By Martin Hutchinson
After pretending an unwonted firmness for a few weeks, the central banks in both Britain and the United States caved last week, accepting financial-sector bailouts and, in the US Federal Reserve's case, lowering interest rates. Moral hazard has thus been made immoral certainty; financial-market participants who indulge in grossly speculative activity can be "highly confident" (in the words of the old Drexel Burnham commitment letters) that they will be bailed out by the taxpayer. Rarely has there been such an obvious subsidy of the overpaid by the beleaguered. It raises the question: What if anything is the point of central banks in the new world we have entered?
With the Northern Rock debacle, Britain suffered its first run on a major bank since the Overend, Gurney collapse of 1866. The Bank of England initially took the same principled (if, in that case, mistaken) line it took over Barings in 1995. As queues of withdrawing depositors spread over British TV screens, however, it was quickly overruled by Chancellor of the Exchequer Alistair Darling.
Darling, not content with rescuing just one bank, grandly announced that all failing banks would have their deposits guaranteed by the taxpayer, thus flushing 313 years of bank-supervision policy down the pan. (It will be remembered that in 1720 the Sword Blade Bank, bankers to the South Sea Company, was allowed to fail, since Robert Walpole, unlike his distant successors, had a shrewd grasp of the "moral hazard" concept.) By the middle of the week the Bank of England was offering to lend money against dodgy home-mortgage portfolios.
Meanwhile in the United States, the Fed cut interest rates, thus causing a massive Wall Street stock surge, undermining the value of the dollar, sending gold up to US$740 per ounce and doing very little to help the home-mortgage borrower, since long-term rates rose almost as much as he had cut short-term rates - unlike Fed chairman Ben Bernanke, the bond market fears inflation.
Then their regulators allowed the over-leveraged and accounting-inept housing agencies Fannie Mae and Freddie Mac (the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp) to buy another $20 billion of mortgage-backed securities, to the further ultimate risk of the taxpayer - Freddie promptly snapped up CIT's US$4 billion portfolio of securitized subprime junk, precisely the rubbish that puts its solvency in most jeopardy. Finally Ben Bernanke appeared before Congress and supported legislation allowing Fannie Mae and Freddie Mac "temporarily" to guarantee "jumbo" mortgages above the current statutory limit of $417,000.
The idea that large mortgages should be in effect government-guaranteed beggars belief in principle. It also supports the overbuilt high end of the housing market, bailing out borrowers who, being richer, should be more able to bear the risk of lower house prices and higher interest rates than their poorer countrymen.
It is a subsidy from the middle class to the rich, supporting the least productive, most energy-inefficient and least deserving sector of the US economy. John Edwards, he of the $400 haircuts and the 28,000-square-foot home, is no doubt rejoicing at the news.
This is all very depressing. When King Philip II of Spain sat in the gloomy Escorial, counting his gold and silver hoard from the Americas, he doubtless pulled at his beard in puzzlement at where all the damn inflation was coming from. One rather hoped that modern central bankers had gotten beyond Philip's limited monetary understanding. However, it appears that in times of crisis, when badgered by politicians, they revert to a 16th-century world view. It's as if after the Chernobyl nuclear disaster scientists had resorted to alchemy in the hope of preventing it happening again.
It is now clear that all the intellectual advances in central banking of the past 300 years have disappeared. Gone with the wind are the concept of "moral hazard", the idea that central banks should be independent of political control, the idea that lowering interest rates might cause inflation and the knowledge that widespread deposit guarantees and bank bailouts impose huge long-run costs on taxpayers and the economy. In 1720, when the financial world was young and innocent, this would have been forgivable; today as then, it is likely to bring economic chaos in its wake.
Once the long-run costs of bad policy become all too clear, policymakers will make changes, to ensure that they are not repeated. It's thus worth pondering what changes one might recommend.
Regrettably, one possible change, a reversion to a gold standard, is not immediately practicable. Gold supplies can be increased by new discoveries by at most 1% per annum or so. Since world population is currently increasing at about that rate, any significant economic growth, requiring an increased monetary base, would become impossibly deflationary.
Deflation, as Bernanke helpfully but irrelevantly pointed out in 2002, is more dangerous than inflation, because the ability to store money in bullion form without interest can cause the working money supply to collapse (if you can get a safe zero return on cash with 100% liquidity, and prices are dropping 3% a year, why ever would you invest in anything else?).
The gold standard worked fine in the 19th century, with the help of large gold discoveries in California, the Transvaal and the Yukon, but once world population growth started to accelerate after 1900, it became impossibly deflationary, as was discovered in 1925-31. Reversion to a gold standard is an admirable long-term aim, but it had better be deferred until after the magic date around 2050 when the world's excessive population stops increasing and begins to decline.
Theoretically, it should not be impossible under fiat money to run a central bank that does a good job. After leaving the gold standard in 1931, Montagu Norman did an excellent job at the Bank of England, in an exceptionally difficult period. In 1931-39 his policy provided stable prices and facilitated in Britain an economic performance that relative to its major competitors was better than any since Lord Liverpool's time.
In the United States, Paul Volcker in 1979-87 did a brave and admirable job in spite of the Fed being an exceptionally politicized institution by central-banking standards (his successor Alan Greenspan when appointed appeared likely to be as brave and successful, but wasn't). Bundesbank presidents from Karl Blessing through Karl Otto Pohl to Helmut Schlesinger made the Deutschmark the most trusted currency in Europe during the half-century of its independent existence.
These three successes were achieved with very different legal and financial structures. They shared only one common feature: exceptional independence from political pressure. In Norman's case his prestige - he was governor for 24 years - was huge, and in 1931-39 his political counterpart Neville Chamberlain was both capable and sympathetic to his policies.
In Volcker's case, the alternative policy of sloppy inflationism had been wholly discredited by failure. In the Bundesbank's case, the institutional structure worked well; its strength and independence had been set up carefully by chancellor Konrad Adenauer, himself no mean student of monetary discipline.
Independence is not merely statutory; it must be accepted by the political and banking system. In Britain, the incoming Labour government made the Bank of England nominally independent in 1997, but emasculated it in the following year by removing its banking-supervision powers and transferring them to the Financial Services Authority quango.
Why, given its lack of responsibility for Northern Rock's operations, the bank should be expected to bail it out is an interesting question; the system is a horrid mess, which doesn't represent true independence. A free marketer might suggest privatizing the Bank of England and returning it to its pre-1946 corporate form, but in today's world that would doubtless result only in its being bought by Dubai, China or Gazprom, not an improvement.
The US had two perfectly good central banks in the two Banks of the United States, but on both occasions populist pressure led to their being dissolved. The Fed is a messy compromise, typical of progressive legislation in that it has been given several internally contradictory mandates, and is constrained by an altogether excessive level of political control.
While the Bundesbank worked fine, the European Central Bank appears to work rather less well. In theory, it should be exceptionally independent, since the various political factions pulling at it should be impossible to unite across Europe's strong national borders. In practice, it appears to be frightened of stirring up political opposition, not surprising since politicians have spent the past decade blaming all economic problems on the creation of the euro, which it manages.
Its conflicts are likely to become sharper in the future. The euro in the next few years will be perpetually overvalued against the rest of the world's currencies, so deflation in the Eurozone is almost inevitable. It appears impossible to create a monetary policy that avoids harsh deflation in some European countries such as Italy without causing idiotic housing booms in other countries such as Spain and Ireland.
Logically, we have now arrived at a position where no central bank can be trusted against the twin temptations of the gigantic financial-services industry and the gigantic public sector. On the other hand, unraveling a century of "progress" and returning to a pure gold standard might be economically damaging as well as politically impossible.
Setting up a supervisory committee of top economists is also unlikely to help much; a feature of the US monetary expansion and bubble creation since 1995 was the support for Greenspan's folly by the world's leading monetary economist, the late Milton Friedman. The only solution is to find another Paul Volcker or Montagu Norman, but those don't grow on trees.
Rather than try to adapt a fiat money system to remove its deficiencies, it may be simpler to adapt a gold standard to remove its excessive deflation. The best way to do this might be that dusty staple of 1890s politics, bimetallism. If gold and silver were both coined, at a fixed ratio between them, new discoveries of both would increase the world's money supply, giving it more flexibility than a pure gold standard (also, silver supplies could presumably be increased more rapidly than gold, as the metal is more plentiful in the Earth's crust). A world monetary conference could be held once a decade to make modest adjustments to the coinage ratio between the two metals or, if necessary, to debase the coinage slightly.
Such a mechanism would give just sufficient flexibility to avoid excessive deflation. More important, it would provide an automatic check on central-bank money creation, thereby preventing asset and stock-market bubbles of more than modest size and duration. If such a system had been in effect in the late 1990s, for example, a money flow out of the US at the time of the Long Term Capital Management crisis would have brought the bubble to a halt 18 months earlier than it did, even if such a flow had not occurred earlier, at the time of Greenspan's "irrational exuberance" speech. After 2001, a bimetallic standard would have prevented Greenspan from lowering interest rates so far, thus preventing the housing bubble, while the capital inflow in 2001-02, at the time of the strong dollar, would have avoided deflation.
A new monetary system will be demanded in the next few years, after the excessive inflation and moral hazard of the present system have caused the inevitable major crash. At that point, a bimetallic quasi-gold standard should be the alternative to work for against the statist and inflationary nostrums that will doubtless be proposed.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com. Copyright 2005-07 David W Tice & Associates.)
Thursday, September 27, 2007
Inflation eats into China's mooncakes
By Antoaneta Bezlova
BEIJING - The beloved national tradition of nibbling sweet pastry mooncakes and admiring the fullness of the harvest moon in the Mid-Autumn, or Moon, Festival has been hit by China's runaway inflation, forcing vendors to opt for frugal variations of the rich treat.
The round pastries eaten and given away as gifts during the lunar festival, which this year falls on Wednesday, have fallen prey to inflationary pressures along with all other food products. Annual inflation in China hit an 11-year high of 6.5% in August, raising fears of rapid erosion of living standards and potential social unrest.
Producers of mooncakes have found themselves in a bind. As China's food prices have soared, the cost of raw materials to produce the cakes has increased by 15-30% too. But worried that surging prices could touch off unrest across the country, the government has issued stern edicts warning against price gouging and dictated that the prices of the traditional treat should be kept stable.
Once splurging on luxurious packaging of wood, silk and even gold to entice their customers to choose from a tantalizing variety of mooncakes, vendors now have to reduce production costs by settling for plain and down-to-earth packaging.
Many producers, including such established brands as Holliland and Guixiangcun, have joined a government-supported initiative to revive the traditional spirit of the Mid-Autumn Festival by packaging their cakes in environment-friendly recycled paper.
Others, still hoping to offset the higher prices of manufacturing, have opted for pairing the cakes with health supplements, trumpeting a new, "green" way of celebrating the centuries-old tradition.
The Mid-Autumn Festival is believed to commemorate a Chinese uprising against the Mongol rulers of the Yuan Dynasty (1271-1368). Plotting to overthrow the Mongol government, Chinese conspirators exchanged secret messages about the day of the rebellion written on slips of paper and hidden inside mooncakes. The uprising, which brought down the Yuan Dynasty, took place on the 15th day of the eight month of the lunar calendar.
Long void of its rebellious meaning, the Mid-Autumn Festival has come to celebrate the end of the summer harvest season when the moon is closest to the Earth. Families would gather together to enjoy the beauty of the full harvest moon and snack on little cakes with a round shape that imitates its fullness.
The small pastries with a thick, sticky filling either of lotus seed or red bean paste are so rich in taste that tradition dictates they have to be cut into slivers and consumed with sips of tea.
This accompaniment has inspired several companies to include brands of famous Chinese tea in gift packs for the festival. A packet of aged Pu'er tea - China's mystery tea famous for its health-giving benefits (see The bubble bursts for Pu'er tea, Asia Times Online, June 26 - added to a simply adorned box of mooncakes has become the hot trend of this year's Mid-Autumn Festival, according to several vendors.
"It is only natural that as people become more concerned about their health and well-being, they prefer healthful selections of mooncakes rather than any of the modern versions that are so rich and fattening," said Zhu Yanhua, a saleswoman for Holliland mooncakes staffing a stall in front of supermarket in suburban Beijing.
Recent years have witnessed the rise and fall of fashions in trendy new cakes made in every imaginable style: ice-cream mooncakes marketed and sold weeks ahead of the festival by ice-cream giant Haagen-Dazs, chocolate mooncakes produced by Belgian chocolatiers, jelly mooncakes and even foie gras and champagne mooncakes.
But the explosion of taste varieties is only part of the mooncake-transformation story. Purists have deplored what they call the fashion of waste and decadence, which has dictated ever more elaborate and pricey packaging year by year.
The Chinese press has reported about resourceful producers in the central city of Zhengzhou who came up with mooncakes made of silver and adorned with 56 precious stones selling at a price of 6,900 yuan (US$920).
Not to be outdone, their counterparts in the northern city of Changchun produced a 1,800-yuan mooncakes box containing also a golf club, while mooncake makers in Yunnan province have also managed to pack a digital camera in with the traditional pastries.
"Such travesties have caused the degeneration of mooncakes as a symbol of family reunion during the harvest season," argued Beijing Youth Daily columnist Pang Hongqi. "These are no longer family mooncakes but by-products of a vulgar gift-bearing culture".
Announcing their price-cutting campaign to sell mooncakes in simple, recycled paper rather than lavish wrappings and boxes, government officials have tried to present the current inflation as a crisis with a silver lining. The packaging drive will help spread the concepts of frugality, rationality and health, Liu Jian, a marketing official with the Beijing municipal bureau of commerce, told the Xinhua News Agency.
"Luxurious packages not only distort the meaning of mooncakes but are necessarily wasteful," he was quoted as saying.
(Inter Press Service)
BEIJING - The beloved national tradition of nibbling sweet pastry mooncakes and admiring the fullness of the harvest moon in the Mid-Autumn, or Moon, Festival has been hit by China's runaway inflation, forcing vendors to opt for frugal variations of the rich treat.
The round pastries eaten and given away as gifts during the lunar festival, which this year falls on Wednesday, have fallen prey to inflationary pressures along with all other food products. Annual inflation in China hit an 11-year high of 6.5% in August, raising fears of rapid erosion of living standards and potential social unrest.
Producers of mooncakes have found themselves in a bind. As China's food prices have soared, the cost of raw materials to produce the cakes has increased by 15-30% too. But worried that surging prices could touch off unrest across the country, the government has issued stern edicts warning against price gouging and dictated that the prices of the traditional treat should be kept stable.
Once splurging on luxurious packaging of wood, silk and even gold to entice their customers to choose from a tantalizing variety of mooncakes, vendors now have to reduce production costs by settling for plain and down-to-earth packaging.
Many producers, including such established brands as Holliland and Guixiangcun, have joined a government-supported initiative to revive the traditional spirit of the Mid-Autumn Festival by packaging their cakes in environment-friendly recycled paper.
Others, still hoping to offset the higher prices of manufacturing, have opted for pairing the cakes with health supplements, trumpeting a new, "green" way of celebrating the centuries-old tradition.
The Mid-Autumn Festival is believed to commemorate a Chinese uprising against the Mongol rulers of the Yuan Dynasty (1271-1368). Plotting to overthrow the Mongol government, Chinese conspirators exchanged secret messages about the day of the rebellion written on slips of paper and hidden inside mooncakes. The uprising, which brought down the Yuan Dynasty, took place on the 15th day of the eight month of the lunar calendar.
Long void of its rebellious meaning, the Mid-Autumn Festival has come to celebrate the end of the summer harvest season when the moon is closest to the Earth. Families would gather together to enjoy the beauty of the full harvest moon and snack on little cakes with a round shape that imitates its fullness.
The small pastries with a thick, sticky filling either of lotus seed or red bean paste are so rich in taste that tradition dictates they have to be cut into slivers and consumed with sips of tea.
This accompaniment has inspired several companies to include brands of famous Chinese tea in gift packs for the festival. A packet of aged Pu'er tea - China's mystery tea famous for its health-giving benefits (see The bubble bursts for Pu'er tea, Asia Times Online, June 26 - added to a simply adorned box of mooncakes has become the hot trend of this year's Mid-Autumn Festival, according to several vendors.
"It is only natural that as people become more concerned about their health and well-being, they prefer healthful selections of mooncakes rather than any of the modern versions that are so rich and fattening," said Zhu Yanhua, a saleswoman for Holliland mooncakes staffing a stall in front of supermarket in suburban Beijing.
Recent years have witnessed the rise and fall of fashions in trendy new cakes made in every imaginable style: ice-cream mooncakes marketed and sold weeks ahead of the festival by ice-cream giant Haagen-Dazs, chocolate mooncakes produced by Belgian chocolatiers, jelly mooncakes and even foie gras and champagne mooncakes.
But the explosion of taste varieties is only part of the mooncake-transformation story. Purists have deplored what they call the fashion of waste and decadence, which has dictated ever more elaborate and pricey packaging year by year.
The Chinese press has reported about resourceful producers in the central city of Zhengzhou who came up with mooncakes made of silver and adorned with 56 precious stones selling at a price of 6,900 yuan (US$920).
Not to be outdone, their counterparts in the northern city of Changchun produced a 1,800-yuan mooncakes box containing also a golf club, while mooncake makers in Yunnan province have also managed to pack a digital camera in with the traditional pastries.
"Such travesties have caused the degeneration of mooncakes as a symbol of family reunion during the harvest season," argued Beijing Youth Daily columnist Pang Hongqi. "These are no longer family mooncakes but by-products of a vulgar gift-bearing culture".
Announcing their price-cutting campaign to sell mooncakes in simple, recycled paper rather than lavish wrappings and boxes, government officials have tried to present the current inflation as a crisis with a silver lining. The packaging drive will help spread the concepts of frugality, rationality and health, Liu Jian, a marketing official with the Beijing municipal bureau of commerce, told the Xinhua News Agency.
"Luxurious packages not only distort the meaning of mooncakes but are necessarily wasteful," he was quoted as saying.
(Inter Press Service)
Indonesia's richest man loses his mine
By Bill Guerin
JAKARTA - Indonesia's richest man last week lost a drawn-out legal tussle over his 40% ownership claim to the country's second-largest coal-mining company, PT Adaro Indonesia (Adaro). This comes crucially at a time when the energy commodity is enjoying its biggest boom ever. The decision was made by Singapore's High Court, bypassing Indonesia's notoriously politically pliable judiciary, though paper and plantation tycoon Sukanto Tanoto is weighing his appeal options.
The legal saga over the highly coveted mine's ownership is as complicated as it is contentious among the competing international claimants to the assets, which includes the world's biggest exporter of power-station-grade coal. Tanoto claimed that PT Dianlia Setyamukti (Dianlia), owned by another tycoon, Edwin Soeryadjaya, together with his cousin T P Rachmat and others conspired illegally with Deutsche Bank to buy his shares in PT Adaro Indonesia and PT Indonesia Bulk Terminal, which serves the Adaro mine.
The shares had been pledged as collateral by Singapore-based investment company Beckkett, partly owned by Tanoto and Hashim Djojohadikusumo and his sister-in-law, Titiek Prabowo, former president Suharto's second daughter, through their Tirtamas group. Beckkett held the shares through a subsidiary, PT Swabara Mining and Energy (SME).
The roller-coaster saga stretches back as far as 1991, when PT Asminco Bara Utama (Asminco) took over management of the Adaro concession. Asminco, which owned a 15% stake in Adaro, then borrowed US$100 million from Deutsche Bank in October 1997, mainly to buy out the 25% stake in Adaro and 15% in the related bulk terminal held by Tirtamas. The guarantor of the loan was Beckkett, which owned Asminco and pledged all 40% of its shares as collateral
However, no repayments were made on the loan, prompting Deutsche Bank to sell the shares at an alleged below-market value of $46 million to Dianlia in a November 2001 agreement made under Singaporean law. With coal prices rising even then, the stake was estimated to be worth more than $400 million. Beckkett held the shares through SME, and claimed that because the sale was illegal under Indonesian law, it was therefore invalid.
Undaunted, Soeryadjaya, son of the founder of Indonesia's national car company Astra, in June 2005 sold Adaro to a consortium of international banks and strategic investors for $950 million, leaving him and Rachmat each with about one-third of the company. Among the foreign investors were the Singapore Investment Corp, owned by the Singapore government, and the private-equity arms of Goldman Sachs Group and Citigroup.
Along with his family, Tanoto, who owns the widely diversified Singapore-based Raja Garuda Mas International, with core businesses in pulp and paper, palm oil, energy, and construction and engineering, had a net worth of $2.8 billion as of September 2006, according to Forbes Asia. The magazine noted that Tanoto and Eka Tjipta Widjaja, a fellow ethnic-Chinese tycoon who is worth an estimated $2 billion, had built their fortunes by turning Indonesia's trees into paper and pulp.
The timing of the court verdict could hardly be worse for Tanoto, or better for Soeryadjaya, in terms of the profit potential of coal, currently the world's fastest-growing energy source despite growing global-warming concerns. Indonesia's coal output is on track to reach an expected 205 million tonnes this year, up from 193.5 million tonnes in 2006. According to the Indonesian Coal Mining Association, output could jump to as much as 218 million tonnes next year, which would be double the level five years ago.
Even before the verdict, Soeryadjaya had disclosed plans to capitalize on Indonesia's coal potential, including plans to buy up to four more mines and form a new asset-holding company that would go public with a planned $600 million listing on the Jakarta Stock Exchange by early next year.
King of coal
Indonesia has coal deposits of about 38.9 billion tonnes and, thanks to Adaro's output, has overtaken Australia as the world's largest exporter of thermal coal, the type used in power stations. Regional thermal-coal prices have almost doubled since 2004, and hit a record high of $72.37 a tonne last month, up almost 50% at the same time last year, and pushed up because of supply constraints after certain Indonesian mines said for undisclosed reasons they would miss some contracted shipments.
Domestic demand is also rising fast, expected to increase to 58 million tonnes in 2008 from about 49 million tonnes this year, to fuel several more coal-fired power plants expected to come on line early next year as part of the government's drive to slash its consumption of expensive crude oil. State-owned electricity utility PLN is building several coal-fired plants to meet spiking domestic electricity demand, which is growing by some 7% a year.
These should add an extra 10,000 megawatts to the national grid by the end of 2009. While PLN still uses petroleum-based fuels in about a quarter of its power plants, the lower production costs associated with new coal-fired plants in 2006 helped PLN cut losses to just over Rp1 trillion ($95 million) from Rp4.92 trillion in 2005.
Meanwhile, exports are expected to reach 160 million tonnes in 2008, up slightly from an expected 156 million tonnes this year, amid surging demand from China and India. Both energy-starved economic giants continue to seek out regionally long-term secure coal supplies. Analysts at UBG Investment Research predict that
up to 73% of China's new power capacity built between now and 2020 will be coal-fired; southern China's Guangdong province imported 4.5 million tonnes of Indonesian coal in the first half of 2007, almost two and a half times the amount in the same period last year.
Coal prices are expected to remain strong as production continues to lag behind demand, creating lucrative investment incentives for foreign acquisitions or minority share purchases of local mining companies. China's largest coal miner Shenhua Energy reportedly plans to buy Indonesian coal operations and India's Tata Power has bought 30% stakes in both PT Kaltim Prima Coal and PT Arutmin.
They paid $1.3 billion in April to Bumi Resources (Bumi) for shares in the two mines that have made Bumi the country's top coal producer. It is controlled by the Bakrie family, including holdings by the country's coordinating minister for people's welfare Aburizal Bakrie.
In March 2006, Bumi announced an agreement to sell the lucrative mines for $3.2 billion to a consortium headed by Borneo Lumbung Energi, an affiliate of Jakarta-based investment bank Renaissance Capital, and the Marubeni Corp, Japan's fifth-largest trading company. Marubeni was expected to fund up to 50% of the purchase, rationalizing that it needed more coal to boost existing supplies from its own mines in Australia and Canada to meet increased demand for coal at power plants in both Japan and China.
Bumi's total outlay for the two mines had been just under $251 million, so the sale would have earned it a net profit of just under $3 billion. Renaissance Capital could not close the deal, which was officially canceled a few weeks later. Another recent Bumi deal was the joint-venture agreement struck with Australia's coal-seam gas company Westside Corp Ltd to develop these types of projects in Kalimantan along with PT Arutmin.
Thailand's biggest coal miner, Banpu, is also planning an initial public offering of its 95%-owned local unit PT Indo Tambangraya Megah, which operates four coal-mining concessions in Indonesia. The IPO, expected during the first quarter of next year, will still leave Banpu owning 80% of its Indonesian unit.
Surging regional demand and skyrocketing prices for coal mean the recent Singaporean court decision against Tanoto represents a big loss to his company's future profitability. A spokesman for Beckkett has said it is too early for the company to make a decision on whether it will move to appeal the verdict to Singapore's Supreme Court, although the option is not being ruled out and the company is also still considering filing a counter-lawsuit in Indonesia.
A Deutsche Bank statement in Hong Kong suggested that the verdict fully vindicated the bank's legal position and actions in recovering a long overdue debt. "In confirming the lender's rights, it will be welcomed by the broader banking community," spokesman Mike West said in the statement. Whether it will be welcomed by the broader borrowing community is still open to debate, however.
Beckkett noted in its written statement that the verdict had actually affirmed the claims it had made all along: that Deutsche Bank did not undertake the share sale in a proper manner. For its part, RGM International is forging ahead with a $4 billion expansion of its pulp-and-paper, palm-oil, energy, and other interests toward the aim of increasing its asset base by 70% by 2009, Tanoto told Reuters in an interview in May.
Meanwhile, Indonesian mining firm PT Darma Henwa shares soared nearly 70% in their stock-market debut on Wednesday, making it one of Jakarta's best-performing first-day issues this year. The shares opened at Rp550 and then quickly rose to Rp565, well above the offer price of Rp335. The firm's businesses include mining, infrastructure services, coal marketing and power generation. Darma Henwa, owned by British Virgin Islands-based Zurich Assets International and local company PT Indotambang Perkasa, raised $117.25 million from the IPO for its working capital.
Bill Guerin, a Jakarta correspondent for Asia Times Online since 2000, has been in Indonesia for more than 20 years, mostly in journalism and editorial positions. He specializes in Indonesian political, business and economic analysis, and hosts a weekly television political talk show, Face to Face, broadcast on two Indonesia-based satellite channels. He can be reached at softsell@prima.net.id.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
JAKARTA - Indonesia's richest man last week lost a drawn-out legal tussle over his 40% ownership claim to the country's second-largest coal-mining company, PT Adaro Indonesia (Adaro). This comes crucially at a time when the energy commodity is enjoying its biggest boom ever. The decision was made by Singapore's High Court, bypassing Indonesia's notoriously politically pliable judiciary, though paper and plantation tycoon Sukanto Tanoto is weighing his appeal options.
The legal saga over the highly coveted mine's ownership is as complicated as it is contentious among the competing international claimants to the assets, which includes the world's biggest exporter of power-station-grade coal. Tanoto claimed that PT Dianlia Setyamukti (Dianlia), owned by another tycoon, Edwin Soeryadjaya, together with his cousin T P Rachmat and others conspired illegally with Deutsche Bank to buy his shares in PT Adaro Indonesia and PT Indonesia Bulk Terminal, which serves the Adaro mine.
The shares had been pledged as collateral by Singapore-based investment company Beckkett, partly owned by Tanoto and Hashim Djojohadikusumo and his sister-in-law, Titiek Prabowo, former president Suharto's second daughter, through their Tirtamas group. Beckkett held the shares through a subsidiary, PT Swabara Mining and Energy (SME).
The roller-coaster saga stretches back as far as 1991, when PT Asminco Bara Utama (Asminco) took over management of the Adaro concession. Asminco, which owned a 15% stake in Adaro, then borrowed US$100 million from Deutsche Bank in October 1997, mainly to buy out the 25% stake in Adaro and 15% in the related bulk terminal held by Tirtamas. The guarantor of the loan was Beckkett, which owned Asminco and pledged all 40% of its shares as collateral
However, no repayments were made on the loan, prompting Deutsche Bank to sell the shares at an alleged below-market value of $46 million to Dianlia in a November 2001 agreement made under Singaporean law. With coal prices rising even then, the stake was estimated to be worth more than $400 million. Beckkett held the shares through SME, and claimed that because the sale was illegal under Indonesian law, it was therefore invalid.
Undaunted, Soeryadjaya, son of the founder of Indonesia's national car company Astra, in June 2005 sold Adaro to a consortium of international banks and strategic investors for $950 million, leaving him and Rachmat each with about one-third of the company. Among the foreign investors were the Singapore Investment Corp, owned by the Singapore government, and the private-equity arms of Goldman Sachs Group and Citigroup.
Along with his family, Tanoto, who owns the widely diversified Singapore-based Raja Garuda Mas International, with core businesses in pulp and paper, palm oil, energy, and construction and engineering, had a net worth of $2.8 billion as of September 2006, according to Forbes Asia. The magazine noted that Tanoto and Eka Tjipta Widjaja, a fellow ethnic-Chinese tycoon who is worth an estimated $2 billion, had built their fortunes by turning Indonesia's trees into paper and pulp.
The timing of the court verdict could hardly be worse for Tanoto, or better for Soeryadjaya, in terms of the profit potential of coal, currently the world's fastest-growing energy source despite growing global-warming concerns. Indonesia's coal output is on track to reach an expected 205 million tonnes this year, up from 193.5 million tonnes in 2006. According to the Indonesian Coal Mining Association, output could jump to as much as 218 million tonnes next year, which would be double the level five years ago.
Even before the verdict, Soeryadjaya had disclosed plans to capitalize on Indonesia's coal potential, including plans to buy up to four more mines and form a new asset-holding company that would go public with a planned $600 million listing on the Jakarta Stock Exchange by early next year.
King of coal
Indonesia has coal deposits of about 38.9 billion tonnes and, thanks to Adaro's output, has overtaken Australia as the world's largest exporter of thermal coal, the type used in power stations. Regional thermal-coal prices have almost doubled since 2004, and hit a record high of $72.37 a tonne last month, up almost 50% at the same time last year, and pushed up because of supply constraints after certain Indonesian mines said for undisclosed reasons they would miss some contracted shipments.
Domestic demand is also rising fast, expected to increase to 58 million tonnes in 2008 from about 49 million tonnes this year, to fuel several more coal-fired power plants expected to come on line early next year as part of the government's drive to slash its consumption of expensive crude oil. State-owned electricity utility PLN is building several coal-fired plants to meet spiking domestic electricity demand, which is growing by some 7% a year.
These should add an extra 10,000 megawatts to the national grid by the end of 2009. While PLN still uses petroleum-based fuels in about a quarter of its power plants, the lower production costs associated with new coal-fired plants in 2006 helped PLN cut losses to just over Rp1 trillion ($95 million) from Rp4.92 trillion in 2005.
Meanwhile, exports are expected to reach 160 million tonnes in 2008, up slightly from an expected 156 million tonnes this year, amid surging demand from China and India. Both energy-starved economic giants continue to seek out regionally long-term secure coal supplies. Analysts at UBG Investment Research predict that
up to 73% of China's new power capacity built between now and 2020 will be coal-fired; southern China's Guangdong province imported 4.5 million tonnes of Indonesian coal in the first half of 2007, almost two and a half times the amount in the same period last year.
Coal prices are expected to remain strong as production continues to lag behind demand, creating lucrative investment incentives for foreign acquisitions or minority share purchases of local mining companies. China's largest coal miner Shenhua Energy reportedly plans to buy Indonesian coal operations and India's Tata Power has bought 30% stakes in both PT Kaltim Prima Coal and PT Arutmin.
They paid $1.3 billion in April to Bumi Resources (Bumi) for shares in the two mines that have made Bumi the country's top coal producer. It is controlled by the Bakrie family, including holdings by the country's coordinating minister for people's welfare Aburizal Bakrie.
In March 2006, Bumi announced an agreement to sell the lucrative mines for $3.2 billion to a consortium headed by Borneo Lumbung Energi, an affiliate of Jakarta-based investment bank Renaissance Capital, and the Marubeni Corp, Japan's fifth-largest trading company. Marubeni was expected to fund up to 50% of the purchase, rationalizing that it needed more coal to boost existing supplies from its own mines in Australia and Canada to meet increased demand for coal at power plants in both Japan and China.
Bumi's total outlay for the two mines had been just under $251 million, so the sale would have earned it a net profit of just under $3 billion. Renaissance Capital could not close the deal, which was officially canceled a few weeks later. Another recent Bumi deal was the joint-venture agreement struck with Australia's coal-seam gas company Westside Corp Ltd to develop these types of projects in Kalimantan along with PT Arutmin.
Thailand's biggest coal miner, Banpu, is also planning an initial public offering of its 95%-owned local unit PT Indo Tambangraya Megah, which operates four coal-mining concessions in Indonesia. The IPO, expected during the first quarter of next year, will still leave Banpu owning 80% of its Indonesian unit.
Surging regional demand and skyrocketing prices for coal mean the recent Singaporean court decision against Tanoto represents a big loss to his company's future profitability. A spokesman for Beckkett has said it is too early for the company to make a decision on whether it will move to appeal the verdict to Singapore's Supreme Court, although the option is not being ruled out and the company is also still considering filing a counter-lawsuit in Indonesia.
A Deutsche Bank statement in Hong Kong suggested that the verdict fully vindicated the bank's legal position and actions in recovering a long overdue debt. "In confirming the lender's rights, it will be welcomed by the broader banking community," spokesman Mike West said in the statement. Whether it will be welcomed by the broader borrowing community is still open to debate, however.
Beckkett noted in its written statement that the verdict had actually affirmed the claims it had made all along: that Deutsche Bank did not undertake the share sale in a proper manner. For its part, RGM International is forging ahead with a $4 billion expansion of its pulp-and-paper, palm-oil, energy, and other interests toward the aim of increasing its asset base by 70% by 2009, Tanoto told Reuters in an interview in May.
Meanwhile, Indonesian mining firm PT Darma Henwa shares soared nearly 70% in their stock-market debut on Wednesday, making it one of Jakarta's best-performing first-day issues this year. The shares opened at Rp550 and then quickly rose to Rp565, well above the offer price of Rp335. The firm's businesses include mining, infrastructure services, coal marketing and power generation. Darma Henwa, owned by British Virgin Islands-based Zurich Assets International and local company PT Indotambang Perkasa, raised $117.25 million from the IPO for its working capital.
Bill Guerin, a Jakarta correspondent for Asia Times Online since 2000, has been in Indonesia for more than 20 years, mostly in journalism and editorial positions. He specializes in Indonesian political, business and economic analysis, and hosts a weekly television political talk show, Face to Face, broadcast on two Indonesia-based satellite channels. He can be reached at softsell@prima.net.id.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
China rates a cut above the US
By Zhou Jiangong
SHANGHAI - China, the world's fastest-developing economy, and the United States, the world's largest economy, are now going in opposite directions in regard to their monetary policy. Interest rates are expected to continue going down in the US but up in China, in at least the coming 12 months.
This trend will worsen the structural problems facing the Chinese economy, making it more difficult for Beijing to rein in the country's overheating economy and inflation with its so-called macroeconomic control policies.
In an unprecedented move, the People's Bank of China (PBoC) - the country's central bank - raised the benchmark interest rates twice in 25 days, with the one-year deposit rate and loan interest rate going up 0.27 percentage point respectively each time. It is almost a knee-jerk response to the looming inflation for August: the year-on-year 6.5% increase in the Consumer Price Index is the highest in a decade.
What will complicate the Chinese government's headache on its breathtaking growth is that the Federal Reserve of the United States cut the Federal Funds rate by half a percentage point from 5.25% to 4.75%, a move that surprised the market. A deep concern for a spreading credit crunch due to the subprime-mortgage crisis caused the aggressive turnaround of the monetary policy by Fed chairman Ben Bernanke. It is widely expected the Fed will cut the rates again next month.
Under the accumulating pressure of inflation, the PBoC is widely expected to be on the track of faster rate hikes. The rates are likely to be raised several times in the coming months. Currently, the one-year deposit rate is 3.87% and one-year loan rate 7.29%.
A slowdown or even a recession in the US economy would help China cool down its white-hot growth. Declining housing prices, together with interest-rate hikes, in the US and other Western countries have triggered the subprime-mortgage crisis that entails a credit crunch and increases the possibility of recession.
Theoretically, a recession in one of the largest markets for China's exports would be a healthy development for its economy: slowing down growth in exports and trade surplus, and slowing down growth of the country's foreign-exchange reserves to enable a slowdown in money supply and reduce excessive liquidity - the "original sin" of all of the current economic problems facing China.
Now the US economy seems to be refueled by the aggressive rate cut. If the cut will prolong (or even boost) US economic expansion, it will continue to fuel China's gigantic exporting engine. And the trend of hiking China's interest rates as well as the lowering of US interest rates will strengthen the expectation of accelerated yuan appreciation, which could lead to more money pouring into China's market chasing after investment-worthy assets.
If the half-percentage-point cut in the US is a strong signal of a turn toward more rate-cutting, the PBoC's rate-raising policy, considering the current rigid currency-exchange regime, will be self-defeating. The higher interest rate for the yuan compared with the US dollar's and the higher expectation of more yuan appreciation and of more money pouring into China resulting in more excessive liquidity will put more upward pressure on prices.
So far, Beijing's macroeconomic adjustment and control measures have largely been nullified by diehard structural problems. The government has used every weapon available: monetary policies, fiscal policies, administrative means, and environmental protection measures. Still, inflation is looming.
The situation casts more doubts on the effectiveness of Beijing's macroeconomic control policy that has been put into effect over past more than four years. In fact, the strong impulse to overheat the economy is deeply embedded in the structure of the China's politico-economic structure, and the current tightening policies from monetary, fiscal, and industrial fronts do no more than deal with short-term issues.
The National People's Congress has become impatient with the ineffectiveness of the four-year belt-tightening policies. During a meeting aimed at reviewing the macro-regulation policy held by the NPC Standing Committee, a member said: "This round of macroeconomic control has continued for four years, and while a number of policies have been carried out by a relevant departments of the central government, the effect is not evident."
The legislators also suggested that the State Council evaluate the effectiveness and the role of the policies and measures. The idiom of only treating the symptoms of the disease rather than tackling the disease itself has been used to criticize the current policy as passive, only focusing on short-term issues and then doing so in a haphazard way.
What worries the legislators is that the growth is unsustainable but virtually unstoppable. The myth of China's robust growth has recently been decoded by more and more economists inside and outside China. Pieter Bottelier, professor of China economy at Johns Hopkins University, points out that China's economy can be described as four imbalances: investment-consumption imbalance, energy-demand imbalance, social imbalances, and growth-environment imbalance.
But the Chinese government seems likely to give priority to popular issues, such as housing prices. In fact, the government failed to contain soaring housing prices in cities from the coastal area to inland China simply because it implemented policies that gave the market a strong signal that the prices will continue to rise. In China, housing prices can be more of a social issue or a political issue than an economic one.
In fact, local governments have been making use of local economic development and urban sprawl as means to boost their revenues (and to enrich local officials in some cases). Collusion between property developers and local-government officials has often occurred, with profits in housing projects shared among them. No local officials are really keen on in providing affordable housing to residents.
Both the central and local governments appear to be awash in cash. But the overhaul of China's social programs - pillars for the "harmonious society" - is long overdue and the programs are poorly funded. Beijing policymakers think a sound social-security system would help people reduce precautionary savings and boost consumption. But that good intention has been distorted as social-security funds are easily embezzled by local-government officials to pursue local growth in gross domestic product.
The NPC Standing Committee suggested that the central government allocate "sufficient funds and precious resources" for the weak links in China's society and economy: education, health care, social security, affordable housing, and rural development.
The short-term complication of China's economic environment and the long-term politico-economy structural issues will be put to a test at the 17th National Congress of the Chinese Communist Party in mid-October. Although the guidelines of "scientific development and harmonious society" are in the right direction, how to implement them remains a big challenge for the party.
Zhou Jiangong is a Shanghai-based analyst on China's economic, political and foreign affairs.
(Copyright 2007 Asia Times Online Ltd. All rights reserved. )
SHANGHAI - China, the world's fastest-developing economy, and the United States, the world's largest economy, are now going in opposite directions in regard to their monetary policy. Interest rates are expected to continue going down in the US but up in China, in at least the coming 12 months.
This trend will worsen the structural problems facing the Chinese economy, making it more difficult for Beijing to rein in the country's overheating economy and inflation with its so-called macroeconomic control policies.
In an unprecedented move, the People's Bank of China (PBoC) - the country's central bank - raised the benchmark interest rates twice in 25 days, with the one-year deposit rate and loan interest rate going up 0.27 percentage point respectively each time. It is almost a knee-jerk response to the looming inflation for August: the year-on-year 6.5% increase in the Consumer Price Index is the highest in a decade.
What will complicate the Chinese government's headache on its breathtaking growth is that the Federal Reserve of the United States cut the Federal Funds rate by half a percentage point from 5.25% to 4.75%, a move that surprised the market. A deep concern for a spreading credit crunch due to the subprime-mortgage crisis caused the aggressive turnaround of the monetary policy by Fed chairman Ben Bernanke. It is widely expected the Fed will cut the rates again next month.
Under the accumulating pressure of inflation, the PBoC is widely expected to be on the track of faster rate hikes. The rates are likely to be raised several times in the coming months. Currently, the one-year deposit rate is 3.87% and one-year loan rate 7.29%.
A slowdown or even a recession in the US economy would help China cool down its white-hot growth. Declining housing prices, together with interest-rate hikes, in the US and other Western countries have triggered the subprime-mortgage crisis that entails a credit crunch and increases the possibility of recession.
Theoretically, a recession in one of the largest markets for China's exports would be a healthy development for its economy: slowing down growth in exports and trade surplus, and slowing down growth of the country's foreign-exchange reserves to enable a slowdown in money supply and reduce excessive liquidity - the "original sin" of all of the current economic problems facing China.
Now the US economy seems to be refueled by the aggressive rate cut. If the cut will prolong (or even boost) US economic expansion, it will continue to fuel China's gigantic exporting engine. And the trend of hiking China's interest rates as well as the lowering of US interest rates will strengthen the expectation of accelerated yuan appreciation, which could lead to more money pouring into China's market chasing after investment-worthy assets.
If the half-percentage-point cut in the US is a strong signal of a turn toward more rate-cutting, the PBoC's rate-raising policy, considering the current rigid currency-exchange regime, will be self-defeating. The higher interest rate for the yuan compared with the US dollar's and the higher expectation of more yuan appreciation and of more money pouring into China resulting in more excessive liquidity will put more upward pressure on prices.
So far, Beijing's macroeconomic adjustment and control measures have largely been nullified by diehard structural problems. The government has used every weapon available: monetary policies, fiscal policies, administrative means, and environmental protection measures. Still, inflation is looming.
The situation casts more doubts on the effectiveness of Beijing's macroeconomic control policy that has been put into effect over past more than four years. In fact, the strong impulse to overheat the economy is deeply embedded in the structure of the China's politico-economic structure, and the current tightening policies from monetary, fiscal, and industrial fronts do no more than deal with short-term issues.
The National People's Congress has become impatient with the ineffectiveness of the four-year belt-tightening policies. During a meeting aimed at reviewing the macro-regulation policy held by the NPC Standing Committee, a member said: "This round of macroeconomic control has continued for four years, and while a number of policies have been carried out by a relevant departments of the central government, the effect is not evident."
The legislators also suggested that the State Council evaluate the effectiveness and the role of the policies and measures. The idiom of only treating the symptoms of the disease rather than tackling the disease itself has been used to criticize the current policy as passive, only focusing on short-term issues and then doing so in a haphazard way.
What worries the legislators is that the growth is unsustainable but virtually unstoppable. The myth of China's robust growth has recently been decoded by more and more economists inside and outside China. Pieter Bottelier, professor of China economy at Johns Hopkins University, points out that China's economy can be described as four imbalances: investment-consumption imbalance, energy-demand imbalance, social imbalances, and growth-environment imbalance.
But the Chinese government seems likely to give priority to popular issues, such as housing prices. In fact, the government failed to contain soaring housing prices in cities from the coastal area to inland China simply because it implemented policies that gave the market a strong signal that the prices will continue to rise. In China, housing prices can be more of a social issue or a political issue than an economic one.
In fact, local governments have been making use of local economic development and urban sprawl as means to boost their revenues (and to enrich local officials in some cases). Collusion between property developers and local-government officials has often occurred, with profits in housing projects shared among them. No local officials are really keen on in providing affordable housing to residents.
Both the central and local governments appear to be awash in cash. But the overhaul of China's social programs - pillars for the "harmonious society" - is long overdue and the programs are poorly funded. Beijing policymakers think a sound social-security system would help people reduce precautionary savings and boost consumption. But that good intention has been distorted as social-security funds are easily embezzled by local-government officials to pursue local growth in gross domestic product.
The NPC Standing Committee suggested that the central government allocate "sufficient funds and precious resources" for the weak links in China's society and economy: education, health care, social security, affordable housing, and rural development.
The short-term complication of China's economic environment and the long-term politico-economy structural issues will be put to a test at the 17th National Congress of the Chinese Communist Party in mid-October. Although the guidelines of "scientific development and harmonious society" are in the right direction, how to implement them remains a big challenge for the party.
Zhou Jiangong is a Shanghai-based analyst on China's economic, political and foreign affairs.
(Copyright 2007 Asia Times Online Ltd. All rights reserved. )
Tuesday, September 25, 2007
The funds are flowing
By Doug Noland
Former US Treasury secretary Paul O'Neill commented that the "Fed put the punch back into the punchbowl". For last week, the Dow and S&P500 gained 2.8%, increasing year-to-date gains to 10.9% and 7.6%. The Morgan Stanley Cyclical index jumped 4.3% (up 18.2% year-to-date), and the Morgan Stanley Consumer index gained 3.1% (up 6.6%).
Utilities rose 2.3% (up 9.7%), and the transports added 0.6% (up 5.9%). The small cap Russell 2000 rallied 3.1% (up 3.2%), and the S&P400 Mid-Cap index gained 2.2% (up 9.6%). Technology stocks added to already strong gains. The NASDAQ100 rose 2.4% (up 16.7%), and the Morgan Stanley High Tech index gained 2.6% (up 16.7%). Semiconductors increased 2.9% (up 7.1%). The Street.com Internet index advanced 2.0% (up 15.7%), and the NASDAQ telecommunications index jumped 3.3% (up 19.9%).
Broker/dealers (down 4.0%) and banks (down 7.7%) both gained 2.3%. With bullion rising $23.90, the HUI gold index surged 9.4% (up 18.2%). The Fed threw the yield curve for a loop. Three-month T-bill rates sank 23 basis points last week to 3.76%. Two-year US government yields were unchanged at 4.04%.
Meanwhile, five-year yields rose 12 basis points to 4.29% and 10-year Treasury yields 16 basis points to 4.62%. Long-bond yields ended the week 16.5 basis points higher at 4.885%. The 2-year/10year spread ended the week at 58 basis points, the high since May '05. The implied yield on three-month December '07 Eurodollars fell 15 bps to 4.74%. Benchmark Fannie Mae MBS yields rose 5 basis points to 5.95%, this week meaningfully outperforming Treasuries. The spread on Fannie's 5% 2017 note narrowed 3 to 46, and the spread on Freddie's 5% 2017 note narrowed 3.5 to 45.6.
The 10-year dollar swap spread declined 3 to 64.3. Corporate bond spreads narrowed. The spread on a junk index ended the week 6 basis points narrower. Investment grade debt issuers included Tyco $2.05bn, Marathon Oil $1.5bn, Suncor $1.15bn, Rockies Express $600 million, Leucadia National $500 million, Southwest Air $500 million, Weyerhaeuser $450 million, Liberty Properties $300 million, Avery Dennison $250 million, and San Diego G&E $250 million. Junk issuers included RH Donnelley $1.0bn, Compucom Systems $210 million and Baseline Oil $165 million.
Convert issuers included Powerwave Technologies $150 million and Equinix $350 million. Foreign dollar bond issuance included Barclays $2.0bn, Glitnir Bank $1.0bn, Rede Empresas Energia $575 million, and Canadian National Railroad $550 million.
German 10-year bund yields surged 19 bps to 4.36%, as the DAX equities index jumped 4.0% (up 18.2% year-to-date). Japanese 10-year "JGB" yields rose 13.5 bsais points to 1.675%. The Nikkei 225 rose 3.1% (down 5.3% year-to-date). Emerging debt markets were mixed to higher, while equities went higher and higher. Brazil's benchmark dollar bond yields fell 10 basis points to 5.85%. Brazil's Bovespa equities index burst 5.7% higher (up 30% year-to-date). The Mexican Bolsa gained 1.6% (up 15.6% year-to-date).
Mexico's 10-year $ yields rose 7 basis points to 5.56%. Russia's RTS equities index jumped 4.3% (up 5.4% year-to-date). India's Sensex equities index surged 6.2% (up 20.1% year-to-date). China's Shanghai Composite index added 2.7% to close at yet another record high (up 104% year-to-date and 213% over the past year).
Freddie Mac posted 30-year fixed mortgage rates rose 3 basis points last week to 6.34% (down 6 basis points year-on-year). Fifteen-year fixed rates added one basis point to 5.98% (down 8 basis points year-on-year). One-year adjustable rates dipped one basis point to 5.65% (up 11 basis points year-on-year).
Bank Credit increased $11.4 bn (week of 9/12) to a record $8.924 TN. After a seven-week surge of $284bn, bank credit has now increased $628bn year-to-date, or a rate of 10.6%. For the week, Securities Credit surged $26.9bn. Loans and leases dropped $15.5bn to $6.528 TN (seven-week gain of $200bn). C&I loans gained $12.15bn and real estate loans added $0.2bn. Consumer loans fell $10.0bn. Securities loans were little changed, while Other loans dropped $17.1bn. On the liability side, (previous M3) Large time deposits supped $23.9bn.
M2 (narrow) "money" fell $17.3bn to $7.349 TN (week of 9/10). Narrow "money" has expanded $305bn year-to-ddate, or 6.1% annualized, and $473bn, or 6.9%, over the past year. For the week, Currency added $0.3bn, while Demand & Checkable Deposits sank $49bn. Savings deposits jumped $34.2bn, and small denominated deposits added $1.1bn. Retail money fund assets declined $3.7bn.
Total Money Market Fund Assets (from Inves. Co Inst) dipped $3.1bn to $2.825 TN. Money Fund Assets have increased $443bn year-to-date, a 25.5% rate, and $600bn over 52 weeks, or 26.9%.
Total CP dropped another $48bn to $1.869 TN, boosting the six-week decline to $354.4bn. Asset-backed CP dropped another $15.9bn (6-wk drop of $244.5bn) to $928.9bn. Year-to-date, total CP is now down $105.2bn, with ABCP declining $155bn. Over the past year, Total CP is now down $13bn, or 0.7%.
Asset-backed Securities (ABS) issuance increased modesly to $7.2bn last week. Year-to-date total US ABS issuance of $453bn (tallied by JP Morgan) is now running 29% behind comparable 2006. At $209bn, year-to-date home equity ABS sales are 49% below last year's pace. Year-to-date US CDO issuance of $260 billion is running 5% ahead of 2006 sales.
Fed Foreign Holdings of Treasury, Agency Debt (week ended 9/19) rose $6.2bn to $1.987 TN. "Custody holdings" were up $235bn year-to-date (18.4% annualized) and $314bn during the past year, or 18.8%. Federal Reserve Credit last week declined $4.2bn to $853bn. Fed Credit has increased $0.8bn y-t-d and $24.1bn over the past year (2.9%).
International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi – were up $933bn y-t-d (26.5% annualized) and $1.153 TN y-o-y (25.1%) to $5.743 TN.
Credit market dislocation watch
September 22 - Financial Times (James Politi): "KKR and Goldman Sachs yesterday attempted to pull the plug on the $8bn buy-out of Harman International, the high-end US electronics company, as the battle over the completion of deals signed before the credit squeeze turned increasingly ugly. The move by KKR and Goldman's private equity arm could prove to be a watershed moment for buy-out firms that went on an extraordinary dealmaking binge earlier this year but are now facing higher financing costs and a shaky economic outlook.
"It signals that in certain cases, private equity groups are willing to sacrifice the reputational risk associated with abandoning deals, and the danger of not being viewed as credible buyers in future takeovers, in order to clear unwanted deals from their table in this cycle. KKR and Goldman told Harman that they could walk away from the deal because of a "material adverse change" in the contract - presumably a deterioration in the company's main business of supplying audio systems to luxury carmakers such as Mercedes and BMW. But Harman disputed the claim by KKR and Goldman, saying it 'disagrees that a MAC has occurred or that it has breached the merger agreement'."
September 21 - Financial Times (Chris Giles and Peter Thal Larsen): "On Monday evening Mervyn King believed the first real crisis of his Bank of England stewardship had – as he put it to friends – been sorted. Beset by images of customers rushing to withdraw their money from Northern Rock, Alistair Darling, the chancellor, had offered depositors a blanket assurance that their cash was safe. But within five days, Mr King's optimism had been proved comprehensively and humiliatingly unfounded. In one of the most extraordinary weeks in British banking history – one which saw the global credit squeeze spill on to the nation's streets – the bank had on Wednesday performed an abrupt volte face. It had decided to extend emergency lending against mortgage collateral to all banks – a step that just 24 hours earlier the governor had privately ruled out. As the week draws to a close the focus of account holders and bank chief executives alike is on what happened in those missing hours. What persuaded the Bank to capitulate and throw its own money and good name into rescuing commercial banks from their own funding mistakes?"
September 21 - Financial Times (Javier Blas): "Gold reached its highest price yesterday for almost 28 years at more than $735 a troy ounce. Investors rushed to buy the yellow metal amid US dollar weakness and inflation concerns. Bullion hit an intraday high of $738.30 an ounce, the highest level since February 1980, and was later trading at $737.35-$738.05 an ounce, up 15% this year. Gold was at a high of $850 an ounce in January 1980. It reached $730 in May 2006, which was a 26-year high. The price jump came after the US dollar fell to a record low of $1.4087 to the euro. The US currency has sunk since the Federal Reserve cut interest rates by 50 basis points to 4.75% on Tuesday in an attempt to prop up economic growth."
September 21 - Financial Times (Michael Mackenzie in New York and Krishna Guha and Eoin Callan): "The dollar plunged, government bond yields soared and the price of oil hit a record high yesterday amid growing concern that interest rate cuts by the Federal Reserve could stoke inflation. The gyrations came as Ben Bernanke, Fed chairman, told Congress that the 50 basis point cut in rates this week was a pre-emptive move to prevent market turmoil from harming the economy. He said the Fed cut rates 'to try to get out ahead of the situation and try to forestall potential effects of tighter credit conditions on the broader economy'."
September 21 - Financial Times (Francesco Guerrera ): "Corporate America is about to be hit by a new wave of business failures as the credit squeeze forces weak, highly leveraged, companies to default on $35bn-worth of debt, Standard & Poor's warned ... The credit rating agency said that the slowing economy and ongoing liquidity squeeze put some 75 junk-rated companies, mostly in the media, healthcare and consumer products sectors, at a high risk of default over the next 15 months. John Bilardello, S&P's head of corporate ratings, said the level of defaults could turn out to be much higher if the economy and the debt markets were to worsen further in 2008."
September 21 - Financial Times (Paul J Davies): "Structured investment vehicles (SIVs) will remain under pressure if there is not a quick improvement in short-term funding markets, and more vehicles are likely to face ratings downgrades, according to Derivative Fitch, the rating agency. The agency said it did not expect a short-term improvement in either the short-term commercial paper environment or for the illiquidity and re-pricing of credit risk in the market. SIVs, which aim to profit from the difference between cheap short-term borrowing rates in the money markets and the higher returns available on longer term debt investments, have come under pressure during the turmoil of recent months."
Currency watch
September 21 - Financial Times (Peter Garnham ): "The Canadian dollar rose to parity against the US dollar for the first time since 1976 yesterday, buoyed by soaring oil prices and broad-based weakness in the greenback. Adam Cole, at RBC Capital Markets, said he expected the Canadian dollar to continue its upward path. 'Canada produces the commodities the world wants - it is still the number one commodity play among major currencies,' he said." The dollar index sank 1.3% to 78.60. On the upside, the New Zealand dollar increased 5.3%, the Australian dollar 4.0%, the Brazilian real 2.8%, the South African rand 3.1%, the Canadian dollar 2.7%, and the Swedish krona 2.7%. On the downside, the Japanese yen declined 0.3%. The Euro gained 1.6% to a record high.
Commodities watch
For last week, Gold jumped 3.4% to $731.5 and Silver 7.2% to $13.62. December Copper rose 5.9%. November crude ended the week at a record $81.62, up $3.53 on the week. October gasoline gained 3.5%, while October Natural Gas declined 3.2%. December Wheat was little changed. For the week, the CRB index surged 3.8% (up 8.4% year-to-date), and the Goldman Sachs Commodities Index (GSCI) jumped 3.5% (up 25.5% year-to-date).
Japan watch
September 18 – Bloomberg (Toru Fujioka): "Japanese households' assets rose to a record in the three months ended June 30, as individuals earned higher returns on stocks, mutual funds and bonds. The value of households’ assets rose 2.9% to 1,555 trillion yen ($13.5 trillion) from a year earlier, the Bank of Japan said ..."
September 19 – Bloomberg (Kathleen Chu): "Land prices in Japan's three largest metropolitan areas rose for a second-straight year, and nationwide commercial land prices rose for the first time in 16 years as the country's property market continued its rebound. The value of property in the Tokyo, Osaka and Nagoya regions gained 5.1% on average for the year ended June 30 ..."
China watch
September 19 – Market News International: "China's retail sales are expected to rise 15% to 8.8 trln yuan in 2007, the Ministry of Commerce's Department of market regulation said ... In the first eight months, retail sales were up 15.7% ..."
India watch
September 21 – Bloomberg (Cherian Thomas): "India may cut cash held by lenders for the fourth time this year as currency sales by the central bank aimed at curbing rupee gains flood the economy with excess money, Credit Suisse AG and Nomura Securities Co said. India's currency has strengthened beyond 40 per dollar for the first time in nine years amid unprecedented overseas investment in local shares. The central bank has injected rupees worth $43.1 billion in the nine months to July, almost three times the amount in previous nine months."
Asia watch
September 21 – Bloomberg (Perris Lee): "Taiwan's export orders grew at a slower pace in August as a housing recession eroded demand from the US, the island's second-biggest overseas market. Orders for shipment overseas rose 16.32% from a year earlier, slowing from July's 23.49% gain ..."
September 21 – Bloomberg (Karl Lester M. Yap): "Philippine money supply grew less than 20% in August, central bank Deputy Governor Diwa Guinigundo told reporters ..."
Unbalanced global economy watch
September 18 – Bloomberg (David M Levitt and Bryan Keogh): "The world economy 'is probably at its scariest point since the Depression' as fallout from the US subprime mortgage crisis crimps access to credit, said Ethan Penner, a pioneer of the $600 billion commercial mortgage-backed securities market in the early 1990s. 'We're probably at the closest point to a big meltdown, a depression-type meltdown than we have been in our lives,' said Penner ... now a principal at real estate fund management firm Lubert-Adler Partners LP ... The US housing market is an 'unmitigated disaster' ... As foreclosures rise, lenders will try to sell the properties they acquire at depressed prices, dragging the market down further, he said."
September 19 – The Wall Street Journal Europe: "UK housing boom has been a long time coming, but it has finally arrived. The 3% August drop in the average house price, as reported by property Web site Rightmove, certifies the beginning of the new era. The end comes when prices are too high by any measure ... The Bank of England tried to prick the bubble with rhetoric and higher interest rates. But its tactics proved much less potent than the credit crunch."
September 19 – Bloomberg (Fergal O’Brien): "Europe's manufacturing and service industries grew at the slowest pace in two years this month after paralysis in the credit markets hurt banks, adding to evidence economic growth is waning."
Latin America watch
September 19 –Dow Jones (Anthony Harrup): "First it was tortillas, then milk, and now Mexican bread prices are going up, corroborating the central bank's persistent warnings about food prices threatening its inflation outlook. Mexico's baking industry confirmed this week that it plans to raise bread prices by 15% to 17% on average to recoup rising costs of wheat flour and other raw materials. Antonio Arias Ordonez, president of the Mexican Bakeries Industry Chamber, said he expects all of the country’s roughly 26,500 bread shops to raise their prices. 'It would be unusual if they didn't after raw materials costs have risen between 55% and 65%' Arias said ... Apart from flour, prices of margarine, eggs and sugar, have also been rising, he added."
Bubble economy watch
September 21 - Financial Times (Francesco Guerrera ): "Victory lap or last hurrah? Buy-out titans and hedge fund managers stormed the citadel of US wealth last year, barging their way into the Forbes 400 annual list of richest Americans on the back of buoyant capital markets and record merger activity. Nearly half of the 45 new entrants in the magazine's latest tally of US billionaires – which was topped once again by Bill Gates – came from the neighbouring worlds of private equity and hedge funds. But before Connecticut yacht dealers and Palm Beach property agents begin bombarding 'new super rich' such as Carlyle's David Rubenstein and hedge fund manager John Paulson with phone calls, they might want to consider the ephemeral nature of fortunes gained in such volatile industries."
September 18 – Bloomberg (Carlyn Kolker): "US companies increased total compensation for their chief in-house lawyers by 14% in 2007, according to a survey by legal consultant Altman Weil Inc., which cited competition for legal talent ... Median total pay for chief legal officers was $457,000, according to the survey ... Salaries rose 5.8% to $300,000, and bonuses were up 43% to $157,000. 'This may reflect a need to counter the dramatic increases in law firm starting salaries as general counsel compete with law firms for talent,' Altman Weil consultant James Wilber said ... Several New York-based law firms raised pay for first-year attorneys to $160,000 this year."
Central banker watch
September 18 – Bloomberg (Bob Willis and Tom Keene): "Conrad DeQuadros, senior economist at Bear Stearns & Co. in New York, comments on the Federal Reserve's decision yesterday to cut its benchmark interest rate to 4.75% from 5.25%. In a note to clients, he and Bear Stearns chief US economist John Ryding called yesterday a 'black day' for the Fed. Dequadros spoke in an interview ... On the language in his note: It is strong language. For the Fed to cut rates aggressively while citing that inflation risks remain, that risks the Fed's inflation fighting credibility ... There are also issues of credibility about Fed communications in that there was no signal from Fed officials that such a move was coming ... The direction we seem to be on in terms of adding liquidity to a financial system that already has plenty of liquidity risks putting us in a scenario in which the Fed might have to constrain monetary expansion very drastically at some point down the road."
September 19 – The Wall Street Journal (Greg Ip ): "Federal Reserve chairman Ben Bernanke moved aggressively to stop the spreading credit crunch from sinking the nation's economy with a surprising half-percentage-point cut in interest rates, casting aside for now worries about appearing to bail out investors. The cut, which exceeded the quarter-point reduction most economists had expected, signals that Mr Bernanke, fearing broad damage from the market turmoil that erupted a month ago, preferred to risk doing too much rather than too little. The move came amid a sizable drop in home sales, construction and prices that could send mortgage defaults higher and damp consumer spending. With yesterday's move, Mr Bernanke may have shown himself closer in style and tactics to predecessor Alan Greenspan than some market watchers had suspected. That carries risks: Critics may start referring to the 'Bernanke put', as they once spoke of the 'Greenspan put' under the former Fed chairman ... "
September 18 – Bloomberg (Christian Vits): "European Central Bank council member Axel Weber said he expects stronger economic growth and rising oil prices to stoke inflation. 'We have to expect somewhat higher inflation rates for the rest of the year,' Weber, who also heads Germany's Bundesbank, said ..."
September 1 - Market News International (Steven K. Beckner): "There are many interesting aspects of former Federal Reserve Chairman Alan Greenspan's just-released book, but perhaps the most important are his warnings about inflation ... from a Fed watchers' standpoint, Greenspan's premonitions about inflation and long-term interest rates are the most timely ... Greenspan ascribes much of the Fed's ability to get inflation under control in recent years to globalization. 'The continuing acceleration of the flow of workers to competitive markets during the past decade has been a potent disinflationary force ...' This disinflation has in turn helped hold down long-term interest rates ... But he writes that 'the rate of flow of workers to competitive labor markets will eventually slow, and as a result, disinflationary pressures should start to lift. China's wage-rate growth should mount, as should its rate of inflation'.
Chinese export prices ... will rise further, he predicts. The result will be 'a pickup of price inflation and wage growth in the United States', writes Greenspan, adding, 'the burden of managing this shift will fall on the Federal Reserve'. 'How significant - and how corrosive - these price pressures will become for the American economy will depend in large part on the Fed's ability to respond', he writes, adding, 'The degree of monetary restraint required to contain any given rate of inflation will increase'."
September 19 – Bloomberg (Pimm Fox and Kevin Carmichael): "Paul O'Neill, a former US Treasury secretary and now a special adviser to Blackstone Group LP, comments on the Federal Reserve's decision yesterday to lower interest rates ... ' The markets were very fearful of the liquidity crunch. Markets basically stopped trading. They were reassured by the chairman's action yesterday. One might say Ben put the punch back in the punchbowl. There was nothing in the punchbowl. He succeeded in reassuring the markets that the Fed was not going to let this linger on. I think that's what we needed'."
California watch
September 21 – Bloomberg (William Selway): "A majority of Californians expect the economy to worsen in the most populous US state over the next year as housing sales plunge and more residents lose their homes to foreclosure, the results of a poll released today show. Fifty-nine percent of adults expect 'bad times' financially over the next 12 months, a jump of 10 percentage points since June ... "
GSE watch
September 18 – Bloomberg (James Tyson): "Federal Reserve Chairman Ben S Bernanke opposed a push to allow Fannie Mae and Freddie Mac to buy mortgages higher than $417,000, saying it may undermine efforts to strengthen regulation of the two largest US mortgage finance companies. A proposal in Congress to increase the limit 'would be ill-advised if it has the practical effect of reducing the incentives to achieve meaningful' regulatory tightening over the companies, Bernanke said ... [Representative] Frank and other Democrats, seeking to reverse the biggest housing market slump in 16 years, have called on the Bush administration to allow Fannie Mae and Freddie Mac to buy bigger mortgages and expand their $1.5 trillion investment portfolios. The companies’ regulator announced today it will allow the companies to annually increase their purchases of home loans and mortgage bonds by 2%. Bernanke in the letter written two days ago said ... 'Both the size and composition of the portfolios should be tied to reforms that both reduce the systemic risks posed by the portfolios and also clarify the public purpose', Bernanke said ..."
Mortgage finance bust watch
September 21 - Reuters: "A record 26% of US homeowners say the value of their homes has fallen during the past year, above the previous peak of 24% seen in 1992, a survey released on Friday showed. Reflecting the extent of the prolonged housing slump, 21% of homeowners polled in September expect the value of their home to decline in the year ahead, up from 18% in August, according to the data from Reuters/University of Michigan Surveys of Consumers. 'Overall, the data indicate no let-up in the slump in home prices,' said Richard Curtin, director of the consumer surveys, in a statement."
September 18 – Marketwatch (Robert Schroeder): "Reaching out to hard-hit borrowers in the subprime-mortgage market, the House ... passed a bill that lowers down payments for borrowers, raises loan limits and boosts funds for housing counseling. Passed by a vote of 348 to 72, the bill reforms the Federal Housing Administration and is the latest lifeline thrown to borrowers from Washington ... About two million loans are expected to reset to higher rates in the next two years, with defaults expected to follow ... The bill directs up to $300 million a year into an affordable housing fund. A motion offered by Rep Jeb Hensarling, R-Texas, to kill the fund was rejected ... Lawmakers also passed an amendment to the bill offered by [Representative] Frank that would raise the agency's loan limit from its current $417,000 to as much as $729,750. 'Such an increase would ensure that FHA is a viable option for borrowers who have payment option and interest-only adjustable rate mortgages (ARMs), which will be resetting in the next few years,' said Stanford Group Company analyst Jaret Seiberg."
Foreclosure watch
September 18 – Associated Press (Alex Veiga): "The number of foreclosure filings reported in the US last month more than doubled versus August 2006 and jumped 36% from July, a trend that signals many homeowners are increasingly unable to make timely payments on their mortgages or sell their homes amid a national housing slump. A total of 243,947 foreclosure filings were reported in August, up 115% from 113,300 in the same month a year ago ... RealtyTrac Inc. said ... 'The jump in foreclosure filings this month might be the beginning of the next wave of increased foreclosure activity, as a large number of subprime adjustable rate loans are beginning to reset now', RealtyTrac Chief Executive James J Saccacio said ... The latest figures also reflect an increase in the number of homes going into foreclosure that are not being picked up in estate sales and are ending up going back to lenders. The number of bank repossessions jumped to 42,789 in August, compared with 20,116 a year earlier, the RealtyTrac said. In July, there were 26,842 bank repossessions. Nevada, California and Florida had the highest foreclosure rates in the country last month, the firm said ... California's foreclosure rate was one filing for every 224 households. The state reported the most foreclosure filings of any single state with 57,875, up 48% from July and an increase of more than 300% from August 2006."
September 19 – Bloomberg (Bob Ivry): "As many as half of the 450,000 subprime borrowers whose mortgage payments increase in the next three months may lose their homes because they can't sell, refinance or qualify for help from the US government. 'Short of the cavalry riding in over the hill, a lot of these people are just stuck,' said Christopher Cagan, director of research and analytics at ... First American CoreLogic ... The number of borrowers whose mortgage payments jump in the next three months will be the second-highest ever for a quarter, according to Credit Suisse ... Twenty-seven percent have already missed a payment, said First American LoanPerformance, which owns the largest database of US mortgages. That makes them ineligible for the Federal Housing Administration bailout proposed last month by President George W Bush."
MBS/ABS/CDO/CP/money funds and derivatives watch
September 18 – Bloomberg (Jody Shenn): "Securities backed by prime US jumbo mortgages may be riskier than investors think because almost half of the underlying loans are from California, where home prices may again collapse, according to Barclays PLC. California accounts for 45% of jumbo mortgages in securities sold last year, up from 35% in 1989, Barclays mortgage-bond analysts wrote ... Following a housing boom, home prices in California declined by 12.5% between 1991 and 1995. Losses after foreclosures on jumbo loans securitized in 1989 rose to 3%, which would be enough to cause many current investment-grade bonds to default. 'The current housing environment in California appears similar to the 1990s,' wrote the ... analysts led by Ajay Rajadhyaksha. 'Many investors believe that jumbo credit is sound. We think that this sense of security is misplaced'."
Real estate bubbles watch
September 18 – Bloomberg (Dan Levy): "San Franciscans soon may have to crane their necks back a bit farther to gaze up at the city's tallest buildings. City officials are pushing for construction of two office and residential towers of 1,200 feet or more – at least 80 stories. They would dwarf the Transamerica Pyramid, which at 853 feet has been the tallest building in San Francisco since 1972. The new structures would challenge the 1,250-foot height of the Empire State Building in New York, the second-tallest US building. It's 'imperative' for San Francisco to keep pace as super-tall towers spring up around the globe, Mayor Gavin Newsom said ... 'Tall buildings are symbols of cities that don't want to be left behind in a competitive world,' architect Daniel Libeskind, who worked on designs for towers to replace Manhattan's World Trade Center, said ... "
September 17 – Bloomberg (Peter Woodifield): "Construction of the London office tower dubbed 'the Shard' may be delayed because of an increase in borrowing costs, according to the developer of the building that would be the UK's tallest. Talks about financing the project 'have, unfortunately, been affected by the recent adverse credit markets', said Sten Mortstedt, chairman of CLS Holdings Plc ... Work on the 72-story building, which will cost about 400 million pounds ($799 million), is due to start later this year."
Speculator watch
September 18 – Bloomberg (Jesse Westbrook and Jenny Strasburg): "The US Securities and Exchange Commission is examining hedge funds for signs of insider trading, demanding information about relationships between managers, employees, family members and public companies. SEC officials told hedge funds to list clients and workers who serve as officers or directors of publicly traded companies, along with the names of any relatives who hold such posts, according to a 27-page letter to industry executives ... The SEC confirmed its authenticity."
COMMENTARY
Q2 2007 flow of funds:
Considering third-quarter financial market developments, it is tempting to view Q2 Credit analysis as somewhat less than timely and relevant. Yet the data do provide evidence of worsening unstable dynamics - in particular, an energized Financial Sphere expanding at breakneck speed, easily outdistancing the flagging Economic Sphere. Highlights for the quarter included double-digit growth rates for both Commercial Bank and Broker/Dealer balance sheets. The ABS market continued its streak of double-digit growth, and Agency MBS posted back-to-back quarters of double-digit expansion. The Money Market Complex expanded at an almost 17% rate. Rest of World (ROW) holdings of US Assets expanded double-digit rates as well.
Overall, Total Net Borrowing in the Credit Markets increased at a SAAR (seasonally-adjusted and annualized rate) $3.757 TN during Q2 to $46.573 TN. This was down only slightly from Q1's SAAR $3.784 TN, and, for perspective, compares to 2006's growth of $3.825 TN, 2005's $3.380 TN, 2004's $3.085 TN, 2003's $2.767 TN, and 2002's $2.365 TN. Notably, Corporate borrowings expanded at a 10.7% rate during the quarter, state and local governments 11.9%, and the Financial Sector 9.8%. Financial sector borrowings built on Q1's brisk pace (9.7%) to the strongest rate of expansion in a year. And while recent Credit market turmoil has imposed borrowing restraint, it is worth noting that first-half corporate debt growth was at the fastest pace since 1999.
Total Non-Financial Debt expanded at a SAAR $2.080 TN (to $29.869TN), down somewhat from Q1's $2265 TN. By sector, Household debt expanded SAAR $926bn (vs. Q1's $908bn) to $13.292 TN; Non-Financial Corporations SAAR $626bn (vs. Q1's $520bn) to $6.050 TN; Non-Farm Non-Corporate SAAR $348bn (vs. Q1's 267bn) to $3.260 TN; Farm Business SAAR $5.1bn (vs. $20.6bn) to $210bn; and State & Local Govt. SAAR $246bn (vs. $224bn) to $2.130 TN. Accounting for more than all of Q2's decline in Non-Financial Debt Growth, Federal Government borrowings actually contracted SAAR $71bn, compared to Q1's expansion of SAAR $326bn. Federal government fiscal improvement will be fleeting.
Continuing a trend that became quite pronounced last year, near double-digit financial sector growth far exceeds that of the real economy. Financial Sector Credit Market Borrowings (FCMB) increased SAAR $1.423 TN (up from Q1's $1.377 TN) to $14.866 TN. For perspective, FCMB expanded $1.282 TN during 2006, $1.092 TN in 2005, $980bn in 2004, $1.053 TN in 2003, and $869bn in 2002. It is illuminating to note the type of Credit instruments that financed the financial sector expansion. During the quarter, "Open Market Paper" increased SAAR $360bn, "GSE Issues" SAAR $99bn, Agency-and GSE-backed securities SAAR $544bn, Corporate bonds SAAR $365bn, Bank Loans SAAR $47bn, and (bank liabilities) Mortgages SAAR $8.2bn. It will likely be some time before "Open Market Paper" and corporate bonds expand at such rates.
The Wall Street bubble was alive and well during Q2. The Broker/Dealers expanded Assets at SAAR $703bn to $3.155 TN. Broker/Dealer Assets inflated $413.1bn (nominal) during the first half, or 30.1% annualized. This expansion was second only to 2006's full-year $615bn growth. For perspective, Broker/Dealer Assets increased $282bn during 2005, $232 in 2004, and $278 in 2003 – and actually contracted $130bn during 2002. Examining the nature of Asset growth during the quarter, Corp & Foreign bonds increased SAAR $84bn, Securities Credit SAAR $219bn, and "Miscellaneous" SAAR $621bn. Treasury holdings declined SAAR $157bn and Agency/GSE MBS fell SAAR $101bn. On the Liability Side, Miscellaneous Liabilities increased SAAR $525bn, Securities Credit SAAR $95bn, and Trade Payables $55bn.
Wall Street "structured finance" enjoyed a booming and, perhaps, foretelling Q2. GSE Assets expanded SAAR $176bn (to $2.923TN), the strongest growth in a year. Still, GSE assets were up only 1.1% y-o-y. Agency MBS surged SAAR $544bn, up from Q1's $499bn and the year earlier $300bn. Agency MBS expanded at a 12.3% rate during the quarter, with one-year gains of 10.8%. Asset-Backed Securities expanded SAAR $545bn (to $4.295 TN), down only modestly from Q1's $574bn. And despite the slowest quarter in some time, the ABS market still enjoyed a 13.3% growth rate for the quarter and 18.1% growth over the past year. The ABS market has expanded 63% during the past 10 quarters, extraordinary growth that hit the wall with a thud with the homecoming of market tumult in Q3.
Interestingly, Total Mortgage Debt (TMD) expanded SAAR $1.167 TN (to $13.982 TN), up from Q1's SAAR $1.087 TN. TMD actually expanded at a robust 9.0% rate, the largest expansion since Q3 2006 - suggesting that ultra-easy Credit Conditions endured outside of subprime. Even Home Mortgage debt growth accelerated, rising to a 7.7% rate from Q1's 7.3%. Meanwhile, the Commercial Mortgage lending boom went to "blow-off" extremes – expanding at a 15.6% pace (vs. Q1's 10.1%). For the quarter, Home Mortgage lending expanded SAAR $756bn to $10.750 TN and Commercial Mortgage a record SAAR $344bn to $2.344 TN. Total Mortgage debt has expanded 9.2% over the past year and 24% over two years, with Commercial mortgage debt up 13.9% y-o-y and 31%. It will be fascinating to learn how dramatically mortgage debt growth slowed during Q3. Credit restraint hit all sectors.
Quite possibly, Q3 will see record banking sector asset growth, both building on Q2 momentum and taking up the slack created by the Breakdown of Wall Street Risk Intermediation. During the second quarter, Commercial Banking Assets expanded SAAR $1.037 TN to $10.455 TN. For comparison, Bank Assets grew $897bn during 2006, $763bn in 2005, $762bn in 2004, $495bn in 2003 and $477bn in 2002. On a percentage basis, Q2 experienced Bank Asset growth of 10.5%, with Loans up 8.9%. Over the past year, Bank Loans have expanded 9.0%, with a two-year gain of 22.9%. Bank holdings of Mortgage loans expanded at a 9.9% rate during the quarter (to $3.462TN), with one-year growth of 10.5%. Corporate Bond holdings jumped $44.4bn (22.1% annualized) to $848bn, with one-year growth of 15.5%. It's an inopportune time in the Credit Cycle for the banking system to expand so aggressively.
There were some interesting happenings on the Bank Liability side – the new Credit instruments created in the process of financing robust asset growth. Total Deposit growth slowed markedly to a 3.3% rate during the quarter to $6.162 TN (up 7.6% y-o-y). "Fed Funds & Net Repo" Liabilities expanded at a 14.3% pace to $1.327 TN (up 11.7% y-o-y). Credit Market Liabilities expanded at a brisk 18.5% rate to $1.063 TN (up 19.4% y-o-y). Miscellaneous Bank Liabilities grew at a 36.3% pace to $1.942 TN (up 10.5% y-o-y), and Bond Liabilities increased at a 22.9% rate to $625bn (up 18.3% y-o-y). One can make a strong argument that it has not been the ideal environment to aggressively expand capital markets liabilities to fund risky loan growth.
Money Market Mutual Funds (MMF) expanded a robust SAAR $442bn to $2.490 TN. MMF assets were up 16.7% annualized during the quarter, 20.4% y-o-y and 35.9% over two years. "Security RP" holdings expanded SAAR $85.8bn during the quarter to $413bn. Credit Market Instruments increased SAAR $350.8bn, with Open Market Paper up SAAR $90.4bn (to $664bn), Treasury Securities up SAAR $38.7bn (to $89bn), Agency- and GSE MBS up SAAR $31.1bn (to 126bn), Municipal Securities SAAR $58.4bn (to $399bn), and Corporate & Foreign Bonds SAAR $132bn (to $422bn). And it has definitely been a risky backdrop for enormous money fund intermediation of late-cycle risky credits.
"Open Market Paper" expanded a record SAAR $410bn during Q2 to $2.110 TN. This was a notable 22.4% rate of expansion during the quarter, with one-year growth of 16.7%. Virtually all Q2 growth was in Commercial Paper, although this amount and more will be reversed during the current quarter. The ABS sector issued a record SAAR $295bn of (asset-backed) Commercial Paper during the quarter (to $885bn). At SAAR $140.7bn, "Funding Corps" were the largest purchasers of Open Market Paper. Funding Corp Asset growth slowed during Q2 (to 7.1% ann.), reducing its first-half growth rate to 20.7% (to $1.681 TN). Fed Funds & Net Repo Asset growth also slowed (to an 8.2% rate), reducing the pace of first-half growth to a still blistering 19.0% (to $2.731TN)
Delving briefly into other financial operators, Life Insurance Cos. expanded Assets at a 10.2% rate during the quarter to $4.868 TN (up 8.7% y-o-y); Financial Companies at a 0.7% rate to $1.896 TN (up 2.1% y-o-y); Saving Institutions at a 1.3% rate to $1.673 TN (down 5.4% y-o-y); Credit Unions up at a 3.9% rate to $749bn (up 6.4% y-o-y); and REIT assets down at a 7.1% rate to $391bn (up 7.6% y-o-y).
As always, the Household (& Non-Profit) Balance Sheet illuminates powerful Credit Bubble dynamics. The value of Household Assets inflated $1.510 TN (nominal) during the quarter, or 8.6% annualized, to $71.672 TN. And with Household Liabilities increasing "only" $301bn, or 8.9% annualized, to $13.813 TN, Household Net Worth inflated an additional $1.206 TN, or 8.5% annualized, during the quarter to a record $57.859 TN. Expanding at an 11% annualized rate, Financial Assets increased $1.186 TN (nominal) to $44.284 TN. Real Estate Assets grew a moderate $274bn, or 4.8% annualized, to $23.193 TN.
Over the past year, Financial Asset holdings have increased $3.980 TN, or 9.9%, and Real Estate Assets $1.135 TN, or 5.1%. Total Household Assets have ballooned $5.271 TN, or 7.9%, in four quarters. With Liabilities up $1.076 TN, or 8.5%, Household Net Worth has inflated $4.195 TN over the past year, or 7.8%. Household Net Worth is up $8.512 TN, or 17.2%, in two years, certainly supporting consumer confidence and expenditures.
The Rest of World (ROW) Balance Sheet also typically exposes Credit Bubble effects. This quarter's report, unfortunately, is somewhat convoluted – and with major revisions to confuse the issue. For the quarter, the ROW acquired US Financial Assets at an unprecedented SAAR $2.535 TN, while ROW US Liabilities increased a record SAAR $1.934. In nominal dollars for Q2, ROW Assets holdings increased an enormous $522bn, or 14.1% annualized, to (a heavily revised) $15.366 TN. Credit Market holdings increased $215bn, or 15% annualized, to $6.947 TN. Treasury Holdings dipped $7.8bn to $2.185 TN, while Agencies jumped $86bn to $1.134 TN. Corporate Bond holdings rose $111bn to $2.990 TN.
Over the past year, ROW holdings of U.S. Assets were up an unfathomable $2.659 TN, or 20.9% (ROW Liabilities up $1.172 TN to $6.877 TN). Credit Market holdings have increased $919bn, or 15.2%. Elsewhere, Security Repos increased $265bn (28.2%) y-o-y, and Direct Investment rose $226bn (11.5%). Corporate Bonds (that include ABS) increased $787bn, while "Other" Assets were up almost $400bn and Deposits $118bn.
Second quarter numbers suggests the scope of global dollar "recycling" requirements has inflated substantially. The Federal Reserve's aggressive rate cuts last week definitely only exacerbate what is becoming an untenable outward flow of dollar liquidity from the U.S. financial system to the Rest of World (that must, at a price, be "recycled" back into US assets).
We believe the current course of Fed policy is an attempt to sustain the unsustainable. The Q2 Flow of Funds report certainly confirms the enormity of ongoing Credit creation, intensive Risk Intermediation, and Financial Sector Ballooning – Classic Credit Bubble Dynamics. The bottom line is that only extreme levels of Credit expansion and intermediation now sustain bloated and maladjusted financial, economic and asset market structures. As we've witnessed, any interruption in the Credit creation process will almost immediately instigate financial dislocation. The Fed has chosen aggressive action in hopes of resuscitating Credit excess and Bubble Perpetuation. A less risky strategy for our system and currency would necessitate air flowing in the other direction - out of Credit, asset and economic Bubbles. Postponing the adjustment process at this point ensures greater future financial tumult and economic hardship.
Doug Noland is a market strategist for the Prudent Bear Funds.
(Republished with permission from PrudentBear.com. Copyright 2005-2007 David W Tice & Associates.)
Former US Treasury secretary Paul O'Neill commented that the "Fed put the punch back into the punchbowl". For last week, the Dow and S&P500 gained 2.8%, increasing year-to-date gains to 10.9% and 7.6%. The Morgan Stanley Cyclical index jumped 4.3% (up 18.2% year-to-date), and the Morgan Stanley Consumer index gained 3.1% (up 6.6%).
Utilities rose 2.3% (up 9.7%), and the transports added 0.6% (up 5.9%). The small cap Russell 2000 rallied 3.1% (up 3.2%), and the S&P400 Mid-Cap index gained 2.2% (up 9.6%). Technology stocks added to already strong gains. The NASDAQ100 rose 2.4% (up 16.7%), and the Morgan Stanley High Tech index gained 2.6% (up 16.7%). Semiconductors increased 2.9% (up 7.1%). The Street.com Internet index advanced 2.0% (up 15.7%), and the NASDAQ telecommunications index jumped 3.3% (up 19.9%).
Broker/dealers (down 4.0%) and banks (down 7.7%) both gained 2.3%. With bullion rising $23.90, the HUI gold index surged 9.4% (up 18.2%). The Fed threw the yield curve for a loop. Three-month T-bill rates sank 23 basis points last week to 3.76%. Two-year US government yields were unchanged at 4.04%.
Meanwhile, five-year yields rose 12 basis points to 4.29% and 10-year Treasury yields 16 basis points to 4.62%. Long-bond yields ended the week 16.5 basis points higher at 4.885%. The 2-year/10year spread ended the week at 58 basis points, the high since May '05. The implied yield on three-month December '07 Eurodollars fell 15 bps to 4.74%. Benchmark Fannie Mae MBS yields rose 5 basis points to 5.95%, this week meaningfully outperforming Treasuries. The spread on Fannie's 5% 2017 note narrowed 3 to 46, and the spread on Freddie's 5% 2017 note narrowed 3.5 to 45.6.
The 10-year dollar swap spread declined 3 to 64.3. Corporate bond spreads narrowed. The spread on a junk index ended the week 6 basis points narrower. Investment grade debt issuers included Tyco $2.05bn, Marathon Oil $1.5bn, Suncor $1.15bn, Rockies Express $600 million, Leucadia National $500 million, Southwest Air $500 million, Weyerhaeuser $450 million, Liberty Properties $300 million, Avery Dennison $250 million, and San Diego G&E $250 million. Junk issuers included RH Donnelley $1.0bn, Compucom Systems $210 million and Baseline Oil $165 million.
Convert issuers included Powerwave Technologies $150 million and Equinix $350 million. Foreign dollar bond issuance included Barclays $2.0bn, Glitnir Bank $1.0bn, Rede Empresas Energia $575 million, and Canadian National Railroad $550 million.
German 10-year bund yields surged 19 bps to 4.36%, as the DAX equities index jumped 4.0% (up 18.2% year-to-date). Japanese 10-year "JGB" yields rose 13.5 bsais points to 1.675%. The Nikkei 225 rose 3.1% (down 5.3% year-to-date). Emerging debt markets were mixed to higher, while equities went higher and higher. Brazil's benchmark dollar bond yields fell 10 basis points to 5.85%. Brazil's Bovespa equities index burst 5.7% higher (up 30% year-to-date). The Mexican Bolsa gained 1.6% (up 15.6% year-to-date).
Mexico's 10-year $ yields rose 7 basis points to 5.56%. Russia's RTS equities index jumped 4.3% (up 5.4% year-to-date). India's Sensex equities index surged 6.2% (up 20.1% year-to-date). China's Shanghai Composite index added 2.7% to close at yet another record high (up 104% year-to-date and 213% over the past year).
Freddie Mac posted 30-year fixed mortgage rates rose 3 basis points last week to 6.34% (down 6 basis points year-on-year). Fifteen-year fixed rates added one basis point to 5.98% (down 8 basis points year-on-year). One-year adjustable rates dipped one basis point to 5.65% (up 11 basis points year-on-year).
Bank Credit increased $11.4 bn (week of 9/12) to a record $8.924 TN. After a seven-week surge of $284bn, bank credit has now increased $628bn year-to-date, or a rate of 10.6%. For the week, Securities Credit surged $26.9bn. Loans and leases dropped $15.5bn to $6.528 TN (seven-week gain of $200bn). C&I loans gained $12.15bn and real estate loans added $0.2bn. Consumer loans fell $10.0bn. Securities loans were little changed, while Other loans dropped $17.1bn. On the liability side, (previous M3) Large time deposits supped $23.9bn.
M2 (narrow) "money" fell $17.3bn to $7.349 TN (week of 9/10). Narrow "money" has expanded $305bn year-to-ddate, or 6.1% annualized, and $473bn, or 6.9%, over the past year. For the week, Currency added $0.3bn, while Demand & Checkable Deposits sank $49bn. Savings deposits jumped $34.2bn, and small denominated deposits added $1.1bn. Retail money fund assets declined $3.7bn.
Total Money Market Fund Assets (from Inves. Co Inst) dipped $3.1bn to $2.825 TN. Money Fund Assets have increased $443bn year-to-date, a 25.5% rate, and $600bn over 52 weeks, or 26.9%.
Total CP dropped another $48bn to $1.869 TN, boosting the six-week decline to $354.4bn. Asset-backed CP dropped another $15.9bn (6-wk drop of $244.5bn) to $928.9bn. Year-to-date, total CP is now down $105.2bn, with ABCP declining $155bn. Over the past year, Total CP is now down $13bn, or 0.7%.
Asset-backed Securities (ABS) issuance increased modesly to $7.2bn last week. Year-to-date total US ABS issuance of $453bn (tallied by JP Morgan) is now running 29% behind comparable 2006. At $209bn, year-to-date home equity ABS sales are 49% below last year's pace. Year-to-date US CDO issuance of $260 billion is running 5% ahead of 2006 sales.
Fed Foreign Holdings of Treasury, Agency Debt (week ended 9/19) rose $6.2bn to $1.987 TN. "Custody holdings" were up $235bn year-to-date (18.4% annualized) and $314bn during the past year, or 18.8%. Federal Reserve Credit last week declined $4.2bn to $853bn. Fed Credit has increased $0.8bn y-t-d and $24.1bn over the past year (2.9%).
International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi – were up $933bn y-t-d (26.5% annualized) and $1.153 TN y-o-y (25.1%) to $5.743 TN.
Credit market dislocation watch
September 22 - Financial Times (James Politi): "KKR and Goldman Sachs yesterday attempted to pull the plug on the $8bn buy-out of Harman International, the high-end US electronics company, as the battle over the completion of deals signed before the credit squeeze turned increasingly ugly. The move by KKR and Goldman's private equity arm could prove to be a watershed moment for buy-out firms that went on an extraordinary dealmaking binge earlier this year but are now facing higher financing costs and a shaky economic outlook.
"It signals that in certain cases, private equity groups are willing to sacrifice the reputational risk associated with abandoning deals, and the danger of not being viewed as credible buyers in future takeovers, in order to clear unwanted deals from their table in this cycle. KKR and Goldman told Harman that they could walk away from the deal because of a "material adverse change" in the contract - presumably a deterioration in the company's main business of supplying audio systems to luxury carmakers such as Mercedes and BMW. But Harman disputed the claim by KKR and Goldman, saying it 'disagrees that a MAC has occurred or that it has breached the merger agreement'."
September 21 - Financial Times (Chris Giles and Peter Thal Larsen): "On Monday evening Mervyn King believed the first real crisis of his Bank of England stewardship had – as he put it to friends – been sorted. Beset by images of customers rushing to withdraw their money from Northern Rock, Alistair Darling, the chancellor, had offered depositors a blanket assurance that their cash was safe. But within five days, Mr King's optimism had been proved comprehensively and humiliatingly unfounded. In one of the most extraordinary weeks in British banking history – one which saw the global credit squeeze spill on to the nation's streets – the bank had on Wednesday performed an abrupt volte face. It had decided to extend emergency lending against mortgage collateral to all banks – a step that just 24 hours earlier the governor had privately ruled out. As the week draws to a close the focus of account holders and bank chief executives alike is on what happened in those missing hours. What persuaded the Bank to capitulate and throw its own money and good name into rescuing commercial banks from their own funding mistakes?"
September 21 - Financial Times (Javier Blas): "Gold reached its highest price yesterday for almost 28 years at more than $735 a troy ounce. Investors rushed to buy the yellow metal amid US dollar weakness and inflation concerns. Bullion hit an intraday high of $738.30 an ounce, the highest level since February 1980, and was later trading at $737.35-$738.05 an ounce, up 15% this year. Gold was at a high of $850 an ounce in January 1980. It reached $730 in May 2006, which was a 26-year high. The price jump came after the US dollar fell to a record low of $1.4087 to the euro. The US currency has sunk since the Federal Reserve cut interest rates by 50 basis points to 4.75% on Tuesday in an attempt to prop up economic growth."
September 21 - Financial Times (Michael Mackenzie in New York and Krishna Guha and Eoin Callan): "The dollar plunged, government bond yields soared and the price of oil hit a record high yesterday amid growing concern that interest rate cuts by the Federal Reserve could stoke inflation. The gyrations came as Ben Bernanke, Fed chairman, told Congress that the 50 basis point cut in rates this week was a pre-emptive move to prevent market turmoil from harming the economy. He said the Fed cut rates 'to try to get out ahead of the situation and try to forestall potential effects of tighter credit conditions on the broader economy'."
September 21 - Financial Times (Francesco Guerrera ): "Corporate America is about to be hit by a new wave of business failures as the credit squeeze forces weak, highly leveraged, companies to default on $35bn-worth of debt, Standard & Poor's warned ... The credit rating agency said that the slowing economy and ongoing liquidity squeeze put some 75 junk-rated companies, mostly in the media, healthcare and consumer products sectors, at a high risk of default over the next 15 months. John Bilardello, S&P's head of corporate ratings, said the level of defaults could turn out to be much higher if the economy and the debt markets were to worsen further in 2008."
September 21 - Financial Times (Paul J Davies): "Structured investment vehicles (SIVs) will remain under pressure if there is not a quick improvement in short-term funding markets, and more vehicles are likely to face ratings downgrades, according to Derivative Fitch, the rating agency. The agency said it did not expect a short-term improvement in either the short-term commercial paper environment or for the illiquidity and re-pricing of credit risk in the market. SIVs, which aim to profit from the difference between cheap short-term borrowing rates in the money markets and the higher returns available on longer term debt investments, have come under pressure during the turmoil of recent months."
Currency watch
September 21 - Financial Times (Peter Garnham ): "The Canadian dollar rose to parity against the US dollar for the first time since 1976 yesterday, buoyed by soaring oil prices and broad-based weakness in the greenback. Adam Cole, at RBC Capital Markets, said he expected the Canadian dollar to continue its upward path. 'Canada produces the commodities the world wants - it is still the number one commodity play among major currencies,' he said." The dollar index sank 1.3% to 78.60. On the upside, the New Zealand dollar increased 5.3%, the Australian dollar 4.0%, the Brazilian real 2.8%, the South African rand 3.1%, the Canadian dollar 2.7%, and the Swedish krona 2.7%. On the downside, the Japanese yen declined 0.3%. The Euro gained 1.6% to a record high.
Commodities watch
For last week, Gold jumped 3.4% to $731.5 and Silver 7.2% to $13.62. December Copper rose 5.9%. November crude ended the week at a record $81.62, up $3.53 on the week. October gasoline gained 3.5%, while October Natural Gas declined 3.2%. December Wheat was little changed. For the week, the CRB index surged 3.8% (up 8.4% year-to-date), and the Goldman Sachs Commodities Index (GSCI) jumped 3.5% (up 25.5% year-to-date).
Japan watch
September 18 – Bloomberg (Toru Fujioka): "Japanese households' assets rose to a record in the three months ended June 30, as individuals earned higher returns on stocks, mutual funds and bonds. The value of households’ assets rose 2.9% to 1,555 trillion yen ($13.5 trillion) from a year earlier, the Bank of Japan said ..."
September 19 – Bloomberg (Kathleen Chu): "Land prices in Japan's three largest metropolitan areas rose for a second-straight year, and nationwide commercial land prices rose for the first time in 16 years as the country's property market continued its rebound. The value of property in the Tokyo, Osaka and Nagoya regions gained 5.1% on average for the year ended June 30 ..."
China watch
September 19 – Market News International: "China's retail sales are expected to rise 15% to 8.8 trln yuan in 2007, the Ministry of Commerce's Department of market regulation said ... In the first eight months, retail sales were up 15.7% ..."
India watch
September 21 – Bloomberg (Cherian Thomas): "India may cut cash held by lenders for the fourth time this year as currency sales by the central bank aimed at curbing rupee gains flood the economy with excess money, Credit Suisse AG and Nomura Securities Co said. India's currency has strengthened beyond 40 per dollar for the first time in nine years amid unprecedented overseas investment in local shares. The central bank has injected rupees worth $43.1 billion in the nine months to July, almost three times the amount in previous nine months."
Asia watch
September 21 – Bloomberg (Perris Lee): "Taiwan's export orders grew at a slower pace in August as a housing recession eroded demand from the US, the island's second-biggest overseas market. Orders for shipment overseas rose 16.32% from a year earlier, slowing from July's 23.49% gain ..."
September 21 – Bloomberg (Karl Lester M. Yap): "Philippine money supply grew less than 20% in August, central bank Deputy Governor Diwa Guinigundo told reporters ..."
Unbalanced global economy watch
September 18 – Bloomberg (David M Levitt and Bryan Keogh): "The world economy 'is probably at its scariest point since the Depression' as fallout from the US subprime mortgage crisis crimps access to credit, said Ethan Penner, a pioneer of the $600 billion commercial mortgage-backed securities market in the early 1990s. 'We're probably at the closest point to a big meltdown, a depression-type meltdown than we have been in our lives,' said Penner ... now a principal at real estate fund management firm Lubert-Adler Partners LP ... The US housing market is an 'unmitigated disaster' ... As foreclosures rise, lenders will try to sell the properties they acquire at depressed prices, dragging the market down further, he said."
September 19 – The Wall Street Journal Europe: "UK housing boom has been a long time coming, but it has finally arrived. The 3% August drop in the average house price, as reported by property Web site Rightmove, certifies the beginning of the new era. The end comes when prices are too high by any measure ... The Bank of England tried to prick the bubble with rhetoric and higher interest rates. But its tactics proved much less potent than the credit crunch."
September 19 – Bloomberg (Fergal O’Brien): "Europe's manufacturing and service industries grew at the slowest pace in two years this month after paralysis in the credit markets hurt banks, adding to evidence economic growth is waning."
Latin America watch
September 19 –Dow Jones (Anthony Harrup): "First it was tortillas, then milk, and now Mexican bread prices are going up, corroborating the central bank's persistent warnings about food prices threatening its inflation outlook. Mexico's baking industry confirmed this week that it plans to raise bread prices by 15% to 17% on average to recoup rising costs of wheat flour and other raw materials. Antonio Arias Ordonez, president of the Mexican Bakeries Industry Chamber, said he expects all of the country’s roughly 26,500 bread shops to raise their prices. 'It would be unusual if they didn't after raw materials costs have risen between 55% and 65%' Arias said ... Apart from flour, prices of margarine, eggs and sugar, have also been rising, he added."
Bubble economy watch
September 21 - Financial Times (Francesco Guerrera ): "Victory lap or last hurrah? Buy-out titans and hedge fund managers stormed the citadel of US wealth last year, barging their way into the Forbes 400 annual list of richest Americans on the back of buoyant capital markets and record merger activity. Nearly half of the 45 new entrants in the magazine's latest tally of US billionaires – which was topped once again by Bill Gates – came from the neighbouring worlds of private equity and hedge funds. But before Connecticut yacht dealers and Palm Beach property agents begin bombarding 'new super rich' such as Carlyle's David Rubenstein and hedge fund manager John Paulson with phone calls, they might want to consider the ephemeral nature of fortunes gained in such volatile industries."
September 18 – Bloomberg (Carlyn Kolker): "US companies increased total compensation for their chief in-house lawyers by 14% in 2007, according to a survey by legal consultant Altman Weil Inc., which cited competition for legal talent ... Median total pay for chief legal officers was $457,000, according to the survey ... Salaries rose 5.8% to $300,000, and bonuses were up 43% to $157,000. 'This may reflect a need to counter the dramatic increases in law firm starting salaries as general counsel compete with law firms for talent,' Altman Weil consultant James Wilber said ... Several New York-based law firms raised pay for first-year attorneys to $160,000 this year."
Central banker watch
September 18 – Bloomberg (Bob Willis and Tom Keene): "Conrad DeQuadros, senior economist at Bear Stearns & Co. in New York, comments on the Federal Reserve's decision yesterday to cut its benchmark interest rate to 4.75% from 5.25%. In a note to clients, he and Bear Stearns chief US economist John Ryding called yesterday a 'black day' for the Fed. Dequadros spoke in an interview ... On the language in his note: It is strong language. For the Fed to cut rates aggressively while citing that inflation risks remain, that risks the Fed's inflation fighting credibility ... There are also issues of credibility about Fed communications in that there was no signal from Fed officials that such a move was coming ... The direction we seem to be on in terms of adding liquidity to a financial system that already has plenty of liquidity risks putting us in a scenario in which the Fed might have to constrain monetary expansion very drastically at some point down the road."
September 19 – The Wall Street Journal (Greg Ip ): "Federal Reserve chairman Ben Bernanke moved aggressively to stop the spreading credit crunch from sinking the nation's economy with a surprising half-percentage-point cut in interest rates, casting aside for now worries about appearing to bail out investors. The cut, which exceeded the quarter-point reduction most economists had expected, signals that Mr Bernanke, fearing broad damage from the market turmoil that erupted a month ago, preferred to risk doing too much rather than too little. The move came amid a sizable drop in home sales, construction and prices that could send mortgage defaults higher and damp consumer spending. With yesterday's move, Mr Bernanke may have shown himself closer in style and tactics to predecessor Alan Greenspan than some market watchers had suspected. That carries risks: Critics may start referring to the 'Bernanke put', as they once spoke of the 'Greenspan put' under the former Fed chairman ... "
September 18 – Bloomberg (Christian Vits): "European Central Bank council member Axel Weber said he expects stronger economic growth and rising oil prices to stoke inflation. 'We have to expect somewhat higher inflation rates for the rest of the year,' Weber, who also heads Germany's Bundesbank, said ..."
September 1 - Market News International (Steven K. Beckner): "There are many interesting aspects of former Federal Reserve Chairman Alan Greenspan's just-released book, but perhaps the most important are his warnings about inflation ... from a Fed watchers' standpoint, Greenspan's premonitions about inflation and long-term interest rates are the most timely ... Greenspan ascribes much of the Fed's ability to get inflation under control in recent years to globalization. 'The continuing acceleration of the flow of workers to competitive markets during the past decade has been a potent disinflationary force ...' This disinflation has in turn helped hold down long-term interest rates ... But he writes that 'the rate of flow of workers to competitive labor markets will eventually slow, and as a result, disinflationary pressures should start to lift. China's wage-rate growth should mount, as should its rate of inflation'.
Chinese export prices ... will rise further, he predicts. The result will be 'a pickup of price inflation and wage growth in the United States', writes Greenspan, adding, 'the burden of managing this shift will fall on the Federal Reserve'. 'How significant - and how corrosive - these price pressures will become for the American economy will depend in large part on the Fed's ability to respond', he writes, adding, 'The degree of monetary restraint required to contain any given rate of inflation will increase'."
September 19 – Bloomberg (Pimm Fox and Kevin Carmichael): "Paul O'Neill, a former US Treasury secretary and now a special adviser to Blackstone Group LP, comments on the Federal Reserve's decision yesterday to lower interest rates ... ' The markets were very fearful of the liquidity crunch. Markets basically stopped trading. They were reassured by the chairman's action yesterday. One might say Ben put the punch back in the punchbowl. There was nothing in the punchbowl. He succeeded in reassuring the markets that the Fed was not going to let this linger on. I think that's what we needed'."
California watch
September 21 – Bloomberg (William Selway): "A majority of Californians expect the economy to worsen in the most populous US state over the next year as housing sales plunge and more residents lose their homes to foreclosure, the results of a poll released today show. Fifty-nine percent of adults expect 'bad times' financially over the next 12 months, a jump of 10 percentage points since June ... "
GSE watch
September 18 – Bloomberg (James Tyson): "Federal Reserve Chairman Ben S Bernanke opposed a push to allow Fannie Mae and Freddie Mac to buy mortgages higher than $417,000, saying it may undermine efforts to strengthen regulation of the two largest US mortgage finance companies. A proposal in Congress to increase the limit 'would be ill-advised if it has the practical effect of reducing the incentives to achieve meaningful' regulatory tightening over the companies, Bernanke said ... [Representative] Frank and other Democrats, seeking to reverse the biggest housing market slump in 16 years, have called on the Bush administration to allow Fannie Mae and Freddie Mac to buy bigger mortgages and expand their $1.5 trillion investment portfolios. The companies’ regulator announced today it will allow the companies to annually increase their purchases of home loans and mortgage bonds by 2%. Bernanke in the letter written two days ago said ... 'Both the size and composition of the portfolios should be tied to reforms that both reduce the systemic risks posed by the portfolios and also clarify the public purpose', Bernanke said ..."
Mortgage finance bust watch
September 21 - Reuters: "A record 26% of US homeowners say the value of their homes has fallen during the past year, above the previous peak of 24% seen in 1992, a survey released on Friday showed. Reflecting the extent of the prolonged housing slump, 21% of homeowners polled in September expect the value of their home to decline in the year ahead, up from 18% in August, according to the data from Reuters/University of Michigan Surveys of Consumers. 'Overall, the data indicate no let-up in the slump in home prices,' said Richard Curtin, director of the consumer surveys, in a statement."
September 18 – Marketwatch (Robert Schroeder): "Reaching out to hard-hit borrowers in the subprime-mortgage market, the House ... passed a bill that lowers down payments for borrowers, raises loan limits and boosts funds for housing counseling. Passed by a vote of 348 to 72, the bill reforms the Federal Housing Administration and is the latest lifeline thrown to borrowers from Washington ... About two million loans are expected to reset to higher rates in the next two years, with defaults expected to follow ... The bill directs up to $300 million a year into an affordable housing fund. A motion offered by Rep Jeb Hensarling, R-Texas, to kill the fund was rejected ... Lawmakers also passed an amendment to the bill offered by [Representative] Frank that would raise the agency's loan limit from its current $417,000 to as much as $729,750. 'Such an increase would ensure that FHA is a viable option for borrowers who have payment option and interest-only adjustable rate mortgages (ARMs), which will be resetting in the next few years,' said Stanford Group Company analyst Jaret Seiberg."
Foreclosure watch
September 18 – Associated Press (Alex Veiga): "The number of foreclosure filings reported in the US last month more than doubled versus August 2006 and jumped 36% from July, a trend that signals many homeowners are increasingly unable to make timely payments on their mortgages or sell their homes amid a national housing slump. A total of 243,947 foreclosure filings were reported in August, up 115% from 113,300 in the same month a year ago ... RealtyTrac Inc. said ... 'The jump in foreclosure filings this month might be the beginning of the next wave of increased foreclosure activity, as a large number of subprime adjustable rate loans are beginning to reset now', RealtyTrac Chief Executive James J Saccacio said ... The latest figures also reflect an increase in the number of homes going into foreclosure that are not being picked up in estate sales and are ending up going back to lenders. The number of bank repossessions jumped to 42,789 in August, compared with 20,116 a year earlier, the RealtyTrac said. In July, there were 26,842 bank repossessions. Nevada, California and Florida had the highest foreclosure rates in the country last month, the firm said ... California's foreclosure rate was one filing for every 224 households. The state reported the most foreclosure filings of any single state with 57,875, up 48% from July and an increase of more than 300% from August 2006."
September 19 – Bloomberg (Bob Ivry): "As many as half of the 450,000 subprime borrowers whose mortgage payments increase in the next three months may lose their homes because they can't sell, refinance or qualify for help from the US government. 'Short of the cavalry riding in over the hill, a lot of these people are just stuck,' said Christopher Cagan, director of research and analytics at ... First American CoreLogic ... The number of borrowers whose mortgage payments jump in the next three months will be the second-highest ever for a quarter, according to Credit Suisse ... Twenty-seven percent have already missed a payment, said First American LoanPerformance, which owns the largest database of US mortgages. That makes them ineligible for the Federal Housing Administration bailout proposed last month by President George W Bush."
MBS/ABS/CDO/CP/money funds and derivatives watch
September 18 – Bloomberg (Jody Shenn): "Securities backed by prime US jumbo mortgages may be riskier than investors think because almost half of the underlying loans are from California, where home prices may again collapse, according to Barclays PLC. California accounts for 45% of jumbo mortgages in securities sold last year, up from 35% in 1989, Barclays mortgage-bond analysts wrote ... Following a housing boom, home prices in California declined by 12.5% between 1991 and 1995. Losses after foreclosures on jumbo loans securitized in 1989 rose to 3%, which would be enough to cause many current investment-grade bonds to default. 'The current housing environment in California appears similar to the 1990s,' wrote the ... analysts led by Ajay Rajadhyaksha. 'Many investors believe that jumbo credit is sound. We think that this sense of security is misplaced'."
Real estate bubbles watch
September 18 – Bloomberg (Dan Levy): "San Franciscans soon may have to crane their necks back a bit farther to gaze up at the city's tallest buildings. City officials are pushing for construction of two office and residential towers of 1,200 feet or more – at least 80 stories. They would dwarf the Transamerica Pyramid, which at 853 feet has been the tallest building in San Francisco since 1972. The new structures would challenge the 1,250-foot height of the Empire State Building in New York, the second-tallest US building. It's 'imperative' for San Francisco to keep pace as super-tall towers spring up around the globe, Mayor Gavin Newsom said ... 'Tall buildings are symbols of cities that don't want to be left behind in a competitive world,' architect Daniel Libeskind, who worked on designs for towers to replace Manhattan's World Trade Center, said ... "
September 17 – Bloomberg (Peter Woodifield): "Construction of the London office tower dubbed 'the Shard' may be delayed because of an increase in borrowing costs, according to the developer of the building that would be the UK's tallest. Talks about financing the project 'have, unfortunately, been affected by the recent adverse credit markets', said Sten Mortstedt, chairman of CLS Holdings Plc ... Work on the 72-story building, which will cost about 400 million pounds ($799 million), is due to start later this year."
Speculator watch
September 18 – Bloomberg (Jesse Westbrook and Jenny Strasburg): "The US Securities and Exchange Commission is examining hedge funds for signs of insider trading, demanding information about relationships between managers, employees, family members and public companies. SEC officials told hedge funds to list clients and workers who serve as officers or directors of publicly traded companies, along with the names of any relatives who hold such posts, according to a 27-page letter to industry executives ... The SEC confirmed its authenticity."
COMMENTARY
Q2 2007 flow of funds:
Considering third-quarter financial market developments, it is tempting to view Q2 Credit analysis as somewhat less than timely and relevant. Yet the data do provide evidence of worsening unstable dynamics - in particular, an energized Financial Sphere expanding at breakneck speed, easily outdistancing the flagging Economic Sphere. Highlights for the quarter included double-digit growth rates for both Commercial Bank and Broker/Dealer balance sheets. The ABS market continued its streak of double-digit growth, and Agency MBS posted back-to-back quarters of double-digit expansion. The Money Market Complex expanded at an almost 17% rate. Rest of World (ROW) holdings of US Assets expanded double-digit rates as well.
Overall, Total Net Borrowing in the Credit Markets increased at a SAAR (seasonally-adjusted and annualized rate) $3.757 TN during Q2 to $46.573 TN. This was down only slightly from Q1's SAAR $3.784 TN, and, for perspective, compares to 2006's growth of $3.825 TN, 2005's $3.380 TN, 2004's $3.085 TN, 2003's $2.767 TN, and 2002's $2.365 TN. Notably, Corporate borrowings expanded at a 10.7% rate during the quarter, state and local governments 11.9%, and the Financial Sector 9.8%. Financial sector borrowings built on Q1's brisk pace (9.7%) to the strongest rate of expansion in a year. And while recent Credit market turmoil has imposed borrowing restraint, it is worth noting that first-half corporate debt growth was at the fastest pace since 1999.
Total Non-Financial Debt expanded at a SAAR $2.080 TN (to $29.869TN), down somewhat from Q1's $2265 TN. By sector, Household debt expanded SAAR $926bn (vs. Q1's $908bn) to $13.292 TN; Non-Financial Corporations SAAR $626bn (vs. Q1's $520bn) to $6.050 TN; Non-Farm Non-Corporate SAAR $348bn (vs. Q1's 267bn) to $3.260 TN; Farm Business SAAR $5.1bn (vs. $20.6bn) to $210bn; and State & Local Govt. SAAR $246bn (vs. $224bn) to $2.130 TN. Accounting for more than all of Q2's decline in Non-Financial Debt Growth, Federal Government borrowings actually contracted SAAR $71bn, compared to Q1's expansion of SAAR $326bn. Federal government fiscal improvement will be fleeting.
Continuing a trend that became quite pronounced last year, near double-digit financial sector growth far exceeds that of the real economy. Financial Sector Credit Market Borrowings (FCMB) increased SAAR $1.423 TN (up from Q1's $1.377 TN) to $14.866 TN. For perspective, FCMB expanded $1.282 TN during 2006, $1.092 TN in 2005, $980bn in 2004, $1.053 TN in 2003, and $869bn in 2002. It is illuminating to note the type of Credit instruments that financed the financial sector expansion. During the quarter, "Open Market Paper" increased SAAR $360bn, "GSE Issues" SAAR $99bn, Agency-and GSE-backed securities SAAR $544bn, Corporate bonds SAAR $365bn, Bank Loans SAAR $47bn, and (bank liabilities) Mortgages SAAR $8.2bn. It will likely be some time before "Open Market Paper" and corporate bonds expand at such rates.
The Wall Street bubble was alive and well during Q2. The Broker/Dealers expanded Assets at SAAR $703bn to $3.155 TN. Broker/Dealer Assets inflated $413.1bn (nominal) during the first half, or 30.1% annualized. This expansion was second only to 2006's full-year $615bn growth. For perspective, Broker/Dealer Assets increased $282bn during 2005, $232 in 2004, and $278 in 2003 – and actually contracted $130bn during 2002. Examining the nature of Asset growth during the quarter, Corp & Foreign bonds increased SAAR $84bn, Securities Credit SAAR $219bn, and "Miscellaneous" SAAR $621bn. Treasury holdings declined SAAR $157bn and Agency/GSE MBS fell SAAR $101bn. On the Liability Side, Miscellaneous Liabilities increased SAAR $525bn, Securities Credit SAAR $95bn, and Trade Payables $55bn.
Wall Street "structured finance" enjoyed a booming and, perhaps, foretelling Q2. GSE Assets expanded SAAR $176bn (to $2.923TN), the strongest growth in a year. Still, GSE assets were up only 1.1% y-o-y. Agency MBS surged SAAR $544bn, up from Q1's $499bn and the year earlier $300bn. Agency MBS expanded at a 12.3% rate during the quarter, with one-year gains of 10.8%. Asset-Backed Securities expanded SAAR $545bn (to $4.295 TN), down only modestly from Q1's $574bn. And despite the slowest quarter in some time, the ABS market still enjoyed a 13.3% growth rate for the quarter and 18.1% growth over the past year. The ABS market has expanded 63% during the past 10 quarters, extraordinary growth that hit the wall with a thud with the homecoming of market tumult in Q3.
Interestingly, Total Mortgage Debt (TMD) expanded SAAR $1.167 TN (to $13.982 TN), up from Q1's SAAR $1.087 TN. TMD actually expanded at a robust 9.0% rate, the largest expansion since Q3 2006 - suggesting that ultra-easy Credit Conditions endured outside of subprime. Even Home Mortgage debt growth accelerated, rising to a 7.7% rate from Q1's 7.3%. Meanwhile, the Commercial Mortgage lending boom went to "blow-off" extremes – expanding at a 15.6% pace (vs. Q1's 10.1%). For the quarter, Home Mortgage lending expanded SAAR $756bn to $10.750 TN and Commercial Mortgage a record SAAR $344bn to $2.344 TN. Total Mortgage debt has expanded 9.2% over the past year and 24% over two years, with Commercial mortgage debt up 13.9% y-o-y and 31%. It will be fascinating to learn how dramatically mortgage debt growth slowed during Q3. Credit restraint hit all sectors.
Quite possibly, Q3 will see record banking sector asset growth, both building on Q2 momentum and taking up the slack created by the Breakdown of Wall Street Risk Intermediation. During the second quarter, Commercial Banking Assets expanded SAAR $1.037 TN to $10.455 TN. For comparison, Bank Assets grew $897bn during 2006, $763bn in 2005, $762bn in 2004, $495bn in 2003 and $477bn in 2002. On a percentage basis, Q2 experienced Bank Asset growth of 10.5%, with Loans up 8.9%. Over the past year, Bank Loans have expanded 9.0%, with a two-year gain of 22.9%. Bank holdings of Mortgage loans expanded at a 9.9% rate during the quarter (to $3.462TN), with one-year growth of 10.5%. Corporate Bond holdings jumped $44.4bn (22.1% annualized) to $848bn, with one-year growth of 15.5%. It's an inopportune time in the Credit Cycle for the banking system to expand so aggressively.
There were some interesting happenings on the Bank Liability side – the new Credit instruments created in the process of financing robust asset growth. Total Deposit growth slowed markedly to a 3.3% rate during the quarter to $6.162 TN (up 7.6% y-o-y). "Fed Funds & Net Repo" Liabilities expanded at a 14.3% pace to $1.327 TN (up 11.7% y-o-y). Credit Market Liabilities expanded at a brisk 18.5% rate to $1.063 TN (up 19.4% y-o-y). Miscellaneous Bank Liabilities grew at a 36.3% pace to $1.942 TN (up 10.5% y-o-y), and Bond Liabilities increased at a 22.9% rate to $625bn (up 18.3% y-o-y). One can make a strong argument that it has not been the ideal environment to aggressively expand capital markets liabilities to fund risky loan growth.
Money Market Mutual Funds (MMF) expanded a robust SAAR $442bn to $2.490 TN. MMF assets were up 16.7% annualized during the quarter, 20.4% y-o-y and 35.9% over two years. "Security RP" holdings expanded SAAR $85.8bn during the quarter to $413bn. Credit Market Instruments increased SAAR $350.8bn, with Open Market Paper up SAAR $90.4bn (to $664bn), Treasury Securities up SAAR $38.7bn (to $89bn), Agency- and GSE MBS up SAAR $31.1bn (to 126bn), Municipal Securities SAAR $58.4bn (to $399bn), and Corporate & Foreign Bonds SAAR $132bn (to $422bn). And it has definitely been a risky backdrop for enormous money fund intermediation of late-cycle risky credits.
"Open Market Paper" expanded a record SAAR $410bn during Q2 to $2.110 TN. This was a notable 22.4% rate of expansion during the quarter, with one-year growth of 16.7%. Virtually all Q2 growth was in Commercial Paper, although this amount and more will be reversed during the current quarter. The ABS sector issued a record SAAR $295bn of (asset-backed) Commercial Paper during the quarter (to $885bn). At SAAR $140.7bn, "Funding Corps" were the largest purchasers of Open Market Paper. Funding Corp Asset growth slowed during Q2 (to 7.1% ann.), reducing its first-half growth rate to 20.7% (to $1.681 TN). Fed Funds & Net Repo Asset growth also slowed (to an 8.2% rate), reducing the pace of first-half growth to a still blistering 19.0% (to $2.731TN)
Delving briefly into other financial operators, Life Insurance Cos. expanded Assets at a 10.2% rate during the quarter to $4.868 TN (up 8.7% y-o-y); Financial Companies at a 0.7% rate to $1.896 TN (up 2.1% y-o-y); Saving Institutions at a 1.3% rate to $1.673 TN (down 5.4% y-o-y); Credit Unions up at a 3.9% rate to $749bn (up 6.4% y-o-y); and REIT assets down at a 7.1% rate to $391bn (up 7.6% y-o-y).
As always, the Household (& Non-Profit) Balance Sheet illuminates powerful Credit Bubble dynamics. The value of Household Assets inflated $1.510 TN (nominal) during the quarter, or 8.6% annualized, to $71.672 TN. And with Household Liabilities increasing "only" $301bn, or 8.9% annualized, to $13.813 TN, Household Net Worth inflated an additional $1.206 TN, or 8.5% annualized, during the quarter to a record $57.859 TN. Expanding at an 11% annualized rate, Financial Assets increased $1.186 TN (nominal) to $44.284 TN. Real Estate Assets grew a moderate $274bn, or 4.8% annualized, to $23.193 TN.
Over the past year, Financial Asset holdings have increased $3.980 TN, or 9.9%, and Real Estate Assets $1.135 TN, or 5.1%. Total Household Assets have ballooned $5.271 TN, or 7.9%, in four quarters. With Liabilities up $1.076 TN, or 8.5%, Household Net Worth has inflated $4.195 TN over the past year, or 7.8%. Household Net Worth is up $8.512 TN, or 17.2%, in two years, certainly supporting consumer confidence and expenditures.
The Rest of World (ROW) Balance Sheet also typically exposes Credit Bubble effects. This quarter's report, unfortunately, is somewhat convoluted – and with major revisions to confuse the issue. For the quarter, the ROW acquired US Financial Assets at an unprecedented SAAR $2.535 TN, while ROW US Liabilities increased a record SAAR $1.934. In nominal dollars for Q2, ROW Assets holdings increased an enormous $522bn, or 14.1% annualized, to (a heavily revised) $15.366 TN. Credit Market holdings increased $215bn, or 15% annualized, to $6.947 TN. Treasury Holdings dipped $7.8bn to $2.185 TN, while Agencies jumped $86bn to $1.134 TN. Corporate Bond holdings rose $111bn to $2.990 TN.
Over the past year, ROW holdings of U.S. Assets were up an unfathomable $2.659 TN, or 20.9% (ROW Liabilities up $1.172 TN to $6.877 TN). Credit Market holdings have increased $919bn, or 15.2%. Elsewhere, Security Repos increased $265bn (28.2%) y-o-y, and Direct Investment rose $226bn (11.5%). Corporate Bonds (that include ABS) increased $787bn, while "Other" Assets were up almost $400bn and Deposits $118bn.
Second quarter numbers suggests the scope of global dollar "recycling" requirements has inflated substantially. The Federal Reserve's aggressive rate cuts last week definitely only exacerbate what is becoming an untenable outward flow of dollar liquidity from the U.S. financial system to the Rest of World (that must, at a price, be "recycled" back into US assets).
We believe the current course of Fed policy is an attempt to sustain the unsustainable. The Q2 Flow of Funds report certainly confirms the enormity of ongoing Credit creation, intensive Risk Intermediation, and Financial Sector Ballooning – Classic Credit Bubble Dynamics. The bottom line is that only extreme levels of Credit expansion and intermediation now sustain bloated and maladjusted financial, economic and asset market structures. As we've witnessed, any interruption in the Credit creation process will almost immediately instigate financial dislocation. The Fed has chosen aggressive action in hopes of resuscitating Credit excess and Bubble Perpetuation. A less risky strategy for our system and currency would necessitate air flowing in the other direction - out of Credit, asset and economic Bubbles. Postponing the adjustment process at this point ensures greater future financial tumult and economic hardship.
Doug Noland is a market strategist for the Prudent Bear Funds.
(Republished with permission from PrudentBear.com. Copyright 2005-2007 David W Tice & Associates.)
Monday, September 24, 2007
Rocking the land of Poppins
By Chan Akya
Queues outside banks that stretched for several streets. Angry depositors who got into scuffles over queue-jumping by those late to realize their savings were in trouble. Banks imposing daily limits on withdrawals and increasing penalties for breaking fixed deposits. Rumors on every street corner concerning the next bank to fail. Central bankers who literally sweat under the spotlight. Government ministers calling up the head of the central bank to appear before an urgent committee where said banker was reprimanded quite severely. Satirical magazines that have steered clear of their usual beat around politics instead to make fun of bankers and depositors.
The above scenes were not from Thailand or Indonesia in 1997 or South Korea and Russia in 1998. Rather, it was in the staid old world of the United Kingdom, where the stiff upper lip apparently gave way to quivering bouts of sentimentality.
The world of Mary Poppins, scones with your afternoon tea and warm beer with your chips appears to exist only for tourist consumption, as locals go around behaving exactly as the much-criticized poor people in various emerging markets do from time to time.
England's sportsmen have had a bad time in various international games this week, ranging from rugby to cricket; perhaps all of them had savings locked up with Northern Rock, the failing English bank that was urgently propped up by the Bank of England barely a week after its governor, Mervyn King, decried the behavior of the US Federal Reserve and the European Central Bank for interrupting the normal functioning of markets by intervening too frequently.
I wrote in a recent column [1] about the dysfunctional nature of Group of Seven (G7) financial systems. Reading that article again, I am myself astounded by how "nice" I was in focusing merely on the interbank system rather than the wider implications for depositors. When G7 countries start facing good old-fashioned bank runs, it is the time for every central banker around the world to stand up and take notice.
This is especially true for Asia, which supplies much of the capital that allows G7 governments to rescue their banks from time to time. [2] To state the obvious, the region must not expect similar favors from G7 countries should local financial systems ever lurch into disaster mode. Indeed, we should instead expect to hear the usual homilies about "rigorous market discipline", "robust checks and balances" and other such reasons any financial crisis is a problem for Asians and not something with which G7 countries should help them.
I don't want to dwell too much on the obvious hypocrisy of G7 countries that helps them to adopt a holier-than-thou attitude while scrumptiously helping their own banks avoid troubles. The 50-basis-point cut of the US Federal Reserve this week falls into the same category.
What it means for Asia
Last year I wrote about the major financial systems in Asia [3] to highlight the potential dangers lurking below the surface in both China and India. The summary of those observations was that banks had increased their exposure to low-quality US financial assets to boost their overall income. Their balance sheets are stretched by loans to highly risky but politically connected borrowers in their respective operating areas. Chinese banks enjoy substantial liquidity but make poor investment and loan decisions all too often. While Indian banks are nominally better managed, their liquidity constraints are higher.
What helps the two systems is the substantial increase in the deposit base over the past 10 years as a natural consequence of economic growth. This has allowed banks in the two countries to expand their branch networks, increase their investment books and generally adopt more automation (although Indian trade unions have prevented state-owned banks from going too far down this route).
This economic growth allows a number of risky borrowers to avoid defaults, as their business environment remains robust, thereby keeping them honest - that is, it costs them more to default than to stay in business, and thus they choose to repay the banks, albeit with loans from other banks in most cases.
The growth in retail lending is hamstrung by poor legislation. It is a fairly lengthy process for banks in China and India to repossess homes of delinquent mortgage borrowers, for example. This difficulty in turn encourages slightly more risky behavior by some borrowers, although cultural factors such as the social stigma attached to being bankrupt helps keep such risks on the lower side overall.
Additionally, there are not a lot of avenues for banks in China and India to sell their risks. The use of financial derivatives to diminish risk on the asset side of their balance sheets is quite low, even as the banks are themselves enthusiastic buyers of similar instruments originated in the US and Europe. I blame both the absence of securities regulations and the lack of investor education for this state of affairs. Granted that these are broadly the same category of financial derivatives that got US and European banks into trouble, their use is however justified by the sheer scale of risk being handled by banks in China and India relative to their capital bases.
Last comes the issue of supervision. Asian central bankers are in general less sophisticated than the dictates of modern financial systems. I rate the Reserve Bank of India ahead of the People's Bank of China in this respect, but that's like saying Josef Stalin was a better human being than Adolf Hitler. The central banks have a poor understanding of financial derivatives and their ability to distribute risk, as well as the benefits of rigorous risk analysis. Overall staffing levels are actually too low for their remit, and all too often officers are promoted for political rather than reasons of merit.
What to do
Rather than let all these issues simmer below the surface, Asian central banks must act immediately. I suggest the following measures to be adopted with great urgency by governments as well as central banks.
First, merge small and medium-sized banking entities into larger operations. Risks are often too localized when banks concentrate on specific regions. Examples of this can be found across the southern Chinese coast, where a number of banks quite literally only serve a single region and are therefore overexposed to certain industrial sectors. Merging these banks with those operating in different environments would be mutually beneficial.
Second, all public banks must be listed on the stock exchange, with foreigners allowed to own shares. While this is not in any way to suggest that foreigners are smarter than Asians at assessing risks, they do demand higher disclosures and transparency. Additionally, the insights of various dedicated fund managers specializing in bank stocks cannot but be good for the system as a whole - witness for example the improvements brought about in Japan by foreign-owned companies.
Third, securities legislation must incorporate new classes of financial derivatives and provide incentives for banks to sell down their risks (bank regulation). This would allow the development of proper bond markets across China and India that could help increase the flexibility of Chinese and Indian banks in terms of trimming their balance-sheet exposures to some assets while providing themselves with additional sources of liquidity.
Fourth, central banks must increase their supervision standards. In the case of Northern Rock, one of the key failures appears to be that the bank was maintaining low cash balances with the central bank to take advantage of the "averaging" of cash balances. Using averages is pretty dumb for banks - central banks must monitor variance and step in whenever balances fall, say, 20% below the required amount. This requires improved systems and better supervision.
Last, government-mandated limits on bank lending must be scrapped. These limits force banks in China and India to lend to specific sectors and regions because of the "priority" focus of the central government. That is a matter of fiscal rather than commercial intervention; therefore the direct responsibility for such loans must remain with the government rather than individual commercial banks.
Conclusion
China and India are well positioned now to undertake serious structural reforms. They should not wait for a crisis of the Northern Rock magnitude to force their hands, but rather act immediately. My suggestions above only represent a start for the sector. Forget air-conditioning the branches and providing free tea to the people visiting them; more urgent work beckons behind the scenes.
Notes
1. In gold we trust, September 8, 2007.
2. Asia and the vicious cycle of bank bailouts, August 11, 2007.
3. Chinese, Indian banks plunge at different rates, August 3, 2007.
Queues outside banks that stretched for several streets. Angry depositors who got into scuffles over queue-jumping by those late to realize their savings were in trouble. Banks imposing daily limits on withdrawals and increasing penalties for breaking fixed deposits. Rumors on every street corner concerning the next bank to fail. Central bankers who literally sweat under the spotlight. Government ministers calling up the head of the central bank to appear before an urgent committee where said banker was reprimanded quite severely. Satirical magazines that have steered clear of their usual beat around politics instead to make fun of bankers and depositors.
The above scenes were not from Thailand or Indonesia in 1997 or South Korea and Russia in 1998. Rather, it was in the staid old world of the United Kingdom, where the stiff upper lip apparently gave way to quivering bouts of sentimentality.
The world of Mary Poppins, scones with your afternoon tea and warm beer with your chips appears to exist only for tourist consumption, as locals go around behaving exactly as the much-criticized poor people in various emerging markets do from time to time.
England's sportsmen have had a bad time in various international games this week, ranging from rugby to cricket; perhaps all of them had savings locked up with Northern Rock, the failing English bank that was urgently propped up by the Bank of England barely a week after its governor, Mervyn King, decried the behavior of the US Federal Reserve and the European Central Bank for interrupting the normal functioning of markets by intervening too frequently.
I wrote in a recent column [1] about the dysfunctional nature of Group of Seven (G7) financial systems. Reading that article again, I am myself astounded by how "nice" I was in focusing merely on the interbank system rather than the wider implications for depositors. When G7 countries start facing good old-fashioned bank runs, it is the time for every central banker around the world to stand up and take notice.
This is especially true for Asia, which supplies much of the capital that allows G7 governments to rescue their banks from time to time. [2] To state the obvious, the region must not expect similar favors from G7 countries should local financial systems ever lurch into disaster mode. Indeed, we should instead expect to hear the usual homilies about "rigorous market discipline", "robust checks and balances" and other such reasons any financial crisis is a problem for Asians and not something with which G7 countries should help them.
I don't want to dwell too much on the obvious hypocrisy of G7 countries that helps them to adopt a holier-than-thou attitude while scrumptiously helping their own banks avoid troubles. The 50-basis-point cut of the US Federal Reserve this week falls into the same category.
What it means for Asia
Last year I wrote about the major financial systems in Asia [3] to highlight the potential dangers lurking below the surface in both China and India. The summary of those observations was that banks had increased their exposure to low-quality US financial assets to boost their overall income. Their balance sheets are stretched by loans to highly risky but politically connected borrowers in their respective operating areas. Chinese banks enjoy substantial liquidity but make poor investment and loan decisions all too often. While Indian banks are nominally better managed, their liquidity constraints are higher.
What helps the two systems is the substantial increase in the deposit base over the past 10 years as a natural consequence of economic growth. This has allowed banks in the two countries to expand their branch networks, increase their investment books and generally adopt more automation (although Indian trade unions have prevented state-owned banks from going too far down this route).
This economic growth allows a number of risky borrowers to avoid defaults, as their business environment remains robust, thereby keeping them honest - that is, it costs them more to default than to stay in business, and thus they choose to repay the banks, albeit with loans from other banks in most cases.
The growth in retail lending is hamstrung by poor legislation. It is a fairly lengthy process for banks in China and India to repossess homes of delinquent mortgage borrowers, for example. This difficulty in turn encourages slightly more risky behavior by some borrowers, although cultural factors such as the social stigma attached to being bankrupt helps keep such risks on the lower side overall.
Additionally, there are not a lot of avenues for banks in China and India to sell their risks. The use of financial derivatives to diminish risk on the asset side of their balance sheets is quite low, even as the banks are themselves enthusiastic buyers of similar instruments originated in the US and Europe. I blame both the absence of securities regulations and the lack of investor education for this state of affairs. Granted that these are broadly the same category of financial derivatives that got US and European banks into trouble, their use is however justified by the sheer scale of risk being handled by banks in China and India relative to their capital bases.
Last comes the issue of supervision. Asian central bankers are in general less sophisticated than the dictates of modern financial systems. I rate the Reserve Bank of India ahead of the People's Bank of China in this respect, but that's like saying Josef Stalin was a better human being than Adolf Hitler. The central banks have a poor understanding of financial derivatives and their ability to distribute risk, as well as the benefits of rigorous risk analysis. Overall staffing levels are actually too low for their remit, and all too often officers are promoted for political rather than reasons of merit.
What to do
Rather than let all these issues simmer below the surface, Asian central banks must act immediately. I suggest the following measures to be adopted with great urgency by governments as well as central banks.
First, merge small and medium-sized banking entities into larger operations. Risks are often too localized when banks concentrate on specific regions. Examples of this can be found across the southern Chinese coast, where a number of banks quite literally only serve a single region and are therefore overexposed to certain industrial sectors. Merging these banks with those operating in different environments would be mutually beneficial.
Second, all public banks must be listed on the stock exchange, with foreigners allowed to own shares. While this is not in any way to suggest that foreigners are smarter than Asians at assessing risks, they do demand higher disclosures and transparency. Additionally, the insights of various dedicated fund managers specializing in bank stocks cannot but be good for the system as a whole - witness for example the improvements brought about in Japan by foreign-owned companies.
Third, securities legislation must incorporate new classes of financial derivatives and provide incentives for banks to sell down their risks (bank regulation). This would allow the development of proper bond markets across China and India that could help increase the flexibility of Chinese and Indian banks in terms of trimming their balance-sheet exposures to some assets while providing themselves with additional sources of liquidity.
Fourth, central banks must increase their supervision standards. In the case of Northern Rock, one of the key failures appears to be that the bank was maintaining low cash balances with the central bank to take advantage of the "averaging" of cash balances. Using averages is pretty dumb for banks - central banks must monitor variance and step in whenever balances fall, say, 20% below the required amount. This requires improved systems and better supervision.
Last, government-mandated limits on bank lending must be scrapped. These limits force banks in China and India to lend to specific sectors and regions because of the "priority" focus of the central government. That is a matter of fiscal rather than commercial intervention; therefore the direct responsibility for such loans must remain with the government rather than individual commercial banks.
Conclusion
China and India are well positioned now to undertake serious structural reforms. They should not wait for a crisis of the Northern Rock magnitude to force their hands, but rather act immediately. My suggestions above only represent a start for the sector. Forget air-conditioning the branches and providing free tea to the people visiting them; more urgent work beckons behind the scenes.
Notes
1. In gold we trust, September 8, 2007.
2. Asia and the vicious cycle of bank bailouts, August 11, 2007.
3. Chinese, Indian banks plunge at different rates, August 3, 2007.
Friday, September 21, 2007
A rate pirate on the high debt sea
By Max Fraad Wolff
There are many opinions on how best to captain a gigantic national economy across roiled seas. No one can presume to know the best course with certainty. All must contend with an unknowable future string of consequences from action and inaction. History is hard to know with clarity and context is ever changing. Every US Federal Reserve chairman is owed some deference as he charts a course to please diverse constituencies, dodge rocks, and sail through storms.
Now that we gotten that out of the way, what is Federal Reserve head Ben Bernanke thinking? We have heard much of his disciplined and prudent approach. We have been treated to talk of his careful and technically advanced reliance on cold calculation. Oops, that seems to have lasted through about one month of market turmoil.
On Tuesday, the Federal Open Market Committee (FOMC) cut its target rate for interbank loans - the Federal Funds rate - by 50 basis points or 0.5 percentage point. During the same meeting, a 50-basis-point cut was made in the discount rate - the rate at which the Fed lends to banks. This brought the Fed Funds target rate to 4.75% and the discount rate to 5.25%.
The Fed felt the pressing need to cut its target Fed Funds rate by 9.5% and its discount rate by 8.7%. Markets, speculators and Congress have been calling for such a dramatic response to buoy markets and financial conditions. Oh yeah, they also blabbered something about helping families like the 260,000 that saw their homes enter foreclosure in August. It is too late for them, but they make better poster children than the likely beneficiaries.
By way of benchmarking these rates, some historical perspective is in order. In the 50-year period from 1957-2006, the average effective Federal Funds rate was 5.88%. We were below the long-run average before Tuesday's cut and are now well below it. The average for the past 20 years was 4.9%. We are now below that average as well. Over the period from 1957-2002, the average discount rate was 5.59%. We have moved below this average as well. The 20-year discount-rate average was 5.64%.
Thus it would be fair to say we were below the averages prior to Tuesday's cuts and are now further below the averages. How might one understand that? The United States is a debt economy and requires more accommodative and easy money then ever before. Turmoil in credit markets is very dangerous, and the US can no longer have a stable economy with historically "normal" interest rates. Give us cheap, easy money or the economy walks the plank!
A million years ago, on August 7, Fed economists saw inflation risks and a generally strong economy. I must admit, I found that shocking and wondered what they were smoking. They must have too, because a mere 10 days later, they acted in complete contradiction to that position.
On August 17, the Fed slammed those betting on markets to fall by suddenly slashing the cost, conditions and collateral for bank borrowing. They cut the discount rate and began accepting more types of collateral for longer periods. Banks did take advantage of this. They hit the Fed credit buffet like Las Vegas tourists. These well-fed bankers are yet to extend any extra opportunity to legions of distressed debtors. Foreclosures continued to break records and went on to a 115% increase over August 2006.
Not to worry, monetary policy is really made for middle- and lower-income Americans. The bankers may be at the buffet, but the great unwashed get to play in the bankruptcy casino downstairs. Who wants a free meal when there are opportunities to play foreclosure roulette?
The August 7 FOMC statement issues sounds of confidence and offers an all-clear:
Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.
In Fed-speak this is tantamount to an "all is well, remain calm". Thus Tuesday's actions and pronouncement are strange and contradictory:
Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.
The latest action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time. Readings on core inflation have improved modestly this year. However, the committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.
There is so much to say here. The first half of the year ended before either meeting. US economic growth in the second quarter has been revised upward since the August meeting, so it is better than we thought on August 7. It appears that the Fed is acting to prevent a downward economic trend. That sounds great until you realize that this has already come to pass. Whom are they kidding?
Not the quarter-million US households that formally entered the losing-their-house good times in August. Backward-looking data that measure August made inflation look moderate. Preliminary access to those data was available during the August meeting and throughout last month.
New data for September are available now - after all, it is September now. These data suggest rising prices led by surging oil, wheat, gold and foreign-currency prices. Not to worry, the Fed will monitor that while pumping money into banks and slashing rates to prevent the economic downturn that has already arrived!
In early August it was clear that foreclosures were spiking, markets were boiling over and panic was rife. Bernanke decided that it was time to sound the all-clear with a cautionary note on inflation risks. After all, oil was a whopping and scary US$70 a barrel back then. Now it has settled down to $82, and so the worry has lifted?
Food costs - especially wheat - have surged in the month since the Fed worried about inflation. I guess that is why we are now worried about financial-market conditions. Across the one month and one week between the meetings, the broadest US stock-market index, S&P500, went from 1,476.71 to Monday's close of 1,476.65. This must have been the radical deterioration that caused the about-face!
Bernanke is ideally focused on inflation-fighting, price stability and economic growth. It would seem he is concerned about bank demands for liquidity and equity-market indices. I am not saying there is anything wrong with that. I am saying the talk, the action and the statements are not anywhere near to being on the same page.
Action and pronouncement swing between mutually exclusive broad outlooks. Fast and furious actions are targeting asset prices and ignoring reported economic data, except when obsessed with increasingly outdated numbers. There must be a real drawdown in the rum supply aboard the Pirate Ship Bernanke.
The truth is that Tuesday's reassurance and logic are as frightening as the logic and all-clear sounded on August 7. Buckling under Wall Street pressure and slashing rates help stock prices. The way and timing in which the discount rate was cut - twice now - attack market shorts and artificially push up stock prices.
Thus it will be seen as genius by those you hear on TV, radio, and many newspapers. I am concerned that the Fed acted late, is confused about where we are in the calendar year, pays no mind to its recent statements, and is acting to head off future economic trouble that everyone else knows is already here.
Max Fraad Wolff is a doctoral candidate in economics at the University of Massachusetts, Amherst, and editor of the website GlobalMacroScope.
There are many opinions on how best to captain a gigantic national economy across roiled seas. No one can presume to know the best course with certainty. All must contend with an unknowable future string of consequences from action and inaction. History is hard to know with clarity and context is ever changing. Every US Federal Reserve chairman is owed some deference as he charts a course to please diverse constituencies, dodge rocks, and sail through storms.
Now that we gotten that out of the way, what is Federal Reserve head Ben Bernanke thinking? We have heard much of his disciplined and prudent approach. We have been treated to talk of his careful and technically advanced reliance on cold calculation. Oops, that seems to have lasted through about one month of market turmoil.
On Tuesday, the Federal Open Market Committee (FOMC) cut its target rate for interbank loans - the Federal Funds rate - by 50 basis points or 0.5 percentage point. During the same meeting, a 50-basis-point cut was made in the discount rate - the rate at which the Fed lends to banks. This brought the Fed Funds target rate to 4.75% and the discount rate to 5.25%.
The Fed felt the pressing need to cut its target Fed Funds rate by 9.5% and its discount rate by 8.7%. Markets, speculators and Congress have been calling for such a dramatic response to buoy markets and financial conditions. Oh yeah, they also blabbered something about helping families like the 260,000 that saw their homes enter foreclosure in August. It is too late for them, but they make better poster children than the likely beneficiaries.
By way of benchmarking these rates, some historical perspective is in order. In the 50-year period from 1957-2006, the average effective Federal Funds rate was 5.88%. We were below the long-run average before Tuesday's cut and are now well below it. The average for the past 20 years was 4.9%. We are now below that average as well. Over the period from 1957-2002, the average discount rate was 5.59%. We have moved below this average as well. The 20-year discount-rate average was 5.64%.
Thus it would be fair to say we were below the averages prior to Tuesday's cuts and are now further below the averages. How might one understand that? The United States is a debt economy and requires more accommodative and easy money then ever before. Turmoil in credit markets is very dangerous, and the US can no longer have a stable economy with historically "normal" interest rates. Give us cheap, easy money or the economy walks the plank!
A million years ago, on August 7, Fed economists saw inflation risks and a generally strong economy. I must admit, I found that shocking and wondered what they were smoking. They must have too, because a mere 10 days later, they acted in complete contradiction to that position.
On August 17, the Fed slammed those betting on markets to fall by suddenly slashing the cost, conditions and collateral for bank borrowing. They cut the discount rate and began accepting more types of collateral for longer periods. Banks did take advantage of this. They hit the Fed credit buffet like Las Vegas tourists. These well-fed bankers are yet to extend any extra opportunity to legions of distressed debtors. Foreclosures continued to break records and went on to a 115% increase over August 2006.
Not to worry, monetary policy is really made for middle- and lower-income Americans. The bankers may be at the buffet, but the great unwashed get to play in the bankruptcy casino downstairs. Who wants a free meal when there are opportunities to play foreclosure roulette?
The August 7 FOMC statement issues sounds of confidence and offers an all-clear:
Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.
In Fed-speak this is tantamount to an "all is well, remain calm". Thus Tuesday's actions and pronouncement are strange and contradictory:
Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.
The latest action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time. Readings on core inflation have improved modestly this year. However, the committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.
There is so much to say here. The first half of the year ended before either meeting. US economic growth in the second quarter has been revised upward since the August meeting, so it is better than we thought on August 7. It appears that the Fed is acting to prevent a downward economic trend. That sounds great until you realize that this has already come to pass. Whom are they kidding?
Not the quarter-million US households that formally entered the losing-their-house good times in August. Backward-looking data that measure August made inflation look moderate. Preliminary access to those data was available during the August meeting and throughout last month.
New data for September are available now - after all, it is September now. These data suggest rising prices led by surging oil, wheat, gold and foreign-currency prices. Not to worry, the Fed will monitor that while pumping money into banks and slashing rates to prevent the economic downturn that has already arrived!
In early August it was clear that foreclosures were spiking, markets were boiling over and panic was rife. Bernanke decided that it was time to sound the all-clear with a cautionary note on inflation risks. After all, oil was a whopping and scary US$70 a barrel back then. Now it has settled down to $82, and so the worry has lifted?
Food costs - especially wheat - have surged in the month since the Fed worried about inflation. I guess that is why we are now worried about financial-market conditions. Across the one month and one week between the meetings, the broadest US stock-market index, S&P500, went from 1,476.71 to Monday's close of 1,476.65. This must have been the radical deterioration that caused the about-face!
Bernanke is ideally focused on inflation-fighting, price stability and economic growth. It would seem he is concerned about bank demands for liquidity and equity-market indices. I am not saying there is anything wrong with that. I am saying the talk, the action and the statements are not anywhere near to being on the same page.
Action and pronouncement swing between mutually exclusive broad outlooks. Fast and furious actions are targeting asset prices and ignoring reported economic data, except when obsessed with increasingly outdated numbers. There must be a real drawdown in the rum supply aboard the Pirate Ship Bernanke.
The truth is that Tuesday's reassurance and logic are as frightening as the logic and all-clear sounded on August 7. Buckling under Wall Street pressure and slashing rates help stock prices. The way and timing in which the discount rate was cut - twice now - attack market shorts and artificially push up stock prices.
Thus it will be seen as genius by those you hear on TV, radio, and many newspapers. I am concerned that the Fed acted late, is confused about where we are in the calendar year, pays no mind to its recent statements, and is acting to head off future economic trouble that everyone else knows is already here.
Max Fraad Wolff is a doctoral candidate in economics at the University of Massachusetts, Amherst, and editor of the website GlobalMacroScope.
Thursday, September 20, 2007
Careful what you wish for, China may grant it
22 June 2007
By Julian Delasantellis
In Greek mythology, one of the most effective methods the gods used to punish impudent and hubristic humans was to grant them their most fervent desires.
Inevitably, the weak and feckless mortals would find that getting everything they ever desired would lead to their total ruination, as befell King Midas when granted the wish to have everything he touched turn to gold. The implicit lesson to be learned from these stories was that mortals must temper their wishes and desires, lest they suffer the same fate.
Is the administration of US President George W Bush learning the same fate as regards its trading policy with China?
The big news currently roiling the financial markets is the rapid rise in yields for long-term government bonds issued by the world's major industrial powers. The benchmark US Treasury 10-year note has risen 0.85 percentage points in yield, from 4.50% to almost 5.35% (in bond trader lingo, that's 85 "basis points") from early March to early June, with most of that rise coming since just late May. This represents the highest level of US 10-year rates since 2002.
Other major-traded government debt issuances have risen in yield (and thus fallen in price) along with US notes. After yielding about 1% for the better part of a decade, Japanese government bonds have risen more than 50 basis points over the same period to yield just under 2% now. British government bonds, called gilts, have risen 70 basis points.
Euro bonds, called "bunds" (from their origins as debt obligations of the German Federal Republic, the Bundesrepublik) have also risen more than 80 basis points since late winter. There is concern that these interest rate hikes, by raising the price of investment capital, will finally act to cool down the current white-hot global economy.
In my March 6 article Rocking the subprime house of cards, I explained how the issue of causation, of "why" something happens in the financial markets, is frequently hard to answer, especially when analyzing something other than individual stocks. This is the case with the current government-debt rout.
When bond-market investors hand over their money to buy a government bond they have to hold for an extended period of time, be it one, five, 10 or 30 years, they want to be confident that inflation will not eat away at the purchasing power of what they will receive back at the bond's expiration. If they think that might be the case, they will demand higher interest rates of return before forking over their wealth.
However, in this case, the standard explanations/conventional wisdom for rising interest rates, a spreading market perception among bond investors that economic growth is accelerating, soon to be followed upon by rising inflation, don't seem to have been sufficient to have engendered interest-rate rises this high this quick.
US economic growth for the January-May period was a measly 0.6%, the slowest rate since late 2002. As the US economy gets pulled down by the heavy weight of the subprime mortgage crisis (explored in my March 6 article, as well as in my March 16 article The subprime dominoes in motion), recent reports are showing that growth has not merely slowed in the US real-estate sector, it is now in full-throttle reverse, as some localized real-estate markets are showing double-digit average price declines from last year.
The problems in the real-estate sector, along with the fact that anemic sales reports from many US retailers seem to be indicating that the once super-avaricious US consumer seems finally to have been banished from the malls by high energy prices, do not seem to portend the rapidly accelerating economic growth that could be causing the rising government-bond yields, neither in the United States nor in the other major industrial capitalist economies.
The "economic growth causing rising rates" argument is not confirmed by certain internal market indicators, either. There are three major traded instruments that professional traders watch to see if inflationary fears are seeping into the markets. These are the so-called "TIPS spread" (the difference between standard Treasury bond yields and newer, inflation-indexed TIPS - Treasury Inflation-Protected Securities - bonds), the price of gold, and the levels of various commodity basket indices.
You would expect the prices of all three to be appreciating should inflationary fears be spreading, but, surprisingly, all three have in essence been stable to minimally higher throughout the worldwide bond-market rout. Something has been causing the recent rising bond yields, and it has nothing to do with the conventional wisdom.
It may not seem so now, but in the future, George W Bush will probably go down foremost in history as the US president who sat by with his cowboy boots up on the table (as he shoveled what will probably turn out to be the better part of a trillion dollars into the bloody furnace called Iraq) as world economic dominance passed from the US to China.
At first, the corporate elite class that put its man in the White House probably thought the rise in Chinese economic power was at least serendipitous, since its main cause, US manufacturers offshoring production to China, was putting intense pressure on wages; this is a central factor in the fact that a proportion of US national income going to owners of capital (business and stock owners), as against labor, has now skewed dramatically in favor of capital.
No one saw it at the time, but a central manifestation of the freedom revolution that spread across the world upon the fall of the Berlin Wall in 1989 was that First World employers were now free to put their employees in an employment pool to compete for their jobs with about a billion other employees from nations with much lower standards of living, especially China and India. Wages might be being pressured downward, but on the other side of the seesaw, profits were soaring.
As economists Lawrence Mishel and Jared Bernstein of the Economic Policy Institute put it, "Over prior business cycles, profits (including interest income) have accounted for 23% of the growth in corporate-sector income, on average, with total compensation accounting for the remaining 77%. In the current business cycle, the distribution is almost reversed: profits have claimed nearly 70% of total growth in the corporate sector, while increases in compensation (from increased employment and higher hourly compensation) have received just over 30% of total income growth."
This is the dynamic that has fueled China's explosive recent economic progress, with first-quarter year-over-year economic growth a more than healthy (in fact, a rather inflationary) world-leading 11.1% rise in gross domestic product. The GDP growth rate has been in double-digit territory since early 2005; figures for industrial production growth, currently at 18.1% year over year, also lead the world. This growth is far and away export-led; Chinese internal consumption, while growing steadily, is a very small part of the story of the Chinese economic miracle. In May, China reported a $22.5 billion trade surplus, up 73% from the previous year. More than half of that trading surplus is with the United States.
Naturally, this has resulted in a tremendous shift of wealth from the US to China. Chinese economic officials would not allow this tremendous surge of First World wealth to be loosed upon a Third World economy, with the limited domestic consumption opportunities of the Third World. It was feared, probably correctly, that this tremendous wave of cash hitting the underdeveloped markets for domestically traded goods would cause a dramatic spike in inflation.
Therefore, the Chinese have decided to let most of their export proceeds rest comfortably as reserves, currently at a world-topping $1.2 trillion (growing at a rate of a billion dollars a day), at the central People's Bank of China.
When, as World War II drew to a close, it became obvious that a new international financial architecture would be needed to fund the postwar world, allied financial chiefs gathered at Bretton Woods, New Hampshire, to hammer out what became known as the Bretton Woods accords.
These replaced the gold-centered prewar international financial structure with fixed exchange rates focused around the US dollar. When this system collapsed in the early 1970s, it led to the introduction of the current system of variable, market-derived exchange rates. In this system, the currencies of countries that run large trade surpluses, such as the China, were supposed to appreciate in value, thus making it cheaper for their citizens to purchase imports; countries that ran big trade deficits, such as the US, would see their currencies fall in value so that, eventually, they would not be able to afford so many imports.
Like the water levels in the opened locks of a canal, eventually, the system intended that the countries with trade surpluses and deficits would see their numbers equalize, and the system would eventually balance itself without any government intervention.
This has not happened with the Chinese/US trading relationship of this decade. The Chinese currency, the yuan, does not "float" in value, as do such currencies as the euro or pound. For many years it was fixed at a rate of about 8 yuan to the dollar (meaning that each individual yuan was worth 12.5 cents). Over the past year or so, it has been allowed to rise to 7.62 yuan per dollar, meaning that each individual yuan has gone up all the way to be now worth 13.1 US cents.
This meager yuan appreciation is not nearly enough to reverse Chinese trade surpluses, which are still growing. Instead, a new international financial architecture seems to have developed, one that economists Nouriel Roubini and Brad Setser, on their weblog RGE Monitor, call Bretton Woods 2.
Here's how Bretton Woods 2 works. China (or the other, lesser players in this game, Japan, Taiwan and South Korea) does not sell its export-earned dollars. Rather, it banks them. Without this excess selling pressure, the dollar does not fall in value against the yuan; it remains stable, which allows American consumers to continue their monthly billion-dollar overseas spending spree. Chinese factories keep humming, employment is strong, the Chinese people are far too content buying new stuff to come out to protest again at Tiananmen Square, and China's Communist Party rulers are very happy about that.
This is much like what happened with the billions of petrodollars that were raised by oil-exporting countries after the oil-price rises of the 1970s. The billions of dollars of China's current export earnings get sent back to the US, mostly to be invested in Treasury securities. This keeps dollar interest rates, including mortgage rates, lower than they would have been, and this keeps the US economy humming and the consumer, still fat, dumb and happy, flush with cash and plastic to keep the cycle going for at least one more round.
But no human agency or endeavor lasts forever. The internal contradictions of Bretton Woods 1 caused it to fall, and the same seems to be happening with Bretton Woods 2. Specifically, what if China doesn't want 1.2 trillion in US dollar reserves?
Bretton Woods 2 greatly benefited Bush administration officials, by both pressuring wage rates to help out their business buddies and spurring the economic growth that got them re-elected in 2004. Still, it is somewhat embarrassing to be the president of the nation with the most massive trade deficits in history. Like spoiled rich kids since time immemorial, the Bush administration is blaming somebody else.
The administration, along with its mouthpieces in the corporate conservative media machine, is arguing that, even with a huge budget deficit and virtually non-existent national savings, the trade deficit is not America's fault. It's not that the US is spending too much and saving too little, it's that the surplus countries, especially China, are saving too much and spending too little.
This interpretation of savings as bad is certainly new in the working theory of capitalist economies; in classical economics, savings are a very good thing, since the market can direct them to future investments that will maintain economic growth. A rough parallel would be an inebriate claiming that he doesn't have a problem, it's the rest of the world that suffers from inadequate alcohol consumption syndrome.
But in business, the customer is right even when he's not, and the United States is now far and away China's biggest customer. For example, it is now estimated that up to 70% of Wal-Mart's inventory is of Chinese origin; a remarkable turnaround for a company that until this decade broadcast advertisements that trumpeted the red, white and blue all-American manufacture of its products. Wal-Mart's current trade with China alone, estimated at more than $25 billion a year, surpasses the GDP of the smallest 112 national economies of the world.
In letting the yuan appreciate, although maddeningly slowly, China is responding to demands for action from US officials, especially in Congress. Another demand is that China stop just letting its huge stash of foreign-currency reserves sit around earning interest. They should go out and buy American stuff, preferably goods and services, so that the trade balance can start to equalize.
But as the Greek gods warned, be very careful what you wish for.
In my July 6, 2006, article Hedge funds: Playing dice with the universe, I explained how hedge funds, very lightly regulated pools of private capital used as high-octane investment vehicles to the world's supranational moneyed elite, were having more and more impact on events in the world's financial markets. I postulated that hedge funds acting in unison may have been a prime cause of the May 2006 cross-border equity-market meltdown. It was estimated then that, collectively, the thousands of the world's hedge funds had more than $1 trillion in assets under management.
That's just about what the single personage of Zhou Xiaochuan, the governor of the People's Bank of China, has at his disposal for investment from foreign-exchange reserves.
Last year, the big chatter in the world's financial markets was over the growing power of hedge funds, and how their huge concentrated financial resources had the possibility of dwarfing any or all governments' ability to regulate national markets. This year, a new specter haunts the markets, one whose potential impact on markets far exceeds the puny $1 trillion-plus that the hedge funds have at their disposal.
They're called sovereign wealth funds (SWFs). Basically, it seems that many of the countries that lately have accumulated huge foreign-exchange reserves exporting to the United States are getting bored with just having their money sit around earning interest at US Treasury rates. China and the other big exporters, which until recently were seemingly happy at lending back to the US the dollars to continue to buy their stuff, now see the need to earn greater rates of return than the 5% that US Treasuries currently earn.
Many of them are facing demographic time-bombs consisting of their growing elderly populations needing eventual pension support, and, for all the glamour and glitz of today's Shanghai, going beyond China's big cities still reveals grinding rural poverty that the central government knows it must address.
SWFs will act as super-hedge funds, in that they will look for opportunities all across the investment spectrum. China is in the process of setting up its own SWF, which reportedly will be funded with some $300 billion of reserves.
And that's $300 billion that will not make its way into the market for Treasury securities.
In my March 24, 2006, article US living on borrowed time - and money, I introduced readers to the US Treasury's monthly TIC (Treasury International Capital) report, the data that enumerate just how much foreign capital the US is importing every month to finance its extravagant lifestyle. During much of 2005, the US was net-importing more than $100 billion of investment capital every month, but the bottom line net number is falling sharply; last December, the US actually failed to attract any capital at all.
One TIC data set of particular interest to bond players is just how great the investment in US government securities by foreign governments is each month. These numbers are the core of the flows that constitute Bretton Woods 2, for they derive mostly from US dollar reserves held at foreign central banks.
They've been falling, too. From averaging more than $6 billion a month in 2006, foreign government purchases of US Treasury have fallen to average just over $1 billion a month for the first four months of 2007.
It is of course far from coincidental that, when US Treasury 10-year notes were at their lows in yield, in mid-2005, TIC data were showing foreign flows into Treasuries at their highest. The central reality of the bond market is that the yield of bonds traded in it go down as more people buy them; more important for the current moment, yields go up as fewer people buy them.
If China has sharply curtailed its US Treasury purchases, unless other buyers step up to the plate, then Treasury securities prices have nowhere to go but down, and yields have nowhere to go but up - just as they have recently.
The US Treasury will not release May TIC data until mid-July, but there are indications that suggest that is precisely what is happening here. A recent Treasury auction of new 10-year notes had the lowest rate of foreign government purchase participation in years. On some financial trader blogs it is being noticed that, on many days during the current market rout, the US Treasury market has opened, at 8:20am New York Time (when the Treasury futures markets open in Chicago), with large order imbalances to the sell side.
The speculation here is that this results from Chinese sellers putting in big sell orders before they retire for the night (Shanghai time is 12 hours ahead of New York) so they can see whether, or how significantly, their orders moved the market.
Of particular significance to the future is the connection between SWFs and interest rates. On May 21, China's still-nascent SWF announced its first prospective investment; it was going to take a $3 billion stake in the upcoming initial public offering of the Blackstone Group, the huge US private equity buyout firm (I wrote about the current mania for private equity in my February 22 article The highs and lows of buyouts). It was after that announcement that the fiercest selling befell the world's Treasury markets, as if traders suddenly realized that the long-feared prospect of Asian central banks abandoning bonds for other investments was finally coming true.
World equity markets stuttered a bit in the face of the world bond selloff, but they soon recovered their footing and are once again moving up. That should not be surprising; if SWFs are about to pounce on the world's stock markets, that will be unquestionably good news for share prices.
But will it be too much of a good thing? Even with buying support from SWFs, can world stock markets appreciate much further in the face of rising bond yields? Or would continued equity-market appreciation in the face of rising bond yields be prima facie evidence of what Alan Greenspan once called irrational exuberance? Right now the only world stock market that Chinese prosperity is supporting is the Shanghai Stock Exchange A-share exchange.
That market has tripled in 14 months, and academic economists the world over are frightened that when this speculative bubble finally bursts, as all speculative bubbles must inevitably do, it will take the world's economy with it. Specifically, with so many ordinary Chinese citizens playing the Shanghai market like a never-losing roulette wheel, will the Chinese government feel threatened by the rapid destruction of domestic wealth that a burst stock market would cause? Will they try to support the shares with reserves, either from the People's Bank of China or from its SWF? What will that do to the investments in the West that the reserves had been supporting?
A more frightening prospect is if non-China stock markets start acting like Shanghai - if SWF money starts supporting or, more likely, deluging them. Trading volumes in Shanghai are still small enough, compared with Western equity markets, that the Chinese government probably could backstop a Shanghai crash, but if the world's other stock markets, supported by Asian SWF money, start replicating Shanghai's parabolic, meteoric rise, then all the reserves, tea, or anything else in China will not be sufficient to support them when their towers finally topple.
This decade's boom started in China. Will it end there too?
Will the economic historians of the future, when tracking back to ascertain the cause of the world crash of 2007, find that the dominoes were put in motion when George W Bush started urging the Chinese to buy more American stuff, and the Chinese responded with purchases of US companies and stocks?
Like the Sorcerer's Apprentice of legend, perhaps it would have been better if, while an business-administration graduate student at Harvard in the early 1970s, the future president would have actually read the instructions on how to run the world economy.
By Julian Delasantellis
In Greek mythology, one of the most effective methods the gods used to punish impudent and hubristic humans was to grant them their most fervent desires.
Inevitably, the weak and feckless mortals would find that getting everything they ever desired would lead to their total ruination, as befell King Midas when granted the wish to have everything he touched turn to gold. The implicit lesson to be learned from these stories was that mortals must temper their wishes and desires, lest they suffer the same fate.
Is the administration of US President George W Bush learning the same fate as regards its trading policy with China?
The big news currently roiling the financial markets is the rapid rise in yields for long-term government bonds issued by the world's major industrial powers. The benchmark US Treasury 10-year note has risen 0.85 percentage points in yield, from 4.50% to almost 5.35% (in bond trader lingo, that's 85 "basis points") from early March to early June, with most of that rise coming since just late May. This represents the highest level of US 10-year rates since 2002.
Other major-traded government debt issuances have risen in yield (and thus fallen in price) along with US notes. After yielding about 1% for the better part of a decade, Japanese government bonds have risen more than 50 basis points over the same period to yield just under 2% now. British government bonds, called gilts, have risen 70 basis points.
Euro bonds, called "bunds" (from their origins as debt obligations of the German Federal Republic, the Bundesrepublik) have also risen more than 80 basis points since late winter. There is concern that these interest rate hikes, by raising the price of investment capital, will finally act to cool down the current white-hot global economy.
In my March 6 article Rocking the subprime house of cards, I explained how the issue of causation, of "why" something happens in the financial markets, is frequently hard to answer, especially when analyzing something other than individual stocks. This is the case with the current government-debt rout.
When bond-market investors hand over their money to buy a government bond they have to hold for an extended period of time, be it one, five, 10 or 30 years, they want to be confident that inflation will not eat away at the purchasing power of what they will receive back at the bond's expiration. If they think that might be the case, they will demand higher interest rates of return before forking over their wealth.
However, in this case, the standard explanations/conventional wisdom for rising interest rates, a spreading market perception among bond investors that economic growth is accelerating, soon to be followed upon by rising inflation, don't seem to have been sufficient to have engendered interest-rate rises this high this quick.
US economic growth for the January-May period was a measly 0.6%, the slowest rate since late 2002. As the US economy gets pulled down by the heavy weight of the subprime mortgage crisis (explored in my March 6 article, as well as in my March 16 article The subprime dominoes in motion), recent reports are showing that growth has not merely slowed in the US real-estate sector, it is now in full-throttle reverse, as some localized real-estate markets are showing double-digit average price declines from last year.
The problems in the real-estate sector, along with the fact that anemic sales reports from many US retailers seem to be indicating that the once super-avaricious US consumer seems finally to have been banished from the malls by high energy prices, do not seem to portend the rapidly accelerating economic growth that could be causing the rising government-bond yields, neither in the United States nor in the other major industrial capitalist economies.
The "economic growth causing rising rates" argument is not confirmed by certain internal market indicators, either. There are three major traded instruments that professional traders watch to see if inflationary fears are seeping into the markets. These are the so-called "TIPS spread" (the difference between standard Treasury bond yields and newer, inflation-indexed TIPS - Treasury Inflation-Protected Securities - bonds), the price of gold, and the levels of various commodity basket indices.
You would expect the prices of all three to be appreciating should inflationary fears be spreading, but, surprisingly, all three have in essence been stable to minimally higher throughout the worldwide bond-market rout. Something has been causing the recent rising bond yields, and it has nothing to do with the conventional wisdom.
It may not seem so now, but in the future, George W Bush will probably go down foremost in history as the US president who sat by with his cowboy boots up on the table (as he shoveled what will probably turn out to be the better part of a trillion dollars into the bloody furnace called Iraq) as world economic dominance passed from the US to China.
At first, the corporate elite class that put its man in the White House probably thought the rise in Chinese economic power was at least serendipitous, since its main cause, US manufacturers offshoring production to China, was putting intense pressure on wages; this is a central factor in the fact that a proportion of US national income going to owners of capital (business and stock owners), as against labor, has now skewed dramatically in favor of capital.
No one saw it at the time, but a central manifestation of the freedom revolution that spread across the world upon the fall of the Berlin Wall in 1989 was that First World employers were now free to put their employees in an employment pool to compete for their jobs with about a billion other employees from nations with much lower standards of living, especially China and India. Wages might be being pressured downward, but on the other side of the seesaw, profits were soaring.
As economists Lawrence Mishel and Jared Bernstein of the Economic Policy Institute put it, "Over prior business cycles, profits (including interest income) have accounted for 23% of the growth in corporate-sector income, on average, with total compensation accounting for the remaining 77%. In the current business cycle, the distribution is almost reversed: profits have claimed nearly 70% of total growth in the corporate sector, while increases in compensation (from increased employment and higher hourly compensation) have received just over 30% of total income growth."
This is the dynamic that has fueled China's explosive recent economic progress, with first-quarter year-over-year economic growth a more than healthy (in fact, a rather inflationary) world-leading 11.1% rise in gross domestic product. The GDP growth rate has been in double-digit territory since early 2005; figures for industrial production growth, currently at 18.1% year over year, also lead the world. This growth is far and away export-led; Chinese internal consumption, while growing steadily, is a very small part of the story of the Chinese economic miracle. In May, China reported a $22.5 billion trade surplus, up 73% from the previous year. More than half of that trading surplus is with the United States.
Naturally, this has resulted in a tremendous shift of wealth from the US to China. Chinese economic officials would not allow this tremendous surge of First World wealth to be loosed upon a Third World economy, with the limited domestic consumption opportunities of the Third World. It was feared, probably correctly, that this tremendous wave of cash hitting the underdeveloped markets for domestically traded goods would cause a dramatic spike in inflation.
Therefore, the Chinese have decided to let most of their export proceeds rest comfortably as reserves, currently at a world-topping $1.2 trillion (growing at a rate of a billion dollars a day), at the central People's Bank of China.
When, as World War II drew to a close, it became obvious that a new international financial architecture would be needed to fund the postwar world, allied financial chiefs gathered at Bretton Woods, New Hampshire, to hammer out what became known as the Bretton Woods accords.
These replaced the gold-centered prewar international financial structure with fixed exchange rates focused around the US dollar. When this system collapsed in the early 1970s, it led to the introduction of the current system of variable, market-derived exchange rates. In this system, the currencies of countries that run large trade surpluses, such as the China, were supposed to appreciate in value, thus making it cheaper for their citizens to purchase imports; countries that ran big trade deficits, such as the US, would see their currencies fall in value so that, eventually, they would not be able to afford so many imports.
Like the water levels in the opened locks of a canal, eventually, the system intended that the countries with trade surpluses and deficits would see their numbers equalize, and the system would eventually balance itself without any government intervention.
This has not happened with the Chinese/US trading relationship of this decade. The Chinese currency, the yuan, does not "float" in value, as do such currencies as the euro or pound. For many years it was fixed at a rate of about 8 yuan to the dollar (meaning that each individual yuan was worth 12.5 cents). Over the past year or so, it has been allowed to rise to 7.62 yuan per dollar, meaning that each individual yuan has gone up all the way to be now worth 13.1 US cents.
This meager yuan appreciation is not nearly enough to reverse Chinese trade surpluses, which are still growing. Instead, a new international financial architecture seems to have developed, one that economists Nouriel Roubini and Brad Setser, on their weblog RGE Monitor, call Bretton Woods 2.
Here's how Bretton Woods 2 works. China (or the other, lesser players in this game, Japan, Taiwan and South Korea) does not sell its export-earned dollars. Rather, it banks them. Without this excess selling pressure, the dollar does not fall in value against the yuan; it remains stable, which allows American consumers to continue their monthly billion-dollar overseas spending spree. Chinese factories keep humming, employment is strong, the Chinese people are far too content buying new stuff to come out to protest again at Tiananmen Square, and China's Communist Party rulers are very happy about that.
This is much like what happened with the billions of petrodollars that were raised by oil-exporting countries after the oil-price rises of the 1970s. The billions of dollars of China's current export earnings get sent back to the US, mostly to be invested in Treasury securities. This keeps dollar interest rates, including mortgage rates, lower than they would have been, and this keeps the US economy humming and the consumer, still fat, dumb and happy, flush with cash and plastic to keep the cycle going for at least one more round.
But no human agency or endeavor lasts forever. The internal contradictions of Bretton Woods 1 caused it to fall, and the same seems to be happening with Bretton Woods 2. Specifically, what if China doesn't want 1.2 trillion in US dollar reserves?
Bretton Woods 2 greatly benefited Bush administration officials, by both pressuring wage rates to help out their business buddies and spurring the economic growth that got them re-elected in 2004. Still, it is somewhat embarrassing to be the president of the nation with the most massive trade deficits in history. Like spoiled rich kids since time immemorial, the Bush administration is blaming somebody else.
The administration, along with its mouthpieces in the corporate conservative media machine, is arguing that, even with a huge budget deficit and virtually non-existent national savings, the trade deficit is not America's fault. It's not that the US is spending too much and saving too little, it's that the surplus countries, especially China, are saving too much and spending too little.
This interpretation of savings as bad is certainly new in the working theory of capitalist economies; in classical economics, savings are a very good thing, since the market can direct them to future investments that will maintain economic growth. A rough parallel would be an inebriate claiming that he doesn't have a problem, it's the rest of the world that suffers from inadequate alcohol consumption syndrome.
But in business, the customer is right even when he's not, and the United States is now far and away China's biggest customer. For example, it is now estimated that up to 70% of Wal-Mart's inventory is of Chinese origin; a remarkable turnaround for a company that until this decade broadcast advertisements that trumpeted the red, white and blue all-American manufacture of its products. Wal-Mart's current trade with China alone, estimated at more than $25 billion a year, surpasses the GDP of the smallest 112 national economies of the world.
In letting the yuan appreciate, although maddeningly slowly, China is responding to demands for action from US officials, especially in Congress. Another demand is that China stop just letting its huge stash of foreign-currency reserves sit around earning interest. They should go out and buy American stuff, preferably goods and services, so that the trade balance can start to equalize.
But as the Greek gods warned, be very careful what you wish for.
In my July 6, 2006, article Hedge funds: Playing dice with the universe, I explained how hedge funds, very lightly regulated pools of private capital used as high-octane investment vehicles to the world's supranational moneyed elite, were having more and more impact on events in the world's financial markets. I postulated that hedge funds acting in unison may have been a prime cause of the May 2006 cross-border equity-market meltdown. It was estimated then that, collectively, the thousands of the world's hedge funds had more than $1 trillion in assets under management.
That's just about what the single personage of Zhou Xiaochuan, the governor of the People's Bank of China, has at his disposal for investment from foreign-exchange reserves.
Last year, the big chatter in the world's financial markets was over the growing power of hedge funds, and how their huge concentrated financial resources had the possibility of dwarfing any or all governments' ability to regulate national markets. This year, a new specter haunts the markets, one whose potential impact on markets far exceeds the puny $1 trillion-plus that the hedge funds have at their disposal.
They're called sovereign wealth funds (SWFs). Basically, it seems that many of the countries that lately have accumulated huge foreign-exchange reserves exporting to the United States are getting bored with just having their money sit around earning interest at US Treasury rates. China and the other big exporters, which until recently were seemingly happy at lending back to the US the dollars to continue to buy their stuff, now see the need to earn greater rates of return than the 5% that US Treasuries currently earn.
Many of them are facing demographic time-bombs consisting of their growing elderly populations needing eventual pension support, and, for all the glamour and glitz of today's Shanghai, going beyond China's big cities still reveals grinding rural poverty that the central government knows it must address.
SWFs will act as super-hedge funds, in that they will look for opportunities all across the investment spectrum. China is in the process of setting up its own SWF, which reportedly will be funded with some $300 billion of reserves.
And that's $300 billion that will not make its way into the market for Treasury securities.
In my March 24, 2006, article US living on borrowed time - and money, I introduced readers to the US Treasury's monthly TIC (Treasury International Capital) report, the data that enumerate just how much foreign capital the US is importing every month to finance its extravagant lifestyle. During much of 2005, the US was net-importing more than $100 billion of investment capital every month, but the bottom line net number is falling sharply; last December, the US actually failed to attract any capital at all.
One TIC data set of particular interest to bond players is just how great the investment in US government securities by foreign governments is each month. These numbers are the core of the flows that constitute Bretton Woods 2, for they derive mostly from US dollar reserves held at foreign central banks.
They've been falling, too. From averaging more than $6 billion a month in 2006, foreign government purchases of US Treasury have fallen to average just over $1 billion a month for the first four months of 2007.
It is of course far from coincidental that, when US Treasury 10-year notes were at their lows in yield, in mid-2005, TIC data were showing foreign flows into Treasuries at their highest. The central reality of the bond market is that the yield of bonds traded in it go down as more people buy them; more important for the current moment, yields go up as fewer people buy them.
If China has sharply curtailed its US Treasury purchases, unless other buyers step up to the plate, then Treasury securities prices have nowhere to go but down, and yields have nowhere to go but up - just as they have recently.
The US Treasury will not release May TIC data until mid-July, but there are indications that suggest that is precisely what is happening here. A recent Treasury auction of new 10-year notes had the lowest rate of foreign government purchase participation in years. On some financial trader blogs it is being noticed that, on many days during the current market rout, the US Treasury market has opened, at 8:20am New York Time (when the Treasury futures markets open in Chicago), with large order imbalances to the sell side.
The speculation here is that this results from Chinese sellers putting in big sell orders before they retire for the night (Shanghai time is 12 hours ahead of New York) so they can see whether, or how significantly, their orders moved the market.
Of particular significance to the future is the connection between SWFs and interest rates. On May 21, China's still-nascent SWF announced its first prospective investment; it was going to take a $3 billion stake in the upcoming initial public offering of the Blackstone Group, the huge US private equity buyout firm (I wrote about the current mania for private equity in my February 22 article The highs and lows of buyouts). It was after that announcement that the fiercest selling befell the world's Treasury markets, as if traders suddenly realized that the long-feared prospect of Asian central banks abandoning bonds for other investments was finally coming true.
World equity markets stuttered a bit in the face of the world bond selloff, but they soon recovered their footing and are once again moving up. That should not be surprising; if SWFs are about to pounce on the world's stock markets, that will be unquestionably good news for share prices.
But will it be too much of a good thing? Even with buying support from SWFs, can world stock markets appreciate much further in the face of rising bond yields? Or would continued equity-market appreciation in the face of rising bond yields be prima facie evidence of what Alan Greenspan once called irrational exuberance? Right now the only world stock market that Chinese prosperity is supporting is the Shanghai Stock Exchange A-share exchange.
That market has tripled in 14 months, and academic economists the world over are frightened that when this speculative bubble finally bursts, as all speculative bubbles must inevitably do, it will take the world's economy with it. Specifically, with so many ordinary Chinese citizens playing the Shanghai market like a never-losing roulette wheel, will the Chinese government feel threatened by the rapid destruction of domestic wealth that a burst stock market would cause? Will they try to support the shares with reserves, either from the People's Bank of China or from its SWF? What will that do to the investments in the West that the reserves had been supporting?
A more frightening prospect is if non-China stock markets start acting like Shanghai - if SWF money starts supporting or, more likely, deluging them. Trading volumes in Shanghai are still small enough, compared with Western equity markets, that the Chinese government probably could backstop a Shanghai crash, but if the world's other stock markets, supported by Asian SWF money, start replicating Shanghai's parabolic, meteoric rise, then all the reserves, tea, or anything else in China will not be sufficient to support them when their towers finally topple.
This decade's boom started in China. Will it end there too?
Will the economic historians of the future, when tracking back to ascertain the cause of the world crash of 2007, find that the dominoes were put in motion when George W Bush started urging the Chinese to buy more American stuff, and the Chinese responded with purchases of US companies and stocks?
Like the Sorcerer's Apprentice of legend, perhaps it would have been better if, while an business-administration graduate student at Harvard in the early 1970s, the future president would have actually read the instructions on how to run the world economy.
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