By Julian Delasantellis
Precisely as I have been predicting since mid-August, foreign state-owned investment pools, sovereign wealth funds (SWVs), have now commenced the process of riding to the rescue of the poor, weakened, self-mutilated US financial system.
I hate to be smug and tell you "I told you so." Ah, come on, who am I trying to kid? I absolutely love to be able to say that, just as much as the next boorish preening pundit.
It was announced prior to the opening of trading on Tuesday that the Abu Dhabi Investment Authority, the world's largest SWF, was paying US$7.5 billion to buy a 4.9% stake in Citigroup, the largest financial institution in the United States. Citigroup, facing what the markets fear may amount to a $30 billion or more hit on its capital base due to its problems with subprime mortgages and associated derivative financial products, recently had its chief executive officer, Charles O Prince, fall on his sword in an effort to satisfy the mobs of angry shareholders. This did little to assuage the howling furies; they're still lashing the company, with sell orders whipping off their computer mice. The stock is down over 45% this year, almost 25% this month.
Citigroup did rally on the news, but the price move was far from anything all that impressive - the stock rose about 1.75%.
Citigroup's rescue did not come cheap. The deal was structured in the form of convertible securities that will require the company to pay junk-bond levels of coupon interest, reported by Barron's to be close to 11%, for the privilege of selling part of America's premier consumer financial institution into foreign hands.
For me, the most surprising, and possibly the most upsetting thing about the Citigroup news was the absolutely orgiastic reaction to it. The general media, of course, saw this only in the context of something that would cause the stock market to go up, so it must be good. (Dead white American suburban young women = bad, rising stock prices = good; it's not that hard to be a US TV news producer these days.) The Dow Jones Industrial Average opened strong, gave up most of its gains midday, then was rallying into the close to finish up 215, a fairly average price change these days.
If the electronic media are now history's first draft, then, to judge by the reaction of the on-air personnel on business cable channel CNBC, America has just had its best day since the famous New York City Times Square victory celebrations at the end of World War II.
All day long the smooth and clean faces of CNBC shone happy and bright, overjoyed that, just as the losses in the Dow in the past two months had reached the psychologically important 10% level the previous day, at last a savior had arisen. Surely, almost as if the financial markets had become a sort of children's holiday pageant, the Abu Dhabi Investment Authority was a modern John the Baptist, proclaiming the good news of imminent salvation, namely, lots more foreign SWF money to refloat America's sagging markets, economy and spirits.
Defying any and all naysayers, CNBC anchor Dylan Ratigan summed up the Good News for modern traders:
At the end of the day, though, we could spend four hours talking about all the terrible things that could potentially still happen, today's a good day - $7.5 billion for the banking system came in, for better or worse. Granted its only 1% of all the money in Abu Dhabi, granted that there could be future writedowns, but at the end of the day, $7.5 billion is a lot of money.
Of course, what's going out as the $7.5 billion comes in is the shining jewel called ownership. The origins of Citigroup go back to the founding of the City Bank of New York in 1812. Over these past 195 years, the institution has been carefully built and nurtured, and its prosperity has enriched countless thousands of American stockholders. That wealth creation, as it circulated around and across the American economy, also enriched the American community as a whole.
Then comes the first decade of the 21st century. Citigroup goes for the gusto, grabs for the brass ring, reaches out for the fat, seemingly riskless returns being offered by a new generation of subprime mortgage derivative products. This experiment goes horribly wrong for Citigroup, as it has for much of the US financial system.
Citigroup then has a choice, as does the rest of the financial system, as does the rest of the country. Accept a year or two of diminished earnings, dividends and prosperity, until the entire subprime thing works its way through and out of the financial system, or sell out and attempt to once again live the good life that much sooner.
The cost? The cost, of course, is that in the future commensurately fewer Americans will be enjoying the fruits of ownership that have accrued through the hard work, enterprise and ingenuity of this two-century-old venture.
As has been proven so many times in the recent past, from America's budget and trade deficits to its crumbling infrastructure, its appallingly dysfunctional primary and secondary school system, its non-existent savings rate, and the total diffidence with which it approaches the global environmental impact of its prosperity, this is a country that looks at the prospect of any pain or inconvenience in the present with such boundless levels of abhorrence that it is more than willing to satisfy its heroin-like addiction to immediate gratification with sales of any or all of its national heirlooms.
A comparable absurdity would be Americans selling their houses and forever being renters in order to gain the requisite funds to, in the newly sacrosanct modern tradition, line up at big box electronic retailers in the cold early hours of the morning after Thanksgiving.
Wait a minute. As a matter of fact, that's precisely what the Americans who took out home equity loans to spend away the appreciated wealth locked up in their homes have done. It's no wonder that Citigroup doing the same thing looks so normal.
In essence, in commencing the process of selling away America's remarkably innovative and profitable financial system, the country will now be paying a rent, in the form of the profits accruing to Abu Dhabi and the other SWF buyers that must surely follow its lead, equal to what it once collected for itself.
A recent survey of students at New York University revealed that two thirds of them were willing to sell away their right to vote in exchange for next year's tuition (which is over $47,000 for tuition, room and board - at least the youngsters are not selling themselves cheap); half said that they'd be willing to forever forfeit their franchise for a cool million dollars.
Middle-aged power pundits and basic cable savants were aghast, oh dear, what has become of the values of the young?
But in reality, weren't the little tykes at New York University just, as children are wont to do at any age, imitating their parents, in that everything timeless and hard-won, sacred and cherished, can and should eventually be bartered away for a current comfortable price?
One thing about Abu Dhabi's investment that seemed to particularly please the pretty CNBC on-air faces was their speculation that Citigroup's stock dividend, worth currently about 8% of the stock's market price, might now be that much more safe from a possible cut.
Well, there's good news. It means that America's legions of coupon-clipping Paris Hilton wannabes will thus be more likely to be spared the soul-extirpating experience of shopping at Rodeo Drive rather than Macy's this holiday season.
Take care, wherever you are. Even if Paris Hilton still hasn't got her driver's license back, by any means necessary America is getting its money back; the practical effect is just about the same.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
Thursday, November 29, 2007
Monday, November 19, 2007
Playing 'chicken' with the markets
By Julian Delasantellis
Any parent knows that sometimes you have to tell a child something more than once to get your point across. If you’re dealing with a teenager who has been allowed to have his or her own way for too long, you may have to repeat the message that things have changed, that there are new expectations, a few times before it sinks in.
That’s what US Federal Reserve chairman Ben Bernanke is doing with the markets these days - trying to send the message that he’s instituting new rules of conduct, of proper behavior, for both the Fed and the markets.
Will the markets get and accept the message? We’ll know at the next Fed meeting, on December 11.
In a speech delivered to the Cato Institute in Washington on Wednesday, Bernanke expounded his views on what should be the proper inputs that influence the policy decisions of America’s central bank. Taken together they indicate that, now 21 months into his 7 year term as chairman, he has finally found footing and confidence sufficient to make a fairly significant policy change from his predecessor, the illustrious Alan Greenspan.
The first major change elucidated by Bernanke refers to a new emphasis on what is called “overall” inflation, in the place of a previously greater focus on what is called “ core” inflation.
The distinction between core and overall inflation is simple to understand. Overall inflation is a measure of price increases in that place economists are rarely concerned about, the real world. It’s what you feel when you get a haircut, go out to dinner, and especially these days, fill your car with gas.
But, traditionally, overall inflation has not been the preferred inflation gauge for economists. In its stead, they have favored looking at something called “core” inflation, defined as price changes for retail goods excluding food and energy.
There are some good reasons, other than economists’ traditional desire to live in a fantasy world, to look at core inflation. Energy and food prices are much more volatile than prices of other consumer goods, they frequently are affected by many factors unrelated to the basic health or weakness of the underlying economy. Killing freezes in Florida (which, most likely due to global warming, are now much less frequent than they used to be) can cause price spikes in winter citrus, and geopolitical tension in the oil producing regions regularly produces what is called a “fear premium” in oil and oil products prices.
By removing these volatile factors, the argument goes, you get a better look at whether economic growth or weakness, which, in contrast to the weather or OPEC, the Fed can control, is causing the general level of prices in the economy to rise or fall.
But the drawback of core inflation is that, in times such as these, with food and energy prices rising rapidly, the Fed loses credibility when it says that core inflation only rose 0.2% in October, and consumers then compare what they hear from their leaders with what they see on their supermarket check out tape and on the price signboards of gasoline stations, which are currently now America’s real inflation index.
Therefore, Bernanke is now saying that the Fed is going to tip the scales a bit back towards reality.
"Ultimately, households and businesses care about the overall, or 'headline' rate of inflation; therefore, the FOMC [Federal Open Market Committee] should refer to an overall inflation rate when evaluating whether the committee has met its mandated objectives over the long run. For that reason, the committee has decided to publish projections for overall inflation as well as core inflation. In its policy statements and elsewhere, the committee makes frequent reference to core inflation because, in light of the volatility of food and energy prices, core inflation can be a useful short-run indicator of the underlying trend in inflation. However, at longer horizons, where monetary policy has the greatest control over inflation, the overall inflation rate is the appropriate gauge of whether inflation is at a rate consistent with the dual mandate.”
But the real impact of this policy change is to make future Federal Reserve interest rate cuts less likely, and probably less frequent. The tremendous economic growth of the petroleum-poor economies of China and India has been spurring oil demand for much of this decade. As for food demand, that is also being driven by these countries' newly elevated living standards, as well as the not insignificant factor of agricultural production once dedicated to foodstuffs now being diverted to the production of ethanol. If you are going to re-focus your monetary policy on inflation, and if you are going to measure inflation in such a way that it makes inflation look worse than previously, then, in effect, the Fed is tying itself up in a straitjacket of its own knitting in regard to future rate cuts.
But the real change in Bernanke’s speech was related to what is called "inflation targeting". In my September 18 ATol article, A rate cut with a shoeshine and a smile, and in my October 6 review of Alan Greenspan’s autobiography, The Age of Turbulence, (Reaping what is sown) I noted how, throughout Greenspan’s 18-year tenure as Fed chief, and continuing into the early months of Bernanke’s, it frequently seemed that pure economic fundamentals were of secondary importance in deciding whether or when to change short-term interest rates, especially if that change was a rate cut.
After taking office as Fed chief in August 1987, Greenspan’s first move was to show off his monetary masculinity with half point hikes in the Federal Funds target and discount rates on September 4; six weeks later came the crash of '87. Greenspan was stung by charges that his first rate move caused the debacle, notwithstanding the fact that these charges arose from Wall Street types who wouldn’t have known the difference between selling stocks and selling shoes. Greenspan cut rates repeatedly in the three months after the October 1987 crash, and the economy recovered rapidly; the fears that the market calamity might act similarly to the Crash of 1929 and produce another Great Depression proved unfounded. The pattern was set, the stock markets came to realize that they could always rely on chairman Greenspan.
From July to December of 1990 the markets sold off nervously in response to Iraq’s invasion of Kuwait, and the Dow Jones Industrial Average lost over 16% of its value. In response, the Greenspan Fed cut the Federal Funds target rate five times. In mid 1998, as the Dow sold off 11%, over 1,000 points, and as the East Asian financial crisis concluded with the bankruptcy of the Long Term Credit Management (LTCM) hedge fund, the Fed cut again, trimming 75 basis points off the Federal Funds target rate.
At the opening of trading on September 17, 2001, the first day of trading after the four-day shutdown caused by 9/11, Greenspan welcomed the markets back with a 50 basis point cut. After a brief recovery rally in the autumn of 2001 the markets continued to fall, spooked by both the gathering evidence of a US economic slowdown and the Iraq war talk coming from Washington. The Dow Jones bottomed out under 7,200 in early October 2002, down almost 40% from its highs in early 2000. Over that period, the Greenspan Fed cut rates 12 times; lowering the Federal Funds target rate to 1.25% as the rate cutting cycle concluded.
Of course most of these rate cuts did occur in times of great economic stress, but, after a while, it began to seem as if Greenspan was using the level of the stock market not as a predictor of future economic disruption, but almost as a proxy for it. After that, it was a just a natural extension of the implied logic to assume that the stock market declines were not just a harbinger of future economic distress; they were, in effect, the actual economic distress that had to be countered with rate cuts. It began to be said that one of the factors that was underpinning the strong rally in stock prices that began late in 2002 was the existence of what was called the “Greenspan put”, a put being a stock option instrument that an investor uses to put a floor under any potential losses in an equity he owns. In effect, by seeming to always come to the rescue of a stock market in trouble, the stock market acquired the impression that the US Federal Reserve would always be there to bail them out.
Bernanke, who appeared to be following this pattern with his rate cuts of August and September, now seems to want to disabuse the markets of this notion. In my November 2 ATol article, Bernanke: Don't take me for granted, boys, I noted that there were leaks emanating from the Federal Reserve regarding a desire to change the market’s expectation that stock selloffs would always be met with rate cuts. In his Cato speech, Bernanke further expanded on these ideas.
Bernanke seems to desire moving Fed policy away from Fed cuts to be expected upon market hiccups towards a policy called “inflation targeting”, common with other central banks such as the Bank of England.
Very much as the name implies, inflation targeting means setting a formal inflation goal, and altering policy in order to zero in on the desired goal, for instance, raising rates to tighten monetary policy should inflation be coming in above the target goal.
Bernanke informed Cato of his views on inflation targeting. “As you may know, I have been an advocate of the monetary policy strategy known as inflation targeting, used in many countries around the world. Inflation targeting is characterized by two features: an explicit numerical target or target range for inflation and a high degree of transparency about forecasts and policy plans.”
Bernanke’s new policy states that the Federal Reserve will double, from two to four, the number of annual forecasts it gives regarding how it sees future prospects for inflation. The “transparent” aspect of the policy is that the goals will be public, there for all to see.
But besides fighting inflation, the Federal Reserve has also been ordered by Congress to promote economic growth in order to move towards full employment. “As I have emphasized today, the Federal Reserve is legally accountable to the Congress for two objectives, maximum employment and price stability, on an equal footing. My colleagues and I strongly support the dual mandate and the equal weighting of objectives that it implies.“
But there is nothing in the new Bernanke approach that implies that one of the new goals will be enhancing “market stability”, the catchphrase codewords employed by Greenspan to ride to the rescue of the markets. Almost like a parent who deflects a child’s wish for a higher allowance by producing and displaying an overdrawn bank statement, the new policy seems to have the Fed someday telling the markets, “We’d like to cut rates, but, sorry, our rules say that we just can’t.”
It is highly questionable whether under the new policy guidelines the Fed would have cut rates the three times it has since August 17, for, by the Fed’s own admission, the overwhelming rationale for at least the first and second cuts, and a major factor in the third, was alleviating financial market turmoil.
The question now becomes, will the new policy preclude another cut at the Fed’s next meeting, on December 11? If the Cato speech represents new policy guidance then the answer is probably yes.
Inflation fears are, if anything, growing; the US dollar is plunging, and two of the bond market’s prime gauges for judging future inflationary expectations are flashing red. The spread in yield (called the “yield curve” in the markets) between what is being offered in yield by two-year and 10-year US Treasury securities is at a two and a half-year high, as is another closely watched inflation warning indicator, the “TIPS” spread between conventional fixed rate and inflation protected 10-year Treasury securities.
It also does not appear that another cut can be justified with an argument that economic growth is slowing. Third quarter US GDP growth, at 3.9%, is surprising strong; the subprime/credit crisis spooking the markets more and more with each passing day implies an economic slowdown that has not really commenced, at least not yet.
But the markets are acting as if nothing has changed with the Fed. Federal Funds futures, reacting to the continuing equity market selloffs, are still giving 94% odds of a cut at or before December 11.
On November 12, BCA Research, a prominent Montreal research organization, expressed the standard "equity market weakness equals Fed rate cuts" paradigm in this way. “Increasing stress in the financial system and signs of reduced credit availability mean that the Fed has a lot more easing ahead. The shift to a neutral bias by the FOMC was misplaced given the renewed rioting in the financial markets.”
This is thinking that the stock markets can understand, that selloffs will always be met by cuts. Unless there is an unbelievably rapid improvement in the subprime/credit picture in the four weeks before the next meeting, it will be the picture that will greet the Fed governors on December 11. If they do cut, finding a way to produce some sort of justifying blather in the accompanying post-meeting statement, right in the face of the current Fed independence bravado represented by the Cato speech, will be difficult if Bernanke is to have any credibility attached to any of his public statements for the remaining 6 years of his term.
If they disappoint the markets and fail to cut, listen for the screams of anything but joy as the stock market roller coaster takes a long, hard plunge.
Notwithstanding Cato, I think they’ll cut. American society is currently at a place where, if a child falls and skins a knee on an unfilled crack in a school playground, the local TV stations will send video crews to hound the poor school janitor, or better yet, the feckless school bureaucrat in charge, until the poor sod ends his misery and sticks his head in a gas oven. At which point, the media would be very satisfied.
“Justice for little Timmy. Story at 10.”
Imagine the media coverage of the huge losses that would follow upon the markets being disappointed by the lack of a cut. In the 24/7 vigilante pundit saturnalia that has taken the place of what Americans once received as news, a hunt would be initiated for the responsible scalps, and, for this, Bernanke’s hirsute challenged pate will do very nicely.
But perhaps they won’t, maybe Bernanke’s pride will come before a very big fall. Bernanke and the markets are like two teenage boys playing “chicken” with very fast cars. Both are waiting for the other to pull away, to blink.
For all our sakes, I hope somebody takes their car keys away before the entire world’s economy crashes.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
Any parent knows that sometimes you have to tell a child something more than once to get your point across. If you’re dealing with a teenager who has been allowed to have his or her own way for too long, you may have to repeat the message that things have changed, that there are new expectations, a few times before it sinks in.
That’s what US Federal Reserve chairman Ben Bernanke is doing with the markets these days - trying to send the message that he’s instituting new rules of conduct, of proper behavior, for both the Fed and the markets.
Will the markets get and accept the message? We’ll know at the next Fed meeting, on December 11.
In a speech delivered to the Cato Institute in Washington on Wednesday, Bernanke expounded his views on what should be the proper inputs that influence the policy decisions of America’s central bank. Taken together they indicate that, now 21 months into his 7 year term as chairman, he has finally found footing and confidence sufficient to make a fairly significant policy change from his predecessor, the illustrious Alan Greenspan.
The first major change elucidated by Bernanke refers to a new emphasis on what is called “overall” inflation, in the place of a previously greater focus on what is called “ core” inflation.
The distinction between core and overall inflation is simple to understand. Overall inflation is a measure of price increases in that place economists are rarely concerned about, the real world. It’s what you feel when you get a haircut, go out to dinner, and especially these days, fill your car with gas.
But, traditionally, overall inflation has not been the preferred inflation gauge for economists. In its stead, they have favored looking at something called “core” inflation, defined as price changes for retail goods excluding food and energy.
There are some good reasons, other than economists’ traditional desire to live in a fantasy world, to look at core inflation. Energy and food prices are much more volatile than prices of other consumer goods, they frequently are affected by many factors unrelated to the basic health or weakness of the underlying economy. Killing freezes in Florida (which, most likely due to global warming, are now much less frequent than they used to be) can cause price spikes in winter citrus, and geopolitical tension in the oil producing regions regularly produces what is called a “fear premium” in oil and oil products prices.
By removing these volatile factors, the argument goes, you get a better look at whether economic growth or weakness, which, in contrast to the weather or OPEC, the Fed can control, is causing the general level of prices in the economy to rise or fall.
But the drawback of core inflation is that, in times such as these, with food and energy prices rising rapidly, the Fed loses credibility when it says that core inflation only rose 0.2% in October, and consumers then compare what they hear from their leaders with what they see on their supermarket check out tape and on the price signboards of gasoline stations, which are currently now America’s real inflation index.
Therefore, Bernanke is now saying that the Fed is going to tip the scales a bit back towards reality.
"Ultimately, households and businesses care about the overall, or 'headline' rate of inflation; therefore, the FOMC [Federal Open Market Committee] should refer to an overall inflation rate when evaluating whether the committee has met its mandated objectives over the long run. For that reason, the committee has decided to publish projections for overall inflation as well as core inflation. In its policy statements and elsewhere, the committee makes frequent reference to core inflation because, in light of the volatility of food and energy prices, core inflation can be a useful short-run indicator of the underlying trend in inflation. However, at longer horizons, where monetary policy has the greatest control over inflation, the overall inflation rate is the appropriate gauge of whether inflation is at a rate consistent with the dual mandate.”
But the real impact of this policy change is to make future Federal Reserve interest rate cuts less likely, and probably less frequent. The tremendous economic growth of the petroleum-poor economies of China and India has been spurring oil demand for much of this decade. As for food demand, that is also being driven by these countries' newly elevated living standards, as well as the not insignificant factor of agricultural production once dedicated to foodstuffs now being diverted to the production of ethanol. If you are going to re-focus your monetary policy on inflation, and if you are going to measure inflation in such a way that it makes inflation look worse than previously, then, in effect, the Fed is tying itself up in a straitjacket of its own knitting in regard to future rate cuts.
But the real change in Bernanke’s speech was related to what is called "inflation targeting". In my September 18 ATol article, A rate cut with a shoeshine and a smile, and in my October 6 review of Alan Greenspan’s autobiography, The Age of Turbulence, (Reaping what is sown) I noted how, throughout Greenspan’s 18-year tenure as Fed chief, and continuing into the early months of Bernanke’s, it frequently seemed that pure economic fundamentals were of secondary importance in deciding whether or when to change short-term interest rates, especially if that change was a rate cut.
After taking office as Fed chief in August 1987, Greenspan’s first move was to show off his monetary masculinity with half point hikes in the Federal Funds target and discount rates on September 4; six weeks later came the crash of '87. Greenspan was stung by charges that his first rate move caused the debacle, notwithstanding the fact that these charges arose from Wall Street types who wouldn’t have known the difference between selling stocks and selling shoes. Greenspan cut rates repeatedly in the three months after the October 1987 crash, and the economy recovered rapidly; the fears that the market calamity might act similarly to the Crash of 1929 and produce another Great Depression proved unfounded. The pattern was set, the stock markets came to realize that they could always rely on chairman Greenspan.
From July to December of 1990 the markets sold off nervously in response to Iraq’s invasion of Kuwait, and the Dow Jones Industrial Average lost over 16% of its value. In response, the Greenspan Fed cut the Federal Funds target rate five times. In mid 1998, as the Dow sold off 11%, over 1,000 points, and as the East Asian financial crisis concluded with the bankruptcy of the Long Term Credit Management (LTCM) hedge fund, the Fed cut again, trimming 75 basis points off the Federal Funds target rate.
At the opening of trading on September 17, 2001, the first day of trading after the four-day shutdown caused by 9/11, Greenspan welcomed the markets back with a 50 basis point cut. After a brief recovery rally in the autumn of 2001 the markets continued to fall, spooked by both the gathering evidence of a US economic slowdown and the Iraq war talk coming from Washington. The Dow Jones bottomed out under 7,200 in early October 2002, down almost 40% from its highs in early 2000. Over that period, the Greenspan Fed cut rates 12 times; lowering the Federal Funds target rate to 1.25% as the rate cutting cycle concluded.
Of course most of these rate cuts did occur in times of great economic stress, but, after a while, it began to seem as if Greenspan was using the level of the stock market not as a predictor of future economic disruption, but almost as a proxy for it. After that, it was a just a natural extension of the implied logic to assume that the stock market declines were not just a harbinger of future economic distress; they were, in effect, the actual economic distress that had to be countered with rate cuts. It began to be said that one of the factors that was underpinning the strong rally in stock prices that began late in 2002 was the existence of what was called the “Greenspan put”, a put being a stock option instrument that an investor uses to put a floor under any potential losses in an equity he owns. In effect, by seeming to always come to the rescue of a stock market in trouble, the stock market acquired the impression that the US Federal Reserve would always be there to bail them out.
Bernanke, who appeared to be following this pattern with his rate cuts of August and September, now seems to want to disabuse the markets of this notion. In my November 2 ATol article, Bernanke: Don't take me for granted, boys, I noted that there were leaks emanating from the Federal Reserve regarding a desire to change the market’s expectation that stock selloffs would always be met with rate cuts. In his Cato speech, Bernanke further expanded on these ideas.
Bernanke seems to desire moving Fed policy away from Fed cuts to be expected upon market hiccups towards a policy called “inflation targeting”, common with other central banks such as the Bank of England.
Very much as the name implies, inflation targeting means setting a formal inflation goal, and altering policy in order to zero in on the desired goal, for instance, raising rates to tighten monetary policy should inflation be coming in above the target goal.
Bernanke informed Cato of his views on inflation targeting. “As you may know, I have been an advocate of the monetary policy strategy known as inflation targeting, used in many countries around the world. Inflation targeting is characterized by two features: an explicit numerical target or target range for inflation and a high degree of transparency about forecasts and policy plans.”
Bernanke’s new policy states that the Federal Reserve will double, from two to four, the number of annual forecasts it gives regarding how it sees future prospects for inflation. The “transparent” aspect of the policy is that the goals will be public, there for all to see.
But besides fighting inflation, the Federal Reserve has also been ordered by Congress to promote economic growth in order to move towards full employment. “As I have emphasized today, the Federal Reserve is legally accountable to the Congress for two objectives, maximum employment and price stability, on an equal footing. My colleagues and I strongly support the dual mandate and the equal weighting of objectives that it implies.“
But there is nothing in the new Bernanke approach that implies that one of the new goals will be enhancing “market stability”, the catchphrase codewords employed by Greenspan to ride to the rescue of the markets. Almost like a parent who deflects a child’s wish for a higher allowance by producing and displaying an overdrawn bank statement, the new policy seems to have the Fed someday telling the markets, “We’d like to cut rates, but, sorry, our rules say that we just can’t.”
It is highly questionable whether under the new policy guidelines the Fed would have cut rates the three times it has since August 17, for, by the Fed’s own admission, the overwhelming rationale for at least the first and second cuts, and a major factor in the third, was alleviating financial market turmoil.
The question now becomes, will the new policy preclude another cut at the Fed’s next meeting, on December 11? If the Cato speech represents new policy guidance then the answer is probably yes.
Inflation fears are, if anything, growing; the US dollar is plunging, and two of the bond market’s prime gauges for judging future inflationary expectations are flashing red. The spread in yield (called the “yield curve” in the markets) between what is being offered in yield by two-year and 10-year US Treasury securities is at a two and a half-year high, as is another closely watched inflation warning indicator, the “TIPS” spread between conventional fixed rate and inflation protected 10-year Treasury securities.
It also does not appear that another cut can be justified with an argument that economic growth is slowing. Third quarter US GDP growth, at 3.9%, is surprising strong; the subprime/credit crisis spooking the markets more and more with each passing day implies an economic slowdown that has not really commenced, at least not yet.
But the markets are acting as if nothing has changed with the Fed. Federal Funds futures, reacting to the continuing equity market selloffs, are still giving 94% odds of a cut at or before December 11.
On November 12, BCA Research, a prominent Montreal research organization, expressed the standard "equity market weakness equals Fed rate cuts" paradigm in this way. “Increasing stress in the financial system and signs of reduced credit availability mean that the Fed has a lot more easing ahead. The shift to a neutral bias by the FOMC was misplaced given the renewed rioting in the financial markets.”
This is thinking that the stock markets can understand, that selloffs will always be met by cuts. Unless there is an unbelievably rapid improvement in the subprime/credit picture in the four weeks before the next meeting, it will be the picture that will greet the Fed governors on December 11. If they do cut, finding a way to produce some sort of justifying blather in the accompanying post-meeting statement, right in the face of the current Fed independence bravado represented by the Cato speech, will be difficult if Bernanke is to have any credibility attached to any of his public statements for the remaining 6 years of his term.
If they disappoint the markets and fail to cut, listen for the screams of anything but joy as the stock market roller coaster takes a long, hard plunge.
Notwithstanding Cato, I think they’ll cut. American society is currently at a place where, if a child falls and skins a knee on an unfilled crack in a school playground, the local TV stations will send video crews to hound the poor school janitor, or better yet, the feckless school bureaucrat in charge, until the poor sod ends his misery and sticks his head in a gas oven. At which point, the media would be very satisfied.
“Justice for little Timmy. Story at 10.”
Imagine the media coverage of the huge losses that would follow upon the markets being disappointed by the lack of a cut. In the 24/7 vigilante pundit saturnalia that has taken the place of what Americans once received as news, a hunt would be initiated for the responsible scalps, and, for this, Bernanke’s hirsute challenged pate will do very nicely.
But perhaps they won’t, maybe Bernanke’s pride will come before a very big fall. Bernanke and the markets are like two teenage boys playing “chicken” with very fast cars. Both are waiting for the other to pull away, to blink.
For all our sakes, I hope somebody takes their car keys away before the entire world’s economy crashes.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
Friday, November 16, 2007
Subprime mortgages, subprime currency
By John Lee
Last week, US Federal Reserve chairman Ben Bernanke told the US Congress he would support raising the limit on the size of the individual loans eligible for securitization by the government-sponsored mortgage finance entities from US$417,000 to $1 million, on a temporary basis.
He suggested that Fannie Mae and Freddie Mac could pay insurance premiums on these loans to the federal government, which would "act as guarantor" by taking on some of the credit risk.
Charles Schumer, the Democratic chairman of the Joint Economic Committee, enthusiastically welcomed the idea and said he would try to insert it into legislation already before Congress.
It came as Bernanke told Congress that estimates that set the total losses from subprime mortgages at about $150 billion were probably "in the ballpark".
Given that the Fed and European Central Bank have already injected well over $150 billion since August, Bernanke obviously lied about his ballpark figure. But just how big is this subprime mess?
To measure subprime losses, we have to first find out the size of the subprime market. Fed data pegs the total US residential value at $20 trillion and the US residential mortgage market at $10 trillion. This number is substantial, as it eclipses the US treasury market of $9 trillion.
Of the $10 trillion mortgage market, government sponsored enterprises (GSEs) like Fannie and Freddie hold about $1.5 trillion, leaving $8.5 trillion in private hands. Within this $8.5 trillion, we have various grades and categories, with grades ranging from AAA, AA, Alt-A, BBB, and categories such as the traditional 30-year fixed, and non-traditional ARM, ARM with teaser rate, interest only, and negative-amortization.
The exact definition of subprime is not clear, with various sources estimating that the total subprime portfolio is between $1.5 trillion to $3 trillion. To precisely break down US$8.5 trillion by categories proves to be difficult. Nonetheless below is our estimate. We have valued the subprime market at $2 trillion. This is in line with an estimate by MSNBC reporter and research firm First American Loan Performance.
So just how much of the $2 trillion subprime position is lost? Various sources including First American Loan Performance estimated a default rate of 15%; this would translate to $300 billion of non-collectable principal and interest.
That in itself is not a big deal, as every year the United States spends well over $100 billion in Iraq and $400 billion on the military outside Iraq. The real concern is how such defaults are affecting the value of the existing outstanding subprime portfolio. In other words, would you eat beef knowing that one in 10 cows is a mad cow?
We follow the ABX index published by Markit.com, which is the basket of derivatives linked to subprime securities. As financial tools go, this index is far from perfect, since it is barely two years old, and tends to be thinly traded. But right now it has the unfortunate distinction of being the only tool easily available to measure sentiment in the opaque subprime securities world. And in the past couple of weeks, the message emerging from this measure has started to look utterly dire, as it shows subprime mortgages are changing hands at 25 cents on the dollar.
As we have shown in the pie chart above, this 80% haircut applies to potentially $2 trillion worth of mortgages if investors of those mortgages were to exit today. The loss is not $150 billion, but more like $1.6 trillion.
What's more, the ABX shows that since September 2007, the value of AAA mortgages has begun to crater, and now trades at a stunning 70 cents on the dollar. This means if all AAA and Alt-A mortgage portfolios were to be marked to market, the loss would amount to another $2 trillion.
Despite the fact that Bernanke and the Fed moved to a neutral balance of risks assessment last week, the market now sees a roughly 55% chance that the central bank will cut rates by another 50 basis points by the close of its January policy meeting, and an additional 15% chance that it will cut by 25 points by then.
And now you understand why Bernanke was so frantic in lowering interest rates and proposing the drastic policy measure of more than doubling the GSE limit to $1 million. In essence Bernanke is trying to increase the share of GSE in the pie and hopes the problem will go away.
The curious mind asks, who holds those trillions of dollars worth of mortgages? Thanks to the genius of the American banking and marketing machine, just about every sizable institution underneath the sun with a fixed income portfolio. From Europeans to Asians, from banks to brokerages, from hedge funds to pension funds, institution to retail, trusts to endowments.
Allow me to quote an FT.com article of November 1:
[T]he experience of living through the Enron scandals earlier this decade means that the audit industry is now terrified that it could face lawsuits if it is perceived to be too lax towards its clients. So some now appear to be demanding that their banking clients reprice their mortgage assets according to the only visible market tool - namely the ABX. It is thus little wonder that some banks have suddenly been forced to increase their writedowns in recent weeks. Indeed, I would wager that the pernicious combination of ABX and the “Enron factor” is a key reason for the recent shocks emanating from Merrill Lynch.
However, the rub is that while auditors at some Wall Street banks are becoming quasi-evangelical about the need to reprice subprime assets, there are still other, vast swathes of the financial system which have not been touched by the full blast of transparency yet. Moreover, many financiers outside the world of Wall Street banks remain very wary of rewriting their mortgage assets to current ABX price levels, due to a lingering hope that the recent ABX slump will remain temporary.
Most of those aforementioned outfits are in a state of shock and have been reluctant to mark their $1 trillion-plus subprime portfolio to market. Every other day there is new revelation of substantial subprime loss. First it was New Century in March, then American Mortgage and Countrywide in September, then it got worse as Wells Fargo, Bank of America, Credit Suisse First Boston, Citibank (albeit with a new CEO now) came out of the woodwork. Last Friday it was Wachovia (US's 4th largest), and on Tuesday it was Etrade. Not one major bank dealing with mortgages was immune. If there is such thing as systemic risk, we are sure looking at it, and therefore expect a lot more skeletons to come out of the closet in the months to come.
How about interest rates? Hiking interest rates on US debts is like giving a discount on mad-cow tainted beef: it’s not going to make a difference or help it sell.
At this juncture, the Fed has no choice but to redeem any and all mortgages at near face value directly, through GSEs or offshore vehicles. The more the Fed redeems, the more dollars they print. When you print $1 trillion (10%) a year, people can reasonably swallow the extra money supply, but when you print $1 trillion in a hurry and in a conspicuous way, you are directly challenging money managers’ intelligence and you will see a squeeze in gold. It’s that simple.
No sane foreign institution is going to finance American home owners, and why should they when they can finance the Brazilians, Canadians, Thais, Russians, Chinese, Indians, with an appreciating currency? The dollar's reserve status is now shattered. Mind you, it’s not that we are against the dollar in particular, we just don’t think any fiat currency deserves to be the world’s reserve currency.
To those who say gold is due for a prolonged correction at $800, you are missing the big picture. To us gold’s run has just started, with the emperor now naked for all to see.
John Lee is a portfolio manager at Mau Capital Management. He is a CFA charter holder and has degrees in economics and engineering from Rice University. He previously studied under James Turk, a renowned authority on the gold market, and is specialized in investing in junior gold and resource companies.
Last week, US Federal Reserve chairman Ben Bernanke told the US Congress he would support raising the limit on the size of the individual loans eligible for securitization by the government-sponsored mortgage finance entities from US$417,000 to $1 million, on a temporary basis.
He suggested that Fannie Mae and Freddie Mac could pay insurance premiums on these loans to the federal government, which would "act as guarantor" by taking on some of the credit risk.
Charles Schumer, the Democratic chairman of the Joint Economic Committee, enthusiastically welcomed the idea and said he would try to insert it into legislation already before Congress.
It came as Bernanke told Congress that estimates that set the total losses from subprime mortgages at about $150 billion were probably "in the ballpark".
Given that the Fed and European Central Bank have already injected well over $150 billion since August, Bernanke obviously lied about his ballpark figure. But just how big is this subprime mess?
To measure subprime losses, we have to first find out the size of the subprime market. Fed data pegs the total US residential value at $20 trillion and the US residential mortgage market at $10 trillion. This number is substantial, as it eclipses the US treasury market of $9 trillion.
Of the $10 trillion mortgage market, government sponsored enterprises (GSEs) like Fannie and Freddie hold about $1.5 trillion, leaving $8.5 trillion in private hands. Within this $8.5 trillion, we have various grades and categories, with grades ranging from AAA, AA, Alt-A, BBB, and categories such as the traditional 30-year fixed, and non-traditional ARM, ARM with teaser rate, interest only, and negative-amortization.
The exact definition of subprime is not clear, with various sources estimating that the total subprime portfolio is between $1.5 trillion to $3 trillion. To precisely break down US$8.5 trillion by categories proves to be difficult. Nonetheless below is our estimate. We have valued the subprime market at $2 trillion. This is in line with an estimate by MSNBC reporter and research firm First American Loan Performance.
So just how much of the $2 trillion subprime position is lost? Various sources including First American Loan Performance estimated a default rate of 15%; this would translate to $300 billion of non-collectable principal and interest.
That in itself is not a big deal, as every year the United States spends well over $100 billion in Iraq and $400 billion on the military outside Iraq. The real concern is how such defaults are affecting the value of the existing outstanding subprime portfolio. In other words, would you eat beef knowing that one in 10 cows is a mad cow?
We follow the ABX index published by Markit.com, which is the basket of derivatives linked to subprime securities. As financial tools go, this index is far from perfect, since it is barely two years old, and tends to be thinly traded. But right now it has the unfortunate distinction of being the only tool easily available to measure sentiment in the opaque subprime securities world. And in the past couple of weeks, the message emerging from this measure has started to look utterly dire, as it shows subprime mortgages are changing hands at 25 cents on the dollar.
As we have shown in the pie chart above, this 80% haircut applies to potentially $2 trillion worth of mortgages if investors of those mortgages were to exit today. The loss is not $150 billion, but more like $1.6 trillion.
What's more, the ABX shows that since September 2007, the value of AAA mortgages has begun to crater, and now trades at a stunning 70 cents on the dollar. This means if all AAA and Alt-A mortgage portfolios were to be marked to market, the loss would amount to another $2 trillion.
Despite the fact that Bernanke and the Fed moved to a neutral balance of risks assessment last week, the market now sees a roughly 55% chance that the central bank will cut rates by another 50 basis points by the close of its January policy meeting, and an additional 15% chance that it will cut by 25 points by then.
And now you understand why Bernanke was so frantic in lowering interest rates and proposing the drastic policy measure of more than doubling the GSE limit to $1 million. In essence Bernanke is trying to increase the share of GSE in the pie and hopes the problem will go away.
The curious mind asks, who holds those trillions of dollars worth of mortgages? Thanks to the genius of the American banking and marketing machine, just about every sizable institution underneath the sun with a fixed income portfolio. From Europeans to Asians, from banks to brokerages, from hedge funds to pension funds, institution to retail, trusts to endowments.
Allow me to quote an FT.com article of November 1:
[T]he experience of living through the Enron scandals earlier this decade means that the audit industry is now terrified that it could face lawsuits if it is perceived to be too lax towards its clients. So some now appear to be demanding that their banking clients reprice their mortgage assets according to the only visible market tool - namely the ABX. It is thus little wonder that some banks have suddenly been forced to increase their writedowns in recent weeks. Indeed, I would wager that the pernicious combination of ABX and the “Enron factor” is a key reason for the recent shocks emanating from Merrill Lynch.
However, the rub is that while auditors at some Wall Street banks are becoming quasi-evangelical about the need to reprice subprime assets, there are still other, vast swathes of the financial system which have not been touched by the full blast of transparency yet. Moreover, many financiers outside the world of Wall Street banks remain very wary of rewriting their mortgage assets to current ABX price levels, due to a lingering hope that the recent ABX slump will remain temporary.
Most of those aforementioned outfits are in a state of shock and have been reluctant to mark their $1 trillion-plus subprime portfolio to market. Every other day there is new revelation of substantial subprime loss. First it was New Century in March, then American Mortgage and Countrywide in September, then it got worse as Wells Fargo, Bank of America, Credit Suisse First Boston, Citibank (albeit with a new CEO now) came out of the woodwork. Last Friday it was Wachovia (US's 4th largest), and on Tuesday it was Etrade. Not one major bank dealing with mortgages was immune. If there is such thing as systemic risk, we are sure looking at it, and therefore expect a lot more skeletons to come out of the closet in the months to come.
How about interest rates? Hiking interest rates on US debts is like giving a discount on mad-cow tainted beef: it’s not going to make a difference or help it sell.
At this juncture, the Fed has no choice but to redeem any and all mortgages at near face value directly, through GSEs or offshore vehicles. The more the Fed redeems, the more dollars they print. When you print $1 trillion (10%) a year, people can reasonably swallow the extra money supply, but when you print $1 trillion in a hurry and in a conspicuous way, you are directly challenging money managers’ intelligence and you will see a squeeze in gold. It’s that simple.
No sane foreign institution is going to finance American home owners, and why should they when they can finance the Brazilians, Canadians, Thais, Russians, Chinese, Indians, with an appreciating currency? The dollar's reserve status is now shattered. Mind you, it’s not that we are against the dollar in particular, we just don’t think any fiat currency deserves to be the world’s reserve currency.
To those who say gold is due for a prolonged correction at $800, you are missing the big picture. To us gold’s run has just started, with the emperor now naked for all to see.
John Lee is a portfolio manager at Mau Capital Management. He is a CFA charter holder and has degrees in economics and engineering from Rice University. He previously studied under James Turk, a renowned authority on the gold market, and is specialized in investing in junior gold and resource companies.
Saturday, November 10, 2007
What's Chinese for 'Ponzi'?
By Chan Akya
Quietly this week, China has crossed yet another milestone in its evolution as the new economic superpower for the 21st and 22nd centuries. Four of the top 10 companies by market capitalization globally are Chinese, compared to only three in the United States (the other three are European). This is a stunning achievement, and one that deserves kudos from around the world.
I don't really care that this victory came about due to the unraveling of the financial legerdemain of US banks such as Citigroup and Bank of America, both of which fell below the top 10 this week. This kind of price adjustment to unexpected write-offs may strike some as an over-reaction, but not people like me who have been arguing for a long time that US and European banks depend on Asia for bailouts anyway [1].
To be sure, I am fully confident that US banks will claw their way back, if for nothing else because they work in the unforgiving realm of market capitalism [2]. That is not to say though that they will necessarily exceed the market values of Chinese banks in the near term, because many financial chiefs now acknowledge that it will take more than three quarters for these banks to put their subprime problems behind them.
The other point that doesn't worry me is that Chinese companies (and Asian companies in general) trade at lofty price-earnings ratio multiples (PER in the equity investors' parlance) especially relative to the US and European companies. Well, what do you expect when one economy is growing at well over 10% while others are stuck in the 1 to 2% growth range? When adjusted for underlying growth, Chinese ratios do not look expensive. That's why I don't really care that billionaire investment guru Warren Buffett sold his stake in PetroChina recently; his record of being a successful stock market investor is anyway overstated by a large margin (but that's a topic for another article).
The factors that do worry me are not usually discussed in Asian newspapers or indeed the wider financial media, which is why readers here will do well to keep them in mind: these include unsustainable levels of money growth, the implied protection of equity values that has caused excessive investor confidence, poor standards of corporate governance, and lastly the legacy of state control that leaves much to be desired in terms of free capital transfers. In the following paragraphs, each of these four factors are examined in turn.
Too much money
The most important reason for the growth in Chinese stock markets is the unsustainable money growth unleashed by the government's decision to keep the yuan pegged to the US dollar [3]. By adopting gradual appreciation against the US dollar against a larger one-off movement, the government has effectively shot its own central bank, the People's Bank of China, in the foot by disallowing price stability.
The new Great Wall of Money in China has effectively corralled its stock and property markets into a web of rapid price rises, protecting the markets from externally-induced price adjustments, for example because of any changes in global economic growth expectations.
This is good as far as it goes, but when money growth goes into reverse at some point when China realizes its mistake and allows the yuan to float (as I have long argued it must), the Wall will disappear overnight, and leave the stock and property markets at the mercy of speculators who can easily topple the values of all the large companies in China today.
Implied protection
Declines in the stock market wouldn't be a problem but for the unique nature of China's markets. Ever since the fiasco with the trust and investment companies (ITIC) sector in the late 1990s [4], Chinese authorities have been very cautious about understanding exactly what public expectations are with respect to any investment.
Thus, they clarified the position of the big four "policy" commercial banks - Bank of China, Agricultural Bank of China, Industrial and Commercial Bank of China and China Construction Bank - relative to smaller banks around the country. Similarly, when property markets appeared to get out of hand in Shanghai, then president Jiang Zemin moved to dismiss the local mayor and ensure that the property market did not get too hot.
Unfortunately, and thanks to the government's obduracy on the yuan highlighted above, the stock market has gone to dizzying heights, propelled by every student, housewife and street corner geriatric imaginable. The stunning growth of brokerage accounts - over 100,000 per day earlier this year, has pushed money out of bank accounts into the stock market, where it chases "cannot fail" companies.
This logic is flawed because while no one expects the likes of Bank of China to fail, that doesn't mean the stock price will stay where it is now! Investors in China’s local markets simply do not appreciate the difference between the safety of a bank deposit and that of a share, and herein lies a big fault line for the government to cross.
This is why the central bank and concerned officials talk the market down from time to time. Their words go unheeded, and that in turn may force a sharper reaction at some point - because about the last thing the government wants now is for a million shareholders to come on to the streets and demand compensation for stock market losses.
Poor corporate governance
The third major problem with Chinese companies is the abysmal corporate governance standards in place. Granted, there is no real comparable "gold" standard in Asia today - think for example about accounting standards of Japanese companies - but there is still a lot of room for improvement.
Dodgy accounting is certainly something that has recently caught Americans with their pants down, but it is my hope - not my belief - that Chinese companies will do better. A casual analysis of some financial statements shows substantial levels of income from unexplained sources, like investments. While that is all right for investment companies, I am less clear why telecom and steel companies should have a large portion of their annual earnings being derived from gains on the stock market.
This is a dangerous game to play, as the Japanese companies found out in the 1990s. With a large number of cross shareholding and direct market bets helping to boost the Japanese firms' own earnings, the first decline in stock markets soon produced massive earnings write-offs from companies that had really no business being in stock market investments, like retail stores and tire manufacturers. That in turn perpetuated the stock market decline in Japan, leading to the country's permanent state of recession since then.
State control
The last troubling bit, and by no means the least, is the significant extent of state control on Chinese companies. This produces multiple distortions. Firstly, the number of shares actually traded is lower than what is available to trade. As market capitalization of US companies almost always covers free floating shares, their values are more believable than those of Chinese companies where more than 50% of large companies' stocks do not actually trade at all because they are owned by the government. In turn, this produces the phenomenon of too much money chasing too few stocks, known in the markets as the "Dot Con" phenomenon.
The second element of distortion brought by state control is the lack of professional management that could force companies to indulge in sub-optimal behavior. Thus, while a petroleum refiner may or may not choose to deal with Sudan based on commercial interests, the element of state control makes it more likely that the decision is politically tainted, and therefore eventually dangerous for shareholders.
The sector with the biggest risks on this score is obviously the commercial banks. With state-directed lending and government-influenced investments on the rise (for example by a Beijing investment company in the rescue effort of a US investment bank), it is clear that the seeds of further problems are being sown today. For example, there is a lot of talk that US Treasury Secretary Hank Paulson has requested direct assistance from Chinese banks for the problems of the structured investment vehicles sector. With even US banks shying from this proposal, it is very likely that Chinese banks will be left holding the baby of unexpected losses for years to come, should they comply with the request because of government pressure.
Conclusion
Reading all these four factors together, it is clear to me that China's victory parade must be put on ice for a while. The government should let the currency float and remove excessive money growth as well as sell off its own stakes in these companies in order to get the right market levels. Chinese investors must be better educated about the outcomes of investing in stock markets, and not expect any government bailout.
Without all these factors in play, investors could very well look back in two years time at what went on this year as the seeds of a Ponzi [5] scheme that eventually collapsed under its own weight. There is time yet, but too many things can go wrong for China's future for authorities to remain hands-off in the current situation. It is time to act now.
Notes
1. Asia and the vicious cycle of bank bailouts Asia Times Online, August 11, 2007.
2. Off with their heads Asia Times Online, November 6, 2007.
3. Deja Wu: Why China must revalue Asia Times Online, June 30, 2007.
4. Attempting to trim the power of Guangdong provincial officials, the authorties shut down the operations of Guangdong ITIC or GITIC, in turn causing a panic withdrawal of deposits from all other ITICs in the country. Only the Beijing-based China ITIC (CITIC) survived, leaving bondholders in other ITICs nursing their wounds for years to come.
5. A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns ("profits") to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It is named after Charles Ponzi. Wikipedia entry.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
Quietly this week, China has crossed yet another milestone in its evolution as the new economic superpower for the 21st and 22nd centuries. Four of the top 10 companies by market capitalization globally are Chinese, compared to only three in the United States (the other three are European). This is a stunning achievement, and one that deserves kudos from around the world.
I don't really care that this victory came about due to the unraveling of the financial legerdemain of US banks such as Citigroup and Bank of America, both of which fell below the top 10 this week. This kind of price adjustment to unexpected write-offs may strike some as an over-reaction, but not people like me who have been arguing for a long time that US and European banks depend on Asia for bailouts anyway [1].
To be sure, I am fully confident that US banks will claw their way back, if for nothing else because they work in the unforgiving realm of market capitalism [2]. That is not to say though that they will necessarily exceed the market values of Chinese banks in the near term, because many financial chiefs now acknowledge that it will take more than three quarters for these banks to put their subprime problems behind them.
The other point that doesn't worry me is that Chinese companies (and Asian companies in general) trade at lofty price-earnings ratio multiples (PER in the equity investors' parlance) especially relative to the US and European companies. Well, what do you expect when one economy is growing at well over 10% while others are stuck in the 1 to 2% growth range? When adjusted for underlying growth, Chinese ratios do not look expensive. That's why I don't really care that billionaire investment guru Warren Buffett sold his stake in PetroChina recently; his record of being a successful stock market investor is anyway overstated by a large margin (but that's a topic for another article).
The factors that do worry me are not usually discussed in Asian newspapers or indeed the wider financial media, which is why readers here will do well to keep them in mind: these include unsustainable levels of money growth, the implied protection of equity values that has caused excessive investor confidence, poor standards of corporate governance, and lastly the legacy of state control that leaves much to be desired in terms of free capital transfers. In the following paragraphs, each of these four factors are examined in turn.
Too much money
The most important reason for the growth in Chinese stock markets is the unsustainable money growth unleashed by the government's decision to keep the yuan pegged to the US dollar [3]. By adopting gradual appreciation against the US dollar against a larger one-off movement, the government has effectively shot its own central bank, the People's Bank of China, in the foot by disallowing price stability.
The new Great Wall of Money in China has effectively corralled its stock and property markets into a web of rapid price rises, protecting the markets from externally-induced price adjustments, for example because of any changes in global economic growth expectations.
This is good as far as it goes, but when money growth goes into reverse at some point when China realizes its mistake and allows the yuan to float (as I have long argued it must), the Wall will disappear overnight, and leave the stock and property markets at the mercy of speculators who can easily topple the values of all the large companies in China today.
Implied protection
Declines in the stock market wouldn't be a problem but for the unique nature of China's markets. Ever since the fiasco with the trust and investment companies (ITIC) sector in the late 1990s [4], Chinese authorities have been very cautious about understanding exactly what public expectations are with respect to any investment.
Thus, they clarified the position of the big four "policy" commercial banks - Bank of China, Agricultural Bank of China, Industrial and Commercial Bank of China and China Construction Bank - relative to smaller banks around the country. Similarly, when property markets appeared to get out of hand in Shanghai, then president Jiang Zemin moved to dismiss the local mayor and ensure that the property market did not get too hot.
Unfortunately, and thanks to the government's obduracy on the yuan highlighted above, the stock market has gone to dizzying heights, propelled by every student, housewife and street corner geriatric imaginable. The stunning growth of brokerage accounts - over 100,000 per day earlier this year, has pushed money out of bank accounts into the stock market, where it chases "cannot fail" companies.
This logic is flawed because while no one expects the likes of Bank of China to fail, that doesn't mean the stock price will stay where it is now! Investors in China’s local markets simply do not appreciate the difference between the safety of a bank deposit and that of a share, and herein lies a big fault line for the government to cross.
This is why the central bank and concerned officials talk the market down from time to time. Their words go unheeded, and that in turn may force a sharper reaction at some point - because about the last thing the government wants now is for a million shareholders to come on to the streets and demand compensation for stock market losses.
Poor corporate governance
The third major problem with Chinese companies is the abysmal corporate governance standards in place. Granted, there is no real comparable "gold" standard in Asia today - think for example about accounting standards of Japanese companies - but there is still a lot of room for improvement.
Dodgy accounting is certainly something that has recently caught Americans with their pants down, but it is my hope - not my belief - that Chinese companies will do better. A casual analysis of some financial statements shows substantial levels of income from unexplained sources, like investments. While that is all right for investment companies, I am less clear why telecom and steel companies should have a large portion of their annual earnings being derived from gains on the stock market.
This is a dangerous game to play, as the Japanese companies found out in the 1990s. With a large number of cross shareholding and direct market bets helping to boost the Japanese firms' own earnings, the first decline in stock markets soon produced massive earnings write-offs from companies that had really no business being in stock market investments, like retail stores and tire manufacturers. That in turn perpetuated the stock market decline in Japan, leading to the country's permanent state of recession since then.
State control
The last troubling bit, and by no means the least, is the significant extent of state control on Chinese companies. This produces multiple distortions. Firstly, the number of shares actually traded is lower than what is available to trade. As market capitalization of US companies almost always covers free floating shares, their values are more believable than those of Chinese companies where more than 50% of large companies' stocks do not actually trade at all because they are owned by the government. In turn, this produces the phenomenon of too much money chasing too few stocks, known in the markets as the "Dot Con" phenomenon.
The second element of distortion brought by state control is the lack of professional management that could force companies to indulge in sub-optimal behavior. Thus, while a petroleum refiner may or may not choose to deal with Sudan based on commercial interests, the element of state control makes it more likely that the decision is politically tainted, and therefore eventually dangerous for shareholders.
The sector with the biggest risks on this score is obviously the commercial banks. With state-directed lending and government-influenced investments on the rise (for example by a Beijing investment company in the rescue effort of a US investment bank), it is clear that the seeds of further problems are being sown today. For example, there is a lot of talk that US Treasury Secretary Hank Paulson has requested direct assistance from Chinese banks for the problems of the structured investment vehicles sector. With even US banks shying from this proposal, it is very likely that Chinese banks will be left holding the baby of unexpected losses for years to come, should they comply with the request because of government pressure.
Conclusion
Reading all these four factors together, it is clear to me that China's victory parade must be put on ice for a while. The government should let the currency float and remove excessive money growth as well as sell off its own stakes in these companies in order to get the right market levels. Chinese investors must be better educated about the outcomes of investing in stock markets, and not expect any government bailout.
Without all these factors in play, investors could very well look back in two years time at what went on this year as the seeds of a Ponzi [5] scheme that eventually collapsed under its own weight. There is time yet, but too many things can go wrong for China's future for authorities to remain hands-off in the current situation. It is time to act now.
Notes
1. Asia and the vicious cycle of bank bailouts Asia Times Online, August 11, 2007.
2. Off with their heads Asia Times Online, November 6, 2007.
3. Deja Wu: Why China must revalue Asia Times Online, June 30, 2007.
4. Attempting to trim the power of Guangdong provincial officials, the authorties shut down the operations of Guangdong ITIC or GITIC, in turn causing a panic withdrawal of deposits from all other ITICs in the country. Only the Beijing-based China ITIC (CITIC) survived, leaving bondholders in other ITICs nursing their wounds for years to come.
5. A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns ("profits") to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It is named after Charles Ponzi. Wikipedia entry.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
Wednesday, November 7, 2007
US stocks jump as investors buy bargains
NEW YORK (AP) - Wall Street bounded higher Tuesday as investors still mindful of widening credit problems nonetheless went in search of bargain stocks.
The Dow Jones industrial average rose 117 points, with soaring oil and precious metals prices driving up the companies that produce those commodities.
Investors remain haunted by the big debt problems at banks, notably Citigroup Inc. and Merrill Lynch & Co.
But companies outside of the banking, lending and housing industries have been posting strong financial results - on Tuesday, Tenet Healthcare Corp., Nortel Networks Corp. and Archer Daniels Midland Co. impressed Wall Street with their quarterly earnings.
And with no major bad news to follow up Citigroup's Sunday announcement that it was preparing to mark down another $8 (euro5.50) to $11 billion (euro7.56 billion) of subprime debt, even bank stocks, pummeled in recent months, looked like bargains.
Citigroup fell, but JPMorgan Chase & Co., Bank of America Corp., Wachovia Corp., Wells Fargo and Washington Mutual Inc. - which all hit 52-week lows Monday - each jumped Tuesday.
"There was an absence of bad news,'' said Jim Herrick, manager of equity trading at Baird & Co.
"But there's room for another shoe to drop. I don't think we're out of the woods yet. It's a classic relief rally.''
The Dow Jones industrial average rose 117.54 or 0.87 percent, to 13,660.94.
The size of the gain masked the nervousness in the market; stocks were earlier in the session.
Broader stock indicators also turned higher.
The Standard & Poor's 500 index rose 18.10, or 1.20 percent, to 1,520.27, and the Nasdaq composite index rose 30.00, or 1.07 percent, to 2,825.18.
Government bonds dipped as money flowed back into stocks.
The yield on the 10-year Treasury note, which moves opposite the price, rose to 4.37 percent from 4.34 percent late Monday.
The Dow is about 500 points, about 3.5 percent, below the all-time high close of 14,164.53 it reached Oct. 9.
Many companies, particularly in the technology and industrial sectors, have been consistently posting strong quarterly results, and appear undervalued.
But third-quarter weakness in the financial sector - the biggest in the S&P 500 - has dragged down overall U.S. earnings growth.
"We've had a pretty good run, as far as a return for the year for the broad market indices,'' said Janna Sampson, director of portfolio management at Oakbrook Investments, pointing out that the S&P 500 index is up more than 8 percent for the year.
"There may not be, given the level of earnings growth, a lot more for this quarter.''
The dollar reached yet another record low against the euro. The 13-nation currency rose to a high of $1.4569 before pulling back slightly.
Crude oil on the New York Mercantile Exchange briefly passed $97 a barrel for the first time, before settling up $2.72 at a record $96.70.
Gold on the Nymex rose to another 27-year high, settling up $12.60 $823.40 an ounce.
One of the most active stocks on the NYSE Tuesday was silver and gold miner Coeur d'Alene Mines Corp., which shot higher on higher metals prices and a Bear Stearns analyst's comment that the stock is underpriced. Shares climbed 52 cents, or 13.5 percent, to $4.36.
Exxon Mobil Corp., one of the 30 Dow components, was another big gainer, rising $2.72, or 3.1 percent, to $90.38.
Anthony Conroy, managing director at BNY ConvergEx Group, said it's a stock-picker's market. "If you do your due diligence, you can make money in the markets.''
In earnings news, hospital operator Tenet Healthcare reported its third-quarter loss narrowed on higher charges and more admissions in commercial managed care.
Tenet rose 72 cents, or 22.3 percent, to $3.95.
Nortel Networks said it swung to a profit in the third quarter despite lower revenue.
The Canadian telecom equipment supplier reported its best operating margin since 2004. Nortel rose $2.90, or 17.8 percent, to $19.18.
Agricultural processor Archer Daniels Midland Co. said its fiscal first-quarter profit rose 9 percent as improved results at its oilseeds processing business offset higher corn prices.
ADM rose $2.37, or 6.9 percent, to $36.89. Advancing issues outnumbered decliners by about 7 to 4 on the New York Stock Exchange, where volume came to $1.50 billion shares.
The Russell 2000 index of smaller companies rose 11.34, or 1.43 percent, to 801.77.
Federal Reserve Chairman Ben Bernanke spoke in San Antonio, Texas, Tuesday afternoon, but his prepared remarks did not address monetary policy or the direction of interest rates.
Investors are awaiting his scheduled testimony Thursday before the U.S. Congress' Joint Economic Committee.
The Dow Jones industrial average rose 117 points, with soaring oil and precious metals prices driving up the companies that produce those commodities.
Investors remain haunted by the big debt problems at banks, notably Citigroup Inc. and Merrill Lynch & Co.
But companies outside of the banking, lending and housing industries have been posting strong financial results - on Tuesday, Tenet Healthcare Corp., Nortel Networks Corp. and Archer Daniels Midland Co. impressed Wall Street with their quarterly earnings.
And with no major bad news to follow up Citigroup's Sunday announcement that it was preparing to mark down another $8 (euro5.50) to $11 billion (euro7.56 billion) of subprime debt, even bank stocks, pummeled in recent months, looked like bargains.
Citigroup fell, but JPMorgan Chase & Co., Bank of America Corp., Wachovia Corp., Wells Fargo and Washington Mutual Inc. - which all hit 52-week lows Monday - each jumped Tuesday.
"There was an absence of bad news,'' said Jim Herrick, manager of equity trading at Baird & Co.
"But there's room for another shoe to drop. I don't think we're out of the woods yet. It's a classic relief rally.''
The Dow Jones industrial average rose 117.54 or 0.87 percent, to 13,660.94.
The size of the gain masked the nervousness in the market; stocks were earlier in the session.
Broader stock indicators also turned higher.
The Standard & Poor's 500 index rose 18.10, or 1.20 percent, to 1,520.27, and the Nasdaq composite index rose 30.00, or 1.07 percent, to 2,825.18.
Government bonds dipped as money flowed back into stocks.
The yield on the 10-year Treasury note, which moves opposite the price, rose to 4.37 percent from 4.34 percent late Monday.
The Dow is about 500 points, about 3.5 percent, below the all-time high close of 14,164.53 it reached Oct. 9.
Many companies, particularly in the technology and industrial sectors, have been consistently posting strong quarterly results, and appear undervalued.
But third-quarter weakness in the financial sector - the biggest in the S&P 500 - has dragged down overall U.S. earnings growth.
"We've had a pretty good run, as far as a return for the year for the broad market indices,'' said Janna Sampson, director of portfolio management at Oakbrook Investments, pointing out that the S&P 500 index is up more than 8 percent for the year.
"There may not be, given the level of earnings growth, a lot more for this quarter.''
The dollar reached yet another record low against the euro. The 13-nation currency rose to a high of $1.4569 before pulling back slightly.
Crude oil on the New York Mercantile Exchange briefly passed $97 a barrel for the first time, before settling up $2.72 at a record $96.70.
Gold on the Nymex rose to another 27-year high, settling up $12.60 $823.40 an ounce.
One of the most active stocks on the NYSE Tuesday was silver and gold miner Coeur d'Alene Mines Corp., which shot higher on higher metals prices and a Bear Stearns analyst's comment that the stock is underpriced. Shares climbed 52 cents, or 13.5 percent, to $4.36.
Exxon Mobil Corp., one of the 30 Dow components, was another big gainer, rising $2.72, or 3.1 percent, to $90.38.
Anthony Conroy, managing director at BNY ConvergEx Group, said it's a stock-picker's market. "If you do your due diligence, you can make money in the markets.''
In earnings news, hospital operator Tenet Healthcare reported its third-quarter loss narrowed on higher charges and more admissions in commercial managed care.
Tenet rose 72 cents, or 22.3 percent, to $3.95.
Nortel Networks said it swung to a profit in the third quarter despite lower revenue.
The Canadian telecom equipment supplier reported its best operating margin since 2004. Nortel rose $2.90, or 17.8 percent, to $19.18.
Agricultural processor Archer Daniels Midland Co. said its fiscal first-quarter profit rose 9 percent as improved results at its oilseeds processing business offset higher corn prices.
ADM rose $2.37, or 6.9 percent, to $36.89. Advancing issues outnumbered decliners by about 7 to 4 on the New York Stock Exchange, where volume came to $1.50 billion shares.
The Russell 2000 index of smaller companies rose 11.34, or 1.43 percent, to 801.77.
Federal Reserve Chairman Ben Bernanke spoke in San Antonio, Texas, Tuesday afternoon, but his prepared remarks did not address monetary policy or the direction of interest rates.
Investors are awaiting his scheduled testimony Thursday before the U.S. Congress' Joint Economic Committee.
Tuesday, November 6, 2007
US stocks pull back as Citigroup write-downs stir concerns
NEW YORK (AP) - Wall Street pulled back in erratic trading Monday as investors grew more concerned about a deteriorating housing market and the widening impact of soured debt after Citigroup Inc. warned it plans to book $8 billion (euro5.52 billion) to $11 billion (euro7.59 billion) in additional losses.
Citi's expected losses came on top of the $6.5 billion (euro4.49 billion) in asset markdowns and other credit-related losses the company recorded in the third quarter.
The re-emergence of credit concerns - like those that pummeled Wall Street this summer - comes as the market is also contending with concerns about housing and the health of consumer spending, and with rising expectations that the Federal Reserve is leaning away from cutting interest rates when it meets next month.
Meanwhile, a central banker's warning Monday that the subprime mortgage market will likely deteriorate further added to the pressure on stock prices. Fed Gov. Randall Kroszner told the Consumer Bankers Association Fair Lending Conference in Washington that "conditions for subprime borrowers have the potential to get worse before they get better.''
The problems may be spreading.
A Federal Reserve survey of banks showed that lenders are making it harder to get a home loan, even for borrowers with good credit.
About 40 percent of respondents said they had tightened lending standards on prime mortgages during October, up from just 15 percent in July.
"We're at the point now where more and more evidence is starting to emerge that the next 12 months are going to be more difficult,'' said Joe Battipaglia, market strategist with Stifel Nicolaus & Co.'s private client group.
"Problems in housing market are getting deeper and more treacherous,'' as home inventories rise and sale prices fall.
The Dow Jones industrial average fell 51.70, or 0.38 percent, at 13,543.40.
The Dow was down nearly 150 points early in the session and briefly popped into the plus side in the late afternoon.
The late-session buying was likely the result of short covering, when traders buy stock to cover bets they made earlier that the market would decline.
In short covering, traders are not looking to economics or other market fundamentals when they decide to buy.
"I think we're seeing a market that is probably absorbing all the negative news out of subprime and staying in a trading range now,'' said Peter Cardillo, chief market economist at brokerage house Avalon Partners Inc.
"When we get down to certain technical levels, buying comes in and we're seeing that today.''
Broader stock indicators also fell.
The Standard & Poor's 500 index fell 7.48, or 0.50 percent, to 1,502.17, and the Nasdaq composite index fell 15.20, or 0.54 percent, to 2,795.18.
The Russell 2000 index of smaller companies fell 7.34, or 0.92 percent, to 790.45.
Bonds prices fell, with the yield on the benchmark 10-year Treasury note rising to 4.34 percent, up from 4.32 percent late Friday.
A snapshot of the service sector appeared to briefly soften some investor concerns that the troubles in the financial sector would prove onerous enough to spill into other areas of the economy.
The Institute for Supply Management said the service sector grew at a faster-than-expected pace in October amid strength in new orders.
The ISM's index gauging the health of non-manufacturing industries rose to 55.8 from 54.8 in September.
A reading above 50 signifies economic expansion.
The unease over Citi's debt follows the widely expected decision by Charles Prince to resign as the company's chairman and chief executive at an emergency meeting of its board Sunday.
Citi fell $1.83, or 4.9 percent, to $35.90 and was the steepest decliner among the 30 stocks that make up the Dow industrials.
Prince's resignation came less than a week after Stan O'Neal stepped down as CEO at Merrill Lynch & Co.
Both Citi and Merrill have struggled with securities they hold that are tied to subprime loans, those made to borrowers with poor credit.
A faltering housing market has made it difficult for those struggling with mortgage payments to refinance and pay off debts.
Now, foreclosure rates are spiking and many banks are left holding loans worth far less than they had once been.
As it had Friday, Merrill Lynch fell amid concerns it would have to make an announcement of further write-downs.
Last month, Merrill Lynch said it would write off $8.4 billion (euro5.8 billion) in losses.
Merrill fell $1.40, or 2.4 percent, to $55.88 after falling nearly 8 percent Friday.
"Financials are struggling with this really unknowable and unending plague of asset quality,'' said John Merrill, chief investment officer at Tanglewood Capital Management in Houston.
He expects that while the big financial houses will likely continue to book write-downs as homeowners default on their mortgages the stock prices of the financials aren't likely to fall precipitously from where they stand.
Citigroup is down about 36 percent since the start of the year while Merrill Lynch is down about 40 percent.
Beyond concerns about debt, political uncertainty over a weekend decision by Pakistan President Gen. Pervez Musharraf to suspend the constitution helped shore up some support for the U.S. dollar as investors sought safety.
The dollar rose against most other major currencies, while gold prices rose.
Declining issues outnumbered advancers by about 3 to 1 on the New York Stock Exchange, where volume came to 1.53 billion shares, compared with volume of 1.72 billion shares at the close of trading on Friday.
Citi's expected losses came on top of the $6.5 billion (euro4.49 billion) in asset markdowns and other credit-related losses the company recorded in the third quarter.
The re-emergence of credit concerns - like those that pummeled Wall Street this summer - comes as the market is also contending with concerns about housing and the health of consumer spending, and with rising expectations that the Federal Reserve is leaning away from cutting interest rates when it meets next month.
Meanwhile, a central banker's warning Monday that the subprime mortgage market will likely deteriorate further added to the pressure on stock prices. Fed Gov. Randall Kroszner told the Consumer Bankers Association Fair Lending Conference in Washington that "conditions for subprime borrowers have the potential to get worse before they get better.''
The problems may be spreading.
A Federal Reserve survey of banks showed that lenders are making it harder to get a home loan, even for borrowers with good credit.
About 40 percent of respondents said they had tightened lending standards on prime mortgages during October, up from just 15 percent in July.
"We're at the point now where more and more evidence is starting to emerge that the next 12 months are going to be more difficult,'' said Joe Battipaglia, market strategist with Stifel Nicolaus & Co.'s private client group.
"Problems in housing market are getting deeper and more treacherous,'' as home inventories rise and sale prices fall.
The Dow Jones industrial average fell 51.70, or 0.38 percent, at 13,543.40.
The Dow was down nearly 150 points early in the session and briefly popped into the plus side in the late afternoon.
The late-session buying was likely the result of short covering, when traders buy stock to cover bets they made earlier that the market would decline.
In short covering, traders are not looking to economics or other market fundamentals when they decide to buy.
"I think we're seeing a market that is probably absorbing all the negative news out of subprime and staying in a trading range now,'' said Peter Cardillo, chief market economist at brokerage house Avalon Partners Inc.
"When we get down to certain technical levels, buying comes in and we're seeing that today.''
Broader stock indicators also fell.
The Standard & Poor's 500 index fell 7.48, or 0.50 percent, to 1,502.17, and the Nasdaq composite index fell 15.20, or 0.54 percent, to 2,795.18.
The Russell 2000 index of smaller companies fell 7.34, or 0.92 percent, to 790.45.
Bonds prices fell, with the yield on the benchmark 10-year Treasury note rising to 4.34 percent, up from 4.32 percent late Friday.
A snapshot of the service sector appeared to briefly soften some investor concerns that the troubles in the financial sector would prove onerous enough to spill into other areas of the economy.
The Institute for Supply Management said the service sector grew at a faster-than-expected pace in October amid strength in new orders.
The ISM's index gauging the health of non-manufacturing industries rose to 55.8 from 54.8 in September.
A reading above 50 signifies economic expansion.
The unease over Citi's debt follows the widely expected decision by Charles Prince to resign as the company's chairman and chief executive at an emergency meeting of its board Sunday.
Citi fell $1.83, or 4.9 percent, to $35.90 and was the steepest decliner among the 30 stocks that make up the Dow industrials.
Prince's resignation came less than a week after Stan O'Neal stepped down as CEO at Merrill Lynch & Co.
Both Citi and Merrill have struggled with securities they hold that are tied to subprime loans, those made to borrowers with poor credit.
A faltering housing market has made it difficult for those struggling with mortgage payments to refinance and pay off debts.
Now, foreclosure rates are spiking and many banks are left holding loans worth far less than they had once been.
As it had Friday, Merrill Lynch fell amid concerns it would have to make an announcement of further write-downs.
Last month, Merrill Lynch said it would write off $8.4 billion (euro5.8 billion) in losses.
Merrill fell $1.40, or 2.4 percent, to $55.88 after falling nearly 8 percent Friday.
"Financials are struggling with this really unknowable and unending plague of asset quality,'' said John Merrill, chief investment officer at Tanglewood Capital Management in Houston.
He expects that while the big financial houses will likely continue to book write-downs as homeowners default on their mortgages the stock prices of the financials aren't likely to fall precipitously from where they stand.
Citigroup is down about 36 percent since the start of the year while Merrill Lynch is down about 40 percent.
Beyond concerns about debt, political uncertainty over a weekend decision by Pakistan President Gen. Pervez Musharraf to suspend the constitution helped shore up some support for the U.S. dollar as investors sought safety.
The dollar rose against most other major currencies, while gold prices rose.
Declining issues outnumbered advancers by about 3 to 1 on the New York Stock Exchange, where volume came to 1.53 billion shares, compared with volume of 1.72 billion shares at the close of trading on Friday.
Off with their heads
By Chan Akya
If any of you are fortunate enough to be friends with the chief executive officer (CEO) of a Wall Street bank, now may be a good time to get yourselves invited for a cup of coffee, enjoy the views from the top floor office, play a round of golf at the exclusive country club he (I am not being sexist here, they are all men) belongs to, take a trip on the corporate jet and whatever else may grab your fancy. The reason for the time-bound offer is that your friend will most likely be out of his job by Christmas this year.
Following close on the heels of the CEO of Merrill Lynch, Stan O'Neal, who was deposed last week, comes news that the head of Citigroup, Chuck Prince, will also leave his position this week. In both cases, the evisceration of executive ranks engendered by the incumbents has caused the appointment of interim heads - simply put, the boards of both banks don't have a clue who to appoint as a replacement.
Inevitably, these dismissals (and please don't insult anyone's intelligence by calling them retirements or any such euphemism) would be highlighted as the failures of Anglo-Saxon capitalism, where overly grabby CEOs somehow get their just desserts in the middle of a night of long knives. In particular, I would expect some commentaries in Europe and Asia to focus on the relative superiority of their own systems against that of the Americans.
This is wrong. Much as the process of management changes in American banks can be considered rather too newsworthy, the fact of the matter is that it happens all the time. Any system is bound to the values of corporations, and its shareholders: therefore, the search for profits is bound to falter from time to time. With the US banks, sudden changes of CEOs are meant to signal new directions for the companies, often to less volatile or more profitable businesses.
Citigroup is an excellent example. It is a motley collection of businesses ranging from traditional retail banking in the US to significant emerging market businesses as well as a large investment bank. Using the value assigned to peers in different businesses - for example HSBC, Standard Chartered and others, analysts have predicted that the implied value of Citigroup's investment bank is actually negative. In other words, selling or closing or trimming the investment bank will actually increase the share price of Citigroup.
What about diversification? Banks get into a number of businesses because they like to diversify the decline in one area with potential increases in other businesses. That is certainly a good reason to keep an investment bank within a commercial bank, but only so long as the management quality, risk controls and basic trading philosophy gels with the rest of the bank.
It is obvious that the quality of management at Citigroup, Merrill Lynch and other banks fell victim to the rapid expansion of the business, producing too many gaps between acceptable practice and business realities. The CEOs of these banks are ultimately responsible for risk management and ensuring that enough resources are devoted to control functions.
Unnatural losses mean, obviously, that the CEOs have to lose their jobs - the next chap in hopefully learns this lesson, and fixes the element of surprise. That means, in practice that they would insist on comprehensive write-offs that can be blamed on their predecessors, from which they can show progress in coming quarters. These write-offs, while scary, serve the function of keeping markets alive.
Putting things in perspective
The useful comparison, and contrast, here would be the Japanese banks whose failures in the 1990s were essentially hidden. Let us not forget here that what has ailed the share price of American banks is the fear of more write-offs on asset values, that could help wipe billions from shareholder value.
Last week, market reports of billions in further losses to be taken by a motley crew of American and European banks helped to drive share prices sharply lower on Thursday and Friday. When these assets are written down though, we will be left with financial values that are closer approximations of reality. This would in turn start the process of asset trading in earnest.
Take an example of a new community that consists of a large number of houses in some part of California. A company owns the project, and its revenues consist of rents from all tenants. Furthermore, because the company in question wants to develop other properties, it entered into a securitization agreement with a bank, which sold this package of bonds to investors across the world including the friendly Asian central bank that manages your currency. As a goodwill gesture, the investment bank holds some of these bonds on its own books.
Now, with house prices in free fall and vacancies rising sharply, there is a real chance that rents in this development will decline as well, in turn making the cash value of the bonds written on the project more volatile. In this case, the three sides to the transaction - the company on whose name the bond is issued, the investment bank, which arranged the transaction, and the investor who bought some of the bonds - have multiple options, none of which are too nice.
Option number 1: Anglo-Saxon
The investment bank in this case can go out on a limb (especially with its brand new CEO) and say that the value of its bonds, which were bought at 100, are now only 50. This means that the investors have to take similar hits on their portfolios, if their accountants are awake. If their accountants are asleep, of course the investor can pretend that the assets are still worth 100.
By marking the books at 50, the investment bank throws open the floor for trading. Now, the benchmark price is 50 - so the company owning the project can for example make some useful comparisons based on actual rent receipt and determines that the bonds are worth more than 50. It can therefore buy back the bonds from the investment bank or the investor. In case this loss is too much for the company, it would declare bankruptcy, and sell its assets, ie, the houses, cheaper to anyone interested, with the proceeds going to pay for the debt previously issued.
Meanwhile, the investor who has taken a 50% loss can decide that this is not a game they want to play, because none of the managers have been to California and what with all the wildfires, wouldn't want to go there either - so they choose to sell their bonds at 50 and put the losses behind them.
With the price at 50, other investors who would not normally care for these assets would get into the picture, with a view to riding the wave to say, 70. Also, with the value of the asset at 50, they can also get loans from banks to fund the purchases. All that trading causes money to flow once again, and market equilibrium is restored. In time, new houses will be built in California, and new bonds be issued once again.
Option number 2: Japanese
Faced with a similar decline in property prices in the 1990s, Japanese banks chose the second option, namely do nothing. Thus, the banks continued to value the assets at 100, and this meant that there were no losses taken initially. Unfortunately though, this also created a logjam between the investors and companies owning the property, as the latter did not want to repurchase their obligations at 100, and investors had no reason to sell at below 100.
With income falling rapidly for these companies, the banks were forced to make new loans to get their interest payments on time (what was known as evergreening) to the companies, in turn making money unavailable for more deserving borrowers. At the economic level, this completely removed the effectiveness of the banking system, creating the specter of "zombies" - companies that were really dead, but were still walking around.
Investors in such companies knew well enough that they had suffered loan losses, but would wait till the last moment before recognizing these losses. That meant they wouldn't have the ability or the willingness to buy any more assets, in effect shutting themselves from new investments.
This is why the Japanese banking system ground to a halt in the middle of the '90s. Even today, these banks boast asset values that pale in significance to their market capitalization, because no investor believes that the assets are actually worth that much to any outsider. This "discount" also forces Japanese banks to avoid any global acquisitions, perpetuating their domestic focus.
Between the two options, the first is clearly preferable, as it keeps the market economy well lubricated and functional. This is the context in which to look at the exit of various CEOs - that the market has more opportunities in the weeks ahead, rather than a protracted period of non-activity. American shareholders have chosen well.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
If any of you are fortunate enough to be friends with the chief executive officer (CEO) of a Wall Street bank, now may be a good time to get yourselves invited for a cup of coffee, enjoy the views from the top floor office, play a round of golf at the exclusive country club he (I am not being sexist here, they are all men) belongs to, take a trip on the corporate jet and whatever else may grab your fancy. The reason for the time-bound offer is that your friend will most likely be out of his job by Christmas this year.
Following close on the heels of the CEO of Merrill Lynch, Stan O'Neal, who was deposed last week, comes news that the head of Citigroup, Chuck Prince, will also leave his position this week. In both cases, the evisceration of executive ranks engendered by the incumbents has caused the appointment of interim heads - simply put, the boards of both banks don't have a clue who to appoint as a replacement.
Inevitably, these dismissals (and please don't insult anyone's intelligence by calling them retirements or any such euphemism) would be highlighted as the failures of Anglo-Saxon capitalism, where overly grabby CEOs somehow get their just desserts in the middle of a night of long knives. In particular, I would expect some commentaries in Europe and Asia to focus on the relative superiority of their own systems against that of the Americans.
This is wrong. Much as the process of management changes in American banks can be considered rather too newsworthy, the fact of the matter is that it happens all the time. Any system is bound to the values of corporations, and its shareholders: therefore, the search for profits is bound to falter from time to time. With the US banks, sudden changes of CEOs are meant to signal new directions for the companies, often to less volatile or more profitable businesses.
Citigroup is an excellent example. It is a motley collection of businesses ranging from traditional retail banking in the US to significant emerging market businesses as well as a large investment bank. Using the value assigned to peers in different businesses - for example HSBC, Standard Chartered and others, analysts have predicted that the implied value of Citigroup's investment bank is actually negative. In other words, selling or closing or trimming the investment bank will actually increase the share price of Citigroup.
What about diversification? Banks get into a number of businesses because they like to diversify the decline in one area with potential increases in other businesses. That is certainly a good reason to keep an investment bank within a commercial bank, but only so long as the management quality, risk controls and basic trading philosophy gels with the rest of the bank.
It is obvious that the quality of management at Citigroup, Merrill Lynch and other banks fell victim to the rapid expansion of the business, producing too many gaps between acceptable practice and business realities. The CEOs of these banks are ultimately responsible for risk management and ensuring that enough resources are devoted to control functions.
Unnatural losses mean, obviously, that the CEOs have to lose their jobs - the next chap in hopefully learns this lesson, and fixes the element of surprise. That means, in practice that they would insist on comprehensive write-offs that can be blamed on their predecessors, from which they can show progress in coming quarters. These write-offs, while scary, serve the function of keeping markets alive.
Putting things in perspective
The useful comparison, and contrast, here would be the Japanese banks whose failures in the 1990s were essentially hidden. Let us not forget here that what has ailed the share price of American banks is the fear of more write-offs on asset values, that could help wipe billions from shareholder value.
Last week, market reports of billions in further losses to be taken by a motley crew of American and European banks helped to drive share prices sharply lower on Thursday and Friday. When these assets are written down though, we will be left with financial values that are closer approximations of reality. This would in turn start the process of asset trading in earnest.
Take an example of a new community that consists of a large number of houses in some part of California. A company owns the project, and its revenues consist of rents from all tenants. Furthermore, because the company in question wants to develop other properties, it entered into a securitization agreement with a bank, which sold this package of bonds to investors across the world including the friendly Asian central bank that manages your currency. As a goodwill gesture, the investment bank holds some of these bonds on its own books.
Now, with house prices in free fall and vacancies rising sharply, there is a real chance that rents in this development will decline as well, in turn making the cash value of the bonds written on the project more volatile. In this case, the three sides to the transaction - the company on whose name the bond is issued, the investment bank, which arranged the transaction, and the investor who bought some of the bonds - have multiple options, none of which are too nice.
Option number 1: Anglo-Saxon
The investment bank in this case can go out on a limb (especially with its brand new CEO) and say that the value of its bonds, which were bought at 100, are now only 50. This means that the investors have to take similar hits on their portfolios, if their accountants are awake. If their accountants are asleep, of course the investor can pretend that the assets are still worth 100.
By marking the books at 50, the investment bank throws open the floor for trading. Now, the benchmark price is 50 - so the company owning the project can for example make some useful comparisons based on actual rent receipt and determines that the bonds are worth more than 50. It can therefore buy back the bonds from the investment bank or the investor. In case this loss is too much for the company, it would declare bankruptcy, and sell its assets, ie, the houses, cheaper to anyone interested, with the proceeds going to pay for the debt previously issued.
Meanwhile, the investor who has taken a 50% loss can decide that this is not a game they want to play, because none of the managers have been to California and what with all the wildfires, wouldn't want to go there either - so they choose to sell their bonds at 50 and put the losses behind them.
With the price at 50, other investors who would not normally care for these assets would get into the picture, with a view to riding the wave to say, 70. Also, with the value of the asset at 50, they can also get loans from banks to fund the purchases. All that trading causes money to flow once again, and market equilibrium is restored. In time, new houses will be built in California, and new bonds be issued once again.
Option number 2: Japanese
Faced with a similar decline in property prices in the 1990s, Japanese banks chose the second option, namely do nothing. Thus, the banks continued to value the assets at 100, and this meant that there were no losses taken initially. Unfortunately though, this also created a logjam between the investors and companies owning the property, as the latter did not want to repurchase their obligations at 100, and investors had no reason to sell at below 100.
With income falling rapidly for these companies, the banks were forced to make new loans to get their interest payments on time (what was known as evergreening) to the companies, in turn making money unavailable for more deserving borrowers. At the economic level, this completely removed the effectiveness of the banking system, creating the specter of "zombies" - companies that were really dead, but were still walking around.
Investors in such companies knew well enough that they had suffered loan losses, but would wait till the last moment before recognizing these losses. That meant they wouldn't have the ability or the willingness to buy any more assets, in effect shutting themselves from new investments.
This is why the Japanese banking system ground to a halt in the middle of the '90s. Even today, these banks boast asset values that pale in significance to their market capitalization, because no investor believes that the assets are actually worth that much to any outsider. This "discount" also forces Japanese banks to avoid any global acquisitions, perpetuating their domestic focus.
Between the two options, the first is clearly preferable, as it keeps the market economy well lubricated and functional. This is the context in which to look at the exit of various CEOs - that the market has more opportunities in the weeks ahead, rather than a protracted period of non-activity. American shareholders have chosen well.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
Friday, November 2, 2007
Delhi forgets Bhopal and fights for Dow
By Sudha Ramachandran
BANGALORE - India is preparing to roll out the red carpet for Dow Chemicals to invest in India. The government is said to be considering removing all "legal hurdles" in the way of the US giant.
The cabinet is believed to have drafted a note calling to absolve Dow Chemicals of all legal liabilities relating to the Bhopal gas tragedy in which the main accused - Union Carbide - which Dow Chemicals acquired in 2001, was charged with culpable homicide.
On December 3, 1984, Union Carbide's plant in Bhopal in central India spewed over 40 tons of lethal methyl isocyanate gas. Its cost-cutting measures had effectively disabled safety procedures essential to prevent or alert employees of such disasters.
Some 4,000 people died in the immediate aftermath of gas leak. Over 15,000 have died in the years since of related diseases, while hundreds of thousands of survivors suffer from debilitating diseases caused by inhaling the toxic fumes or drinking water contaminated by the chemicals.
Following the disaster, Union Carbide and its officials, including chief executive officer Warren Anderson, were charged by a Bhopal district court with culpable homicide, grievous assault and other serious offenses. Union Carbide and its officials never showed up in court to face trial and repeatedly ignored the court's summons. They are fugitives from the law.
Under an out-of-court settlement reached in 1989, Union Carbide agreed to pay US$470 million in damages to people exposed to the deadly gas - about $400 per person. Union Carbide officials are reported to have said that "the amount was plenty good for an Indian".
This paltry pay-off got it off the hook in the civil suit brought by the Indian government. But its criminal liabilities survive. And Union Carbide never cleaned up the environment in Bhopal. It denied legal obligation to conduct or finance the clean up, arguing that with the 1989 settlement its obligations had ended.
According to the "polluter pays principle" which is valid both in the United States and India, Union Carbide/Dow must pay for the clean up in Bhopal. But Dow argues otherwise.
Since 2001 when it acquired Union Carbide as a 100% subsidiary, Dow Chemicals has insisted on distancing itself from Union Carbide's liabilities. It faces a lawsuit in Madhya Pradesh, the state of which Bhopal is the capital. India's Ministry of Chemicals and Fertilizers has demanded a token deposit of $250 million as initial payment for the costs of cleaning up.
Dow Chemicals has argued that Union Carbide had sold its shares in Union Carbide India in 1994, seven years before Dow Chemicals acquired it and that Dow cannot be held accountable for Union Carbide's liabilities.
Sections in the Indian government concur with this view.
Dow Chemicals has said that it will not invest in India unless the lawsuit against it is withdrawn and it is cleared of all its legal liabilities in India. It has been lobbying hard, directly and through the US government to have the "legal hurdles" on its way to investment in India removed.
The Indian government is reported to be working to help that happen.
Dow has said that it wants to invest US$100 million to set up a research and development center near Pune, in the Western state of Maharashtra. Dow has promised to make other major investments in India.
Backing the effort to absolve Dow Chemicals of all legal liabilities in connection with the Bhopal gas disaster is a formidable phalanx of ministers, officials and business leaders from India and the United States. India's Finance, Commerce and Law ministries are said to be in favor of absolving Dow of legal liabilities but the Chemical and Fertilizer Ministry is opposing the move.
An April Cabinet Secretary note was categorical about what the government's course of action should be and why. "Given the scope for future investments in the sector, it stands to reason that instead of continuing to agitate these issues [Dow's legal liability] in court for a protracted period, due consideration be given to the prospect of settling these issues appropriately. An important aim is to remove uncertainties and pave the way for promoting investments in the sector."
It now appears the government is considering withdrawing the affidavit against Dow Chemicals and opting for an out-of-court settlement. Indian industrialist and chairman of the Tata Group, Ratan Tata, has said he will head a corpus with the help of other Indian companies and Dow to clean up the Bhopal plant site. Dow has reportedly indicated its willingness to contribute to this corpus, but is insisting that this should not be seen as arising from an obligation.
The Indian government's effort to let Dow Chemicals off the hook stems from its interest in the large investment that the multinational company has promised to make in India. But more importantly fear that stern action against the multinational will scare away investors has stood in the way of India demanding justice on behalf of its citizens.
India signaled its soft approach towards Union Carbide within days of the Bhopal gas tragedy. In his first reaction to the disaster, India's then ambassador in Washington announced that the tragedy would not affect India-US relations or India's foreign investment policies. It allowed Anderson and other officials to slip out of the country and its efforts to have them extradited have been lukewarm. Its out-of-court settlement with Union Carbide, which was done without consulting the victims, was nothing short of a sell-out.
And now comes the move to absolve Dow Chemicals of its legal obligations.
However, alumni of the Indian Institutes of Technology (IIT), the country's premier engineering colleges, have decided to do their bit to get Dow Chemicals and others to clean up their act.
In May 2005, IIT alumni intervened and forced the organizers of the Global IIT 2005 Conference at Washington DC to cancel the key-note address by William Stavropoulos, then chief executive officer of Dow Chemical.
And now they are putting pressure on the IIT management to prevent campus interviews being conducted by the company. Recently, Dow Chemicals was forced to cancel its pre-placement talks in IIT Madras and IIT Bombay when students objected to any partnership between the IITs and this company.
The Indian government might be eager to put out the welcome mat for Dow's investment. But if the company wants to hire India's finest technical brains, it will need to clean up its act.
Sudha Ramachandran is an independent journalist/researcher based in Bangalore.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
BANGALORE - India is preparing to roll out the red carpet for Dow Chemicals to invest in India. The government is said to be considering removing all "legal hurdles" in the way of the US giant.
The cabinet is believed to have drafted a note calling to absolve Dow Chemicals of all legal liabilities relating to the Bhopal gas tragedy in which the main accused - Union Carbide - which Dow Chemicals acquired in 2001, was charged with culpable homicide.
On December 3, 1984, Union Carbide's plant in Bhopal in central India spewed over 40 tons of lethal methyl isocyanate gas. Its cost-cutting measures had effectively disabled safety procedures essential to prevent or alert employees of such disasters.
Some 4,000 people died in the immediate aftermath of gas leak. Over 15,000 have died in the years since of related diseases, while hundreds of thousands of survivors suffer from debilitating diseases caused by inhaling the toxic fumes or drinking water contaminated by the chemicals.
Following the disaster, Union Carbide and its officials, including chief executive officer Warren Anderson, were charged by a Bhopal district court with culpable homicide, grievous assault and other serious offenses. Union Carbide and its officials never showed up in court to face trial and repeatedly ignored the court's summons. They are fugitives from the law.
Under an out-of-court settlement reached in 1989, Union Carbide agreed to pay US$470 million in damages to people exposed to the deadly gas - about $400 per person. Union Carbide officials are reported to have said that "the amount was plenty good for an Indian".
This paltry pay-off got it off the hook in the civil suit brought by the Indian government. But its criminal liabilities survive. And Union Carbide never cleaned up the environment in Bhopal. It denied legal obligation to conduct or finance the clean up, arguing that with the 1989 settlement its obligations had ended.
According to the "polluter pays principle" which is valid both in the United States and India, Union Carbide/Dow must pay for the clean up in Bhopal. But Dow argues otherwise.
Since 2001 when it acquired Union Carbide as a 100% subsidiary, Dow Chemicals has insisted on distancing itself from Union Carbide's liabilities. It faces a lawsuit in Madhya Pradesh, the state of which Bhopal is the capital. India's Ministry of Chemicals and Fertilizers has demanded a token deposit of $250 million as initial payment for the costs of cleaning up.
Dow Chemicals has argued that Union Carbide had sold its shares in Union Carbide India in 1994, seven years before Dow Chemicals acquired it and that Dow cannot be held accountable for Union Carbide's liabilities.
Sections in the Indian government concur with this view.
Dow Chemicals has said that it will not invest in India unless the lawsuit against it is withdrawn and it is cleared of all its legal liabilities in India. It has been lobbying hard, directly and through the US government to have the "legal hurdles" on its way to investment in India removed.
The Indian government is reported to be working to help that happen.
Dow has said that it wants to invest US$100 million to set up a research and development center near Pune, in the Western state of Maharashtra. Dow has promised to make other major investments in India.
Backing the effort to absolve Dow Chemicals of all legal liabilities in connection with the Bhopal gas disaster is a formidable phalanx of ministers, officials and business leaders from India and the United States. India's Finance, Commerce and Law ministries are said to be in favor of absolving Dow of legal liabilities but the Chemical and Fertilizer Ministry is opposing the move.
An April Cabinet Secretary note was categorical about what the government's course of action should be and why. "Given the scope for future investments in the sector, it stands to reason that instead of continuing to agitate these issues [Dow's legal liability] in court for a protracted period, due consideration be given to the prospect of settling these issues appropriately. An important aim is to remove uncertainties and pave the way for promoting investments in the sector."
It now appears the government is considering withdrawing the affidavit against Dow Chemicals and opting for an out-of-court settlement. Indian industrialist and chairman of the Tata Group, Ratan Tata, has said he will head a corpus with the help of other Indian companies and Dow to clean up the Bhopal plant site. Dow has reportedly indicated its willingness to contribute to this corpus, but is insisting that this should not be seen as arising from an obligation.
The Indian government's effort to let Dow Chemicals off the hook stems from its interest in the large investment that the multinational company has promised to make in India. But more importantly fear that stern action against the multinational will scare away investors has stood in the way of India demanding justice on behalf of its citizens.
India signaled its soft approach towards Union Carbide within days of the Bhopal gas tragedy. In his first reaction to the disaster, India's then ambassador in Washington announced that the tragedy would not affect India-US relations or India's foreign investment policies. It allowed Anderson and other officials to slip out of the country and its efforts to have them extradited have been lukewarm. Its out-of-court settlement with Union Carbide, which was done without consulting the victims, was nothing short of a sell-out.
And now comes the move to absolve Dow Chemicals of its legal obligations.
However, alumni of the Indian Institutes of Technology (IIT), the country's premier engineering colleges, have decided to do their bit to get Dow Chemicals and others to clean up their act.
In May 2005, IIT alumni intervened and forced the organizers of the Global IIT 2005 Conference at Washington DC to cancel the key-note address by William Stavropoulos, then chief executive officer of Dow Chemical.
And now they are putting pressure on the IIT management to prevent campus interviews being conducted by the company. Recently, Dow Chemicals was forced to cancel its pre-placement talks in IIT Madras and IIT Bombay when students objected to any partnership between the IITs and this company.
The Indian government might be eager to put out the welcome mat for Dow's investment. But if the company wants to hire India's finest technical brains, it will need to clean up its act.
Sudha Ramachandran is an independent journalist/researcher based in Bangalore.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
Chinese investment in ASEAN rising
NANNING, China - More and more Chinese businesspeople are launching and expanding their businesses in Southeast Asian countries, counterbalancing previous capital flows in an overwhelmingly single opposite direction, officials and businessmen said at an ongoing exposition.
Mochtar Riady, chairman of Malaysia's renowned Lippo Group, said Chinese businesses have accumulated an abundance of capital in the economic boom over the past 30 years, leading to a strong desire to invest overseas, while some member states of the 10-member Association of Southeast Asian Nations (ASEAN) wanted investment, especially in infrastructure projects.
ASEAN will be "the main destination of China's growing overseas investment in future", the Chinese-Indonesian billionaire said at the China-ASEAN Expo in Nanning, which was due to close on Wednesday.
ASEAN member states have invested a total of US$41.9 billion in China since the country began it reform and opening up drive in late 1978, according to statistics from the China's Ministry of Commerce.
With China's fast development, Chinese investment in ASEAN countries increased rapidly in recent years. In a single move at the exposition, China's Guangxi State Farms Group alone inked 42 investment projects with ASEAN enterprises, involving a total value of 19 billion yuan (US$2.5 billion).
So far, more than 1,000 Chinese companies have made investment in ASEAN member countries, mainly in sectors such as agriculture, manufacturing, mining, tourism, electricity and infrastructure construction.
In the first two days of the China-ASEAN Expo which opened on Sunday, businesses from the two sides reached agreements on 92 projects. Under the pacts, Chinese companies will invest $1.19 billion in 37 projects in ASEAN countries, while ASEAN businesses will put $2.81 billion in another 55 projects in China.
"Capital flow in both directions, rather than the previous single-direction movement, has emerged as a new trend within the China-ASEAN cooperation," said Zhang Jian, a professor of China-ASEAN studies at Guangxi Normal University.
China and ASEAN countries have been pushing hard for the birth of the world's most populous free trade area in the region targeted for 2010.
Chinese Vice Premier Zeng Peiyan has called on the two sides to expand investment in both directions within the framework of regional cooperation.
China and the ASEAN are in talks over easier access for investors to each other's market, and an agreement is expected as early as next year, a spokesman for China's Ministry of Commerce revealed.
At the Expo, Chinese and Southeast Asian officials and financial experts on Tuesday urged the countries to strengthen financial cooperation, stressing it is crucial to stability in countries, the region and the world as a whole.
Ten years after the financial crisis that swept Asia and crumbled the results of development in many Asian countries, especially those in Southeast Asia, to dust, financial experts gathered in the south China city of Nanning to discuss what should be drawn from the "bloody lesson".
"We have learned from the crisis that only by strengthening financial cooperation can we ensure stability," said Ng Lip Yong, Malaysia's vice minister of trade and industry, at a forum during the four-day China-ASEAN Expo. "If we had had an effective financial cooperation mechanism at that time, the financial crisis might have been avoided," he added.
Now it has become a consensus of economists in China and Southeast Asian countries to accelerate financial cooperation to meet the demand for guarding against financial crisis and establishing a free trade area covering China and ASEAN members. China is not a ASEAN member country, though it is part of the larger ASEAN Regional Forum.
Under such circumstances, dialogue on regional fiscal and financial policies cooperation in institutional capacity building has been strengthened, while leading financial institutions have targeted other countries in the region as their potential market.
However, Bank of China's vice president Wang Yongli warned it is a must to strengthen a country's financial system and regulation. "Establishing a sound financial system in a country could avoid financial bubbles and risks from increasing to some extent," Wang said.
Chartsiri Sophonepanich, president of the Bangkok Bank, Thailand, called for better management of capital and foreign exchange reserves of ASEAN and China.
The China-ASEAN region has become one experiencing the fastest economic growth in the world, holding about half of the world's foreign exchange reserve. "If we only rest on buying US Treasury bonds with our foreign exchange reserve, it will not bring any force to drive our economic development," he said.
The Thai banker suggested using foreign exchange reserves to invest in the Asian bond market, which, together with the establishment of an even wider regional bond and financial market and effective regional financial cooperation and coordination, could help reduce the adverse impact of unpredictable economic crises.
He also called for the establishment of an Asia monetary organization to facilitate trade and investment in the region.
Mochtar Riady, chairman of Indonesia's Lippo Group, suggested taking the Chinese currency as the basic currency for regional trade cooperation and designing an Asia dollar based on it.
Zhai Kun, senior Chinese researcher on Southeast Asia studies, urged academic circles to cooperate in the study of financial crises to be able to make quick judgments and predictions before a crisis arises.
However, financial experts say, as China and ASEAN member countries enhance financial regulation and participate in international financial cooperation, their ability to guard against and deal with crises has improved markedly.
(Asia Pulse/Xinhua News Agency)
Mochtar Riady, chairman of Malaysia's renowned Lippo Group, said Chinese businesses have accumulated an abundance of capital in the economic boom over the past 30 years, leading to a strong desire to invest overseas, while some member states of the 10-member Association of Southeast Asian Nations (ASEAN) wanted investment, especially in infrastructure projects.
ASEAN will be "the main destination of China's growing overseas investment in future", the Chinese-Indonesian billionaire said at the China-ASEAN Expo in Nanning, which was due to close on Wednesday.
ASEAN member states have invested a total of US$41.9 billion in China since the country began it reform and opening up drive in late 1978, according to statistics from the China's Ministry of Commerce.
With China's fast development, Chinese investment in ASEAN countries increased rapidly in recent years. In a single move at the exposition, China's Guangxi State Farms Group alone inked 42 investment projects with ASEAN enterprises, involving a total value of 19 billion yuan (US$2.5 billion).
So far, more than 1,000 Chinese companies have made investment in ASEAN member countries, mainly in sectors such as agriculture, manufacturing, mining, tourism, electricity and infrastructure construction.
In the first two days of the China-ASEAN Expo which opened on Sunday, businesses from the two sides reached agreements on 92 projects. Under the pacts, Chinese companies will invest $1.19 billion in 37 projects in ASEAN countries, while ASEAN businesses will put $2.81 billion in another 55 projects in China.
"Capital flow in both directions, rather than the previous single-direction movement, has emerged as a new trend within the China-ASEAN cooperation," said Zhang Jian, a professor of China-ASEAN studies at Guangxi Normal University.
China and ASEAN countries have been pushing hard for the birth of the world's most populous free trade area in the region targeted for 2010.
Chinese Vice Premier Zeng Peiyan has called on the two sides to expand investment in both directions within the framework of regional cooperation.
China and the ASEAN are in talks over easier access for investors to each other's market, and an agreement is expected as early as next year, a spokesman for China's Ministry of Commerce revealed.
At the Expo, Chinese and Southeast Asian officials and financial experts on Tuesday urged the countries to strengthen financial cooperation, stressing it is crucial to stability in countries, the region and the world as a whole.
Ten years after the financial crisis that swept Asia and crumbled the results of development in many Asian countries, especially those in Southeast Asia, to dust, financial experts gathered in the south China city of Nanning to discuss what should be drawn from the "bloody lesson".
"We have learned from the crisis that only by strengthening financial cooperation can we ensure stability," said Ng Lip Yong, Malaysia's vice minister of trade and industry, at a forum during the four-day China-ASEAN Expo. "If we had had an effective financial cooperation mechanism at that time, the financial crisis might have been avoided," he added.
Now it has become a consensus of economists in China and Southeast Asian countries to accelerate financial cooperation to meet the demand for guarding against financial crisis and establishing a free trade area covering China and ASEAN members. China is not a ASEAN member country, though it is part of the larger ASEAN Regional Forum.
Under such circumstances, dialogue on regional fiscal and financial policies cooperation in institutional capacity building has been strengthened, while leading financial institutions have targeted other countries in the region as their potential market.
However, Bank of China's vice president Wang Yongli warned it is a must to strengthen a country's financial system and regulation. "Establishing a sound financial system in a country could avoid financial bubbles and risks from increasing to some extent," Wang said.
Chartsiri Sophonepanich, president of the Bangkok Bank, Thailand, called for better management of capital and foreign exchange reserves of ASEAN and China.
The China-ASEAN region has become one experiencing the fastest economic growth in the world, holding about half of the world's foreign exchange reserve. "If we only rest on buying US Treasury bonds with our foreign exchange reserve, it will not bring any force to drive our economic development," he said.
The Thai banker suggested using foreign exchange reserves to invest in the Asian bond market, which, together with the establishment of an even wider regional bond and financial market and effective regional financial cooperation and coordination, could help reduce the adverse impact of unpredictable economic crises.
He also called for the establishment of an Asia monetary organization to facilitate trade and investment in the region.
Mochtar Riady, chairman of Indonesia's Lippo Group, suggested taking the Chinese currency as the basic currency for regional trade cooperation and designing an Asia dollar based on it.
Zhai Kun, senior Chinese researcher on Southeast Asia studies, urged academic circles to cooperate in the study of financial crises to be able to make quick judgments and predictions before a crisis arises.
However, financial experts say, as China and ASEAN member countries enhance financial regulation and participate in international financial cooperation, their ability to guard against and deal with crises has improved markedly.
(Asia Pulse/Xinhua News Agency)
Thursday, November 1, 2007
The rich get richer
By Indrajit Basu
KOLKATA - It is difficult to imagine that a country that is still far, far away from becoming what the world considers an industrialized nation; a country that is still full of vast slums, poverty-stricken villages and a crumbling infrastructure; let alone problems of corruption, pollution, religious violence and child labor, could produce the richest man in world after just 15 years of economic liberalization.
Yet, as India's benchmark stock index, the Sensex, shattered the psychological 20,000-point barrier on Monday, the head of one of India's most high-profile industrial groups, Reliance Group, emerged as the richest man in the world.
Mukesh Ambani, 50, chairman of the oil, textiles and chemicals giant Reliance, is now ahead of American software czar Bill Gates and US investment guru Warren Buffett, as well as Mexican business tycoon Carlos Slim Helu, after the combined value of his stakes in his three group companies, Reliance Industries Ltd, Reliance Petroleum Ltd and Reliance Industrial Infrastructure Ltd, rose to US$63.2 billion.
His wealth includes $53.3 billion from Reliance Industries (a 50.98% stake), $9.4 billion from Reliance Petroleum (37.5%) and $532 million from Reliance Industrial Infrastructure 46.23%).
The net worth of Gates and Helu is estimated to be slightly lower, at about $62.29 billion each, with Warren Buffett, previously the third-richest in the world, dropping one position with a net worth of about $56 billion.
The only other Indian businessman - although he now holds a British passport - who is in Ambani's wealth league is London-based Lakshmi N Mittal, head of Arcelor Mittal, whose 44.8% in the world's largest steel producer is worth $52 billion.
Ambani's rise is perhaps one of the most conspicuous examples of India's economic prosperity and its unprecedented stock market boom. Ambani, a chemical engineer who quit his studies at Stanford University in the US in 1981 to join Reliance Industries, the flagship company founded by his father, the legendary Dhirubhai Ambani. According to Gita Piramal, corporate chronicler and editor of Smart Manager magazine, Ambani is "a manager with the rare ability of being able to think both wide and deep, to see both the big picture and keep track of the minuscule details in which lie profits".
When he took over the Reliance Group in July 2002 following the death of his father, Reliance's strategy of backward and forward vertical integration as chalked out by his father had almost run its course. Ambani realized that "to remain competitive in the global arena", Reliance Industries would have to further "leverage economies of scale to reduce costs".
Thus he initiated a fresh course of backward integration that went deeper, from textiles and polyester fibers to petrochemicals and oil. During this process, Ambani led the creation of 51 new, world-class manufacturing facilities involving diverse technologies that raised Reliance's manufacturing capacities many times.
Simultaneously, he embarked on an acquisition spree to consolidate Reliance's position in the petrochemical industry. He started by acquiring ailing local petrochemicals company IPCL Ltd in 2002, followed by a similar company, Nocil, in 2004. Within months of these two takeovers, Ambani claimed that he was able to turn around these companies "impressively" through growth caused by "geographical expansion, market consolidation, acquisitions and green-field investments".
The world's largest petroleum refinery now being built, Reliance Petrochemicals Ltd, under construction in Jamnagar, Gujarat state, is his brainchild, as is Reliance Infocomm, one of the largest mobile phone operators in the country. (After a split in the Reliance empire, he had to give up control of this company to his brother, Anil Ambani.)
Ambani is now entering the retail sector in a big way with the establishment of giant "Wal-Mart-like" retail stores all over the country. Recently he forayed into special economic zones (a project created by the government to promote exports) involving investment of millions of dollars. Currently, he is also steering Reliance's initiatives on a world scale into offshore, deep-water oil and gas exploration and production. His petroleum retail network in India involves 5,800 outlets and he started a research-led life sciences program covering medical, plant and industrial biotechnology.
But the one big factor in Ambani's phenomenal rise to the richest man in the world is the stupendous rise in Indian stock values, fueled by over $17 billion of foreign institutional money this year. In the past three years, India's main stock index, the Sensex, has more than tripled, aided by India's economy that is in the throes of a three-year boom.
According to a case study undertaken by Smart Manager on Ambani's management style, although his father followed a highly visible and high-profile existence, Mukesh Ambani's leadership style is not that of an attention-seeker. To many he is shy, almost a recluse, a strict vegetarian who abstains from drinking alcohol.
"India does not need a tie-wearing, golf-playing leader," he said recently in comments on his management style. "You don't need leaders who say we will motivate you, but leaders - and by leaders I am not talking of chief executive officers but leaders at all levels - who can drive your company as strong knowledge-based achievers."
Ambani has generated his share of controversies. Three years ago he was embroiled in a high-profile feud with his brother Anil that saw a vertical division of the group's assets, and a long period of uncertainty regarding the future of the Reliance Group as a whole. Last year he drew a fair amount of criticism from local social organizations for building an extravagant 27-storey family home - that reportedly includes six floors for parking the family's 168 imported cars - over the site of a former Mumbai orphanage. He has a wife, Nita, and three children.
Still, he has managed to come out unscathed because, he says, of his single-minded focus on pursuing growth and consolidation. "Over the years, Reliance has developed the main competency of building businesses from scratch, of building businesses which it did not know anything about ... the way we do it is really grow, consolidate, put a separate team to again grow and the cycle continues," he said in an interview.
Small wonder then that some like Shobhaa De, a bestselling novelist and cultural observer, considers that "he's pretty much running India".
"Policy decisions [that Ambani makes and] the direction India is taking [could fulfill] his ambition to be the most powerful man in the region," she said.
Indrajit Basu is a Kolkata-based journalist.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
KOLKATA - It is difficult to imagine that a country that is still far, far away from becoming what the world considers an industrialized nation; a country that is still full of vast slums, poverty-stricken villages and a crumbling infrastructure; let alone problems of corruption, pollution, religious violence and child labor, could produce the richest man in world after just 15 years of economic liberalization.
Yet, as India's benchmark stock index, the Sensex, shattered the psychological 20,000-point barrier on Monday, the head of one of India's most high-profile industrial groups, Reliance Group, emerged as the richest man in the world.
Mukesh Ambani, 50, chairman of the oil, textiles and chemicals giant Reliance, is now ahead of American software czar Bill Gates and US investment guru Warren Buffett, as well as Mexican business tycoon Carlos Slim Helu, after the combined value of his stakes in his three group companies, Reliance Industries Ltd, Reliance Petroleum Ltd and Reliance Industrial Infrastructure Ltd, rose to US$63.2 billion.
His wealth includes $53.3 billion from Reliance Industries (a 50.98% stake), $9.4 billion from Reliance Petroleum (37.5%) and $532 million from Reliance Industrial Infrastructure 46.23%).
The net worth of Gates and Helu is estimated to be slightly lower, at about $62.29 billion each, with Warren Buffett, previously the third-richest in the world, dropping one position with a net worth of about $56 billion.
The only other Indian businessman - although he now holds a British passport - who is in Ambani's wealth league is London-based Lakshmi N Mittal, head of Arcelor Mittal, whose 44.8% in the world's largest steel producer is worth $52 billion.
Ambani's rise is perhaps one of the most conspicuous examples of India's economic prosperity and its unprecedented stock market boom. Ambani, a chemical engineer who quit his studies at Stanford University in the US in 1981 to join Reliance Industries, the flagship company founded by his father, the legendary Dhirubhai Ambani. According to Gita Piramal, corporate chronicler and editor of Smart Manager magazine, Ambani is "a manager with the rare ability of being able to think both wide and deep, to see both the big picture and keep track of the minuscule details in which lie profits".
When he took over the Reliance Group in July 2002 following the death of his father, Reliance's strategy of backward and forward vertical integration as chalked out by his father had almost run its course. Ambani realized that "to remain competitive in the global arena", Reliance Industries would have to further "leverage economies of scale to reduce costs".
Thus he initiated a fresh course of backward integration that went deeper, from textiles and polyester fibers to petrochemicals and oil. During this process, Ambani led the creation of 51 new, world-class manufacturing facilities involving diverse technologies that raised Reliance's manufacturing capacities many times.
Simultaneously, he embarked on an acquisition spree to consolidate Reliance's position in the petrochemical industry. He started by acquiring ailing local petrochemicals company IPCL Ltd in 2002, followed by a similar company, Nocil, in 2004. Within months of these two takeovers, Ambani claimed that he was able to turn around these companies "impressively" through growth caused by "geographical expansion, market consolidation, acquisitions and green-field investments".
The world's largest petroleum refinery now being built, Reliance Petrochemicals Ltd, under construction in Jamnagar, Gujarat state, is his brainchild, as is Reliance Infocomm, one of the largest mobile phone operators in the country. (After a split in the Reliance empire, he had to give up control of this company to his brother, Anil Ambani.)
Ambani is now entering the retail sector in a big way with the establishment of giant "Wal-Mart-like" retail stores all over the country. Recently he forayed into special economic zones (a project created by the government to promote exports) involving investment of millions of dollars. Currently, he is also steering Reliance's initiatives on a world scale into offshore, deep-water oil and gas exploration and production. His petroleum retail network in India involves 5,800 outlets and he started a research-led life sciences program covering medical, plant and industrial biotechnology.
But the one big factor in Ambani's phenomenal rise to the richest man in the world is the stupendous rise in Indian stock values, fueled by over $17 billion of foreign institutional money this year. In the past three years, India's main stock index, the Sensex, has more than tripled, aided by India's economy that is in the throes of a three-year boom.
According to a case study undertaken by Smart Manager on Ambani's management style, although his father followed a highly visible and high-profile existence, Mukesh Ambani's leadership style is not that of an attention-seeker. To many he is shy, almost a recluse, a strict vegetarian who abstains from drinking alcohol.
"India does not need a tie-wearing, golf-playing leader," he said recently in comments on his management style. "You don't need leaders who say we will motivate you, but leaders - and by leaders I am not talking of chief executive officers but leaders at all levels - who can drive your company as strong knowledge-based achievers."
Ambani has generated his share of controversies. Three years ago he was embroiled in a high-profile feud with his brother Anil that saw a vertical division of the group's assets, and a long period of uncertainty regarding the future of the Reliance Group as a whole. Last year he drew a fair amount of criticism from local social organizations for building an extravagant 27-storey family home - that reportedly includes six floors for parking the family's 168 imported cars - over the site of a former Mumbai orphanage. He has a wife, Nita, and three children.
Still, he has managed to come out unscathed because, he says, of his single-minded focus on pursuing growth and consolidation. "Over the years, Reliance has developed the main competency of building businesses from scratch, of building businesses which it did not know anything about ... the way we do it is really grow, consolidate, put a separate team to again grow and the cycle continues," he said in an interview.
Small wonder then that some like Shobhaa De, a bestselling novelist and cultural observer, considers that "he's pretty much running India".
"Policy decisions [that Ambani makes and] the direction India is taking [could fulfill] his ambition to be the most powerful man in the region," she said.
Indrajit Basu is a Kolkata-based journalist.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
End of the guns and butter economy
By Scott B MacDonald
NEW YORK - Over the past 30 years, the United States has sought and to some extent achieved a guns and butter economy; that is the pursuit of both political-military objectives and an affluent lifestyle.
On the political front, it has dominated the international system, presiding over the defeat of the Soviet Union, its hegemonic rival during the Cold War, and forming a successful military coalition to liberate Kuwait in the first Iraq war in 1991. It became even more unilateral under the Bush the younger administration, with aggressive policies against militant Islam and Iraq in Middle East and South Asia.
At the same time, the consumer-driven US economy continued to expand, with the last great burst being the spike in homeownership in the 2003-2006 period. Homeownership since the mid-1950s was long stuck at 65% of the total population, but by year-end 2006, on the back of cheap credit and lax underwriting standards, it reached 69%.
Significantly, countries such as China, Japan and Germany benefited from the US guns and butter economy, content to sell their exports and finance their purchases via the buying of US debt. This was the upside of globalization.
But in July, the US financial system signaled that the era of cheap money and lax standards was over. Two Bear Stearns hedge funds collapsed and panic hit credit markets, pounding the stock and bond values of any company associated with mortgage lending and housing. By August the rout filtered into the derivatives market (especially those structured financial products that contained exposure to US subprime debt), negatively impacting European and Asian bank and insurance investment portfolios.
The contagion eventually rippled into London's inter-bank market, forcing central banks to inject considerable amounts of liquidity to keep the system running. Even then, nervousness about the standing of banks, especially those dependent on short-term commercial paper for mortgage lending, forced Britain's Northern Rock into a government rescue. This was the downside of globalization.
The US economy is edging toward a significant slowdown in what is left of 2007; it will take concerted effort and luck to avoid a recession. The housing sector is hitting depths associated with the 1930s. The Federal Reserve's September 18 cuts in the discount window and in Fed Funds gave markets a temporary relief, a situation helped along by private sector actions to consolidate the financial sector. This is reflected in Bank of America's purchase of Countrywide Financial shares and Citigroup's stepping up with credit lines for GMAC. But there remains a long distance to the shore of economic safety.
A shadow is being cast by a deficit of unresolved problems in an economy overloaded with debt, a retreating federal responsibility for national infrastructure, and large (and seemingly unending) overseas burdens. In the short term, the problem that looms is that the housing meltdown is finally chipping away at the consumer, who in the butter part of the US economy accounts for about 70% of gross domestic product.
The consumer relied on home equity (and foreign capital) to finance the ongoing parade of goods and drove many households into negative territory in terms of savings. Why save when you are penalized (taxed) on savings amid an unrelenting society-wide pitch to consume? Easy money during the Alan Greenspan years at the Fed helped keep the guns and butter economy afloat without too many major adjustments. That dynamic has changed.
On the short term side there is going to be further bad news on housing. There is a very real prospect of steeper declines in housing prices, pushed along by a growing inventory (already nine months of new homes waiting to be sold not to mention those homes taken off the market by frustrated would be sellers).
In addition, there is a huge resetting of adjustable rate mortgages over the next 12 months, with a large spike in March 2008. Adding to the list of woes is the increasing pace of personnel downsizing in the mortgage industry and declining profitability in the financial sector.
On the longer-term side of the equation, the economic landscape is chilling, considering the massive structural problems. The guns part of the economy is a concern - the war in Iraq and other missions (Afghanistan and Africa) cost somewhere between US$3-5 billion a day.
In August, the Congressional Budget Office (CBO) estimated as of June 2007 up to $500 billion has been spent on combat operations in Iraq. The CBO also noted that if the United States were to maintain 75,000 troops in Iraq over the next five years, the nation would have to pay an additional $900 billion. Moreover, there are further costs attached to training police and ground forces in Iraq and Afghanistan as well as long-term health costs associated with wounded personnel.
There are other structural problems - a long-term imbalance between government expenditures and revenues (related to ongoing pressure for tax cuts). There is a massive problem with national infrastructure - it is aging rapidly and needs to be upgraded with a price tag of $1.6 trillion. That includes roads, bridges, ports and other public utilities.
Any doubt of the infrastructure problem one need only point to the steam conduit that exploded in July in Manhattan - the piping was laid 83 years ago when Calvin Coolidge was president and was part of a system that started to provide energy to New York City in 1882.
In August, a 40-year-old bridge in Minneapolis collapsed, leaving several dead in the accident's wake. The national infrastructure is literally falling down around the population, but the most recently passed Senate transportation and housing bill contained at least $2 billion for pet projects that include a North Dakota peace garden, a Montana baseball stadium and a Las Vegas history museum.
Equally important is the issue of Medicare, Medicaid and Social Security, the combined basis of which is expected to grow 22% faster than the economy over the next decade. This should come more sharply into focus next year when the first of 78 million baby boomers become eligible for early social security benefits.
American politics have reached a very dysfunctional stage, with considerable energy given to the indulgence of maintaining an economy and the debt required to keep it going, with little thought being given to the adjustments now in motion.
Along these lines, it is easier to blame the outside world for troubles at home, hence the turn to protectionism (with a number of bills pending in the US Congress). The plunging value of the US dollar and the huge sell-off in US securities by foreigners in August ($163 billion) should convey the message that not all is well and that unless there is an effort to start living more within one's means, the rest of the world is going to stop financing the North American credit glutton.
The days of guns and butter for the US economy are over; what is going to replace it is a much more volatile world, with substantial questions over the US dollar as the major international currency and the ability of the US consumer to absorb the world's exports. As the US adjusts to this changing scenario, so will the rest of the global economy. It is not going to be an easy transition.
Scott B MacDonald is editor of KWR International Advisor.
(Posted with permission from KWR International, Inc, (KWR), a consulting firm specializing in the delivery of research, communications and advisory services.)
NEW YORK - Over the past 30 years, the United States has sought and to some extent achieved a guns and butter economy; that is the pursuit of both political-military objectives and an affluent lifestyle.
On the political front, it has dominated the international system, presiding over the defeat of the Soviet Union, its hegemonic rival during the Cold War, and forming a successful military coalition to liberate Kuwait in the first Iraq war in 1991. It became even more unilateral under the Bush the younger administration, with aggressive policies against militant Islam and Iraq in Middle East and South Asia.
At the same time, the consumer-driven US economy continued to expand, with the last great burst being the spike in homeownership in the 2003-2006 period. Homeownership since the mid-1950s was long stuck at 65% of the total population, but by year-end 2006, on the back of cheap credit and lax underwriting standards, it reached 69%.
Significantly, countries such as China, Japan and Germany benefited from the US guns and butter economy, content to sell their exports and finance their purchases via the buying of US debt. This was the upside of globalization.
But in July, the US financial system signaled that the era of cheap money and lax standards was over. Two Bear Stearns hedge funds collapsed and panic hit credit markets, pounding the stock and bond values of any company associated with mortgage lending and housing. By August the rout filtered into the derivatives market (especially those structured financial products that contained exposure to US subprime debt), negatively impacting European and Asian bank and insurance investment portfolios.
The contagion eventually rippled into London's inter-bank market, forcing central banks to inject considerable amounts of liquidity to keep the system running. Even then, nervousness about the standing of banks, especially those dependent on short-term commercial paper for mortgage lending, forced Britain's Northern Rock into a government rescue. This was the downside of globalization.
The US economy is edging toward a significant slowdown in what is left of 2007; it will take concerted effort and luck to avoid a recession. The housing sector is hitting depths associated with the 1930s. The Federal Reserve's September 18 cuts in the discount window and in Fed Funds gave markets a temporary relief, a situation helped along by private sector actions to consolidate the financial sector. This is reflected in Bank of America's purchase of Countrywide Financial shares and Citigroup's stepping up with credit lines for GMAC. But there remains a long distance to the shore of economic safety.
A shadow is being cast by a deficit of unresolved problems in an economy overloaded with debt, a retreating federal responsibility for national infrastructure, and large (and seemingly unending) overseas burdens. In the short term, the problem that looms is that the housing meltdown is finally chipping away at the consumer, who in the butter part of the US economy accounts for about 70% of gross domestic product.
The consumer relied on home equity (and foreign capital) to finance the ongoing parade of goods and drove many households into negative territory in terms of savings. Why save when you are penalized (taxed) on savings amid an unrelenting society-wide pitch to consume? Easy money during the Alan Greenspan years at the Fed helped keep the guns and butter economy afloat without too many major adjustments. That dynamic has changed.
On the short term side there is going to be further bad news on housing. There is a very real prospect of steeper declines in housing prices, pushed along by a growing inventory (already nine months of new homes waiting to be sold not to mention those homes taken off the market by frustrated would be sellers).
In addition, there is a huge resetting of adjustable rate mortgages over the next 12 months, with a large spike in March 2008. Adding to the list of woes is the increasing pace of personnel downsizing in the mortgage industry and declining profitability in the financial sector.
On the longer-term side of the equation, the economic landscape is chilling, considering the massive structural problems. The guns part of the economy is a concern - the war in Iraq and other missions (Afghanistan and Africa) cost somewhere between US$3-5 billion a day.
In August, the Congressional Budget Office (CBO) estimated as of June 2007 up to $500 billion has been spent on combat operations in Iraq. The CBO also noted that if the United States were to maintain 75,000 troops in Iraq over the next five years, the nation would have to pay an additional $900 billion. Moreover, there are further costs attached to training police and ground forces in Iraq and Afghanistan as well as long-term health costs associated with wounded personnel.
There are other structural problems - a long-term imbalance between government expenditures and revenues (related to ongoing pressure for tax cuts). There is a massive problem with national infrastructure - it is aging rapidly and needs to be upgraded with a price tag of $1.6 trillion. That includes roads, bridges, ports and other public utilities.
Any doubt of the infrastructure problem one need only point to the steam conduit that exploded in July in Manhattan - the piping was laid 83 years ago when Calvin Coolidge was president and was part of a system that started to provide energy to New York City in 1882.
In August, a 40-year-old bridge in Minneapolis collapsed, leaving several dead in the accident's wake. The national infrastructure is literally falling down around the population, but the most recently passed Senate transportation and housing bill contained at least $2 billion for pet projects that include a North Dakota peace garden, a Montana baseball stadium and a Las Vegas history museum.
Equally important is the issue of Medicare, Medicaid and Social Security, the combined basis of which is expected to grow 22% faster than the economy over the next decade. This should come more sharply into focus next year when the first of 78 million baby boomers become eligible for early social security benefits.
American politics have reached a very dysfunctional stage, with considerable energy given to the indulgence of maintaining an economy and the debt required to keep it going, with little thought being given to the adjustments now in motion.
Along these lines, it is easier to blame the outside world for troubles at home, hence the turn to protectionism (with a number of bills pending in the US Congress). The plunging value of the US dollar and the huge sell-off in US securities by foreigners in August ($163 billion) should convey the message that not all is well and that unless there is an effort to start living more within one's means, the rest of the world is going to stop financing the North American credit glutton.
The days of guns and butter for the US economy are over; what is going to replace it is a much more volatile world, with substantial questions over the US dollar as the major international currency and the ability of the US consumer to absorb the world's exports. As the US adjusts to this changing scenario, so will the rest of the global economy. It is not going to be an easy transition.
Scott B MacDonald is editor of KWR International Advisor.
(Posted with permission from KWR International, Inc, (KWR), a consulting firm specializing in the delivery of research, communications and advisory services.)
Bernanke: Don't take me for granted, boys
By Julian Delasantellis
For this Halloween, it seems that US Federal Reserve chairman Ben Bernanke chose to dress up as Betty "Riz" Rizzo, the young social outcast in the 1978 film Grease.
Riz sings a song of remorse, expressing outward pride but inner shame over being the girl the 1950s boys know they can go to when they want an assured good time:
There are worse things I could do,
Than go with a boy or two.
Even though the neighborhood thinks I'm trashy,
And no good,
I suppose it could be true,
But there are worse things I could do.
I could flirt with all the guys,
Smile at them and bat my eyes.
Press against them when we dance,
Make them think they stand a chance,
Then refuse to see it through.
That's a thing I'd never do.
Picture Bernanke, with signature form-fitting black pedal pusher pants, teased hair, hot pink lipstick, and a tight, "Pink Ladies" girl gang leather jacket, going trick or treating at Wednesday's Federal Open Market Committee meeting, singing a song of his own individual professional conflict between values and popularity:
There are worse things I could do
Than lower an interest rate or two ...
For the third time in the last 75 days, the US Federal Reserve has made a major move to lower interest rates in order to attempt to revive a US economy whose future prospects are looking ever bleaker with each successive economic report.
This move involved a cut of 0.25%, or 25 basis points in money market lingo, in the Federal Funds target rate, to 4.50%; there was also an accompanying 25 basis point cut in the Federal Reserve Discount rate, the interest rate the Fed charges member banks who must borrow from it due to the fact that they have been denied funding at reasonable rates from the private, commercial money markets.
In total, since this current easing rate cycle began on August 17, the discount rate has now been cut a total of 125 basis points, and the Federal Funds rate by 75. US Federal Reserve rate moves usually come in successive series, called cycles, in the same direction, that can last many months or years. There is every indication that due to economic weakness arising from a crippled housing sector, the US is now in the early stages of a new rate cutting cycle, one that we will not see the end of until at least early 2009, perhaps even beyond that.
Unlike the previous Fed move on September 18, when the markets were surprised with stronger than expected twin 50-point cuts of both the Fed Funds target rate and the discount rate, this move was pretty well expected and discounted by the markets prior to the meeting.
In the recent past, during the Alan Greenspan Federal Reserve era, having a predictable Fed was seen as a positive value, something that America's central bank should strive for. There are indications that this policy objective - predictability, or, in market lingo, transparency - is losing favor as a core Fed institutional virtue, and that puts us in the international community of Federal Reserve watchers; indeed, it puts the entire financial world in a wholly new situation.
In an article posted on the Financial Times website, "Fed concern at expectation of rate cut", on October 28, Krishna Guna reported that being a bit too loose with the boys in the financial markets was emerging as a major policy concern with the Bernanke Fed board.
"According to anecdotal reports, there is some resistance among Fed insiders to the notion of a guaranteed rate cut. Many would have preferred to go into the meeting with market odds more evenly balanced, which would give the central bank greater latitude to make its determination without risking market turmoil."
Since at least the opening years of the Alan Greenspan Fed in the early 1990s, the results of the regularly scheduled Federal Reserve meetings have rarely been much of a surprise. Invariably, a few days before the meeting, you'd see stories in the financial media about "Fed insiders" or "highly placed Fed sources" in essence telling the world what the outcome of the meeting would be.
The "Fed insiders" and "highly placed Fed sources" were, of course, Fed officials close to Greenspan; these stories were, in a Washington tradition that probably predates Pierre L'Enfant's arrival in the city to design it, leaks. The leakers did not have to, like Bob Woodward's Watergate era "Deep Throat", meet the reporter in the wee hours in an empty car park; since Greenspan obviously fully approved the procedure, the source probably got some good whiskey and a steak dinner for this valued service to the Fifth Estate.
Greenspan endorsed this dance of the seven Fed veils because he believed that unpredictability carried a cost to the general economy. Unpredictable and unexpected Federal Reserve moves were invariably followed by large concomitant movements in the financial markets. If you are a participant in the markets, whether it be a buyer or seller of stocks, bonds or commodities, your life is made infinitely more complex if you have to provide and plan for regularly expected potential 3-5% moves, in either direction, in your market, rather than more sedate 1% moves.
You can go into the options markets and take out "insurance", buying puts and calls, against extreme market moves, but that costs money, costs that rise along with the projected near-term volatility of the markets. Greenspan believed that the corporate funds utilized to guard - "hedge" - against excess volatility could be better spent on more productive capital investments like plant and equipment.
But as this operational paradigm became a finely honed tradition, an inherent contradiction in the process emerged.
If the markets know, and factor into securities prices, what the
results of a Fed meeting will be prior to the actual meeting, does that mean, in effect, that when the full Federal Reserve Open Markets Committee members gather on meeting day, they will feel that their hands are tied, that they can't act in such a way other than the market expects, for fear of provoking a severe selloff?
Is the tail wagging the dog here? More importantly, in this case, who's the dog and who's the tail?
The Greenspan Fed felt that this was a cost worth incurring, in order to avoid the greater costs of unpredictability. Thus, an entire industry of Fed watchers developed, like Cold War Kremlinologists, in order to read the monetary policy tea leaves, to ascertain the direction and quantity of upcoming Federal Reserve moves so as to profitably position trades in advance of the actual announced decisions.
The Chicago Board of Trade futures exchange actually initiated a commodities futures contract, Federal Funds futures, so that commercial hedgers and punters alike could seek to profit from how the Fed would act.
The Greenspan Fed, and in its early months the Bernanke Fed, never disappointed the markets. Thus, if it is seen that the Fed always follows the markets' lead, then, in essence, it is as if the markets are controlling the Fed, not the other way around. (I wrote about this perception in my September 18 piece, A rate cut with a shoeshine and a smile.)
Bernanke apparently wants to change how the cards in this game are dealt. He surprised the markets with his double-barreled rate cut on September 18, and he found a way to surprise the markets on Wednesday.
The markets did get the dual twenty five basis point rate cuts they had expected, but it was in the post-meeting statement, the booming voice of the monetary gods thundering down from the Olympian heights of their headquarters in Marriner Eccles Hall in Washington, where it can be seen that Bernanke might be trying to make himself a little bit of a mystery to the boys in the markets.
The September post-meeting statement gave the markets every indication, every reason to believe, that there would also be seen a cut at the October meeting, the cut we actually did see on Wednesday.
"Developments in financial markets since the Committee's last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth," the Fed said in September.
But after Wednesday's meeting, it seems that Bernanke batted his eyes, flirtatiously telling the boys that in the future, maybe yes, maybe no.
"Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth."
At first, the markets were puzzled by this coquettish new Fed. The Dow Jones Industrial Average was up over 100 points before the announcement, it quickly dropped to be down 20 points after the market got a chance to read the statement, rallied back to close up 134; for now, at least, the market agrees with Hamlet's mother that "The lady doth protest too much."
This leaves the markets, and the economy, in an entirely new place. The worldwide Fed analysis community is certainly not going to pack up and go away. If the Fed is now placing an equal or greater value on unpredictability over transparency, in order to retrieve the policy initiative it feels it imprudently ceded to the markets, will it then take this thinking to its logical conclusion and someday fail to act in such a way that the economy needs, just so that it can surprise the markets?
It is entirely possible, and widely expected in the markets, that the current subprime mortgage mess will spread and intensify, festering across at least the entire housing and financial sectors. If pride holds Bernanke's hand from cutting rates and providing liquidity when he should, just because the markets called it first, the markets will look on this situation very negatively. A lot of wealth could be destroyed in the markets very, very quickly.
It's not as if pride has never ruled over policy in Washington. Veteran journalist Bill Moyers tells a story that, when he was working as president Lyndon Johnson's press secretary in the 1960s, word came down that LBJ was planning to fire cantankerous, obstreperous FBI Director J Edgar Hoover.
As he thought Johnson wanted, Moyers spread the word to the press; when the story came out before Johnson got a chance to make the official announcement, out of pique, he reversed his decision and reappointed Hoover to another term, where he stayed until his death in 1972.
Maybe we in the markets are taking Bernanke for granted. We should not be treating him like a cheap pickup in a singles bar. We should call him the next day. We should send flowers. Maybe we need take the entire Fed board out to breakfast the day after.
Dr Bernanke, did you just want to be held?
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
For this Halloween, it seems that US Federal Reserve chairman Ben Bernanke chose to dress up as Betty "Riz" Rizzo, the young social outcast in the 1978 film Grease.
Riz sings a song of remorse, expressing outward pride but inner shame over being the girl the 1950s boys know they can go to when they want an assured good time:
There are worse things I could do,
Than go with a boy or two.
Even though the neighborhood thinks I'm trashy,
And no good,
I suppose it could be true,
But there are worse things I could do.
I could flirt with all the guys,
Smile at them and bat my eyes.
Press against them when we dance,
Make them think they stand a chance,
Then refuse to see it through.
That's a thing I'd never do.
Picture Bernanke, with signature form-fitting black pedal pusher pants, teased hair, hot pink lipstick, and a tight, "Pink Ladies" girl gang leather jacket, going trick or treating at Wednesday's Federal Open Market Committee meeting, singing a song of his own individual professional conflict between values and popularity:
There are worse things I could do
Than lower an interest rate or two ...
For the third time in the last 75 days, the US Federal Reserve has made a major move to lower interest rates in order to attempt to revive a US economy whose future prospects are looking ever bleaker with each successive economic report.
This move involved a cut of 0.25%, or 25 basis points in money market lingo, in the Federal Funds target rate, to 4.50%; there was also an accompanying 25 basis point cut in the Federal Reserve Discount rate, the interest rate the Fed charges member banks who must borrow from it due to the fact that they have been denied funding at reasonable rates from the private, commercial money markets.
In total, since this current easing rate cycle began on August 17, the discount rate has now been cut a total of 125 basis points, and the Federal Funds rate by 75. US Federal Reserve rate moves usually come in successive series, called cycles, in the same direction, that can last many months or years. There is every indication that due to economic weakness arising from a crippled housing sector, the US is now in the early stages of a new rate cutting cycle, one that we will not see the end of until at least early 2009, perhaps even beyond that.
Unlike the previous Fed move on September 18, when the markets were surprised with stronger than expected twin 50-point cuts of both the Fed Funds target rate and the discount rate, this move was pretty well expected and discounted by the markets prior to the meeting.
In the recent past, during the Alan Greenspan Federal Reserve era, having a predictable Fed was seen as a positive value, something that America's central bank should strive for. There are indications that this policy objective - predictability, or, in market lingo, transparency - is losing favor as a core Fed institutional virtue, and that puts us in the international community of Federal Reserve watchers; indeed, it puts the entire financial world in a wholly new situation.
In an article posted on the Financial Times website, "Fed concern at expectation of rate cut", on October 28, Krishna Guna reported that being a bit too loose with the boys in the financial markets was emerging as a major policy concern with the Bernanke Fed board.
"According to anecdotal reports, there is some resistance among Fed insiders to the notion of a guaranteed rate cut. Many would have preferred to go into the meeting with market odds more evenly balanced, which would give the central bank greater latitude to make its determination without risking market turmoil."
Since at least the opening years of the Alan Greenspan Fed in the early 1990s, the results of the regularly scheduled Federal Reserve meetings have rarely been much of a surprise. Invariably, a few days before the meeting, you'd see stories in the financial media about "Fed insiders" or "highly placed Fed sources" in essence telling the world what the outcome of the meeting would be.
The "Fed insiders" and "highly placed Fed sources" were, of course, Fed officials close to Greenspan; these stories were, in a Washington tradition that probably predates Pierre L'Enfant's arrival in the city to design it, leaks. The leakers did not have to, like Bob Woodward's Watergate era "Deep Throat", meet the reporter in the wee hours in an empty car park; since Greenspan obviously fully approved the procedure, the source probably got some good whiskey and a steak dinner for this valued service to the Fifth Estate.
Greenspan endorsed this dance of the seven Fed veils because he believed that unpredictability carried a cost to the general economy. Unpredictable and unexpected Federal Reserve moves were invariably followed by large concomitant movements in the financial markets. If you are a participant in the markets, whether it be a buyer or seller of stocks, bonds or commodities, your life is made infinitely more complex if you have to provide and plan for regularly expected potential 3-5% moves, in either direction, in your market, rather than more sedate 1% moves.
You can go into the options markets and take out "insurance", buying puts and calls, against extreme market moves, but that costs money, costs that rise along with the projected near-term volatility of the markets. Greenspan believed that the corporate funds utilized to guard - "hedge" - against excess volatility could be better spent on more productive capital investments like plant and equipment.
But as this operational paradigm became a finely honed tradition, an inherent contradiction in the process emerged.
If the markets know, and factor into securities prices, what the
results of a Fed meeting will be prior to the actual meeting, does that mean, in effect, that when the full Federal Reserve Open Markets Committee members gather on meeting day, they will feel that their hands are tied, that they can't act in such a way other than the market expects, for fear of provoking a severe selloff?
Is the tail wagging the dog here? More importantly, in this case, who's the dog and who's the tail?
The Greenspan Fed felt that this was a cost worth incurring, in order to avoid the greater costs of unpredictability. Thus, an entire industry of Fed watchers developed, like Cold War Kremlinologists, in order to read the monetary policy tea leaves, to ascertain the direction and quantity of upcoming Federal Reserve moves so as to profitably position trades in advance of the actual announced decisions.
The Chicago Board of Trade futures exchange actually initiated a commodities futures contract, Federal Funds futures, so that commercial hedgers and punters alike could seek to profit from how the Fed would act.
The Greenspan Fed, and in its early months the Bernanke Fed, never disappointed the markets. Thus, if it is seen that the Fed always follows the markets' lead, then, in essence, it is as if the markets are controlling the Fed, not the other way around. (I wrote about this perception in my September 18 piece, A rate cut with a shoeshine and a smile.)
Bernanke apparently wants to change how the cards in this game are dealt. He surprised the markets with his double-barreled rate cut on September 18, and he found a way to surprise the markets on Wednesday.
The markets did get the dual twenty five basis point rate cuts they had expected, but it was in the post-meeting statement, the booming voice of the monetary gods thundering down from the Olympian heights of their headquarters in Marriner Eccles Hall in Washington, where it can be seen that Bernanke might be trying to make himself a little bit of a mystery to the boys in the markets.
The September post-meeting statement gave the markets every indication, every reason to believe, that there would also be seen a cut at the October meeting, the cut we actually did see on Wednesday.
"Developments in financial markets since the Committee's last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth," the Fed said in September.
But after Wednesday's meeting, it seems that Bernanke batted his eyes, flirtatiously telling the boys that in the future, maybe yes, maybe no.
"Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth."
At first, the markets were puzzled by this coquettish new Fed. The Dow Jones Industrial Average was up over 100 points before the announcement, it quickly dropped to be down 20 points after the market got a chance to read the statement, rallied back to close up 134; for now, at least, the market agrees with Hamlet's mother that "The lady doth protest too much."
This leaves the markets, and the economy, in an entirely new place. The worldwide Fed analysis community is certainly not going to pack up and go away. If the Fed is now placing an equal or greater value on unpredictability over transparency, in order to retrieve the policy initiative it feels it imprudently ceded to the markets, will it then take this thinking to its logical conclusion and someday fail to act in such a way that the economy needs, just so that it can surprise the markets?
It is entirely possible, and widely expected in the markets, that the current subprime mortgage mess will spread and intensify, festering across at least the entire housing and financial sectors. If pride holds Bernanke's hand from cutting rates and providing liquidity when he should, just because the markets called it first, the markets will look on this situation very negatively. A lot of wealth could be destroyed in the markets very, very quickly.
It's not as if pride has never ruled over policy in Washington. Veteran journalist Bill Moyers tells a story that, when he was working as president Lyndon Johnson's press secretary in the 1960s, word came down that LBJ was planning to fire cantankerous, obstreperous FBI Director J Edgar Hoover.
As he thought Johnson wanted, Moyers spread the word to the press; when the story came out before Johnson got a chance to make the official announcement, out of pique, he reversed his decision and reappointed Hoover to another term, where he stayed until his death in 1972.
Maybe we in the markets are taking Bernanke for granted. We should not be treating him like a cheap pickup in a singles bar. We should call him the next day. We should send flowers. Maybe we need take the entire Fed board out to breakfast the day after.
Dr Bernanke, did you just want to be held?
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved.)
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