Monday, March 24, 2014

Phisix: Have You Been Aware of This Week’s Peso Meltdown?

In this issue:

Phisix: Have You Been Aware of This Week’s Peso Meltdown?
-The Numerous Impossible Things before Breakfast
-Philippine Peso Crushed as Ms. Yellen Spoke of Interest Rate Increase
-The Peso-Phisix Correlation
-More “Marking the Close” at the PSE
-The Peso as Secondary Source of Stagflation
-The BSP Indicates Tightening, Really?
-Are the Risks to Philippine BoP coming from the Capital Account?

Phisix: Have You Been Aware of This Week’s Peso Meltdown?

The Numerous Impossible Things before Breakfast
Alice laughed. "There's no use trying," she said: "one can't believe impossible things."

"I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for half-an-hour a day. Why, sometimes I've believed as many as six impossible things before breakfast."[1]
Much more than the ‘six impossible things’ Lewis Carroll’s White Queen’s advice to Alice, a vast majority of global financial industry—including the so-called economic sphere whose preaching has underpinned the wisdom of populist politics—have entrenched their beliefs in a constellation of the impossible things. 

Fantastic examples…

Savings is BAD, spending is GOOD…
Currency (theft) devaluation EQUALS economic growth…
Economic repression GENERATES economic growth…
Wealth transfer channeled through policy induced debt financed asset bubbles PRODUCES economic growth…
Asset bubbles have NEUTRAL effects in the price levels of the general economy (particularly, consumer and input prices)…
Asset Bubbles WILL last forever…
Welfarism ENCOURAGES productivity…
Wars have MORE benefits than costs…
Nationalism (and nationalism based spending) is BEYOND the scope of economics and economic reasoning…
Technocracy backed political administration KNOWS best…
The political economy of 1 MINUS 1 EQUALS TWO…
Corruption is a function of PERSONAL ethical depravity (rather than from the politics of resource distribution that enables and facilitates such unscrupulous behaviors via arbitrary, immoral, repressive and uneconomic legislation and social policies)
Tea leaf reading from statistics IS economic analysis…
Momentum-Yield chasing REDOUNDS to investment…
And stratospheric stock market valuations as reflected by prices have reached “PERMANENTLY high plateau

I have repeatedly[2] been writing about how outrageously mispriced Philippine stocks (and even bonds[3] via the convergence trade) have been at current levels; well, based on the contrast principle/effect, 30-60 PERs of Philippine stocks seem a speck or ‘dirt cheap’ to the even more outlandish valuations of popular tech stocks in the US.

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As you can see on the left pane, the financial ratios data from Fairfax Holdings as of March 7, 2014[4] reveals that Linkedin, Netflix and Facebook has an astronomical PER of 887, 186 and 116 respectively!!! Incredible.

Given the fresh record for key benchmarks as the Dow Industrials, S&P 500 and Russell 2000 or the near record levels of the NASDAQ), it is likely that the above mentioned ratios could be much higher.

And such seems even peanuts relative to the other technology based companies which continue to post losses yet whose market values have been priced to perfection! The still capital burning companies of Twitter, Yelp, Service Now and Netsuite has price to sales ratios of a jaw dropping 38, 27, 22 and 21!!!

And as illustrated on the right pane, where “equities no longer follow earnings”[5] or stated differently, central bank policies have been intensifying the yield chasing momentum by pushing participants out on the risk curve through the bidding up of the markets via PE multiple expansion rather than by earnings growth. Such dynamics reverberates with actions in the Philippine Stock Exchange or elsewhere.

And this comes as US IPOs from companies with negative earnings (similar to the above) has been gushing into the markets to almost reach February 2000 highs[6]!

The legendary investor Benjamin Graham, in one of his recorded lectures, admonished on the risks from the herding effect [7] (bold mine)
Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes — in fact, very frequently — they make mistakes by buying good stocks in the upper reaches of bull markets.
And such excessive speculation comes as record issuance of junk bonds has nearly doubled from $1 trillion in March 2009 to the recent $1.97 trillion that has prompted bond guru Jeffrey Gundlach to warn that “They’ve squeezed all the toothpaste out of the tube,” in a Bloomberg interview such that “There is interest-rate risk that’s just being masked by fund flows holding up the prices of junk bonds.”[8]

In Ms. Janet Yellen’s debut as US Federal Reserve chairwoman presiding over the Federal Open Market Committee, she and the FOMC made good the third round of “taper” last March 19th which brought down the Fed’s asset buying program by another $10 billion to $55 billion[9].

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The result has been to materially push up US Treasury yields across the curve. However the spike has been pronounced on the shorter end of the curve, particularly the 2 year (left) and the 5 year (right) notes (stockcharts.com).

In addition, the spread between the longer end of the curve particularly the 10 year notes and 30 year bonds has markedly narrowed[10] which has been indicative that markets are now pricing in higher interest rates.

So we seem on track towards ‘Wile E. Coyote moment’ via the deepening convergence of 3 contravening forces: soaring asset prices (financed by credit) and sustained increase in record debt levels in the face of rising rates (or a tightening environment). 

The Wile E. Coyote moment will extrapolate to the disorderly unmasking of most of the impossible things the mainstream has come to firmly believe in. Psychological escapism which has evolved out of asset bubbles will see a rude awakening pretty much soon.

Philippine Peso Crushed as Ms. Yellen Spoke of Interest Rate Increase

Ms. Yellen didn’t just reduce the Fed’s quantitative easing programs, she uttered something considered a taboo in today’s contemporary finance: raising interest rates.

Ms Yellen’s signaling, either deliberate or may have been Freudian slip, has rattled most of Asian-ASEAN markets[11]. Except for Indonesia, the bulk of the damage has been endured by the bond and currency markets. 

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Incidentally, Indonesia’s equity bellwether, the JCI, has more than eviscerated the previous Friday’s 3.23% jump. This week the JCI sank 3.66% and chipped of 89% of last week’s 4.11% gains.

This marks another evidence of extreme volatility in both directions.

And surprise, surprise, surprise the Aldous Huxley (Facts do not cease to exist because they are ignored) syndrome strikes again!

Little of mainstream media has covered how the Philippine peso has been crushed last week! And the little attention paid to the domestic currency only dealt with facts with hardly any rationalization from their favored experts.

The implication is that the falling peso has little or no bearing on the Philippine economy or that such development has not been aligned with the views of the politically correct theme of asset bubble worshipping.

Except for India’s rupee, Asian currencies fell hard against the US dollar.

But the most devastated has been the Philippine peso which relative to the US dollar crashed by 1.42%! The Philippine peso even performed worse than the collapsing Chinese currency the yuan, where the latter tanked by 1.23% over the week.

As a side note, Chinese stocks rocketed this week by 2.16%. Yet each time news of a default or coming default comes out, the Chinese government counters such negativity or adverse events with promises of stimulus or of reinvented means of access to new credit—this time “preferred shares”[12]. Chinese stock markets has so far ignored what seems as tremors occurring in increasing frequency and intensity and focus on such promises.

The Chinese government’s operating standard to resolve her nation’s debt problem—promise more debt and debt financed spending. More impossible things before breakfast

Back to the Peso.

Didn’t the credit ratings agency the Moody’s declared last week that the Philippines won’t be hurt by a sudden stop? So what happened to the supposed strength of the Philippines? Why did the peso hemorrhage?

And it has not just been the peso, yields of 10 Philippine sovereign bonds spiked by 39 bps last Thursday to 4.571% from last week’s 4.18%. I would expect a much lesser reaction to Philippines treasury markets since banks and the government holds a tight grip of the said fixed income market.

As of the 4Q13 according to ADB’s AsianBondsOnline[13], the largest grouping of investors in government securities comprised banks and financial institutions with 31.6% of the total. Contractual savings institutions—including the Social Security System (SSS), Government Service Insurance System (GSIS), Pag-ibig, and life insurance companies—and tax-exempt institutions—such as trusts and other tax-exempt entities—accounted for 24.4% or the second largest holders. The share of funds being managed by BTr, which includes the Bond Sinking Fund, ranks third at 18.9%. Custodians (BSP accredited agencies mostly banks) hold a 13.2% share while other government entities and other investors, which include individuals and private corporations had 11.8% share.

Essentially the local currency denominated sovereign bonds market has largely been a duopoly of Philippine banks and the Philippine government. The stranglehold by both parties backed by the ‘boom’, e.g. trifecta of credit rating upgrades, justified the further lowering down the Philippine yield spread with the US counterparts to a record 78-80 bps last November. Such convergence trade has served as this administration’s trade secret that has pillared much of the so-called this ‘time is different’ economic boom that really has been bank credit inflation driven statistical economic growth. There is an ocean of difference between statistical and real economic growth.

Yet mainstream growth has been limited to a minority segment of the society, specifically to those with access to credit in the formal banking system. Yet the inverse side of such growth has been that credit risks have become increasingly concentrated. But because of the lack of exposure of the general populace to the formal sector financing, the growth in credit risks has largely been unnoticed by mainstream pundits whom has largely been focused on statistical reading.

Through public subsidies of government liabilities via negative real rates, zero bound rates benefited the government foremost. This is known as the financial repression. Second, zero bound rates engendered a massive credit driven boom in the bubble sectors, particularly real estate, construction, trade, hotel and financial intermediation. Such credit fueled boom provided the government with inflated tax revenues. Thus inflated revenues from a bubble boom and from low refinancing costs through public subsidies via negative real rates have been feeding on the insatiable expansion by the Philippine government as evidenced by rate of spending growth and her continued assault on the informal economy.[14]

On the other hand, the banks, the government’s key partner in the domestic sovereign bond market, have been the primary avenue for financing the boom, and have thus been the secondary beneficiaries. The banks’ implicit role has been to finance government expenditures through credit issuance to mostly bubble industries as well to provide financing access to the government and to government related institutions. Banks also operate as sales agencies for government securities and as collection agencies for taxes, and finally as strategic partner in control of the domestic LCY sovereign bond markets. So one should expect that should any substantial problems befall on the ‘too-big-to-fail’ version of domestic banks, such will translate to a prospective bailout.

This brings us back to last week’s surge in bond yields.

Given the tight relationship between banks and the government as explained above, the spike in bond yields, or inversely bond prices fall, should imply of a ‘crack’ in the consortium’s tight control of the supposed ‘risk free’ version of the fixed income markets. One or some of the parties could be experiencing pressures from the recent tightening for them to allow for a yield spike.
Should bond yields continue to ascend then such unseen or undeclared strains may likely signify escalation of tensions.

The Philippine central bank, the Bangko Sentral ng Pilipinas (BSP) even appeared to have attempted to stem the peso’s dive through information management—through the release of two positive developments last Friday—at the heat of the meltdown. Such involves the improvement in external debt down to $58.5 billion[15] and fourth quarter’s $1.8 billion current account surplus[16]. Yet the peso seems to have shrugged off the good news to close the day’s session near the USD-Peso peak or inversely near lows for the peso.

So who has been selling the peso and buying the US dollar? And why?

The Peso-Phisix Correlation

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The mainstream hardly seems to realize that since Abenomics and Bernanke’s June Taper, the USD-Peso and the Philippine Phisix has been demonstrating an increasingly tighter correlationship.

As I have been saying today’s operating environment has been vastly different from the heydays of 2013. Then the Phisix boom has been in confluence with zero bound rates, low statistical consumer price inflation figures and a firming Peso. In essence, the Phisix sailed in the tailwind of a Risk ON easy money landscape. Today, tailwind has morphed into headwind—falling peso, rising yields and even higher statistical price inflation. Yet stock market punters have been desperately forcing to reinstate or resurrect the past.

The Abenomics-Bernanke Taper appears to have reconfigured the domestic marketplace. Notice that each time the USD-Peso soared in the last 3 occasions (green lines), namely May-July, July-September and October-February, the 3 accounted rallies in the Phisix had been aborted (red curved lines).

Also notice that this week’s sharp ascent, which seemed like a fat-tailed move either indicated a further upside swing as in June (see left violet rectangle) or a top as in September (mid violet rectangle).

To be fair to Ms. Yellen, her interest rate signaling only functioned as aggravating circumstance to a prior weakening peso. The 2-day .98% loss equates to about 70% of this week’s drubbing.

I believe that the February 3rd closing high of 45.41 will serve as the critical resistance level for the USD-PHP. This will signify as only 1,200 pips (percentage in points—equivalent to 1/100 of a cent). Given the lack of liquidity and thus the gaping bid-ask spread in the USD-Php forex trade, 1,200 pips signifies just a stone throw’s distance that may easily be breached.

More “Marking the Close” at the PSE

Let me add that Phisix participants have been highly complacent. Proof of this has been that despite the weakening peso, punters continue to frantically support an increasingly fragile risk-reward environment characterized by a stunningly overvalued and outrageously overpriced securities. 

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The Phisix was supposed to end at a positive note this week, but another “marking the close” event struck on a curiously none end of the month Friday session.

Opposite to the February 28th session which had an intraday upside spike, the Phisix collapsed by about 1% from the pre-close to the closing bell (leftmost chart from technistock.net) where the difference spelled the 1.22% retracement of the day and the -.81% for the week. The amazing intraday dive came with a heavy volume similar to February 28th of 2013. You can see the February 28th intraday charts of 2013 and 2014 in the link; this I tackled early March[17].

Eight companies with the exception of EDC, comes from three sectors (see middle table from the PSE), particularly holding (-1.72%), services (-1.44%) and financials (-1.06%) that spurred the fantastic 5 minute interval dump. The eight companies that suffered a last minute reversal of sentiment as measured by the difference between the last pre-close trade and closing prices: JG Summit (-5.34%), GT Capital Holdings (-3.4%), Energy Development Corporation (-2.6%), BDO Unibank (-2%), Globe Telecoms (-1.9%), Bank of the Philippine Islands (-1.79%), PLDT (-1.6%) and SM Investments (-1.4%).

Interestingly JG Summit which had been the hardest hit (rightmost chart from COL Financial) was even up by .1% at the last pre-close trade, thus the closing variance of -5.24%.

Of the 8 companies, 2 posted foreign buying and 6 foreign selling. And there is no clear indication if such actions had been in response to the peso or the spike in bond yields.

Last minute spikes and dumps appear to have increased in frequency.

Last October[18], the Philippine Stock Exchange’s publicly declared that the stated purpose of extending the pre-close period has been to “allow the trading participants to assess and counter a sharp price move at the close”. This seems to have only amplified the opposite. Such last minute spike or dumps are manifestations or symptoms of the severe lack of depth and liquidity by the domestic stock market. And by adapting programs intended to “align with practices in the region” appears gravely misguided because the relative operating environment which the PSE uses as basis for her actions have been almost entirely different. Thus even from the perspective of private practice—the PSE is a monopoly—we see the law of unintended consequence in action.

Like most of how the political environment operates here, actions have been focused at the superficial rather than from the structural.

The Peso as Secondary Source of Stagflation

Back to the Peso.

I believe that the Philippine peso will continue to significantly weaken overtime primarily based on the maturation of the credit boom which presently is being vented via the shocking 38.6% M3 annualized January 2014 growth[19]. As I noted last February, the peso has now become a victim of BSP’s credit boom which has led to a deepening stagflationary environment. 

And such stagflationary environment will be further compounded by the slumping peso.

38.6% M3 growth accounts for about 68% of claims on other financial corporations and non-financial private sector. Those are past economic actions of which the effects in the relative price levels are being felt today in asymmetric time intervals and in relative sectors attached to the real estate industry and beyond.

My projections show that the property sector will be raising a very conservative Php 250 billion in capex for the 2014, this means another wave of mostly credit fuelled spending spree. And there are other industries that will likely have real estate requirements too such as manufacturing or services. So demand from other industries will add to the price pressure on property prices.

Think of it, land is not produced or generated therefore are fixed asset inventories. Thus money creation relative to land means higher land prices. The race to bid up on acquiring land inventories should further intensify the property price increases. In essence there will be too much money chasing on a limited inventory of property for development.

But developers won’t just be land banking, they will be putting up edifices. So they will be contracting or sub-contracting construction companies who will use steel, cement, nuts and bolts, paints, construction equipment, transportation and etc… in the erection of these buildings.

Thus the competition to bid up property would extrapolate to added demand for construction materials, transportation, equipment, machinery and others. The items in demand may be sourced entirely from local producers or from external agents or from foreign producers or from a combination of both. Prices will, thus, act as signal to coordinate the use of resources.

Even if sourced locally, if the demand surpasses available stocks then prices will rise. And rising domestic prices will likely push domestic companies to seek relatively affordable alternative sources from abroad

But the latter window will now be closing. The falling peso should mean higher priced imports. And the slumping peso will even impact more supplies with limited competition or availability from domestic sources. Eventually high prices will increase project costing of companies and thus reduce demand or expansion

Philippine external trade data suggest that perhaps a significant portion of the supplies of the domestic property and ancillary industries comes from imports.

Philippine import data as of December 2013[20] show that Mineral Fuels, Lubricants and Related Materials ranks second only to Electronic Products which has been the largest in terms of Philippine import bill. But the difference in their share of the import pie has been only marginal: 22.4% for the former and 22.6% for the latter. Transport Equipment placed third with 12.5 percent% share. Industrial Machinery and Equipment, ranks fourth with 4.5 % while Iron and Steel has been part of the top ten.

This also implies that the plunging peso will likely impact the non-bubble manufacturing sector and even perhaps exports of electronic products.

So relative price inflation will come from two directions.

The main source will be from the credit driven spending activities of the property and property related bubble sectors. The second source will emanate from import prices. 

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Given that the Philippines has been relatively significantly less productive economy (as revealed by the huge informal economy and the lack of depth in both formal banking and capital markets) the average populace are likely to be more prone or highly sensitive to price inflation compared to her much wealthier neighbors.

Price increases in energy, food, rentals and transportation will effectively reduce the average resident’s disposable income as spending will be diverted to essentials. This is the income effect.

And should there be residual disposable income, rising prices may impel the average consumer to conserve resources by switching into the more affordable alternatives. This is the substitution effect.

Sustained price pressures on basic goods would imply that the forces of the income and the substitution effects[21] will increasingly come into play.

Note: While the above data is from 2003[22], I doubt if there has been a material change in the above distribution.

Aside from higher input costs and reduced demand, the falling peso (in tandem with the domestic source of inflation via credit financed spending) will compound on the predicament of entities with exposure to foreign currency, or specifically, US dollar denominated debt.

Even if these companies secured their financing via fixed rates, the falling peso would mean more pesos required to pay for every US dollar debt. This will be even worse for companies whose foreign liabilities are priced from variable rates especially that Ms. Yellen has hinted on raising interest rates.

Thus in the face of slowing demand and higher input costs, the declining peso will add to the increase business costs further crimping profits and thus raise the risks of defaults.

I have already noted that many publicly listed companies[23] have acquired and will likely be burdened by foreign currency debt.

And add to the interest rate pressure will be the increased demand for credit.

The BSP Indicates Tightening, Really?

The BSP governor Amando Tetangco Jr responded to Ms. Yellen’s statement hinting to a possible pre-emption of interest rate increase as “early measured adjustments” that would make his “monetary policy as ideal”. He notes that domestic inflation remains “within target”[24]

Political rhetoric has been mostly devious and evasive.

First of all, this is not the first time the BSP governor played into the taper talk. Following the first account of emerging market tremors from Abenomics-Bernanke Taper in May-June, the BSP governor floated on the idea that the BSP may tighten in July 2013 since he boasted “we don’t see any real need for stimulus at this point”[25]. From then until last week, the BSP governor spent the entire period defending the current monetary stance or the “stimulus” of zero bound interest rate subsidies.

Second, another proof is in BSP’s self imposed banking sector loan cap to the real estate industry. The cap has been breached in May 2013, but the BSP apparently looked the other way. By November loan quota on the real estate sector has grown to 22% of overall loans or a 10% increase. Yet there are hardly any signs that the BSP will curtail such loans as I believe the BSP knows that restricting the real estate industry would extrapolate to the emperor has no clothes.

Third the good governor says that inflation remains “within target”. Well that’s in the context of price inflation as measured by his political organization.

I am reminded by my indirect mentor Dr. Marc Faber who in a recent interview made a very pertinent comment about government statistics[26].
Governments will always publish the statistics that they wish to show irrespective whether that is in China or in other countries. Governments control basically the statistical offices, so they can show whatever they want. As Stalin said, it’s not important who votes but who counts the votes. And the government counts the statistics.
So instead of looking at solely looking at government statistics we look at market prices to see how they conform to government’s declared actions. The Austrian school of economics calls this demonstrated preference.

The peso fell to its lowest point in February 3rd 2014 a level last seen in August of 2010. What has been the BSP’s response? Well instead of using the interest rate channel, the BSP opted to expend some 5.7% of her US dollar Gross International Reserves last January in an obvious attempt to contain the peso’s fall. Why GIRs instead of policy interest rates? The most likely answer is that subsidies of low interest rates must be kept to support his “ideal” monetary policy.

While February GIR has partly recovered, this week’s peso meltdown will likely test the BSP’s resolve. My guess is that BSP will use the GIR option anew.

Again the epileptic convulsion by the peso is a sign that markets have also not been “within target” of the BSP.

Let me repeat again again and again. The BSP has been BOXED into a corner.

Option 1. If the BSP tightens then the whole phony credit fueled statistical economic boom collapses. So will be the destiny of free lunch for the Philippine government.

Option 2. If the BSP maintains current negative real rates or invisible subsidies via financial repression to the government through a banking financed boom, then stagflation will deepen and spur higher interest rates despite the BSP’s King Canute rhetoric.

So we are most likely to end up with Option 1 where economic reality via the markets will force the BSP to eventually tighten, or else God forbid, the Philippines suffer even a far worst fat tailed disaster: hyperinflation.

The difference between Option 2 and Option 1 is that the BSP intends to buy time and hope that the problem of economic imbalances from monetary interventions will merely breeze over. Unfortunately a policy based on hope will have a serious backlash. This is going to be a man-made disaster and not some nature based Typhoon that will exhaust itself and vanish.

This is another example of policy based belief of impossible things before breakfast.

The Falling Peso, Rising Exports and Positive Trade Balance Fallacy

I hear people say that weak peso should benefit exports and remittances. How you wish.

Yet any of such positive effects will be transient and limited. The problem with devaluation is that any advantages from a weak currency regime will be neutralized by the impact of domestic price inflation.

In the current case of the Philippines, domestic inflation has been prompting for a lower currency. As explained above the declining peso will function as a second order cause that will feed into domestic inflation which should worsen the current conditions.

Let us look at the proportionality of foreign revenue gains from remittances and exports relative to the overall statistical economy.

Philippine merchandise trade as % of GDP equates to 47% in 2012 according to the World Bank. It is important to note that the share of merchandise trade to the Philippine economy has halved from 2004.

Let us assume that we split these evenly between exports and imports. This means only 23.5% foreign revenues from exports contribute to the statistical GDP.

Let us further take into consideration the role of remittances. Remittances grew by 7.6% to hit a record US $25.1 billion in 2013[27]. The cash remittance share of GDP accounts for 8.4% according to the BSP

Combined foreign revenues contribute to only 31.9% of the GDP. This means that while part of that number may benefit, a still bigger 68.1% will pay for the transfer price or subsidies to foreign exchange recipients. So how in the world will 31.9% become greater than 68.1%???

But again the cheap currency equals strong exports has little relevance with reality.

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The Peso has lost 95.3% against the US dollar—from 2 pesos in 1960 to the 2013 BSP’s annual average rate of 42.45 per US dollar. So the destruction of the peso’s exchange rate value should have implied strong exports and positive trade balance for the Philippines. But where?

But before I proceed, let me cite that there are practically two phases of the Peso’s decline. One is the Marcos and post Marcos transition where the Peso declined from 2 to 27 against the US dollar. The salad days of the pre-Asian crisis era had the peso rangebound, which traded between 25-27 against the US dollar from 1991 to 1996. Then the second stage of collapse; the Asian crisis and its aftermath which culminated in 2004 where the peso peaked at an annual average of 56.04.

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While Philippine exports grew from 1995 until 2007 in nominal US dollar terms, Philippine trade balance chart reveals that a majority of deficits means relative MORE import growth rather than exports. There were instances of surpluses from 1999-2000 but such didn’t last. From 2008-2013 exports traded sideways.

So the collapse in the peso hardly helped in promoting exports. Why? Because domestic policies remain highly restrictive against enterprises. Policies such as choking capital controls continue to inhibit capital movements.

From 2001 until 2013, Philippine trade balance remained in a deficit despite the seesaw movements in the peso. Since 2009 when the peso began to recover from the global crisis, the trade deficit has only worsened. This has not been due to a tradeoff in exports relative to imports in the way mercantilists would prefer to see them.

But instead, the halving of merchandise trade meant that both exports and imports have stagnated or declined relative to GDP as the economic structure shifted. But exports bore the brunt. That’s because 2010 represented the spring board leap to the domestic credit fuelled asset bubble boom. This implies that a large force of the formal economy redirected their efforts to blowing the property and property related bubbles rather than to the production for exports.

Another offshoot from the long term collapse of the peso has been labor exports. The dearth of investment and job opportunities in the face of the shrinking peso has compelled 10+% of the citizenry to seek greener pasture abroad. Finding job overseas has been a product of spontaneous response to impoverishment brought about by systematic political interventions to the economy[28]. The informal economy has been the sibling of the unintended labor exports.

Now the government claims credit to what has been the positive effects from circumventing political order. The government calls OFWs as modern day heroes because of the voting constituents the sectors has influence on. Yet the government has been the albatross over the neck of OFW families.

Yet remittances and the growth of BPO service industry has essentially offset trade deficits and contributed to current day surpluses

Are the Risks to Philippine BoP coming from the Capital Account?

As a final observation, the index mundi chart reveals that capital account as of 2011 has sharply risen.

Capital account should reflect on the net change in ownership of national assets. Capital account includes the financial account which represents portfolio flows, net foreign direct investments, other investments or flows into and out of bank accounts or provided as or payments of loans and reserve account or the buying and selling of foreign currencies by the central bank.

Movements in capital according to Wikipedia.org[29] reflects on either “a surplus in the capital account means money is flowing into the country, but unlike a surplus in the current account, the inbound flows will effectively represent borrowings or sales of assets rather than payment for work. A deficit in the capital account means money is flowing out the country, and it suggests the nation is increasing its ownership of foreign assets.”

I have yet to dwell into the details of the BSP's capital account but in passing by looking at FDIs and portfolio flows, these have largely vacillated.

I suspect that part of the big jump in capital flows could either be from foreign speculation on local property markets or borrowing from external sources.

If the latter two has been true, then the mainstream could be overlooking another major source of risks.

The risk from external originated loans is that if foreign lenders see rising risks in emerging markets from changes in developed economy monetary policies, they could call on these loans[30].

Moreover if the part of the BoP surpluses comes from speculation on local properties then the reported “scramble” to sell properties by Chinese speculators on their Hong Kong portfolio[31] due to “liquidity issues” risks sparking a wave of global selling of properties even in the Philippines. Liquidity issues signify debt repayment problems.

To recall, domestic real estate insiders has swaggered about foreign speculation on local properties as alternative to Hong Kong and Singapore[32] Unfortunately if the issue of Hong Kong property sell off has been debt repayments then there won’t likely be a shift to anywhere. Rather if there are Chinese investors in local properties they could start the domestic liquidation process.

At the very least Chinese selling of Hong Kong property markets translates to a shrinking pie of foreign buyers for local properties. In the worst case, the forces of financial and economic Black Swan have begun to snowball.

The bottom line is that the peso is vulnerable from mainly internal sources but also sensitive to external contagion risks.

The risks environment seems to be intensifying. 




[1] Lewis Carroll (Charles Lutwidge Dodgson), Chapter 5: Wool and Water Through the Looking-Glass wikiquote.com



[4] Tim Price Pop! March 18, 2014 Cobden Center

[5] Zero Hedge Just Two Charts March 20, 2014


[7] Benjamin Graham Lecture Number Seven The Rediscovered Ben Graham






[13] Asian Development Bank ASIA BOND MONITOR March 2014 p.73 illustration p.76


[15] Bangko Sentral ng Pilipinas Outstanding External Debt Drops Further in Q4 2013 March 21, 2014

[16] Bangko Sentral ng Pilipinas Strong Current Account Continues to Support BOP Surplus in 2013 March 21, 2014


[18] Philstar.com PSE extends pre-close period October 17, 2013

[19] Bangko Sentral ng Pilipinas, Domestic Liquidity Growth Rises in January February 28, 2014

[20] National Statistics Office External Trade Performance: December 2013 February 25, 2014 census.gov.ph

[21] Economicshelp.org Income Substitution effect








[29] Wikipedia.org Capital account



Saturday, March 22, 2014

Graphics: Cigarette ‘Sin’ Taxes Equals Smuggling US Edition Updated

Nice graphics exhibiting how populist 'sin' taxes fuel smuggling. This is an update from my January 2013 post

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-Large differentials in cigarette taxes across states create incentives for black market sales.

-Smuggled cigarettes make up substantial portions of cigarette consumption in many states, and greater than 25 percent of consumption in twelve states.

-The highest inbound cigarette smuggling rates are in New York (56.9 percent), Arizona (51.5 percent), New Mexico (48.1 percent), Washington (48 percent), and Wisconsin (34.6 percent).

-The highest outbound smuggling rates are in New Hampshire (24.2 percent), Wyoming (22.3 percent), Idaho (21.3 percent), Virginia (21.1 percent), and Delaware (20.9 percent).

-Cigarette tax rates increased in 30 states and the District of Columbia between 2006 and 2012.

Public policies often have unintended consequences that outweigh their benefits. One consequence of high state cigarette tax rates has been increased smuggling as criminals procure discounted packs from low-tax states to sell in high-tax states. Growing cigarette tax differentials have made cigarette smuggling both a national problem and a lucrative criminal enterprise.
Read the rest here


If it can happen to the US, then this can happen elsewhere. Yet in contrast to the popular wisdom where proliferation of smuggling has been a consequence of delinquent administration or lax enforcement, the crux of the problem is in the taxation.

Dealing with symptoms will hardly serve as a sufficient cure to the disease.

Friday, March 21, 2014

Lured by More Debt, Chinese Stocks Zoom

All it takes is to give the substance which addicts pine for.

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Friday’s closing from Bloomberg

From Bloomberg: (bold mine)
China’s stocks rallied, sending the benchmark index to its biggest gain in four months, amid speculation the government is loosening funding restrictions for property developers and banks to support economic growth.

Shanghai Pudong Development Bank Co. (600000) and Industrial Bank Co. both surged at least 6.6 percent. The China Securities Regulatory Commission said after exchanges closed that lenders can issue preferred shares. China Vanke Co. and Poly Real Estate Group Co. jumped more than 6 percent after the Shanghai Securities News reported regulators are reviewing financing applications from “many” listed developers.

The Shanghai Composite Index (SHCOMP) climbed 2.7 percent to 2,047.62 at the close, the biggest gain since Nov. 18, after reaching record-low valuations yesterday. Policy makers are trying to bolster real estate and financial companies as the economy slows and bad debts increase. Allowing lenders to sell preferred shares would give them a new way to meet long-term fundraising requirements…

The Shanghai index has dropped 3.2 percent this year as analysts cut their estimates for 2014 economic growth, the nation suffered its first onshore corporate bond default and an unlisted developer collapsed. Today’s announcement on preferred shares follows a government statement this week that China will speed up construction projects to bolster the economy.
Preferred stocks are a hybrid instruments or as defined by Wikipedia.org "may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument". So the Chinese government essentially incentivize the overindebted entities to have access to more credit via alternative ways.

This announcement comes a day after reports that China’s largest private steel maker the Highsee Group has failed to repay a 3 billion yuan ($3.75 billion) that threatens another account of bankruptcy or default.

Another report also says that Chinese economy has been materially slowing

From another Bloomberg report
China’s economy slowed this quarter, with industries including retail and mining showing weaker revenue growth while loans through non-traditional channels became more expensive, according to a private survey.

Even with the moderation, the labor market and wage growth were little changed from the previous quarter, according to the China Beige Book survey, published by New York-based CBB International.

The report adds to signs that Premier Li Keqiang may face difficulties reaching an expansion target of 7.5 percent this year without stimulus. The State Council, or cabinet, said this week it will speed up construction projects and other measures to support the economy after data showed moderating growth in industrial production and investment.
So the Chinese government seems to be applying a whack-a-mole approach or to deal with the problem as they appear. Treating symptoms rather than the disease is a kick the can down the road strategy. Yet the debt problems comes in the face of a slowing economy which magnifies the default risks.

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But don’t worry be happy. Stocks should continue to rise even when problems mount.

China's debt problem is further compounded by her currency woes. 

China’s currency continues to crash as shown by the US Dollar-renminbi (yuan). The USD-Rmb collapsed by 1.2% this week!

The yuan has now crossed the Rmb 6.2 threshold considered by some analyst as “danger zone” because the previously one way trade has attracted many export companies to use “complex hedging products” with the said level as the watershed for losses. There has been “roughly $150bn of such positions remained open when the renminbi began its rapid decline in mid-February, and that current mark-to-market losses on such products stand at more than $2bn,” according to the Financial Times.

As I noted during this week’s second default
Have a debt problem? Easy, for modern day government the solution has just been to borrow and spend. Problem solved.

How many more stimulus in the face of waves of debt defaults just to boost the markets? Interesting stuff.
The same question applies.

Social Cycles: The Rise and Fall of Civilizations

Cycle as defined by dictionary.com is “any complete round or series of occurrences that repeats or is repeated.”

And cycles are not only evident in natural sciences (e.g. planetary, organic, physics), but most importantly in the dynamics of human social relations.

Aside from business economic cycles which occupies much of the discussion of this blog, the rise and fall of civilizations is another example of such social cycles.

There are important lessons to learn from social cycles.

As example, Sovereign Man’s Simon Black has an eloquent narrative of the rise and fall of the French empire. (bold mine)
Throughout the 18th century, for example, France was the greatest superpower in Europe, if not the world.

But they became complacent, believing that they had some sort of ‘divine right’ to reign supreme, and that they could be as fiscally irresponsible as they liked.

The French government spent money like drunken sailors; they had substantial welfare programs, free hospitals, and grand monuments.

They held vast territories overseas, engaged in constant warfare, and even had their own intrusive intelligence service that spied on King and subject alike.

Of course, they couldn’t pay for any of this.

French budget deficits were out of control, and they resorted to going heavily into debt and rapidly debasing their currency.

Stop me when this sounds familiar.

The French economy ultimately failed, bringing with it a 26-year period of hyperinflation, civil war, military conquest, and genocide.

History is full of examples, from ancient Mesopotamia to the Soviet Union, which show that whenever societies reach unsustainable levels of resource consumption and allocation, they collapse.
Mr. Black goes on to cite a recent NASA funded study which identified 32 advanced civilizations that rose and collapsed. Again Mr. Black.

A recent research paper funded by NASA highlights this same premise. According to the authors:

“Collapses of even advanced civilizations have occurred many times in the past five thousand years, and they were frequently followed by centuries of population and cultural decline and economic regression.”

The results of their experiments show that some of the very clear trends which exist today– unsustainable resource consumption, and economic stratification that favors the elite– can very easily result in collapse.

In fact, they write that “collapse is very difficult to avoid and requires major policy changes.”

This isn’t exactly good news.

But here’s the thing– between massive debts, deficits, money printing, war, resource depletion, etc., our modern society seems riddled with these risks.

And history certainly shows that dominant powers are always changing.

Empires rise and fall. The global monetary system is always changing. The prevailing social contract is always changing.
Social cycles are a product of the same series of human interactions that leads to parallel consequences. In short, people hardly ever learn from mistakes to keep repeating them. And such cyclical transitions are hardly ever smooth sailing.

But not everything is bad news. 

Again Mr. Black.
But there is one FAR greater trend across history that supercedes all of the rest… and that trend is the RISE of humanity.

Human beings are fundamentally tool creators. We take problems and turn them into opportunities. We find solutions. We adapt and overcome.

The world is not coming to an end. It’s going to reset. There’s a huge difference between the two.

Think about the system that we’re living under.

A tiny elite has total control of the money supply. They wield intrusive spy networks and weapons of mass destruction. The can confiscate the wealth of others in their sole discretion. They can indebt unborn generations.

Curiously, these are the same people who are so incompetent they can’t put a website together.

It’s not working. And just about everyone knows it.

We’re taught growing up that ‘We the People’ have the power to affect radical change in the voting booth. But this is another fairy tale.

Voting only changes the players. It doesn’t change the game.

Technology is one major game changer. The technology exists today to completely revolutionize the way we live and govern ourselves.

Today’s system is just a 19th century model applied to a 21st century society. I mean– a room full of men making decisions about how much money to print? It’s so antiquated it’s almost comical.

But given that the majority of Western governments borrow money just to pay interest on money they’ve already borrowed, it’s obvious the current game is almost finished.

When it ends, there will be a reset… potentially a tumultuous one.
The 19th century industrial age top-down centralized model has been running on a head on collision with the deepening of the information age characterized by decentralization. And such underlying seismic shifts causes massive societal strains as previously discussed. This is what futurist Alvin Toffler once predicted as the Third Wave

And when the socio-political-economic system has been routinely abused to the point that the accrued imbalances reaches a climax and a critical mass, the system eventually implodes. Nonetheless people will adjust to such changes.Thus a reset.

This quote MISattributed to British lawyer and Alexander Fraser Tytler on democracy captures some of the essence of the political-behavioral cycle (wiikiquote):
The average age of the world's greatest civilizations from the beginning of history has been about 200 years. During those 200 years, these nations always progressed through the following sequence:

-From bondage to spiritual faith; 

-From spiritual faith to great courage; 

-From courage to liberty; 

-From liberty to abundance; 

-From abundance to complacency; 

-From complacency to apathy;

-From apathy to dependence;

-From dependence back into bondage.
The reset nears.

Thursday, March 20, 2014

Do you know that Shanghai was once an Almost Free City-State?

Austrian economist Dr. Richard Ebeling narrates of Shanghai's laissez faire capitalism experience at the Northwood University blog
China’s impressive modernization since the death of Mao Zedong in 1976 and the end to the destructive madness of the Cultural Revolution has been epitomized by the dramatic growth of the industrial and port city of Shanghai, with its majestic skyline of impressive futuristic skyscrapers. It is forgotten that Shanghai already was a commercial and industrial center before the Second World War, built on the principles of laissez-faire capitalism.

Following the Chinese-British War of 1842, several ports along the China coast were opened to Western merchants. In these “treaty ports,” portions of the cities were recognized to be under European jurisdiction. Known as “concession” areas, the European powers administered these areas according to Western principles of the “rule of law,” with recognition and protection of property rights, personal freedom and civil liberties.

By the end of the 19th century, Shanghai had become the most important of the treaty ports. Indeed, it was the industrial, commercial and cultural center of modem China until the Japanese occupation of the city in December 1941, following the attack on Pearl Harbor.

Shanghai an Almost Free City-State

The Western-administered portions of Shanghai were divided into two districts: the French Concession and the International Settlement. A Consul-General appointed by Paris administered the French Concession.

But the much larger International Settlement was administered by a Municipal Council composed of fourteen members elected by the permanent foreign residents of the city, with the franchise based on being a “ratepayer,” i.e., a tax-paying property owner within the boundaries of the International Settlement. By the 1930s, around 90,000 Europeans and Americans lived in Shanghai.

Hence, Shanghai’s International Settlement was almost an independent “city-state” based on the nearly unhampered principles of free trade and free enterprise under the protection of the Western Powers (which ended up meaning mostly a British and American military presence).

In general, the economic policies of Shanghai’s International Settlement followed the ideas of Adam Smith’s system of natural liberty and laissez faire. The Municipal Council limited itself primarily to three functions: administration of justice; police protection of individual liberty and property; and the undertaking of a limited number of “public works,” such as construction of roads, traffic control (administered by Sikh policemen brought by the British from India), harbor patrol, and the dredging of the Whangpoo River that connects Shanghai with the mouth of the Yangtze.
Read the rest here

ASEAN Financial Markets Convulses on Janet’s Yellen’s FOMC Debut

At her inaugural news conference as the head of the US central bank, the US Federal Reserve, Ms. Janet Yellen uttered something that has largely been considered a “taboo” in the financial world.

What did she say? From Reuters:
The U.S. Federal Reserve will probably end its massive bond-buying program this fall, and could start raising interest rates around six months later, Fed Chair Janet Yellen said on Wednesday, in a comment which sent stocks and bonds tumbling…
Ms. Yellen's market shaking statement:
"I -- I, you know, this is the kind of term it's hard to define, but, you know, it probably means something on the order of around six months or that type of thing. But, you know, it depends -- what the statement is saying is it depends what conditions are like."
Why should the higher interest rates suffer the markets? Well the simple answer is DEBT.

So how did ASEAN financial markets react?

Let us first check on Asia’s currency markets.

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The Bloomberg data shows that the US dollar soared by over .5% against 5 Asian currencies, the Indonesian rupiah (1.16%), Indian rupee (+.62%), the Philippine Peso (+.58%), the Chinese yuan (+.55%) and the Korean won (+.52%). The US dollar even firmed against the New Zealand and Aussie dollars. 

It was an all US dollar show for today for the rest of Asia.

For the Peso, the USD-Peso has now breached the 45 level (45.1) and is within striking distance at the 52-week high of 45.48. Today’s sharp losses by the Peso essentially piggybacks on the declines of the early week.

Now let us move to the bonds.

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ASEAN bonds crumbled today. This has been led by…guess who?…the Philippines whose yields has spiked by 31.3 bps!

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Yields of 10 year Philippine bonds have now surpassed the July 2013 “taper tremor” highs.

Didn’t Moody’s just recently blessed the Philippines saying the she won’t be hurt by a sudden stop?  Then why today’s violent  reaction?

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Most Asian stocks as shown by the Bloomberg had been hit pretty hard. The Nikkei plunged 1.65%, the Shanghai Index 1.4%, Australia’s S&P/ASX 200 1.15% and Taiwan 1.06%.

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Except of Indonesia’s JKSE, ASEAN stocks were the least relatively damaged. 

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Indonesia’s JKSE was hammered down by 2.54%. Today's loss which adds to this week’s earlier declines has nearly erased Friday’s dramatic 3.23% advance. 

ASEAN’s stock market still remains very complacent. So far stock markets of Malaysia, Philippines and Thailand appear to be implying that falling currencies and higher yields won’t impact earnings. 

They seem to also forget that once monetary policies of US and other developed economies tightens, emerging markets including emerging Asia will need to align with them. And such policy adjustments will expose on her unsustainable debt levels accrued during zero bound days. Thus the likelihood of more market earthquakes as I previously discussed.

Well good luck to the staunch worshipers of bubbles who believe that they are immune to the growing variety of risks.
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Perhaps Ben Bernanke could be asking Asian-ASEAN markets: "Miss me yet?" (hat tip zero hedge)

Russia’s Interventions in Crimea: The Geopolitics of Oil Prices

Global politics are a complex dynamic.

I previously noted that Russia’s response to the Ukraine’s political crisis may have been a pushback on what the former’s political leaders see as “encirclement strategy” (Russia’s government doesn’t want to see US-NATO troops on her door steps). This via indirect interventions by the US on the latter’s affair.

But there seems to be another angle: the actions of the Russian government could have been meant to keep oil prices up. As the prolific fund manager Louis-Vincent Gave of Gavekal.com sums up “when the oil price is high, Russia is strong; when the oil price is weak, Russia is weak”

Mr. Gave writes [www.gavekal.com, hat tip John Mauldin, with Mr. Gave’s permission, Thanks Louis] (bold mine, italics original):
Nineteenth century statesman Lord Palmerston famously said that “nations have no permanent friends or allies, they only have permanent interests.” As anyone who has ever opened a history book knows, Russia’s permanent interest has always been access to warm-water seaports. So perhaps we can just reduce the current showdown over Crimea to this very simple truth: there is no way Russia will ever let go of Sevastopol again. And aside from the historical importance of Crimea (Russia did fight France, England and Turkey 160 years ago to claim its stake on the Crimean peninsula), there are two potential reasons for Russia to risk everything in order to hold on to a warm seaport. Let us call the first explanation “reasoned paranoia,” the other “devilish Machiavellianism.”
Reasoned paranoia

Put yourself in Russian shoes for a brief instant: over the past two centuries, Russia has had to fight back invasions from France (led by Napoleon in 1812), an alliance including France, England and Turkey (Crimean War in the 1850s), and Germany in both world wars. Why does this matter? Because when one looks at a map of the world today, there really is only one empire that continues to gobble up territory all along its borders, insists on a common set of values with little discussion (removal of death penalty, acceptance of alternative lifestyles and multi- culturalism...), centralizes economic and political decisions away from local populations, etc. And that empire may be based in Brussels, but it is fundamentally run by Germans and Frenchmen (Belgians have a hard enough time running their own country). More importantly, that empire is coming ever closer to Russia’s borders.

Of course, the European Union’s enlargement on its own could be presented as primarily an economic enterprise, designed mainly to raise living standards in central and eastern Europe, and even to increase the potential of Russia’s neighbors as trading partners. However, this is not how most of the EU leaders themselves view the exercise; instead the EU project is defined as being first political, then economic. Worse yet in Russian eyes, the combination of the EU and NATO expansion, which is what we have broadly seen (with US recently sending fighter jets to Poland and a Baltic state) is a very different proposition, for there is nothing economic about NATO enlargement!

For Russia, how can the EU-NATO continuous eastward expansion not be seen as an unstoppable politico-military juggernaut, advancing relentlessly towards Russia’s borders and swallowing up all intervening countries, with the unique and critical exception of Russia itself? From Moscow, this eastward expansion can become hard to distinguish from previous encroachments by French and German leaders whose intentions may have been less benign than those of the present Western leaders, but whose supposedly “civilizing” missions were just as strong. Throw on top of that the debate/bashing of Russia over gay rights, the less than favorable coverage of its very expensive Olympic party, the glorification in the Western media of Pussy Riot, the confiscation of Russian assets in Cyprus ... and one can see why Russia may feel a little paranoid today when it comes to the EU. The Russians can probably relate to Joseph Heller’s line from Catch-22:“Ju st because you're paranoid doesn't mean they aren't after you.” 

Devilish Machiavellianism

Moving away from Russia’s paranoia and returning to Russia’s permanent interests, we should probably remind ourselves of the following when looking at recent developments: 1) Vladimir Putin is an ex-KGB officer and deeply nationalistic, 2) Putin is very aware of Russia’s long-term interests, 3) when the oil price is high, Russia is strong; when the oil price is weak, Russia is weak. 

It is perhaps this latter point that matters the most for, away from newspapers headlines and the daily grind of most of our readers, World War IV has already started in earnest (if we assume that the Cold War was World War III). And the reason few of us have noticed that World War IV has started is that this war pits the Sunnis against the Shias, and most of our readers are neither. Of course, the reason we should care (beyond the harrowing tales of human suffering coming in the conflicted areas), and the reason that Russia has a particular bone in this fight, is obvious enough: oil. 

Indeed, in the Sunni-Shia fight that we see today in Syria, Lebanon, Iraq and elsewhere, the Sunnis control the purse strings (thanks mostly to the Saudi and Kuwaiti oil fields) while the Shias control the population. And this is where things get potentially interesting for Russia. Indeed, a quick look at a map of the Middle East shows that a) the Saudi oil fields are sitting primarily in areas populated by the minority Shias, who have seen very little, if any, of the benefits of the exploitation of oil and b) the same can be said of Bahrain, where the population is majority Shia.

Now of course, Iran has for decades tried to infiltrate/destabilize Shia Bahrain and the Shia parts of Saudi Arabia, though so far, the Saudis (thanks in part to US military technology) have done a very decent job of holding their own backyard. But could this change over the coming years? Could the civil war currently tearing apart large sections of the Middle East get worse?

At the very least, Putin has to plan for such a possibility which, let’s face it, would very much play to Russia’s long-term interests. Indeed, a greater clash between Iran and Saudi Arabia would probably see oil rise to US$200/barrel. Europe, as well as China and Japan, would become even more dependent on Russian energy exports. In both financial terms and geo-political terms, this would be a terrific outcome for Russia.

It would be such a good outcome that the temptation to keep things going (through weapon sales) would be overwhelming. This is all the more so since the Sunnis in the Middle East have really been no friends to the Russians, financing the rebellions in Chechnya, Dagestan, etc. So having the opportunity to say “payback’s a bitch” must be tempting for Putin who, from Assad to the Iranians, is clearly throwing Russia’s lot in with the Shias. Of course, for Russia to be relevant, and hope to influence the Sunni-Shia conflict, Russia needs to have the ability to sell, and deliver weapons. And for that, one needs ships and a port. Ergo, the importance of Sevastopol, and the importance of Russia’s Syrian port (Tartus, sitting pretty much across from Cyprus).

The questions raised

The above brings us to the current Western perception of the Ukrainian crisis. Most of the people we speak to see the crisis as troublesome because it may lead to restlessness amongst the Russian minorities scattered across Eastern Europe and Central Asia, and tempt further border encroachments across a region that remains highly unstable. This is of course a perfectly valid fear, though it must be noted that, throughout history, there have been few constants to the inhabitants of the Kremlin (or of the Winter Palace before then). But nonetheless, one could count on Russia’s elite to:

a) Care deeply about maintaining access to warm-water seaports and
b) Care little for the welfare of the average Russian

So, it therefore seems likely that the fact that Russia is eager to redraw the borders around Crimea has more to do with the former than the latter. And that the Crimean incident does not mean that Putin will try and absorb Russian minorities into a “Greater Russia” wherever those minorities may be. The bigger question is that having secured Russia’s access to Sevastopol, and Tartus, will Russia use these ports to influence the Shia-Sunni conflict directly, and the oil price indirectly?

After all, with oil production in the US re-accelerating, with Iran potentially foregoing its membership in the “Axis of Evil,” with GDP growth slowing dramatically in emerging markets, with either Libya or Iraq potentially coming back on stream at some point in the future, with Japan set to restart its nukes ... the logical destination for oil prices would be to follow most other commodities and head lower. But that would not be in the Russian interest for the one lesson Putin most certainly drew from the late 1990s was that a high oil price equates to a strong Russia, and vice-versa.

And so, with President Obama attempting to redefine the US role in the region away from being the Sunnis’ protector, and mend fences with Shias, Russia may be seeing an opportunity to influence events in the Middle East more than she has done in the past. In that regard, the Crimean annexation may announce the next wave of Sunni-Shia conflict in the Middle East, and the next wave of orders for French-manufactured weapons (as the US has broadly started to disengage itself, France has been the only G8 country basically stepping up to fight in the Saudi corner ... a stance that should soon be rewarded with a €2.7bn contract for Crotale missiles produced by Thales and a €2.4bn contract for Airbus to undertake Saudi’s border surveillance). And, finally, the Crimean annexation may announce the next gap higher in oil prices.

In short, buying a straddle option position on oil makes a lot of sense. On the one hand, if the Saudis and the US want to punish Russia for its destabilizing actions, then the way to do it will be to join forces (even if Saudi-US relations are at a nadir right now) and crush the oil price. Alternatively, if the US leadership remains haphazard and continues to broadly disengage from the greater Middle East, then Russia will advance, provide weapons and intelligence to the Shias, and the unfolding Sunni- Shia war will accelerate, potentially leading to a gap higher in oil prices. One scenario is very bullish for risk assets, the other is very bearish! Investors who believe that the US State Department has the situation under control should plan for the former. Investors who fear that Putin’s Machiavellianism will carry the day should plan for the latter (e.g., buy out-of-the-money calls on oil, French defense stocks, Russian oil stocks).
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My thoughts 

The above chart from Daily Reckoning which I earlier pointed out represents oil prices required to maintain welfare states of many top oil producing countries (based on 2012). This should much higher today. So if the US-Saudi consortium will punish Russia by way of forcing down oil prices then many of these oil welfare states will incur financing problems that may lead not only to bigger fiscal issues but also to another wave of internal political upheavals or “Arab Spring” 2.0. This may lead to oil supply disruptions and higher prices.

And since Saudi Arabia’s breakeven may be at $80 per bbl, then a dramatic drop in oil prices seem not to be in the interest of Saudi.

On the other hand, Mid-East wars and the risks of its escalation that will cause a spike in oil prices or an “oil shock” will likely spur more economic and political uncertainties. This should also bring forth stagflation which means soaring interest rates that may prick global debt bubbles.

And as previously noted “oil shocks” have been linked with recessions.
University of California economic professor James Hamilton argues that an “oil shock” played a substantial role in the recession of 2008. Mr. Hamilton further noted that high oil prices had been linked with 11 of the 12 post World War II recessions.
So current developments in Crimea may extrapolate to a deeper conundrum for global financial markets and world economies.

Wednesday, March 19, 2014

Video: 1,000 Years of Constant European Border Shifts

The Marketwatch.com writes: (ht: Gary North)
The borders of Europe have been static since the breakups of the Soviet Union, Czechoslovakia and Yugoslavia, and the reunification of Germany, but look set to shift shortly, if the Duma in Moscow ratifies the stated desire of a Crimean majority to quit Ukraine for Russia. But a broader perspective, taking into account the past 1,000 years of European history, shows that change on the continent has been a near-constant.

Watch on Loiter.co as Centennia Historical Atlas software condenses Europe’s history into a 3 ½-minute video representing the shifting borders from A.D. 1,000 through 2003: