By Julian Delasantellis
Like salmon driven upstream by instinctual forces beyond their control, there is something deep down, probably at the core of our DNA programming, that forces pundits to make predictions for the new year in early January. Here's my economic prediction for 2008. The American economy may very well come to resemble scenes from the two Dawn of the Dead movies.
And that's the good news.
First made in 1978 by horror maestro George Romero, as a sequel to his 1968 classic Night of the Living Dead, remade by Zack Snyder in 2004, Dawn of the Dead tells the story of the human race under siege from hordes of recently deceased risen zombies, ambulating about with no higher brain functions, only existing to feed lustily on the rapidly decreasing numbers of actual people still around.
In both the 1978 original and the 2004 sequel, a hardy group of human survivors seeks shelter and security in an abandoned shopping mall, barricading themselves from the zombies until some salvation for the human race can emerge.
But the zombies still come. They mill around aimlessly in the parking lot, (making them fine sporting practice for the survivors, with their high-powered rifles filched from the mall's sporting goods stores, shooting away what used to be the zombies' brains) occasionally attempting to overcome the survivors' improvised defenses to gain access to the mall. The survivors are astounded, but then they come to realize their mistake in seeking shelter in a shopping mall. The zombies, even with most of their brains decayed or shot away, still carry an inherent memory of the malls as a place that once held a central focus of their lives.
As one of the survivors put it: "They're after the place. They don't know why, they just remember. Remember that they want to be in here."
Mindless zombies haunting shopping malls as if by instinct, for reasons they barely know. You don't have to wait until the end of the world to see that - you can see it all the time, including during the recently concluded holiday shopping season, in any American shopping mall. And that just may be the salvation of the American economy after all.
We're now coming up on what I consider to be the first anniversary of the starter's pistol of the subprime crisis, HSBC Holdings' February 5, 2007, announcement of the problems at its Household Bank subsidiary that first alerted the financial world to the putrescent swamp that US housing finance had fallen into over the past few years.
I started writing about the seriousness of the problems with subprimes in March; slowly, a lot of the pundit community has followed suit. Many prominent economic analysts and forecasters, among them former Federal Reserve chairman Alan Greenspan, Economics Nobel Prize winner Joseph Stiglitz and Goldman Sachs chief US economist Jan Hatzius, are now putting the odds of a US recession (technically defined as two quarters - six months - of negative economic growth) at roughly 50-50.
Maybe they're right. But as someone who has followed every twist and tribulation of the subprime crisis since its inception, I'm starting to wonder if subprime's hype has outrun its reality.
Subprime is one crisis with multiple manifestations. First is the effect on the US housing sector.
A core reason why it is frequently so difficult to get a grip on just where housing is at any one moment is the fact that there are so many varied metrics that seek to provide snapshots.
You have reports on home sales. Home prices. Home inventories. New-home sales prices and volumes, existing-home prices and sales volumes, new-home starts, pending home sales, mortgages becoming delinquent, mortgages entering foreclosure; all available for the nation as a whole, and, more importantly, for the widely varied individual regional markets that, amalgamated, comprise the national housing picture.
It is true that, for the past year, most of the indicators have marched in lockstep in one direction - down. Still, you occasionally get outliers, reports that indicate things may not be as bad as they seem. Among these was the report on December 31 that sales of existing homes actually rose 0.4% in November. In contrast to sales of new homes - those omnipresent cookie-cutters, New England-style in the Arizona desert housing-development monstrosities that despoil the virgin landscape like indelible ink spots around America's outer suburbs - existing home sales seemed to have reached a plateau late in 2007, stabilizing at around an annual rate of about 5 million units.
Home prices are falling in the US, but it is important to keep that data in a geographical and historical perspective.
On all but the most superficial level of analysis, it is probably incorrect to think of a unified US housing market. The housing picture in the US more closely resembles an agglomerated average of all the different individualized local and regional housing markets.
Thus, the current price declines in US real estate values are concentrated in places such as the US Midwest, devastated by the continuing contraction in the US auto industry, and southern California and Florida, where real estate speculation was at its irrationally exuberant best up to the end of 2006. Most other markets have real estate prices stable to only declining marginally; in some markets, such as the Pacific Northwest and the area around Charlotte, North Carolina, real estate price appreciations continue, albeit at a more reasonable pace.
Here it is also important to look at the bigger picture. According to the Case-Shiller Real Home Price Index, US home prices fell about 3.4% in 2007. Even with the declines seemingly accelerating to around a 10% rate by the end of the year, that should be looked at in the context of a 52% rise in prices since 2001.
In other words, if you bought your home before, say, mid-2005, and unless you borrowed away the appreciated value of that home with home equity loans, your home can still be your piggy bank. You can still head to the mall with the other zombies.
It's true that every month about a quarter of a million Americans are losing their homes through foreclosure, and that number should continue through 2008. The subprime "teaser" mortgage resets should peak in April, then taper off into mid-2009. Still, if one is expecting the American consumer to go into spending mourning over the fate of his poor foreclosed brethren, one has not spent all that much time with American consumers lately.
Just before Christmas, the US television network ABC had on its Nightline news program the most insightful broadcast report I've seen yet on how American society is adapting to the subprime crisis. Far from being a dour and foreboding account of sad homeowners gathering their paltry belongings in preparation for foreclosure, the report showed happy, giddy prospective homeowners on big tour buses, on an excursion, organized by a Stockton, California real estate agent (who provided the snacks and drinks), to view recently foreclosed properties.
The atmosphere on the buses was more approbation than Armageddon, more game show than Gotterdammerung: "You wanna get a good deal off someone else's life-wrecking misfortune - come on down!"
"It hadn't crossed my mind," one prospective homeowner replied when asked if he was giving any thought to the misfortunes of the previous homeowner. "I look at it as more or less an opportunity."
An opportunity to then join the zombies at the mall's home furnishing store, no doubt.
The other side of the subprime crisis coin is what the subprime securities did to the balance sheets of America's proudest and most austere names of commercial finance.
Through much of the late summer and autumn, I elaborated on this site how it was then being revealed how some of the bluest names of American blue-chip finance, names like Bear Stearns, UBS, Merrill Lynch and Citibank, had treated subprime-related and originated debt securities not as the highly speculative investments they have now revealed themselves to be, but as hot dogs at the quintessentially American "sport" called competitive eating, greedily stuffing as many subprime securities down their fat portfolio gullets as their trading desks could find.
When it became obvious just how little real value these securities actually contained, the tumbrels rumbled down Wall Street and the heads rolled, most prominent among them Merrill Lynch chief executive officer (CEO)Stanley O'Neal and Citigroup CEO Charles Prince, along with roughly 100,000 other finance-related jobs. So far, US financial conglomerates have "written down" (ie admitted as most likely worthless) about US$80 billion of subprime-related debt. Everybody knows there will much more to come; that the total amount of writedowns may finally end up in the $250 billion to $400 billion neighborhood.
Still, as 2007 drew to a close, Wall Street seemed quite complacent with the prospect of around another $300 billion or so of American finance capital being wiped out of existence.
With the exception of mortgage insurers such as MBIA (who probably sang "Auld Lang Syne" for themselves after learning that they will soon have a Warren Buffett financed entity as a competitor), most of the stocks of America's finance industry have held at the lows of mid-November, before Federal Reserve chairman Ben Bernanke raised the white flag and indicated his willingness to continue cutting rates. Some, like Morgan Stanley and Goldman Sachs, even show signs of the beginnings of a rally.
Perusing comments from traders, I see some credit accruing to Bernanke from this at least temporary respite from the long fall off the cliff that most of the financial sector suffered in 2007. A lot more is being given to the real heroes of the end of 2007, the sovereign wealth funds (SWFs) , the huge Asian and Middle East pools of government capital that are beginning to fulfill my prediction that, flying out of the sun like Han Solo in the Millennium Falcon, they would save the day for plucky little American finance capital. ( I first wrote of the likelihood of US finance capital being rescued by SWFs in my August 21 ATol piece When the big guns fail, call in China, and when the rescues actually commenced, my November 29 ATol piece, Selling the US by the dollar).
With the belief now pervading the markets that the SWFs are going to be buying up American finance, US traders are commensurately less willing to sell its stocks, figuring that it's better to hold on to them now in order to sell them dearer to the SWFs later.
Am I saying that the subprime crisis is over, that its once again morning in America, that all Americans can once more, after morning services at the megachurch, settle down in front of the 50-inch plasma TV with rack upon rack of baby-back pork ribs to watch Dallas defeat all comers in the NFL playoffs?
Not in the least. If it turns out that the total subprime bill is substantially in excess of the current projected figure, say past $500 billion or more, the bloodletting on Wall Street will resume, as it will should a major financial institution actually shutter its doors and fail.
What I am saying is that for the first time since at least last spring, Wall Street seems to think that it can see the far side of the subprime crisis. Yes, there's plenty of bad news now, and plenty more to come, but bad news is an essential component of rising stock prices - the time to worry is when the news is all good, not all bad. An old stock market adage is that bull markets climb a wall of worry. At least for now, Wall Street seems to think that it can at last see over the wall.
Another old Wall Street adage, sometimes attributed to one of the barons Rothschild, is to "buy when there's blood in the streets". Maybe Stan O'Neal and Chuck Prince's headless corpses fit the bill for that.
What about the American consumer and homeowner, the other main actor in the subprime drama? A backbone of conservative, free-market economic theory is what is called the "rational expectations" school of economic thought. This theory states that economic actors, be they investors, business owners, farmers or consumers, keep tabs on the economic news of the day, make an informed assessment of what the news means for their individual future prospects and then act accordingly. They spend and/or invest more should they believe future prospects are bright and cut back if things look less promising.
If rational expectations were right there is no way we would have seen the roughly 3.6% rise in holiday retail spending that America saw for this just concluded holiday season. This was less than in the booming years of 2004-2006, but still, you only had to go back to 2002 to find a similarly "bad" holiday season. If you listened to many pre-holiday economic prognosticators, you might have thought that America was facing the worst holiday season since the soup kitchens and breadlines of the Great Depression, maybe the worst shopping season since the British burned Washington in the war of 1812.
Why didn't rational expectations work? Why did Americans ignore all the bad news to once again be zombies at the mall?
One thing that the rational expectations theorists probably didn't factor into their calculations as to why Americans ignore economic news is that Americans just hate economic news. Whenever it comes on the TV there is a mad, desperate scramble for the remote control to change the channel; anything, whether it be meetings of the local sewage treatment committee on the community affairs cable channel or Venezuelan soap operas, will get some viewing time in preference to actually watching economics news on TV.
Had it not be for the fact that the viewers of business cable channel CNBC have the most desirable demographics of all US television, in other words they're rich, the meager ratings of business and economics TV in America would not have survived past the 1980s.
So the reason that the news of the subprime crisis has not led to a greater contraction of US consumer spending is that most Americans have little or no comprehension or understanding of what the subprime crisis actually is. They know it involves big words and complicated concepts, and in high school or college they got out of their economics requirement by substituting another elective, basketweaving or woodworking, maybe "Contextual Critical Analysis of Bruce Springsteen-101".
What Americans do know is that they have jobs. At 4.7% the US unemployment rate is still very low, just 0.3% off the low for this cycle set in March, 2006. Former US president Harry Truman once said that Americans define a recession as a neighbor losing their job, a depression as them losing their own jobs. By that measure, with American employment still strong, Americans just don't see that much urgency in cutting back spending.
And that's what's keeping the US economy humming. If they don't see a few of the people they used to see in the neighborhood, because they've been foreclosed on and are thus now living in a rental property in a far less desirable location, well, that is sad, but look at the bright side. There's a lot less wait for the swings on the neighborhood jungle gym, or to get a latte every morning at Starbucks.
This is why it is so absolutely critical to follow the monthly US employment reports, starting with the report for December due out on the morning of January 4. As long as the US consumer has a job he is going to keep spending ("Saving? What's that, oh, I know, it's what the goalkeepers in soccer do!") and as long as the spending spree continues there is a safety net as to just how bad the subprime crisis is going to hurt the American, and by extension the world, economy.
Americans feel more secure if they see the headline unemployment number still low. A factor that is probably artificially keeping the employment numbers rosy is the fact that the layoffs in the US construction industry don't really show up in US employment numbers.
That is because it has been an unacknowledged but obvious fact that, for most of this decade, the boom in US real estate construction has been populated by America's signature reserve army of the unemployed, its undocumented, primarily Hispanic, illegal alien workforce. These workers weren't really counted among the officially employed during the boom, and, as housing construction employment now evaporates, they're not now counted as among the unemployed in the bust. (I wrote on the phenomenon of illegal immigrants building US housing in my March 29, 2007 ATol piece Exurbia-built on paradox and hypocrisy.) The hard-working builders of America's homes and hearths are proving to be as disposable as tissue paper, which, if you ever talk to the immigrants themselves, pretty much sums up how they feel America always saw them in the first place.
Like many other observers, I have been astounded at the continuing prosperity of the US economy during the latter half of 2007, a time when the nation's financial system essentially became dysfunctional.
The financial sector and "real" economic sectors are supposed to work in close tandem, with the financial system providing finance for investment and then having the real economy place the profits from that investment back into the financial sector to be turned into more productive new investments.
By all accounts, this transmission procedure broke down in the second half of 2007, as credit quality concerns arising from out of the subprime crisis caused lenders to pull back from loans to even the previously most creditworthy borrowers. Still, consumers kept spending, and the economy kept chugging along, posting a very impressive 3.9% growth rate for the third quarter of 2007.
Maybe we need a new metaphor for the relationship between finance and the real economy. Instead of being something like twin brothers working together in the family business, the free-market ideologues' total deregulation of the financial services industry in the early years of this decade has turned the real economy into the sound, sensible brother capably managing the family business, with the financial sector being the uncontrollably bipolar sibling, prone to extremes of giddy elation (as in the credit creation orgy of 2003-2006 that stoked the subprime crisis) and suicidal despair (as in the current crisis). Meanwhile, the real economy goes to work each day, earns a paycheck, supports its family and the country.
Squeezing the metaphor until it screams, proper regulation of the financial sector is like Prozac. In the colloquial jargon of psychopharmacology, the financial sector needs to get back on its meds.
In what is, according to some media reports, the bleakest time in finance history since the moneychangers were driven from the Temple, Americans keep spending. How can they not? As that the French are justifiably proud of their culture and cuisine, the Germans their engineering and manufacturing prowess, what is it that Americans can be more proud about than their continued willingness to exhaust 200 years of built-up treasure on cheap trinkets that they will dispose of and replace in six months? No matter what the politicians bleat on in the Iowa cornfields about the centrality of Jesus in American life, the country's real unifying faith, affirmed no matter what race, color, creed, gender, or sexual orientation, is mindless consumerism.
In this, the nation's 1,100 enclosed shopping malls are temples to this national faith, with the 500-store Mall of America, in Bloomington, Minnesota, the faith's new Vatican, its shining food court on a hill.
With the consumerist religion flourishing as it is in America, it will take more than what we've seen from the subprime crisis so far to shake the foundations of the faith. A moral philosopher or theologian might question the value of the new creed to its believers' souls; then again, isn't the whole point of being a zombie that you've lost your soul?
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.
Friday, January 4, 2008
Storm warning for Asia
By Chan Akya
Sailors are famously more wary of fire than wind. They are well trained to handle the odd typhoon or five but find it much more difficult to battle a fire on board, especially while carrying flammable cargo. This is roughly the situation facing Asia over the course of 2008, with the region's business community braced for the likely recession in the US that threatens to worsen before any improvement can be discerned, even as they have to look around for dangers much closer to home.
In my review for 2007 (Annus financialitis Asia Times Online, December 22, 2007) the scope of the damage to the global financial system was laid out, with a conclusion that Asian economies could perhaps push through the difficult period if their central banks or governments changed the excessive dependence on exports to domestic consumption. While volatility in economic performance is a given, there were enough reasons to presume elemental shifts that engender positive results.
Some of that may have changed in the last few days of 2007. Firstly, the damage to global investment banks is worse than previously assumed, as extrapolation of current market levels on difficult-to-value securities (Level 3 assets in the bromide parlance of accountants) at the end of 2007 implying that some investment banks have wiped out their entire capital base. Their capital raising with Asian central banks and investment companies highlight their desperation, but the joke may eventually be on the Asians as they realize that they were suckered into buying assets that are in essence worthless rather than merely being worth less (ah, the wonders of semantics, which allow a simple space bar push to determine the difference between a company with 30 billion in capital and one without any capital at all). I will come back to this point later.
Secondly, rising security risks have assumed greater urgency in light of events in Pakistan and Russia over the past few weeks. Make no mistake the assassination of Benazir Bhutto is part of my central hypothesis of Pakistan’s nuclear weapons falling into the hands of rabid fundamentalists (Playing South Asia's World War III game Asia Times Online, November 17, 2007). Tied to a president who has unfortunately cried wolf too many times [1], strategic options for the US are severely limited at this stage.
Yes, the American public is generous in its accommodation of flawed presidents in their last year in office, but even they may choke at the possibility of a war on Pakistan. That limits options to either letting the unpopular President Pervez Musharraf continue in power or endorsing the more Islamist-democratic option of Nawaz Sharif as premier. A classic Devil vs Deep Sea choice, and one entrusted to a lame duck president to boot. The sole winners are the Islamic fundamentalists, whose ability to recruit will improve dramatically in coming months even as they become kingmakers in Pakistan over the near term.
As if the US economy and Pakistan weren't enough to worry about, Russia has wandered into the geopolitical chessboard like a bear nursing one hangover too many. President Vladimir Putin appears keen to open a last strategic front against the US before he leaves office - at least formally - this year. This is most likely to be in the parts of Russia bordering restive Asian states such as Iran and Afghanistan, even if the immediate strategic priority should be westwards towards Europe. The entry of Russia into the quagmire would immediately elicit responses from other regional powers including China and India, not to mention the suitcases filled with gold coins (no US dollars, thank you) that will leave Riyadh airport almost immediately.
Japan and Asia
What I described at the beginning of December as an emerging trend quickly cascaded into the central capital-raising plan for US investment banks by the end of the month. As results for the year ended December 31 are being prepared by major commercial banks, it is quite likely that more capital raising will follow, especially given the rock-bottom prices recorded on some securities during December.
There is another disturbing aspect to the financial meltdown being seen by the various US commercial and investment banks. This pertains to the potential for one of these firms to actually go bust in coming weeks, in turn triggering a failure to pay on various derivative contracts. Now, these contracts have been cited as the major reason for many banks to claim their "net" exposure is small, therefore if any link in the chain fails, the entire chain may collapse.
Imagine that you have a billion dollars of loans to a housing developer, and you bought credit protection from one of your competitors. The net exposure to the housing developer would then be shown as nothing, therefore meaning that you have no danger of losing money if that developer goes out of business. Now if your counterparty fails, you have that exposure straight back on your books, with nowhere to hide as other firms will probably now refuse to provide default protection on this developer.
Bank audit committees can no longer pretend that many of their vaunted "triple A" securities are anything of the sort, or that they are fully hedged on some assets just because they bought protection from another firm that looks just like them across the street. At best, the assets are worth between 20 and 30 cents on the dollar based on the trades seen in December [2], while calculations for net exposure will have to rise sharply. This erosion of capital is perhaps the reason why a number of investment banks rushed to shore up their capital by entering into capital structure deals with their accommodative Asian friends. As I wrote in my year-end review cited above, the capital injections will prove insufficient and it is quite likely that Asian investors will lose billions.
Parallels can be drawn to the surge of Japanese investments into the United States during the late 1980s and early 1990s, in deals that led to the acquisition of large tracts of prime real estate and Hollywood studios by Japanese conglomerates. In pretty much every one of these situations, Japanese investors lost money and some even had to file for bankruptcy. Ironically enough, one of the largest Japanese banks that funded such foreign acquisitions eventually fell into the hands of a US private equity firm.
The "pioneering" work of Asian central banks buying stakes in American banks and investment houses thus will come to naught as the real depth of the crisis takes hold. Without capital, these banks will have to offload billions of non-core assets. These include strategic stakes in a number of Chinese banks that will probably flood the stock market before Chinese New Year celebrations can begin in earnest in February.
That set of stake sales will probably be the first blow to regional stock markets this year. Following from there, I would expect other technical factors including the potential for currency regime changes, US economic weakness and reduced earnings multiples to cause further declines in stock markets.
Still, there is enough domestic money chasing stocks in China and India, while foreign investors remain committed to the region. This trend argues for quick reversals of share price declines for these markets over the course of 2008.
Minnows suffer
In the context of economic weakness in the US and Europe, it is likely that investors will continue to increase their exposure to emerging markets, especially as the strategy produced rich returns in 2007. In that light, much of the preceding discussions on the weaknesses of the US financial system appear to strengthen the case for further improvements in the Asian story this year.
That view however ignores what is known as the crowding-out effect, wherein the presence of an attractive and large asset causes the diminution of other assets in its class. Thus, if a liquid government bond were available at 5% yield, no one would really care to buy a company bond at 5.1% as the incremental yield does not compensate for credit quality and liquidity differences. This would push the yield on the latter to perhaps 6% before anyone bothers to be interested. I wrote about this in a previous article (Vanishing minnows Asia Times Online, December 1, 2007).
This is a central risk for Southeast Asian stock markets, as well as others around the region such as Pakistan over the course of 2008. Why should investors have to deal with political turmoil such as what is being seen in Thailand and Pakistan when they can make similar returns without the drama in larger (and hence more liquid) markets such as China and India? Herein lies the major story for 2008, which is increased separation of asset performance across Asian markets and economies. By the end of this year, I very much doubt that anyone will have a unified story to tell about the region.
Notes
1. Crying wolf: first, Afghanistan, where the "war on terror" was started in earnest some seven years ago with the ostensible intention of flushing out terror luminaries such as Osama bin Laden and Mullah Omar, has gone really nowhere. Second, the mess in Iraq with respect to weapons of mass destruction, and we all know how that's going. Third, the fracas over the course of 2007 with respect to Iranian nukes, until the CIA buried that story.
2. Readers with spare time should take a look at the acquisition of E*Trade by Citadel, a hedge fund, at the beginning of December. A number of collateralized debt obligations (CDOs) owned by E*Trade were bought at around 27 cents on the dollar, and while investment banks may well have better quality collateral and structures, they will find it difficult to argue that their CDOs are still worth over 80 cents on the dollar given this transaction.
Sailors are famously more wary of fire than wind. They are well trained to handle the odd typhoon or five but find it much more difficult to battle a fire on board, especially while carrying flammable cargo. This is roughly the situation facing Asia over the course of 2008, with the region's business community braced for the likely recession in the US that threatens to worsen before any improvement can be discerned, even as they have to look around for dangers much closer to home.
In my review for 2007 (Annus financialitis Asia Times Online, December 22, 2007) the scope of the damage to the global financial system was laid out, with a conclusion that Asian economies could perhaps push through the difficult period if their central banks or governments changed the excessive dependence on exports to domestic consumption. While volatility in economic performance is a given, there were enough reasons to presume elemental shifts that engender positive results.
Some of that may have changed in the last few days of 2007. Firstly, the damage to global investment banks is worse than previously assumed, as extrapolation of current market levels on difficult-to-value securities (Level 3 assets in the bromide parlance of accountants) at the end of 2007 implying that some investment banks have wiped out their entire capital base. Their capital raising with Asian central banks and investment companies highlight their desperation, but the joke may eventually be on the Asians as they realize that they were suckered into buying assets that are in essence worthless rather than merely being worth less (ah, the wonders of semantics, which allow a simple space bar push to determine the difference between a company with 30 billion in capital and one without any capital at all). I will come back to this point later.
Secondly, rising security risks have assumed greater urgency in light of events in Pakistan and Russia over the past few weeks. Make no mistake the assassination of Benazir Bhutto is part of my central hypothesis of Pakistan’s nuclear weapons falling into the hands of rabid fundamentalists (Playing South Asia's World War III game Asia Times Online, November 17, 2007). Tied to a president who has unfortunately cried wolf too many times [1], strategic options for the US are severely limited at this stage.
Yes, the American public is generous in its accommodation of flawed presidents in their last year in office, but even they may choke at the possibility of a war on Pakistan. That limits options to either letting the unpopular President Pervez Musharraf continue in power or endorsing the more Islamist-democratic option of Nawaz Sharif as premier. A classic Devil vs Deep Sea choice, and one entrusted to a lame duck president to boot. The sole winners are the Islamic fundamentalists, whose ability to recruit will improve dramatically in coming months even as they become kingmakers in Pakistan over the near term.
As if the US economy and Pakistan weren't enough to worry about, Russia has wandered into the geopolitical chessboard like a bear nursing one hangover too many. President Vladimir Putin appears keen to open a last strategic front against the US before he leaves office - at least formally - this year. This is most likely to be in the parts of Russia bordering restive Asian states such as Iran and Afghanistan, even if the immediate strategic priority should be westwards towards Europe. The entry of Russia into the quagmire would immediately elicit responses from other regional powers including China and India, not to mention the suitcases filled with gold coins (no US dollars, thank you) that will leave Riyadh airport almost immediately.
Japan and Asia
What I described at the beginning of December as an emerging trend quickly cascaded into the central capital-raising plan for US investment banks by the end of the month. As results for the year ended December 31 are being prepared by major commercial banks, it is quite likely that more capital raising will follow, especially given the rock-bottom prices recorded on some securities during December.
There is another disturbing aspect to the financial meltdown being seen by the various US commercial and investment banks. This pertains to the potential for one of these firms to actually go bust in coming weeks, in turn triggering a failure to pay on various derivative contracts. Now, these contracts have been cited as the major reason for many banks to claim their "net" exposure is small, therefore if any link in the chain fails, the entire chain may collapse.
Imagine that you have a billion dollars of loans to a housing developer, and you bought credit protection from one of your competitors. The net exposure to the housing developer would then be shown as nothing, therefore meaning that you have no danger of losing money if that developer goes out of business. Now if your counterparty fails, you have that exposure straight back on your books, with nowhere to hide as other firms will probably now refuse to provide default protection on this developer.
Bank audit committees can no longer pretend that many of their vaunted "triple A" securities are anything of the sort, or that they are fully hedged on some assets just because they bought protection from another firm that looks just like them across the street. At best, the assets are worth between 20 and 30 cents on the dollar based on the trades seen in December [2], while calculations for net exposure will have to rise sharply. This erosion of capital is perhaps the reason why a number of investment banks rushed to shore up their capital by entering into capital structure deals with their accommodative Asian friends. As I wrote in my year-end review cited above, the capital injections will prove insufficient and it is quite likely that Asian investors will lose billions.
Parallels can be drawn to the surge of Japanese investments into the United States during the late 1980s and early 1990s, in deals that led to the acquisition of large tracts of prime real estate and Hollywood studios by Japanese conglomerates. In pretty much every one of these situations, Japanese investors lost money and some even had to file for bankruptcy. Ironically enough, one of the largest Japanese banks that funded such foreign acquisitions eventually fell into the hands of a US private equity firm.
The "pioneering" work of Asian central banks buying stakes in American banks and investment houses thus will come to naught as the real depth of the crisis takes hold. Without capital, these banks will have to offload billions of non-core assets. These include strategic stakes in a number of Chinese banks that will probably flood the stock market before Chinese New Year celebrations can begin in earnest in February.
That set of stake sales will probably be the first blow to regional stock markets this year. Following from there, I would expect other technical factors including the potential for currency regime changes, US economic weakness and reduced earnings multiples to cause further declines in stock markets.
Still, there is enough domestic money chasing stocks in China and India, while foreign investors remain committed to the region. This trend argues for quick reversals of share price declines for these markets over the course of 2008.
Minnows suffer
In the context of economic weakness in the US and Europe, it is likely that investors will continue to increase their exposure to emerging markets, especially as the strategy produced rich returns in 2007. In that light, much of the preceding discussions on the weaknesses of the US financial system appear to strengthen the case for further improvements in the Asian story this year.
That view however ignores what is known as the crowding-out effect, wherein the presence of an attractive and large asset causes the diminution of other assets in its class. Thus, if a liquid government bond were available at 5% yield, no one would really care to buy a company bond at 5.1% as the incremental yield does not compensate for credit quality and liquidity differences. This would push the yield on the latter to perhaps 6% before anyone bothers to be interested. I wrote about this in a previous article (Vanishing minnows Asia Times Online, December 1, 2007).
This is a central risk for Southeast Asian stock markets, as well as others around the region such as Pakistan over the course of 2008. Why should investors have to deal with political turmoil such as what is being seen in Thailand and Pakistan when they can make similar returns without the drama in larger (and hence more liquid) markets such as China and India? Herein lies the major story for 2008, which is increased separation of asset performance across Asian markets and economies. By the end of this year, I very much doubt that anyone will have a unified story to tell about the region.
Notes
1. Crying wolf: first, Afghanistan, where the "war on terror" was started in earnest some seven years ago with the ostensible intention of flushing out terror luminaries such as Osama bin Laden and Mullah Omar, has gone really nowhere. Second, the mess in Iraq with respect to weapons of mass destruction, and we all know how that's going. Third, the fracas over the course of 2007 with respect to Iranian nukes, until the CIA buried that story.
2. Readers with spare time should take a look at the acquisition of E*Trade by Citadel, a hedge fund, at the beginning of December. A number of collateralized debt obligations (CDOs) owned by E*Trade were bought at around 27 cents on the dollar, and while investment banks may well have better quality collateral and structures, they will find it difficult to argue that their CDOs are still worth over 80 cents on the dollar given this transaction.
China piles up interest
By Qi Jingmei
BEIJING - China’s one-year benchmark deposit rate, was increased by 27 basis points to 4.14% effective from December 21, while the one-year lending rate was up by 18 basis points to 7.47%. It the sixth interest rate rise announced by the People's Bank of China (PBoC) in 2007.
The rate for demand deposits was lowered by 9 basis points to 0.72%, unprecedented in previous rate hikes. The interest rate for mortgage loans made from the public housing fund was not changed.
Compared with previous interest rate increases, the latest jump was made against a much more complicated background in and out of the country. With the continuous appreciation of the yuan against the US dollar, the increase will attract more capital into the country, which could worsen the already excessive liquidity here.
However, by lowering the rate for demand deposits, the authorities aimed at reducing the money in circulation and easing the pressure of excessive liquidity.
The earlier rate gains have played a role in checking estate speculation by increasing costs, but they have also placed a heavy burden on home-buyers. The rate increases and the 10 hikes in the deposit reserve requirement for commercial banks have also directly reduced the profits of commercial banks.
Considering all these factors, the authorities have obviously aimed at striking a balance in their multiple monetary policy objectives. The central bank raised the rate for loans by 18 basis points and the rate for deposits by 27 basis points, changing the current margin between the rates for loans and deposits.
Widely called an "asymmetric" rate rise, the differential makes it less profitable for banks to make loans. Thus, it could check their lending impulse, help to tighten money supply and cool the economy. The lowered rate for demand deposits can compensate the potential loss of banks for the overall narrowed margin between loans and deposits.
Different from the earlier rate hikes, the sixth increase did not change the rate of mortgage loans made from the public housing fund, a government-initiated project to offer low-interest loans to salary earners by pooling their own savings and the money handed in by employers.
Since the latest interest hike was just two weeks ago, it is too early to say whether it can achieve policy goals smoothly and its influence on the economy cannot be foretold easily.
Judging from current conditions, the interest rate rise will be a strong aid for the authorities concerned about inflation pressure. According to a PBoC survey, 47.6 % of respondents thought prices rose "too dramatically to accept" in the fourth quarter of 2007 and 64.8 % expected prices to keep rising in 2008.
The wide inflation expectations will affect decisions on consumption, saving, production and investment by individuals and businesses, becoming an engine to drive prices up. It will also increase demand for commodities of investment value and capital assets.
The interest rate rise will tame this expectation by changing the prices of financial assets on the market. It will also stabilize prices and maintain the living standards of the common people.
Under normal conditions, a higher interest rate would drain the capital supply from the stock market by raising the financing costs of listed companies. But an asymmetric rate rise may not do so.
The lowered rate for demand deposits would attract considerable money, estimated to be between 6.8 trillion (US$897 billion) and 8.5 trillion yuan across the country, into deposit accounts of fixed maturity. The rest of the capital would flow to more rewarding investments. The estate market, an alternative investment tool to the stock market, has become sluggish and risky in many cities as a result of cooling policies introduced by the government.
So it is not difficult to predict that the stock market, which is in a relatively lower position than it was even lat autumn, will soon receive money inflows. following the sixth rate rise.
This rise will have a minor impact on home-buyers, most of whom have chosen to repay their mortgage loans over a 10-year period or even longer. At the same time, those seeking investment revenue from estate deals may see potentially higher costs. Most estate speculators borrow loans over a five-year maturity period or even shorter, the rate has also been raised this time.
Estate developers, especially those not listed and relying on banks for financing, will feel an even more substantial blow to their expansion or even everyday operations.
After six rounds of hikes, the actual interest rate of the country, the interest rate minus the growth rate in the consumer price index and the tax for interest income, is still under zero. With a negative actual interest rate, bank deposits could decrease at a surprising rate. This needs to be addressed urgently.
Qi Jingmei is an economist with the State Information Center
BEIJING - China’s one-year benchmark deposit rate, was increased by 27 basis points to 4.14% effective from December 21, while the one-year lending rate was up by 18 basis points to 7.47%. It the sixth interest rate rise announced by the People's Bank of China (PBoC) in 2007.
The rate for demand deposits was lowered by 9 basis points to 0.72%, unprecedented in previous rate hikes. The interest rate for mortgage loans made from the public housing fund was not changed.
Compared with previous interest rate increases, the latest jump was made against a much more complicated background in and out of the country. With the continuous appreciation of the yuan against the US dollar, the increase will attract more capital into the country, which could worsen the already excessive liquidity here.
However, by lowering the rate for demand deposits, the authorities aimed at reducing the money in circulation and easing the pressure of excessive liquidity.
The earlier rate gains have played a role in checking estate speculation by increasing costs, but they have also placed a heavy burden on home-buyers. The rate increases and the 10 hikes in the deposit reserve requirement for commercial banks have also directly reduced the profits of commercial banks.
Considering all these factors, the authorities have obviously aimed at striking a balance in their multiple monetary policy objectives. The central bank raised the rate for loans by 18 basis points and the rate for deposits by 27 basis points, changing the current margin between the rates for loans and deposits.
Widely called an "asymmetric" rate rise, the differential makes it less profitable for banks to make loans. Thus, it could check their lending impulse, help to tighten money supply and cool the economy. The lowered rate for demand deposits can compensate the potential loss of banks for the overall narrowed margin between loans and deposits.
Different from the earlier rate hikes, the sixth increase did not change the rate of mortgage loans made from the public housing fund, a government-initiated project to offer low-interest loans to salary earners by pooling their own savings and the money handed in by employers.
Since the latest interest hike was just two weeks ago, it is too early to say whether it can achieve policy goals smoothly and its influence on the economy cannot be foretold easily.
Judging from current conditions, the interest rate rise will be a strong aid for the authorities concerned about inflation pressure. According to a PBoC survey, 47.6 % of respondents thought prices rose "too dramatically to accept" in the fourth quarter of 2007 and 64.8 % expected prices to keep rising in 2008.
The wide inflation expectations will affect decisions on consumption, saving, production and investment by individuals and businesses, becoming an engine to drive prices up. It will also increase demand for commodities of investment value and capital assets.
The interest rate rise will tame this expectation by changing the prices of financial assets on the market. It will also stabilize prices and maintain the living standards of the common people.
Under normal conditions, a higher interest rate would drain the capital supply from the stock market by raising the financing costs of listed companies. But an asymmetric rate rise may not do so.
The lowered rate for demand deposits would attract considerable money, estimated to be between 6.8 trillion (US$897 billion) and 8.5 trillion yuan across the country, into deposit accounts of fixed maturity. The rest of the capital would flow to more rewarding investments. The estate market, an alternative investment tool to the stock market, has become sluggish and risky in many cities as a result of cooling policies introduced by the government.
So it is not difficult to predict that the stock market, which is in a relatively lower position than it was even lat autumn, will soon receive money inflows. following the sixth rate rise.
This rise will have a minor impact on home-buyers, most of whom have chosen to repay their mortgage loans over a 10-year period or even longer. At the same time, those seeking investment revenue from estate deals may see potentially higher costs. Most estate speculators borrow loans over a five-year maturity period or even shorter, the rate has also been raised this time.
Estate developers, especially those not listed and relying on banks for financing, will feel an even more substantial blow to their expansion or even everyday operations.
After six rounds of hikes, the actual interest rate of the country, the interest rate minus the growth rate in the consumer price index and the tax for interest income, is still under zero. With a negative actual interest rate, bank deposits could decrease at a surprising rate. This needs to be addressed urgently.
Qi Jingmei is an economist with the State Information Center
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