign currency mismatches in their liabilities- it is unclear that the deterioration in the financial and economic environment would result to an outright disintegration of the Euro monetary union or trigger an October 2008 like contagion across the globe.

Figure 6 Danske Bank: EM Stock markets

The fact that EM stockmarkets have been performing divergently as shown in figure 6, where LATAM (blue), Asia (apple green), CIS (Commonwealth of Independent States-gray) appear to be recovering, while the CEE (red) and MSCI (dark green) index are down, hardly implies of a contagion at work yet.

Moreover, as we earlier noted, credit spreads of major indicators haven’t seen renewed stress and seems to remain placid despite the recent CEE ruckus.

Thus from our standpoint the present strength of the US dollar encapsulates the ongoing Emerging Market phenomenon called the “sudden stop” or capital “flight” (resident capital) or “exodus” (non-resident capital) from the region, which has siphoned off the availability and accessibility of the US dollar in the global financial system which has probably led to the steep rally in the US dollar almost across-the-board.

We believe that 2009 will be a year of divergence as concerted policy induced liquidity measures will likely have dissimilar impact to all nations depending on the economic, financial markets, and political structures aside from the policy responses to the recent crisis and recession.

Even among Emerging Markets such divergences will likely be elaborate.

Marked Improvements On Some Key Credit Spreads

Despite the recessionary pressures, some credit spreads have markedly eased (all charts from Bloomberg).

TED Spread

LIBOR-OIS

ECB Liquidity Deposit

Euribor 3 month

Hong Kong HIBOR

BBA LIBOR 3 months

3 month LIBOR-OIS spread

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...

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.

Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

``The business cycle is brought about, not by any mysterious failings of the free market economy, but quite the opposite: By systematic intervention by government in the market process. Government intervention brings about bank expansion and inflation, and, when the inflation comes to an end, the subsequent depression-adjustment comes into play.” Murray N. Rothbard, Economic Depressions: Their Cause and Cure

While blood on the streets could essentially represent a once in a lifetime opportunity, one must understand too why it requires additional contemplation of the operational dynamics that lead markets to be consumed by fear.

Riots From Lehman’s CDS Settlement?

One of the stated reasons behind last week’s bloodbath has been attributed to the settlement of Credit Default Swaps contracts from the bankrupted Lehman Bros.

According to Wikipedia.org ``A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" makes periodic payments to the "seller" in exchange for the right to a payoff if there is a default or credit event in respect of a third party or "reference entity"” In essence, CDS contracts function like an insurance where bond or loans are insured by the underwriters “sellers” and paid for by those seeking shelter from potential defaults “the buyers”.

In Lehman’s case its $128 million bonds (Bloomberg) was reportedly priced at 8.625 cents to a dollar which meant that insurance sellers had to pay its counterparties or buyers at 91.375 on a US dollar or cough up an estimated $365 billion (washingtonpost.com) to settle for each of the contracts which covered more than 350 banks and investors worldwide.

Generally this won’t be a problem for banks that has direct access to the US Federal Reserve, except for its booking additional accounting losses. But for institutions without direct channels to the US Fed this implies raising cash by means liquidating assets, hence the consequent selloffs.

Figure 4: New York Times: CDS Market Shrinking But Still Gargantuan

Although the CDS market has been said to decline from more than $60 TRILLION to $54 TRILLION, the sum is staggering.

According to the New York Times, ``The 12 percent decline, to $54.6 trillion, still left the market vastly larger than the total amount of debt that can be insured. The huge total reflects the way the market is structured, as well as the fact that someone does not need to actually be owed money by a company to be able to buy a credit-default swap. In that case, the buyer is betting that the company will go broke.

``Within that huge market, many contracts offset one another — assuming that all parties honor their commitments. But if one major firm goes broke, the effect could snowball as others are unable to meet their commitments.”

In other words if the present crisis could worsen and lead to more bankruptcies of major institutions this could put the viability of CDS counterparties at risk. Hence, it’s not the issue of settlement but the issue of sellers of CDS of defaulted bonds having enough resources to pay for their liabilities.

For instance, while news focused on politicians bickering over $700 billion bailout, the US Congress passed $25 billion loan package (USA Today) to the US automakers. Yet despite this, the S&P raised the risks potential of bankruptcies for the big three; General Motors, Ford and Chrysler (Bloomberg). Presently these automakers have been pressuring the government to release the funds recently appropriated for by the US Congress (money.cnn.com).

Some analysts warn that CDS exposures to GM bonds are worth some $ 1 trillion even when GM’s market capitalization is today less than $3 billion. They suggest that a bankruptcy could entail another bout of market upheaval. Maybe.

While this week’s market riots can’t be directly attributed as having been caused by the Lehman CDS settlement, they may have contributed to it.

Spreading Credit Paralysis

What seems to be more convincing is what has been happening at the world credit markets. Remember this crisis began with the advent of the credit crunch in July of 2007. And after the Lehman bankruptcy, events seem to have rapidly deteriorated.

Credit stress indicators as seen in likes of LIBOR (London Interbank Offered Rate) and TED spread have sizably widened even as the US Federal Reserve introduced a new program aimed at surgically bypassing the commercial market by providing direct funding to affected financial companies by directly acquiring unsecured commercial papers and asset backed securities, called the Commercial Paper Funding Facility (CPFF)

Figure 5: Danske Bank: Commercial Paper and Asset Backed Securities Plunges

As you can see in Figure 5, the commercial paper (CP) market for financial institutions have effectively dried up (see redline) just recently. Aside from the Asset Backed Commercial paper (ABSP) which continues to fall from last year, the CP market’s decline has coincided with the recent crash in global equity markets.

Remember, the commercial paper market is a fundamental source of funding for working capital by corporations. Hence with the apparent difficulties to access capital, the alternative option for companies with no direct access to the Federal Reserve or for companies that have exhausted their revolving capital, is to sell into the markets their most liquid instrument regardless of the price.

This could be the reason why the VIX index has soared to UNPRECENDENTED levels simply because financial companies had NO CHOICE but to monetize all assets at whatever price to keep their businesses afloat!

And this has spread about to every financial center from Hong Kong, Singapore, Japan and others, including the Philippines. According to a report from Bloomberg, ``Rising Libor, set each day in the center of international finance, means higher payments on financial contracts valued at $360 trillion -- or $53,500 for each person worldwide --including mortgages in Britain, student loans in the U.S. and the debt of companies like CIIF in Makati City, the Philippines.”

And this difficulty of raising money today has equally led to hedge funds redemptions especially by institutional investors which may have contributed to the carnage, from Wall Street Journal,

``Larger investors, like pension funds, which had in some instances borrowed money to invest in hedge funds, are pulling out because the credit crunch makes it difficult to raise money.

``Investors can't redeem their money from hedge funds at will; often they have quarterly windows when they can do so. Many investors had until Sept. 30 to tell hedge funds they wanted out. While the funds are typically not required to redeem the money until the end of the year, the redemptions were greater than some funds expected. That caused a scramble to raise cash to pay the investors back. And one quick way to raise cash is often to sell holdings of stock.

Some of these hedge fund liquidations have been even traced to the collapse in Hong Kong’s market (the Hang Seng Index lost 16% week on week), according to Xinhua.net, ``In a sign of redemption pressures on the investment funds, the Hong Kong unit of Atlantis Investment Management said it has suspended redemptions in its Atlantis China Fortune Fund -- a hedge fund with outstanding performance -- due to market volatility.”

Institutional Bank Run

As you can see banks refusing to lend to each other, deterioration in money market, collapse in the commercial paper market, massive hedge fund redemptions and fears of credit derivative counterparty viability could be diagnosed as an institutional bank run.

Honorary Professor at the Frankfurt School of Finance & Management Thorsten Polleit makes our day to come up with a lucid explanation at the Mises.org,

``What spells trouble, however, is an institutional bank run: banks lose confidence in each other. Most banks rely heavily on interbank refinancing. And if interbank lending dries up, banks find it increasingly difficult, if not impossible, to obtain refinancing (at an acceptable level of interest rates).

``An institutional bank run is particularly painful for banks involved in maturity transformation. Most banks borrow funds with short- and medium-term maturities and invest them longer-term. As short- and medium-term interest rates are typically lower than longer-term yields, maturity transformation is a profitable.

``However, in such a business, banks are exposed to rollover risk. If short- and medium-term interest rates rise relative to (fixed) longer-term yields, maturity transformation leads to losses — and in the extreme case, banks can go bankrupt if they fail to obtain refinancing funds for liabilities falling due.

``Growing investor concern about rollover risks has the potential to make a bank default on its payment obligations: interest rates for bank refinancing go up, so that loans falling due would have to be refinanced at (considerably) higher interest rates.

While banks are protected from depositors run by deposit insurance, what protects banks from an institutional run?

The European Experience

Ireland broke the proverbial ice in declaring a blanket guarantee on a wide-ranging arrangement that covered deposits and debts of its six financial institutions aimed at ``easing the banks’ short-term funding’ (Financial Times) among European countries.

This created a furor among its neighbors which contended that the ‘Beggar-thy-neighbor’ policies risks fomenting destabilization of capital flows. The reason is that the public would naturally tend to gravitate on the countries or institutions that issue a guarantee on their deposits, hence lost business opportunities for those that don’t do so.

Instinctively the radical policy adopted by Ireland evolved into a domino effect; despite the protests, every EU nations followed to jointly increase their savers to €50,000 (breakingnews.ie).

The problem is according to the Economist (with reference to Ireland or to those who initially went on a blanket deposit guarantee), ``it is not entirely clear how governments would pay these bills, if they ever came due. The chances of governments having to make good on all deposits seems remote, but the figures involved are eye-popping. In Ireland, for instance, national debt would jump from about 25% of GDP to about 325% if the value of its banks’ deposits and debts were taken on to the government’s books, according to analysts at Morgan Stanley, an investment bank. Similarly in Germany, national debt would jump to almost 200% of GDP if it included bank deposits (and about 250% if it included all the debts of its banking system). This may explain why interest rates on Irish government bonds have been rising in recent days.” (emphasis mine)

In other words, should losses consume a substantial portion of the resources of Ireland’s banking system, taxpayers will be on the hook and bear the onus for such unwarranted policy actions. As you can see, desperate times call for desperate measures regardless of the consequences. Nonetheless, Ireland expanded its deposit guarantees to cover 5 foreign owned banks (Economic Times India) presumably to avoid the Iceland experience, again despite the objection of most its neighbors.

Yet, strong pressures to guarantee the domestic banking system at all costs have taken a strain on the solvency of its neighbor Iceland.

From the same Economist magazine article, ``While governments on mainland Europe were trying to save their banks, Iceland was trying to save the country after it had overextended itself trying to bail-out its banking system. Its economy had been doing well, but its banks had expanded rapidly abroad, amassing foreign liabilities some ten times larger than the country’s economy, many funded in fickle money markets. Since the country nationalised Glitnir, its third-largest bank, last week the whole Icelandic economy has come under threat. Its currency is tumbling and the cost of insuring its national debt against default is soaring. As of Monday it was desperately calling for help from other central banks and was considering radical actions including using the foreign assets of pension funds to bolster the central bank’s reserves. These stand at a meagre €4 billion or so, according to Fitch, a rating agency, and in effect are now pledged to back more than a €100 billion in foreign liabilities owed by its banks.”

Iceland, a country of about 300,000 population and the 6^th richest in per capita GDP (nationmaster.com), behaved like a hedge fund whose banking system immersed on the carry trade during the boom days. They borrowed short and invested long (overseas) or the maturity transformation (see Polleit) and additionally took on currency risk. In fact many of their home mortgages have been pegged to foreign currencies which has aggravated both the conditions of bankers and borrowers, from the New York Times,

``Some Icelanders with recently acquired mortgages face a double threat. Home prices have been falling, and analysts expect them to decline further. But many of these mortgages were taken out in foreign currencies — marketed by the banks as a way to benefit from lower interest rates abroad, as rates in Iceland rose into the double digits over the last year.

``Now, with the Icelandic krona plunging, homeowners have to pay back suddenly far more expensive euro- or dollar-value of their mortgages — a kind of negative equity, squared.”

Figure 6: Ino.com: Iceland’s Krona Plunge Against the US dollar (left) and the Euro (right)

In addition, Iceland’s guarantees initially extended to only local depositors and did not to cover overseas investors many of which came from UK, hence ensuing threats of lawsuits. But as of this writing Iceland seems to have reached a deposit accord with UK and Netherlands (Bloomberg).

Moreover, another critical problem is that Iceland found no aid from its Western allies even as a NATO member and had to rush into the arms of political rival Russia which promised a loan for €4 billion (US $5.43 billion)! This is a dangerous precedent for central banks. Of course while this might seem like isolated case- in Asia Japan earlier rushed to offer loans to South Korea when the latter’s currency got pounded, aside from eyeing to create a scheme under the IMF to assist EM countries (Japan Times) and the urgency to revive the Asian counterpart of IMF (AFP)- such risks could worsen if the crisis deepens.

With the nationalization of Iceland’s top banks, taxpayers will also be responsible for the realized losses from the outsized liabilities, from which we agree with London School of Economics Professor Willem Buiter who says, ``The acquisition by the government of a 75 percent stake in Glitnir and the recent nationalisation of Landsbanki were therefore a mistake. Rather than hammering its tax payers and the beneficiaries of its public spending programmes, rather than squeezing the living standards of its households through a sustained masstive real exchange rate depreciation and terms of trade deterioration, and rather than creating a massive domestic recession/depression to try and keep its banks afloat, it should now let Glitnir, Landsbanki and Kaupthing float or swim on their own. The interests of domestic tax payers and workers should weigh more heavily than the interests of the creditors of these banks.”

Here are some lessons:

-Iceland through its nationalization of banks now suffers from the risks of currency, market, rollover and payment losses having to overextend themselves overseas and whose policies will eventually take a heavy toll on its citizenry.

-It’s not about the interest of taxpayers but of the interest of a few who control and become too entrenched into the system and whose risks has now become systemic.

-The Iceland experience of isolation in times of need reveals that central banks can’t always guarantee assistance to one another.

-In times of turmoil, national policies such as the action taken by Ireland can have negative externality effects- incur immediate political and future economic and financial costs.

-The risks of an institutional bank run which threatens the entire global banking system is clearly a top concern for European banks who seem to be acting out of desperation.

-Blanket guarantees (which had been limited to some countries so far) and nationalization of the banking industry will most likely be the ultimate tool used by central banks when pushed to the wall.

Global Liquidity Shortages and Falling Forex Reserves

In today’s turmoil, foreign currency reserves held by emerging markets appear to have been used as defense mechanism against a shortage of US dollar in the present environment in order to defend local currencies.

As affected US and European banks continue to raise capital and shrink balance sheets by selling assets and hoarding and conserving cash resulting to a lack of liquidity into the system, despite the massive infusion in the system by the global central banks led by the US Federal Reserve, this may also be construed as a symptom of the ongoing ‘institutional bank run’.

Figure 7: yardeni.com: Falling reserve growth

The chart courtesy of yardeni.com shows the declining growth rate of forex accumulation from developing and industrial countries. Since September, the growth rate is likely to have turned negative as more economies use their spare reserves to cushion the fall of their currencies.

From Bloomberg, ``Latin American central banks are being forced to draw on record foreign reserves built up during the six-year commodities rally to stop their currencies from sinking in the worst financial crisis since the Great Depression..

``The worst currency meltdown in Latin America since the emerging-market economic crises of the 1990s is causing companies' dollar debts to swell as well as sparking derivatives losses, and may stoke inflation. The decision to intervene came after central banks in the U.S., Europe and Canada cut interest rates in a coordinated effort to boost confidence…

``Brazil and Mexico join Argentina and Peru in selling dollars. Central banks in Chile and Colombia have so far used derivatives contracts to arrest the decline of their currencies, without touching reserves.

So it’s not just Latin Americans selling their US dollar surpluses but likewise in India ($8 billion in one week-hindubusinessline.com) and South Korea (estimated $25 billion since March).

Moreover current deficit economies including the US are likely to be at greater risks since it would need surpluses from foreign investors to fund the imbalances.

While the US continues to see strong inflows from central banks into US treasuries, our favorite fund flow analyst Brad Setser says that Central banks have either been shifting into US dollars from the euro or their reserve managers have also lost confidence in the international banking system or is moving into the safest and most liquid assets via the treasuries.

As per Mr. Setser. ``I would bet that this is more a flight away from risky dollar assets toward Treasuries than a flight into the dollar.”

Conclusion

I don’t like to sound alarmist, but all the present actions seem to indicate of the genuine risk of a failure in the global banking system. And this probably could be the reason behind why the recent turmoil in the financial markets has been quite intensive and amplified.

So the most likely steps being undertaken by global regulators in the realization of such risks (why do you think global central banks cut rates together?) will be to rapidly absorb or nationalize troubled banks (if not the entire industry) and continue to inject massive liquidity and lower interest rates aside from outright guarantees on deposits and loans in the hope to restore confidence to a faltering Paper Money system. In short, they intend to reinflate the impaired banking system.

Yet even under such conditions we can’t be sure if governments can provide sufficient shelter for the depositors and users of the system if conditions should deteriorate further. Present capital in the domestic system won’t probably be enough when the economic functions (clearing and settlement, payment processing, credit intermediation, currency exchange, etc.) of external banking system becomes dysfunctional, even under the context of our government guarantees (which will largely depend on its balance sheet and the ability for the citizenry to carry more public liabilities). Moreover, the international division of labor will likely be curtailed, leading to societal hardships and risks of political destabilization.

The key is to watch the conditions of the credit spreads, commercial paper and money market. Any material improvement in the major credit spread indicators will likely ease the pressure on regulators and relieve the pressure on most markets. Thus, while the potential for a rebound in the stockmarket seems likely given the severely oversold conditions, the vigor and sustainability will greatly depend on the clearing of the flow of global credit.

But on the optimistic part, the markets have already painfully reflected on the necessary adjustments of prices. While it is doubtful if we have reached the level of market clearing enough for the economic system to be able to pay for its outstanding liabilities given the amount of leverage embedded, it may have relieved additional pressures for a repeat performance of this week’s gore.

Of course, any action that government does which may coincide with a recovery is likely to be deemed as government’s success by liberals, it is not. The markets have already violently reacted.

Next, global depressions are aggravated by protectionism. This means that for as long as globalization in trade and finance can be given the opportunity to work, it may be able to accrue real savings to enough to recuperate the system. Besides, technology can vastly aid such process.

Another, this crisis episode is likely to generate a massive shift in productivity and wealth. The losses absorbed by crisis affected nations will impact their economies by reduced productivity on greater tax obligations. Thus, we are likely to see a faster recovery on economies that survived the ordeal with less baggage from government intervention. That is why we believe that some emerging markets including most of Asia should recover faster.

Moreover it isn’t true that if the banking industry goes the entire economy goes. As example, the Philippines has a large informal economy which is largely a cash economy. True, a dysfunctional international banking system abroad can create economic dislocations which may result to hardships but markets can be innovative.

As a final note, don’t forget that historical experiments over paper money have repeatedly flunked. We don’t know if this is signifies as 1) a mere jolt to the system or 2) the start of the end of the Paper money system or 3) the critical mass that would spur a major shift in the present form of monetary standard.