321gold: When Currency Empires Fall by Professor Avinash Persaud

When Currency Empires Fall
Professor Avinash Persaud
12 October, 2004

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

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

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

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

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

The spoils of reserve currency status

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

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

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

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

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

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

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

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

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

The future is not rosy for the dollar

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

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

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

Hope for the euro?

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

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

The renminbi's path

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

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

A dollar peg today, a float tomorrow

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

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

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

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

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

Avinash Persaud
7 October 2004

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

Eventual lunch bill may spell end to dollar's dominance

By Gary Duncan

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The implications of such a shift would be truly seismic

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

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

By Carl Mortished, International Business Editor

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Ameinfo.com

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Economist: The magnetism of metals

The magnetism of metals
Oct 11th 2004 From

The Economist Global Agenda

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

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

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

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

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

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

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

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

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

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

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

Robert Folsom: The Missing Link

Please consider these headlines.

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

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

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

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

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

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

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

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

October 11 Philippine Stock Market Daily Review

Oil Again??!!

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

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

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

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

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

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

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

Morgan Stanley's Andy Xie: More Inflation Scares Ahead

More Inflation Scares Ahead
Andy Xie (Hong Kong)

Summary and Investment Conclusion

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

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

Beneath Greenspan's magic wand: cheap Chinese labor

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

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

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

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

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

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

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

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

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

Rising food and energy prices signal a different game

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

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

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

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

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

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

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

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

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

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

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

Another inflation scare may be coming

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

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

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

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

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

Is it stagflation or deflation beyond the boom?

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

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

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

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

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

Pump priming
Sep 30th 2004 BANGKOK AND JAKARTA

From The Economist print edition

Dear oil and subsidised petrol are hurting Asia's economies

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

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

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

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

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

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

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

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

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

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

Has America Achieved Economic Paradise On Earth?

Paul Kasriel and Asha Banglore

Northern Trust

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

Eric Fry of the Rude Awakening: Nuthin' To Drill

Nuthin' To Drill

Eric Fry

The Rude Awakening

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

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

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

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

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

But first a little history.

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

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

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

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

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

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

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

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

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

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

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

Morgan Stanley's Daniel Lian: Sino Hollow

Sino Hollow
Daniel Lian (Singapore)

The Three Scenarios of the Sino Hollow Thesis

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

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

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

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

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

Pessimists and Complacent Asian Policy-Makers

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

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

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

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

Examining Hard Data a Decade After China’s Ascent

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

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

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

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

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

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

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

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

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

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

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

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

Bottom Line: Southeast Asia Has Breathing Space

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

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

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

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

Mises.org: Raiders of the Taxpayer's Money by Grant Nulle

Raiders of the Taxpayer's Money
by Grant M. Nülle

October 8, 2004

Misis.org (Ludwig Von Misis Institute)

For a government as vast and powerful as America's, $60 billion is hardly a substantial amount of money, considering it boasts a large populace and economy to plunder; such a sum is a mere three-fifths of what the U.S. Army alone requested for fiscal year 2005.

In the case of the Philippines, an erstwhile vassal of America, $60bn is an exorbitant total that also happens to approximate the country's sovereign debt. Staring acute financial hardship in the face, government officials are imploring the nation, particularly Filipino taxpayers, to bail them out of a crisis of their own making.

Mountains of Debt

Despite prior foreign investment bank prognostications and concerns, economists at the University of the Philippines (UP)—a state institution—ironically brought the country's impending fiscal crunch into sharp relief. Eleven academics, many of them senior economic officials in previous Philippine presidential administrations, collaborated to identify the causes of the country's rapid accumulation of sovereign debt[i]and predicted that if left unchecked, a genuine fiscal crisis would soon befall the country.

They found that between 1997 and 2003 approximately 2.01 trillion pesos ($36.4bn) were added to the national debt, which is almost 1.5 times the debt burden –1.35 trillion pesos ($25.4bn) that existed in 1997. The outstanding government debt is at a level well above what bond rating agencies consider as the median load for similarly rated sovereigns. Divided roughly half and half between domestically and externally-held financial instruments, government servicing of these obligations could become impossible to manage if global interest rates continue to rise and recurring budget deficits cannot be attenuated.

Indeed, since 1998, the Philippines' budget balance has gone south, posting sizable budget deficits annually. The unmitigated deterioration of the government finances comes in spite of modest economic growth in the aftermath of the East Asian Financial Crisis of 1997 and 1998. Like other nations in the region, the Philippine currency suffered speculative attack, precipitating a rise in domestic interest rates by the Philippine Central Bank and a subsequent slowdown in the financial sector and wider economy.

Notwithstanding a rise in unemployment, currency depreciation and an attendant spike in inflation, the Philippine economy, relative to other East Asia countries like Indonesia, Malaysia and Thailand, rebounded rather quickly. Wide-ranging structural reforms initiated at the beginning of the 1990s, including opening an exceedingly protected economy to foreign trade, provided the country the flexibility necessary to rebound from a recession.

However, the government also resorted to public spending to stimulate growth, tapping international capital markets to plug the resultant deficit. In fact Manila's March 1999 sale of a 350m-euro bond was Asia's first debt float in the new European currency.[ii] What differentiates the period of modest economic growth in the Philippines between 1993 and the Asian Crisis and the period afterwards is an erosion of the government's finances, bulging budget deficits and burgeoning debt in the latter period.

As the UP economists enumerate, 43% of the increase in the national debt can be attributed to a surfeit of government expenditures over tax take, 19% to adverse currency movements and 37% to assumed liabilities and subsidization of state corporations.

Leaving aside the currency factor, Government Owned or Controlled Corporations (GOCCs) and the government's budget deficit merit closer examination. Beginning with the former, chronic loss-making state corporations pose an additional budgetary onus upon the government's coffers. Although its debts are not de jure obligations of the government, state enterprises can expect an implicit state bailout should it encounter financial difficulties, thus pushing the public sector debt load (as opposed to the national government) to 135.6% of GDP.

Chief among the beneficiaries of state largesse is the National Power Corporation (Napocor), a notoriously inefficient firm that lost $2.06bn last year and has had nearly $818m of debt absorbed by Manila over the past five years.

According to the country's Freedom from Debt Coalition[iii], Napocor's debt has grown from $2.2bn to $25.4bn between 1994 and 2003 and represents more than 40% of the $61.8bn debt. Unable to borrow in global capital markets, the loss-making entity has had the national government purchase its bonds and then obtain financing from foreign lenders in the government's name, including a $400m sovereign bond flotation, part of Napocor's $27.3m borrowing requirement for 2004.

In addition to current or recent government absorption of quasi-public agencies' debts, it has volunteered to service the obligations incurred during the profligate Marcos era. Even the Central Bank required financial assistance, a notion nearly incomprehensible in America or Europe where such institutions are considered omnipotent. Of course, the heroic decision of Philippine officials to assume these excesses will not be paid out of the state's or their own ill-gotten assets, but by squeezing hapless taxpayers.

Show me the money

The discrepancy between government expenditures and the property it can coerce from the populace account for 43% of the upsurge in the nation's sovereign debt. Contrary to countries that have courted fiscal crises due to increased spending, the Philippines has actually experienced a slight decline in spending levels since 1999, attributable to president Gloria Malacañang Arroyo's (GMA) determination (so far marginally successful) to cull the country's budget deficit since assuming power in 2001.

Rather, private property seizures are descending at a gait quicker then spending. The tax take has fallen from around 17% of GDP to 12.5% of GDP between 1997 and 2003. Investment banks estimate the country's rampant tax evasion totals in the billions of dollars per year. Philippine enterprises are thought to pay only 60% of the Valued Added Tax (VAT) that the state demands as tribute, while domestic financial institutions rarely pay levies on interest income commensurate to what they purportedly owe. Corruption within the government, including the Bureau of Internal Revenue (BIR) contributes to disappearing receipts. Not to be outdone, the judiciary is inclined to issue a free pass to tax dodgers. GMA has publicly condemned the endemic tax evasion and has directed the bureaucracy and citizenry to wage a Kulturkampf against it.

As for the Philippine political system, it vindicates columnist H.L. Mencken's characterization of elections as an advance auction of stolen goods. Washington's occupation of the Philippines from 1898 until 1946 imposed the American system of government on its client, complete with a president, bicameral legislature and Supreme Court. The U.S. legacy proved to be a boon to the leading families of a country encompassing thousands of islands and dozens of disparate local languages. Ambitious clans, already fluent in English (an essential in Manila) could establish provincial fiefs in the native tongue as a springboard to either house of congress and even the presidency.

Party affiliation is subordinate to filial ties; about three-fifths of the last Congress had relatives in office[iv] . Legislator loyalty can be bought (with taxpayers' money of course) to assemble majorities on any piece of legislation. What is more, elected representatives find time to grant themselves and connected friends tax exemptions (e.g. in the legal and medical professions) as well as augment their own pay for all of that taxing work. Specifically, Congress managed to almost triple its own budget over the past 15 years. But then again, the 24-member Senate does need the extra funding to discharge the expense of 36 permanent committees and 16 ad hoc oversight committees (by contrast America's upper chamber has only 16 and four permanent and special committees, respectively).

Granted, tax exemptions are always just—no matter who receives them (see Rothbard[v]) especially in the case of people who are forced to contribute to public services they themselves do not use.

Do I smell bacon?

Mounting a successful political campaign is prohibitively expensive, running into the tens of millions of dollars to conduct a serious legislative or presidential bid. In a country where a substantial portion of the population live in abject poverty, the sums expended on political campaigning is staggering. The prize, however, is lucrative: command of discretionary funds, government perks, and the ability to influence legislation and appropriations favorable to congressmen, their families and business associates.

The chief tool of personal aggrandizement at the legislator's disposal is the aptly named pork barrel. A term gleaned from the American occupiers, "pork barrel" dates back to the United States's antebellum period when masters gave African slaves salted pork stored away in barrels. Like congressmen in America, Filipino legislators mob the pork barrel to secure government appropriations for pet projects.

Marcos actually abolished the pork barrel when he disbanded congress and imposed martial law in 1972. Not until a few years after the strongman stepped down did the personal legislative allotments resume and incrementally grow in value from 1990 onward. At present, senators and representatives receive an average pork barrel (officially referred to as the Priority Development Assistance Fund) of $3.7m and $1.2m, respectively.

Nominally earmarked for development projects (roads, schools, hospitals, etc.) of their choice, legislators do deliver the goods to their constituents, although not before enriching themselves. Former Finance Secretary Salvador Enriquez reckoned that up to 45% of the pork barrel is actually lost to so-called commissions, kickbacks or rebates. The stories of Filipino firms that have won pork barrel contracts illustrate the pervasive corruption.

Neophytes quickly learn that representatives are less interested in the sales pitch than the percentage cut in the transaction they will receive. A 40 to 50 percent rebate is an acceptable sum on anything from school supplies to medicines. Payments, made in cash, are usually transferred to the legislator or a designated third party at restaurants, hotels or homes. Despite the hefty discount incurred, contractors can frequently muster a marginal profit by skimping on materials, using inferior substitutes and doing a shoddy job.

Besides retaining considerable sway over the disbursement of government money to the legislative branch, the Philippine presidency commands its own pork barrel. Dwarfing the senators' discretionary allotment by five-fold, the executive's $18.2m allotment is evenly split between a "social fund" and "intelligence fund." Although GMA has managed to keep her hands clean, her predecessor, Joseph Estrada, was impeached (but not convicted) and later ousted from office for accepting kickbacks in an illicit gambling ring and Marcos was thought to have pilfered millions.

In the same vein the civil service is bloated and inefficient; government expenditures on operating expenses and salaries constitute half the budget. Not only are Filipinos compelled to surrender their property to fund the country's bureaucracy, they receive shoddy public services from inept, indebted, and monopolistic state enterprises and government contractors as recompense, not before their "honorable representatives" lop off a portion of the tax receipts for themselves.

Dial "A" for austerity

How then is the Philippine government going to avert a looming fiscal crisis, which has been mounting for years? Of course, taxpayers will have to principally atone for the enormous debts run up by bureaucrats, legislators and managers of GOCCs.

"We are already in the midst of a fiscal crisis and we have to face it squarely wielding our courage, resourcefulness and solidarity as a nation of a people," said GMA when she laid bare the gravity of the situation on August 23, indicating that yet again the government would externalize its mistakes on the populace at large.

The federal government's medium term fiscal plan is designed to obtain solvency over the next six years. It plans to exact revenue (projected take) by implementing a two-step increase in the VAT rate ($362m); tax on telecommunications franchises ($91m); adoption of gross income taxation for corporate and self-employed payers ($305m), indexation of tobacco, alcohol, etc. excises ($127.3m); augment excise on petroleum ($540m); rationalization of fiscal incentives ($91m) and a general tax amnesty. Failing legislative endorsement of these measures the executive has mooted reversing the 1997 income tax exemption granted to the country's 7m citizens working abroad.

Others have pointed out that the best performing (and lightly taxed) sectors of the economy—exports and agriculture—deserve to assume a greater share of the burden. Shame on these people who do not appreciate the connection between low taxes and high growth.

The taxmen have been encouraged to vigorously collect all unpaid interest income withholdings that banks have declined to surrender. The ongoing professionalization of the tax bureaucracy will continue, albeit marred by imbedded corruption in the BIR. Recently some staff refused to collect taxes when one of their superiors tried to proscribe bribery in the ranks.

Moreover, public service user fees—specifically the electricity rate charged by Napocor—will climb. From 26 September onward, the price per kilowatt-hour will provisionally rise by 40%. Not only are Filipinos already forced to defray the debts of this tax-consuming monstrosity, but now are also compelled to devote a higher share of their income to the dismal services provided by this monopolistic entity.

Coupled with its proposals to coercively seize legitimately held property, the Philippine government has plans in the works to employ its stolen goods more efficiently. Administrative changes are to be implemented, requiring cost cutting in the bureaucracy on utilities, travel, supplies, etc. Superfluous offices are to be junked or consolidated and a voluntary trimming of the public payroll is in the works. GOCC creation—an oft-abused presidential prerogative—is to be frozen indefinitely and the 2005 budget proposal envisages reducing pork barrel allocations by 40%; the government is even preparing to privatize Napocor.

Furthermore, the executive is seeking to pass a fiscal responsibility bill, which will impose a debt cap on government borrowing and prohibit new spending without new taxes. Finally, the president will seek legislative authority to revamp executive departments and agencies as well as GOCCs. There is talk of limiting Internal Revenue Allotments (tax revenue transfers) to local governments by as much as 25% ($2.64bn) keeping that money in the federal government's accounts.

Taken together, the government's revenue and expenditure proposals promise by 2010 to balance the budget, increase the tax take, and reduce the public sector debt burden substantially.

Fuzzy math

Despite these ambitious measures, it remains to be seen if the supposedly radical rationalization measures evolve into something more than cosmetic reshuffling. Quite obviously the second element of the fiscal responsibility law is dreadful; the government's ability to tax and spend is at the root of the debt problem.

In the meantime, the government's projected 2005 budget of 907.6bn pesos ($16.5bn)—including $2.45bn in subsidies—is 5.3% higher than the previous year. Somehow an additional $2bn request for unspecified items and cash deficit has been left off the tender. Even GMA's promise to slash travel expenses fail to hold water, as the budget provides an extra $13.3m for this purpose.

Equally mysterious, the $6.26bn of principal payments due in 2005 has been left out of the proposal, which when added would allow the budget total to exceed the 1 trillion peso threshold for the first time ever. One of Asia's most spendthrift states owes $11.81bn in interest and principal repayments next year, an 81% increase since 2002[vi]. The budget deficit is projected to be another $9.31bn, financed by domestic borrowing. Moreover, the current presidential administration—which in only three years was able to borrow more than its two most recent predecessors managed to do over a span of eight years—is preparing to spend more than it pilfers from the populace for the next four years, prompting it to amass further debt.

As appealing as the moratorium on GOCCs and the vague promise to limit government guarantees to these firms may be, it does not adequately address the chief culprit of the Philippines' gaping fiscal deficit and substantial debt: the GOCCs themselves. Records from the country's budget department indicate that state corporations are collectively expected to register at least a $2.4bn loss during Fiscal year 2004. Blithely ignoring their financial drain on the country, many top GOCC administrators have awarded themselves lavish pay packets and discretionary funds (by Philippine standards) and then asked the government for subsidies and bailouts.

In the case of Napocor, the 40% provisional rate increase, with another unspecified rise scheduled in another 6 months, will merely serve to help it pay off interest payments amounting to more than $1bn over the next year. A clutch of company executives were recently paid $218m in retirement and severance pay and then subsequently rehired with a higher salary. After a bout of obfuscation by Napocor's management a government audit of the firm's books in 2003 discovered $2.55bn of accounting irregularities. Quite rightly, the Senate's Ways and Means Committee has deplored the systematic waste at the power provider.

Indeed, Napocor's $2.06bn loss in 2003 far exceeds the $618m per annum (before the 40% reduction in pork barrel) spent on corruption-riddled congressional pork barrel and the legislature's budget. Before Napocor is privatized Philippine taxpayers are poised to assume $9.1bn of its debts.

Perhaps a more politically palatable and positively outlandish method of plugging the budget gap would be a plan floated by President Arroyo in early 2003. She claimed that more than $18bn-worth of gold rests within the island of Mindanao's Mount Diwalwal. The Japanese occupation forces during the Second World War are reputed to have left behind buried treasures all over the country, which have enticed several Filipino presidents (along with Thai and Indonesian authorities in their own countries) to launch abortive, Indiana Jones-like searches for the missing caches. Indeed, Estrada had the garden of a presidential residence overturned in search of loot[vii].

Debt repudiation, not service

The aforementioned UP Economists reckon a debt crisis cannot be avoided for more than three years and that action must be taken within the next year to assuage financial markets. In April 2003, Standard & Poor's S&P lowered the Philippines long-term foreign currency rating (BB+ to BB), followed by Fitch in June 2003 and Moody's (Ba2 to Ba1) in January 2004. On September 8, S&P critisized the Philippine government's willingness to enact reforms and admonished authorities to reverse its negative fiscal trajectory in a fundamental and sustainable manner, lest it court an increasingly onerous debt burden.

Rather than comparing Manila's plight to that of Argentina, which defaulted on its sovereign debts in late 2001, one need look no further than the crunch and contraction that the Philippines suffered between 1983 and 1984. Spearheaded by the licentiousness of GOCCs and abetted by brisk petroleum price rises, the rapid accumulation of government debt during the late 1970s and early 1980s prompted the Marcos regime to default on its foreign obligations in 1983. An acute peso depreciation ensued, and the country plunged into economic and political turmoil for the rest of the decade.

On the heels of GMA's national announcement of impending fiscal difficulties, her subordinates quickly assured international capital markets that debt service would not be interrupted. They stressed that the definition of "fiscal crisis," as accepted by the IMF and credit agencies, is a situation that occurs only when: a country is in default, its deficit is unsustainable and the country does not have access to capital markets. S&P cautioned Philippine authorities that the recent 40% increase and future rise in Napocor's power rate would not save the company, much less the country, and urged authorities to introduce additional tax measures and enhance collection.

The S&P's advice indicates a proper method to resolve the Philippines debt situation, albeit not in the manner the rating agency advocates. Instead of devoting more of their income to Manila's debt problem, the Filipinos should press the government to repudiate all outstanding obligations to multilateral and private lenders alike.

To the casual observer this suggestion is anathema for it violates the sanctity of contracts. However, as Murray Rothbard[viii] correctly explained, there is a fundamental distinction between private and public debt.

In the former case, where a low-time preference creditor lends money to a high-time preference borrower in exchange for repayment plus interest, to repudiate one's debts is tantamount to depriving the lender of his property, which is indefensible. In regard to public debt, governments do not pledge their own assets, but taxpayers' instead, with creditors cognizant that the principle and interest will be paid through the involuntary confiscation of private property—taxation. In effect, both sides are complicit in the violation of property rights of a third party in the future, which scarcely deserves to be acknowledged as a contract.

Beyond the dodgy status of sovereign borrowing, debt repudiation is beneficial in that it immediately alleviates the citizenry of onerous repayments on obligations issued by present and previous governments. Politicians, bureaucrats, and their constituencies that receive succor at the public trough parasitically exist at the expense of productive tax-paying members of society. Why should the latter be made to pay for the former group's livelihood, much less its mistakes?

More importantly, by denying the Philippine government credit, as lenders are wont to do, the state will be compelled to operate within the confines of a balanced budget, certainly an unorthodox but necessary development.

Undoubtedly, the Philippine economy will be buffeted by a severe downturn as the country's private sector incurs the wrath of international capital markets. However, when the citizenry is relieved of massive tax-funded repayments on these obligations and no longer saddled with a credit-worthy government, foreign lending will return to invest in promising private enterprises. Likewise, indigenous capital formation can emerge as the profligate public sector is reined in. Fortunately, the estimated $7bn in annual remittances from Filipino workers abroad can serve as seed money for productive investments.

With respect to private creditors, as shameful as the blatant deprivation of the funds loaned to the Philippines may be, such arrangements clearly infringe third-party property rights and are an affront to liberty. As Rothbard suggested, a government mulling unilateral cancellation of its debts could at least partially allay creditor contempt by selling state assets and channeling the receipts to servicing its obligations. Auctioning off ill-gotten properties would divest the government of its coercion-acquired and maintained ascendancy.

Hopefully, debt repudiation by the Philippines would serve notice to prospective lenders that states, the only entity in society besides criminals that exist at the expense of others, are parasitic and wasteful consumers of capital undeserving of investment.

Grant M. Nülle is a Research Fellow with the Ludwig von Mises Institute. Contact him at grantn007@yahoo.com. Post comments on the blog.

[i] De Dios, Emmanuel S., et al. "The Deepening Crisis: The Real Score on Deficits and the Public Debt." University of the Philippines.
[ii] Milo, Melanie. "Contagion Effects of the Asian Crisis, Policy Responses and Their Social Implications." Philippine Institute for Development Studies. Discussion Paper Series No. 99-32. Dec. 1999.
[iii] "Past and Present Administrations Responsible for State-owned Power Firm's Heavy Loss." Freedom from Debt Coalition. 4 May 2004.
[iv] Democracy as Showbiz." The Economist. 9 July 2004.
[v] Rothbard, Murray N. Power and Market. 1970: 120–21.
[vi] "RP's 'Real' Debt Service Not Indicated in 2005 Budget." Manila Times. 28 August 04.
[vii] "All That Glisters..." The Economist. 16 January 2003.[viii] Rothbard, Murray N. "Repudiating the National Debt." Mises.org. 16 Jan. 2004.