Global Economies and Markets: From Debt Deflation To Creative Destruction?

``Yet “revolutions” every generation, as was recommended by Thomas Jefferson, are not the solution. We know that “revolution” is not achievement and the new dawn. It results from senile decay, from the bankruptcy of ideas and institutions, from a failure of self-renewal. The only way in which an institution – whether a government, a university, a business, a labor union, an army – can maintain continuity is by building systematic, organized innovation into its very structure. Institutions, systems, policies, eventually outlive themselves, as do products, processes, and services. They do it when they accomplish their objectives, and they do it when they fail to accomplish their objectives. Innovation and entrepreneurship are thus needed in society as much as in the economy, in public service institutions as much as in business. The modern organization must be a destabilizer; it must be organized for innovation.-Peter Drucker, Modern Organization Must Be a Destabilizer

The mainstream has argued sternly about the “myth of decoupling”, when the term decoupling has been a palpable misnomer.

In the globalization heyday of yesteryears, which means the integration of finance, trade, investment and labor, “convergence” was obviously the natural outcome. Thus, global markets and economies had been mostly coordinated or harmonized as the bubble blossomed.

But when the US originated global credit bubble imploded, this globalization platform have effectually been reduced, as world trade is expected to decline by more than 2% (usatoday.com), and capital flows around the world is also expected to crater- world Foreign Direct Investment (FDI) is expected to slump by 21% (Dailystar.net) and capital flows to Emerging Economies is likewise expected to tumble to $165 billion from $466 billion according to the Institute of International Finance (Marketwatch.com).

In addition, ongoing debt deflation in major economies have been reversing capital flows, as major financial institutions vie to meet capital requirements hence repatriate capital from liquidated overseas investments.

And as we previously argued, the recent surge of the US dollar’s price against most of the world’s currencies has been a function of dollar shortage in the system, the BIS recently issued a report which essentially validates our view [see The US dollar's Vitality Stems From Debt Deflation Prompted US Dollar Shortage]

Worst, the rising protectionist sentiment seen in many diverse forms are being resurrected and may further add to negatively impact trade and financial flows [as discussed in Will Deglobalization Lead To Decoupling?].

Hence, the natural incipient impact from deglobalization was also a synchronous meltdown seen late last year.

Now a new trend seems to be evolving.

In contrast to the macroeconomic perspective, whose penchant is to view the world in terms of aggregates and who seem to believe that people behave like automatons and tend to think alike, we think that people respond differently to the circumstances, hence may lead to diverse reactions. In short, people act based on purposeful behavior or incentives.

The carnage in October of 2008 instigated by the institutional run or “electronic run” in the US banking system seems to have posed as a severe mental shock known as the Posttraumatic Stress Disorder (PTSD) to the world economic activities and the financial markets. In some accounts, such mental discord has been labeled as the “After Lehman” syndrome [see our latest post, Global Posttraumatic Stress Disorder (PTSD): The After Lehman Syndrome].

And as the world fell in into a transient suspended animation from such anxiety disorder, the consequent spillover to the real economy have been transmitted through a deep retrenchment of the credit driven demand and the subsequent sharp downside adjustments in the global supply chain, which reflected on the abrupt dismantling of the production structure built around the bubble global paradigm.

This means that the compression of the supply chain had been equally manifested in the mass closure of relative excess capacities, the efforts to reduce existing surplus inventories and the reduction of labor and or rationalization of wages. Likewise, expected valuations in on diverse asset markets during the bubble days are being intensely reappraised, as the once euphoria outlook seems to have transmogrified into a depression mentality.

In short, as explained in Fruits From Creative Destruction: An Asian and Emerging Market Decoupling?, the world’s financial markets and economies appear to be undergoing ‘creative destruction’, where the speculative excesses from the bubble structure is being undone by market forces, despite government’s exhaustive travails to futilely sustain them.

As Friedrich Hayek once wrote, ``The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed. The only way permanently to 'mobilise' all available resources is, therefore to leave it to time to effect a permanent cure by the slow process of adapting the structure of production.” (bold highlight mine)

Signs of Positive Impact From Creative Destruction?

However, considering the scale and depth of collapse, much of these precipitate changes may have been overdone. Yet, combined with the idiosyncrasies of the political, capital and production structure of each nation, signs of creative destruction may have started to reinforce signs of “divergence dynamics”- in a world where globalization trends have apparently been on a descent.

Proof? See figure 1.

Figure 1: Danske Bank Weekly: Last In, First Out

China appears to be leading the way out of the global economic morass, as industrial (manufacturing) activity, credit growth and car sales appear to be markedly recovering even as the US remains in doldrums.

According to Steen Bocian Chief Economist of Danske, ``China was one of the last countries to be dragged into the global financial crisis, and now looks set to be one of the first to come out the other side.”

And it's not only China but other East Asian countries as well.

And this development seems congruent to what we wrote in July of 2008 in Phisix: Learning From the Lessons of Financial History,

``This I think is what the global financial market has thus far priced in, aside from the ongoing delevaraging process that has fomented the forcible selling of most liquid asset classes by institutions caught in the web of illiquidity stasis.

``And if Asia is not a bubble then the likelihood is that the bear market arising from the present contagion conditions as mentioned above could be likewise be cyclical and temporary in nature. If our analysis is correct then we should see the rendition of the same patterns even amongst our neighbors.”

While much of Asia’s equity markets hasn’t been lifted by these developments yet, but instead dragged by dreary global sentiments, China’s Shanghai index remains as the world’s market leader up 5.29% for the week and up 20.4% over the year.

It should be a reminder that in every cyclical transition there will always be a change in market leadership and perhaps, China could be assuming such a role, if the recovery will be sustained.

Economic Restructuring Will Restore Global Growth

Nevertheless, it would be a misguided collectivist notion to think that China would even attempt to save the world. China will only act to protect its political, financial or economic self-interest. And any spillover will mostly be coincidental than intended, except perhaps for extraordinary circumstances which is exigent to their self-interest.

Take this report from Chinastakes.com, ``Chinalco’s $19.5 billion capital injection into Rio Tinto, so far the largest foreign investment of any Chinese enterprise, is believed to signal China’s holding’s transition into strategic resources. Officials and leaders of state-owned enterprises also suggest the government inject some of the reserve into state-owned enterprises to help them invest overseas or establish funds for overseas acquisition.”

Ironically, common sense tell us, where everyone wants to be saved, the world is simply too enormous and too complex to be saved with restricted resources.

And the harsh reality is that world will have to undergo an economic restructuring than continue to survive on a farcical political economic landscape dependent on sustained bubble blowing.

Otherwise what may seem like a temporary recovery may even lead to a malevolent nightmare, as Joseph Schumpeter in the The Economics of Recovery Program observed, ``"Depressions are not simply evils, which we might attempt to suppress but-perhaps undesirable-forms of something which has to be done, namely, adjustment to previous economic change. Most of what would be effective in remedying a depression would be equally effective in preventing this adjustment. This is especially true of inflation, which would, if pushed far enough, undoubtedly turn depression into the sham prosperity so familiar from European post war experience, but which, if it be carried to that point, would, in the end, lead to a collapse worse than the one called in to remedy.”

Global Posttraumatic Stress Disorder (PTSD): The After Lehman Syndrome

We opined that the collapse in world economic and market activities in the last quarter of 2008, which was principally an outgrowth of the seizure in the US banking system, engendered a psychological "shock and awe" trauma for the world.

Similar to infamous 9/11 tragedy, such anxiety disorders overwhelmed the public's psychological defenses, wherein the subsequent reaction have been to dramatically undertake massive adjustments in the ecosystem as fear governed. [See discussed in "What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis."]

This is what I think the world is presently enduring.

And we seem to have found clues to support our thesis. Mr. Andrew Foster, Chief Investing Officer of Matthews Asia/Matthews International capital noted of a "Before Lehman and After Lehman" stigma, in his recent sojourn in 4 Asian countries.

This is his observation (all bold highlights mine)...

``I would venture to guess that many of the managers I met on my trip would have struggled to recognize the name “Lehman” prior to last September, and very few could claim to have suffered directly as result of Lehman’s collapse (e.g. exposure as a creditor or an investor). Yet what was interesting about the phrase was the universal way that these managers were using “Lehman” as a means to explain (or excuse) the frustrating downturn in the performance of their companies. For me, this highlighted the external nature of the current crisis: these managers were not coping with changing technologies, heightening competition or demand destruction; rather, a strange and unseen external shock had suddenly crippled the outlook for their businesses. It was as if all the managers were struggling simultaneously to understand the nature of this invisible shock, and had picked up the same newspaper on the same day, read the same headline, and said to themselves, “Oh, that’s what it is.”

``One illustration of this comes to mind: a newspaper company in Delhi that I visited publishes two editions, one in English and the other in Hindi. The former was seeing ad revenues decline by roughly a 20% annual clip, presumably because gloomy headlines in the English-language press were reverberating around the world, robbing confidence, and with it, economic prospects. Meanwhile, the Hindi version was seeing growth of nearly 30% in its ad rates. This growth may not be sustained; the global shock may come to roost in the Hindi segment as well. I asked management about this anomaly. They had asked the same question of some of their customers, to which the somewhat ironic reply was, “What recession?” Apparently the dour headlines had yet to penetrate those parts of India."...

Here is the clincher...

Again from Mr. Foster...

``But interestingly, most are simply frozen in stasis, paralyzed by a sort of uncertainty about what the future might hold. People everywhere are struggling to cope with what the headlines mean for them. While the shock Lehman precipitated was severe, the uncertainty—even fear—it generated has been more widely felt."

Like us, Mr. Foster believes that time will heal such mental stresses...

Again from Mr. Foster, ``Yet it is my experience that with time and stability fear tends to pass. And here is a possible silver lining: when the present fear does pass, many of these Asian companies might find that the fundamentals they once enjoyed (save perhaps easy access to financing) have not deteriorated to the same extent as they have elsewhere in the world, especially here in the United States. "B.L. / A.L." will undoubtedly be scorched in investors' memories permanently. Yet with a bit of luck, it will become more of a catch phrase rather than destiny itself."

So I'd be wary of any analysis, which omits the context of human psychology to deal with anxiety disorders such as the PTSD, and utilize the "After Lehman syndrome" to project into the future.

Cartoon of the Day: Correlation-Causation Dilemma

Source xlcd.com

The US dollar's Vitality Stems From Debt Deflation Prompted US Dollar Shortage

We have long argued that the recent strength of the US dollar, which was seen almost across most major currencies, have been mainly a function of the US dollar's role as an international currency serve. [see latest Asian Currencies Fall On CEE To South Korean Won Contagion]

Apparently the Bank of International Settlements in its Quarterly Review has a similar perspective.

The chart according to the BIS "examines cross-currency funding, or the extent to which banks invest in one currency and fund in another. This requires a breakdown by currency of banks’ gross foreign positions, where positive (negative) positions represent foreign claims (liabilities).

``For some European banking systems, foreign claims are primarily denominated in the home country (or “domestic”) currency, representing intra-euro area crossborder positions (eg Belgian, Dutch, French and German banks). For others (eg Japanese, Swiss and UK banks), foreign claims are predominantly in foreign currencies, mainly US dollars. These foreign currency claims often exceed the extent of funding in the same currency. (bold emphasis mine)

So how did the shortage come about? From the unraveling debt deflation process...

Again from the BIS (bold emphasis mine),

``European banks’ funding pressures were compounded by instability in the non-bank sources of funds on which they had come to rely. Dollar money market funds, facing large redemptions following the failure of Lehman Brothers, withdrew from bank-issued paper, threatening a wholesale run on banks (see Baba et al in this issue). Less abruptly, a portion of the US dollarforeign exchange reserves that central banks had placed with commercial banks was withdrawn during the course of the crisis. In particular, some monetary authorities in emerging markets reportedly withdrew placements in support of their own banking systems in need of US dollars.

``Market conditions made it difficult for banks to respond to these funding pressures by reducing their US dollar assets. While European banks held a sizeable share of their net US dollar investments as (liquid) US government securities, other claims on non-bank entities – such as structured finance products – were harder to sell into illiquid markets without realising large losses. Other factors also hampered deleveraging of US dollar assets: prearranged credit commitments were drawn, and banks brought off-balance sheet vehicles back onto their balance sheets...

``The frequency of rollovers required to support European banks’ US dollar investments in non-banks thus became difficult to maintain as suppliers of funds withdrew from the market. The effective holding period of assets lengthened just as the maturity of funding shortened. This endogenous rise in maturity mismatch, difficult to hedge ex ante, generated the US dollar shortage."

Despite the tremendous amount of financing generated by the US Federal Reserve, the losses in the US banking system compounded by the pressures on the European Banking system has been far greater in reducing supply of US dollars in the global financial system. Nonetheless, all these reveals of the inherent privileges of the world's currency reserve.

In short, the factors of demand and supply of currencies dictate on relative currency values, with special emphasis over the short term, more than just economic conditions.

CDS market: Japan Ranks Highest In Credit Concerns

An updated ranking of Country Default Risk from Bespoke Invest...

According to Bespoke, ``As shown, Japan's default risk is up the most in 2009, although it remains on the low side when compared to other countries. The United States' default risk is up 41% year to date. All CDS prices, with the exception of the US, are priced in US dollars, while US CDS prices are quoted in Euros. Sovereign debt insurance makes you wonder, especially for the big countries that are probably "too big to fail."

It's kinda peculiar to see developed economies dominate the pecking order of concerns over the risks of credit default, led by Japan, Germany, France, UK and the US, while many EM economies appear as "less risky" (in terms of the growth clip of CDS prices and not based on nominal pricing)...and this includes the Philippines.

Another important point is that while everyone seems focused on the credit conditions of the US which has been splurging on government spending programs, it is Japan's credit ratings that have been taking a severe drubbing.

And this isn't merely reflected in the Credit Default Swap standings but likewise in the Japanese Yen (top window) and its equity benchmark, the Nikkei 225 (main chart).

The Yen rallied furiously at the onset of the unraveling of the global "deleveraging" process as many of the cross currency arbitrages or the "carry trade" had been reversed. However, as the deleveraging aged, it appears that concerns have now shifted over the country's credit worthiness.

Aside from being the largest debtor among developed economies, the horrid impact from a loss of global demand from the ongoing crisis recently collapsed its export oriented economy, which resulted to a reversal of its unbroken string of current account surplus trend since 1981. And this has also been compounded by the diminishing savings wrought by its aging society.

From the Economist

In addition, Japan has previously announced that it would be undertaking its own $250 billion of stimulus package and may conduct its version of "quantitative easing" by allocating $10 billion to purchase of corporate bonds maturing within the year and another $10 billion to acquire equity shares held by Japanese banks (Reuters). All these may have conspired to put investor concerns over Japan's credit eligibility.

Tom Dyson of Daily Wealth suggests that Japan may be in the path of bankruptcy ,``Of the major industrial economies in the world, Japan's government is the most indebted.

``Since its recession began 20 years ago, Japan has plowed trillions into its banking system via numerous bailout programs. Japan's mantra is growth without cost. As a result, the Japanese government has built up the world's most crippling debt load."

``The government of Japan owes $7.8 trillion. That's $157,000 per capita.

``We've been using government debt per capita to compare the government debts of Britain, the United States, and Japan. But government debt to GDP is the ratio economists use to compare the indebtedness of countries. The UK has a government debt-to-GDP ratio of 48%. The U.S. has a government debt-to-GDP ratio of 75%. Japan has a government debt-to-GDP ratio of 187%.

``If there's going to be a major sovereign bankruptcy, it's going to happen in Japan. Its economy is a shambles. For years, Japan has relied on exports... but even that's drying up now. In January, Japan's exports plunged 47%, producing a trade deficit. People talk about Japan as a "nation of savers." But that's not true anymore. Japan's personal savings rate has collapsed from 16% in the early 1990s to 2.2% last year."

With $15 trillion of estimated household assets, and less levered corporate and banking sector relative to its OECD peers, I doubt a Japan bankruptcy.

From Paper Money to Food Backed Money?

Since last year's market crash we noted of the reemergence of barter as way of conducting trade among nations. Essentially the difficulties or gridlock in the US banking sector has prompted many nations to administer direct bilateral exchange.

Now in some areas of the US, we read of accounts where local trade have been conducted with "local" currency units. But in contrast to merely paper money, the local currency called "Mendo Credits" reportedly is backed by "Food".
This interesting article from Jason Bradford at the Oil Drum

``Mendo Credits is a new food-backed local currency project partly funded by a grant from the California Endowment...

``Mendo Credits are backed by a tangible asset. In other words, Mendo Credits are a “reserve currency” as opposed to a “fiat currency” like Federal Reserve dollars. Many people are familiar with money backed by gold, which was once the case with U.S. dollars, but Mendo Credits are backed by reserves of stored food. Our reserve currency has a number of desirable properties at this time in history.

``The asset value of Mendo Credits remains stable over a significant time period because we lock in an exchange rate for specific quantities of food for one year from the date of issue. Whereas gold and silver are inedible, Mendo Credits can be redeemed for the sustenance of life. When you hold a Mendo Credit note, you know it represents the quantity of food printed on its face and, if you want or need to, you can actually get that food..

``Mendo Credits are just beginning to circulate in the town of Willits, CA and we hope this spreads around our region. Four central downtown businesses are serving as sales outlets for the new currency: The Bank of Willits, Mendonesia Café, The Book Juggler, and Leaves of Grass Bookstore. NCO also sells them at the Willits Farmers’ Market."

Read the rest here

Jim Rogers: Destruction of America as the World's Most Powerful Nation and Farming Boom

Once again the sensational Jim Rogers at CNBC last March 2 2009...

(hat tip: Jim Rogers Channel)

Some noteworthy excerpts...

``I think it’s astonishing they’re ruining the US economy, the ruining US government, the ruining the US Central bank and their ruining the US dollar, I mean this is…you’re watching in front of our eyes, very historically which is basically the destruction of New York as a financial center and the destruction of America as the world’s most powerful country."

``Power is shifting now from the money shifters, that got us to trade to paper and money, to people who produce real goods, whether it is agriculture or mining or whatever. This has happened many times in history, what you should do is become a farmer, or you should go and start a farming network. That’s what you do, because in the future the farmers are going to be one of the best professions you can possibly have."

Alternative Energy: Geothermal Versus Coal

The debate on which alternative energy would be the most feasible should likewise apply to the Philippines, which has one of the world's largest geothermal reserves.

Read the rest of the article here from Scientific American

Additional Comment: If market forces are allowed to prevail then coal and geothermal would likely dominate the Philippine energy landscape. Hence, the ruckus over reviving the Bataan Nuclear Power Plant won't be required.

Video:Breaking Down Buffett's Letter

courtesy of CNBC

Note: Despite the "Sage of Omaha"'s controversial "Buy American, I am" encouraging Americans to support equity markets, the fact is that he hasn't been buying much equities since (only $1.3 billion according to Mario Gabelli), and even sold some positions recently. 

I don't share the views that most of the recent liquidations from Berkshire's Portfolio were meant to be rotated into "banks", simply because Berkshire balance sheet remains substantially cash rich. In short, you don't need to rotate when you have so much available or spare cash. Liquidity isn't the issue. Mr. Buffett sold parts of his flagship's holdings period. Yet, most of the recent positions have been into banks' "preferred stock" which is a fixed income investment derived from recent "special" deals during the meltdown last September. 

As an Obama supporter, the folksy Mr. Buffett appears to have been transformed into a sweet talking politico or had been used as a political instrument. 

Nonetheless, on the positive side, there are many amusing but worthwhile investing lessons from his annual shareholder's letter. Although as usual, you'd be disarmed by his candor to his shareholders. 

RGE on Philippine Remittances

RGE Monitor Asia shows of some statistical charts of Philippine Remittances

Major Sources of OFW Remittances in 2008 breakdown by country

Number of OFWs in 2007 Breakdown by Region

Remittance Growth Trends

RGE Monitor's growth estimates:
Base Case -6.17%
Best Case 0%
Worst Case -11%

From RGE's Mikka Pineda (bold highlight mine), ``The Filipino diaspora spans almost 170 countries, but is concentrated in the US, Saudi Arabia, Canada, UK, Italy, UAE, Japan, Singapore, Hong Kong and Australia. Except for Australia, these are also among the top ten remitters, with the addition of Germany, accounting for 88% of all remittances (see Chart 1 titled, “Major Sources of 2008 OFW Remittances”). Most OFWs in the US, Canada, Japan, Germany and Australia are permanent residents. Permanent residents often bring their families over to join them, hence they eventually have less need to send remittances back to the Philippines. Most of the stock of permanent land-based OFWs is nurses hired during the 1970s and 1980s to relieve nursing shortages in developed countries, especially the US.

``Nowadays, most deployment growth is driven by the Middle East, despite overtures to workforce nationalization in the Persian Gulf. Most workers in the Middle East and in general are temporary. As of 2007, 42.3% of the stock of OFWs were permanent, 47.4% were temporary, and 10.3% were irregular (illegals or undocumented workers). Temporary workers tend to remit most of their income as they expect to return and reside permanently in the Philippines. Domestic helpers are able to remit half of their income as many are provided with food and shelter if they are live-in housekeepers or nannies. Other temporary workers tend to be employed in other low-wage occupations, such as factory production or restaurant service."

Read the rest here

Our observation: We have long expected a downturn in remittance trends especially focusing on the plight of low skilled workers. But apparently this haven't been happening yet. A slowdown yes, but not yet negative growth.

Nonetheless, it doesn't mean that just because it hasn't happened, that it won't.

Maybe the collapse in last quarter's global trade would account for a belated or lagged impact.

And maybe too growth trend could be fall in between -11% (worst case) to 0% (best case) as suggested by Mikka Pineda (perhaps a Filipina?) of RGE.

Just a short note on equity markets… (part 2)

Bespoke Invest has an even better perspective of the global equity performance on a year to date basis, (as of March 2nd) compared to our earlier post Just a short note on equity markets…

Of course this doesn't seem to include last night's rout.(The Philippine Phisix appears to have been spared from the carnage)

But so far, there seems to be some emergent signs of distinction- the deepest losses have been accounted for by G-7 economies, continental Europe and European EM (CEE) nations, except for some outliers as Puerto Rico, Qatar, Kenya and Nigeria. And there appears to be more bourses in the green compared to last year.

We don't know if such a divergent trend will hold, but we suspect that there might be a good chance...

Hat tip Bespoke

US Real Estate Bubble Bust: Chinese On A Shopping Spree!

Savings rich Chinese individuals are doing their own version of "stimulus financing" of Americans, by buying bargain priced houses.

From America is for sale Expo 2009
Video from NBC Los Angeles

Asian Currencies Fall On CEE To South Korean Won Contagion

``Devaluation is the modern euphemism for debasement of the coinage. It always means repudiation. It means that the promise to pay a certain definite weight of gold has been broken, and that the devaluing government, for its bonds or currency notes, will pay a smaller weight of gold.”- Henry Hazlitt, From Bretton Woods to Inflation

Peso Bears: Being Right For the Wrong Reason

The US dollar rallied spiritedly against major global currencies for the second week.

In Asia except for Indonesia’s rupiah, currencies fell across the board see figure 1.

Figure 1: Bloomberg: Bloomberg-JP Morgan Asia Dollar Index Breaks Down!

The Bloomberg-JP Morgan Asia Dollar Index is a trade and liquidity weighted index that incorporates the 10 most-active currencies in the region excluding the Japanese yen.

And as you can see from above chart, the market action during the past two weeks has been relatively volatile on a downside bias. Along with the global tide, the Philippine Peso fell 1.04% to Php 48.8.

And with the obvious breakdown, momentum appears to favor MORE weakening of Asian currencies over the INTERIM.

And for those forecasting a weaker peso, they may likely be proven correct BUT for the WRONG reasons.

From The CEE To The South Korean Won Contagion

As we have discussed in last week’s Central And Eastern Europe’s “Sudden Stop” Fuels US Dollar Rally, the problem in Europe have now reached Asian shores, where the principal manifestation of the apparent contagion has been through the nexus in the South Korean Won which hit an 11 year LOW see Figure 2.

Figure 2: Reuters: Rising Default Risks Weigh on the South Korean Won

According to a report from Reuters (highlight mine), ``South Korea's massive dollar-selling intervention late last year had helped the won recover some momentum, but fears of defaults and balance of payments crises in eastern European this year have sapped investors confidence anew.

``Investors are worried that the heightened risk aversion would make it extremely difficult for South Korea to tap into the global market to secure sufficient dollar funding to pay back maturing foreign debt.”

In other words, our observation of Europe’s CEE asphyxiation of capital flows or the typical emerging market crisis symptom known as the “sudden stop” appears to validate our thesis.

More from the same Reuters report, ``The won's drop came even after data showed on Friday that South Korea's balance of payments surplus hit a near 2-year high in January as domestic investors sold off their foreign portfolio holdings and foreigners bought local shares.

``Banks in South Korea, including those run by foreigners, had $126.6 billion of foreign debt due this year as of the end of January, out of the total $182.3 billion worth, the government said Friday.

``South Korea has said its foreign currency reserves of more than $200 billion and currency swap arrangements sealed with the United States, Japan and China totalling some $90 billion were more than sufficient to cover any emergency situation.

``It has also said it was not obliged to repay all the debts because some were owed by foreign banks and some others were linked to currency hedging by their corporate clients.”

It is rare to find mainstream articles that are objectively framed such as the above.

Figure 3 Reuters: Asia’s Corporate Debt Maturity

Nonetheless the problem of the won seem to focus on securing “rollover” financing for maturing US dollar corporate debts (see figure 3) as the immediate concern.

The scramble for US dollars as consequence to the “sudden stop” in the CEE region compounded by the near term maturities of mostly South Korean debt comprising 51% of Asia’s debt exposure for 2009, appears to have created an artificial US dollar shortage. Thus, the surge of the US dollar across Asia.

Notice that ASEAN’s share of maturing corporate debts are spread over the coming years albeit with incremental increase in volume. This suggests that there seem to be less liquidity constraints over the interim but nonetheless the region’s currency performances have been weighed by predominantly glum sentiment than warranted by fundamentals.

And South Korea’s policy approach to help alleviate the problem, again from the Reuters, ``it would exempt foreign investors from income and capital gains taxes on investment in local treasury bonds and monetary stabilisation bonds to lure more foreign capital into the country.”

Put differently, the South Korean government appears to be reacting out of the confusion wrought from the market distress. On one hand, South Korea threatens to default on loans acquired from currency hedges which could further raise property right issues and compound capital efflux, and on the other hand, the recent tax exemption on taxes on foreigners have been designed to attract capital flows.

Fooled By Both Complexity and Simplicity

Yet in nearly every article, almost every “experts” quoted blamed Asia’s falling currencies on the collapse of exports which for us is highly fallacious. Why?

Because:

One, NOT because “A” and “B” regularly occur together, does it necessitate the conclusion that “A” is the cause of “B”. This known as the fallacy of “Confusing Cause and Effect”.

Falling exports are last month’s data, while the currency markets should be “forward looking”. Therefore, the reading of last month’s data which is used as basis to project into the future is almost equivalent to interpreting events linearly (or assuming continuity of past events) in a highly complex world. If you read into the terms of services of investment institutions, the fine print usually says “Past Performance does not guarantee future outcome”.

This rationalization seems similar to our homegrown experts who, on the other hand, diagnose the ‘weakening’ of the Philippine Peso to the prospects of falling remittances. But even worst, such oversimplification appears hardly associated at all!

As we pointed in The Tenuous Correlation of Remittances and the Philippine Peso, ``Here are the facts: The Peso in 2008 fell 15% even as remittance growth accounted for 15% for the first 11 months according to the IHT (estimated by World Bank to account for 18% growth for 2008). Growing remittances against a falling Peso, so how valid is this concept?”

Two, lacking the depth of analysis meant for oversimplified explanation for public consumption, the availability of current events are then utilized as the functional cause-and-effect variables. This is a cognitive folly known as the Available bias.

News outfits are meant to cater to easy explanations more than comprehensive analysis, thus the public usually gets what they deserve.

To quote my favorite client, who delivers an incisive comment, ``It's a paradox: those involved are fooled by complexity and those analyzing the situation are fooled by simplicity.”

The world or markets isn’t merely about “demand” or “exports” only, as some experts would like us to believe. To quote Friedrich August von Hayek in a 1992 interview, ``You can't explain anything of social life with a theory which refers to only two or three variables.” Currency values reflect on the complexity of social phenomenon.

Three, this represents as wooly economic reasoning.

The problem of falling exports or falling remittances as driver for currency prices is established upon reduced foreign exchange receipts, which obviously, revert to the concern of the relative state of the Balance of Payment (BoP) of the countries in focus.

But what if imports fall FASTER than exports, as in the case of China (see Figure 5)?

Figure 5: Tradingeconomics.com: China’s imports falling faster than exports

The palpable reply is that net Balance of Trade remains a surplus. Similar to China’s case, despite a nasty fall in exports which had been offset by an even nastier collapse in imports, China’s trade surplus remained at second to the highest recorded level seen last November.

The principal concern is that current account deficit countries, like those in the CEE region, won’t be adequately financed and would prompt for sharp adjustments in currency values which subsequently would percolate to the real economy in the manifestation of an economic recession or a crisis.

Although, fundamentally, current account deficits derived from falling exports can always be financed out of foreign currency reserves or by foreign currency borrowing from the local or international markets or as in the past case of US- exports of toxic financial claims. All these depend on the degree of deficits or the availability and the accessibility of financing and importantly the prevailing market sentiment.

And as the Reuters report aptly pointed out, concerns over these “rollover refinancing” on US dollar denominated debts has raised default concerns.

Fourth, currencies are like a coin, they are two faced.

As we have repeatedly been saying the currency market is basically a zero sum game, where one wins and the other loses. This means you can’t evaluate currencies from a ONE dimensional perspective.

If the concerns in Asia seem mainly about the prospective “deficits” arising from the slackening of foreign exchange receipts, then the US which has had substantial improvements in its current account balances, but still remains on a deficit, would also most likely encounter prospective funding pressures as their government embarks on a massive fiscal program.

According to CNN, ``Based on the proposed budget, the administration projects the deficit for fiscal year 2009 will reach $1.75 trillion, or 12.3 percent of U.S. gross domestic product. That's a record in dollar terms and is the highest as a share of GDP since World War II.”

The ballooning fiscal deficit will eventually translate to expanded current account deficits as the expanded budget will be realized as government spending. And we believe that more government spending will be in store not only for the US but for most of the world.

In short, both Asia and the US are faced with the risks of deficit financing.

Figure 6: Financial Times: Sectoral and Public Debt Distribution

Fifth, the law of scarcity means competition for funds.

In the US, today’s deflating debt bubble discernibly means a shriveling of the financial and household sector debt which constituted as the core of the boom in credit growth during the bubble years see figure 6 (left pane). And government debt which remained “underutilized” has now been calibrated as a substitute (right pane) and is seen as exploding.

As Doug Noland aptly comments in this week’s Credit Bubble Bulletin, ``Today’s unparalleled expansion of federal debt and obligations is being dressed up as textbook “Keynesian.” It’s rather obvious that we are in dire need of some new books, curriculum and economic doctrine. But from a political perspective, the title is appropriate enough. From an analytical framework perspective such policymaking is more accurately labeled “inflationism” – a desperate attempt to prop inflated asset prices, incomes, business revenues, government receipts and economic “output”. There have been many comparable sordid episodes throughout history, and I am not aware of any positive outcomes.”

In other words, the exhaustive attempt to prop the old bubble system with government as the surrogate could extrapolate to multifaceted risks in the future. And as governments accelerate “reflation” with even more dosage of “reflation” in the future, global governments will actively be competing against each other to secure financing from global or local investors or savers.

Therefore, Asia and the US doesn’t only face risks from financing deficits, they will be competing feverishly against each other if only to pay for the present government expenditures.

Sixth, the silence of King Dollar’s role.

Everybody talks about “deficits” (exports, trade, current account etc…), but nobody talks about relative deficits. Are risks from deficits only an ex-US dollar phenomenon? Particularly, nary an interest has been made to categorically distinguish between the deficit risks of the US dollar and of the other currencies.

As the de facto currency international standard, whose liabilities are denominated on its own currency, the US dollar operates on a privileged platform. Since the global banking reserves and world trade are mostly anchored to the US dollar, the US has the ability to underwrite its own deficits. On the other hand, foreigners fund US deficits by buying US denominated financial claims.

Nonetheless, the US dollar’s authority doesn’t come without limitations. If there will be a funding shortfall, this implies of higher interest rates and greater than expected “inflation” or the risks of hyperinflation which may also translate to currency risks.

To quote Joachim Fels of Morgan Stanley, ``given the size of the current and prospective economic and financial problems, and given the size of the monetary and fiscal stimulus that central banks and governments are throwing at these problems, investors would be well advised not to ignore this tail risk, especially as markets are priced for the opposite outcome of lasting deflation in the next several years. Put differently, we believe that buying some insurance against the black swan event of high inflation or even hyperinflation makes sense and is relatively cheap currently.”

The Case For A Short Term US dollar Rally

Finally, the presently falling Asian currencies could reflect a combination of the following factors:

1. Improving US trade account balances in the US suggests of lesser US dollars in circulation worldwide. As the US buys less than what she sells to the world, this implies that more US dollars are going INTO the US than headed overseas.

2. The persisting turmoil in the US banking and financial system as signified by the concerns over the outright nationalization of key banks as the Citibank and Bank of America suggest that the gargantuan money printed by the US Federal Reserve and or money from the US Treasury earmarked for the financial system on its alphabet soup of programs, hasn’t been enough to cover the losses in the US financial system. This seems to be validated by the continued decline of US equity markets which have been weighed by banking and finance related losses. The top 5 industries with most losses according to bigcharts.com on a year to date basis are US Full line insurance 67.31%, Life insurance index 53.41%, Forestry and Paper Index 50.86%, Paper Index 50.86% and Banks 48.82%.

Therefore, such deficits appear to signify continued drainage of substantial liquidity in the global financial system despite the collective measures of central banks to patch these.

3. The ensuing capital deficiencies in the US and European banking system have diffused into emerging markets. This has triggered a “sudden stop” in the CEE region, which has exacerbated the present economic conditions. Combined with the unintended consequences from government guarantees (where capital or savers temporarily seek refuge or have shifted their monies to countries with guarantees on the financial system that has an international reserve currency stamp), the dearth in liquidity and overwhelmingly morose market sentiment (such as chatters of dismemberment of the Euro) have prompted for capital flight and exodus in the region. Conversely, this means greater demand of US dollars.

4. Sporadic evidences of speculative attacks on emerging market currencies such as in Mexico’s Peso, according to the Northern Trust.

5. The deglobalization trends in the financial world. Government rescues of several home institutions have mandated reduced overseas exposure. The Financial Times Alphaville’s Gwen Robinson quotes a study from Greenwich Associates, ``the shift in corporate banking business from global to local providers appears to be gathering steam as the world’s biggest financial firms face new political pressures that make international lending more difficult, the report noted. Right now, there is little incentive for the big UK and US banks to extend credit to companies outside of their home markets and it is becoming increasingly hard to operate as an international bank, it noted.”

Deglobalization trends imply less liquidity in the system.

6. Lastly concerns over the paucity of systemic liquidity have raised concerns over the ability to rollover maturing near term US dollar denominated debt seem to have fueled a speculative run on the South Korean won.

The run in the won has equally undermined most of Asia’s currencies last week, except the Indonesia’s rupiah which was bolstered by speculations of a possible currency swap arrangement with the US.

According to Bloomberg, ``Indonesia proposed a currency-swap accord with the U.S. to help bolster the rupiah, during Secretary of State Hillary Clinton’s visit to Jakarta last week.” Despite the appearance of exemplary performance, the Rupiah is reportedly down 4.5% over the month.

As you can see the recent softening of Asian currencies can’t be read simplistically from an “export meltdown” or “slowdown in remittances” angle.

Using the Occam Razor’s rule or where “one should not increase, beyond what is necessary, the number of entities required to explain anything,” the deflationary and recessionary pressures appear to be twin forces that have conspiring to suction out liquidity from the financial sphere.

Seen from the obverse perspective, despite the surge in its fiscal deficit, the recent strength of the US dollar has virtually been drawn from its authority as the world’s reserve currency status more than anything else.

However, with the US government attempting to massively inflate the system by undertaking direct expenditures, which is a similar route taken by Zimbabwe’s Dr. Gideon Gono; funding concerns, higher interests rate and greater than expected inflation could likely undercut the strength of the US dollar. This gets to be highlighted once the distribution of government financing exceeds the losses in the system. Until when such deflationary forces shall prevail is something we can’t say, albeit we appear to be witnessing signs of recovering commodity prices.

In short, the strength of the US dollar is likely to be temporary (short to medium term) feature.

Our Version of The Risks of A US Dollar Crash

``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system”- Ludwig von Mises Human Action p.555

The prospective shortfall from the frontloading of fiscal deficits has prompted accelerated concerns over a crash of the US dollar.

For some the definition of a US dollar crash is simply a wave of selling of US financial claims from major official creditor nations, i.e. central banks and sovereign wealth funds.

For us, the incentive to drastically and simultaneously unload US assets appears unlikely, because it won’t be to any country’s interest to foment a US dollar crash as this will be equivalent to mutually assured destruction. To quote Luo Ping, a director-general at the China Banking Regulatory Commission who spoke with levity over a recent public engagement, ``“We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.” [emphasis mine]

Moreover, many have been suggesting for the US to massively devalue by running up the printing presses, a step similarly undertaken by then US President Franklin Delano Roosevelt during the Great Depression. This should ostensibly reduce the real value of debt by reducing the currency’s purchasing power.

However, the privilege from “devaluing” translates to lost savings and a significantly lower standard of living and even more poverty. To quote money manager Axel Merk of Merkfund.com, ``Somehow policy makers have it backward. Many of us like our jobs, but not so much that we love to give up half our net worth for the opportunity to go back to work.”

Besides, the basic problem of the US dollar devaluation seems to be, “to devalue against whom or what”?

During the Great Depression, the US dollar was operating on a gold standard platform which allowed for it to devalue. Our paper money system isn’t tied to gold anymore.

I might add that to conduct an arbitrary massive devaluation can be construed also as a form of non tariff protectionism.

Therefore, it would seem rather unlikely for the US or for that matter to any major OECD country or regional economies to perhaps impose on such irresponsible protectionist stance without expecting the same punitive retaliatory measures.

This means, as we have repeatedly pointed out in the past, the likely scenario from unilateralist US dollar devaluation could be the risks of a currency war, which ultimately leads to the disintegration of the present paper money system, and possibly, a world at war.

While many countries appear to be itching towards adopting or gradually espousing non tariff populist protectionist policies such as export restrictions, import quotas, anti dumping duties, non automatic licensing, technical regulation to trade covering health and environment and subsidies to national industries, it is unlikely that governments could veer towards radicalism. Nations which depends on trade, together with the World Trade Organization and multinational companies will possibly lobby to maintain sangfroid temperaments.

Hence, an orderly coordinated devaluation may occur only if done under an international rapprochement similar to the 1985 Plaza Accord. The same multilateral approach can be undertaken when considering global debt restructuring or a reconfiguration of the monetary architecture.

Nonetheless we beg to differ from the conventional expectations of US dollar crash paradigm.

We concur with Brad Setser when he cites that the present dynamics as shifting from reduced significance of external based financing to increasing contribution from domestic savings.

Here is Mr. Setser, ``The overarching assumption behind the stimulus is that a rise in US household savings (linked to the fall in US household wealth) will create a pool of domestic savings that will flow, given the ongoing contraction in private investment, into the Treasury market. The rise in private savings and fall in private investment will allow the US government to borrow more even as the US economy as whole borrows less from the rest of the world. The key to the Treasuries rally in 2008 was the surge in private demand, not the strengthening of official demand. My guess is that the Treasury market will be driven by developments in the US – not developments in China – in 2009.”

This means a US dollar crash will probably occur if private creditors alongside official creditors instigate a run on the US banking system. That will happen only if a surge in inflation or the debt burden becomes intolerable. On the other hand the other possible scenario, as mentioned above, could be a currency war. Of course there maybe other possible scenarios, which at present, escapes our thought for the moment.

Just a short note on equity markets…

``There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realised.”- Peter L. Bernstein Insight: The flight of the long run

At the start of the year, we propounded the scenario where 2009 could likely manifest some divergences in the global equity markets.

Despite the continuous decline in the major US equity bellwethers, we seem to be seeing some marginal proof of such transitioning.

Figure 7: stockcharts.com: Emerging Divergences Among Global Equities?

Although pressures from the worsening recession in the US continues to weigh on most Emerging Market bourses, the degree of decline hasn’t been as steep or as deep, based from December 23^rd of 2008, as shown in figure 7.

Probably this could be because most EM bourses fell steeply more than US benchmarks in 2008. As discussed in Black Swan Problem: Not All Markets Are Down in 2008!, In 2008, the US fell 38.49%, Chile lost 22.13%, Brazil 41.22%, Malaysia 39.33%, Thailand 47.56%, Indonesia 50.64% and the Philippines 48.29%.

In fact, the current losses of the US bellwethers seem to match, if not exceed, the losses attained by some of these bourses at their lows.

Nonetheless we seem to be seeing some outperformers: Chile lost only 22.13% during the dramatic meltdown in 2008 but is already slightly up on a year to date basis. We also see Venezuela (growing signs of dictatorships gaining acceptance?) and Colombia among the other Latin American honor roll.

Across the ocean, we have Morocco and last year’s member of the 3 amazing bourses which defied the tide, Tunisia as another hotshot. This, despite the global economic woes affecting their exports and tourism revenues, aside from a sharp slowdown in the national economic growth.

To quote Marion Mühlberger of Deutsche Bank, ``So it looks as though Tunisia cannot decouple completely from the global financial crisis but is unlikely to suffer any major economic or banking crisis”. Probably not in terms of traditional economic metrics but certainly has “decoupled” in terms of financial markets performance in 2008.

Not that we believe that this is anything about “economic recovery”, but from the monetary viewpoint, the potential response stems from the impact from we believe as the liquidity spillover or our “spillage effect” from the collective attempts by central banks and governments to inflate asset markets and the economies. Governments are essentially driving the public to speculate and turbocharge asset inflation.

As we noted above, the losses have vacuumed most of the liquidity generated by global authorities, although last week’s surge in select commodities as oil (+11.82%) and copper (+7.7%) seem to validate our supposition of a prospective spillover. Albeit Gold’s (6%) decline could be indicative of an emerging rotation, or possibly, rebalancing of the Gold-oil ratio which has surged to record levels in favor of gold.

Figure 8: PSE: Sectoral Performances

Finally we seem to see the same signs of divergences even in the Philippine Stock Exchange (figure 8).

Based on sectoral performance on a year to date basis we see commercial industrial (pink-up 15.27%) and the mining sector (green up 11.75%) outperforming the rest of the field- Property blue (-9.47%), banking black (-10.79%), holding red (-1.51%), all maroon (+1.17%) and service orange (+1.34%).

The surge in the commercial industrial has been powered by energy stocks.

The Phisix (-.03% year to date) continues to drift sideways which implies a likely bottoming cycle, despite the October like performance in the US. This seems largely due to the diminished scale of foreign selling activities which may have validated our assessment of the deleterious impact of forcible selling or delevaraging to the local equity market, regardless of fundamentals.

Nonetheless, if we see a continued rise by the present market leaders, then this “inflationary driven” run may start to spread over to the broader market. And people may start to read market prices as “justification” of an economic “recovery” and pile on them; even when this may be due to sublime responses to monetary policies.

However, we will need to be further convinced with technical improvements on some key local and select benchmarks, aside from key commodity prices and similarly progress in domestic market internal activities.