Michael Crichton And The Complexity Theory

I loved the Jurassic Park movie series (Jurassic Park, Lost World and Jurassic III).

Although I didn’t realize that John Michael Crichton (October 23, 1942-November 4, 2008) was more than a highly distinguished author and an acclaimed film connoisseur (wikipedia.org), but as well, a medical doctor and importantly a contrarian socio-environmentalist.

In a fabulous speech in 2005, Complexity Theory and Environmental Management, his controversial views openly challenged the popular beliefs that appear to have engendered a preponderant influence in the direction of policymaking framework.

His basic premise was that science have repeatedly been used as a political tool to scare people into embracing unwarranted regulations. The problem is, “well intended” regulations operating under a complex environment tend to have undesired effects which has caused more harm than otherwise intended.

Two popular instances, which Mr. Crichton raised, that incited undue fears (and likewise entailed political repercussions…)

1. The Chernobyl disaster in 1986.

Media portrayed the Chernobyl accident as a catastrophe.

Yet according to Mr. Crichton,

``The initial reports in 1986 claimed 2,000 dead, and an unknown number of future deaths and deformities occurring in a wide swath extending from Sweden to the Black Sea. As the years passed, the size of the disaster increased; by 2000, the BBC and New York Times estimated 15,000-30,000 dead, and so on…

``Now, to report that 15,000-30,000 people have died, when the actual number is 56, represents a big error. Let’s try to get some idea of how big. Suppose we line up all the victims in a row. If 56 people are each represented by one foot of space, then 56 feet is roughly the distance from me to the fourth row of the auditorium. Fifteen thousand people is three miles away. It seems difficult to make a mistake of that scale.

``But, of course, you think, we’re talking about radiation: what about long-term consequences? Unfortunately here the media reports are even less accurate.

``But most troubling of all, according to the UN report in 2005, is that "the largest public health problem created by the accident" is the "damaging psychological impact [due] to a lack of accurate information…[manifesting] as negative self-assessments of health, belief in a shortened life expectancy, lack of initiative, and dependency on assistance from the state."

``In other words, the greatest damage to the people of Chernobyl was caused by bad information. These people weren’t blighted by radiation so much as by terrifying but false information. We ought to ponder, for a minute, exactly what that implies. We demand strict controls on radiation because it is such a health hazard. But Chernobyl suggests that false information can be a health hazard as damaging as radiation. I am not saying radiation is not a threat. I am not saying Chernobyl was not a genuinely serious event.

2. Y2K

Predictions like this

And this…

From Mr. Crichton, ``But once again, notice the urgent language. The situation is desperate, unprecedented action is necessary, ordinary values must be pushed aside, anyone who disagrees is dangerous and reactionary. Terror, fear, and the end of civilization.”

Mr. Crichton’s message was that when people get frightened (even from unsubstantiated claims), they become very vulnerable into allowing political forces to dominate them. People are willing to sacrifice their freedom in exchange for safety (via regulatory control).

However, Mr. Crichton lucidly articulates why most of the time regulations can’t hold up with a dynamic and complex environment.

The purpose of this article is to excerpt Mr. Crichton’s trenchant explanation of the Complexity Theory.

From Mr. Crichton’s speech (which is a highly recommended read),

All highlights mine

``In a word, we must embrace complexity theory. We must understand complex systems.

``We live in a world of complex systems. The environment is a complex system. The government is a complex system. Financial markets are complex systems. The human mind is a complex system---most minds, at least.

``By a complex system I mean one in which the elements of the system interact among themselves, such that any modification we make to the system will produce results that we cannot predict in advance.

``Furthermore, a complex system demonstrates sensitivity to initial conditions. You can get one result on one day, but the identical interaction the next day may yield a different result. We cannot know with certainty how the system will respond.

``“Third, when we interact with a complex system, we may provoke downstream consequences that emerge weeks or even years later. We must always be watchful for delayed and untoward consequences.

``The science that underlies our understanding of complex systems is now thirty years old. A third of a century should be plenty of time for this knowledge and to filter down to everyday consciousness, but except for slogans—like the butterfly flapping its wings and causing a hurricane halfway around the world—not much has penetrated ordinary human thinking.

``On the other hand, complexity theory has raced through the financial world. It has been briskly incorporated into medicine. But organizations that care about the environment do not seem to notice that their ministrations are deleterious in many cases. Lawmakers do not seem to notice when their laws have unexpected consequences, or make things worse. Governors and mayors and managers may manage their complex systems well or badly, but if they manage well, it is usually because they have an instinctive understanding of how to deal with complex systems. Most managers fail.

``Why? Our human predisposition treat all systems as linear when they are not. A linear system is a rocket flying to Mars. Or a cannonball fired from a cannon. Its behavior is quite easily described mathematically. A complex system is water gurgling over rocks, or air flowing over a bird’s wing. Here the mathematics are complicated, and in fact no understanding of these systems was possible until the widespread availability of computers.

``One complex system that most people have dealt with is a child. If so, you've probably experienced that when you give the child an instruction, you can never be certain what response you will get. Especially if the child is a teenager. And similarly, you can’t be certain that an identical interaction on another day won’t lead to spectacularly different results.

``If you have a teenager, or if you invest in the stock market, you know very well that a complex system cannot be controlled, it can only be managed. Because responses cannot be predicted, the system can only be observed and responded to. The system may resist attempts to change its state. It may show resiliency. Or fragility. Or both.

``An important feature of complex systems is that we don’t know how they work. We don’t understand them except in a general way; we simply interact with them. Whenever we think we understand them, we learn we don’t. Sometimes spectacularly.

Lessons:

FEAR is tool for bondage.

Before adhering to mainstream media or any politician’s angle of truth, think of possible unseen effects, untold truths or the veiled interest behind claims.

Remember, complex systems can hardly be controlled but can be responded with.

Lastly, regulations have in many cases unintended “harmful” consequences.

RIP Mr. Michael Crichton.

The Icelandic Drama in Video

In our previous post, Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?, we pointed out how the global financial crisis has prompted Iceland's sudden transformation from a rich country to one mired with extreme financial difficulties.

Naturally economic difficulties will always be vented through politics, as this video courtesy of Wall Street Journal shows..

A Critical Week for US Markets? Will A Bottom Be Forged?

A “Bottom” is an indispensable part of the market cycle.

It doesn’t translate to the popular impression of fantasizing about identifying a precise low, which should be the work of tarot card readers.

It means that bottom as a cycle involves time process.

Of course, it is a truism that bottom can always be seen from the privilege of fait accompli.

But in looking forward, anticipating a market bottom can be assessed from valuations view point (example below)…

Courtesy of Bespoke Investment

or from sentiment…

Courtesy of stockcharts.com

or from technical formations or patterns such as W,U,V or other variations based from historical performances...

Courtesy of US global Investors

Courtesy of US global Investors

Courtesy of US global Investors

or a combination thereof.

Remember, there is no simplified answer, formula or a Holy Grail for this.

This also means anticipating market bottoms can also be construed as a bet based on probabilities: that in considering the tradeoff between risk vis-à-vis return, the estimated returns should vastly outweigh risks given an expected time horizon regardless of the day to day activities reflected in the tape.

Courtesy of US global Investors

And perhaps US markets could have been attempting to forge a bottom, where the critical landmark for either a success or failure of market’s attempt to its floor could be shaped or determined over the coming sessions (days or weeks) by virtue of market action.

According to John Derrick of US Global, ``History shows that three-quarters of the retesting events occurred within 44 days of a bottom, so if the October 10 low in fact marked a bottom, a retest (which could create a new low) should be expected prior to November 23. The longest span for retesting a low was 104 days in 2002. A repeat of that extreme case would schedule the retest for January 22, 2009.” (highlight mine)

Of course any successful recovery from the repeated retests of the October 10 lows could also translate to an interim bottom more than the “THE” Bottom.

Although again bottom as a market cycle, like wine, ages with time.

But for the meantime market action says: Fasten your seat belts.

Reflexivity Theory And $60 Oil: Fairy Tales or Great Depression?

``Oil prices are coming down for all the wrong reasons: low economic growth and low demand. What we are not seeing is oil prices coming down because there is new supply coming on to the market or because the world has got more efficient.” Tony Hayward, BP chief executive

Allow me to disinterest you with a prosaic discourse on market psychology. Why? Because psychology drives the markets more than anything else. Said differently, economies and or markets are driven by people’s incentives to act for a particular goal. And present activities seem to reflect emerging signs of inconsistencies enough to make us discern that some prices haven’t been reflecting “reality”, but of “perceptions” of reality.

Since we will dwell much of successful speculator George Soros’ “reflexivity theory”, this also means we will be having a quote-fest from Mr. Soros.

Understanding George Soros’ Reflexivity Theory

Let me begin with Mr. Soros’ fundamental explanation of the Reflexivity theory [The Alchemy of Finance p. 318]

``The structure of events that have no thinking participants is simple: one fact follows another ending in an unending casual chain. The presence of thinking participants complicates the structure of events enormously: the participants thinking affects the course of action and the course of action affects the participants thinking. To make matters worst, participants influence and affect each other. If the participants’ thinking bore some determinate relationship to the facts there would be no problem: the scientific observer could ignore the participants’ thinking and focus on the facts. But the relationship cannot be accurately determined for the simple reason that the participants’ thinking does not relate to facts; it relates to events in which they participate, and these events become facts only after the participants’ thinking has made its impact on them. Thus the causal chain does not lead directly from fact to fact, but from fact to perception and from perception to fact with all kinds of additional connections between participants that are not reflected fully in the facts.

``How does this complex structure affect the ability of an observer to make valid statements about the course of events? His statements must also be more complex. In particular, they must allow for a fundamental difference between past and future: past events are a matter of record, while the future is inherently unpredictable. Explanation becomes easier than prediction.” (all emphasize mine)

Essentially, there are three variables that shape the reflexivity theory: facts, events and perception.

Let me cite a hypothetical situation:

Fact: Falling Prices or bear market

Event: Official Recession is declared

Perceptions:

1) Concerns about recession prompt for falling prices.

2) Falling prices impels the perception of an economic recession.

The dilemma: This becomes a chicken and egg problem of having to ascertain which among the two comes first or which causes which?

In the same plane, we ask “does the causal chain equate to events (recession) reinforcing the facts (falling prices) or has the facts (falling prices) been shaping events (recession)?”

Facts or events are always seen from the privilege of hindsight or ex-post. But since people don’t exactly know the future, it is always easier to explain away as predictions by the convenience of associations, buttressed by additional connections, the past activities. Essentially, such predicament represents as feedback loop transmission which predominate the thinking process operating in the marketplace.

And where such feedback loop gets bolstered-both falling prices and economic weakness are increasingly being felt and validated-the tendency is to draw enough “following” or “crowd” to shape the growing conviction into a major trend or into a socially accepted and popularly entrenched view or belief.

A vivid empirical example, a non-financial or non-market practitioner neighbor whom I recently bumped into at the local “sari-sari” store confidently insisted to me that the Philippines will experience an “economic recession” in 2009! Wow. Obviously his pronouncements had either been influenced by the headlines from the broadsheet or from news broadcasted by the media airwaves.

Now going back to the feed back loop mechanism of falling prices and recession, such chain of linear “cause-and-effect” thinking leads to the point where the denouement extrapolates to our perdition, or said differently, the ultimate outcome from such induction process is that prices will fall to zero and or society will stop functioning-which is nothing but plain balderdash.

If the US is now in the “eye” of the recession storm, it means that many parts of its “complex” or highly structured economy, which has been unduly boosted by tremendous doses of debt driven malinvestments, are presently enduring from a painful but necessary adjustment process which involves the clearing out of such excesses.

But it doesn’t mean that ALL of the US economy is suffering, because people’s lifestyle fine tune under dynamic operating conditions. The fact that the world’s largest publicly listed company (money.con.com) and retail behemoth Walmart reported a 10% rise in profits (Reuters) amidst the third quarter squall suggest of the societal response to income elasticity of demand, where changes of income prompts for a change in consumption pattern. The truism is that people will continue to live or society will continue to exist, even at more financially or economically difficult environment, but some sectors are likely to benefit from such adjustments.

The other obvious point is that the present “prevailing bias” dynamics (of falling prices-deleveraging/recession feedback loop) will eventually outlive its usefulness, whose popular convictions will extend to the extremes and morph into a false premise.

To quote Mr. Soros anew, ``Economic history is a never-ending series of episodes based on falsehoods and lies. The object is to recognize the trend whose premise is false, ride the trend, then step off before the premise is discredited." (highlight mine)

Reflexivity and Oil Prices: Spotting False Premises?

In recognition of a trend whose premises could seemingly false, where prices don’t square with economics, oil prices could be an embodiment.

The fact: Prices for oil as measured by the WTIC (West Texas Intermediate Crude) have been in a bear market. To date, prices have lost some 60% from its peak last July.

The event: Pronouncements from energy authorities that demand growth could become negative.

This excerpt from Wall Street Journal (highlight mine): ``The International Energy Agency warned Thursday that world oil-demand growth this year is on the cusp of falling into negative territory for the first time in 25 years, as global economic problems hammer away at energy consumption.

``In a new twist from past months, the agency also substantially lowered its forecast for oil demand in China and other emerging markets, where much of the growth in energy consumption is coming from. The IEA cut its expectations for demand in 2009 in these nations by 260,000 barrels a day.

``The IEA, in its monthly oil market report, said world oil demand will grow by 0.1% in 2008, down from a previous growth projection of 0.5% and far below the 1.1% growth in 2007. Globally, consumers and businesses will use on average 86.2 million barrels a day, 330,000 barrels lower than IEA's previous report.”

The popular perception: Falling demand have sparked a fall in oil prices. Falling oil prices reflect oil demand deterioration. So a feedback loop between falling demand and falling oil prices have fundamentally been reinforcing each other.

In our latest outlook, Demystifying the US Dollar’s Vitality we noted how OIL prices peaked at the same time the US dollar bottomed. We equally pointed out that the rapid pace of acceleration in the surge of the US dollar (as measured by the US dollar index basket) mirrored the sharp degree of descent by oil prices where we opined that the carry trade of being “short the US dollar- long commodities” have basically been unwinding.

We also posited that the all important driver that has virtually been encompassing the divergent global markets- such as the surge in the US dollar, the downside volatilities in the ex-US dollar currencies (except the Yen), the crash of the oil, commodities, emerging markets, the widening of various credit spreads, the collapse of asset backed markets, commercial paper markets, globally stock markets, surfacing of various crisis in different nations (such as Iceland, Hungary, Pakistan, South Korea etc.) and the disruptions in trade finance-have been the ongoing debt deflation or “deleveraging” dynamics.

The recent seizure of the credit markets and the ensuing gridlock in the US banking system has fundamentally impaired the flow of financing enough to have a substantial spillover impact to the global economy.

Thus, the prevailing bias or perception has been one of decelerating global economic dynamics prompting for the selling pressure in oil prices as indicated by the above by the Wall Street report.

And amidst falling oil prices and empirical evidences of deteriorating global economic growth, the feedback loop transmission of falling prices and falling demand has now been fostered into a conventional theme.

So where does this race to the bottom all stop?

With such linear based thinking, some questions pop into our mind: will oil fall below $50 to $10 per barrel or even to zero? Will people shun traveling? Will commerce stop? Will our lives grind to a complete halt?

The world is evidently so consumed with the Keynesian brand of economics, where almost everything seems centered on demand aggregates such that the mainstream appears to have forgotten the supply side variables.

It’s Not All About Demand, Supply Matters Too

Here is where we part with the consensus.

Figure 1: IEA World Production By Source In The Reference Scenario

As Figure 1 from IEA world energy outlook 2008 shows how conventional oil fields (dark blue) are expected to rapidly deteriorate following a “peak” by 2010.

And even without the popular political rhetoric of “energy independence” (an issue we will discuss in the future), such a gap would need to be filled by new oil fields or non-conventional oil or natural gas liquids.

According to the IEA fact sheet, ``The world’s endowment of oil is large enough to support the projected rise in output, but rising oilfield decline rates will push up investment needs. Proven reserves of close to 1.3 trillion barrels equal more than 40 years of output at current rates; remaining recoverable resources of conventional oil alone are almost twice as big. But there can be no guarantee that those resources will be exploited quickly enough to meet the level of demand projected in our Reference Scenario. Decline rates – the rate at which individual oilfields decline annually – are set to accelerate in the long term in each major world region. The average observed decline rate worldwide is currently 6.7% for fields that have passed their production peak. This rate rises to 8.6% in 2030.” (underscore mine)

This means that massive investments are needed to cover such deficits.

But the question is, how will the investments come about and where will the investments come from when access to credit have been severely limited, or if not, the cost of money have been pricier, or oil prices have not been enough to prompt for a revenue stream required to fund or finance future oil projects?

Windfall Profit Taxes and Fairy Tale Oil Prices

Figure 2: Agorafinancial.com: Estimated Cost of Oil Production

Figure 2 shows that at $57 oil, most of the alternatives to the conventional oil have been rendered unfeasible, as present prices appear to be at below the estimated cost of production. This also means at present prices oil companies, whether state owned or privately owned companies are suffering from losses.

Proof?

From Timesonline.co.uk (highlights mine),

``Leading Russian oil producers, including TNK-BP, BP's Russian affiliate, are grappling with a collapse in profits from the export of Siberian oil.

``Heavy export tariffs have almost wiped out the profit margin from selling crude oil outside Russia, forcing Siberian producers to sell at prices as low as $10 a barrel on Russia's domestic market. Fears are mounting that the profits squeeze may speed the decline in Russian oil output, already down 6 per cent this year.

``The profits crunch, caused by the collapse in the worldwide price of crude, is provoking concern within Russia's oil community that capital expenditure budgets will have to be cut if profits from oil sales do not recover. “The tax burden is very tough,” Valeri Nesterov, an oil analyst at Troika Dialog, the Moscow brokerage, said. “The problem is that the future of the oil sector might be jeopardised if the Government doesn't reduce the tax burden.”

As you can see, high taxes and a sharp drop in oil prices pose as double whammies and threaten to curb the immediate supply in the global oil markets as capex are likely to get excised if losses continue to mount.

Besides, high taxes are products of reactionary government policies aimed at attempting to secure more revenues in anticipation of “eternally” high oil prices.

This should also serve as lesson to windfall profit advocates. What has been missed by governments and their social liberal proponents of taxing windfall profits are that

1) Oil is a cyclical commodity

2) Oil prices are never permanent and subject to the balance of demand and supply

3) High taxes tend to compound the miseries of oil companies when prices become unfavorable.

4) Profits are needed to fund or finance future oil or energy supplies.

5) Speculation or “greed” does not drive oil prices as evidenced by the 60% loss from the top.

To quote Steven Landsburg, ``Most of economics can be summarized in just four words: People respond to incentives. The rest is commentary."

More proof?

Figure 3 ntrs.com: Mexico’s Rapidly Declining Crude Production

Mexico, the third largest oil exporter to the US following Canada and Saudi Arabia (EIA) has been encountering a precipitate decline in oil production as shown in figure 2. The Cantarell oil field which accounts for 60% of Mexico’s oil production has been declining at a rate by nearly 20% and could reach 30% (oil drum).

Remember, about 40% of state revenues come from the oil industry which means unless Mexico’s economy diversifies or expand its oil output, the country runs the risk of declining revenues, which given the present conditions of state spending could lead to a debt default.

Yet for years, Mexico has prohibited foreign companies from exploring on its national geography, which has been controlled by state owned monopoly the PEMEX. But recent events have reinforced the political and economic exigency to expand production by accepting foreign investments. Hence, the Mexican government, despite the unpopularity of the measure, has signaled its willingness to subcontract exploration and drilling to foreign companies (time.com).

To quote James Pressler of Northern Trust, ``The only thing that could make this situation worse for Mexican oil production would be an actual storm. The Mexican government, seeing the same warnings we are, has finally passed a much-contested and watered-down energy reform bill to get the sector back in shape by allowing foreign investment – though some fear that it is too little too late. The concern is that the weak legislation is not nearly enough to reverse the strong, downward trends of the oil sector. The justification: Pemex posted a $1.3 billion loss in Q3 as crude production fell almost 10% from a year ago. Clearly, it’s going to take a lot of foreign investment to turn Pemex around, and a lot of time. The real question is, will any private firm invest now that oil has fallen below $60 pb, the credit markets have all but seized up, and Mexican security conditions have worsened?”

And just how much investments are needed to bring supplies on stream to balance with demand?

Mr. Byron King writing in the Rude Awakening from agorafinancial.com gives us a clue,

``According to the IEA, even with massive levels of investment in the oil patch, the best estimate is that the global oil industry can reduce the rate of depletion to perhaps the 6% range. So the world energy industry will have to run faster just to keep from falling too far behind the demand curves.

``Again, you need to keep in mind that current energy prices are just too low to support the level of energy investment that the world needs going forward. (Meanwhile, the U.S. government is spending trillions of dollars just to bail out the banks and bankers, not one of whom runs pump jacks.)

``The IEA estimates that the oil industry will have to invest over $350 billion per year to counter the steep rates of decline in output. And even that will not be sufficient to maintain levels of output for traditional forms of crude oil. Thus, much of the future investment will have to go toward extracting other kinds of hydrocarbon substances. And these "other kinds" tend to be very expensive to develop.”

In addition, capital cost expected for the energy sector is projected at $26.3 trillion going into 2030 with 52% of the total or $13.2 trillion earmarked for the power sector and the balance for upstream oil and gas industry (IEA). Over the present term some of this are at risk.

So unless the world falls into a great depression (version 2.0), which seems unlikely unless global government start erecting barriers that would restrict trade and finance flows, the likelihood is that oil demand trends will continue to be strong over the medium to long term and will pose as hazardous strain to the demand-supply equation.

From the basis of the continuance of present government policies, the IEA also predicts that the “primary demand for oil (excluding biofuels) rises by 1% per year on average, from 85 million barrels per day in 2007 to 106 mb/d in 2030”, where most of these demand would come from non-OECD countries, see figure 4.

Figure 4: IEA Estimated Change in oil Demand by Region

From the IEA, ``These global trends mask big differences across regions. All of the projected increase in world oil demand comes from non-OECD countries. India sees the fastest growth, averaging 3.9% per year over the projection period (to 2030), followed by China, at 3.5%. High as they are, these growth rates are still significantly lower than in the past. Other emerging Asian economies and the Middle East also see rapid growth. In stark contrast, demand in all three OECD regions (North America, Europe and the Pacific) falls, due to declining non-transport demand. The share of OECD countries in global oil demand drops from 57% in 2007 to 43% in 2030.”

Conclusion: Groping For A Guidepost

As you can see based on the above projections, oil below $60 dollars hasn’t been unambiguously reflective of real world economics. To paraphrase Agora’s Byron King, $60 oil seems priced at “Fairy Tale” levels.

Instead, oil at $60 has been a function of indiscriminate selling, triggered by the massive waves of debt deflation or delevaraging dynamics.

This downside overshoot only aggravates the structural imbalances in the supply demand equation over the medium to long term basis that risks an equivalent fierce overshoot to the upside once the present trends inflects or reverses.

This also means that while oil prices can remain at depressed levels as global financial markets attempt to find its footing, from which George Soros once observed ``“When a long-term trend loses momentum, short-term volatility tends to rise, it is easy to see why that should be so: the trend-following crowd is disoriented”, the brewing imbalances are likely incite a sharp recovery perhaps sooner than expected.

Furthermore, this also demonstrates how market psychology works; the public has been anchoring oil prices on the premise of a deep global recession, if not a great depression from a prospective an OECD deflationary environment. The latter idea is something we don’t share unless governments, as we stated earlier, start erecting firewalls.

As in the case of Zimbabwe, we understand that a government determined to inflate don’t need a functioning private credit system in order to inflate.

All it needs is 24/7 full scale operations by the printing presses and an expanding network of bureaucracy (or helicopters). As we noted in Black Swan Problem: Not All Markets Are Down!, its 231,000,000% (hyper) inflation has prompted for a year-to-date return of 960 QUADRILLION % (!!!) in its stock market as people flee its national currency. Why the refuge in stocks? Perhaps because to quote Mr. Soros, ``stock markets is one of the most important repositories of collateral”.

And as global governments combine to adopt a path to Zero Interest Rate Policy and have been flooding the world with “money from thin air” to rescue entities affected by the bubble bust, this equally reflects another reason why oil at $60 seems like a fantasy.

Finally, Mr. Soros tells us that ``People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”

Applied to the oil markets, it simply means that once oil prices begin to reverse, the “expert” rationalizations over “deflation and depression” will likely be replaced with stories of “recoveries” and renewed concerns over inflation.

China’s Bailout Package; Shanghai Index At Possible Bottom?

``Financial success depends on the ability to anticipate prevailing expectations and not real world events.” -George Soros, Alchemy of Finance

When bad news comes, it pours.

China hasn’t been unscathed by the recent turn of events.

There have been increasing signs of impacts related to the contagion from the global financial crisis, even if its capital markets have been heavily regulated or its linkages to foreign markets or economies have been limited.

Reports like the “slowest industrial growth in seven years” (Bloomberg), “a sharp fall in manufacturing survey” by CLSA indicative of a prospective recession (Bloomberg), “the narrowing profit margins” and concerns over the “rising incidences of bad loans from overseas investment” (Bloomberg) or from declining financial markets, or decelerating export growth (Bloomberg) amidst a record trade surplus are just a few examples. Yet, despite the seemingly downcast message, the statistical figures still remain positive albeit ostensibly slowing.

Some strident perma bears have launched the offensive to downscale China’s economic growth forecast to 5-6% to reflect a hard landing, apparently to chime with their deflationary bias.

Figure 5: Economist: Breakdown of China’s GDP

For starters, despite being popularly known for its export prowess, figure 5 from the Economist exhibits that net exports (exports-imports) account for about 3% of its GDP.

Arthur Kroeber at Dragonomics estimates that about 21% China’s manufacturing value is exported, while manufacturing accounts for only a third of GDP value and investment, of which only 7% of China’s investments are directly linked to export production.

Meanwhile the largest chunk of China’s GDP has been in investments which is estimated at 40% (the Economist) or 30% (Dragonomics-GaveKal) of the economy where over half of these are into infrastructure [30.8% of total construction investments (source: Dragonomics-Gavekal)] and property [24% of total construction investments].

Figure 6: Guinness Atkinson: Declining China Property Growth

Reflating China.

Faced with deteriorating signs of health in the global economy, despite a still vigorous export growth clip (emerging markets have offset declines in the US), emerging signs of strains in manufacturing, slumping stock markets and worst, declining real estate values as shown in Figure 6, aside the declining rate of investments in real estate (xinhua.net), instinctively, China’s recent response have been to launch a massive stimulus of $568 billion (Bloomberg) or equivalent to around 14% of its GDP in dollar terms (Economist).

Edmund Harriss of Guinness Atkinson lists latest policy measures undertaken by Chinese government prior to its massive $586 stimulus package namely, Tax rebates for exporters, Three interest rate cuts, Two cuts in the required reserve ratio, An injection of $4.4 billion into the banking system to ensure liquidity, An increase in bank lending quotas for smaller and medium-sized businesses, Lowering of the mandatory mortgage down-payment from 30% to 20%, Cut property transaction taxes and lowered mortgage rates, Municipal governments have launched a series of additional property supporting measures specific to their local markets.

In addition, the latest stimulus is said to cover (source Danske Bank):

-Construction of more affordable low-rent housing.

-Increasing investment in rural infrastructure (mainly road and power grids).

-Boosting investment in transportation (railway, airports and upgrade of urban power grids).

-Increase spending on healthcare and education.

-Improve environmental protection by investing in sewage, rubbish treatment and energy conservation.

-Extending reform in VAT reform to all industries (cut corporate taxation by CNY120bn).

-Income support by increasing agricultural subsidies and subsidies to low income urbane residents.

Some observations:

1) China’s bailout package reflects the general trend of global governments to concertedly ease monetary policies and use government coffers to pump prime the economy.

2) It is unclear how much of the total package represents new spending. Many of them were previously announced but have been currently incorporated probably aimed at gaining media or political mileage or having some impact on the financial markets.

3) It would appear that the main thrust of the stimulus would be to cushion the impact of the decline in investments which account for the biggest share in China’s GDP.

4) The spending measures will definitely benefit certain sectors or nations. But there will be lingering questions on the overall efficacy of such programmes or its possible unintended consequence.

5) Some have made comparisons to an almost similar policy stimulus program instituted during the Asian Crisis which managed to keep growth rates at nearly 8% in 1998-1999 (indexmundi.com). Although, China today is much bigger in size compared to the 90s, in as much as the extent of the external shock threatening China.

6) While the program is said be implemented within a two year window (Economist), such policy measures will take time before any material impact can be felt or assessed.

7) There is always the question of financing. It’s been said that the national government will account for 25% of the package, with unspecified amount to be shouldered by the local governments and the rest by so-called “social investments” (Northern Trust). The ambiguities from the sources of financing have led some to speculate on the risks that China could sell US treasuries at a time when the US is in dire need of funding for its fiscal programs. And selling US assets (mostly treasuries or agencies) could be detrimental to the already sensitive and volatile markets.

This doesn’t seem likely though. China has a national savings rate of 51.2% last year (San Francisco Chronicle) which could be channeled instead to fund such government expenditures than propping up of losing private investments in the property sector (as the US has done). Besides, roiling the already volatile markets could have undesired effects financially, economically or even politically.

Anticipating Prevailing Expectations: Shanghai Composite At Bottom?

How does this affect China’s markets or of Asia?

Well China has thrown various tools as mentioned above even prior to the latest stimulus program. It didn’t stop the major benchmarks from the hemorrhage. But this doesn’t mean the past will be the same.

Our idea is to look at history first.

Figure 7 chartrus.com: 17 year chart of China’s Shanghai Composite

China’s1993-1995 bear market manifested a peak to trough loss of 73%, while the 2001-2005 version lost some 56%.

Of course the conditions of those years are starkly different than from today. Although from the standpoint of bear market losses- from which the Shanghai index peaked from October of 2007 (6,036.28) to its recent November lows (1719.77)- have registered a loss of nearly 72%, almost at the same depth as the bear market trough of the 90s.

In my view, this means that the market (barring a great depression) is likely near or at the bottom with or without the stimulus.

Although the stimulus could possibly work as a psychological booster. See figure 8.

Figure 8: stockcharts.com: US markets-China/Japan/Asian Markets Diverging?

This has been the same dynamics going on in the US markets. Many have been hoping for government actions to successfully prop up its domestic market, but to no avail.

Last week the US benchmarks attempted to test the October 10 lows and fleetingly passed. But maybe we might see a repeat of the test next week as the recent gains haven’t been successfully safeguarded.

Once again this takes us to the edge of our seats as to whether the US markets makes a pivotal decision point of either establishing a bottom or a new low.

However, as figure 8 shows, China’s Shanghai Composite (SSEC) seem to be “diverging” alongside with other Asian markets as the Nikkei or Asia ex-Japan. As US markets seem testing the lows, Asian markets appear to be holding ground.

Likewise, the SSEC seems to have been boosted by the National Bailout program. But as we have earlier mentioned the SSEC have been treading in historical bottom pattern which makes the 1,719 area a strong support level.

As we have long mentioned, it has been a longstanding bias of mine that the Asian markets are likely to recover first considering the impact from the present crisis have been one emanating from the periphery than from the epicenter.

Put differently, Asian markets have borne the brunt of the contagion than as source of the crisis. Fundamentally speaking, many factors favor a recovery in the Asian markets (less debt or leverage in both internal and external liabilities, sizeable currency reserves, demographic advantage, growing middle class, significantly improving productivity, rising income and etc.).

But one or two weeks doesn’t a trend make.

So we will have to stay in the sidelines and watch for further confirmations.

Currency Markets 101: FX Swaps and Cross-currency basis swap

One of the objectives of this blog is to spread financial literacy.

And considering the growing sophistication of financial markets, market participants may have learn, understand and perhaps consider using some of the available diverse tools to hedge on risks aimed at enhancing corporate returns or at financing investments.

This week we feature basics of FX Swaps and Cross-currency basis swaps which we will excerpt from a working paper by the Bank of International Settlements entitled “Price discovery from cross-currency and FX swaps: a structural analysis”

Note this is different from the US Federal Reserve instituted Swap lines as we discussed in How Does Swap Lines Work? Possible Implications to Asia and Emerging Markets.

All highlights mine…

1. Cross-currency basis swap

There are numerous types of cross-currency swap contracts, among which the most widely used in recent years is a type of contract named the cross-currency basis swap. A typical cross-currency basis swap (hereafter “currency swap”) agreement is a contract in which Japanese banks borrow U.S. dollars (USD) from, and lend yen (JPY) to, non-Japanese banks simultaneously. Figure 1(i) illustrates the flow of funds associated with this currency swap. At the start of the contract, bank A (a Japanese bank) borrows X USD from, and lends X× S JPY to, bank B (a non-Japanese bank), where S is the FX spot rate at the time of contract. During the contract term, bank A receives JPY 3M LIBOR+α from, and pays USD 3M LIBOR to, bank B every three months. When the contract expires, bank A returns X USD to bank B, and bank B returns X× S JPY to bank A. At the start of the contract, both banks decide α, which is the price of the basis swap. In other words, bank A (B) borrows foreign currency by putting up its home currency as collateral, and hence this swap is effectively a collateralised contract.

These currency swaps have been employed by both Japanese and non-Japanese banks to fund foreign currencies, for both their own and their customers’ account, including multinational corporations engaged in foreign direct investment. Currency swaps have been also used as a hedging tool, particularly for issuers of so-called Samurai bonds, which are JPY-denominated bonds issued in Japan by non-Japanese companies. By nature, most of these transactions are long-term, ranging from one year to 30 years.

Illustration by BIS

2. FX swap

A typical FX swap agreement is also a contract in which Japanese banks borrow USD from, and lend JPY to, non-Japanese banks simultaneously. The main differences from the currency swap are that: (i) during the contract term, there are no exchanges of floating interest between JPY and USD rates; and (ii) at the end of the contract, the different amount of funds is returned compared with the amount exchanged at the start.

Figure 1(ii) illustrates the flow of funds associated with the FX swap. At the start of the contract, bank A (Japanese bank) borrows X USD from, and lends X × S JPY, to bank B (non-Japanese bank), where S is the FX spot rate at the time of contract. When the contract expires, bank A returns X USD to bank B, and bank B returns X × F JPY to bank A, where F Is the FX forward rate as of the start of contract. As is the case with currency swaps, FX swaps are effectively collateralised contracts.

FX swaps have been employed by both Japanese and non-Japanese banks for funding foreign currencies, for both their own and their customers’ account, including exporters, importers, and Japanese institutional investors in hedged foreign bonds. FX swaps have also been used for speculative trading. The most liquid term is shorter than one year, but in recent years, transactions with longer maturities have been actively conducted for purposes such as foreign currency funding for corporate direct investments and arbitrage activities with crosscurrency swaps. In fact, many market participants point out that the liquidity of FX swaps with maturities longer than one year has improved during the past several years.

Free Lunch Isn’t For Everyone, Ask Japan

Pundits have long debated about why and how Japan’s policies (e.g. ZIRP, Quantitative Easing, Infrastructure spending, etc…) have failed to “reinflate” its economy following the bubble bust in 1990s, which eventually led to “the lost decade”.

Naturally there won’t be one single or simplified answer to a complex problem, although it is just our thought that this article just may have provided one important clue.

This excerpt from Washington Post’s article entitled “Free Money? In Japan, Most Say They Will Pass”.

All highlight mine.

Japan is having trouble giving away a free lunch.

To perk up the fast-shrinking economy, Prime Minister Taro Aso announced late last month that his government would give everybody money. A family of four would get $600.

Then the trouble -- and the confusion -- started.

Should rich people get it? How rich is rich? Who decides who is rich, and how long will it take to decide?

Aso, who came to power in September and within a year must call a national election that polls show he may well lose, declared initially that everyone, rich and poor, would get the money.

Then Kaoru Yosano, the minister for economic and fiscal policy, said that perhaps the rich should not get any money. He noted that such a giveaway could be viewed as an unseemly attempt by the prime minister and his ruling Liberal Democratic Party to curry favor with voters.

Aso found that to be a reasonable argument and said an income cap would probably be a good idea.

Then his finance minister, Shoichi Nakagawa, said that figuring out who is too rich for a handout would create an excessive workload for local governments. He also said it would delay the distribution of money, which Aso wants to get into people's pockets by March.

Aso found this, too, to be a reasonable argument and said on Monday, "No income cap will be implemented."

Now it turns out that voters do not want the money.

Sixty-three percent said they think that a handout is unnecessary, according to a poll published Wednesday in the Asahi, a national daily. Every age group opposes it, as does a majority in Aso's ruling party, the poll found.

One answer is C-U-L-T-U-R-E.

The Japanese are such fanatical savers that they are the reigning titlist as the world’s biggest savers, which according to aol.com, ``boast nearly $15 trillion in domestic household financial assets, about half of which sit in bank deposit accounts.”

So with so much money stashed in the banks, obviously there isn’t any urgency for most of the Japanese for free lunches in the same way most of the world drools over such opportunity.

The other dilemma clearly emphasized by the article is how noble intentions dreamt or conjured up by regulators and egalitarians get cluttered with the argument over classifications, conflict of interest and the unintended consequence of bureaucratic nightmare.

The morals of the story:

Since everyone would have different set of values, you simply can’t please everybody.

There is no single "regulatory" solution to the problems of mankind.