Martin Spring's On Target: Marc Faber’s Views on Investing Now

Lifted from Martin Spring's latest On Target newsletter, Mr. Springs features an interview with marquee contrarian market savant Dr. Marc Faber...

Marc Faber’s Views on Investing Now

I took time off from holidaying in Northern Thailand for the privilege of a two-hour discussion with Marc Faber, the well-known commentator and editor of The Gloom, Boom & Doom Report, at his Chiang Mai home. Here’s how it went…

The Dollar

Spring: Do you expect the greenback to continue losing value?

Faber: Over the next three to six months there is likely to be a dollar rally, ahead of news of favourable events such as an improvement in the US current account. Although we could see the dollar go on to make a new low against the euro, it’s possible that the low of the current cycle has already occurred -- at the turn of the year.

Over the longer term, all paper money will lose purchasing power, but Asian currencies less so than the US dollar.

Inflation

Spring: Almost all commentators argue that central banks’ money supply creation must eventually produce renewed inflation, which is why they are consistently negative about bonds. Is that realistic?

Globally, the imbalance between supply and demand puts downward pressure on prices, and that seems set to continue, given the vast new low-cost manufacturing capacity being created in China. In real terms, interest rates remain low, suggesting that central banks aren’t worried about inflation. What is your view?

Faber: There is already plenty of inflation! You can see it in the prices of things like property, insurance, education, a lot of which doesn’t show up in the official consumer price indexes, where governments manipulate figures to keep them down.

Because of the highly leveraged financial markets, central banks will always accept inflation as the price of warding off any recession threat. The moment the banks see economic slowdown, they will stop their current tightening and revert to “printing” money.

You can be sure that in ten years’ time just about everything will cost more than it does now. The integration into the global economy of 3 billion people emerging from communism and socialism is producing demand pushing up the prices of many resources. Oil, for example, is four times more expensive than it was in 1998.

Although there will always be some pockets of falling prices, I don’t believe the world will see across-the-board deflation. Long bonds such as 30-year Treasuries may continue to rally for a while, but I don’t believe interest rates can stay this low, because they will have to react to higher visible inflation.

Within the next 20 years we could easily see annual inflation in the US rise as high as 10 per cent – accompanied, of course, by a depreciating dollar.

US interest rates

Spring: Currently the financial markets are positioned to assume that the Fed will continue pushing up interest rates till its lending rate reaches about 5 per cent. Is that realistic, given the dangerous leveraging involved in the carry trade, and the Fed’s history of reacting nervously to any perceived threat by flooding the system with credit?

Faber: The Fed isn’t particularly smart, as it showed by creating the asset bubble.

Because the Fed currently – and erroneously – believes the US economy is fundamentally sound, it will continue to push up rates. But not to 5 per cent. Perhaps to, say, 3½ per cent. That would be enough to cool down the economy considerably, without putting too much strain on the debt markets, particularly housing finance.

For the next few months bonds will continue to perform; but there are large downside risks in bonds. Rising short-term rates are good for bonds… and for the greenback. Dollar-denominated zero-coupon bonds are a buy. When policy changes, so will the dollar… and bonds.

There is a stronger case for owning euro-denominated long bonds. We’re not likely to see much inflation in Europe, and in some parts, even deflation.

The problem with investment markets now is that there is no compelling buy – not stocks, not bonds, not real estate. It’s very hard to find anything with an upside potential of 500 per cent and a downside risk no more than 20 per cent. There’s so much money slushing around and being used by hedge funds, the trading departments of banks and other big speculators to chase up the prices of momentum plays.

China

Spring: Will the Chinese economy slow down, as is generally expected? Longer-term, will it continue to deliver the extraordinary growth rates we’ve seen in recent decades?

Faber: We have already seen a sharp slowdown in sectors such as automobiles, electricity and real estate. I am leaning towards the view that we’re going to see a hard landing in China. The capital investment binge has produced such overcapacities – in steel, for example, capacity has doubled over the past three years.

If interest rates continue to rise in the US, that will dampen Chinese export growth. The effects will be transmitted directly into the Chinese economy because of the yuan’s fixed link to the dollar.

However, industrial production continues to expand strongly. Even if economic growth continues at say 4 per cent, that will feel like recession.

Longer-term, say over the next ten years, I expect annual growth to continue to average between 6 and 8 per cent.

China is at the heart of an Asian economic bloc that is already the world’s largest. Its industrial production is already 50 per cent higher than the US or Europe. There are already 330 million mobile phone subscribers in China! There are growing populations, and fast-growing middle classes.

Investing in Asia

Spring: How can international investors profit from the coming economic growth in Asia? Currently dividend yields look good, dividend growth has been good, operational cashflows are good, and balance sheets have been strengthened considerably, with deleveraging.

Faber. Unfortunately there is no correlation between economic growth and share prices. The environment for investors may not be all that good.

However, Asian currencies are no longer vulnerable as they were in 1997. Assets are undervalued relative to those of the US and Europe.

Even if there is a world recession, that won’t necessarily be bad for Asian manufacturers. A slump drives companies to look for cheaper sources of supply. It could lead to Asian exports increasing rather than decreasing.

Some argue that the recent strong rise in the Indian stock market has been overdone, but in dollar terms Indian equities are no higher than they were in 1994, and the political and economic environment is now much more attractive than it was then.

I am not keen on buying Indian shares now, but in five years’ time they will be higher. The market is currently trading on an earnings multiple of 13 times, which is OK.

In January we saw an interesting development in Asian stock markets, when they decoupled from the rest of the world’s. The reason is favourable macroeconomic conditions. Real estate and equity valuations are low to reasonable. Asia’s sensitivity to the risk of faltering export markets is probably over-estimated.

Look to the importance of improving domestic demand. In China we are seeing a deflationary boom as goods become more affordable, as happened in the US in the 19th century.

In the short run, a “hard landing” could see some sales of Asian stocks by international investors. There is some froth in Asia’s older stock markets.

There’s a downside risk of say 10 to 20 per cent in Thailand, for example. But there are always opportunities to be found. In Thailand, in companies oriented towards domestic markets, or food product exporters. A market earnings multiple of 12 times isn’t unreasonable in a world of inflated asset prices.

There is some potential in Singapore companies offering 5 per cent dividend yields. Malaysia offers a well-educated population, stability, and valuations that aren’t overstretched.

As you know, I argued in my book “Tomorrow’s Gold” that one of the best ways to invest in Asia’s growth is through commodities.

In the short run rising commodity prices could be painful, but as additional output is encouraged, we could see oil fall back to perhaps $35 a barrel, and industrial metals retrench perhaps 30 to 40 per cent. At this stage opportunities look best in the soft commodities such as corn, wheat and soya beans.

Political risks

Spring: Are investors ignoring the political risks, with China’s increasing economic power producing greater military power, rising tension with Japan, and intensifying international competition for natural resources?

Faber: Political tensions are not likely to lead to military confrontation.

The Chinese are being very smart with their “soft colonization” of the world through investment and building trade relationships – which will be followed by migration of Chinese businesses and people to other countries.

South America, and especially Africa, are a perfect economic fit with China. They are areas with huge resources, marked by poor government and corruption, uneducated populations, and no manufacturing bases outside South Africa that could compete with China. They are big potential sources of resources such as oil, and foodstuffs.

Japan

Spring: Japan seems condemned to low economic growth, with a structural savings surplus and an aging population. Yet it could be the major beneficiary of China’s growth because of its growing markets and investments there. What do you think?

Faber: Although Japan has had low growth for 13 years, don’t forget that the typical household has enjoyed appreciating wealth. Houses, other assets, consumer goods, are much cheaper. Only bonds are more expensive.

Even with economic growth of only 1 per cent, there is a very favourable environment for financial assets.

Companies have moved much of their manufacturing to China and other low-cost parts of Asia. In time, they will earn the bulk of their profits outside Japan.

Stocks are now relatively appealing. I would rather invest in a country with a good savings rate than in one making no savings at all!

The Japanese stock market capitalization has declined from 50 per cent of the world’s at its peak in 1989 to around 9 per cent now. That makes Japanese stocks attractive, and I expect them to outperform the US over the next five years.

Gold

Spring: The recovery in the gold price in recent years has largely been a dollar phenomenon – I have described the yellow metal, at this stage, as being little more than an anti-dollar play. Do you agree?

Faber: In a world of inflated assets, gold is cheap relative to oil, the S&P500 and other assets. And with interest rates so low, the opportunity cost of holding gold is low. We are at the beginning of a long-term bull market in gold – and silver.

Europe

Spring: Given its over-regulated, over-taxed environment, with public opposition to reforms and increasing political stresses within the European Union, how can Europe hope to compete with Asia and the US?

Faber: The incorporation of the Central and East European nations into the Union will discipline the Western Europeans and force them to change. They’ll either have to work more or work for less pay, or they’ll lose jobs to the new member-states.

The living standards of Europeans are going to decline relative to those of Asians. A worker in Europe won’t be able to continue earning 20 times as much as one in Asia; an engineer five times as much as one in India.

The multinationals like Nestlé will continue to do OK, but worldwide they will face intensifying competition from the emerging “national champions” of China and India, as they have done in the past from those of Japan.

We are likely to see increasing polarization in the world between the rich and the middle classes – the latter have been the prime beneficiaries of asset inflation, especially in real estate. A newly rich class in Asia and Russia will be buying their houses in Belgravia, so there will be pockets of wealth in Europe.

You will also see some movement of wealthier people from Europe to Asia. Here in Northern Thailand you can live for just 20 per cent of what it costs in Europe.

Channel News Asia: China spends US$195 billion to maintain currency peg

China spends US$195 billion to maintain currency peg
Channel News Asia

BEIJING : China's central bank spent 1.61 trillion yuan (195 billion dollars) buying foreign currency last year to maintain the yuan's peg with the dollar, a rise of 40 percent over 2003.

The People's Bank of China also drained 669 billion yuan from the banking system via open market operations last year, more than double the 282 billion yuan used in 2003, Xinhua news agency said citing a central bank report.

"The central bank faces comparatively large pressure in the management of money flow and currency control," it said.

China keeps its currency pegged to the US unit in a very narrow trading bank of about 8.28 yuan, a level which trading partners, especially the United States, say gives Chinese exports an unfair advantage.

The government is not only under political pressure to let its currency appreciate but the central bank is struggling to mop up the extra cash in the system flowing in on speculative bets that it will free up the peg.

China has resisted foreign pressure to loosen the yuan peg but has promised that it will move over time towards a more flexible exchange rate regime.

Balloning trade surpluses and years of foreign investment have flooded the financial system with cash and market players say the central bank has been virtually the only buyer of surplus hard currency such as the dollar.

As a result, China's foreign reserves in 2004 soared to a record 609.9 billion dollars from 403.3 billion dollars in 2003, with the increase equal to the total intervention amount.

Meanwhile, China's 60 billion dollar current account surplus, up 25 billion dollars from 2003, and 61 billion dollars of foreign direct investment (FDI), were additional large sources of foreign exchange, ING economist Tim Condon said in a note.

This still leaves 74 billion dollars (614 billion yuan) of non-FDI capital flows, coincidentally roughly the same amount as the central bank drained from the system through its open market operations.

"This is the monetary management issue that we believe will motivate the authorities to reform their exchange rate regime by introducing greater two-way risk some time in the second quarter of 2005," Condon said.

In attempt to ease pressure on the currency, China will cut its growing balance of payments surplus by permitting more foreign currency to leave the country, state media reported earlier this week. – AFP

*****

Prudent Investor says

While the going gets good...China has been able to finance its currency peg with its large surpluses, plump foreign reserves and 'turning on the crank'...until when?

Bloomberg: Oil Surges, Gasoline Rises to Record as U.S. Refinery Use Falls

Oil Surges, Gasoline Rises to Record as U.S. Refinery Use Falls

March 2 (Bloomberg) -- Crude oil rose above $53 a barrel for the first time in four months and gasoline surged to an all-time high on concern that oil production and refining capacity are not keeping up with rising demand.

Refineries used 89.3 percent of their capacity in the week ended Feb. 25, the lowest since October when companies were performing repairs after a hurricane hit the Gulf of Mexico, the Energy Department report showed. Hedge-fund managers and other large speculators purchased contracts after the report was released at 10:30 a.m. today, bidding prices higher.

``There has been a string of refinery disruptions when we need all of our refineries to be up and running,'' said John Kilduff, senior vice president of energy risk management with Fimat USA in New York. ``There is a speculative element as well. There are too many dollars chasing too few barrels of oil.''

Crude oil for April delivery gained $1.37, or 2.7 percent, to $53.05 a barrel on the New York Mercantile Exchange, the highest close since Oct. 26. Prices are up 45 percent from a year ago.

Gasoline for April delivery rose 8.11 cents, or 5.8 percent, to $1.4838 a gallon in New York, the highest close since the contract began trading in 1984. Prices are 30 percent higher than a year ago.

The average U.S. retail price for regular gasoline rose 2.3 cents to $1.928 a gallon in the week ended Feb. 28, the Energy department reported on Feb. 28. The price is up 12 percent from $1.717 a gallon a year ago.

U.S. stocks declined on concern that the rising energy prices will hurt company profits. The Dow Jones Industrial Average fell 18.03, or 0.2 percent, to 10,811.97. The Standard & Poor's 500 Index was down 0.33 at 1210.08.

Oil company stocks advanced with oil prices. Exxon Mobil Corp., the world's biggest publicly traded oil company, rose 58 cents, or 0.9 percent, to $62.68 in New York Stock Exchange composite trading.

Refinery Disruptions

Lyondell-Citgo Refining LP, a joint venture between Lyondell Chemical Co. and Citgo Petroleum Corp., shut a unit at its Houston crude-oil refinery yesterday, state regulators said.

Lyondell Chemical spokesman David Harpole declined to comment on the report or the refinery's operations. The refinery can process 265,000 barrels of crude oil a day.

A fire on Feb. 26 at BP Plc's Whiting, Indiana, refinery didn't reduce crude-oil processing or fuel production at the company's second-largest plant, a spokesman said.

U.S. Inventories

U.S. crude-oil inventories gained 2.4 million barrels to 299.4 million, the highest since July. The median forecast of 12 analysts surveyed by Bloomberg was for a rise of 1 million barrels. Gasoline stockpiles climbed 973,000 barrels to 224.5 million. Analysts expected an increase of 1.1 million barrels.

Inventories of distillate fuel, a category that includes heating oil and diesel, fell 1.7 million barrels to 110 million, the report showed. Analysts expected a 1.2 million barrel decline.

``The crude number was slightly bigger than expected while the gasoline and distillate numbers were right on the money,'' said Ed Silliere, vice president of risk management at Energy Merchant LLC in New York. ``The most important thing about the numbers is that they are out of the way, which is allowing the funds to come in and buy crude with both hands.''

Speculators, including investment funds, last week had their biggest bet on higher oil prices in eight months, according to the Commodity Futures Trading Commission. So-called net-longs in New York soared by 22,548 contracts to 54,176 in the week ended Feb. 22, the commission reported. The net-long positions peaked at 82,451 contracts in March 2004.

Funds

Increased fund buying may boost commodity prices, Kevin Norrish, head of commodities research at Barclays Capital in London, said in a report yesterday. Funds are reaping the higher returns of investing in commodities. The Reuters-CRB index rose 11 percent last year compared with 9 percent for the Standard & Poor's 500 Index. Oil in New York gained 34 percent last year.

Prearranged agreements to buy or sell futures, known as stops, were clustered at $52.50 a barrel, Silliere said. We are now ``looking at the record $55.67 and the funds will then aim at $60,'' he said.

Oil surged to a record $55.67 a barrel in New York on Oct. 25 because of high global demand, particularly from China, and the threat of disruptions to oil shipments from Iraq, Russia and Nigeria.

Restraining Demand

``Oil prices will likely stay in the $40- to $50-per-barrel range and may have to move higher still to restrain demand,'' said James Buckee, chief executive of Calgary-based Talisman Energy Inc. The company produces oil and gas in North America, Asia, the U.K. and Middle East.

Prices surged in 1974 after an oil embargo that followed the Arab-Israeli war and from 1979 through 1981 after Iran cut oil exports. The average cost of oil used by U.S. refiners was $35.24 a barrel in 1981, according to the Energy Department, or $75.71 in today's dollars.

The Organization of Petroleum Exporting Countries, which pumps about 40 percent of the world's oil, is concerned that rising inventories will lead to a decline in prices during the second quarter of the year. OPEC will discuss production targets at a meeting in Isfahan, Iran, on March 16.

The 11-member group's president, Sheikh Ahmad Fahd al-Ahmad al-Sabah, who is also the Kuwaiti oil minister, said in January OPEC may be willing to let global inventories get large enough to cover 56 days of demand before it cuts supplies. Al-Sabah said inventories covered 52 days of demand on Jan. 30.

``The higher-than-expected gain in crude oil inventories ensures that OPEC won't be increasing production when they meet,'' said Phil Flynn, vice president of risk management with Alaron Trading Corp. in Chicago.

In London, the April Brent crude-oil futures contract rose $1.11, or 2.2 percent, to $51.22 a barrel on the International Petroleum Exchange, the highest close since Oct. 26.

****
Prudent Investor says...

Notice that crude oil has been climbing in spite of increased stockpiles or supplies. On the contrary, there has been an intensive build up of net long positions. Put differently the market sees oil prices climbing either through speculations "too many money chasing oil prices" or anticipations that current supplies will not sufficient to meet demand. For me, this is just part of the unfolding rendition of the 5 year old trend, which is unlikely to be broken given current conditions.

Yahoo News: Iran, Russia sign key nuclear fuel deal

Iran, Russia sign key nuclear fuel deal

February 27
By Paul Hughes

TEHRAN (Reuters) - Russia and Iran (news - web sites) signed a nuclear fuel supply deal long opposed by Washington on Sunday which will pave the way for the Islamic state to start up its first atomic power plant next year, state media reported.

The agreement, signed by the two countries' nuclear energy chiefs at the Bushehr atomic reactor in southern Iran, came as Tehran faced heightened pressure from the United States, which accuses it of secretly developing nuclear weapons.

Iran denies the charge and has received strong backing from Moscow, which is keen to extend its commercial interest in Iran's drive to produce electricity from nuclear reactors.

"This is a very important incident in the ties between the two countries and in the near future a number of Russian experts will be sent to Bushehr to equip the power station," Iranian state television quoted Alexander Rumyantsev, head of Russia's Federal Atomic Energy Agency, as saying.

A key part of the agreement is aimed at addressing U.S. concerns, obliging Tehran to repatriate all spent nuclear fuel to Russia.

Moscow hopes this will allay U.S. worries that Tehran may use the spent fuel, which could be reprocessed to make bomb-grade material, to develop arms.

FIRST BATCH OF FUEL READY TO GO

Details on the timing for the supply and repatriation of fuel were not disclosed. Iranian officials said on Saturday disagreements over when Russia would send the first shipment of fuel to Iran had delayed the deal's signing by 24 hours.

Rumyantsev said the first batch of enriched uranium for Bushehr, which is surrounded by anti-aircraft defenses against possible attack, was ready to go.

Gholamreza Aghazdeh, head of Iran's Atomic Energy Organization, said Bushehr would be ready to go on-line some time after March 2006.

"Based on the agreement, the installation and assembly of the power station's equipment will finish in the next 10 months and six months after that ... the official launching of the power station starts," television quoted him as saying.

When operational Bushehr will generate 1,000 MW of electricity. Initiated before Iran's 1979 Islamic revolution and badly damaged during the 1980-88 Iran-Iraq (news - web sites) war, the project was later revived with Russian help in the late 1980s and has cost about $800 million.

Iran has announced plans to build several more power plants, generating 7,000 MW from nuclear power by 2021. Russia hopes to claim a significant share of this new business.

The Bushehr power station has aroused less concern in the West than Iran's plans to produce its own nuclear fuel for future reactors using uranium mined, processed and enriched inside the country.

The European Union (news - web sites) and United States want Iran to scrap its uranium enrichment plans entirely. Iran has refused but has suspended enrichment while it tries to reach a negotiated settlement with the European Union.

(Additional reporting by Sonia Oxley in Moscow)

India Times: Commodities trading spreads into 400 cities

Commodities trading spreads into 400 cities

TIMES NEWS NETWORK[ WEDNESDAY, FEBRUARY 23, 2005 12:23:37 AM]

Equities could be the obvious road to wealth, but commodities are now beginning to capture the punter’s imagination too. From zero volumes a year ago, the combined trading volume achieved on the national commodity exchange platform has reached Rs 260,659 crore in ‘04.

Futures trading has landed in over 400 cities in India, covering 1,000 brokers through 5,000 terminals.

The budget can give it a further boost by straightening regulations, promising legal changes, and allowing institutional investors to buy commodity contracts (which are considered securities by the Securities Contract Regulation Act).

How big is the market? Already, the futures market for gold and silver is about four times and 40 times, that of spot markets respectively. With imports of over 700 tonnes of gold every year and around 10,000-15,000 tonnes of gold stocked in the country, the futures market is definitely raring to grow. In other countries like America, futures volumes are as high as 72.9 and 55 (‘01) times the gold and silver spot markets respectively.

India is in a hurry. More than a dozen Indian banks have already taken up stake in various exchanges. Jignesh Shah, MD of MCX, which is promoted by a consortium of 10 banks says, “banks and other financial institutions like mutual funds should be allowed to participate in trading.”

Mutual fund participation on commodity exchanges is also likely, considering the regulators are open to the idea. NCDEX CEO, P Ravikumar says mutual funds will be able to diversify investors’ portfolios and ensure higher returns at limited risks.

“The biggest beneficiary of derivatives trading could be the agricultural community”, says Kailash Gupta, MD, NCME — India’s first national commodity exchange. The government support price, quota system and intervention in procurement at administered prices has distorted the market, he says.

Exchanges agree that a major reform in this segment would be the introduction of options and index-based trading, which is currently not permitted by the Forward Contract Regulation Act.

Already the FMC has recommended a modification of section 19 of the FCRA Act to allow options. FMC is also favouring the introduction of exotic commodities like weather and emissions.

Brokers, who are largely responsible for getting liquidity, have sought a modification in section 194-H of the Income Tax Act, which stipulates commission and brokerage payments. Exchanges like the MCX, argue that commodities futures trading should be viewed at par with the securities business, so that the commodities brokers are not discriminated against.

The treatment of “speculative income” is another contentious issue. Exchanges say the government must recognise commodities trading as a “line of business” and not as pure speculation, as considered under section 43(5) of the Income Tax Act.

Industry expectation is that the negotiability status of the warehouse receipt could also find a mention in the budget. A proper warehousing mechanism supported by a receipt system could boost the trade finance system.

The industry also demands rationalisation of the stamp duty. Though it is a state subject, the fact remains that due to the applicability of different stamp duties, the cost of transactions varies tremendously.

The much talked-about VAT will also have an impact on the sector, says NCDEX chief economist Madan Sabanabis. The introduction of VAT would help clear quite a few issues relating to sales tax.

As often said, futures are a zero sum game. So there have to be losers. Regional exchanges have taken a backseat, despite having domain knowledge. Rapidly decaying volumes, dwindling membership and lack of professionalism are creeping into the system.

For example, the once-flourishing East India Jute and Hessian Exchange is a shadow of its former glory, with little liquidity in their Hessian contracts.

All exchanges are unanimous that a strong regulator is the need of the hour.

Financial Times Editorial: Philippine fiddling

Philippine fiddling
Published: February 24 2005 02:00 | Last updated: February 24 2005 02:00
Financial Times

It is not every day that government leaders warn that their countries are heading for an Argentina-style fiscal crisis. Gloria Macapagal Arroyo, the Philippines' president, has done so twice in six months, most recently last week, in an effort to goad lawmakers into acting to put its public finances in order. But is anybody listening?

Not, apparently, members of the national Congress, who are holding up Mrs Macapagal's proposals for badly needed tax reforms - yet who reacted indignantly when Moody's rating agency sharply downgraded the country's sovereign debt this month. Nor is the stock market, which remains strong. Nor, so far, do foreign investors seem any less tempted by the relatively high yields on Filipino issues.

The president's alarmism may seem overdone. Unlike Argentina when it hit trouble, the Philippines has a floating currency and less of its debt is short term. It has also sought to boost revenue by raising alcohol and tobacco taxes and beefing up tax collection.

Yet those measures have, at best, only slowed the sharp deterioration in the country's public finances since Asia's 1997 financial crisis. Lax fiscal policies, lower tariff revenues and corruption have cut its tax take to only 12 per cent of gross domestic product. Public debt, including guarantees to state companies, is about 130 per cent of GDP, while servicing costs may absorb a third of this year's budget.

The country is far from achieving a primary budget surplus large enough to stabilise debt levels - a goal Mrs Macapagal has set for 2010. Congress has put even that leisurely timetable in doubt by passing only two of eight emergency fiscal measures she had vowed to enact by last autumn.

The economy's outwardly robust performance has fuelled political complacency. It grew more than 6 per cent last year and the current account is in surplus. However, this was due largely to remittances and call-centre earnings. Manufacturing exports to China have trailed those of the rest of Asia, and the foreign direct investment needed to increase them remains scarce.

Those structural weaknesses increase the Philippines' vulnerability to external shocks, such as a steep rise in US interest rates, a sharp fall in the dollar or higher oil prices. That makes reforms essential well before campaigning starts for the 2007 elections.

Mrs Macapagal understands the urgency. However, she has too often vacillated in public and yielded too readily to opposition from vested interests. Her re-election last May handed her valuable political capital. She should now spend it by staking her future on ramming her fiscal programme through Congress.

Congress's dawdling is as hard to justify as foreign investors' willingness to indulge it by snapping up public debt. Although some investors sense a crisis in the making, they reason they can get out in time. The longer Filipino politicians procrastinate, the more likely that is to prove a delusion.

***

Prudent Investor says...

While the current flow of regional economic developments tend to favor the recovery of the Philippines, complacency by the country's political leaders are likely to cause a setback on its recent gains.

The deep-seated problem with most politicians of all nations are that they tend to be short sighted and reactive instead of being pro-active and work for the long term interests of their constituents.

Political impediments would likely cause short term volatilities, until the domestic leaders realize that the 'crisis' is staring them on their face. As for the Philippine President, hasn't she learned from Aesop's fable "The Boy Who Cried Wolf"?

Financial Times Editorial: Dollar scare reveals fragile support

Dollar scare reveals fragile support
Published: February 24 2005 02:00 | Last updated: February 24 2005 02:00
Financial Times

Crisis over? Not really. For sure, the market overreacted to reports that the Bank of Korea wanted to reduce the share of dollars in its portfolio. What the Koreans actually said was that they want to diversify out of low-yielding US Treasuries into higher yielding securities, which could include riskier US assets as well as non-US government bonds. And they intend to do so by diversifying the flow of reserves, not the $200bn (£105bn) stock. But while Tuesday's sell-off was founded on error, it nonetheless exposed the underlying weakness of the US currency. If the mighty dollar can be rocked by a single paragraph in a report to the Korean parliament something is amiss.

That something is the dependence of the dollar on a handful of Asian central banks, which between them control $2,400bn reserves. These reserves are already large relative to the size of the Asian economies, and getting bigger by the day. As they grow so does the incentive to guard against capital loss from further dollar depreciation.

Very obviously, if all the Asian central banks were to start selling their stock of dollars the US currency would plunge. But such a generalised rout would also force the Asian currencies to appreciate against the dollar. If either Japan or China were to sell dollars, the effect would probably be the same. However, the first mid-sized country to bail out of the dollar might be able to get a good price for its assets and maintain its bilateral exchange rate, encouraging others to follow.

But even if Asian central banks do not sell their stock of dollars, the US currency is not safe. With private appetite for US assets inadequate and volatile, the US relies on continued purchases by central banks to fund its current account deficit and acquisition of foreign assets by US residents. If their appetite dims, unless private flows soar, the dollar will still fall (and keep on doing so until the change in the relative price of imports and exports narrows the current account deficit to a sustainable level.)

Diversification might not succeed in its objective of minimising capital loss. It all depends on what currency one diversifies into. The euro is no longer obviously cheap. If and when Asia revalues the euro could even fall against the dollar. In this case the capital loss would be greater on euro holdings than on dollars. Asian countries need more Asian assets. Again, in aggregate they cannot obtain them without forcing up their currencies, though individual countries acting alone could do so.

In the end the only sure way to limit capital loss is to stop intervening and allow currencies to rise. The yen and Korean won have appreciated significantly since 2002. But while others remain pegged, such appreciation disrupts intra-Asian exchange rates and trade. The optimal solution is a co-ordinated revaluation, led by China. But while the Chinese economy thrives and inflation stays under control, Beijing has little incentive to agree.

****
Prudent Investor says,

As editorial says, the recent gains of US dollar stands on tenuous grounds such that unconfirmed reports of Central Banks 'diversifying' away from the US dollar could provoke a dash to the exit doors. Currency volatility and the risk of a dollar run remains entrenched for as long as the structural imbalances exists. It surely does look as if Asian Currencies are the best bet in today's largely dicey environment.

Bloomberg Analyst William Pesek Jr.: Is Kafka Running Korea's Currency Policy?

Is Kafka Running Korea's Currency Policy?
by William Pesek Jr.

Feb. 25 (Bloomberg) -- It's THE question in global currency markets: What force of nature prompted South Korea suddenly to scrap plans to sell dollars?

On Tuesday, the dollar was plunging amid a comment by Asia's No. 3 economy that it would diversify foreign-exchange reserves into other currencies. By Wednesday, Korea's central bank said it had no such plan, leaving traders scratching their heads.

Dumping dollars would be a logical move for the world's fourth-largest holder of reserves after Japan, China and Taiwan. Korea, after all, is going against the tide in Asia, letting its currency rise. It no longer needs so many U.S. Treasuries, nor does it want to sustain huge losses as the dollar falls.

Korea's hasty and counterintuitive about-face makes you wonder if U.S. Treasury Secretary John Snow himself made a call to Seoul. It's hardly in the U.S.'s interest to see Korea pull the plug on Treasuries. It could prompt other Asian central banks to do the same, driving up U.S. debt yields.

Or maybe it was Japan, the biggest foreign holder of U.S. Treasuries, pressuring Korea. Shortly after Korea's denial, Japan's vice finance minister for international affairs, Hiroshi Watanabe, referred to ``wild'' moves in the yen and said Tokyo ``will act when necessary'' if its currency rises too rapidly. Asia hardly wants a resumption of Japan's yen-selling campaign.

Franz in Charge?

Conspiracy theories aside, markets could be excused for wondering if Franz Kafka is roaming the halls of Korea's Ministry of Finance -- and whether the Czech writer is running its currency policies.

Kafka, of course, is famed for tales possessing bizarre, illogical and nightmarishly complex qualities. And there are some rather Kafkaesque aspects to recent events, not only in Seoul but also on currency policies throughout Asia.

Korea's retreat from dumping dollars shows the bind central banks are in these days. This region's mercantilist tendencies have manifested themselves in exchange-rate management efforts the likes of which have rarely been seen before.

``Bretton Woods II'' economists have dubbed the system that unofficially replaced the original post-World War II currency regime, which was based on a gold standard that collapsed in 1973. In gold's place, many nations adopted the U.S. dollar as an anchor, formally or informally pegging their currencies to it. We may be seeing the demise of this new system, with Korea in the vanguard.

`Risk Is Growing'

``The risk of a disorderly unraveling of Bretton Woods II -- a sharp correction of the U.S. dollar and of the U.S. bond market, a surge in U.S. long-term interest rates, and a sharp fall in the price of a wide variety of risky assets such as equities, housing, high-yield bonds and emerging-market sovereign debt -- is growing,'' Nouriel Roubini of New York University's Stern School of Business and Brad Setser of Oxford University said in a research paper this month.

As their findings suggest, the current system is looking more and more like a huge pyramid scheme. As long as Asian central banks stick together and buy dollar-denominated securities, things are fine. Once they start selling, virtually everyone loses -- central banks experience capital losses and economies become less competitive. Central banks have an interest in keeping the game going and hoping others do, too.

Yet this week's events underline ``how vulnerable the dollar is to negative news,'' says Carl Weinberg, chief global economist at High Frequency Economics, referring to the dollar's biggest drop against the euro in six months. The news, Weinberg says, ``unwrapped a lot of tightly-wrapped traders who were spring- loaded to sell greenbacks on adverse news.''

No Altruism

Sure, Korea's Treasuries holdings are much smaller than China's, Japan's or Taiwan's, but its $200 billion of reserves may be at the forefront of trends to trim dollar holdings.

Central banks here don't buy U.S. debt out of altruism; it's to hold down currencies to boost growth. Monetary officials find themselves in the unenviable position of having to buy lots of dollar assets they know are likely to lose value over time.

This may be as good a time as any for the region's monetary authorities to avoid losses ahead of a possible surge in U.S. debt yields. Investors won't ignore the record U.S. current-account and budget deficits forever.

Yet it's a complex issue for Asian economies, which find themselves in a ``damned-if-you-do, damned-if-you-don't'' situation.

Devalue vs Reform

Korea seems to have chosen to let the won rise, and it's a good thing. Asia spends inordinate amounts of time weakening currencies, worried about growth a quarter or two out. That distracts from repairing structural problems. It's always easier to devalue your way to growth than to reform financial systems, improve corporate governance and promote entrepreneurship.

Hopefully the rest of Asia will follow Korea's example. Rising currencies are a sign of confidence in an economy, not a problem. They lower bond yields and boost stock prices. Capital a hard money brings in can be more important than increased trade attracted by a softer one.

The Kafkaesque state of the global financial system may leave Asia little choice in the matter.

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Prudent Investor says

Should Mr. Pesek's wish come true, it would mean a BIG "OUCH" for the US dollar and its economy.