Martin D. Weiss: The Greatest Scam of All

The Greatest Scam of All

Martin D. Weiss, Ph.D.
Editor, Safe Money Report

Chairman, Weiss Ratings, Inc

Eliot Spitzer has just launched a major frontal attack on the insurance industry. But it's just the first battle in a long and bitter war.

I know. I've fought a similar battle myself for many years, albeit on a much smaller scale.That's why most insurance companies still don't like me very much. Some may even want me dead.

About 12 years ago, soon after I launched my Weiss insurance ratings, I sent out a press release listing the ten largest insurance companies most likely to fail. The media picked it up, and U.S. News & World Report featured it in a major story.

The next day, my phone began to ring off the hook with calls from insurance company lawyers. They yelled at me and threatened me with litigation. They said my ratings were slanderous. They talked about suing me for many times the money my small Florida company made in a lifetime.

One large company on my "most vulnerable" list, First Capital Life of California, went even further: They sent an entourage of top executives to visit our offices and intimidate me.
Insurance company exec:

"Weiss better shut the @!%# up or get a bodyguard."

We welcomed the group into our humble conference room, and they distributed copies of their presentation.

Then for the next two hours, they ranted about their grand plans for the future. They raved about the top ratings they were still getting from S&P, Moody's, and A.M. Best. They even talked about how they could "help" Weiss build its own business.

But I didn't budge from my D- rating. "Look," I responded. "Your own filings with the state insurance commissioners show you're loaded with sinking junk bonds, but you have virtually no capital to cover the losses. Your own books show you've got money from investors that could be pulled out at a moment's notice, but you have virtually no liquid assets to sell to meet their demands for cash." I made it clear that the company was a time bomb that could go off almost any day.

That's when one of First Capital's executives issued the ultimate threat: "Weiss better shut the @!%# up," he whispered to my associate during a break, "or get a bodyguard."I did neither. To the contrary, I intensified my warnings. And within weeks, the company went belly-up — still boasting high ratings from major Wall Street firms on the very day it failed. In fact, the leading insurance rating agency, A.M. Best didn't downgrade First Capital to a warning level until 5 days after it failed. Needless to say, it was too late for policyholders.

It was a grisly sight — not just for policyholders, but for shareholders as well: The company's stock crashed 99%, crucifying millions of unwitting investors. Then the stock died, wiped off the face of the earth. Three of the company's closest competitors — Executive Life of California, Executive Life of New York, and Fidelity Bankers Life — were also biting the dust. Unwitting investors lost over $20 billion.

If you have cash-value policies in failed insurance company YOUR MONEY WILL BE FROZEN

Meanwhile, the regulators stepped in to take over and froze all the money policyholders had paid in for whole life polices and fixed annuities.

The people weren't allowed to cancel their policies. They weren't even allowed to take the money out through a policy loan. And by the time the freeze was finally lifted many months later, they had lost up to 50 cents on the dollar.

All told, over six million policyholders were trapped. Among these, about two million had cash-value policies, such as whole life and fixed annuities, frozen in limbo for months. (For details, see, "Toward a Full Disclosure Environment in the Insurance Industry," my 1992 testimony before the U.S. Senate Committee on Banking, Housing, & Urban Affairs.)

These policyholders asked: "How could this happen? All of these insurance companies got "good" or "excellent" ratings from A.M. Best, S&P, Moody's, and Duff & Phelps (now Fitch). Why is it that Weiss was the only one that gave them bad ratings?"Congress asked the same question. So did the U.S. General Accounting Office (GAO), now called the Government Accountability Office.

Indeed in a special study comparing Weiss to the other rating agencies, the GAO concluded that Weiss was the only rating agency to consistently warn consumers of the failures in advance; all of the other rating agencies typically issued their first warnings only AFTER the companies failed.

According to the GAO, for the six largest insurance companies that failed in the early 1990s, "Best assigned a 'vulnerable' rating before [failure] in only one of six cases and this was only six days before the [failure] occurred. In one case, Best stopped rating the insurer and never assigned a 'vulnerable' rating. In the remaining four cases, it assigned a 'vulnerable' rating only after the [failure]."

Best complained bitterly. They said their "B" ratings, listed as "good," in their own manual, should also have been considered "warnings of failure" in the GAO study. The GAO disagreed. But they added: "If we had placed Best's "B" and "B-" ratings in the "vulnerable" category, Weiss would still have been first overall. Weiss' advantage would have been decreased from about three to one to about two to one."

But still, the GAO still didn't answer the original question: Why? Why did the other rating agencies fail so miserably?

I can assure you it wasn't because we had better access to insurance company management than the other rating agencies. Nor did we have more analysts. Rather, the fundamental difference between us and them was embodied in one four-letter word: BIAS. The ratings of our competitors were biased by serious conflicts of interest. Ours were not.

You see, A.M. Best, Moody's, S&P, and Duff & Phelps were paid substantial sums BY the insurance companies to provide ratings FOR the insurance companies, a blatant and direct conflict of interest.

To make matters worse, if the company didn't like the rating, the rating agencies agreed not to publish it. The leading insurance company rating agency, A.M. Best, even created a special category for ratings that were non-published because the companies "disagreed with their rating."

Ironically, nearly everyone in the industry knew what was going on. They knew that most of the ratings were bought and paid for by the rated companies. They knew the industry's capital had deteriorated over the years. And they knew that too many large companies were loading up with too many high-risk bonds and speculative real estate. They just didn't talk about it in public, and did everything possible to keep it secret.For example, in the January 1990 issue of Best's Review, Harold Skipper, Professor of Risk Management and Insurance at Georgia State University, pointed out: "with increasing competition from all quarters, insurers are seeking ways to operate on thinner margins, to enhance investment performance through the purchase of ... riskier investments."

In the same issue, Earl Pomeroy, President of the National Association of Insurance Commissioners (NAIC), wrote: "State insurance regulators are observing ominous signs of emerging solvency problems in what traditionally has been the most secure line of all-life insurance."

Similarly, in the March 1990 issue of Best's Review, David F. Wood, past president of the National Association of Life Underwriters, under the title "The Insolvency Chill," stated: "It is widely acknowledged that life insurers' profit margins have declined significantly, primarily because of rapidly increasing costs, slower growth, declining interest rates in the face of long-term higher rate guarantees and stiffer competition. All these factors have severely eroded the capital base of many companies...."

Thus, Best itself was publishing this alarming information on the industry. But they did nothing to downgrade their own ratings.

You'd think the industry and its regulators would have learned a lesson from this experience. But today, very little has changed. The insurance industry continues to harbor deep conflicts of interest that everyone in the industry knows about, that routinely result in hardships to millions of Americans, but that persist just the same. Here are just three examples ...

Conflict of interest #1.

The Insurance Industry with The Insurance Company Rating Agencies

To this day, the established rating agencies — A.M. Best, Moody's, S&P, and Fitch — are still paid huge fees for their ratings.

Plus, they typically empower the rated companies to decide when to be rated, how, and by whom. They often give the companies a preview of the rating before it's published and some agencies grant them the right to suppress publication of any rating they don't agree with.

This is no secret. A.M. Best & Co. clearly states in its 1995 Insurance Reports, page xv: "NA-9 Rating (Company Request): Assigned to companies eligible for ratings, but which request that their rating not be published because they disagree with our rating." And beginning with its 1996 Insurance Reports (page xiv), Best changed its "NA-9" category to "NR-4," but the definition is very similar.

With this mechanism, ratings which might otherwise have served as warnings to the public are removed from public view, with disastrous consequences for consumers.

Indeed, in its 1994 report, the GAO states that in four out of 30 cases rated by both Best and Weiss, "Best never actually assigned a 'vulnerable' rating. Instead, Best changed these ratings from 'secure' to one of its 'not assigned' categories." And in a follow-up report using the same methodology as that used by the GAO, I found that, subsequently, there were another 16 companies in Best's NR category that failed.

In each case, Best's standard operating procedure was to cooperate with the companies, remove the bad ratings from circulation, and hide the financial weaknesses from the public. And in each case, the companies failed, causing severe hardships to consumers.

Some of the agencies have since modified some of their worst practices, but they have not altered their basic business model — the ratings are still bought and paid for by the rated companies.

How much exactly do they charge? No one knows for sure. But one of the nation's most stubborn critics of the insurance industry, Joseph Belth, has documented the fees charged by insurance company rating agencies in his widely respected monthly publication, The Insurance Forum.

A few years ago, Belth reported that Standard & Poor's charges from $10,000 to $50,000 per company per year, Moody's charges from $15,000 to $45,000, and Best's fees were similar to those of Standard & Poor's and Moody's. Belth has not reported on this since, but I suspect that the fees are probably significantly higher today.This is uncanny. You wouldn't eat at a restaurant or send your children to a movie if you knew that their ratings were based on this kind of a payola system. Yet millions of Americans have entrusted a good portion of their life savings — and their life's safety net — to companies that are rated precisely in this way.

Conflict of interest #2.

The Insurance Companies with Insurance Agents and Brokers

Last week, Eliot Spitzer accused some of the nation's largest insurance companies and the world's largest insurance brokers of rigging bids for insurance polices and taking millions of dollars in kickbacks as a standard operating procedure in their business model.

Joseph Treaster, in his New York Times article of October 16, provides the specifics:"The lawsuit brought by Mr. Spitzer against the broker, Marsh Inc., a unit of the Marsh & McLennan Companies, contends that Marsh conducted sham bidding to mislead customers into thinking that they were getting the best price for the coverage they needed. ...

"In addition to the lawsuit, two executives of the American International Group, one of the world's largest insurance companies, pleaded guilty to criminal charges of rigging bids with Marsh.

"While Mr. Spitzer's target yesterday was Marsh, he made clear that he was taking aim at a widespread practice in the insurance industry. 'This investigation is broad and deep and it is disappointing,' he said.

"Mr. Spitzer suggested that he had also come across indications of wrongdoing in the sale of many kinds of personal insurance, including coverage on cars, homes, and health insurance. 'Virtually every line of insurance is implicated,' he said."

"The lawsuit names American International, or A.I.G., and three other insurers, as participants in the bid rigging and steering: the Hartford, a unit of Hartford Financial Services; Ace Ltd., which is based in Bermuda but is a major player in the American insurance market; and Munich American Risk Partners, a unit of Munich Re with offices in Princeton, N.J."

My view: Mr. Spitzer has barely begun.

Reason: The entire system of selling insurance in America — through agents that are ostensively working in the best interests of the consumer but who are actually driven by commissions determined by the insurers — is, itself, a massive and fundamental conflict of interest.

Look. If you want to buy insurance — for health, life, or an annuity ... or for your auto, home, or business — you almost invariably MUST go through an agent. You rarely have the option of buying directly from the insurance company. And it is the insurance company that effectively sets the goals and agenda for most agents.

To get a better idea of how this works, our company once ran an analysis of the ads in an insurance industry magazine for insurance agents.

Most of the ads were placed by insurance companies offering agents all kinds of special commissions to direct business their way. In addition to cash bonuses, they touted special premiums like two-week vacations at Club Med or free cruises in the Mediterranean. The ads appealed to agents selling annuities, life insurance policies, and more.

So I called the publisher to ask if he thought these special commissions deals wouldn't push the agents to sell policies to consumers that might not be in their best interest.The publisher was indignant: "Are you a registered insurance agent? No? Then how did you get a hold of our publication? Our publication is not for you. It's strictly for insurance agents!"

Apparently, I wasn't supposed to know. Nor were millions of American consumers.

My main point: Insurance agents are routinely driven to sell the policies that make them the most money — not the policies that are best for you. Some agents bend over backwards to do what's best for their customers. But to do so, they must often sacrifice their own livelihood.

That's a system that's rotten to the core, and Mr. Spitzer's opening salvo barely scratches the surface.

Insurance Newspeak

Long ago, insurance agents discovered that their customers didn't want to talk about their death, let alone buy insurance for it. So taking a chapter out of Orwell's 1984, they called it "life insurance" instead.

It didn't seem to help much, though. Life insurance was still a very hard sell, and agents who pushed it too hard got a bad reputation for bringing up unpleasant subjects. "Want a row of seats all to yourself on your next flight to Chicago?" went a popular joke. "Then just tell your fellow passengers that you sell life insurance."

Prudential, the Rock-of-Gibraltar, largest insurance company in the world, came up with another very "creative" solution. They figured out a way to disguise the life insurance as an annuity, trained their agents to obfuscate the real nature of the product, and sold it to millions of investors from 1982 through 1995. All annuity policies sold by insurance companies do have a small life insurance component. But that's a far cry from being an actual life insurance policy.

It took many years of litigation before the regulators caught up with them. Prudential execs said they were sorry. The regulators said that wasn't quite enough to make amends. After much heated debate and negotiation, the company belatedly agreed to pay $2.7 billion in restitution to more than 1 million maligned customers, many times more than the largest previous settlement in insurance history. They sold insurance as a "retirement plan," failing to disclose the risks and using policy illustrations, which projected fabulous dividend accumulations as foregone conclusions.So did agents at New York Life and Allstate. Meanwhile, Equitable Life Assurance Society was fined $2 million for selling more than $100 million of improper life insurance policies. If the larger companies can do it, just imagine what the smaller, fly-by-nights are getting away with!

The Prudential, Metropolitan, Allstate, and Equitable messes were finally cleaned up. However, the fundamental problem inherent in the insurance agency system remains.Conflict of interest #3

The Insurance Industry with The Insurance Regulators and Legislators
You know about the long-disputed "revolving door" between private industry and government: Key officials in an industry are appointed as officials to write laws or regulate the same industry ... and then go back again to become lobbyists or executives for top corporations.

This is an inevitable aspect of our democratic, capitalist society. But it is especially egregious in the insurance industry.

For example, in an analysis released over a year ago, the Consumer Federation of America (CFA) found that "at least 40 percent of the leadership of the National Conference of Insurance Legislators (NCOIL), an organization that offers model bills and resolutions on how to regulate insurance, have worked for or with the insurance industry."Furthermore, most of these NCOIL members have current business ties to the insurance industry. NCOIL, which says its primary mission is to 'help legislators make informed decisions on insurance issues,' has taken a series of recent positions on high-profile insurance issues that are favorable, if not identical, to insurance interests and have frequently undermined consumer protections."

"Too often, NCOIL's advocacy is virtually indistinguishable from those of insurance interests," said J. Robert Hunter, CFA's Director of Insurance and former Texas Insurance Commissioner.

Bottom Line

When you buy insurance, watch out! Shop around aggressively, and get quotes from more than one agent and from as many insurers as possible. Despite all the problems in the industry, there are still good companies and good policies worthy of your money. Just make sure the insurer is safe and won't die before you do. I recommend companies that have earned my rating of B+ or better, but I can't vouch for all their policies.

And if you own shares in an insurance company or insurance brokerage firm, take advantage of any rally to get out. Yes, they've already fallen sharply in the past few days. But given the enormity of the scams and conflicts still to be revealed, the share price declines you've seen so far are small in comparison to what's likely still ahead.

Mineweb's Gareth Tredway: Twenty-year bull market

Twenty-year bull market
By: Gareth Tredway
Posted: '14-OCT-04 16:00' GMT

© Mineweb 1997-2004

JOHANNESBURG (Mineweb.com) -- China’s entry into global markets, which has been pushing commodity prices ferociously higher on the back of high demand, could last longer than the historical five-year cycles experienced in the past when other powers have entered the global arena.

This is according to Michael Power, a strategist at South Africa’s Investec Asset Management, who dubs China’s entry onto the world scene as “the most important geo-economic event of our lives.”

“Basically there were two periods when we did see this, and that was when continental Europe in the late-1950s joined global markets, and then when Japan basically joined global markets in the late sixties,” Power told Mineweb Radio Wednesday evening, “And then you basically ended up with a mean reversion trend after they had joined the market.”

“But for a five-year period in both instances, you saw this rising saw-tooth shape in the markets. I think in the case of China, it is going to be longer, and the reason why is that: China is bigger, but it is not just China. What is happening actually is an Asian phenomenon that is centered on China. And standing waiting in the wings is India. And India is another billion people. In fact the Indian sub-continent if you throw in Pakistan, Bangladesh, and Sri Lanka, is actually a larger population than China. So I think we could see something here that could last 20 years. That is going to make life very difficult for investors, because you have to have nerves of steel to play a saw-tooth formation.”

Power says that, on a recent visit to China, he was told by a trading company that the Chinese are now getting wise on how to manage the high prices that are coming from the forecasts of high Chinese demand.

“The rest of the world thinks they are a one-way trade and you can basically sell anything in terms of agricultural and mineral sources to them, and they basically had to take the price that you are selling them at. The Chinese have learned that if they accumulate a little bit of stock, more than they absolutely need in the immediate sense, they can pop bubbles as they arise and basically give particularly speculators a bloody nose. I suspect they may well have been behind the base metals wipe out that we saw today, and I think it did start in Shanghai.”

On Wednesday commodities and resource shares took a knock worldwide, for quite a few reasons, depending where you ask. Robin Bahr, a base metals analyst at Standard Bank in London says the drop was driven by commodity trading advisors and unnerved weak and speculative longs. “Macro funds were happy sitting on their long positions, as there is good potential in base metals,” says Bahr. Bahr says the market does not give the Chinese enough credit, and says they knew that, if they start buying, prices would move against them.

On Wednesday the copper price dropped 10.8 percent from Tuesday’s price, nickel 16.56 percent and aluminium 6.07 percent. Precious metals and resource shares also felt the bite. Bahr calls it a “healthy correction” as prices had been on an unabated rise for over a month. Prices did show small gains by Thursday afternoon, adding meat to Power’s “saw-tooth” theory. Bahr says prices would have to fall another 10 to 20 percent for “what they call” a bull market to become a bear market.

In any event company’s like BHP Billiton, Kumba Resources and Anglo American that have already gained from the China factor, are still tipped as good investments by David Shapiro, a trader from BJM. “I am going Billiton, and Kumba, and I am not sure on my third, I should stay with Anglo American,” Shapiro told Mineweb Radio on Wednesday evening.

Power himself agrees on the diversified players, but also mentioned South African Breweries as a player and Anglo Platinum, the world’s largest platinum producer, as an interesting one. “I think if you have a ten-year horizon I think SA Breweries is going to make an absolute killing in China. I think Amplats (Anglo Platinum) is an interesting one because platinum is something that the Chinese understand extraordinarily well. In 1994 China did not feature in the top 20 platinum consumers in the world, today it takes 21 percent of the world’s platinum.”

As a third choice, Power chose De Beers, the world’s largest producer of rough diamonds and which is owned 45 percent by Anglo American. “The dark horse would be De Beers, there is early signs that they are catching on in terms of their diamond consumption,” says Power, “If you see what De Beers did to Japan in 1945. The diamond giving habit did not exist in Japan, and today over 90 percent of couples getting married use diamonds to seal their fates. You see it when you walk around the streets of Shanghai now, the combination of platinum and diamonds is the gift.” From a South African perspective, Trans Hex, a Johannesburg-listed diamond producer was also pointed out.

China Daily: 15% income tax in Shanghai from expatriates

15% income tax in Shanghai from expatriates (China Daily)Updated: 2004-10-13 00:16
Some 30,000 expatriates in Shanghai were responsible for 15 per cent of the income tax collected during the first half of this year.

Expatriates from 102 countries and regions living and working in Shanghai paid 1.6 billion yuan (US$190 million) in income tax revenue in the first six months of 2004, recent statistics show.

Since the city officially started issuing expatriate work permits on May 1, 1996, some 59,384 people have found employment here.

"We have seen a 30 per cent annual increase, on average, on the work permits," said an official surnamed Sun from the Shanghai Labour and Social Security Bureau.

By the end of September, the bureau had issued 11,106 expatriate work permits.

One out of three were given to Japanese people.

"Japanese investment always makes up the largest proportion among all foreign capital," said Sun.

Americans came in second place, taking some 11 per cent, and South Koreans, about 9 per cent.

The statistics showed that 90 per cent of these expatriates have a university degree or above.

Approximately 70 per cent work in management positions, and another 15 per cent are engineers or senior engineers.

"The city now has at least 3,600 foreign general managers," said Sun.

Most work in foreign invested companies or representative agencies of foreign companies.

"Only about 13 per cent of them are in non-foreign invested companies," said Sun.

"Like any big city in the world, expatriates and immigrants play a vital role in Shanghai's economic and social development," said Zhang Ziliang, researcher from the Shanghai Institute of Public Administration and Human Resources of the Shanghai Personnel Bureau.

"But there are negative impacts too, like their influence on local employment," said Zhang. "The government has realized this and taken measures to tackle it."

The city is becoming more strict in handing out work permits and residence cards to foreigners.

"The government will evaluate the qualifications of every foreigner who applies for residence or a job here, and give them a score," said Zhang.

DR Barton: How to Trade Like a Nobel Prize Winner - Or Not

How to Trade Like a Nobel Prize Winner - Or Not
by D.R. Barton, Jr.
President, Trader’s U

Imagine my surprise. I was reading an article about an important trading concept. Nothing strange about that. What was unusual was that this was an academic article of a recent Nobel Prize winner.

The concept that caught my eye was this: People don't make tough decisions based on statistics. They make them based on emotions and past experiences.

So another economic myth is busted...

Busted because modern economics is based on the assumption that people make "rational" (or thoughtful) decisions in a way that will always give them the biggest reward.But the guys who wrote this dandy article on behavioral finance have exploded that myth. Daniel Kahneman won the 2002 Nobel Prize in Economics for this work, so I'm sure he's a pretty smart guy. In short, he and his co-author proved one important fact:Decision-making changes for most people when they are faced with the combination of:
Losing money, and
Uncertain results

This combination changes people from logical decision-makers to emotional decision-makers. Using emotionally charged shortcuts, or so-called "rule of thumb" guidelines, makes us pretty lousy at deciding things.

I'd have to guess that anyone who has traded stocks or commodities knows what these Nobel laureates were writing about. Because the "trading psychology" of it goes something like this:

Traders and investors love making profits. But they hate losses even more - and will go to great lengths to avoid them. Traders rationalize it in this way: "It's not a loss until I close out the position." So they hang onto little losing positions and let them turn into big losing positions.

On the other hand, traders love to make a winning trade. So they tend to take their winners very quickly instead of giving that winning position the time to turn into an even bigger winner. These are the same findings that Dr. Kahneman wrote about in his groundbreaking article.

You can avoid the decision-making mistakes that made a Nobel Prize winner famous if you follow a few simple rules.

Think Like a Trader, Not Like a Gambler
The Noble prizewinners identified three distinct decision-making problems. This week we'll look at the psychology behind these problems and how you can avoid them in your trading. Next week we'll look at some hard numbers that will give concrete examples of how you can apply these simple concepts to your trading and investing.

Adopt an attitude of indifference to losses. Think of losses as a business expense. Better yet, frame your losses as the necessary "raw materials" for your business. Framing losses in this ways has several clear benefits. You understand that losses are a required part of trading. Since losses are like any other business expense, you no longer avoid them. You just want to minimize their cost like you would the cost of raw materials. (If you never bought any raw materials, you could never make any products.)

Accept uncertainty as a part of trading. The 2002 Nobel winner found that people pay too much to avoid uncertainty. There are many areas in life where people accept uncertainty: relationships are almost always uncertain; so are fishing trips and cheering for the Boston Red Sox. In any of these endeavors, we don't know how they will end (well, except maybe with the Red Sox). It's the same with our trading. Accept that any single trade could be a win or a loss. Get out if you're wrong, and hang on if you're right. Over a large number of trades, good traders and good trading strategies will win. But for one trade, anything can happen. So don't get emotionally attached to a trade. Execute your plan and move on to the next opportunity.

Understand the Law of Small Numbers. Traders, like golfers, seem to be eternal optimists. A golfer can take 100 bad swings and still be excited to go out and play tomorrow because of one good shot. In a similar way, traders often draw broad conclusions from a ridiculously small number of data points. I wish I had a buck for every time I've heard, "That system (or newsletter or strategy) stinks - it lost three times in a row!" After tossing out the latest strategy, the optimist thought process kicks in, "There has to be something better out there!" Realize that it is impossible to draw a meaningful conclusion from a small number of data points. Three, four or even 10 occurrences are not enough to draw a conclusion in the trading world (or in any complex environment). Take the time to understand why your trading or investing strategy works and don't throw it away after a few losses. In terms of statistics, 30 trials is usually a minimum number that is needed to make any meaningful decisions.

As a trader or investor, keep your emotions in check and don't take psychological shortcuts. Let your knowledge of your investing strategy guide your decision making and you'll be on your way to beating a Nobel-sized problem that plagues traders both new and old.

October 13 Philippine Stock Market Daily Review: Star of the Day: Metro Pacific

October 13 Philippine Stock Market Daily Review:

Star of the Day: Metro Pacific


So what drove up the market this time…lower oil prices (still above $50’s), lower Peso, declining inflation perhaps?

Nah. Bargain hunting or technical bounce would be the most probable causes cited by your mainstream stock analysts. Yeah right. When the market goes down a slew of fundamentals are attached to it, when the market rises its all about charts. Such hokum. By the way, speaking of charts which is the more dominant trend, the recent 5 session decline or the 1-year and four months uptrend? So which should dictate the tempo of the market? Go figure.

Today’s market simply reflected the fickleness of our local investors. Haven’t you noticed the market was practically influenced by the movements of Metro Pacific? The Manny Pangilinan real estate-shipping holding company, a trader’s favorite, was initially sold down by its owner First Pacific, as earlier disclosed, that sent shockwaves throughout the market. By the early goings as MPC plumbed to its lows at 35 cents the Phisix and the general market was likewise down. As First Pacific ended its sales, the stock zoomed and recouped its losses to even closed higher (+2.17%)! In the same manner the Phisix closed higher by 5.82 points or .33%. Metro Pacific’s share of the day’s market activities was at an astounding 52.7%. Another noteworthy detail of today’s MPC-led market was that in spite of the selling of First Pacific, MPC recorded the largest foreign inflow of P 286 million!!! Puzzling is it? With deteriorating fundamentals MPC has managed to generate excitement from foreigner/s for a possible turnaround. As technical analyst Ron Nathan of the Philippine Daily Inquirer says “MPC has a checkered history and its book value is only P0.01 because it had to dispose of nearly all its assets to pay off its debts.” And to consider that primary reason behind the First Pacific sales was that the proceeds were meant for the “general corporate requirements” of Metro Pacific. For a company dependent on selling its equity to finance its operations does not indicate or augur for a turnaround stock. Well, as Mr. Nathan tersely explains the market is “PINNING THEIR HOPES (emphasis mine) that Manny Pangilinan will resuscitate the company as he did with PLTL.” Could it be that the foreign buying came from MVP’s group…Buy at 40’s and dump at 50’s?

Now of course, the market has paused from the recent selloffs? Could this be a ‘dead cat’s bounce’ or a recovery at work? Chart indicators show of more room for declines and could indicate that today’s action was a mere reprieve. Although your prudent investor-analyst, being a trendist, will stick to the latter view of a recovery.

What I am looking at is Thursday’s US current account data. With oil averaging $45 for the month of August I expect the unexpected, a record blowout deficit in the $60+ billion levels, as written in my latest newsletter. The consensus estimates is at the record $55 billion. If the macro data proves our forecast right, that the deficit swells to a new record level, then you would most likely see the US dollar fall hard. And if this happens you may expect accelerated buying from foreign money on our local stocks. This means that foreigners may provide the stimulus to buy up local stocks on Friday. Watch for it.

321gold: When Currency Empires Fall by Professor Avinash Persaud

When Currency Empires Fall
Professor Avinash Persaud
12 October, 2004

The United States today, as Britain before, has benefited greatly from having the world's reserve currency as its local currency. This has allowed America to spend 22% more than its income over the past five years. No other country could do that but having the reserve currency means you can write checks and nobody cashes them.

But reserve currencies come and go. Over the past two and a half thousand years there have been over a dozen reserve currencies that no longer exist. Sterling lost its status in the first half of the 20th century, the dollar will lose its status in the first half of this century. The beginning of the end for the dollar will be triggered by an inevitable decision by the Chinese to switch from a dollar peg to a free float - sometime in the next decade.

Losing reserve currency status will lead to a series of economic and political crises in the United States. The world's new reserve currency is an unlikely fellow. It is not the euro and today it is not even convertible. You guess it.

One of the nice things about being a currency forecaster is that expectations of you are very low. Moderate success is greeted with great surprise. But there are a few things which are more certain than others.

For example, at any one time, there tends to be a single dominant currency in the financial world, not two or more, just one. Some people believe that while the euro may not topple the dollar, it will at least share the spoils of financial hegemony. History suggests not. In the currency markets the spoils go to the victor, alone, they are not shared. Either the euro succeeds internationally, or it does not. (Which, least I anger my Europhile friends, does not make it a failure, just not an international currency widely accepted outside the euro-area. Many countries have credible, stable, currencies that are not international currencies, such as Canada, the UK, Japan and Sweden.)

The spoils of reserve currency status

In the past, it was worth asking what the spoils were to being an international or reserve currency. Some countries deliberately tried to avoid their currency becoming internationalized, such as post-war Germany. The Bundesbank felt that the more deutschemarks were held outside of Germany, the less control they would have over money supply and monetary conditions. European aspirations for the euro to become the world's reserve currency are more French than German.

Today, the spoils of reserve currency status are more clearly visible than ever before. If your currency is a reserve currency, you can pay for things by writing checks, which nobody cashes. You can spend more than you earn to a far greater extent than anyone else. This is exactly what the US has done in recent years. In the last five years alone, US national expenditure has exceeded national income by over 22% of GDP.

When that excess spending was due to investment in technology in the late 1990s, it was not clear whether the US was exploiting its status of having a reserve currency or just enjoying an investment boom. But today that excess spending is on unproductive consumption: tanks, bullets and pills. Few countries in the past have ever been able to sustain a deficit on external accounts as large as that in the United States today. And when other countries have run sizeable deficits, they have had to pay significant premiums to borrow the money, not as in the case of the US today, receive a discount. These are some of the immediate advantages of being a reserve currency.

International and reserve currency status also lends the host country even greater influence than otherwise. One of the interesting passages of dollar diplomacy in recent years in early 1998 when Japan and Singapore were both generously putting up the cash to support the east-Asian economies amid the Asian financial crisis, the US Treasury was dictating the terms.

The network power of computer operating systems and global currencies There are good reasons why there is seldom more than one dominant currency. Reserve currencies have the attributes of a natural monopoly or in more modern parlance, a network. If it costs extra to trade with some one who uses a different currency than you, it makes sense for you to use the currency that most other people use, this makes that currency yet bigger and cheaper to use. There is a good analogy with computers. Windows is the dollar of operating systems.

This networking power is why Central banks store dollars in their reserves in a far greater proportion than the proportion of trade with the US. While trade with the US represents around 30% of all trade, central banks on average hold 70% of their reserves in dollars. It is why most commodities, like oil, copper and coffee are priced in dollars wherever they are found and whoever they are sold to.

Something else we can be more certain of is that reserve currencies come and go. They don't last forever. International currencies in the past have included the Chinese Liang and Greek drachma, coined in the fifth century B.C., the silver punch-marked coins of fourth century India, the Roman denari, the Byzantine solidus and Islamic dinar of the middle-ages, the Venetian ducato of the Renaissance, the seventeenth century Dutch guilder and of course, more recently, sterling and the dollar. Size does matter

A necessary condition of a currency becoming a reserve currency appears to be its breadth of use, and cost and ease of transaction, not, as some might think, the ability to hold its value. Clearly hyperinflation would not serve a reserve currency well, and there are currencies that have become reserve currencies by virtue of economic size, that have ended their reign through inflation. Though cause and effect is not altogether clear in these cases, this appears to have been the fate of the denari and the solidus in the 12th century AD. But within the normal bands of inflation, it is size as a trader that matters. In the long-term, the Swiss franc and yen have been better stores of value than the dollar. Since 1980, they have appreciated by more than 21% and 54% versus the dollar respectively. Yet for much of this time, combined, they have represented no more than 10% of central bank reserves.

In the 18th century Britain was the largest economy of the western world, London was the center of international trade and finance, the currency was convertible and so sterling became the world's reserve currency. By the late 19th century, the US had become the world's largest economy, a position solidified by Europe's repeated attempt at self-annihilation from the 1880s to the 1940s. By the 1960s, the dollar had usurped sterling and was the world's new reserve currency with 60% of total central bank reserves being held in dollars, twice the level of sterling reserves.

The future is not rosy for the dollar

But time doesn't stop. By the mid-21st century, the US will no longer be the world's largest economy. By then, China and India will have overtaken the US, western Europe and Japan, on purchasing power parity terms at least, which should represent where exchange rates are likely to be in the long-run. Indeed optimistic measures of sustainable growth in China and India suggest this will be the case in twenty years time. Ladies and gentlemen, within my life time, the dollar will start to lose its reserve currency status, not to the euro, but to the renimbi.

The process is likely to be long and drawn out, rather like sterling's slip, slide away. Although the UK had lost its position of the world's largest economy in the late 19th century, by 1928, it was still the world's major reserve currency with twice as many central bank reserves being held in sterling than in dollars. In part this slow process was a result of the authorities trying to delay it. Gaining reserve currency status is heaven as you write checks and no one cashes them. Losing reserve currency status is hell as everyone starts to cash all the checks you ever wrote back in time. Britain's economic history and politics for the first three quarters of the last century was dominated by the over hang of sterling balances and the pressure on sterling and the economy as these were liquidated.

The principal way in which Britain tried to slow the process was through the use of imperial power and influence. By the 1930s, sterling's reserve currency status was largely a result of sterling balances held by the British colonies. The majority of sterling reserves were in fact held by Ireland, India, Pakistan and Australia, not the major economies of the time, the US, France, Germany or Japan. In the post-war period, the British authorities formalized the sterling area within which there were few restrictions to trade but strict rules controlling the movement of goods and capital into and out of the bloc. One could argue that sterling was no longer an international currency in the sense of third parties voluntarily choosing to use it as a vehicle currency. However, there is no reason to suppose that the US would not follow a new imperialism by exerting similar pressure on countries to stick to the dollar-bloc.

Hope for the euro?

There are three further implications of this thinking. First, those Europeans who want the euro to become the major international currency must consider an aggressive enlargement eastwards. A European Union which by 2025 included the former Soviet-bloc, Turkey and North Africa could rival the dollar and remnimbi.

Second, the loss of reserve currency status for the US will bring economic and political crisis. If it was economically and politically painful for the UK, even though its international reserve position was not in heavy deficit, what will it be for the US which has become the world's largest debtor. There will be an avalanche of checks coming home to be paid when the dollar begins to lose its status. Of course excessive debt in your own currency is spelt, inflation. That is the most likely outcome. This links to my reference earlier of not knowing the cause and effect of the denari's demise, I suspect the loss of reserve currency status itself leads to inflation as a country tries to inflate its way out of the sudden demand by creditors to be paid back.

The renminbi's path

Third, if the renminbi is to become a major reserve currency it first has to leave the dollar-bloc. This will happen later rather than sooner. One of the other certainties in foreign exchange, what I call the Second Rule of Foreign Exchange, is that the smaller, more open an economy is, the more the authorities manage the exchange rate and similarly, the larger, moiré closed an economy is, the less the authorities care about the exchange rate.

Policy makers perceive a trade-off, at least over the course of the political cycle between the economic flexibility afforded by a floating exchange rate that can respond to new and varying circumstances and the economic disruption that a volatile exchange rate, sensitive to external factors, factors often beyond the control of the country, can cause. This potential disruption is greatest the more open an economy is to international trade, small open economies opt for inflexible exchange rates. Large closed economies prefer to keep the flexibility of a floating rate.

A dollar peg today, a float tomorrow

We think of China as a vast country with a growing economy, but in many ways it has the characteristics of a small open economy today with the market sectors of the economy being led, driven and dependent on international trade. Although I am not altogether comfortable about the meaning of some of the national statistics in a command economy, for what they are worth, they suggest that in terms of trade as a percent of GDP, China is far more open than the United States or Euroland, countries which pursue exchange rate flexibility and is more akin to France, Spain and Korea, countries which choose exchange rate management. The current arrangement therefore is likely to persist for a while longer.

That does not mean that there will not be a revaluation of the renmimbi shortly, it could even happen around the end of this year, but that the Chinese will revalue the renmimbi and stick to a pegged system, though the limits may widen a little from the current 1.0%. But a dollar peg is not China's destiny. It may have an open economy today, but longer-term, China will be a large economy, driven by domestic rather than the external sector. Then it will prefer a more flexible exchange rate. The decision to move from a peg to a float will mark the beginning of the end of the dollar's reserve currency status.

Conclusion
To conclude the United States today, as Britain before, has benefited greatly from having the world's reserve currency as its local currency. This has allowed America to spend 22% more than its income over the past five years. No other country could do that but having the reserve currency means you can write cheques and nobody cashes them.

But reserve currencies come and go. They are determined largely by whoever is the biggest economic power of the day. Over the past two and a half thousand years there have been over a dozen reserve currencies that no longer exist. Sterling lost its status in the first half of the 20th century, the dollar will lose its status in the first half of this century. The beginning of the end for the dollar will be triggered by an inevitable decision by the Chinese to switch from a dollar peg to a free float - sometime in the next decade.

Losing reserve currency status will lead to a series of economic and political crises in the United States. The world's new reserve currency is an unlikely fellow. It is not the euro and today it is not even convertible.

Avinash Persaud
7 October 2004

Timesonline: Eventual lunch bill may spell end to dollar's dominance

Eventual lunch bill may spell end to dollar's dominance

By Gary Duncan

IMAGINE a place where you could spend far more than you earned for years without consequence. Imagine a place where you could pay your way by writing cheques that nobody would bother to cash. Welcome to America, today.

Over the past decade or more, the United States has been living far beyond even the vast means commanded by the world’s largest economy. America’s households have spent far more than they earn, borrowing extravagantly against the rising value of their homes and other assets. The US Government has been no less profligate, dramatically increasing spending while making hefty cuts in taxes.

The consequences have been predictable. Over the past five years, America’s national spending has outstripped its income by more than a fifth, leading to a rising tide of red ink. In little more than a decade, the US has become the world’s biggest debtor. America now runs an annual current account deficit approaching 6 per cent of GDP, or more than $660 billion (£370 billion), while its Government’s borrowing this financial year is heading for a record $422 billion.

All of this has been made possible by confidence in the continuing outperformance of the US economy and its financial assets, and the unprecedented willingness of foreigners to accept vast piles of American IOUs in the form of dollar holdings and US Treasury bonds — effectively, cheques that go uncashed. And the keystone supporting the weight of this system has been the dollar’s dominant status as the world’s international reserve currency — a status now seen as being under threat.

Over a decade, the proportion of US government debt held overseas has more than doubled from 20 per cent to about 45 per cent. Underpinning this massive expansion of overseas borrowing has been an inadvertent and undeclared currency pact between America and Asian economies.

Desperate to prevent their currencies rising against the dollar and undercutting their booming exports to the US, Asian nations have bought up billions of dollars and US Treasury bonds to shore up America’s greenback and keep their exchange rates pegged against it. The accidental quid pro quo has been that Asia has been able to continue to keep selling its goods to Americans at highly competitive exchange rates, while America has been able to run up ever-increasing debts to pay for them — helpfully financed by the Asian central banks.

Asia’s huge appetite for American assets to maintain its currency parities with the dollar has sustained heavy demand for US Treasury bonds. In turn, this has kept US market interest rates remarkably low, at levels of 5 per cent or less, even as America’s debts have ballooned.

As Niall Ferguson, the economic historian, has remarked, this looks like “the biggest free lunch in modern economic history”. He and others have compared this Asian-American dollar area to a reincarnation of the post-war Bretton Woods system of largely fixed exchange rates. Taking in China, Japan, and other Asian states, this dollar-dependent zone accounts for more than half of the world’s GDP.

The trillion-dollar question is, of course, can America continue to dine out at the expense of its Asian neighbours. For optimists, the answer remains a resounding yes. This confidence is based on the belief that the US economy will continue to outstrip its rivals, preserving the attractiveness of its assets, while Asia’s central banks will continue to snap up dollars and Treasury bonds, backed by the unlimited finance of their own printing presses.

But just as Bretton Woods I collapsed in the early 1970s, a growing number of commentators believe that the present “Bretton Woods II” will ultimately collapse under the weight of the burgeoning imbalances it has institutionalised. As ever, what looked like a economic free lunch will emerge as a mirage.

No one can predict with certainty if or when the edifice will crumble, but it seems more and more inevitable that, sooner or later, it will. Already, a reviving Japan has abandoned efforts to restrain a rise in the yen, removing one key prop for the system. Perversely, Washington seems intent on kicking away another, persisting in its efforts to persuade Beijing to scrap its currency’s dollar peg and revalue the yuan.

Only last week, President Bush was on the telephone to Beijing, pressing his Chinese counterpart on the yuan issue. Yet, as Avinash Persaud, the leading currency economist, suggested in a speech last Thursday, a yuan revaluation, or even the first steps towards one, could prove the catalyst for collapse of “Bretton Woods II”, and a period of economic trauma for America.

There can be little question of the intensely painful implications for the US should the present Asian-American equilibrium unravel rapidly. A sharp fall in the dollar and the US bond market would simultaneously stoke inflation and drive up market interest rates. And as Professors Persaud and Ferguson, as well as others, have argued, such as scenario could well spell the beginning of the end for the dollar as the world’s reserve currency. Without that status, America could face an avalanche of uncashed Asian IOUs, and US interest rates could be pushed much higher, with horrible repercussions for America’s heavily indebted Treasury and households.

This frightening prospect raises a fascinating and fundamental question: which rival might take the dollar’s place as the world’s dominant currency? For Ferguson, the euro is the strongest candidate, not least since more international bonds are already issued in euros than in dollars. However, the euro’s claim could be hindered by the eurozone’s persistent failure to foster strong growth.

Instead, Persaud argues provocatively that the dollar will be displaced by the yuan as China’s economy overtakes America’s in coming decades.

It is a tantalising prospect, although one that will depend on China’s ability to preserve political stability as its prosperity grows. However, it is not impossible that, in our lifetimes, markets will hang, not on the words of Alan Greenspan or his successor, but on those of the chairman of China’s central bank.

The implications of such a shift would be truly seismic

Timesonline: Saudi Arabia bitter over global taste for sweet and not sour oil

Saudi Arabia bitter over global taste for sweet and not sour oil

By Carl Mortished, International Business Editor

SAUDI ARABIA’s oil minister said his country was ready to pump more oil but it could not find buyers as the Kingdom’s high-sulphur crude was being rejected by Western refineries.

In a bid to quell the surging price of crude, Ali al-Naimi said Saudi Arabia was ready to pump more crude but gave warning to consuming nations that they needed to invest in new refineries to process Saudi Arabia’s “sour” crude.

“We have 500,000 barrels a day extra capacity and we are ready to produce now but there are no buyers. Consumer nations need to build sufficiently sophisticated refineries to be able to handle sour crude,” said Mr Al-Naimi, speaking at an oil conference yesterday in the Gulf.

The Saudi minister’s comments highlight emerging problem of high-sulphur oil reserves. “There’s a difference between sour and sweet crude and what’s on offer now is the light sour crude,” Mr Al-Naimi said.

Tightening emission controls over motor vehicles have increased demand from refiners for low-sulphur (“sweet”) crudes, such as North Sea Brent or Nigeria’s Bonny Light, which are easily refined into high-quality petrol or ultra-low sulphur diesel fuel.

However, supplies from Nigeria are likely to be under threat today from a general strike in the troubled West African state where the main labour union is protesting high petrol prices.

A shortage of sweet crudes, such as Brent and America’s West Texas Intermediate, has driven their prices to extraordinary levels. On Friday, Brent set a new record closing just shy of $50 a barrel.

A chasm is growing between the premium price of sweet crudes and the discounted price at which the bulk of the world’s oil is sold. The surplus of sour crude is hitting the price of Arab Light, a higher-sulphur crude that accounts for most of the Saudi exports, and the Kingdom has been forced to double the discount at which it is priced against Brent.

Russian oil, too, is being shunned for its sulphur content. Urals, the main blend of Russian export crude is now trading at more than $7 below the price of US Light crude, compared with just $2 a year ago.

According to oil industry experts, about 40 per cent of the world’s current crude output is “sweet”, but rough estimates of the proven reserves in the ground show more than 75 per cent is higher-sulphur “sour” crude. A shortage of refineries capable of converting sour crude into low-emission fuels suggests continuing price pressure on sweet blends and high prices for consumers.

“The world is going sour,” said Rafiq Latta of Petroleum Argus, a publication that monitors crude prices. “The only regions where there is room for expanding sweet production is West Africa and Algeria.”

North Sea and Texas oilfields have been the largest, easily accessible sources of low-sulphur crude but these are now in accelerating decline. For future oil supply, the world will increasingly look to the sour crudes of the Gulf and Russia.

Dr. Marc Faber: Just how high will oil prices go?

Just how high will oil prices go?
Dr. Marc Faber

Ameinfo.com

I maintain the view that we may see sometime in future far higher prices than anybody envisions. The current oil bull market is purely a function of increased demand coming principally from Asia at a time global oil production has practically no spare capacity. China's car population has more than doubled since 2002.

Since its last major low in 1998 at $12 (when the Economist published a very bearish piece about oil), crude oil prices have climbed to around $50 at present. The question, therefore, arises whether oil prices are headed for a sharp fall, as most analysts seem to think, or whether far higher prices could become reality in the years to come.

Over the last two years we have repeatedly explained how rising demand for oil in Asia would likely lead to higher prices – this especially because we took the view that the oil producing countries in the world were unlikely to be in a position to increase their production meaningfully.

At $50, one might, however, be tempted to think that oil prices are substantially over-bought – certainly from a near term perspective - and ready to decline again. Therefore, I have noted that numerous market participants have been shorting oil futures in the hope of a sharp fall.

I do agree that near term oil prices might succumb to some profit taking. Bullish consensus runs above 80% and oil has become a popular topic of discussion in the media and at every investment conference I attend.

Moreover, the US administration could decide to sell oil from its strategic reserve, which currently exceeds 630 million barrels. Thus to sell daily 2 million barrels into the market amounting in total to 120 million barrels over a two months period would be an option if prices continued to soar.

Also, since Chinese oil imports were up so far in 2004 by more than 40%, I suspect that some inventory accumulation also occurred in the Middle Kingdom.

Therefore, if the Chinese suddenly decided to curtail their oil imports the same way they stopped buying soybeans in March 2004 – an event which led to an almost 50% decline in prices – prices could come under some near term violent pressure! Still, I maintain the view that we may see sometime in future far higher prices than anybody envisions.

First of all, if we look at oil prices in real terms – that is oil prices adjusted for inflation - the real prices is right now still about 50% lower than it was at its January 1980 peak. In fact, oil is now not much higher than it was in the early 1970s, when the last big oil bull market got underway.

But, what is important to understand is that whereas the 1970 oil price increases were coming from a supply shock, which was driven by OPEC cutting its production all the while large production excess capacities existed, the current oil bull market is purely a function of increased demand coming principally from Asia at a time global oil production has practically no spare capacity which could lead to much higher production than the current 80 million barrels per day.

So, whereas we can say that the 1970s oil shock was 'event driven', today's oil price increase is structural in nature. Specifically the current demand driven oil bull market is fueled by the incremental demand coming from the industrialization of China and the rising standards of living around Asia, which increase the population of energy using consumer durables such as motorcycles, air-conditioners, and cars very rapidly. Just consider that China's car population has more than doubled since 2002 and that it is up tenfold since 1994! Thus, as mentioned above, oil imports of China have risen by 40% so far in 2004. And while I certainly do not believe that Chinese oil imports will rise every year by 40%, it is equally unlikely that oil imports into China will ever decline again meaningfully.

In fact, if we look at what happened to per capita oil consumption during phases of industrialization in the US between 1900 and 1970, we see that per capita consumption rose from one barrel per year to around 28 barrels. In the case of Japan's industrialization between 1950 and 1970 and South-Korea's between 1965 and 1990, per capita oil consumption rose from one barrel to 17 barrels.

In the case of China, oil demand per capita is still only 1.7 barrels per year, and for India it has only reached 0.7 barrels. By comparison Mexico consumes annually about 7 barrels of oil per capita and the entire Latin American continent around 4.5 barrels. Therefore, starting from such a low base, oil consumption in Asia will, in my opinion, double in the next ten to 15 years from currently 20 million barrels per day to around 40 million barrels per day.

Remember also, that if China's per capita oil consumption went to the level of Mexico's per capita consumption China would consume 24 million barrels of oil daily, which would be close to 30% of global production. And since it is most unlikely that current total global oil production of 80 million barrels per day can be increased much – in fact, it may begin to decline because no major oil field has been discovered since 1965 – I expect that prices will increase further in future - possibly far more than anyone is now expecting.

I would, therefore, be very careful when shorting oil and would rather use any weakness, as a buying opportunity.

Lastly, I do concede that if oil prices tumbled to say USD $40 or possibly even $35, equities around the world might well rally temporary (in fact equities would rally in anticipation of such a decline). However, if I am right that in future oil prices could rise much further than is generally expected, geopolitical tension would likely increase dramatically, as countries such as the US and China would increasingly become concerned about adequate supplies.

And, in the case that oil prices were to rise in real terms to their 1980s highs – well over US$ 100 – then the foundation for World War Three would be laid and most certainly begin to weigh heavily on equity prices for which I cannot share the prevailing widespread optimism anyway. Financial stocks have begun to weaken and this is an indication that something is not quite right!

The Economist: The magnetism of metals

The magnetism of metals
Oct 11th 2004 From

The Economist Global Agenda

Oil is not the only commodity soaring in price. So, too, are base metals such as copper, aluminium and lead

IT IS not just the price of oil that is scaling fresh heights. Base metals are close to, or breaking, new records too. The Economist’s metals index, which tracks the prices of copper, lead, zinc, tin, aluminium and nickel, has risen to its highest level in nearly ten years. The prices of some metals have hit all-time highs lately.

Fuelled by China’s seemingly insatiable demand for raw materials and by investors’ desire for an easy profit, the price of copper is within sight of a 16-year high. Nickel is close to its January peak, which was also a 16-year record. And, at double its average level for the past ten years, the price of lead is higher than it has ever been. Unsurprisingly perhaps, the Reuters CRB index, which combines oil, metals and other commodities, has hit a 23-year high.

Some increases are easy to understand: given a shortage of supply and rampant demand, the price of anything can only go up. But how to explain aluminium’s inexorable rise? Last week, the metal reached its highest price for nine years, despite the fact that there was a stockpile of the stuff overhanging the London Metal Exchange. What is going on?

The easy answer is that, after years of under-investment by producers, particularly during the technology boom of the 1990s when most investors considered base metals dirt, the world has finally woken up to the fact that there are not enough raw materials to go round. With China’s economy growing like topsy—last year, its GDP expanded by 9.1%, and this year it is expected to grow by only slightly less—base metals are in demand as never before. In 2003, for example, China’s imports of copper jumped by 15% and those of nickel more than doubled. Until a couple of years ago, America was the world’s biggest consumer of copper, used in electrical wiring and the like. That changed in 2002 when, for the first time, China consumed more than America. Last year, China extended its lead by devouring 35% more than America.

China’s headlong growth has not only caused acute shortages of metals like copper and nickel (which is used, among other things, to make stainless steel and even types of glass). It has also increased the market’s sensitivity to upsets which during times of plenty would barely cause the price to flicker. Last week, the mere mention of a strike by workers at Codelco Norte, Chile’s state-owned mining group and the world’s largest producer of copper, caused prices to surge even higher because of fears that supplies would become shorter still.

Nickel has been in short supply for the past couple of years. The International Nickel Study Group, which represents producing countries, reckons that supply should come more into line with demand next year. So prices for delivery of nickel from 2005 may begin to soften. That is unlikely to be the case with aluminium and zinc, supplies of which could become scarcer still before they get better.

In the case of aluminium, this is partly because of industrial unrest in North America, which is threatening to disrupt supplies from at least two plants, one in the United States and the other in Canada. It is partly also because demand from manufacturers shows no signs of easing. Ingrid Sternby, a metals analyst at Barclays Capital, believes that the price of aluminium is likely to remain high for at least the next few years. “Even though car production and sales are slowing, there are other segments of the transport sector, like trucks and trailers, which are very strong,” she told Reuters news agency.

During previous booms in commodity prices, as in the 1980s, central banks jacked up interest rates in order to choke off demand and so stifle inflation. This time, argues Alan Williamson, a metals analyst with HSBC, things are likely to be different. There is, he says, more spare industrial capacity around the world than during previous metals booms, thanks partly to China’s rapid growth as an industrial power. The result is that the prices of base metals may stay higher for longer.

It is hard to predict the extent to which new mines and production facilities will come on stream because of higher prices and so increase the supply of metals, or how long it will take for that to happen. Many such facilities are small, and probably wouldn’t be viable at lower prices. Yet, taken together, they could add enough capacity to have a rapid effect on the market, says Mr Williamson.

Harder still to predict is the reaction of investors. Spotting what they saw to be a sure thing, many piled into the metals markets during the summer, in the hope of chasing prices higher still. In that they have been mostly successful. How much higher can prices go? Here, investors are split. Some think that worsening imbalances between supply and demand, as with aluminium and zinc, are likely to drive prices higher still. Others are convinced that some metals are poised for a fall. Indeed, as one analyst put it, the words “lemmings and cliff” come to mind.

Robert Folsom: The Missing Link

Please consider these headlines.

Associated Press
Stocks Decline on Surge in Oil Prices
Thursday August 12, 10:34 pm ET
By Michael J. Martinez, AP Business Writer

Associated Press
Stocks Close Higher on Rising Oil Prices
Friday August 13, 8:15 pm ET
By Michael J. Martinez, AP Business Writer

No, you did not read a misprint. The headlines are real.

Yes, both stories came from the same AP Business Writer on consecutive days this past August.

And, yes, the two headlines amount to an absurd contradiction: One claims stocks fell because of rising oil prices, while a day later the other says stocks rose because of rising oil prices. Yet, as I said, the headlines introduced real news articles (both articles were still available this afternoon in Yahoo's financial news archive).

You don't often see an example as laughable and logic-free as the headlines above, but that doesn't mean I'm unfairly exploiting an error or a rare exception. When it comes to how Wall Street and the media explain the stock market, absurd logic is the rule.

There really is no telling what you'll come across when you get your information from sources which argue that external causes are driving the stock market's internal trend.

October 11 Philippine Stock Market Daily Review: Oil Again??!!

October 11 Philippine Stock Market Daily Review

Oil Again??!!

I have argued all so often that oil has had little to do with the latest market correction. First of all, oil even at the $53 per barrel level crude oil is still way below its inflation adjusted high of about $90 per barrel in 1980. Second examining the market internals shows us that these corrections are a matter of continued profit taking instead of the much dreaded ‘oil’ factor.

First, the Phisix 14.5 points or .79% decline was mainly brought about by the corrections in ONLY three heavyweights, specifically Globe Telecoms (-2.69%), PLDT (-.33%) and Metrobank (-1.8%) among the 8 index heavyweights. The others namely, Ayala Land, Ayala Corp., San Miguel A and B, Bank of the Philippine Islands and SM Primeholdings were all UNCHANGED. Don’t tell me that oil has little to do with the business operations of these neutral heavyweights while rising oil prices would heavily hamper the telecom sector’s operations.

Second if oil HAD BEEN THE (spelled with a T-H-E) factor then there would have been rotations towards the defensive stocks such as energy utilities and oil exploration sector, food sector and banks. Meralco A was down 3.1%, Meralco B was likewise lower by 1%, First Philippine Holdings fell 1.8%, oil refinery Petron down 1.7%(!!!), Independent Power Producer Trans Asia lower 1.8% with only Salcon Power up 2.7% on a single trade. Moreover, the OIL index remained unchanged as Oriental A and B shares were unchanged. Meanwhile Petroenergy resources climbed 2% together with Philodrill B up 4.8% on lean volumes. So higher energy prices are supposed to benefit these companies in an oil ‘shocked’ economy, so why haven’t they been rising? Ah, of course, you’d say that oil will compress consumption and the local investors are so future oriented hence the decline in prices. Well for your information, oil and energy issues are considered as inelastic demand companies hence are subsumed as defensive stocks, these are necessities that an individual can hardly do without even during a crisis. Repeat these words these companies are D-E-F-E-N-S-I-V-E!!! And to say that local investors are future oriented, is an insult to common sense. Most stocks they are driving up hardly have the cash flows to back their existence except that most of these issues are the punter’s favorite (note not trader or investor but P-U-N-T-E-R-S) subject to ‘Tall tales’ of buy-in’s, mergers, deals and other claptrap.

Now taking a look at the main losers, aside from the major telecom heavyweights, these are mostly the companies that EXPERIENCED RECENT SPURTS namely Digitel (-12.34%), Metro Pacific (-7.14%), DM Consunji (-10.54%), Empire East (-7.14%) and Leisure and Resorts (-16.67%). In addition, the said issues are ranked within the top twenty most actives. In short, these outperformers or celebrities of the most recent pasts have succumbed to profit taking. Read my lips, P-R-O-F-I-T T-A-K-I-N-G.

And to consider, foreign money continues to cushion the market’s decline. Foreign money accounted for a net inflow of P 37.952 million. Aside, overseas investors bought more issues than it sold, hence the continued bullish outlook of overseas money to local equities IN SPITE of HIGHER OIL Prices!!!!

What if the market rises during the midweek and oil prices remain within $50 barrel levels, what would be the so-called experts say? Amidst a denial for a market to climb in rising oil environment, they probably say ‘technical rebound’ or influenced by so-so market. Such Hooey!!

So if I was an analyst whom would adamantly argue that oil has been the cause, then I am simply not analyzing but presuming based on headline news and common known sentiment. These analysts are definitely NOT worth their paychecks.

Morgan Stanley's Andy Xie: More Inflation Scares Ahead

More Inflation Scares Ahead
Andy Xie (Hong Kong)

Summary and Investment Conclusion

The monetary bubble that the Fed has created post-tech burst has created property and commodity inflation (mainly in food and oil). I anticipate the cost-push inflation will spread to general inflation in the coming months, which may shake the bond market.

I believe the global economy is headed toward either mild deflation or stagflation. If central banks cut interest rates in 2005 in response to slowing growth — an outcome of the oil shock — the global economy may be headed toward stagflation. If central banks focus on price stability and, hence, do not cut interest rate in 2005 despite slowing growth, the global economy could be headed toward low growth and low inflation with deflation in certain periods and some sectors.

Beneath Greenspan's magic wand: cheap Chinese labor

The US import price from Asian newly industrialized countries (or NICs) has declined relative to its general import price by 3.5 percentage points per annum and by 5.2 percentage points relative to the US CPI.

The concentration of IT goods in Asian exports is a big part of the story; the US import price for IT products has declined by 60% in the past ten years. The US prices for consumer products have roughly remained constant since 1993 compared to a 31% rise in the US CPI.

The decline in the prices of IT products is not entirely a product issue. The production of consumer goods was rationalized earlier, with the bulk of production relocated to China from higher labor-cost economies ten years ago. The production of IT goods has been relocating to China. The availability of Chinese labor has been a major factor in allowing US IT import prices to decline by 8% per annum.

China has become the first source of supply in the global economy, especially for the US. The elasticity of US imports from China to the US retail sales appear to range between 4-5 in the past ten years.

The US retail sales ex-auto rose by $1 trillion between 1993-2003, and the imports from China by $120 billion. As Chinese products are sold at 3-4 times the import costs, the Chinese imports may have accounted for one-third to one-half of the increase in the US non-auto retail sales.

The nominal wages at the export factories in Pearl and Yangtze River Deltas that account for three-quarters of China's exports have roughly remained constant for the past ten years, mainly due to the influx of migrant workers from inland provinces. This has allowed China's supply curve to remain horizontal during a demand surge.

A horizontal supply curve magnifies the powers of central banks, as the inflationary consequences of monetary policies are absent. What a central bank says becomes very important in such an environment. If it can make market participants optimistic, the monetary stimulus leads to rising asset markets that increase demand subsequently to validate the optimism.

The productivity gains have allowed China's supply curve to shift outward over time, especially through relocation of the production of IT products from high-wage economies to China. This has created a constant downward pressure in the prices of manufacturing goods.

This deflationary pressure has allowed the Fed to create so much liquidity that the ratio of the US money with zero maturity to GDP is 50% above the average in the past three decades. This is why the ratio of the stock-market capitalization to GDP or property price to wage is so much higher than the historical norms.

Rising food and energy prices signal a different game

I believed in deflation (see 'A Look at Pricing Power', October 21, 2002).

The case was built on a massive positive shock to the global labor supply, as technologies allowed Chinese and Indian labor to integrate into the global economy much quicker than before. The declining elasticity of labor demand to GDP in mature economies is the best proof of the new paradigm.

Rising prices of food and oil may have signaled a new era. They may have become the new bottlenecks in the global economy, replacing labor.

Certainly, the prices of food and oil would also be cyclical. The point is that the big cushions from the spare capacity in food and oil supplies may have been exhausted during the furious growth since 1998 stimulated by the loose Fed monetary policy. The cushions made the prices of these essential inputs insensitive to monetary stimulus.

Without the cushions, the prices of these two inputs would flare up quickly in response to monetary stimulus, which decreases the potency of monetary stimulus and makes its inflationary impact immediate.

The linkage between food and oil to Chinese wages makes the Chinese supply curve not horizontal anymore during the US monetary stimulus. Some argue that the food inflation in China is temporary. I think otherwise.

China's grain production peaked in 1998 and has been declining ever since. The combined total of rice, wheat and corn declined from 441 million tons in 1998 to 363 in 2003. The food prices were kept down by the release of inventories.

The rapid industrialization of Yangtze River Delta ('YRD'), which is a grain basket for China, has big impact on China's grain production. The land prices in the region have risen so much due to industrialization and urbanization that it would make economics deteriorate overtime for grain production. When the monetary condition in the US loosens up, it increases the speed of industrialization in YRD and, hence, food prices.

China's consumption, on the other hand, would continue to grow, as the meat consumption-a less efficient diet increases with income growth. As China's production is unlikely to top the last peak in 1998 while consumption would rise above the previous peak, the food prices are on a secular upturn, in my view.

Oil could be another long-term problem. Cyclically, oil prices could come down sharply in 2005, if China has a major correction (see 'A Major Correction Ahead', September 20, 2004). The change in oil is the depletion of overcapacity with OPEC. Oil prices were low as OPEC lost its market share, as it tried to defend prices around $25/barrel, while countries with higher production costs took advantage of the prices to increase production.

Even though proven global oil reserves are still at 42 years of current consumption as in the past, the production of the non-OPEC countries appears to have peaked out. Most reserves that could be bought to the market are in Middle East. It seems that, with non-OPEC countries maxed out, the OPEC can defend higher oil prices. Also, the political and security environment is not good for increasing supply soon. Without a cushion of excess capacity, oil prices would be higher and more volatile than in the past. When monetary policy stimulates demand, oil prices could spike up quickly.

Another inflation scare may be coming

Inflation in most economies is still restricted to food and energy. Financial markets do not expect inflation to spread beyond food and energy. The yield on US treasuries, for example, is negatively correlated with oil price at present; the market seems to believe that a rising oil price slows down the US economy and makes the Fed less likely to tighten and is not worried about the inflationary impact of rising oil prices.

I believe the complacency in the market may be misplaced. I see two reasons why inflation could spread beyond food and energy. First, the relocation of IT production to China may be coming to an end. The cost savings from the relocation have pushed the US import prices down but could be running out. This could signal the end of the downward trend in the US import prices for goods from Asia.

Korea and Taiwan's export prices have been rising since the middle of 2003. This is the longest period of their export prices rising. Higher fuel and steel prices and semiconductor cycle may have contributed to this trend. I suspect that diminishing scope for cost rationalization may be an important factor.

Second, the erosion of real wages for Chinese factory workers is causing a supply backlash. Food and energy account for a large share of the expenditures of the factory workers in China. The reduction of their real wages is so severe that migrant workers are unwilling to move to the coast.

China's export sector has managed to meet demand despite labor shortage, which is due to spare capacities in the system. The spare capacities would be exhausted. As time goes on, even the existing workers may decide to leave, as they could not save enough from their wages to send home. The way out, I suspect, is that the export factories in China would have to raise wages to attract sufficient migrant workers. That would mean that the US import prices for Chinese goods have to rise, which has a big impact on the US retail prices.

Is it stagflation or deflation beyond the boom?

In my view, the current global boom is another monetary bubble. It will burst. When it does, would the global economy face stagflation or deflation?

China is over-investing massively in most of its industries. When the investment bubble bursts, the capacity overhang would cause deflation as occurred between 1996-99. However, oil and food prices were low and falling last time. The balance between overcapacity and oil and food prices would determine if the global economy would feel deflationary or stagflationary.

The key to the outcome is how long the monetary bubble lasts and, hence, how high oil and food prices go. The longer the bubble lasts, the higher the oil and food prices would go, and the more likely the outcome is stagflationary. Even though oil and food prices would come down when the bubble bursts, their inflationary impact takes time to work into general prices.

Where oil prices peak out, therefore, would be a key to a stagflationary outcome. The bond market now appears to believe that higher oil prices are good for bonds, because it makes central banks less likely to raise interest rates. When high prices are high enough to cause a stagflationary outcome, the relationship between bonds and oil would reverse.

The Economist: Pump Priming-Dear oil and subsidised petrol are hurting Asia's economies

Pump priming
Sep 30th 2004 BANGKOK AND JAKARTA

From The Economist print edition

Dear oil and subsidised petrol are hurting Asia's economies

THE high price of oil is taking a serious toll on Asia, in more ways than you might think. Inflation is already ticking up, from Mumbai to Manila. Interest rates are beginning to follow. Increased energy costs, the United Nations reckons, will shave a percentage point off the region's economic growth this year. The Asian Development Bank has just cut its growth forecasts for next year too. In some cases, the prognosis is truly dire: prices of $50 a barrel, if sustained throughout next year, will slash four percentage points off Thailand's growth rate, according to the bank's projections. Yet many Asian governments, including Thailand's, are making a bad situation worse by subsidising fuel prices.

The economies of Asia, like those of most developing countries, are oil-intensive. In other words, Asians consume more oil per unit of output than Europeans or even gas-guzzling Americans. Thailand and China, for example, use more than twice the rich-country average, while India burns through almost three times as much, according to the International Energy Agency. So they naturally suffer more when the oil price rises.

One reason Asian countries get through so much oil is that many of them subsidise it in one way or another. Since the beginning of the year, the Thai government has fixed the retail price of diesel at below market rates, at its own expense. Indonesia has long done the same for all types of petrol. In August, the Indian government cut excise and import taxes on oil, to add to the direct subsidies it already pays on liquefied petroleum gas (LPG) and kerosene. Malaysia, too, keeps petrol prices low through direct subsidies and tax breaks. The government of China sets discounted prices, but leaves it to refiners and distributors, which are largely state-owned, to absorb the shortfall.

Needless to say, all this costs a fortune. The Indonesian government originally planned to spend 14 trillion rupiah ($1.5 billion) on fuel subsidies this year. But as the oil price has risen, the bill has more than quadrupled, to 63 trillion rupiah. That is almost as much as Indonesia's total budget for development. In Malaysia, fuel subsidies and forgone taxes account for roughly half this year's budget deficit of 20 billion ringgit ($5.3 billion). Rating agencies have been muttering about the government's persistent deficits, yet it left the fuel subsidy intact in next year's budget too. India, another compulsive borrower, is spending $1.4 billion this year to subsidise kerosene and LPG alone. The government is also forgoing $540m in tax revenues on various fuels, while state-owned refiners and distributors must also have absorbed considerable costs that do not feature on the government's balance sheet.

Taxpayers, of course, will eventually foot all these bills. Meanwhile, growing public debt puts upward pressure on interest rates and reduces the capital available to more productive borrowers. In the long run, that could cause far more damage than high oil prices.

To make matters worse, artificially low prices encourage waste, along with all the concomitant costs in terms of pollution, traffic congestion and misallocated capital. Thaksin Shinawatra, Thailand's prime minister, claims he is determined to reduce his country's energy bills. To save electricity, he has asked shops to close early and that big buildings should switch off their flood-lights. Yet since January, he has capped the price of diesel—on which most Thai vehicles run—at about three-quarters of the market rate. Motorists, naturally enough, are buying more. Thailand's oil imports have duly surged in volume, as well as just price.

Higher import bills, in turn, have sent Thailand's trade balance into the red. That has depressed the baht, making imported fuel more expensive still, and feeding the inflation the subsidies are supposed to curb. Most Asian nations import at least some of their oil; of all the countries mentioned, only Malaysia is a net exporter. Indeed, Asia as a whole (excluding the Middle East, but including Central Asia) produces only 11% of the world's oil, but consumes about 21%. Oil alone accounts for almost a third of India's imports, for example. Admittedly, a healthy balance of payments and huge foreign-exchange reserves will allow most Asian countries to finance expensive oil imports for a long time to come. But there is no sense in increasing the burden unnecessarily.

Furthermore, most oil subsidies do not go to the people in whose name they are paid: the poor. Cheap petrol, for example, benefits most those who drive the biggest, most inefficient cars, namely the rich. The poorest have no motor vehicles at all. Indonesia effectively subsidises its richer neighbours, thanks to a roaring trade in smuggled petrol. Singapore does not allow locally registered vehicles to leave the country with less than three-quarters of a tank of gas, to prevent them from taking undue advantage of the subsidised stuff across the border in Malaysia. Even targeted subsidies can end up in the wrong hands. Many countries subsidise kerosene, since the poor often cook with it. But so do lots of well-to-do restaurateurs.

The biggest beneficiaries of oil subsidies are the politicians who use them as a crude vote-buying technique. Mr Thaksin has declared that diesel subsidies will remain in place until February, which also happens to be the month by which an election must be held. The previous Indian government did not allow any fuel price rises for five months prior to elections in April. The outgoing Indonesian government, too, put off planned price hikes this year. How unlucky, then, that a record year for oil prices also happened to be a record year for elections in Asia.

Economist Paul Kasriel and Asha Banglore of Northern Trust: Has America Achieved Economic Paradise On Earth?

Has America Achieved Economic Paradise On Earth?

Paul Kasriel and Asha Banglore

Northern Trust

The conventional wisdom is that the Chinese economy has a near infinite capacity to produce goods and services because of its abundant population. The conventional wisdom is that this abundant Chinese population wants to work – i.e., produce goods and services – but has little desire to consume the fruits of its labor. Therefore, China must export if its population is to be employed. The conventional wisdom is that because the Chinese people already own so many U.S. Treasury securities as a result of their central bank’s purchases, they would not dare do anything to bring about a fall in the value of those securities. Therefore, the Chinese central bank will buy any amount of U.S. government securities necessary to preserve the value of the outstandings and to keep the yuan from appreciating. If the conventional wisdom is correct, Americans have achieved an economic heaven on earth. We can now have as many guns and as much butter as we want, thanks to those automatons, the Chinese. Instead of fretting about U.S. government spending and borrowing, we should be encouraging even more of it, if the conventional wisdom is correct. We should be building up our defense systems to the max, issuing government debt to pay for it. After all, the Chinese will buy the debt to keep the yuan from appreciating against the greenback. Heck, we won’t even have to use any of our land, labor or capital to produce these defense systems. The Chinese will be happy to produce them for us and take IOUs in exchange. I know manufactured housing has bad reputation, but I bet those Chinese could turn out some modular models that look like McMansions. So, the U.S. government could buy these kits from China, again giving the Chinese IOUs, and distribute them to Americans. The only constraint would be the amount of vacant land in the U.S. and the labor to assemble the kits. But would not Americans be put out of work by all this? Of course. But so what? The government would write all of us slackers a check for whatever amount we want so that we could purchase all of our desired goods from China. Again, the Chinese people, who evidently only live to work, would gladly exchange the goods they produce for dollar-denominated IOUs. Man, I can hardly wait to take delivery of that 45-foot sailboat I have always wanted! So, if the conventional wisdom is correct, stop worrying about the fact that the U.S. is the world’s largest net debtor economy and start enjoying it. Don’t bother to reflect on the fact that the conventional wisdom is often incorrect.

Eric Fry of the Rude Awakening: Nuthin' To Drill

Nuthin' To Drill

Eric Fry

The Rude Awakening

Crude oil jumped to another all-time record yesterday, in the process increasing the already-considerable wealth of T. Boone Pickens...

"Better late than never" would seem to be a fitting description of Mr. Pickens' financial fortunes. The one-time corporate raider didn't do too badly for himself during the 1980s, when, as president of Mesa Oil, he reaped hundreds of millions of dollars for his shareholders by attempting hostile takeovers of companies like Phillips Petroleum and Cities Services.

But raiding, says Pickens, was never as profitable as simply riding the energy bull market of the last few years. The oil maverick's Dallas-based hedge fund, BP Capital Energy Commodity Fund, has soared 283% so far this year and has racked up profits of more than $1.3 billion since the start of 2000.

"I really needed to win," the 76-year old Pickens explains to Bloomberg News. And win he did! This senior citizen of the oil patch has increased his wealth by more than 3,000% since 1997, finally nosing into the 389th slot on Forbes' list of America's 400 wealthiest people. Pickens says he has paid 75 percent of his lifetime's income taxes since he turned 70.

"He just got lucky," gripes one oil industry consultant. Maybe so, but luck of this magnitude has a mysterious way of repeating itself...which is why we are intrigued by Mr. Pickens' particular brand of luck. He owes most of his good fortune to some extremely prescient - or lucky - calls on the price of natural gas and crude oil. To cut to the conclusion of this tale, T. Boone Pickens believes oil and gas prices are headed higher still...

But first a little history.

In the late 1990s, Pickens launched a tiny hedge fund dedicated to making leveraged bets on oil and gas prices. His fledgling BP Capital Energy Commodity Fund had barely flown the nest before it encountered life-threatening difficulties. The fund suffered large losses in its first two years, 1997 and 1998, trimming Pickens' personal wealth to $24 million from $35 million. But the fund turned the corner in 1999, when it squeaked out a $900,000 profit. BP Capital has been profitable every year since...immensely so. Pickens has seen his personal fortune rise to about $760 million.

"He understands the industry and business like no one else," says billionaire Harold Simmons, one of the BP Capital Energy Commodity Fund's original investors. In 1997 Simmons kicked $5 million into Pickens' hedge fund, only to see the investment shrivel to $400,000 in 1998. "I thought we were going to lose the whole thing," says Simmons.

Instead, as luck would have it, Pickens' fund handed Simmons about $150 million in profits over the ensuing four years. Let's take a closer peak at the DNA of Pickens' good luck...

In late April of 2003, T. Boone Pickens kicked off the Grant's Spring Conference here in Manhattan by declaring, "I don't believe I'll ever see natural gas below $4.50 again." Inventories are extremely low, he explained, supply is falling and demand is holding steady - a potentially explosive situation for gas prices. "If we get another cold winter next year," Pickens predicted, "the gas price could go to $10 an mcf or more...the gas price could do anything, and I mean anything!"

Sure as shucks, the gas price soared above $7.00 later that year, and has only "kissed" $4.50 a couple of times since then. More to the point, the gas price has averaged about $5.60 since Pickens' declaration and topped $7.00 again yesterday.

Fresh from his dead-on prediction for natural gas prices, Pickens issued a second Delphic forecast last May - this time about crude oil prices. "I think you'll see $50 before you see $30 again," said Pickens. At the time, crude oil was changing hands for $41.50, and had averaged only about $36 for the year-to-date. But as we all know now, the price profile of the crude oil market has changed dramatically since then. Crude decisively scaled the $50-mark yesterday and planted its flag at $51.29 before settling in for the night at $51.09.

Pickens continues to up his forecasts. On September 27, he said in a radio interview with Bloomberg News that he expects the price of crude to surge to $60 before it returns to $40. Should we trust his judgment?

Many of the attendees of the May 2003 Grant's conference wondered the same thing, when Pickens' predicted a new era of permanently higher natural gas prices. One skeptical attendee asked the oilman, "If high, and rising, natural gas prices seem so probable, why aren't the exploration and production companies working feverishly to increase their drilling activity?"

The answer, according to Pickens, was that "there's nuthin' to drill." The oil and gas industry keeps poking holes, of course, but they aren't finding very much oil or gas to suck out of those holes. About 1,243 drilling rigs are currently operating on U.S. soil and in contiguous waters, according to Baker Hughes - that's about 12% more than this time last year, and about 40% more than two years ago. Even so, domestic production of crude oil and natural gas has tumbled 5% since 2001.

Proven reserves of U.S. crude oil are close to a 29-year low after falling 3.5% last year. Meanwhile, demand charges ahead. Worldwide oil demand will average 82.2 million barrels a day this year and jump by another 1.8 million barrels next year.

T. Boone Pickens is fallible, of course. But he seems to have a knack for putting himself in luck's path. All else being equal, we'd rather align ourselves with a consistently lucky soul than a consistently unlucky one.

Morgan Stanley's Daniel Lian: Sino Hollow

Sino Hollow
Daniel Lian (Singapore)

The Three Scenarios of the Sino Hollow Thesis

The Sino Hollow thesis – that the rise of China’s competitive manufacturing sector will crowd out that of its key competitor, i.e., Southeast Asia – has been in existence for quite some time now. China’s rise has become a global economic phenomenon in the decade stretching over the last few years of the 20th century and the first few years of the 21st century. China last devalued in 1994, and global MNCs and capital started aggressively embracing the Middle Kingdom again from 1993-94. Following the Asian Crisis of 1997-98, China’s rise became even more assured as global MNCs, FDI and capital abandoned or reduced exposure to Southeast Asia in favor of China.

While the rise of China is not the subject of dispute, there seem to be three competing scenarios, each implying a different fate of Southeast Asia.

First is a complete hollowing out of manufacturing in Southeast Asia, with little proactive response in terms of reforms of the political economy or shifts in economic development strategy. Under this scenario, China’s inroads into global manufacturing are unstoppable, as its manufacturing industry stretches across the whole value-chain, leaving no breathing space for Southeast Asian manufacturers. China’s rise hits Southeast Asia the hardest as the latter was previously the preferred manufacturing outsourcing and production region for global MNCs. The decline of Southeast Asia is real and rapid as a total dismantling of its manufacturing industry cannot be offset by economic growth in other sectors. This is the worst-case scenario for Southeast Asia, whereby China prospers but Southeast Asia is poor.

Second is a massive manufacturing hollowing out met by some degree of reform of the political economy and some shift in economic development strategy. Under this scenario, the fundamental economic relationship between China and Southeast Asia evolves from one of manufacturing competition to a complementary service and resource demand/supply relationship. Southeast Asia’s ability to grow this complementary role, together with its pricing power on service and resource exports, determines its economic well-being. This scenario suggests an ambiguous outcome where China prospers and Southeast Asia’s economic well-being hinges on whether its policy responses bear enough economic fruit to offset the loss resulting from the massive destruction of its manufacturing potential.

Third is a partial hollowing out cushioned by a proactive and successful reform of the political economy and a shift in economic development strategy responses. Under this scenario, global MNCs diversify to avoid over-dependence on China and geopolitical considerations. Moreover, a probable rise in China’s wage bill and the operation of other supply constraints and wage-cost restraints in Southeast Asia contribute further to the incomplete hollowing out. In consequence, Southeast Asia loses some, but not the bulk, of its manufacturing potential. This, coupled with Southeast Asia’s new emphasis on alternative growth areas in services and resources, enables the region to supplement its economic livelihood and made good or better its losses in manufacturing. This is the best possible outcome for Southeast Asia, in my view, whereby China and Southeast Asia prosper together.

Pessimists and Complacent Asian Policy-Makers

There is plenty of evidence that Southeast Asia is now either responding or contemplating responses to the rise of China. Hence, I believe the investment community should assign little weight to the first scenario. Over the past four years, I have analyzed structural economic policy shifts and their progress in Singapore, Thailand and Malaysia. These policy shifts include Singapore’s new three-pronged growth strategy (Twin Trouble, but Different Destiny, August 4, 2004), Thailand’s well established dual track development strategy (Mr. Thaksin Has A Plan, September 21, 2004) and Malaysia’s move towards a more balanced economic platform (Policy Intent Is Key, November 14, 2003). There are also signs that both Indonesia and the Philippines are also contemplating changes. In my view, this constitutes firm evidence that the region is capable of responding to China’s challenge.

However, simply responding is one thing – succeeding in that response is another. Many members of the investment community remain structurally pessimistic about Southeast Asia. They believe that China is destined to become the world’s factory and that Southeast Asia’s decline will be severe and protracted.

I think I am a ‘constructive’ pessimist when it comes to the Sino hollowing arena (see Tycoon versus Labourer, June 7, 2001; Short-Term Breathing Space, November 6, 2001; and Crowded House, May 23, 2002). While I believe there will be proactive responses from Southeast Asia, I have serious doubts over the region’s ability to create high-value-added alternatives to manufacturing as it has chronically underinvested in services and resources. Thus, I subscribe to the more pessimistic aspects of the second scenario. In my view, becoming a low-value service provider and generic resource supplier to China and the world may not prevent a decline in living standards for Southeast Asians.

On the other hand, Asian policy-makers appear to me to be subscribing to the more optimistic part of the second scenario – i.e., successful development of a complementary relationship – as well as the most optimistic third scenario whereby China and Southeast Asia prosper together through shared manufacturing potential and a complementary service and resource demand/supply relationship. I disagree as I think that the Sino-Southeast Asia ‘complementary’ theory is far too complacent and that China will continue to ‘crowd out’ Southeast Asia’s growth potential.

Examining Hard Data a Decade After China’s Ascent

Examining hard economic data 10 years after the start of China’s rapid rise reveals some interesting economic trends.

1. Manufacturing remains very important to Southeast Asia. Most investors would have expected Southeast Asia’s manufacturing output and export shares to have shrunk following a decade of massive build-out in China. However, the ASEAN five actually raised their manufacturing output share as a proportion of GDP from 25% in 1994 to 30% in 2003. Concomitantly, their manufactured export share as a proportion of merchandise exports increased from 73% to 75% over the same period. While the intensity of manufacturing in ASEAN pales net to that in China (where manufacturing output as a proportion of GDP increased from below 40% to 45% and manufactured exports accounted for 88% of merchandise exports at the end of 2003), there is no evidence that China is forcing Southeast Asia to reduce its dependence on manufacturing.

2. China is indeed rapidly expanding its manufacturing potential. In terms of net FDI, the ASEAN five accumulated only US$147 billion (Singapore alone accounted for more than half, at US$82 billion) for the decade 1994-2003, whereas China picked up some US$392 billion. Furthermore, at the beginning of 1994 China’s combined manufacturing output was less than twice that of ASEAN; at the end of 2003, it was more than three times that of ASEAN (US$640 billion versus US$200 billion).

ASEAN’s manufactured exports have also registered far inferior growth compared with those of Greater China (China, Taiwan and Hong Kong). It makes sense to track Greater China as Taiwan and Hong Kong manufactured exports are linked to China’s manufacturing capacity. ASEAN’s manufactured exports grew from US$188 billion to US$326 billion from 1994 to 2003, whereas Greater China’s grew from US$344 billion to US$741 billion. Southeast Asia’s manufactured exports rose 73% over the 10-year period, versus 115% for Greater China.

3. ASEAN and China’s other two major competitors (South Korea and Mexico) have not lost their global share of manufactured exports. It seems that other countries/regions are bearing the brunt of China’s rise. The disaggregated shares of manufactured exports in global merchandise and manufactured exports show ASEAN manufacturing holding its ground despite the rise of China. ASEAN’s share of the global merchandise export shrank from 6.2% to 5.7% over the decade, a figure that is often cited by analysts – but we think this is comparing apples with oranges. In our view, a more accurate comparison is to track the manufactured export shares of global merchandise exports. Here the numbers reveal that ASEAN’s share remained constant, at 4.4%, whereas the shares of China and Greater China leapt from 2.2% to 5.3% and from 8.1% to 10.1%, respectively, implying gains of 3.1% and 2%.

We would make two observations here: first, while the rise in China manufacturing is real, as it has taken an additional 3.1% of the global merchandise export pie, it has taken share away from other manufacturing exporters, not from Southeast Asia. Second, the other usual assumed ‘victims’ of China’s rise – South Korea, Brazil and Mexico – have also avoided significant manufacturing declines. In fact, South Korea and Mexico saw their shares rise from 2.1% to 2.5% and from 1.2% to 1.9%, respectively (note, however, that stagnation in Mexico is evident, as its global share has dropped from a peak of 2.6% in recent years). Brazil lost only 0.1% of global share, declining from 0.8% to 0.7%.

4. Which other countries have lost manufacturing to China? Limited data preclude me from drawing a precise conclusion. However, since Southeast Asia, South Korea, Mexico and Brazil have not lost their global shares, it would seem that some other emerging and/or advanced economies must be the real ‘victims’ of Chinese ascendancy. Given what I see as the absence of other emerging economies with sufficiently sizeable manufactured exports to incur such a big loss of share, I conclude that advanced industrialized countries are the economies losing manufacturing share to China. This is a somewhat unconventional conclusion.
Southeast AsiaShould Avoid the Worst-Case Scenario

It is too early, based on the simple economic data and analysis above, to assert with confidence which of the three potential scenarios will materialize. My views are as follows.

1. There is indeed some ‘relative’ crowding out of Southeast Asian manufacturing by China/Greater China as the latter’s much faster growth rate has led to stagnancy in Southeast Asia’s global share. However, Southeast Asia continues to grow its exports and has not borne the brunt of the impact from China. Even if one uses merchandise exports as the barometer, the hit is minor, with Southeast Asia losing just 0.5% of global share. If the past decade marked China’s most aggressive incursion, then the economic data rule out the worst-case scenario and propel Southeast Asia towards the more favorable ‘partial hollowing out’ scenario.

2. The decade 1994-2003 saw global MNCs aggressively reconstructing their global production and supply chains away from Southeast Asia in favor of China. As a result, FDI flows over the past decade do not augur well for any improvement in, or even maintenance of, Southeast Asian manufacturing potential (the exception being Singapore, which continues to attract significant FDI). Hence, it is plausible that the next decade could well see continued aggressive hollowing. Still, if one assumes such hollowing out by Chinese producers in the coming decade, simple arithmetic suggests that Southeast Asia should not lose much of its manufacturing output and its global share in exports – its manufacturing base is quite large, and it would take a long time for the region to shed its US$200 billion worth of manufacturing output and 4.4% share of global merchandise exports (given that, despite aggressive inroads over the last decade, China has not taken share from Southeast Asia). This again pushes Southeast Asia away from the worst-case scenario and towards the more optimistic ‘partial hollowing’ scenario.

3. Southeast Asia needs political-economy reforms, as well as a shift in economic strategy, to avoid the worst-case scenario. There is ample evidence, albeit in varying stages of development and formulation, that Southeast Asia has embarked on changes to its political economy and economic strategy landscape. Singapore, Malaysia and Thailand thus far are the more proactive countries in this respect. Leaving aside political-economy reforms, just from an economic strategy perspective the efforts thus far include: diversifying and shifting manufacturing to higher-value-added activities (Singapore and Malaysia), creating and strengthening service exports (Singapore, Malaysia, Thailand) and developing sustained domestic demand through second track activities in agricultural, grassroots and SME sectors (Malaysia and Thailand). There are also clear signals from policy-makers in Indonesia and the Philippines that they are seriously contemplating both economic strategy changes and political economy reform. While it is too early to call all of these efforts ‘proactive’ and ‘successful’, the responses thus far certainly suggest to me that Southeast Asia is heading away from the worst-case scenario and towards either the second or third scenario.

Based on the above three points, I submit that Southeast Asia should avoid the worst-case scenario and that there is a chance it will also avoid the ambiguous second scenario.

Bottom Line: Southeast Asia Has Breathing Space

The Sino-Hollow thesis postulates China will make rapid and sustained inroads into global manufacturing and Southeast Asia will be its primary victim as the region used to be the dominant winner of global FDI by manufacturing MNCs.

While the rise of China is not the subject of dispute, there seem to be three competing scenarios, each implying a different fate of Southeast Asia. First is a complete hollowing out of manufacturing with no proactive policy response from Southeast Asia. This is the worst-case scenario for Southeast Asia. Second is a massive manufacturing hollowing out met by some degree of reform of the political economy and a shift in economic development strategy responses from Southeast Asia. This is an ambiguous scenario as the new economic initiatives and better political economy may not offset the loss incurred in manufacturing potential. Third is a partial hollowing out of manufacturing with proactive and successful reform of the political economy and a shift in economic development strategy, whereby Southeast Asia could well retain or even improve its standard of living. This appears the best-case scenario for the region.

Data over the past decade indicate that Southeast Asia’s global share of manufactured exports remains stagnant, at 4.4%, whereas that of China and Greater China has risen from 2.2% to 5.3% and from 8.1 to 10.1%, respectively. Other assumed ‘traditional victims’ of China’s rise – i.e., the manufacturing sectors of South Korea, Mexico and Brazil – were also not hollowed out by China. I think China may, in fact, have gained global manufacturing shares from advanced industrialized countries, as there are no other large manufacturing-intensive emerging economies to be hollowed out.

It is too early to arrive at the right scenario. However, based on the hard evidence of the past decade, policy responses (both political economy reforms and economic strategy shifts) by Southeast Asia, and economic projections based on simple arithmetic, I submit that Southeast Asia should avoid the worst-case scenario. I also see a chance that it can also avoid the ambiguous second scenario and head for the best-case scenario.