Implied Government Guarantees on BRIC Banking system

Even in the BRICS, there has been an implied guarantee by their respective governments on their banking system, as indicated on their credit ratings.

From Reuters:

The ability of Brazil, Russia, India and China to support their leading banks is tightly correlated to the credit rating on the banks, according to ratings agency Moody’s. The agency compares the ratings of four of the biggest BRIC banks which it says are likely to enjoy sovereign support if they run into trouble…

In a self-perpetuating cycle, ratings will be higher because governments are prepared to provide high levels of support to the banks, reflecting the lenders’ systemic importance and in some cases government ownership.

Bailouts on the politically privileged banking system have become a global standard. And this encourages the moral hazard behavior where banks take unnecessary risks because they know they will be supported once "they run into trouble". This adds to the yield chasing phenomenon that increases systemic fragility.

Moreover this implies that the public's savings, even in emerging markets, will continue to be under duress from indirect and direct confiscations in favor of the banking system.

Emerging Markets Eye Insurance Against the US Dollar, Euro

Aside from the pledge to assist in the rescue of the EU, key emerging markets led by the BRICs and South Africa discussed insurance options that goes around the US dollar.

From the China Money Report,

The BRICS countries said on Monday that they’re considering setting up a foreign-exchange reserve pool and a currency-swap arrangement as financial problems threaten to spread across the global economy.Leaders of the five-member group —Brazil, Russia, India, China and South Africa— also said BRICS is “willing to make a contribution” to increase the International Monetary Fund’s ability to rescue troubled economies. President Hu Jintao joined his counterparts from other BRICS nations on Monday morning in the Mexican resort city Los Cabos ahead of the start of the G20 Summit.

According to the Chinese Foreign Ministry, the leaders discussed the currency swap and foreign-exchange reserve pool ideas and tasked their finance ministers and central bank chiefs to implement them, according to China’s Foreign Ministry.

Swap arrangements, which allow nations’ central banks to lend to each other money to keep markets liquid, and the pooling of foreign-exchange reserves are contingency measures aimed at containing crises such as the one roiling the eurozone, analysts said.

Zhang Yuyan, director of the Institute of World Economics and Politics affiliated with the Chinese Academy of Social Sciences, said the new mechanisms established by the emerging markets themselves, who “know their current conditions and demands
much better”.

Amid the global economic slowdown, the pooling of foreign-exchange reserves will help BRICS countries to fight the lack of market liquidity, beef up their immunity to financial crises and boost global confidence, Zhang said.

Contributions to this “virtual” bailout fund, as Brazil’s Finance Minister Guido Mantega put it, would be tied to the size of each BRICS member’s currency reserves, he said. The five leaders also discussed BRICS’ participation in replenishing the IMF’s lending capital. Hu said the G20 should encourage and support the eurozone countries’ adoption of fiscal controls and spending cuts as efforts to improve confidence in world markets. The leaders also urged the IMF to carry out promised reforms of its quota and governance systems. Mexico, which was hosting the G20 Summit on Monday and Tuesday, has said it will use the meeting to press the world’s largest economies to increase IMF resources and build the fund’s capacity to intervene in the European debt crisis.

While these may be constitute added signs that much of the world seem to be getting antsy with the unfolding events in the developed economies, swaps and foreign reserve pools won’t do much when the whole paper money system goes into flame.

The reason for this is that much of the world’s banking and financial system remains anchored on fiat currencies of the western world, where the US dollar and the euro constitute 90% of global reserve currencies (see chart from Wikipedia.org).

Besides, the monetary system of emerging markets operates from the same fractional reserve system as their developed peers, which means that like their developed peers, EM politicians will be seduced to used inflationism to achieve political goals.

Instead, what these economies should do would be to ramp on gold acquisition, and possibly consider a quasi-gold standard possibly through a gold based currency board (as proposed by Professor Steve Hanke) or a return to the gold standard or allow for currency competition with the private sector (free banking, free currency competition as proposed by Ron Paul and Professor Lawrence White).

Since any of the proposed monetary reforms would entail restriction in political actions and simultaneously require massive liberalization of respective economies, these won’t likely be palatable with incumbent political agents, who under such circumstances, lose much of their current privileges (Europe’s deepening crisis are manifestations of these).

Thus, it would likely take a deeper crisis (most likely a currency crisis) to force real reforms in the system.

Filipinos to Join Emerging Market Consortium in the Rescue of the European Political Elite!

Yes you read it right, Filipino taxpayers will be joining Emerging Market contemporaries in transferring resources to European bankers and European politicians, through the IMF, to supposedly “erect a firewall” from an escalating Euro debt crisis.

From Bloomberg,

Emerging-market nations including China and Brazil formalized funding pledges to the International Monetary Fund, helping to almost double its lending power to protect the world economy from Europe’s debt turmoil.

With the addition of new pledges from 12 nations that also includes Russia, India and South Africa, the Washington-based lender said it now has received funding commitments of $456 billion, up from the roughly $430 billion it said it had secured in April. The temporary contributions will add to the $380 billion the IMF currently has available for lending.

“Countries large and small have rallied to our call for action,” IMF Managing Director Christine Lagarde said in a statement on the sidelines of a Group of 20 summit, adding that the new contributions would only be used as “second line of defense” after existing resources are depleted.

G-20 leaders are gathering in the Mexican beach resort of Los Cabos for a two-day summit dominated by the financial crisis in the 17-country euro region just as Spanish borrowing costs soar to a euro-era record. Canada and the U.S. abstained from pitching in for the IMF, despite calls by German Chancellor Angela Merkel for the rest of the world to do more.

“It’s going to be the first time the fund is capitalized without the U.S., which reflects the importance of emerging markets,” Mexican President Felipe Calderon said on June 16.

Pledge Amounts

The meeting’s host said Mexico would contribute $10 billion to the fund, matching pledge amounts made here by Russia, India and Brazil. China said it will provide $43 billion, while South Africa, Colombia, Malaysia, New Zealand and the Philippines were among nations offering smaller amounts.

Where do you think the Philippine government will get the funding to help in the bailout of the European elites? From domestic taxpayers, of course. This includes me.

So the poor (developing nations) will be rescuing the rich (particularly the politicians and the bankers of developed nations). Pope Benedict XVI, are you paying attention?

Emerging market politicians want to swagger about the growing significance of their economies in order to have a greater role in the IMF. But this, by throwing away scarce resources that could be used for local contingencies (e.g. disasters)?

Politicians have been fixated with the present at the expense of the future. What happens if and when another future crisis arrives, especially if such will be a domestic or a regional phenomenon?

This also exhibits that personal status symbols are more the priority for politicians than what they preach as serving the ‘general welfare’.

Also this demonstrates how political agents can thoughtlessly and brazenly fritter away other people’s money.

The European crisis has been transformed into a giant vortex that continues to suck or drain away productive resources out of the global economy.

Since the crisis will likely continue for the simple reason that EU's politicians do not want to deal with its roots, particularly the parasitical relationship of their political economies, and instead look for more hosts to prey upon, then the likelihood is that every nation will get dragged into the financial and economic black hole.

Have a nice day.

Rising Demand for British Butlers by Emerging Market Super Rich

Super Chinese and Russian millionaires seem to have a penchant for English household workers.

Earlier I posted news which exhibited a surge in demand for British nannies, this time we are told that demand for English butlers have been the chic.

From the Bloomberg

English butlers, synonymous with Reginald Jeeves in the novels of P.G. Wodehouse, are answering more calls from super-rich Chinese and Russian clients as wealth shifts between east and west.

The Guild of Professional English Butlers has trained 20 percent more butlers this year than last, placing them with clients as soon as they are ready, according to Robert Watson, head of the firm in southern England, last week. The number of domestic staff registered with Greycoat Placements has trebled over the past three years, Managing Director Debbie Salter said.

“Demand is outstripping supply,” Watson said by telephone. “We deal with people who often are cash rich and time poor. The credit crunch did affect things for a time, but before you get rid of the butler, get rid of the Ferrari.”

As Europe struggles with a debt crisis and the U.S. tries to revive its economy, burgeoning growth in emerging markets is boosting spending on luxuries like never before, and creating opportunities for more people to look after them.

The ranks of millionaires in 10 major Asian economies will more than double to 2.8 million by 2015, according to a Julius Baer Group and CLSA Asia Pacific Markets report on Aug. 31. China’s economy grew 9.1 percent in the third quarter from a year earlier, compared with U.S. growth of 1.5 percent.

We need to qualify who the nouveau super rich Chinese and Russians are, because many of them have attained their status via political privilege.

Yet, shifting preference for Western household workers by EM super millionaires could also signify symptoms of the ongoing wealth convergence from globalization.

And such dynamic could be magnified by the continuing trend to adapt inflationist policies by the West, as Emerging Markets open their economies to the world and or to domestic entrepreneurship. Interesting signs of evolving times.

Policy Divergences: Structural Versus Relations Power

Deutsche Bank’s Emerging Market analyst, Markus Jaeger, explains what I think is a relevant nuance between the role of foreign currency reserve, and one of a national currency (or one that is not)-e.g. US dollar versus Philippine peso or China's yuan.

Mr. Jaeger writes, (bold emphasis mine)

Put differently, the US pursues an economic policy – namely a lax fiscal policy and quantitative easing – it deems to be in its interest and however the EM respond to it is of little consequence to the US. This is a prime example of continued US “structural power”. Structural power is the power of a state to indirectly influence others by controlling the structures within which they must operate – in this instance, the international monetary system. This differs from “relational power”, or the ability of one state to influence another state's behaviour directly in pursuit of specific outcomes. This describes the situation quite accurately, for Washington is not seeking to influence other countries’ policies. It is simply pursuing policies it deems to be in its interest. Meanwhile, the EM have no way of influencing US macro-policy and are therefore left to deal with the QE-driven capital inflows and the implications of rising US government debt.

Some thoughts:

I agree with the essence of the differentiation.

But I think this observation underrates the role played by external influence on US policies. For instance, has Federal Reserve’s QE been aimed solely at ‘jumpstarting aggregate demand’? Or has it been designed to protect the banking system? Or has it been engineered to promote exports? Or possibly all of the above?

Point is: Policymakers can read external goals combined or as part of internal or national interests too. In short, instead of a black and white, gray areas (mixture of internal and external interests) can be assumed to determine policy objectives (The Fed’s loan to Libya’s Gaddafi in 2009 should be an example).

Two, this appears to underscore the Triffin dilemma dynamics—conflicts of interests that may arise from international and domestic objectives from a country whose currency is considered as foreign currency reserve. For example, the US may be applying policies for its own interest but because of its currency reserve status, her policies affect other economies and consequently their policies.

Three, although the implication is that the US has a lopsided influence on the world with its internally driven policies, I think this perspective lacks the perspective of the feedback mechanism as consequence from US policies. Think currency arbitrages (carry trades) or real economic effects of QE-e.g. greater demand for food or oil or other commodities.

Nevertheless, the best evidence that proves or disproves such proposition is if the next bust emanates from Emerging Markets (such as China), then here we should see whether US policies will remain impervious and or unaffected or will adjust accordingly along with economies affected by the EM recession or crisis.

Emerging Market Authorities Lean On Free Trade

Here seems to be more proof that emerging market authorities are more “free market” leaning today.

One of them, as shown below, has even been lecturing developed economies to adapt more liberalization.

This appears to be in stark contrast to the yesteryears where developing nations were subjected to the Washington Consensus or “an orientation towards Neoliberal policies” which refers to “economic reforms that were prescribed just for developing nations, which included advice to reduce government deficits, to liberalise and deregulate international trade and cross border investment, and to pursue export led growth.”

Brazil’s finance minister vehemently assailed the Federal Reserve for its QE,

From Wall Street Journal blog

Brazilian Finance Minister Guido Mantega on Tuesday renewed his attack on the Federal Reserve’s most recent program of quantitative easing, saying the policy had goosed global flows of hot capital and heightened the global problems of rising commodity prices and inflation.

Last year, Mr. Mantega warned that falling currencies — including the U.S. dollar, due to the Fed’s plan to buy up to $600 billion of Treasurys — had triggered a currency war. On Tuesday, the finance minister renewed his opposition to the Fed’s program — at one point correcting his interpreter to specify “quantitative easing” and not just “monetary policy.” (emphasis added)

And he equally slams entrenched protectionist policies...

More from the same article.

The finance minister also blamed the U.S. — and other developed markets — for playing a role in rising commodity prices. The problem, Mr. Mantega said, isn’t solely due to increased demand, unfavorable weather and natural disasters, such as last summer’s drought in Russia. Agricultural subsidies in the developed world, and higher prices for fertilizer made by advanced economies also are factors, he said. One solution Mr. Mantega offered: encouraging production of agricultural commodities in developing, low-income countries. And one sure way to make the situation worse: any type of price controls or restrictions, which the finance minister characterized as the equivalent of shooting one’s self in the foot.

Developed countries should remove subsidies and lift trade barriers to products of emerging countries,” he said. “Also, developed countries should provide new investment opportunities to prevent capital supplies from increasing commodity prices.

Looks like the table has been turned.

An Overextended Phisix, Keynesians On Retreat And Interest Rate Sensitive Bubbles

``The belief that a sound monetary system can once again be attained without making substantial changes in economic policy is a serious error. What is needed first and foremost is to renounce all inflationist fallacies. This renunciation cannot last, however, if it is not firmly grounded on a full and complete divorce of ideology from all imperialist, militarist, protectionist, statist, and socialist ideas.-Ludwig von Mises

The Philippine benchmark, the Phisix, remains overextended. (see figure 4) However, deep into major trends, periods of overextension happens, thus this shouldn’t be a surprise.

Figure 4 stockcharts.com: Phisix, Gold and Asian Markets On The Uptrend

And it appears that we could be, perhaps, in one of these unique periods.

I have been expecting the overheated ASEAN markets and the Philippine Phisix (see Relative Strength Index in top window) to take a breather. Apparently this hasn’t been so. My suspicion is that expectations of more monetary accommodation in developed economies may have prevented this from taking place.

Yet for some, this would seem as unsustainable, from which I agree, except that unsustainable can last several years before suffering from a major implosion or a regression to the mean.

The reason for such is that I understand global inflationism as giving rise to serial bubbles. And I don’t share the view that the world is hounded by lack of aggregate demand or liquidity traps or deflation in a world of central banking unless the later would see global monetary authorities submit to the market forces, a political dynamic of which has yielded no indications whatsoever.

And as the conditions of the Phisix (PSEC main window) and of the ASEAN bellwethers have shown, a financial asset boom signifies one of the symptoms of diffusing inflationism taking hold.

And it is also why chart reading cannot be consistently relied upon because they incorporate past data and performances which do not account for the next or prospective actions by the public and the officialdom, as well as their feedback mechanism, given the ever fluid conditions.

And as one would note, the outperformance of the Phisix shadows an equally vibrant Asian ex-Japan markets (P2DOW) and the gold market (GOLD), which means that NONE of the above has manifested the strains of what mainstream permabears calls as the “deflation menace” which is no more than a mainstream Keynesian bugbear that gives justification for authorities to engage in “inflationism”.

The Last Straw For Keynesians: Serial Bubbles

Of course, the prevailing dominance of the Keynesianism seems to be receiving a well deserved smackdown and a comeuppance in Europe as leaders there have opted to observe fiscal discipline[1] than wantonly engage in wasting taxpayer resources on non-market unproductive ‘pet’ projects of politicians in order spruce up the strawman of “aggregate demand” which for them translates to “employment”.

Contra Keynesians, needless consumption of resources on non-productive politically designated activities translates to a loss of capital, a reduction of productivity and subsequently lowered standards of living.

This may be just one of the evolving paradigm shifts that perhaps could serve as an epiphany over the limitations and the hazards of excessive government interventions.

And in contrast to permabears, the adaption of fiscal discipline is surely a path towards sound recovery and a vital source of optimism.

And as the US heads towards elections in the first week of the coming month, we may also see the same results.

Hence, the last straw for Keynesianism following the political retreat will likely be channeled towards the unelected bureaucrats, the central banks.

And for us, central banks are the clear maestros or engineers when fostering bubbles.

And bubble cycles are steeply sensitive to interest rates movements.

Emerging Markets And Fed Policy Rates

BCA Research has an interesting perspective on how emerging markets have reacted to Fed policies (figure 5).

Figure 5 US Global Funds[2]/BCA Research: Emerging Market Correlations

They posit that correlations with the US interest rates had been negative during the mid 90s and positive during the last crisis, where the BCA infers that a dismal global economic growth won’t likely buoy emerging market equities in spite of a Fed liquidity booster.

My comment is that the supposed divergences may not be all that persuasive.

One, the negative correlation in the 90s (left window) may be a function of lagged effects.

Half-way through the rising Fed rates has shown an equally strong emerging market performance which eventually peaked as the Fed rates continued to rise. Hence, the negative correlation may be skewed more towards the interpretation by the analyst more than evidence of strong correlation.

The second but most important factor is that in the 90s, bubbles were centered outside of the US particularly in Emerging Markets—the Tequila (Mexican) Crisis of 1994 and the Asian Financial Crisis of 1997. This implies that the transmission mechanism from Fed policies may have been eclipsed by unsustainable internal imbalances, seen in the said emerging markets, which imploded even as the US economy and her financial markets were left unscathed and continued to perform robustly.

It’s an entirely different story during the period of supposed positive correlation (right window), where the US had been the epicenter of the crisis which essentially rippled throughout the globe and thus the positive correlation.

In short, the major difference between the performances of the emerging markets and the US Fed policy rates, over the two time zones, has been source of the bubbles. Hence the economic growth story relative to Fed rates, for me, seems largely irrelevant.

Overall, interest rates will likely be the most critical factor in ascertaining the sustainability of financial asset inflation in emerging markets, ASEAN, the Philippines and elsewhere, as previously discussed[3].

For as long as the artificially suppressed rates stay low in real and nominal terms and remain unaffected by rising demand for credit or a surge in inflation or that the credit quality or credit ratings of crisis stricken highly levered developed nations remain beyond doubt, then these would be signs of the sweetspot of inflationism.

Interest rates will only start to impact the financial system and the markets once rising rates would render many highly levered unsound projects or speculative endeavors as unprofitable. We are nowhere near this point.

And even if there could be some interim reprieve in the markets, this means for now, party on!

---

[1] New York Times, Europe Seen Avoiding Keynes’s Cure for Recession, October 20, 2010, Wall Street Journal, Britain's 'Austerity' Lessons, October 22, 2010

[2] US Global Funds, Investor Alert October 22, 2010

[3] See Interest Rates As Key To Stock Market Trends, October 2010

Stock Market Investing: The Search For The Mythical Holy Grail

“A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.” -Fritz Machlup, The Stock Market, Credit And Capital Formation

If you think that the bullmarket in the Philippine Phisix is an isolated ‘special’ affair and has been exhibiting signs of economic or corporate (micro fundamental) improvements or political endorsements, then you would be wrong (see Figure 3).

The same applies to the mainstream permabears who can’t seem to get their focus away from the debt problem angle or the supposed “lack of aggregate demand” in major economies.

The US Dollar Story

Figure 3 Bloomberg: Exploding MSCI Emerging Market and Asian Currencies

As one would note, emerging markets stocks, as represented by the MSCI Emerging Market index (upper window), have been exploding of late. But still has some distance from reaching the 2008 highs.

And this has not just been a dynamic in the Emerging market stock markets, but also in the currencies of Emerging markets and their Asian contemporaries.

This is best represented by the Asian currency index, the Bloomberg-JPMorgan Asia Dollar Index (ADXY) which have similarly spiked (lower window)!

With Asian currencies surging, I would assume that in spite of the recent appreciation of the Philippine Peso, the relative performance of the Peso has been lagging, considering that foreign money flows have been quite active. Nevertheless, despite my suspicion of the repeated intervention by the local central bank, the Bangko Sentral ng Pilipinas (BSP), the Peso should follow her neighbours and appreciate going into the yearend.

So domestic assets are evidently being juiced up by foreign and local money flows.

And as further proof that past performance can’t serve as reliable indicator of the future, even the ongoing troubles in Ireland hasn’t prevented the Euro from appreciating against the US dollar.

And more on more mainstream analysts appear to be getting it.

This from the BCA Research[1], (bold emphasis mine)

``Four currencies – dollar, euro, sterling and yen – currently account for the vast majority of reserve holdings. All of these four major reserve currencies have their own fundamental weaknesses. At the margin, this will force reserve managers to look for alternatives. Indeed, according to the IMF, there is already a sharp spike in holdings of “other” currencies, to 3.6% of total reserves...

``Bottom line: Reserve diversification away from the U.S. dollar remains an ongoing structural theme in the foreign exchange market and commodity currencies will be a main beneficiary.”

It has been an open theme for us here that the so-called policy divergences between the major economies led by the US and emerging market economies, which can be likewise as the called the US dollar carry trade, has underpinned the actions in today’s financial markets.

And the telegraphed actions by the US Federal Reserve in support of a weaker dollar have been causing a flood of liquidity flowing into emerging markets, gold and other commodities.

The Holy Grail Is The Rising Tide

However in the domestic front, I sense alot of psychological changes as some people seem to get aggressive over their expectations of stock market returns.

Some seem to think that the role of the analysts is to provide them optimal returns by capturing the trajectory of price actions via market timing of every issue.

They desire to be in every security that are rapidly going up and expect analysts to be able to identify and predict them.

Yet they read momentum as a way to generate outsized returns and seek all sorts of information (earnings, economic growth and etc...) to confirm on such biases in order to justify their participation. They seem to be seeking the elusive Holy Grail of investing. Unfortunately, either they are being misled or are being overwhelmed by emotions.

Let me reiterate, this isn’t about special events surrounding particular issues. This is about the rising tide lifting all, if not most boats. (see figure 4)

Figure 4: PSE: Number of Traded Issues (Daily)

It’s been happening across emerging markets, where many EM bourses appear to be reacting “positively” to the “leash effects” of the falling dollar-policy divergence trade.

And the same phenomenon seems underway in the local stock exchange where the massive liquidity spillover has been generating a broader interest on publicly listed issues.

The underlying bullmarket has drawn market participants to trade on more issues, where an increasing number of formerly illiquid issues have now become “liquid”. The search for yield has been expanding and lifting prices across the most issues.

This only goes to show how an inflation driven bullmarket has relative effects on prices of securities even when the general level is likewise being lifted overtime.

The other way to say it is that rotational price actions of publicly listed issues is a general feature of a blossoming boom-bust cycle. As for which issues becomes tomorrow’s darling is a phenomenon that can be divined by Lady Luck and not any mortal analysts. Yet to narrow one’s timeframe is to unnecessarily increase risk tolerance and very dicey gambit.

So those who pin their analysis on a variety of non-essentials will certainly get the surprise of their lives when such dynamics reverses. For the meantime, as price levels go up, everyone’s a genius.

Interest Rates As Key

And it is equally important to remember that should there be any pin that may pop this liquidity driven activities (bubble) in the marketplace, it would be due to rising interest rates.

Figure 5: Casey Research[2]: Inflation Is The Biggest Driver of Interest Rate

And the benign levels of interest rates, which have been mainly due to manipulations by the governments will eventually succumb to one of the following factors:

-greater demand for credit or

-deterioration in the expectations of governments’ ability to settle existing liabilities, or

-most importantly, rising consumer price inflation which in the past have been the most pivotal factor in the determining interest rate levels (see figure 5).

As a final note, let me add to Warren Buffett’s advise, “The dumbest reason in the world to buy a stock is because it's going up”, and use all sorts of justifications to do so.

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[1] BCA Research, Prospects For FX Diversification September 28, 2010

[2] CaseyResearch.com Debtflation, September 13, 2010

Global Stock Markets Update: Peripheral Markets Take Center Stage

Going into the last quarter of the year, Bespoke Invest has a great snapshot of what has been happening in global stock markets.

From Bespoke Invest, (bold highlights mine)

The average year to date change for all 82 countries is 5.39%, while the median change is 2.23%. The S&P 500's year to date change of -1.24% is obviously below both of these. The US currently ranks 53rd out of 82 in terms of 2010 performance. At the top of the list is Sri Lanka with a 2010 gain of 73.69%. Bangladesh ranks second at 49.37%, followed by Estonia (41.94%), Ukraine (40.86%), and Latvia (40.26%).

India has been the best performing BRIC country so far this year with a gain of 4.33%. Russia ranks second at 1.42%, Brazil ranks third at -2.43%, and China is down the most at -18.97%. Canada is currently the top G7 country with a gain of 3.26%. Germany and Britain are the other two G7 countries that are up year to date, while Japan is the G7 country that is down the most year to date (-13.58%). Overall, Bermuda has seen the biggest losses this year with a decline of 38.25%. Greece is the second worst at -24.56%.

Additional comments:

1. Global stock markets are MOSTLY higher from a year-to-date basis, be it in terms of average or median changes or in nominal distribution (53 up against 29 down). This hardly evinces of the ballyhooed “double dip”.

2. The best performance has been at the periphery (as previously discussed), particularly in emerging South Asia, the Baltic States (Estonia have been a favourite since she has adapted a laissez faire leaning approach in dealing with the most recent bubble bust) and ASEAN.

This appears to be manifestations of the “leash effect” from policy divergences.

3. The BRICS has underperformed, but that’s because of last year’s outperformance. This excludes China, whose markets have repeatedly been under pressure from government intervention. I expect the BRICs to likewise pick-up, perhaps at the end of the year or in 2011 (perhaps including China).

4. Major East Asian economies have likewise underperformed. But this appears to reflect on the actions of major OECD economies.

Overall, what we seem to be seeing has been a spillover dynamic from the prodigious liquidity generated from coordinated global monetary policies into the peripheral markets. It’s the impact of inflation on asset prices on a relative scale. In addition, this also reflect signs of the allure of inflation’s “sweet spot” phase, especially for the peripheral markets.

As a caveat, while stock markets do resemble some signs of “decoupling”, such divergences can be deceiving.

Decoupling can only be established once the US goes into a recession while peripheral markets and their respective economies ignore this.

Yet, I doubt this will occur.

ASEAN Markets Surge, Where will The Next Bubble Emerge?

``Hot money flows are principally associated with pegged exchange rates. Many analysts have misdiagnosed the so-called hot money problem because they have failed to appreciate this all-important linkage. In consequence, they have prescribed exchange controls as a cure-all to cool off the hot money. That prescription treats the symptoms. It fails to treat the disease: pegged exchange rates. Until pegged rates are abandoned, there will be volatile hot money flows and calls to cool the hot money with exchange controls.”- Steve Hanke, The Dead Hand of Exchange Controls

In this issue:

ASEAN Markets Surge, Where will The Next Bubble Emerge?

-The Bubble Or Inflation Psychology

-No ASEAN Bubble Yet

-Why Capital Controls Can Enhance The Bubble Cycle

-Will The Next Bubble Emanate From Technology Or The Kindleberger Model?

-Will The Next Bubble Emerge From Commodity-Emerging Markets?

Since financial markets have mostly been ‘copacetic’ [slang for ok] and performing in the milieu which we had largely anticipated, ironically I find little to write about this week.

While definitely, we will be encountering several “wall of worries” along the way, I feel that, for this year, it’s going to be mostly a “wait-and-harvest” or “wait-to-be-validated” dynamic.

Of course, it’s never going to be a walkover to challenge many of mainstream’s deeply held superstitions, where people ascribe sundry plausible explanations to the underlying conditions in spite of the falsity of the premises-most of them grounded on either tradition or [political/economic] indoctrination, but in frequently doing so occasionally gets one to be weary.

Nevertheless facts are facts.

Perhaps, no one will dispute that the ASEAN-4 equities appear to be in high octane. As we previously noted, once signs of instability in developed economies become subdued[1], we are likely to see a fervid pace of advance among the ASEAN-4 bourses.

And this exactly what happened this week.

True, the ASEAN-4 has underperformed the US and European markets, but the difference have been starkly remarkable—US and European markets have emerged from the current lows, while ASEAN markets have either been breaking away from recent resistance levels [price ceilings] or adrift at near the resistance levels. (see figure 1)

Figure 1: Bloomberg: ASEAN Equities: Raging Bull Market?!

Well Indonesia’s Jakarta Composite (red line) and Malaysia Kuala Lumpur (orange) are clearly in the second category, while the Philippine Phisix (yellow) and Thailand’s SET (green) are in the breakout zones.

But of course, Indonesia’s JCI has been treading at the newly established milestone highs. And the rest are still below but knocking at record highs, particularly the Philippine Phisix (11.5%) and Malaysia’s KLSE (12.7%).

Meanwhile, Thailand too has been 9.5% off the 5 year (recent boom bust cycle) high, but is still way way way or 54% below her 1994 high.

Figure 2: ChartRUS[2]: Thailand’s Boom Bust Cycle-Asian Crisis

Incidentally as a grim reminder of a bubble cycle, Thailand had been the epicenter of the Asian Crisis of 1997, which during the heyday saw the Thailand’s SET zoom by about 10x (trough-to-peak) before the harrowing crash.

The Bubble Or Inflation Psychology

Thailand’s SET resembles the typical boom-bust or bubble chart seen at the right window. Meanwhile, the crash notably eviscerated almost entirely ALL the gains accrued by the bubble boom days, whereby from peak-to-trough, the SET lost nearly 90%.

The lesson is that bubble cycles, which are fundamentally policy induced, fosters false or deceptive prosperity which results to a net loss in the society (see figure 3).

Bluntly put, short term panaceas have large negative ramifications which basically offset any short term gains.

Professor Ludwig von Mises described exactly how such cycle would result to undeserved sufferings[3] to the populace, (italics mine)

``The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”

How true.

The general perception of the public has been to parse events extensively based on superficial treatment of causal linkages.

Many of these are rooted upon the stakeholder’s problem, whereby the incentive to acquire knowledge is proportional to the degree of direct stakeholdings involved in the decision making process, i.e. anent a specific concern, the lesser the direct stakes involved, the lesser the need to obtain knowledge, and vice versa.

Importantly yet, many apply heuristics or cognitive biases in the way they account for the unfolding events. Thus, even if a person has direct stakes in the marketplace, social pressures which influences one’s mental faculties can lead to reckless undertakings borne about by policy induced false signals.

Particularly prominent is “The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions”─ which largely describes the social attributional bias[4].

This is likewise apparent in the vicissitudes in the relationship between clients and or the public with those engaged in the industry [like me!] (Notice the explosion of the public’s revulsion towards Wall Street as the bubble imploded) or even amongst political leaders (Notice too how politicians are always quick to grab credit on the account of positive economic/financial developments which they intuitively would ‘attribute; to their actions, or notice how politicians hastily blame speculators for greed when an inimical event surfaces).

In addition, the mainstream economic doctrine has mostly been slanted towards using mathematical formalism or what I would call “hiding behind the skirts of accounting identities” to rationalize on policies predicated on time preferences of having instantaneous impact. This is in tradeoff to the possible longer term adverse effects.

The visible short term effect has predominantly been what sells easily to the gullible public, who mostly lack economic comprehension. Economic experts, thus, provide the mathematical or scientific justification, to overwhelm the uninformed public, at which politicians gladly employ at everyone’s expense.

All these combined with human nature’s desire for immediate gratification, skews the public towards “more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about” ─where failure to identify the genuine cause-and-effect would reflexively lead the public to desire for more of the same short term nostrums, which seems similar to the mechanics of illegal substance abuse. Thus, the cumulative psychological distortions induced by inflationary policies.

Figure 3: Google Public Data: ASEAN 5 GNI per Capita Atlas Method[5]

Yet this has been the same phenomenon which has blighted nations afflicted by the current bubble bust cycle seen in the US and several European economies.

And as previously experienced, the ASEAN-5, which includes the Philippines and South Korea, in the aftermath of the 1997 Asian Crisis saw their GNI per capita based on Atlas Method plummet (see figure 3).

And this is concrete evidence that bubble cycles have always been net negative. Yet policymakers seem to be always looking for an artificially triggered unsustainable boom.

No ASEAN Bubble Yet

Let me be clear, this isn’t to say that ASEAN is already in a bubble. This hasn’t been concretely established.

A Bubble essentially is a symptom of government interventionism via extensive inflationism (e.g. interest rate manipulation, guarantees, subsidies, tax policies etc...) which is ultimately vented on the marketplace.

Figure 4: World Bank[6]: World Development Indicators World View

Because bubble cycles have become a regular feature of the global marketplace (see figure 4) since the transition to the current paper money system, we should expect the reappearance of the bubble phenomenon elsewhere.

This is especially true considering the intensive degree of interventionism implemented by global governments to apply band-aid therapy to any economic or financial predicaments including today’s post crisis landscape. As derivative expert and author Satjayit Das narrates[7],

``Botox is commonly used to improve a person’s appearance by removing facial lines and other signs of aging. The effect is temporary and can have significant side effects. The world is currently taking the “botox” cure. A flood of money from central banks and governments -- "financial botox" -- has temporarily covered up unresolved and deep-seated problems.The surface is glossy and smooth, the interior decayed and rotten.”

Moreover, the current state of openness of the international financial system easily functions as transmission mechanism of money in search of yield phenomenon.

Capital mobility, thus, could facilitate to transport bubble conditions from one place to another. It has been no coincidence that bubble cycles has shifted from Japan bubble crash[8] to Mexico’s Tequila Crisis[9] to the Asian Financial Crisis to the Russian Financial Crisis[10] which prompted for the near collapse of the US hedge fund the Long-Term Capital Management[11] to the tech/dot.com[12] bust and finally the US Mortgage crisis triggered Financial crisis of 2007[13]--as global marketplace has become more integrated.

As a caveat, it would be a mistake to treat financial or trade integration as the cause of the crisis. Like knives, trade or financial liberalizations which tend to integrate economic flows are merely tools, whose outcome is based on how it has been utilized.

Why Capital Controls Can Enhance The Bubble Cycle

Globalization cannot by itself engender a bubble because they don’t expand circulation credit (or issuance of credit unbacked by savings). Creation of fiduciary media would be to the account of the banking system.

In addition, globalization isn’t responsible for carefree government expenditures which results to massive budget deficits that periodically have been monetized by government. Thus, inflationism gets to be transmitted outside of the sphere of operations by virtue of the rerating (devaluation) of the currency relative to the others. Devaluation affects the cost structures in the economy and equally this applies to capital flows in reaction to such policies.

Nevertheless financial openness as applied to Asia hasn’t seen any noteworthy progress since the Asian Crisis (see figure 5)

Figure 5: Asian Development Bank: Outlook 2010

According to Asian Development Bank[14],

``The index of de jure financial openness constructed by Chinn and Ito (2008) confirms that, after the Asian financial crisis, restrictions on capital accounts were introduced more often in many Asian economies, including Indonesia, Malaysia, and Thailand. For the rest of developing Asia, de jure financial openness was relatively stable or slightly increasing (i.e., had higher de jure financial index values).”

Capital flows are not significantly a function of ‘fundamentals’, as they are as much determined by relative monetary policies and the relative currency regime, thus capital flows are likely to reflect on the evolving conditions as corollary to these measures, more than “fundamentals” which usually reacts to the incentives provided by the regulatory environment.

Moreover, in contrast to the ADB, which sees the need for capital account restriction as a “guard against economic instability as well as to preserve monetary autonomy”, seems to be a “strawman” argument.

Capital restrictions do not only increase the risk premium by putting property rights into question which inhibits market efficiency thereby restrain economic growth and reduce investment flows, capital controls also fails to account for the backdoor channels where hot money flows can seep into, or smuggled through, which should exacerbate the bubble conditions. As example, despite Venezuela’s stringent capital controls, capital flight[15] from residents appear to accelerate as they flee and seek a safehaven from an increasingly despotic regime.

What deceives people today as the seeming functionality of capital controls is that internal policies have not yet reached enough pressure levels for markets to seek a relief valve.

In other words, regulations will not put a stop to economic order; it will only reconfigure the flows from what is known as legal channels to the underground. Regulations will also not shape the economy in accordance the chimerical whims of the political class. Instead, failed policies will manifest itself in the marketplace or the economy, in terms of shortages, higher rates of inflation, increased unemployment, higher poverty levels and etc..., no matter how the political class exhaustively tries to conceal them.

The basic lesson is that economic laws cannot be repealed by arbitrary regulations.

Yet what is deemed as today’s global imbalances can partly be ascribed to such capital restrictions.

Asian economies may have preferred to recycle to the US their trade surpluses, than within the region largely because of this. And oppositely, the liberal capital flows in the US has attracted Asian money because of the relatively secure property rights which redounds to reduced perception of risks. The liberal capital markets also provide enhanced liquidity which capital restricted markets can’t. So capital restrictions and liquidity are two major factors that also contribute to what mainstream calls as “global imbalances”.

Thus, policy reforms should be directed at capital convertibility for China and more liberalization for Asia and the ASEAN, including the Philippines, than simplistic currency adjustments which does little but promote nonsensical politicking.

Of course, given the fluid political conditions, this equation could dramatically change, especially if China decidedly aims for an aggressively expansion of her influence with her neighbours via economic integration[16], or if the US embarks on policies in the direction of developing economies by virtue of adapting capital controls or by rampant inflationism.

I should further stress that capital restrictions will not “guard against economic instability” because as stated above, capital controls will not prevent markets from ventilating the accrued imbalances as a result of failed policies.

Will The Next Bubble Emanate From Technology Or The Kindleberger Model?

Going back to the risk of an ASEAN bubble, the tendency for bubbles is to look for areas previously unaffected by a bubble bust or from a dislocation such as new technology or new markets (Charles Kindleberger’s model).

It’s not clear if the latter would place a significant influence in the shaping today’s bubble cycles. But as previously pointed out[17], since technology leads the sectoral weightings today in terms of the largest share of market cap of the S&P index, we shouldn’t rule out an emergent bubble from the technology sector.

Technology in terms of services is making an immense headway in shaping today’s global economic trends (see figure 6)

Figure 6. McKinsey Global Institute[18]: How To Compete And Grow

Some factors that may prompt for a technology based dislocation (Kindleberger model) bubble are the following:

-less government intrusion in the market clearing process of the previous dot.com bust,

-swift obsolescence rate of the technology cycle and or rapid rate of innovation could mean new applications

-globalization means more consumers of technology products and services, thus a wider reach and bigger markets, albeit a more niche oriented one (another potential source of dislocation)

-importantly, freer markets which allows for more intensive competition could spawn heightened innovation from which new products with widespread application could emerge.

Yet there are many factors from which technology should play a role in shaping markets and the economy. Fundamentally this involves greater dispersion of knowledge and the deeper role of specialization, which some have labeled as the Hayekian Moment.

The impact of which should include vastly improved business processes via the development of organizational capital[19], provide for more real time activities which immensely reduces transaction costs thereby generate an explosion of commercial or commercial related activities, and significantly flatten organizational hierarchy which becomes attuned to the dynamics of a more competitive environment.

Economic development trends appear to be tilted towards having a greater share of technology based service sector (left window). The more competitive an economy is, the greater the share of the technology based service economy (right window).

This, essentially, is the running transition away from the industrial age towards the information age.

Thus, free market based competition has been directing economic development towards more specialization, or in Austrian economics terms-the lengthening of the production structure.

So a Kindleberger bubble should be on our watch list.

As a caveat bubbles, will not occur without leverage or expanded credit, thus the Kindleberger applies in conjunction with the Austrian Business cycle.

Will The Next Bubble Emerge From Commodity-Emerging Markets?

Of course the other prospective bubble area which I’d remain vigilant with are economies that were largely unscathed by the recent bubble bust.

Figure 7: IMF GSFR[20]: Subdued Property Transactions; Deutsche Bank[21]: BRIC Financial Markets

While it may be true that property prices in major Asian markets could have eased (left window, figure 6), as evidenced by the subdued rate of property transactions, this perhaps suggest of a temporary reprieve than from a prolonged hiatus or even a slump.

In addition, as one of the least exposed in terms systemic leverage, Emerging Asia’s financial markets are vastly underdeveloped (right window) relative to the developed markets.

This implies that in today’s highly expansionary policies, areas with the least leverage could likely be more receptive to these conditions, which I suspect is mainly responsible for the outperformance of ASEAN bourses.

Furthermore, sustained momentum generates followers or believers. This is known as the bandwagon or the herding effect.

Hence, should the ASEAN momentum persists, it is likely to draw in more participants from both the local and international arena. And this will likely reinforce expectations which should prompt for a feedback loop mechanism that enhances the trend. A bubble dynamic will become evident once systemic leverage will accelerate combined with a stratospheric surge in the price levels of assets whereby people will rationalize this as ‘this time is different’ or in different lingo as “tiger economy” or etc…

But this is likely a few years away from now, as systemic leverage is hardly on the radar screen.

At the present moment, momentum is likely to gather speed for ASEAN markets if the global marketplace should see continued reduced volatility. I think that the price signals from the US dollar index should be a great indicator.

Figure 8: Stockcharts.com: Euro And Global Equity Markets Bounce Back

Major global equity markets appear to be confirming the Euro’s rally (see figure 8) as we fortuitously predicted[22].

Major equity markets seemed to have waited out for more confirmation of the sustainability of Euro’s bounce before taking cue. And coincidence suggests to us that from Shanghai (SSEC), the US S&P (SPX) and the Euro Stoxx 50 (STOX), the actions appear to be simultaneous.

Yet what needs to be established is if the current rally signifies as a major reversal of the current trend or just another countercyclical bounce.

While I don’t think the US or European markets are in a bullmarket, they are likely to be higher at the year end from the current conditions. The steep yield curve as we have been saying will be a major factor in providing cushion to the marketplace.

Finally I am in general agreement with those who think that government debts are a bubble.

But the problem is that US treasuries are unlikely to implode if inflation doesn’t pick up and hamstring the US government’s ability to influence the markets. Global governments in collusion can directly or indirectly intervene in the marketplace which I suspect could have been taking place. The US governments needs low interest rates to finance the burgeoning fiscal deficits, aside from low rates to sustain a steep yield curve to keep her banking system afloat.

And intervention is the most likely route since they will have confidence to do so because yields are low. In fact, present low rates are almost the effect of what quantitative easing has previously done. And as we have been saying for the longest time, any signs of economic weakness will prompt for the US government to use the opportunity to intervene anew.

Proof?

From the Washington Post[23],

``Federal Reserve officials, increasingly concerned over signs the economic recovery is faltering, are considering new steps to bolster growth.

``With Congress tied in political knots over whether to take further action to boost the economy, Fed leaders are weighing modest steps that could offer more support for economic activity at a time when their target for short-term interest rates is already near zero. They are still resistant to calls to pull out their big guns -- massive infusions of cash, such as those undertaken during the depths of the financial crisis -- but would reconsider if conditions worsen.”

Q.E.D.

---

[1] See Why The Sell-Offs In Global Markets Are Unlikely Signs Of A Double Dip Recession

[2] Chartrus.com, Thailand’s SET

[3] Mises, Ludwig von; The Market Economy as Affected by the Recurrence of the Trade Cycle, Chapter 20 Section 9, Human Action

[4] Wikipedia.org, Attributional Bias

[5] NationMaster.com, GNI (formerly GNP) is the sum of value added by all resident producers plus any product taxes (less subsidies) not included in the valuation of output plus net receipts of primary income (compensation of employees and property income) from abroad. Data are in current U.S. dollars. GNI, calculated in national currency, is usually converted to U.S. dollars at official exchange rates for comparisons across economies, although an alternative rate is used when the official exchange rate is judged to diverge by an exceptionally large margin from the rate actually applied in international transactions. To smooth fluctuations in prices and exchange rates, a special Atlas method of conversion is used by the World Bank. This applies a conversion factor that averages the exchange rate for a given year and the two preceding years, adjusted for differences in rates of inflation between the country, and through 2000, the G-5 countries (France, Germany, Japan, the United Kingdom, and the United States).

[6] WorldBank.org, World Development Indicators World View, p.10

[7] Das, Satyajit, Botox Economics – Part 1, Satyajit Das’s Blog-Fear & Loathing in Financial Products

[8] Wikipedia.org, Japan Asset Price Bubble

[9] Wikipedia.org, 1994 economic crisis in Mexico

[10] Wikipedia.org 1998 Russian financial crisis

[11] Wikipedia.org, Long-Term Capital Management

[12] Wikipedia.org, dot-com bubble

[13] Wikipedia.org Financial crisis of 2007–2010

[14] Asian Development Bank: Outlook 2010 Macro Management Beyond The Crisis, p.87

[15] Venezuelaanalysis.com, Inflation in Venezuela Higher This Half Year July 9, 2010

[16] See Asian Regional Integration Deepens With The Advent Of China ASEAN Free Trade Zone

[17] See What The Distribution Of S&P 500 Sector Weightings Seem To Say

[18] McKinsey Global Institute, How To Compete And Grow A Sector Guide to Policy, March 2010

[19] Garrett Jones, ``Organizational capital is basically the ideas and habits of work that people build at work. We know what physical capital is--the machines. Businesses also build cultures, R&D labs and trained people. A lot of what we are doing at work is building patterns, processes.” Professor Russ Roberts, Garrett Jones on Macro and Twitter, ecotalk.org

[20] IMF, Global Financial Stability Report, Financial Stability Set Back as Sovereign Risks Materialize, July 2010

[21] Deutsche Bank Research, BRIC Capital Markets Monitor, June 2010

[22] See Buy The Peso And The Phisix On Prospects Of A Euro Rally

[23] Irwin, Neill Federal Reserve weighs steps to offset slowdown in economic recovery Washington Post, July 8, 2010