Quote of the Day: China’s Stock Market Manipulation Exposes on the Perils of Outsized Global Asset Bubbles

…just as in Japan, the US, and Europe, there can be no mistaking what prompted China’s manipulation: the perils of outsize asset bubbles. Time and again, regulators and policymakers – to say nothing of political leaders – have been asleep at the switch in condoning market excesses. In a globalized world where labor income is under constant pressure, the siren song of asset markets as a growth elixir is far too tempting for the body politic to resist.

Speculative bubbles are the visible manifestation of that temptation. As the bubbles burst – and they always do – false prosperity is exposed and the defensive tactics of market manipulation become both urgent and seemingly logical.

Therein lies the great irony of manipulation: The more we depend on markets, the less we trust them. Needless to say, that is a far cry from the “invisible hand” on which the efficacy of markets rests. We claim, as Adam Smith did, that impersonal markets ensure the most efficient allocation of scarce capital; but what we really want are markets that operate only on our terms.

This excerpt is from Stephen S. Roach's Market Manipulation Goes Global published at the Project Syndicate. Mr Roach is former Chairman and chief economist of Morgan Stanley Asia and the firm's chief economist, a senior fellow at Yale University's Jackson Institute of Global Affairs, a senior lecturer at Yale's School of Management and author.

Recommended Links: A Sense of Ending, Misplaced Belief in Central Bankers and Dangerous Delusions

Bond Maven William H Gross believes that the endgame for central bank magic nears. Selected excerpts from his monthly outlook at Janus Capital, (bold mine)

A “sense of an ending” has been frequently mentioned in recent months when applied to asset markets and the great Bull Run that began in 1981. Then, long term Treasury rates were at 14.50% and the Dow at 900. A “20 banger” followed for stocks as Peter Lynch once described such moves, as well as a similar return for 30 year Treasuries after the extraordinary annual yields are factored into the equation: financial wealth was created as never before. Fully invested investors wound up with 20 times as much money as when they began. But as Julian Barnes expressed it with individual lives, so too does his metaphor seem to apply to financial markets: “Accumulation, responsibility, unrest…and then great unrest.” Many prominent investment managers have been sounding similar alarms, some, perhaps a little too soon as with my Investment Outlooks of a few years past titled, “Man in the Mirror”, “Credit Supernova” and others. But now, successful, neither perma-bearish nor perma-bullish managers have spoken to a “sense of an ending” as well. Stanley Druckenmiller, George Soros, Ray Dalio, Jeremy Grantham, among others warn investors that our 35 year investment supercycle may be exhausted. They don’t necessarily counsel heading for the hills, or liquidating assets for cash, but they do speak to low future returns and the increasingly fat tail possibilities of a “bang” at some future date. To them, (and myself) the current bull market is not 35 years old, but twice that in human terms. Surely they and other gurus are looking through their research papers to help predict future financial “obits”, although uncertain of the announcement date. Savor this Bull market moment, they seem to be saying in unison. It will not come again for any of us; unrest lies ahead and low asset returns. Perhaps great unrest, if there is a bubble popping…

At the Grant’s Conference, and in prior Investment Outlooks, I addressed the timing of this “ending” with the following description: “When does our credit based financial system sputter / break down? When investable assets pose too much risk for too little return. Not immediately, but at the margin, credit and stocks begin to be exchanged for figurative and sometimes literal money in a mattress.” We are approaching that point now as bond yields, credit spreads and stock prices have brought financial wealth forward to the point of exhaustion. A rational investor must indeed have a sense of an ending, not another Lehman crash, but a crush of perpetual bull market enthusiasm.

Read the rest here

Sovereign Man’s Simon Black on Walter Bagehot’s exposition of the public's halo effect on central banking (bold mine)

Bagehot was Editor-in-Chief of The Economist at the time. He was a brilliant finanical thinker, and the book, Lombard Street: A Description of the Money Market, was his masterpiece.

For example, the book describes how, even though the British banking system was the most widely used and powerful in the world, it was dangerously overleveraged:

“There was never so much borrowed money collected in the world as is now collected in London,” writes Bagehot.

He further shines a huge spotlight on the risks of illiquidity, describing how Britain’s largest banks only held a very small percentage of their customer’s funds in cash:

“[T]here is no country at present, and there never was any country before, in which the ratio of the cash reserve to the bank deposits was so small as it is now in England.”

He continues:

“[T]he amount of that cash is so exceedingly small that a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it.”

…

Bagehot also blasts the central banking system (dominated by the Bank of England) which had effective control over the economy:

“All banks depend on the Bank of England, and all merchants depend on some bank.”

Of course, no one truly understood how that system worked. Everyone just had confidence that the central bankers were smart guys and absolutely would not fail:

“[F]ortunately or unfortunately, no one has any fear about the Bank of England. The English world at least believes that it will not, almost that it cannot, fail.”

“[N]o one in London ever dreams of questioning the credit of the Bank, and the Bank never dreams that its own credit is in danger.”

But as Bagehot points out, the data showed otherwise:

“Three times since 1844 [the Bank of England] has received assistance, and would have failed without it. In 1825, the entire concern almost suspended payment; in 1797, it actually did so.”

Clearly these central bankers weren’t particularly good at their jobs. Bagehot sums it up like this:

“[W]e have placed the exclusive custody of our entire banking reserve in the hands of a single board of directors not particularly trained for the duty—who might be called ‘amateurs’. . .”

Read the rest here

Former Chairman of Morgan Stanley Asia, now senior fellow at the Yale Institution worries over the world having gone mad, excerpts from the Project Syndicate

But fear not, claim advocates of unconventional monetary policy. What central banks cannot achieve with traditional tools can now be accomplished through the circuitous channels of wealth effects in asset markets or with the competitive edge gained from currency depreciation.

This is where delusion arises. Not only have wealth and currency effects failed to spur meaningful recovery in post-crisis economies; they have also spawned new destabilizing imbalances that threaten to keep the global economy trapped in a continuous series of crises.

Consider the US – the poster child of the new prescription for recovery. Although the Fed expanded its balance sheet from less than $1 trillion in late 2008 to $4.5 trillion by the fall of 2014, nominal GDP increased by only $2.7 trillion. The remaining $900 billion spilled over into financial markets, helping to spur a trebling of the US equity market. Meanwhile, the real economy eked out a decidedly subpar recovery, with real GDP growth holding to a 2.3% trajectory – fully two percentage points below the 4.3% norm of past cycles.

Indeed, notwithstanding the Fed’s massive liquidity injection, the American consumer – who suffered the most during the wrenching balance-sheet recession of 2008-2009 – has not recovered. Real personal consumption expenditures have grown at just 1.4% annually over the last seven years. Unsurprisingly, the wealth effects of monetary easing worked largely for the wealthy, among whom the bulk of equity holdings are concentrated. For the beleaguered middle class, the benefits were negligible.

“It might have been worse,” is the common retort of the counter-factualists. But is that really true? After all, as Joseph Schumpeter famously observed, market-based systems have long had an uncanny knack for self-healing. But this was all but disallowed in the post-crisis era by US government bailouts and the Fed’s manipulation of asset prices.

America’s subpar performance has not stopped others from emulating its policies. On the contrary, Europe has now rushed to initiate QE. Even Japan, the genesis of this tale, has embraced a new and intensive form of QE, reflecting its apparent desire to learn the “lessons” of its own mistakes, as interpreted by the US.

But, beyond the impact that this approach is having on individual economies are broader systemic risks that arise from surging equities and weaker currencies. As the baton of excessive liquidity injections is passed from one central bank to another, the dangers of global asset bubbles and competitive currency devaluations intensify. In the meantime, politicians are lulled into a false sense of complacency that undermines their incentive to confront the structural challenges they face.

Read the rest here

Stephen Roach: Fed is courting an increasingly treacherous endgame at home and abroad

More economist expressing of the baneful effects and depraved ethics of QE.

Here is former chairman Morgan Stanley, Stephen Roach, at the Project Syndicate entitled 'Occupy QE' (bold mine) [hat tip zero hedge]

The Federal Reserve continues to cling to a destabilizing and ineffective strategy. By maintaining its policy of quantitative easing (QE) – which entails monthly purchases of long-term assets worth $85 billion – the Fed is courting an increasingly treacherous endgame at home and abroad.

By now, the global repercussions are clear, falling most acutely on developing economies with large current-account deficits – namely, India, Indonesia, Brazil, Turkey, and South Africa. These countries benefited the most from QE-induced capital inflows, and they were the first to come under pressure when it looked like the spigot was about to be turned off. When the Fed flinched at its mid-September policy meeting, they enjoyed a sigh-of-relief rally in their currencies and equity markets.

But there is an even more insidious problem brewing on the home front. With its benchmark lending rate at the zero-bound, the Fed has embraced a fundamentally different approach in attempting to guide the US economy. It has shifted its focus from the price of credit to influencing the credit cycle’s quantity dimension through the liquidity injections that quantitative easing requires. In doing so, the Fed is relying on the “wealth effect” – brought about largely by increasing equity and home prices – as its principal transmission mechanism for stabilization policy.

There are serious problems with this approach. First, wealth effects are statistically small; most studies show that only about 3-5 cents of every dollar of asset appreciation eventually feeds through to higher personal consumption. As a result, outsize gains in asset markets – and the related risks of new bubbles – are needed to make a meaningful difference for the real economy.

Second, wealth effects are maximized when debt service is minimized – that is, when interest expenses do not swallow the capital gains of asset appreciation. That provides the rationale for the Fed’s zero-interest-rate policy – but at the obvious cost of discriminating against savers, who lose any semblance of interest income.

Third, and most important, wealth effects are for the wealthy. The Fed should know that better than anyone. After all, it conducts a comprehensive triennial Survey of Consumer Finances (SCF), which provides a detailed assessment of the role that wealth and balance sheets play in shaping the behavior of a broad cross-section of American consumers.

In 2010, the last year for which SCF data are available, the top 10% of the US income distribution had median holdings of some $267,500 in their equity portfolios, nearly 16 times the median holdings of $17,000 for the other 90%. Fully 90.6% of US families in the highest decile of the income distribution owned stocks – double the 45% ownership share of the other 90%.

Moreover, the 2010 SCF shows that the highest decile’s median holdings of all financial assets totaled $550,800, or 20 times the holdings of the other 90%. At the same time, the top 10% also owned nonfinancial assets (including primary residences) with a median value of $756,400 – nearly six times the value held by the other 90%.

All of this means that the wealthiest 10% of the US income distribution benefit the most from the Fed’s liquidity injections into risky asset markets. And yet, despite the significant increases in asset values traceable to QE over the past several years – residential property as well as financial assets – there has been little to show for it in terms of a wealth-generated recovery in the US economy.

This essentially validates my latest outlook where I noted “a significant share of stock ownership have been in the upper ranges of the income bracket”.

The basic error of QE, again from Stephen Roach

This underscores yet another of QE’s inherent contradictions: its transmission effects are narrow, while the problems it is supposed to address are broad. Wealth effects that benefit a small but extremely affluent slice of the US population have done little to provide meaningful relief for most American families, who remain squeezed by lingering balance-sheet problems, weak labor markets, and anemic income growth.

In short, using macro tools to solve micro problems are not only  incompatible they are bound to generate unintended adverse consequences

The injustice from QE:

Lost in the angst over inequality is the critical role that central banks have played in exacerbating the problem. Yes, asset markets were initially ecstatic over the Fed’s decision this month not to scale back QE. The thrill, however, was lost on Main Street.

As I wrote:

Such stealth transfer of wealth enabled and facilitated by central bank policies are not only economically unsustainable, they are reprehensively immoral.

ASEAN Meltdown: Phisix and SETI crashes into Bear Markets, Singapore and Malaysia Slumps

Back in June I wrote:

The volatility in global bond markets remains a clear and present danger. Until these markets subside either naturally or through political interventions (in the hope that such interventions will have the desired effect), the prospects of further deterioration of markets should not be discounted. On the contrary, this should be expected.

And continued volatility may push many emerging markets including the Phisix into respective bear markets which increases the risks of a global crisis. There are many flashpoints not limited to Japan. They may come from China, ASEAN, Eurozone or elsewhere. Perhaps the US will be the last in the domino chain.

Today, the Philippine Phisix and Thailand’s SET joined the Indonesia in their respective bear markets partially fulfilling my earlier predictions.

Indonesia's tail spinning equity markets as represented by the JCI has been intensifying at an incredibly alarming rate. The JCI sank 3.71%.

Indonesian Rupiah

10 year Indonesian bond

Indonesia’s rupiah has been under sustained pressures as the domestic 10 year bond yields continue with its almost daily dramatic ascent.

A popular aphorism "misery loves company" seems relevant to the contemporary conditions of ASEAN markets.

The bears have retaken command over the Philippine Phisix which tanked today by another wicked 3.96%, adding to last week's 5.5+% injury.

Foreigners posted net selling of Php 2.457 billion (US $ 55.217) as the local equity benchmark reentered the bear market territory for the second time in three months.  

The second bear market strike essentially reinforces the 1st bear assault last June. Along with 3 ASEAN stocks in bear markets, bears appear to be firmly in command. And it would likely take a Deus ex machina (new QE by the FED perhaps?) to save the day for the bulls. But if the damage from the financial markets spread into the real economy, even a new QE won't likely restore bubble conditions for ASEAN.

While Philippine bonds had been marginally changed, the local currency sympathized with the dreary region, the Peso fell .54% to 44.50. The USD-PHP rose to a 31 month high.

Plummeting by 2.65%, Thailand’s SETI also encroached into the bear market.  The frenzied liquidations also hounded the Thai currency the baht, as well as Thai’s 10 year bonds.

Malaysia’s equities as represented by the KLSE declined 1.23% accompanied by her currency the ringgit. Malaysian bonds had been little changed today.

What seem as striking has been that of the equity markets of Singapore which fell harder than Malaysia today. The STI now trades BELOW the June lows. 

The Singaporean dollar also got battered today.

As I wrote last Sunday, (bold original)

Should the bond vigilantes persist to haunt Singapore, then this would signify as a warning sign for a possible black swan event to occur in Asia.

Add the unfolding events in Indonesia and Thailand with Singapore’s predicament, these are distressing signs, not just of foreign outflows and of the growing risks of a regional recession, but of a brewing regional crisis.

Pardon the appeal to authority but Stephen S. Roach, former chairman and chief economist of Morgan Stanley Asia and senior fellow at Yale University, also suspects that the world could be “in the early stages of another crisis”

Writing at the Project Syndicate, Mr. Roach puts the onus on Asia’s meltdown on Bernanke’s ‘QE Exit strategy’ laps.

Never mind the Fed’s promises that any such moves will be glacial – that it is unlikely to trigger any meaningful increases in policy rates until 2014 or 2015. As the more than 1.1 percentage-point increase in 10-year Treasury yields over the past year indicates, markets have an uncanny knack for discounting glacial events in a short period of time.

Courtesy of that discounting mechanism, the risk-adjusted yield arbitrage has now started to move against emerging-market securities. Not surprisingly, those economies with current-account deficits are feeling the heat first. Suddenly, their saving-investment imbalances are harder to fund in a post-QE regime, an outcome that has taken a wrenching toll on currencies in India, Indonesia, Brazil, and Turkey.

As a result, these countries have been left ensnared in policy traps: Orthodox defense strategies for plunging currencies usually entail higher interest rates – an unpalatable option for emerging economies that are also experiencing downward pressure on economic growth.

In my view and as explained last Sunday, the current EM and ASEAN turmoil has been about the global bond vigilante’s growing recognition of the eroding capability of central banks to influence the markets.

ASEAN's rapidly deteriorating risk environment should not be dismissed or ignored.

Caveat emptor

Video: Stephen Roach: Central Bankers Pulling the Wool Over Our Eyes with ZIRP and Magical QE

[hat tip ZeroHedge]

In the interview with Bloomberg’s Tom Keene at Davos, Morgan Stanley Asia’s Stephen Roach is right to point out that central bankers have been pulling the wool over our eyes with ZIRP and magical QE, which for him does little to sustain economic recovery, and that central bankers have been mired in a policy trap—or commitments to up the ante on current policies to produce short term outcomes.

However Mr. Roach eludes the political aspects of why central bankers have been pulling the wool over our eyes with these monetary nostrums, which palpably has been designed to save the skins of bankers and their political patrons.

And Mr. Roach glosses over the fact that current monetary panacea, which have brought upon the 2008 crisis and which continues to linger today, has real effects to the economy, through accretion of imbalances or malinvestments which engenders another bust down the road. What this means is that boom bust cycles has distortive effects to a large segment of an economy.

Also policy traps are representative of the priorities of typical political agents.

Mr. Roach speaks highly of China’s fine tuning of monetary policies, which he believes the recent gamut tightening measures has been effective enough for the Chinese authorities to allow for policy accommodation under current conditions. Mr. Roach also hopes to see central bankers imbue on the traits of ex-US Federal Reserve chair Paul Volcker. Lastly Mr. Roach says that capitalism built on Greenspan’s policies had been misplaced.

I am sure that Paul Volcker is an exception to the norm, given the environment of the yesteryears, but am not sure if Paul Volker today would apply the same set of policies. In short, I am sceptical of the time consistency of Paul Volcker’s policies.

Further given that Chinese authorities has been operating on Keynesian guided policies, then same boom bust cycles will apply. So far real pool of savings in China has deferred on the day of reckoning, but current policies which extrapolate to capital consumption will eventually expose these imbalances.

Lastly with due respect to Mr. Roach, central banking, or the politicization of money, does not in any way embody capitalism. Remember half of every transactions facilitated by legal tender imposed medium isn’t one determined by the markets but by government.

And neither does Greenspan’s unregulated financial system which has been anchored on manipulating interest rates and bailouts, and whose regulations has been gamed by the political and banking class.

Capitalism does not prevent market from clearing excesses, but to the contrary induces such dynamics. The persistency of the 2008 crisis, which extends today, has been due to policies which has been preventing the required adjustments from previously acquired malinvestments and distortions.

Stephen Roach: Quantitative Easing Won't Work

In a recent CNBC interview, Morgan Stanley's Stephen Roach says that the world has been focused on the wrong problem, and that what ails the so called "imbalances" is principally about savings.

He also adds that currency fix is not going to work and is a result of bad economics and political propaganda.

In addition he says that capital controls are the wrong way to go about. And that quantitative easing will not work because it does not deal with root of the problem-savings.

Stephen Roach: Bernanke Is Just Rerunning Greenspan’s Movie

Morgan Stanley Stephen Roach interviewed by Wall Street Journal in "the Big Interview"

Here are some notes from the interview

-Double dip 40% next year
-Interest rates should be higher
-Bernanke is just rerunning Greenspan’s movie
-I would have voted against Ben Bernanke
-Bernanke-condones asset bubbles
-Chinese monetary policy is preemptive, US is reactive
-China property bubble in High end (10 major cities)
-China has micro bubbles (high end), but not a macro bubble (affordable-socially driven housing etc...)
-Demand is strong for China: 15-20 million people a year from countryside to urban areas
-Economists recommending fiddling around with currency are giving bad advice to political leaders and misleading the public
-Consumer should be more prudent in managing finances

Stephen Roach: Preparing For The Asian Century

McKinsey Quarterly Interviews Morgan Stanley's Stephen Roach on his latest book "The Next Asia".





Find below the transcript of the Interview from McKinsey Quarterly...(if video doesn't appear pls proceed to McKinsey's website


(all bold highlights mine)

Clay Chandler: We’re joined today by Steve Roach, the chairman of Morgan Stanley Asia. Steve, thank you for being with us. You’ve been watching and writing about the dynamism in this region for many decades now. In your new book, The Next Asia, you write about how the region in the next 20 years will be much different than in the past 20 years. What’s driving that change?

Stephen Roach: Well, Clay, I think the Asia of the past 30 years has done an extraordinary job—especially China, but, increasingly, the rest of the region—in lifting standards of living well beyond anything we’ve seen in the annals of economic development. But the drivers have been primarily export led. And there’s been a lot of investment in the export platform that has been required to get that export machine to the state that it’s at.

But this model is close to having outlived its usefulness. The next Asia will be more consumer led, will have a growth dynamic that places greater emphasis on the quality of the growth experience, especially in terms of environmental protection and pollution control.

Clay Chandler: If I’m the chief executive of a Fortune 500 company and I’m thinking about my global strategy, how do I need to be thinking differently about Asia than I might have been before the crisis?

Stephen Roach: I think global multinationals have, up until now, primarily viewed developing Asia—and China in particular—as an offshore-production platform. The offshore-efficiency solution is still an attractive option. But what really could be powerful would be a growing opportunity to tap the region’s 3.5 billion consumers. This has been the dream all along of the Asian potential. But the consumer dynamic has largely been missing in action. And now, as it comes online, this is an extraordinary bonanza for global multinationals as well.

Clay Chandler: In The Next Asia, you strike a very optimistic tone. You note that Asia has always embraced change and that that’s really been the secret of Asia’s dynamism in years past. But the same thing was said in the wake of the Asian financial crisis in 1997. And yet by and large, most Asian economies went right back to the model that worked so well for them before the Asian financial crisis, a model that was heavily focused on exports and government-led investments. What’s different about the economic scene today?

Stephen Roach: The external demands that underpin the export model are now in trouble. So even if Asia is the best and most efficient producer that anyone has ever seen, the external demand is not going to be there the way it was. So if Asia wants to keep growing, if Asia wants to keep developing, if it wants to keep raising the standard of living for its three-and-a-half-billion consumers, it’s got to depend more on its own internal demand. So it really boils down to the fact that Asia’s options have been narrowed in terms of economic development as never before. And it has no choice but to become more internally, rather than externally, dependent.

Clay Chandler: Let’s talk for a moment, if we could, about India, the other big, growing economy in the region.

Stephen Roach: I think the micro has always been very positive in India: a large population of world-class competitive companies; a well-educated, English-speaking, IT-competent workforce; pretty good market institutions; relatively stable financial institutions; rule of law; democracy. The micro has never been the problem.

What’s really been the problem for India has mainly been the macro—inadequate savings; relatively limited foreign direct investment, especially when compared with China; and, of course, the horrible infrastructure. The macro has actually gotten better. In the last three to four years, India’s savings rates have moved from the low 20s nationwide to the mid-to-high 30s, which is still short of China but a huge improvement for India.

Foreign direct investments accelerated dramatically—again, not up to Chinese standards, but a huge acceleration vis-à-vis where India has been historically.

And the third leg of the stool is politics. The mid-May election, by sweeping the Communist Party out of this new coalition, gives the reformers an opportunity to finally deliver on the promises they made five-and-a-half years ago, when they first took power. I think that India actually could be the real sleeper in Asia over the next few years. Just at a time when everybody is all lathered up and excited over a China-centric region.

Clay Chandler: You can’t really talk about Asia’s future without also considering the trajectory of its largest economy. That, of course, is Japan. The story there has been almost unrelentingly gloomy for years. But now we’ve got a new government.

Stephen Roach: Well, you know, Japan is an example of what happens when you take a very prosperous economy and allow it to experience the post-bubble aftershocks of a massive asset-led implosion.

But here Japan sits, 20 years into the post-bubble era, and it’s not clear that it has really awoken from its long slumber, as you aptly put it. This is an economy that remains very much export dependent. Its two largest export markets, the US and China, are not providing much sustenance. The Japanese consumer is very constrained by demography, by unfunded pension liabilities. It still has a very high predisposition toward saving. There has been some capital-spending impetus in recent years but, again, it has largely been driven by a new export linkage into China, and that’s on hold right now. And then finally, Japan has a horrific leadership problem. So the combination of structural problems, this long post-bubble hangover, leadership issues—it’s hard to be too constructive on the Japanese economy going forward, I’m afraid.

Clay Chandler: How about prospects for greater integration and cooperation in Asia as a whole? In your book, you talk about the emergence of what you call a pan-Asian economic framework. What will that framework look like?

Stephen Roach: Well, I think the building blocks of that framework are starting to fall into place. There’s been increased integration in a China-centric supply chain, with most of the large economies in the region—from Japan, to Korea, to Taiwan—now more dependent on exports to China than any of their other major trading partners, including Europe or the United States. So the logistics of an increasingly China-centric supply chain are starting to fall into place.

But here again, I would say that the real challenge for a pan-regional economic integration would be to shift the structure increasingly away from one that’s externally led to one that’s internally led. When the Asian consumer starts to rise and is sourced increasingly by the Asian producer, that’ll be the real, powerful synergy that I think can take this region to the next place.

Clay Chandler: Is it fair, do you think, to say that the Asian Century has finally arrived?

Stephen Roach: The central premise of my book, The Next Asia, is that it’s a little early to crack out the champagne and declare the onset of the Asian Century. It’s the stuff of great headlines and possibly documentary films, but the next Asia—an Asia which is more balanced, one that brings the Asian consumer into the equation—that’s what the Asian Century needs. The Asian Century, in my view, is not a sustainable image if it’s an Asia of producers or exporters selling things to others. The Asian Century is one where Asia produces to its home markets, rather than just to markets around the world. And until we see that, I think, again, that champagne is going to have to stay on ice for awhile".

Stephen Roach On China's Consumers

McKinsey Quarterly's Clay Chandler interviews Morgan Stanley's Stephen Roach on Unlocking the Power of China's consumers.






Here is Mr. Roach's end quote,

``I think China has the potential to become a major engine of global growth. But I think it’s unrealistic to expect China to step into that role immediately in this post-crisis era. I think it’ll take three years, more likely five to ten years, for China to really have the type of balance and scale of its economy that can fill the void that’s about to be left—or that is now being left—by the demise of what heretofore has been the biggest and most dynamic and powerful consumer in the world: the American consumer." (emphasis added)

Read the transcript here

Morgan Stanley's Stephen Roach: Market's Faces Rude Awakening

Morgan Stanley's Stephen Roach, in a CNBC interview says that markets could be faced with a "rude awakening"

Some excerpts from the interview:
-Visible manifestation of all the excess liquidity that monetary authorities have poured into the system
-Markets are priced for a recovery that’s gonna end up disappointing earnings
-Financial Crisis isn’t over
-75% of global economy still contracting
-Markets are in for a rude awakening
-Green shoots...simplistic way to look at the world
-we are going to have an anemic recovery

Fruits From Creative Destruction: An Asian and Emerging Market Decoupling?

``But innovation, in Schumpeter’s famous phrase, is also “creative destruction”. It makes obsolete yesterday’s capital equipment and capital investment. The more the economy progresses, the more capital formation will it therefore need. Thus, the classical economist-or the accountant or the stock exchange-considers “profit” is a genuine cost, the cost of staying in business, the cost of a future in which nothing is predictable except that today’s profitable business will become tomorrow’s white elephant.”- Peter F. Drucker, Profit’s Function, The Daily Drucker.

We read from creditwritedowns.com that Morgan Stanley Asia Chairman Stephen Roach made some predictions, namely:

1 “Asia will have a less acute impact from the global financial and economic crisis”

2. “Export-led regions are followers, not leaders.” Hence would recover after their main export markets, the US and Europe, recovered.

3. “The only possibility (to recover earlier) is China, as it has large infrastructure spending in place that could provide support for economic growth.”

Dr. Roach has been one of the unassuming well respected contrarian voices, whom I have followed, who sternly warned of this crisis.

Nonetheless while we agree with some of his prognosis, where we depart with Dr. Roach is on the aspect of a ‘belated recovery’ of Asia because of its “export dependence” on US and Europe.

Creative Destruction: The Telephone Destroyed The Telegraph

While it is true that the Asian model had functioned as an export-led region over the past years, our favorite cliché, ``Past performance does not guarantee future results” would possibly come into play in the transformation of the playing field.

Let us simplify, if a business paradigm doesn’t work do you insist on pursuing the same model or do you attempt a shift?

Marketing Guru Seth Godin has a terse but poignant depiction of “solving a different problem” response to our question. We quote the terrific guru Mr. Godin,

``The telephone destroyed the telegraph.

``Here's why people liked the telegraph: It was universal, inexpensive, asynchronous and it left a paper trail.

``The telephone offered not one of these four attributes. It was far from universal, and if someone didn't have a phone, you couldn't call them. It was expensive, even before someone called you. It was synchronous--if you weren't home, no call got made. And of course, there was no paper trail.

``If the telephone guys had set out to make something that did what the telegraph does, but better, they probably would have failed. Instead, they solved a different problem, in such an overwhelmingly useful way that they eliminated the feature set of the competition.” (bold highlight mine)

In short, we see human action basically at work. To quote Ludwig von Mises, ``Action is an attempt to substitute a more satisfactory state of affairs for a less satisfactory one. We call such a willfully induced alteration an exchange.”

People who relied on old models didn’t see this coming. They would have resisted until they were overwhelmed.

The fact is the telephone replaced an entrenched system. Joseph Schumpeter, in economic vernacular coined this as “creative destruction”. And creative destruction essentially leads to new operating environments: the rise of the telephone.

Similarly, the Asian export model has been built upon the US credit bubble structure. That bubble is presently deflating and would most possibly dissipate. So is it with Europe’s model.

In other words, the global economy’s trade and investment framework will probably reconfigure based on the present operating economic realities. Countries and regions would probably operate under a set of redefined roles.

Here are three clues of the possible creative destruction transformation.

Deepening Regionalism

Figure 3: ADB: Emerging Asian Regionalism

This from the ADB’s Emerging Asian Regionalism, ``In large part due to the growth of production networks just discussed, trade within Asia has increased from 37% of its total trade in 1986 to 52% in 2006 (Figure 3.3). The share of trade with Europe has risen somewhat, while that with the US and the rest of the world has fallen. As set out in Chapter 2, Asia’s intraregional trade share is now midway between Europe’s and North America’s. It is also higher than Europe’s was at the outset of its integration process in the early 1960s.

``But trade has not been diverted from the rest of the world. On the contrary, trade with each of Asia’s four main partner groups has increased in the last two decades—not just absolutely, but also relative to Asia’s GDP (Figure 3.4). For example, Asia’s trade with the EU has more than doubled as a share of its GDP, from 2.6% in 1986 to 6.0% in 2006. The increase is even larger as a share of the EU’s GDP. The aggregate trade data thus suggests that Asia is steadily integrating both regionally and globally.”

The fact is that Asia has steadily been regionalizing or developing its intraregional dynamics even when the bubble structure had been functional. Today’s imploding bubble isn’t likely to alter such deepening trend.

Moreover, the current unwinding bubble structure is emblematic of a discoordination process from a ‘market clearing’ environment.

Under this phase, spare capacities are being shut or sold, excess labor are being laid off, surplus inventories are being liquidated and losses are being realized. Essentially new players are taking over the affected industries. And new players will be coming in with fresh capital to replace those whom have lost. Fresh capital will come from those economies with large savings or unimpaired banking system (see Will Deglobalization Lead To Decoupling?)

And like any economic cycles, this adjustment process will lead to equilibrium. Eventually a trough will be reached, where demand and supply should balance out and a transition to recovery follows.

The post bubble structure is likely to reinforce and not reduce this intraregional dynamic.

So in contrast to the notion of a belated recovery in Asia hinged on the old decrepit model, a China recovery should lift the rest of Asia out of the doldrums.

Asia and not the old stewards should lead the recovery based on the new paradigm.

And in every new bullmarket there always has been a change in market leadership. We are probably witnessing the incipience of such change today.

Real Savings Function As Basic Consumption

The assumption of the intransigence of Asia as an export led model is predicated on Keynesian theory of aggregate demand. In essence, for as long as borrowing and lending won’t recover in the traditional ‘aggregate demand’ economies, there won’t be a recovery in export led economies.

But in contrast to such consensus view, demand is not our problem, production from savings is.

According to quote Dr. Frank Shostak, ``At any point in time, the amount of goods and services available are finite. This is not so with regard to people’s demand, which tends to be unlimited. Most people want as many things as they can think of. What thwarts their demand is the availability of means. Hence, there can never be a problem with demand as such, but with the means to accommodate demand.

``Moreover, no producer is preoccupied with demand in general, but rather with the demand for his particular goods.”

``In the real world, one has to become a producer before one can demand goods and services. It is necessary to produce some useful goods that can be exchanged for other goods.”

A sole shipwrecked survivor in an island will need to scour for food and water in order to consume. This means he/she can only consume from what can be produced (catch or harvest). It goes the same in a barter economy; a baker can only have his pair of shoes if he trades his spare breads with surplus of shoes made by the shoemaker.

Surplus bread or shoes or produce, thus, constitute as real savings. And to expand production, the shoemaker, the baker or even the shipwrecked survivor would need to invest their surpluses or savings to achieve more output which enables them to spend more in the future.

Instead of getting x amounts of coconuts required for daily nourishment, the shipwrecked survivor will acquire a week’s harvest and use his spare time to make a knife so he can either make ladder (to improve output), build a boat (to catch fish or to go home) or to hunt animals (to alter diet) or to make a shelter (for convenience). Essentially savings allows the survivor to improve on his/her living conditions.

To increase production for the goal of increasing future consumption, the savings of both the shoemaker and the baker would likely be invested in new equipment (capital goods).

Again to quote Dr. Shostak (bold highlight mine), ``What limits the production growth of goods and services is the introduction of better tools and machinery (i.e., capital goods), which raises worker productivity. Tools and machinery are not readily available; they must be made. In order to make them, people must allocate consumer goods and services that will sustain those individuals engaged in the production of tools and machinery.

``This allocation of consumer goods and services is what savings is all about. Note that savings become possible once some individuals have agreed to transfer some of their present goods to individuals that are engaged in the production of tools and machinery. Obviously, they do not transfer these goods for free, but in return for a greater quantity of goods in the future. According to Mises, "Production of goods ready for consumption requires the use of capital goods, that is, of tools and of half-finished material. Capital comes into existence by saving, i.e., temporary abstention from consumption.”

``Since saving enables the production of capital goods, saving is obviously at the heart of the economic growth that raises people's living standards. On this Mises wrote, “Saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material condition of man; they are the foundation of human civilization.”

So what changes this primitive way of production-consumption to mainstream’s consumption-production framework?

The answer is debt. Debt can be used in productive or non-productive spending. But debt today is structured based on the modern central banking.

Think credit card. Credit card allows everyone to extend present consumption patterns by charging to future income. If debt is continually spent on non-productive items, it eventually chafes on one’s capacity to pay. It consumes equity. Eventually, overindulgence in non productive debt leads bankruptcy. And this epitomizes today’s crisis.

But debt issued from real savings can’t lead to massive clustering of errors (bubble burst) because they are limited and based on production surpluses. It is non productive debt issued from ‘something out of nothing’ or the fractional banking system combined with loose monetary policies from interest manipulations that skews the lending incentives and enables massive malinvestments.

To aptly quote Mr. Peter Schiff’s analysis of today’s crisis, ``Credit, whether securitized or not, cannot be created out of thin air. It only comes into existence though savings, which must be preceded by under-consumption. Since savings are scarce, any government guarantees toward consumer credit merely crowd out credit that might otherwise have been available to business. During the previous decade too much credit was extended to consumers and not enough to producers (securitization focused almost exclusively on consumer debt). The market is trying to correct this misallocation, but government policy is standing in the way. When consumers borrow and spend, society gains nothing. When producers borrow and invest, our capital stock is improved, and we all benefit from the increased productivity.”

Now if capital comes into existence by virtue of savings, we should ask where most of the savings are located?

The answer is in Asia and emerging markets.

Figure 4: Matthews Asian Fund: Asia Insight

According to Winnie Puah of Matthews Asia, ``The economic potential and impact of Asian savings have yet to be fully unleashed at home. Indeed, Asia’s excess savings fuelled the recent boom in U.S. consumption and housing markets. Creating a consumption boom in Asia would mean that Asia needs to borrow and spend more. To date, governments are supporting domestic demand with fiscal stimulus packages—but it is household balance sheets that hold the key to developing a consumer culture. Overall, Asian households are well-positioned to increase spending—most have low debt levels and high rates of savings… there is a noticeable divergence in saving patterns between emerging and mature economies over the past decade, particularly since Asia learned a hard lesson from being overleveraged during the Asian financial crisis. Today, most Asian households save 10%—30% of their disposable incomes. China’s households, for example, have over US$3 trillion in savings deposits but have borrowed only US$500 billion.”

Thus I wouldn’t underestimate the power of Asia’s savings that could be converted or transformed into spending.

Asia’s Tsunami of Middle Class Consumers

In my August 2008 article Decoupling Recoupling Debate As A Religion, we noted of the theory called as the “Acceleration Phenomenon” developed by French economist Aftalion, who propounded that a marginal increase in the income distribution of heavily populated countries as China, based on a Gaussian pattern, can potentially unleash a torrent of middle class consumers.

Apparently, the Economist recently published a similar but improvised version of the Acceleration Phenomenon model. And based on this, the Economist says that 57% of the world population is now living in middle class standards (see figure 5)!

Figure 5: The Economist: The Rise of the Middle Class?

From The Economist (bold highlights mine), ``In practice, emerging markets may be said to have two middle classes. One consists of those who are middle class by any standard—ie, with an income between the average Brazilian and Italian. This group has the makings of a global class whose members have as much in common with each other as with the poor in their own countries. It is growing fast, but still makes up only a tenth of the developing world. You could call it the global middle class.

``The other, more numerous, group consists of those who are middle-class by the standards of the developing world but not the rich one. Some time in the past year or two, for the first time in history, they became a majority of the developing world’s population: their share of the total rose from one-third in 1990 to 49% in 2005. Call it the developing middle class.

``Using a somewhat different definition—those earning $10-100 a day, including in rich countries—an Indian economist, Surjit Bhalla, also found that the middle class’s share of the whole world’s population rose from one-third to over half (57%) between 1990 and 2006. He argues that this is the third middle-class surge since 1800. The first occurred in the 19th century with the creation of the first mass middle class in western Europe. The second, mainly in Western countries, occurred during the baby boom (1950-1980). The current, third one is happening almost entirely in emerging countries. According to Mr Bhalla’s calculations, the number of middle-class people in Asia has overtaken the number in the West for the first time since 1700.”

So apparently, today’s phenomenon seems strikingly similar to Seth Godin’s description of the creative destruction of the telegraph.

The seeds of the rising middle class appear to emanate from the wealth transfer from the developed Western economies to Asia and emerging markets. Put differently, Asia and EM economies could be the fruits from the recent ‘creative destruction’.

Some Emerging Signs?

However, there are always two sides to a coin.

For some, the present crisis signify as a potential regression of these resurgent middle class to their poverty stricken state, as the major economies slumps and drag the entire world into a vortex.

For us, substantial savings or capital (the key to consumption), deepening regionalism, underutilized or untapped credit facilities, rapidly developing financial markets, a huge middle class, unimpaired banking system, and most importantly policies dedicated to economic freedom serve as the proverbial line etched in the sand.

One might add that the negative interest rates or low interest policies and the spillage effect from stimulus programs from developed economies appear to percolate into the financial systems of Asia and emerging markets.

Although these are inherently long term trends, we sense some emergent short term signs which may corroborate this view:

1. Despite the 30% slump in the global Mergers and Acquisitions in 2008, China recorded a 44% jump to $159 billion mostly to foreign telecommunication and foreign parts makers (Korea Times). Japan M&A soared last year to a record $165 billion in 2008 a 13% increase (Bloomberg).

2. Credit environment seems to be easing substantially.

According to FinanceAsia (Bold highlights), ``The fallout from Japan's banking crisis offers clues to how the current situation may resolve itself. Back then, healing started first in the areas that had been most affected -- interbank lending recovered earliest, followed by credit markets, volatility markets and finally, many years later, equity markets.

``In today's crisis, interbank lending is already starting to recover. The spread between three-month interbank lending rates and overnight rates, which provides a key measure of the health of credit markets, has dropped significantly from its peak of 364bp in early 2008 down to less than 100bp today. As the interbank market recovers, credit should be next to heal.

``However, at the moment, triple-B spreads are at their highest levels in more than 100 years, which makes credit look like an extremely attractive investment opportunity. And there is every reason to expect that Asian corporates will participate in the healing, perhaps even as quickly as their counterparts in the US. (Oops and I thought everyone said divergence wasn’t possible or decoupling is a myth)

3. Asian companies have begun to engage in debt buyback. Again from FinanceAsia, ``Asian companies are buying back their debt with gusto and this could be a sign that credit markets are on the mend, according to Morgan Stanley.

``Asian companies are betting that credit will offer the best returns in 2009 and, like the smart traders they are, executives in the region are busy buying back their debt with gusto.

4. A picture speaks a thousand words…

Figure 6: A BRIC Decoupling?

China and Brazil appear to be leading the BRIC recovery while India (BSE) and Russia (RTS) seem to initiating their own.

For financial markets of developed economies, don’t speak of bad words.