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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Sequel To Asian Financial Crisis? Not So Fast!

 

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

 

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

 

Look at the following horrid news items:

 

This from the Bloomberg (emphasis mine),

 

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

 

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

 

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

 

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

 

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

 

Or this from UK Timesonline.co.uk

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Horror Stories Deserve A Second Look

 

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

 

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

 

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

 

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

 

Another proof?

 

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

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

 

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

 

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

 

Additional information from the Inquirer.net,

 

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

 

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

 

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

 

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

 

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

 

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

Figure 3: PSE: Once Again, Diminishing Foreign outflows

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Conclusion

 

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

 

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

Will King Dollar Reign Amidst Global Deflation?

``Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”.- John Stuart Mill (1806-1873) British philosopher, political economist, civil servant and Member of Parliament, was an influential liberal thinker of the 19th century.

Deflation proponents have been confidently increasing their pitch of a global depression or “severe and prolonged” recession cheering about the US dollar’s recent gains as signs of such manifestation.

Since the US credit system has turned disorderly and dysfunctional, it is true that an alternative major flux for global “liquidity” stems from the US current account deficit. And an improving US current account deficit suggests of a further drain of liquidity AWAY from the global financial system, thus amplifying risk towards the financial markets.

Deflation proponents emphatically argue that the strength of the US dollar stems from (factually) the US dollar’s role as the de facto world currency reserve and secondarily from its sophisticated, deep and advanced state of the markets that are likely to attract “limited” capital flows away from the hinges and back to the center or the origin. Hence a global meltdown extrapolates to KING dollar reasserting its hegemonic role in the international monetary sphere.

Global Liquidity Story Isn’t Exclusively A US Dollar Issue

The US dollar’s role as the nonpareil currency reserve of the world is yet incontrovertible, meaning the US still maintains its lead position among the other currencies as the elected currency benchmark (or reserves) for central banks.

BUT its leadership isn’t at all the monopoly it once used to be. And this is the important difference: the Euro has incrementally been expanding a material foothold in the share of the composition of the currency reserve market especially in the context of developing countries or emerging markets.

From the IMF’s September 2007 survey (emphasis mine),

``Data reported to the IMF by industrial and developing (nonindustrial) countries, compiled on an aggregate basis in the IMF's Currency Composition of Official Foreign Exchange Reserves (COFER) database, reveal that more developing countries than industrial countries have switched holdings into euros. Nonindustrial countries hold some 30 percent of their reserve assets in euros and 60 percent in dollars (as of December 2006), compared with 19 percent and 70 percent, respectively, six years earlier.

``Industrial countries' use of the euro has risen to 21 percent from 17 percent in December 2000, while their dollar holdings have remained fairly steady at 72 percent compared with nearly 73 percent six years earlier. Their remaining holdings are in such currencies as the Japanese yen and the pound sterling.”

Figure 1: Brad Setser: Central Banks Still Buying Dollars

Figure 1 from our favorite fund flow analyst Brad Setser of the Council of Foreign Relations shows how the composition of global currency reserves have been growing over the past decade.

So even as currency reserves of global central banks have steadily grown in absolute terms, which also translates to growth in other major currencies aside from the US dollar, the Euro seems to have outpaced the growth in the US dollar. Hence, the growing share of the Euro relative to the US dollar in the universe of currency reserves.

Why is this important? Because if the premise for a severe recession comes from financial links in terms of a liquidity crunch (aside from the trade linkage), then from the angle of asymmetries in the current account distribution-the Euro zone against the emerging markets-also matters.

If hypothetically 65% of global currency reserves are in the US dollars, and 25% comes from the Euro then the trade imbalances also project liquidity flows not only from the US (although it signifies the main channel) but also from the secondary reserve currency in the Euro and also (but insignificantly) in others. Hence the Euro is also a contributor to global liquidity!

In other words, global liquidity flows from the premise of the trade-current account is not solely a US perspective and can’t be the only basis to reckon for liquidity flows, see figure 2.

Figure 2:tradingeconomics.com: China Trade Balance

Figure 2 from tradingeconomics.com illustrates China’s growing surplus from its trade balance with the world despite the present economic growth slowdown, which implies a shift of the weight of its trade from the US to the Eurozone. Thus, these surpluses have “partially” contributed to the amazing $1.81 trillion surge in their forex reserves last July in spite of the sagging global economy.

And this shouldn’t be seen in the context of China alone as much as it should apply to other emerging countries such as the oil exporting nations most especially the Gulf Cooperation Council (GCC).

While it may be true that the Eurozone may now be feeling the pinch of a US led dramatic growth economic slowdown as we pointed out in our recent weekday post Global Recession watch: Japan and Euroland Economic Growth Turns Negative!, this will also translate to a second round leash effect on the US, which means it isn’t clear whether the US current account deficit would improve at all (since both exports and imports are likely to deteriorate in the face of a slowing global economy!).

One thing seems clear is that regardless of the state of the US current account, the case for the taxpayer funded government intervention to ameliorate the woes from the deleveraging plagued stricken Wall Street plus the spillover effects on the Main street are likely to more than offset any improvements in the current account, which means more financing needs by the US public-by either of the following options borrowing abroad, selling assets or printing money-and private sector.

The point is improving current account imbalances should reflect both sides of the ledger and doesn’t automatically translate to a complete or outright drain of liquidity as deflation proponents suggest.

Strength of US Dollar Depends On The Reliability Of US Markets?

Yet if the argument will directed to the premise that the inherent advantage of the US markets due to its depth, sophistication and advance conditions signify as main reasons why the perceived “trust” as a safehaven status, this quote from the Bank of the International Settlements over the fate of the Euro as an alternative foreign currency reserves should serve as an eye opener (highlight mine) `` The euro comes closest to challenging the dollar in its role as a store of value. As a unit of account and medium of exchange, the dollar’s role is not as secure as it once was, but the dollar is still preeminent.”

So what defines a store of value for the BIS?

Again the BIS ``In the strictest sense, this will be a currency whose value is reliable in terms of future purchasing power. This in turn is linked to the maintenance of sustainable macroeconomic policies. Moreover, the store of value function can also depend on the anchoring role of a currency to the extent that the central bank tries to align the currency composition of its country’s assets and liabilities. More generally, the store of value function of an international currency is linked to the breadth and depth of financial markets, in particular to the availability of investments which meet wealth holders’ risk-return objectives.”

So if the Euro’s best chance to compete with the US dollar is seen in the role of a store of value, it implies that the Euro’s “breadth and depth of the financial markets” appears to have nearly assimilated the US markets in order for the BIS to issue such qualifying statement.

Besides, in today’s functioning monetary platform in the fiat “paper” money standard whose system is backed by nothing but promises based on “Full Faith and Credit” of governments then the US dollar as the alleged beneficiary via the “safehaven” asset status from a global meltdown overlooks where the epicenter or source of today’s crisis emanates from.

This comment from Yu Yongding, a former adviser to China's central bank on the cataclysmic repercussions for the global financial system on a failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac as quoted by Bloomberg (HT: Craig McCarty)

``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic, if it is not the end of the world, it is the end of the current international financial system.''

If we go by Mr. Yongding’s statement; the end of the current international financial system is tantamount to the end of the US dollar as the global currency reserve!

So how does one consider the US dollar as today’s “safehaven” when it has been a major source (US housing bust, subprime, Fannie and Freddie Mac) for most of the troubles scourging the financial markets today?

True, global central banks continue to accumulate US dollars have been responsible for their policy decisions, but this is done to maintain the status quo or because of the Nash Equilibrium-(wikipedia.org - a game of two or more players wherein “each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his or her own strategy (i.e., by changing unilaterally). If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium.”)

- or its military doctrine equivalent of the Mutually Assured Destruction (MAD) scenario where once such an event unfolds could prove to be devastating to all involved (once deeply exposed trading partners of the US suddenly decide to quit the game)! So for example, if China decides to quit from the US dollar accumulating game, hell would probably break lose (via a US dollar crisis or hyperinflation on a global scale)!

So it isn’t clear that global central banks will continue supporting the US economy or its financial markets, which will likely to be reflected in the state of the US dollar, if economic or political conditions degenerate further.

Besides, US officials seem very much aware of these conditions, hence quickly signed into a new law to provide for a temporary fix to the ailing GSEs; aside from previous bridge liquidity “alphabet soup” of Fed-US treasury programs, widening the scope of collateral acceptance and direct stimulus to the public.

Another, the seeming “resiliency” of the US economy in the face of a housing and financial sector meltdown has been predicated on mainly its “net” exports and global central bank financing. Thus we read into US Federal Reserve Chair Ben Bernanke’s current policy actions as an indirect stimulus meant for global economies especially for countries tied to the US dollar via currency pegs as previously discussed Global Financial Markets: US Sneezes, World Catches Cold!. The US seems banking on “inflating” on global growth to sustain its economy and keep it out from the clutches of recession.

Thus inflation as a US monetary policy is being transmitted globally and the world has been reciprocating.

Proof?

This from Joachim Fels of Morgan Stanley (emphasis mine),

``In most countries – even in many that have raised interest rates this year – the policy stance is fairly easy. Real short-term interest rates (nominal policy rates minus current CPI inflation) are currently negative in no less than 20 of the 36 countries in our coverage universe. Among others, these include the US, Japan, Canada, Switzerland, Russia, Ukraine, the Czech Republic, Korea, Taiwan, Singapore, Indonesia, the Philippines, Malaysia and Peru. With policy easy to start with, there is thus little scope to cut rates aggressively. By contrast, there are only a few countries that have relatively high real short rates and thus tight monetary polices. Apart from Australia and New Zealand (where real short rates stand at 2.75% and 4%, respectively), these include Brazil and Turkey, where real rates stand at 6.6% and 4.65%, respectively.

``Global real policy rate still negative. Aggregating across all countries in our coverage universe, the weighted global monetary policy rate currently stands at 4.5% in nominal terms. However, current global (weighted) inflation is running at 5.3%, so the global real rate is -0.8%, the lowest in this decade. Thus, global monetary conditions remain very expansionary, limiting the room for a major global monetary easing.

So if global monetary environment remains expansionary how can deflation proponents argue that the world will be engulfed with a meltdown from deflationary forces? The US and the UK, Spain, Ireland, Australia and those suffering a structural “housing bust” does not translate to the same predicament all over the world, especially not in the Philippines.

Besides what is to “deflate” in the Philippines or most of Asia?

Figure 3: BIS: Loan/deposit Ratio of banking systems in Asia and the Pacific

Except for Australia and Korea whose loans are above deposit reserves, loans in most of Asia have not been “leveraged” as shown by the BIS and are below reserves of deposits. In other words, the Asian banking system has more deposits than extended loans.

Yes, a global economic slowdown is in the cards-some will experience recession, some won’t-but definitely not from the garden variety type as seen in the deflation paragon.

Deleveraging Is Not A One Way Street; Short Sales And Market Efficiency

Then there’s the other argument where the whole world will be enveloped by the feedback loop of de-leveraging.

Against the common impression deleveraging isn’t a one way-street though, see figure 4, especially when we deal with advanced or sophisticated markets because of the available facilities to bet on EITHER DIRECTIONS.

Figure 4: stockcharts.com: US-dollar Index-commodity Pair trade

The chart in figure 4 shows how gold (candlestick main window) /oil (lower pane) and the US dollar index (black line behind main window) have had a strong inverse correlation, as demarcated by the blue vertical lines (as US dollar troughs when oil/gold peaks and vice versa). The Dow Jones AIG Grain (lowest pane) seems to have moved ahead of its major commodity bellwether.

The tight correlation suggests of the proliferation of “paired” trades, which means participants who shorted/longed the US dollar also bought/sold oil and gold. Such is why the violent action in one market could have reflected an equally volatile action in the another-but in an opposite direction!

It also means that since every transaction is accounted for by an entity, anyone (represented by an individual or by a company) who is “forced to liquidate or delever” on their market position has to closeout (by taking the opposite position-of either a buy or sell-on the original position taken!). If an entity took up a “short sell” position then one closes by “buying”, and in the same manner if the same entity takes up a “long” position then the consummation of the trade translates to a “sell”.

Thus deleveraging doesn’t automatically mean selling, it can also mean buying!

Proof?

Figure 5: US SEC’s Short Sale curb=Magnified Upside For US Financials!

The US SEC imposed a curb on “naked” (selling without actual possession of borrowed shares) short selling on 19 financial companies last July 16^th. And as we demonstrated above, the huge short position taken by the public was forced to unravel, see figure 5 (see blue arrows). This led to a strong simultaneous upside rebound for the beleaguered Dow US financials (main window), the Broker Dealers (pane below the main window) and Banking indices (lowest pane). Yet this doesn’t account for derivatives.

Maybe one factor why the US equity markets have not entirely collapsed in the face of a prospective or ongoing recession, prompted by the meltdown in the housing and financial domain, is because of the public’s liberal access to “short” the market. To quote Mises.org’s Robert Murphy ``But the basic principle is simple enough: just as a speculator who wants to go long can borrow money to buy stocks, so too a speculator who wants to go short can borrow stocks to "buy money." Short selling is no more mysterious than buying stocks on margin.” Hence, the short selling facilities could have minimized the volatility on the downside by allowing for greater pricing efficiency through expanded liquidity.

Well of course since this isn’t back by any evidence, this is just a guess on my part.

But for the world markets especially in dealing with the deleveraging issue, it could be a different story. Deleveraging means global investors have to sell equity holdings as “short facilities” have not been as deep and widely used as those in the US.

For instance, the Philippines now allows for “borrow and lending”, though I have not read the entire regulation, based on my principal’s opinion, the rules seem quite stringent and rigid as to discourage any actual application because of the costs of compliance. If costs exceeds the benefit who will avail of the trade?

Put differently what good is a facility if it is stifled by suffocating regulations or if it can’t be used?

Finally the penchant of deflation proponents is to compare present occurrence to that of the Great Depression,

This quote from Professor Barry Eichengreen of the University of California, Berkeley in the Financial Times should account for a good retort,

``And since other currencies were linked to the dollar by the fixed exchange rates of the gold standard, US deflation caused foreign deflation. As US demand weakened, other countries saw their currencies become over­valued. They were forced to raise interest rates in the teeth of a deflationary crisis. By raising interest rates, foreign countries transmitted deflation back to the US. Only when they delinked from the dollar and allowed their currencies to depreciate did deflation subside.

``The difference now is that the Fed knows this history. Indeed Ben Bernanke, the Fed chairman, wrote the book on the subject. Seeing the analogy, his Fed has responded to the subprime crisis with aggressive lender-of-last-resort operations. If anything, it may have been too impressed by the analogy. Its mistake was to cut interest rates so dramatically at the same time that it extended its credit facilities. It would have been better to lend freely at a penalty rate. Higher interest rates would have made its emergency credit more costly and led to better-targeted lending and less inflation.

``The Fed’s response has forced other central banks that manage their exchange rates against the dollar, mainly in Asia, to import inflation rather than deflation. Their currencies have become undervalued rather than overvalued. As their real interest rates have fallen, these countries are now exporting inflation back to the US. Where global deflation led to the collapse of commodity prices in the 1930s – devastating those countries dependent on exporting commodities – our current inflation is having the opposite effect. This time, primary producers are the biggest beneficiaries.”

In short, the gold standard of then and today’s paper currency standard aside from the transmission effects of the currency pegs supported by mercantilist policies have been important nuances.

One important thing which was not marked by this observation was that the Great Depression was significantly exacerbated by “Protectionism”.

Summary and Recommendations

A global recession may happen but it isn’t likely to be a depression or alternatively said “severe and prolonged”. Not for most of Asia, especially the Philippines. A global recession may occur because OECD or major developed economies seem to be undergoing recession but is not likely the case for most of the EM economies.

The argument for a US current account improvement as effectively draining the global liquidity picture seems incomplete. The Euro is also a secondary contributor. Although a slowing Eurozone could also mean further test on global liquidity conditions.

Likewise, the second round effect from a global economic slowdown is likely to put a stress on US exports clouding the certainty of the improving path of the US current account balance.

What is clear is that the taxpayer funding of the financial sector and of the main street will offset any improvement in the current account which means more financing requirements through external borrowing, selling of assets to foreigners or monetization.

The argument that the US dollar represents as “safehaven” under a global deflation is unclear if not questionable. First, global deflation seems unlikely; the world’s monetary climate seems still expansionary. Besides most of Asia has less to deflate compared to the overleveraged West. Asia’s “contagion” problems will likely fall on liquidity and not solvency issues.

Second, since the US dollar is the source of the present stress, the argument of its “safehaven” status has been in a test since 2002. Such tests isn’t likely to end soon and may get worst.

Third, the recent rebound by the US dollar and the accompanying fierce selloff in the commodities could be as a result of pair trade deleveraging, aside from a reflection of a global economic growth slowdown. Deleveraging does not equate to outright selling since it can also mean buying especially under markets that are advanced, sophisticated and deep.

Fourth, we don’t buy the argument that the US dollar or the Euro or of any paper currencies as representing any insurance from currency debasement policies by global governments. Inflationary policies assure the loss of purchasing power of paper currencies.

Although the US dollar may rally against the Euro, this may signify an interim or cyclical move instead of a complete turnaround similar to 2005. The US dollar has been in a bear market since 2002 and is likely to remain under pressure given the massive fundamental imbalances it is faced with.

Meanwhile, gold has been on a losing streak. Gold and precious metals represent as our insurance against government’s inflationary actions. The precious metal sector could depart from the performances of its industrial siblings based on the question of health of global economies.

We understand gold to be in a long term bullmarket especially from the fundamental perspective where global governments will work to use their inflationary powers to reduce the impact of any financial or economic dislocation for mostly political ends.

Figure 6: US Global Investors: Gold’s Seasonal Performance

We understand too that added to gold’s present infirmities from delevariging issues is that gold is in a seasonal weakness (see figure 6) and could most likely pick up over the next few months once the deleveraging issues fade.