Tuesday, December 30, 2008

FROM 2008 TO 2009

For those of us who have made through it, 2008 might well be remembered for personal successes and achievements, but collectively it has certainly set the world back, at the very least in terms of its wealth, health, environment, security and stability. With the possible exception of scientific progress, the faith in linear historical developments has now been duly, albeit belatedly shattered.

This surely makes us wiser. Yet, by itself, this is not a reason to gloat. As Vernon Sanders Law once quipped: "Experience is a hard teacher because she gives the test first, the lesson afterward". And so, let us bid farewell to 2008 without nostalgic sobs. We may in future remember it as those inexplicably 'hard' teachers from schools. In other words, we will remember 2008 better than other years.

Below are THREE LISTS of various events which occurred in 2008 and, deservedly or not, may linger in our memory. I begin with (rather obvious) negative headlines. This is followed by my own very personal view of what was positive throughout 2008. The third list focuses on the absurdities whose copious supply the passing year ensured regardless of the latitude, longitude and season.

The following TWO LISTS shift emphasis to the uncertainty surrounding the upcoming 365 days. I first review the risks of varying impact and probability of occurrence. Finally, to end on a perhaps naively positive note, I outline my wishes for 2009. They range from perfectly possible to nonsensically dreamlike. But then, the beauty of these times is that we are still free to dream. And to blog freely about it.

2008 - THE BAD:
1. Financial crisis deepens (Societe Generale, Bear Stearns, AIG, Freddie and Fannie, Lehman, fund redemptions, Madoff scandal). Severe liquidity breakdown. Volatility at all-time high. Spreads rocket. Markets collapse.
2. Economic crisis begins: US, China, Japan, Europe, emerging markets are all affected. The immediate response stinks socialism, but not (yet) protectionism.
3. Russia invades Georgia
4. China destroys Tibet
5. Cyclone in Burma
6. The situation in Afghanistan worsens
7. Zimbabwe violence, false hopes and misery
8. Terrorist siege of Mumbai
9. Sichuan earthquake
10. Kenya tribal violence
11. Iran is building up its military capability
12. Crude oil at $147/b
13. Rice prices destabilize markets in West Africa and Southeast Asia
14. Irish referendum freezes Lisbon Treaty
15. Iceland collapses
16. Near defaults in Hungary, Argentina, Pakistan, Latvia, Bulgaria and South Korea
17. Sarah Palin’s neo-fascist harangues stigmatize the ‘bad people’
18. Israel attacks Gaza in response to Hamas’ provocations
19. Fighting resumes in eastern Congo
20. China poisons milk, and not only milk
21. Rioting becomes politics in Thailand
22. Youth riots in Greece
23. Somalia’s piracy proves a rare winner in the Year of Losers
24. Al Qaeda successfully destabilizes Pakistan
25. The Jeremiah Wright case raises questions about Obama’s judgment
26. Clinton as a Secretary of State raises such questions a notch further …
27. Governor affairs reveal the corrupt nature of US politics – from Spitzer to Blagojevich
28. China’s Communist-nationalist propaganda nauseates in “Olympic” sauce
29. Power crisis hits South Africa and China. Supply constraints fuel coal price boom.
30. Doha Development Round negotiations fail
31. Venezuelan nationalizations
32. Fascist upbringing for Russian youth intensifies
33. German politics loses its Right
34. Israeli politics loses its Left
35. Sectarian violence in Nigeria
36. Violent riots over alleged election fraud rock Mongolia
37. Typhoon in the Philippines
38. Hurricane in Haiti and Cuba
39. NATO fails to agree a Membership Action Plan to admit Georgia and Ukraine
40. Tensions in the Turkish and Iraqi Kurdistan pit Ankara against PKK’s positions
41. Maoist Sendero Luminoso reappears in remote regions of Peru
42. Polar bears on endangered species list
43. Saddening departures: Edmund Hillary, Mahmoud Darwish, Bobby Fisher, Harold Pinter, Sydney Pollack, Robert Rauschenberg, Alexandr Solzhenytsin, Paul Newman, Hector Zazou and Lars Hollmer

2008 - THE GOOD:
1. Obama won !!!!!
2. After 13 years on the run, Radovan Karadzic is caught in Belgrade
3. Ingrid Betancourt freed in Colombia shortly after Bogota hobbled FARC’s operational capability in Ecuador
4. Iraq’s (tentative) improvements in State building
5. Some Olympic glory (mostly Jamaican and in the fish-swimming events)
6. Pervez Musharraf bows out in Pakistan
7. Doha compromise averts further bloodshed in Lebanon
8. Constitutional crisis in Turkey avoided when the Court rejects a call to ban AKP
9. Kosovo declared independent
10. The Dalai Lama meets with Bush and with Sarkozy
11. The President of Sudan Omar al-Bashir indicted by the International Criminal Court
12. John McCain’s concession speech
13.The founding of COPE promises the creation a viable (?) opposition in South Africa
14. The Pope blasts pedophile priests during his trip to the US
15. Liberia’s Charles Taylor is put on trial at the Special Court for Sierra Leone and Rwanda’s Theoneste Bagosora is condemned to life imprisonment by the International Criminal Court for Rwanda
16. Gordon Brown thrives in crisis: not a bad performance at all…
17. After 40 years, Spain wins Euro soccer
18. Relative peace in the Taiwan Straits
19. Nambu, Kobayashi and Masukawa receive Nobel Prize in physics for their work on asymmetry
20. Particle accelerators at CERN are now ready to tell us more about it all…

THE ABSURDITIES OF 2008 (almost funny, except, they were true):
1. Private jets bring CEO beggars from Detroit to Capitol Hill
2. Greenspan spits it out: “I was wrong”
3. From London to Paris to Seoul, the Olympic torch “tour” of shame
4. “President” Dmitry Medvedev learns to walk
5. Sarah Palin’s family (was it Piper, Steeler, Rodder and Plater?) can see far from their window
6. Carla Bruni-Sarkozy mania towers over her husband’s high heels
7. Chinese sports fans “forgive” athlete star Liu Xiang for his failure to run 110m hurdle heat
8. Russian war games in the Caribbean (oh, phleeeze!)
9. Hillary Clinton’s tears in New Hampshire save her campaign (for a while). Then the poor woman suffers from Bosnian amnesia, probably caused by sniper fire.
10. Two Russian sumo wrestlers are banned for life by Japan’s Sumo Association for smoking marijuana. What were they thinking? That it would help them regain slim looks?
11. Joe the Plumber almost wins the US presidential ‘debate’, but in the process he inadvertently turns the 1.5% Americans who make $250’000 or more, into a “middle class”
12. Eureka! Eggheads at National Bureau of Economic Research take a year to recognize that US economy has been in recession.
13. Chinese children pose as ‘adults’ in gymnastic events (not enough baby formula perhaps?)
14. Forecasters’ demise. At the beginning of the year, Goldman Sachs made its 12-month predictions: crude oil at $105 per barrel (it is $38/b), natural gas near $11/mmbtu (it is $5.8), gold falling to $750/oz (instead it went up to $869/oz), Korean Won at 900 to the dollar (it is at 1260)…and the Fed Funds rates were supposed to be at 4% (it’s 0.25%)…
15. 40 years after USSR, China sends a manned rocket for a space walk
16. Helicopter Ben in action. US prints $7.6 trillion in bailout money during the first 11 months of the year. The combined debt is now apparently at $67 trillion.
17. Hugo Chavez sings on TV (and then sends troops to the border with Colombia)
18. It snows, so China can’t go on holiday. The Olympics is over, but China forgets to come back from the holiday.
19. Nearly thirteen centuries after Vikings established the first Russian state, Russia offers to “buy” Iceland (like you buy an aircraft carrier)
20. Rudi Giuliani’s presidential “campaign” founders in Miami. Thumbs down, but no one is thrown to the alligators.
21. North Korean nuclear “negotiations”: now you see it, now you don’t
22. Castro dynasty holds on in Cuba (sign of change: people are allowed to buy cellphones)
23. Hollywood strike saddens the nation, but somehow no one rushes with handouts
24. Education in action. Kindergarten kids in California are asked to pledge never to use anti-LGBT (lesbian, gay, bisexual and transgender) slurs…
25. At the peak of the market in June, famed pundits from Jim Rogers to Don Coxe hail commodity investments and launch new products. But they are young enough to be in it “for the long run”.
26. Mr McCain goes to Washington (to save us from the economic crisis). We are relieved.
27. Silvio Berlusconi is back (no grey hair here)
28. John Edwards’ campaign-financed lovemaking fails to ruffle his hairstyle
29. Having scrapped onboard service, punctuality and courtesy, some US airlines now charge for checked-in luggage, a cup of tea and a glass of water. Lavatory use and pillows will be next.
30. Russia recognizes South Ossetia as “independent”. North Ossetia remains ‘part of Russia’.
31. Paulson’s summertime tale: ‘sorry, children, no shorting allowed now’
32. Anglican Church faces a schism. The world holds its breath.
33. Food fascism invades US schools: a child in Connecticut is suspended for buying a candy bar
34. Oprah Winfrey can’t lose weight and Madonna lives sexless life for six long months…
35. Surprise: O.J. Simpson is a bad man. No SUV chases this time due to political incorrectness of the vehicle.

2009 - THE RISKS:
1. The world plunges into global deflation, hobbling both the deleveraging private sector and the re-leveraging public sector. Oil hits $20 per barrel.
2. Competitive currency devaluations
3. Social instability in China redirects the regime to nationalist adventurism abroad
4. Hillary Clinton derails Obama’s agenda
5. Al Qaeda’s operatives in Algeria and Morocco mount a terrorist offensive in Europe
6. Iran gets the Bomb
7. Israel strikes Iran. Iran retaliates. US navy presence in Hormuz strengthens radicals in Tehran.
8. Impoverishment in China triggers another wave of Avian flu
9. Financial deleveraging and precautionary hoarding of capital continues apace
10. Czech Republic’s Vaclav Klaus chairs EU and derails whatever European cooperation there still is
11. Benjamin Netanyahu wins elections in Israel but depends on Mosche Feiglin’s support
12. Felipe Calderon loses the war on drugs in Mexico
13. Obama’s administration taxes capital, and in a chilling reminder of the 1930 Smooth-Hawley act moves to “protect American jobs” from international competition.
14. Trade financing collapses, leaving strained value chains and empty shelves
15. Hamas does what Hezbollah did in 2006, i.e. strengthens radicals after another Israeli military failure
16. In the wake of the above, Egypt falls into chaos, fuelled by Muslim Brotherhood’s radicalization. Amr Khaled’s televangelism loses audience.
17. Major Internet glitch
18. Al Qaeda wins control in the tribal areas of Pakistan
19. Zulus and Xhosas resort to violent means in the fight for political spoils and sinecures in South Africa
20. India intervenes against ‘terrorist camps’ in Pakistan
21. Russia cuts off gas to Ukraine and Europe
22. From US to France to Slovakia to Russia, global automotive industry dies out, rising jobless rates by millions
23. Collapse of $54 trillion market in credit default swaps
24. Global protectionism kicks in (no trade financing, non-tariff barriers, NAFTA moribund, WTO defanged)
25. Global capital expenditure fails to respond to stimulus. Lack of upstream investment lays the foundations for future hyperinflation.
26. Peer Steinbruck wins elections in Germany and allows Russia to reclaim proxy influence in the Baltic Countries
27. Canada disintegrates
28. Bolivia fractures in a violent manner. Santa Cruz struggles to have its independence recognized internationally.
29. Failure to reform “mark-to-market” rules further undermines confidence in the market
30. The Dalai Lama dies, opening the way to overt (and bloody) independence struggle in Tibet
31. Kim Jong Il dies and leaves unstable vacuum of power in North Korea
32. Western military intervention in Darfur fails
33. Warren Buffett proves to be yet another scam…
34. Populist politicking in US kills a proposal to declare a holiday on payroll tax
35. Cash-strapped local governments raise taxes, offsetting national stimuli…
36. Kosovar mafia and Salvadorian maras shake transatlantic hands after yet another year of rising crime rates

1. Osama bin Laden and Ayman Al-Zawahiri are captured and tried for their crimes
2. Major breakthrough in combating cancer (through stem cell research?)
3. International financial and economic cooperation is made possible under Obama/Volcker leadership. Counterparty confidence returns and usable collateral reappears in the market. Interbank funding conditions improve.
4. Nicolas Hayek’s companies in Jura accelerate successful commercialization of a fast electric car
5. Low sunspot activity delays climate change and helps extend glaciers
6. A public exchange for credit derivatives is inaugurated with success
7. Russia runs out of foreign reserves due to its ill-conceived defense of the ruble in the environment of low oil prices. Brave Russians bring the end to the decade of Putinism.
8. Governor Bobby Jindal rises to lead the Republicans. The influence of social conservatives marginalized.
9. Mohammad Khatami runs against Mahmoud Ahmadinejad in Iranian elections and wins
10. Zhang Qingli, Secretary of Communist Party of China in Tibet is put on trial at the International Criminal Court
11. The Fed prints even more dollars and when the bond yields rocket, it buys them back, keeping interest rates low and transferring the wealth from creditors to debtors. In the process, inflation cuts down the debt burden and a weakening dollar radically reduces the value of foreign reserves accumulated during the preceding decade thanks to the mercantilist policies of oil producers and China.
12. Gold protects investors exposed to weakening dollar
13. Global airline industry consolidates into a binary market: low cost and high-end, killing hapless US airlines (and ‘rude hostess’ jobs) in the process
14. The Amazon forest conservation system brings first territorial gains in Brazil. Indonesian officials are invited to study the progress.
15. Dick Cheney, former Vice-President of the United States is accused of, and tried for maintaining links with Halliburton while in public office in 2003
16. In a breakthrough initiative, US induces Israel to abandon illegal settlements in the West Bank. A viable Palestinian state is made possible.
17. Israel gives back Golan Heights. Syria becomes a US ally.
18. EU boosts its defense capabilities and cooperation with NATO, with positive impact on the military engagement in Afghanistan and Darfur
19. Further development of the global market in liquefied natural gas (LNG) and EU investments in Central Asia begin to wean Europe of its dependence on Gazprom
20. Further opening of arable land to cross-border investment in agriculture
21. Governments revitalize corporate credit markets
22. Taiwanese hi-tech companies revolutionize touch screen technology, ushering in a new era in notebook development
23. After international navy forces squash the pirates, the former Somalia is officially divided into three states (Somaliland, Somalia, Puntland) in an international conference which also solves Maakhir and Northland issues
24. Germany, Brazil, India and Japan become permanent members of the UN Security Council and begin to reform the organization
25. A modern, multiracial bi-party system is born in South Africa, with COPE building a strong opposition to ANC. Cyril Ramaphosa returns to politics.
26. Supported by international forces, Kinshasa finally cracks down on Interehamwe’s forces. Rwanda’s security is safeguarded and Laurent Nkunda neutralized.
27. Robert Mugabe dies. Structured international assistance helps Zimbabweans rebuild their country
28. Belarus opens up to the West and sucks in investment, offering high rates of return
29. A new technology is developed to denitrify waters contaminated by overferilization
30. Commodity prices stabilize. Saudi Arabia manages to protect the markets from high volatility in oil prices.
31. Serbia swaps the Kosovo emotionalism for EU membership. Hardline nationalists marginalized.
32. Venezuela’s Chavismo turns less rhetorically virulent and more pragmatic, avoiding clashes with Obama’s administration
33. Beijing redirects defense, navy and 'star wars' funds to education and health care reform
34. Music sharing via internet remains free
35. FARC signs an unconditional peace agreement in Bogota. End to decades-long civil war opens up Colombia to investment and tourism.
36. End to the Yushchenko/Tymoshenko political feud in Ukraine helps stabilize the economy
37. Greek government chills out: less anti-Macedonian rhetoric, more labor market reforms
38. Guinea (Conakry) escapes violence in its transition to democracy
39. Good monsoon relieves pressure on agricultural economies of South Asia
40. A post for an infrastructure Czar is created in the White House, helping to channel stimulus funds without subcommittee filibuster
41. US and Germany regulators abandon plans to destabilize the “banking secret” rules in Switzerland
42. A power-sharing deal ends the political stalemate in Thailand
43. Guantanamo Bay detention centers closed
44. With little export dependence and much interest rate firepower, Indonesia joins Brazil to emerge as the most defensive emerging market anchor for global investment
45. Roger Federer beats Pete Sampras’s grand slam record
46. Due to rising populations, polar bears, tigers, snow leopards, black rhinos and Iberian lynxes are taken off the endangered species list
47. China and Iran abolish death penalty
48. Justice and peace in Burma, Xinjiang, Kashmir, Pakistan, Darfur, Afghanistan, Kurdistan, Kivu, Palestine, Abkhazia, Ossetia, Chechnya, Niger Delta, Ogaden, Eritrea, Cote d’Ivoire, Sri Lanka, Northern Uganda, Michoacan, Mindanao, Dagestan, Fiji, PNG’s Highlands, Bougainville, Tibet, Mauritania, Southern Thailand, Crimea, Nagorno Karabakh, Corse and the Basque Country.
49. Atlantis is re-discovered. Religious zealots and fundamentalists of Evangelical, Sunni, Shiite, Judaist and Hindutva ilk are all relocated to live there in their own, pure way.

Postjudice wishes you all the very best for 2009.

Sunday, December 7, 2008


Over the last several weeks, the focus of the market has shifted from ‘financial crisis’ to ‘global economic crisis’. The surplus savings economies that were supposed to bail us all out have exposed structural weaknesses of their own. For years, the petro-economies and mercantilist Asia plunked their savings in the supposed safety of US Treasuries. This investment inertia has not only led to the relative atrophy of these immature economies’ own capital markets (as a percentage of their GDP), but also crippled any development of their risk management capabilities. If the investment in US Treasuries was, by definition, riskless, then why bother assessing uncertainty of other investments? Risk aversion and paucity of other investment options have now resulted in a new bubble –in cash (mostly US dollar and the Yen) and in US Treasuries, which, at the time of writing yield barely 2.56% on a 10-year note.

When the fabled sovereign wealth funds and other pools of capital were eventually deployed into the Western assets in the late 2007, the subsequent losses proved to be politically unacceptable. Not surprisingly, the massive reserves accumulated by mercantilist China will now most likely be deployed to re-nationalize domestic assets where personal connections allow for building trust networks, an age-old bulwark against risk.

The unfortunate corollary of this collapse in trust is that it not only prevents any rebalancing between the external surplus economies and the external deficit economies, but that it could lead to the collapse of the trading system as we have known it.

Since early in this decade, the global trade flourished even if no new trade liberalization round has been achieved. The integration of China into WTO in 2001 was a major step boosting the trade flows. After the move to re-industrialize its economy (2003-2004), China’s trade links to other emerging markets allowed many smaller economies to flourish. On a net basis, the losers were small textile producers. The winners were commodity exporters.

The commodity imports were, next to craved foreign technology, the only form of large scale imports condoned by China’s mercantilist rulers. Instead of growing internal demand and a balance external accounts, China developed an economic system favoring massive exports based, as it was commonly believed, on cheap labor and undervalued currency. But there was a third factor in this extraordinary export boom. For centuries, China’s economy stagnated because of trust deficiency outside of family networks. The clans were broad-based and often spread their merchant tentacles around island South-East Asia. But further out, in the wild, threatening world of non-kin, plagued by greed and exploitation, you could only purchase something if you paid for this up front. Now, this is exactly what most of us do in Carrefours, Walmarts and Ito Yokados if we decide not to pay with a credit card. But it is different in long distance, long term trade. The British excelled early on in global trade networks because of extraordinary expansion of a reliable merchant credit and credit insurance system. Letters of credit (LOC) were introduced by the banking system to facilitate the flow of goods and ensure the eventual payment.

As China slowly integrated into the world economy, the letter of credit system appeared also in its dealings with overseas trade partners. Buyers’ banks would issue an LOC to the seller, whose own bank would subsequently discount it. The growth was extraordinary. By 2007, almost 70% of China’s exports were financed with LOCs, leaving a smaller percentage to government-led insurance discounting, as well as traditional up-front payments and down payments. Two-point factoring, another form of international trade financing did not expand as fast in China as this system may easily fall victim to a fraud.

On the import side, so vital for supplying China with raw materials, letters of credit were practically the only avenue for trade financing. It is in the current collapse of China’s LOC system that we should see the roots of the devastating, deeply deflationary, catastrophic slump in most commodity prices. It is devastating and catastrophic because unknown in its depth and extension, or so we hear from Australia’s largest company whose ships full of bulk materials float aimlessly in search of an eventual buyer.

Throughout China’s boom years, Beijing failed to develop alternatives to the LOC system, which are necessary to keep the trade flowing during periods of credit stress. Factoring could have been one way to deal with the issue. It is astounding that in an economy of 1.3 billion people, the Chinese government issued only two import factoring licenses over the last 30 years. Even worse - the lack of proper reform of the credit system in China means that exporters into China cannot properly assess credit worthiness of the buyers. 30 years since the opening of China’s economy there still is NO proper credit system in place which would allow you to track information about the buyers, regulate disputes and collect insurance! You do not know who you deal with through proper credit assessment (and risk assessment). You ‘know’ it by holding lengthy, MSG-sprinkled dinners in one of Chinese restaurants. We are back to the limited circle of trust, and away from the modern, albeit never infallible, credit system.

This stunning revelation is coming to our attention only now, when Chinese importers default on ‘long-term’ contracts or disappear into the thin air. Chinese banks are equally fearful of discounting letters of credit for the country’s exporters. This is risk management in the form of risk aversion. Chinese banks do not trust their counterparties overseas, fearing massive bank failures and complicated recourse procedures. Although fear has gripped many corners of the global credit market since September, no single trade financing institution has collapsed as yet. Chinese banks’ risk aversion is, therefore, a self-fulfilling prophecy leading to the ultimate collapse of the trade links. Only yesterday did we hear that the world’s largest container producer, based in Shenzhen, had stopped production since October due to lack of demand. And although it should be expected that the government intervenes in export promotion through more wide-ranging use of insurance discounting, for now many Chinese exporters require up-front payments from overseas importers, which is highly damaging to these partners’ working capital. At a time when equity and credit markets send a deflationary signal that “cash is king”, parting with your current assets to secure imports is a finite solution at best. And after that? Empty shelves at Walmart?

All the hopes that the global crisis will concentrate the minds around a global solution have now been dashed. Mr Wang Qishan and Mr Medvedev are barking at Washington, faulting the US economy’s recession not only for their fast evaporating riches, but also for undermining the very basis of their power, this implicit pact with the local populations that a quest for freedoms is but a secondary, and easily dismissed footnote under the universal desire to live in opulence. Russia’s rapid impoverishment is unprecedented. Within only two months the country which last summer postured with military swagger has lost a staggering $123bn of reserves trying to shore up the rouble, an effort eventually abandoned. China’s growl is even more ominous. Beijing angered EU by executing an Austrian citizen’s father for allegedly ‘spying for Taiwan’ (read: revealing secrets about Chinese leaders’ health). In a huff, China has now also called off a high level summit with European Union after President Sarkozy agreed to meet with the Dalai Lama. Beijing had recently rejected Tibetan envoys’ proposals for regional autonomy (which is enshrined in PRC’s constitution). Yes, the Communists intend to run Tibet’s allegedly ‘Autonomous Region’ directly from Beijing, in a blatant breach of their own constitution. But the economic collapse and 70m unemployed Chinese workers (and counting) are clearly making Beijing fearful, increasingly angry and paranoiac. The country has cornered itself into overdependence on US Treasuries’ performance, but this is only the latest bubble of many that formed over the last 15 years. Since the dollar bottomed in mid-July, yields on 10 year Treasuries have fallen 21%. This is exactly equivalent to gain in US dollar index. This rally, and an even stronger appreciation in the Yen would mean that the world bracing for a deep deflation. Yet, at the same time, in dollar terms, gold has lost only 21% since that mid-July anchor. This means that the yellow has stayed flat in constant dollars. And gold-buying is a sign of inflationary insurance further down the line, which could be brutal when the velocity of money picks up again and the Fed will rue the extraordinary expansion of its balance sheet from $100bn in September to $750bn sixty days later…

The thesis of a very sharp inflation following the impending deflationary spiral is increasingly being hushed about. Someone calculated that, at $7.5 trillion of new bailout money, a stack of $1000 bills would build a tower 760 miles high….

Meanwhile no concomitant expansion has taken place in gold, or indeed in other commodities. There is no doubt in my mind that dollar-denominated assets will again, as they did in the late 1970s, overshoot on the upside, powered not only by this extraordinary expansion in liquidity, but also by the unprecedented contraction in capital expenditure and new project development. The combined effects of collapsing demand, declining corporate profits and surging corporate bond spreads leads not only to shutdown of marginal production, but to outright destruction of future productive capacity. Already, OPEC is warning that the current oil prices are discouraging investment into new capacity. As the Russian oil production ebbs away from the next year on, significant capacity constraints may hit again in the upcycle, even before the global transportation eventually weans itself of its overdependence on diesel, gasoline, jet fuel and bunker fuel. In the mining industry, an estimated $200bn worth of capital expenditure has been taken off the table for the next 4 years. Essentially, the miners are telling China: “you do not want our stuff? Well, you won’t get it when you need it”. Mothballed projects, closed smelters, silent refineries, cold blast furnaces and idle berths do not augur well for the global economy in 2009. But when the tide turns, there will not be enough “stuff” to satisfy the reinvigorated global demand. The investment cycle has been quick to drop to near-zero levels. It will eventually come back, but with a lag. And when it does, brace for mass inflation and high interest rates. But in the meantime, pity Greek shippers.

So are we all going for a long vacation, nesting at home with a new Wii? Maybe not. There are pockets of capital and pockets of activity. Very few people made money in the highly volatile 2008. But there are those whose activity was never too fond of cycles and volatility. Family estates and private operators will pick up listed assets on the cheap. Cash-heavy Japanese trading companies will expand again just as their more market-sensitive competitors need to protect their balance sheets and shrink their portfolios. Drug cartels will thrive in the economic slump and benefit from increased crime rates. What was boring and unexciting in the boom may turn out to be highly rewarding and promising in the slump. And whoever can properly time a ‘long oil, short US Treasury’ trade will be celebrated as the brightest man on the planet.

But there is also a danger. A danger of such a deep socio-economic dislocation that the world re-emerging from this recession could be radically different from the world of allegedly benign ‘global imbalances’. Thai middle class’s anti-democratic street activism could set a dangerous precedent whereby privileged elites fail to take responsibility for the welfare, education and social advancement of other social groups which happen to share the confines of the same international borders. This indifference and latent antagonism, common to many fast growing economies, may, in economic slump, turn into open hostility. It could pit city vs countryside, as it does in Thailand. But it could pit religion vs religion. Majority vs ethnic minority. Nationals vs foreigners. Our nation vs that wicked neighbor. Scapegoating could easily gain traction among vast numbers of unemployed, young and increasingly angry males. And if they do not have enough money to get married or to pay for sex, their anger may boil over. Watch out for skilled demagogues harnessing that frustrated energy.

Fault-finding, angry talk and competitive currency depreciations by Moscow and Beijing will not help resolve this crisis. Rebalancing global demand patterns, on the other hand, would. There are, alas, no global institutions that could constitute a suitable forum for such a solution. Integrating the superficially capitalist economies into the global trade and investment network worked wonders in the boom. It can pin us down to the bottom in the recession. This morning we received data on China’s electricity production. It fell 7% year on year. China is really shrinking. The world should shudder.

Saturday, November 8, 2008


Last weekend we decided to travel towards the Arctic Circle to see migrating polar bears. Although we had had such a vague plan for a long time, we finally pushed the button on it after hearing alarmist reports about these largest land carnivores were becoming endangered species.

It all made sense. After all, polar bears do not prey on land creatures, but mostly depend on ice cover to hunt ringed seals and bearded seals, which must surface through breathing holes. The bears’ extraordinary sense of smell helps them detect the doomed pinnipedia. Their massive forward paws have evolved to make ice breaking look easy. But if there is no more ice, then the bears will be in trouble, forced to swim over large distances between isolated ice floes in the hope of catching the faster and more agile marine mammals. Or so the story goes…

The locals quickly disabused us. People who have been watching bears for decades are quick to laugh off the naiveté of the somewhat uniformist reports. Apparently, bears migrate through the region as they always have, and in large numbers. Watching these white giants stomp, face off, encroach on each other’s territory, fight, wrestle, play and frolic, as we did, it was difficult to think about them as a population in distress. Granted, such casual observations of ecological health are anecdotal at best and carry no statistical validity. The enthralling tundra safari experience, as well as locals’ elucidating comments, focuses only on one of some 20 polar bear populations that inhabit the deep north of our globe but interbreed very rarely. But it is the population in question – the Hudson Bay bears –that has, after only a few years of warmer climes developed an astounding level of adaptation to the changing conditions.

To be fair, these bears still favor the yummy staple of ringed seal fat and will slip adorably on the first ice, through which they are led by the irresistible olfactive call. But the relative unreliability of the freezing seasons has turned these animals to seek substitutes. Woe to caribous. Woe to rodents. Woe to the arctic fox. On land, the fluffy, round giant is able to bolt at incredible speed of a hunting feline. So, who knows? Should winters remain warm, within several years we could even expect to watch exciting NHK, BBC or Discovery Channel documentaries, showing the white beasts charging through petrified caribou herds in a way lions poach wildebeest in East Africa.

Or may be, we will not.

Once in the tundra, north of the tree line, you have enough time to ponder the non-linear enigmas of the climate change. Hudson Bay folks still shudder at the thought of the winter’07/08, the coldest in recent memory since 1993. Indeed, last year the northern hemisphere suffered in an unprecedented way, with deep frost gripping most of Eurasia. Villagers froze in Iran and in Afghanistan. Homebound holidaymakers in China got stuck for days at railroad stations. Power distribution systems broke down. This year’s winter in the southern hemisphere was also unusually cold. Was the whole brouhaha about global warming somewhat premature?

There is no satisfying answer to it as there is no easy explanation for the cold snap in 2007/08. It is possible that Western Europe’s temperatures suffered from increased melting rates of the Arctic ice cap. This mass of lighter, fresh water pumped from the northern latitudes into the Atlantic may have pushed the warm Gulf Stream lower or off its course, depriving Europe’s coast of its moderating role.
As I am writing it, we are already hearing reports about another cool La Niña system approaching America’s shores from the Pacific. Such a phenomenon could mean another dry spell in the Andes, and colder weather in the northern hemisphere, especially in America’s northwest and Asia’s northeast. If this turned out to be true, Southeast Asia and south-western Pacific should brace for another season of floods, with potentially considerable impact on several key agricultural and coal markets.

And yet, if there is anything we can learn from a chaotic system, such as weather, is that no year resembles exactly the previous one. Like in the securities markets, changes make sense only in hindsight and only in the longer term. Not surprisingly, humans are fascinated by what they cannot fathom. Multifactor models do not exhibit monotone relations. Unfortunately, this is what happens when you plug in all the modifications in albedo, Arctic, Greenland and West Antarctic ice sheets, southern oscillation (el Niño and la Niña), Atlantic Thermohaline Circulation, Indian summer monsoons, West African monsoons, the impact of Amazon and Southeast Asian rainforests, Boreal forests, sun flares, cosmic rays, changes to magnetic poles, Greenhouse Gas emissions and the effects of crop overfertilization. Good luck modeling!

But there are certain things we do know. Holocene is bound to be climatically unstable. With the end of the last glacial period some 12000 years ago, temperature anomalies have been commonplace, at least for as much as we can learn from the ice accumulated in polar regions (data from lower latitudes are spotty). But there has been a striking regularity since at least the so-called Maunder Minimum, which lasted for about 200 years and has been often labeled as “little ice age”. This period, immortalized in wintertime canvases of Dutch painters, ended in early 19th century. Since then, a fairly regular succession of 11-year long sunspot cycles provided for a fairly predictable guide to longer term solar activity. Although no scientific proof exists, high sunspot activity has been associated by most casual observers with warmer weather.

But somehow the measurements of recent sunspot activity do not quite fit the cycle predictions. For one, the unprecedented solar flares during the stormy 2005 were not supposed to happen in a cycle that was expected to bottom out in 2006. Nor should the late 2008 qualify, a priori, for a solar activity of low intensity as observed at the moment. The proton storms usually travel from the sun to earth within about two days, causing engrossing auroras in the polar regions. But I caution against travel plans to the frigid Arctic this winter. If you expect to see spectacular celestial displays, you could be sorely disappointed.

What surprises sunwatchers in this uneasy solar lull is that it breaks the regularity of a relatively high sun flare activity that had prevailed during the postwar period. Modern, industrial agriculture has been built around the assumption of consistent temperature and rainfall cycles, but this stability appears unwarranted if longer historical periods are taken into consideration. Some observers even believe that the period of the last 60 years was a climatic anomaly. The problem is that, historically, sudden shifts in sunspot activity seem to have been correlated with dramatic dislocations in food production, as evinced by the starving Chinese cannibals in the 1700s. Conversely, the period following the First Millennium was, apparently, associated with high solar activity. It underwrote sufficient safety in food production to favor pre-industrial exploration (New Foundland), long distance travel (Iceland) and a colonization drive (Greenland) that remained unmatched until the Portuguese ventures five centuries later. Encouragingly, all of these examples point to increased human activity in the higher latitudes, where warming temperatures are mostly beneficial. But should sunspot inactivity truly break away from its predictable 11-year cycles, lower temperatures in tropical regions could, in fact, increase the soil’s capacity to store water and nutrients.

This is not to say that alarmed polar bear fans should not worry about human impact on climate change and long term implications of eventual, higher temperatures. But, like in the markets, the near term weather misbehavior could be the exact opposite of long term consequences. This is what October snowfalls from London to Idaho could signal. The American prairies are now (early November) lying under 2ft snow. And before we realize, our favorite bears could show some mettle and catch the cattle.

Thursday, October 30, 2008


Only several days are left till the final verdict is passed on the relative merits of two finalists in America’s most expensive ever electoral circus. It has been so much fun this time: we have enjoyed a parade including a liberal shrew, a token preacher, a plastic equity guru, a dallying populist, a septuagenarian grouch, a half-black upstart and finally a puck-loving but animal-hating diva.

The onset of the financial crisis messed up the strategies which, amidst fear mongering, would have perkily punted the same “values” message that had brought George W. Bush to power. But the slump in measurable values of homes and pensions has since shifted the rules of the game considerably. So much so that most of the intellectual elite of the country has now embraced a candidate whose official stance on trade would, in other circumstances, make any economically literate voter squeamish.

Will Obama win? The common view is now that the result will hinge on the voting decisions of the independents. Sarah Palin was supposed to rally Hillary’s troops, and she aptly appealed to them in her first public appearance as a vice-presidential nominee. As we now know, the thrust proved short-lived and she instead galvanized the numerically important, yet ideologically isolated minority whose voting record had helped to run the country aground. The independents may be displeased with Obama’s ‘otherness’ as much as with Palin’s increasingly Fascist, ‘shrill, baby, shrill’ wailing tones. Palin’s rallying calls point to an ‘enemy within’, whereby she utilizes sliding signifiers and exploits connotations of fear and alienation. These speeches would make a poor reading as a propaganda piece. But chopped up into an engrossing “call and response” ritual, they confirm the troops in their conviction that someone, somehow must prevent the inevitable.

But is Obama’s win really inevitable? He is close to victory, even though a well-timed video tape from Osama bin Laden could, yet again, help the Republicans and mire the US troops for years to come. Barring such a catastrophic development, the odds against Palin and her presidential running mate are high. Many independents may have now fallen under Obama’s unquestionable personal charm, his calm demeanor, and smooth-as-silk delivery in the otherwise inconclusive debates. Obama’s supporters stress the professionalism of the faultless campaign as a proof of his considerable managerial skills. Yet there are still many others who need another ‘ticking point’ to mark the Obama-Biden slot at the top of the ballot. Will the fear of Obama’s “past associations” trump the genuine fascination with this ambitious young man? Will the scare mongering of a “socialist” tax policy really frighten the middle class?

To be true, the red flag of “socialism” in America is an argument that is just inane and vacuous as Western Europeans’ congenital rejection of “religion” in politics.
Just as Europe’s political ethics is rich in references drawing on religious traditions, so did the US government, on occasion, assume a larger role in the country’s economy than it has been the case since Ronald Reagan’s presidency. As the turbulent Paulson era is now drawing to a close, the battle against “socialism” appears to have been lost without a single shot, regardless of Republican distaste for the ‘Swedish’ solution. Indeed, despite triumphant anti-Americanism on the European left, we may now all be in the same, centrist, boat, whether in America, Sweden or elsewhere. In the third quarter of 2007, the Swedish automaker Volvo received 41000 orders for its trucks. This year, in the corresponding quarter, the same company received barely 115 orders. The collapse of transaction flows in the ‘real economy’ - in America, in Asia and in Europe - should serve as a timely wake-up call against any exploitation of the allegedly contrasting interests of the Wall St and the Main St, la rue, la calle, dajie and die Strasse.

It is the market circumstances, still not fully recognized by the proverbial Joe in the street, that have radically altered the plausibility and feasibility of the grand fiscal plans touted by either party with relation to health care, education and other policies. In an effort to save its financial market, the US government has so far only injected an equivalent of about 6% of GDP. When Japan hit the curb in the early 1990s, the country spent closer to 25% of its GDP to finally put the economy back on track. But Japan’s asset values have never recovered to pre-bubble levels and it might, just as well, take a lot longer than commonly assumed for America to return to the 2007 level of asset wealth.

The comparisons with Japan’s balance sheet recession are ubiquitous, but misinformed. For one, unlike Japan, the US is not a net saver, which will make all the talk of ultimate rescue of its economy reliant on external sources. Japan’s stagnant demography made its growth highly dependent on its trade account and on income from overseas investments. The United States, even at dollar’s low last summer, still had nothing much to export. It will not be able to solve its current conundrum through the turnaround in the current account.

Equally importantly, America does not benefit from the social cohesion that characterizes the racially united and monolingual Japan. Over centuries the Japanese society has perfected a team spirit that only island nations can aspire to (shimaguni konjo). I still recall the shock of the sudden confrontation with homeless people around Shinjuku station and in Ueno Park in Tokyo. Yet at the depth of the economic slump and labor market losses, local shops organized distribution of foodstuffs within 48 hours of expiration. In a country ravaged by periodic natural disasters, a sense of common destiny was just too strong for anyone to remain indifferent.

As I visited poor black neighborhoods in the American South last weekend, the memories of Japan’s deflationary decade loomed again. Persuaded by committed friends, I participated in a last ditch pre-electoral “canvassing” effort. Our role consisted in knocking on doors that we would have otherwise never knocked on. And these were ‘doors’ that barely knew the fruits of America’s economic boom of the last 16 years.

Granted, these are not slums. Many of these modest houses are ‘owned’, which, as we now know means little more than a call option of ownership of the mortgaged property. Many others have been foreclosed. Yet something else struck us when we tried to elicit the response from behind those rickety doors. Many pre-electoral statistics rely on a somewhat automated arithmetic and plug in the numbers of African American population as ‘natural’ Obama’s supporters. They could yet prove mistaken.

Race is a big factor in this election – for better or worse. Many so-called ‘liberals’ (a term curiously referring to left-wingers in the US, but denoting free market apostles in continental Europe) would probably care much less for a Democratic candidate, were it not for the racial symbolic of his rise and a potentially cathartic impact of the election on the depressed black population. Similarly, most, if certainly not all African Americans would rather vote for a black candidate if given a choice. A numerically more important, though less vocal group of white voters may have an issue with a candidate representing a racial or a linguistic minority.

The racial divide remains one of the defining factors of the Democratic Party’s predicament in the Southern United States. Jimmy Carter’s parenthesis notwithstanding, the conservative vote swung away from the Democrats since Lyndon Johnson signed the Anti-Segregation Act in 1964. And whereas before African Americans were not allowed to board the bus through the same door as the whites, today they do not share public buses with white folks at all. The Civil Rights movement may have triumphed. The not so civil economic wrongs could not be so easily unwound.

Walking from door to door and listening to the deeply accented lingo transported directly from the pages of ‘Huckleberry Finn’, I could not escape the feeling that, for many of my accidental interlocutors, an act of voting for an abstract, Washington DC-based position will require an extraordinary personal effort. An effort to switch on the ubiquitous TV blare. An effort to lurch out of the dark bedroom. An effort to leave the familiar neighborhood. An effort to profess a view.

This is not a population accustomed to, or indeed required to make an effort in the first place. We are far, very far from Emersonian self-reliance. As we tried to explain to these half-illiterate people how to mark the ballot, it dawned on me that an act of INDIVIDUAL effort in an abstract (as opposed to physical) task is without precedent in their personal experience. The vote will take place only if and when the organized groups, the local churches, the campaigners or the community organizers provide the necessary assistance to the people who do not, in usual circumstances, take the extraordinary initiative to leave the ghetto.

And then there was hope. A 7-year-old girl opened the door and dragged her mom to the porch. While we were trying to make sure that her mother could understand the intricacies of the arguably confusing presidential, senatorial and gubernatorial ballot, the little girl flourished, flaunting with pride her experience of the ‘vote’ she had already exercised at school. The school game was supposed to prepare the young Americans for their future rights. Flushed, but proud, the little lady confirmed to us that she had ‘voted’ for O-ba-ma. There was no sense of otherness in her scintillating voice. But there was more hope in this statement than in the raucous mass rallies.

Sunday, October 26, 2008


Last week, China announced a number of moves to ease the stress in the real estate market. Down payments have been lowered, interest rates on first home mortgage cut and tax exemption extended. Although these policies should improve home sales in the coming months, they betray the overdependence of the Chinese economy on the government’s continued support for the real estate bubble.

The extraordinary expansion of real estate investment in China created a self-reinforcing loop with accelerated urbanization patterns. Migrations have taken people from Western provinces to Central provinces, from Central provinces to Coastal regions, from Coastal regions to Beijing and Shanghai, and from Beijing and Shanghai to America. Some reverse movement of talent (from US to China’s main cities) and low cost labor (from coastal areas to home provinces) has already begun, but does not yet reverse the overall trend.

The official urbanization rate has reached 43%, growing at 1% every 2 years. The unofficial “target” is 65%, but it could be affected by further trends in FAI and migration policies. Key to understanding the nature of China’s vertiginous growth is not migration, but physical expansion of the cities’ outer rings; much of the statistical “urbanization” took place not through immigration and birth rates, but by swallowing the land around the municipal boundaries, along with the local population. As much as 40% of increase in urban population (120m) has been achieved this way since 1990. In theory, assuming a 2% population growth, the cities could expand by another 350m people (including 240m migrants) by 2025. But that would assume a rate of growth even faster than over the last 18 years, would require funding for health and education services for the migrants who would constitute as much as 40% of urban population.

The population density and wide dispersion of incomes invites comparisons between EU and China. Europe’s 550m inhabitants are but a little less than a third of China’s, but Chinese urbanization plans saw 221 cities of at least 1m population, almost seven times as many as in Europe. However, the same plans see only 170 mass transit systems in China, as compared to 85 in Europe. Clearly, something is just not right.

This process allowed for an unprecedented expansion of wealth in the provinces. Contrary to common misperceptions, it is the local government that retains taxes, subsidizes local industry and licenses retail. Theoretically, during the last four years all the land sales were supposed to proceed through auctions, but in practice much real estate investment was done in hand-to-hand deals (“want to build a clinic in the 4th ringroad? I’ll do it for you. 1m renminbi, please”).

Land in China belongs to “the state”. In rural areas farmers are allowed to own a house, but not their land, which is leased out for 30 years from the state. But in urban areas, leases are for 70 years and people are allowed to “sell” on their apartments as if they owned them. This dichotomy leads to instant profits from land reclassification from “rural” – where no value transfer is possible to “urban” or “industrial”, where long term leases allow the land to accrue commercial value. Since the budgetary de-centralization earlier this decade, such land “reclassification” has constituted an important source of provincial income, ranging from 10% to as much as 40% of the budget, second only to VAT.

Realtors realize that there always is an official and an unofficial price for the land. Although in theory land auctions have been mandatory, there are many ways to go around it. Unlike in Singapore, Chinese bureaucrats are routinely underpaid and this form of ‘urbanization’ has been a very important source of grey income. The worst corruption occurs at the lowest level, where the officials are very poorly paid. It is among this group that one finds full size replicas of the White House and entire Audi fleets. In practice, passive corruption is punishable, but active corruption is not and investors may $cement their guanxi with impunity.

The other main driver of urbanization has been the Dong Qian process of inner city rehabilitation (2004-08). This process has now come to an end in the largest urban centers.

The real estate market is not entirely dependent on immigration as there is still potential demand for housing among existing urbanites, over at least 4 years, should the market conditions remain healthy. Prior to 2006, supply of residential units outstripped demand. The market shot up in 2007, with the average price running up 50%, with some cities registering even higher jumps. So far this year we have seen an average of 60% drop in transaction volume, and 40% fall in price in the main cities. Floor area sales usually improve in summer (Jul-Aug), which was not the case this year.

China’s downcycles usually last between 12 and 18 months, but could last longer if purchasing power deteriorates for some reason. That could be the case if GDP growth contracts considerably. Although household incomes still rose faster in 2007 than house prices, this reflected mean incomes, not median incomes.

Beijing has currently 15 months’ worth of inventory, so it could be surprising that price per sq meter is not falling yet. But the capital is home to an estimated army of 400000 bureaucrats from the central government many of whom are literally maintained by private entrepreneurs in order to keep up good guanxi. Nor is there any other reason for the $1000/night rooms at Ritz Carlton with herds of available girls always ready for the hot shots. The three Chinese status symbols (apartment, car, prostitutes) find a well structured demand in Beijing, making this market less volatile than the coastal areas.

The other reason why Beijing market will hold up better is the prestige and social standing accruing from a family member who moved to the capital and owns an apartment there. Many cousins in the countryside will scrap funds together to be linked, by extension, to such a status symbol. Over the past 7 years, some 0.5m people immigrated into Beijing every year (including the above-mentioned graduates). There is no consensus to what extent this trend may be sustained, but the only natural boundary is formed by the mountain range in Hebei, to the north of the capital.
In Beijing, on the 5th ringroad, a 90 sq m apartment costs around $175k. Usually property developers would target a 6/1 annual income ratio, so a two-person family with an income of $29k pa qualifies easily. That translates into 8300 renminbi per month – right in the middle of the urban middle class bracket. Statistically, some 15 - 20% of Beijing’s population within the 5th ringroad makes this amount of money.

The above figure of 20% would, on paper, clash with the current ownership rate of 80% (in Beijing). However, 80% of available units are purchased by the companies and allocated to their employees (similar to the now defunct Japanese kaisha system). Among the owners, 30% are first time buyers, a further 40% upgrade to larger units (or more appropriate location) and 30% are well-off investors who upgrade even further or hold multiple residences. Although many hold speculative property in expectation of higher prices (apartments are empty, not rented), some are suffering wealth effects (cash is tied up in the stock market and won’t realize losses and are priced out of the market due to liquidity problems).

A 120 sq m (2 bedroom) apartment in central Shanghai costs around $730k. This could appear pricey, but Shanghai and Beijing dominate China in the war for talent. 150’000 graduates from Beijing universities end up staying there after graduation. 28% of Shanghai’s workforce has tertiary education, but there are not enough graduates for 2nd tier cities.

The impact of the US credit crisis has been limited on the big four (state owned) banks as most of them trade only RMB-denominated debt. FX bonds are a tiny (and highly regulated) part of their business.

China’s property bubble should not be understood as a fallout from past credit excesses. In fact, if China does experience an increase in non-performing loans, it will probably be on the manufacturing side, rather than in real estate. Loans to realtors and loans to property owners have been a relatively small portion of banks’ portfolios. Overall, developers’ loans account for only 7% of bank assets and real estate companies’ liability to asset ratio is 73%. This is why the impact from the property slump on overall consumption will be limited (no home equity loans here).
The bubble was pricked by two regulatory moves initiated as far back as September 2007, when the government banned lending for land purchase purposes and land hoarding period was shortened through revised land auction rules. However, due to the huge fiscal boost injected on the occasion of the new 5-year plan, the effects were not immediately apparent in the market. Not surprisingly, after years of heady growth, the realtors were still very cash-rich.

Banks are under guidelines that limit lending to property developers who wish to build profitable (i.e. larger units). However, if the realtor complies with the 70/90 rule and agrees to build smaller units, the bank will release the loan immediately. For all other types of residential property, the realtor will have to be 1 year advanced into the development and post a 30%-40% margin (“equity”, not necessarily cash), which severely limits leverage. Importantly, the recent relaxation of lending quota did not apply to property development.

In the absence of bank lending for property development, realtors turn to wealthy backers. But here the lending costs are very onerous. The bill comes with a 20% interest, plus the cost of protection from renminbi appreciation, and access to 60% of value of the property. Such a “loan” is only extended to those who hold all the 5 property certificates (land, ownership, construction, inspections and – most coveted – sale permit).

The second reason why Chinese property bubble will not transform into a severe credit crunch lies in the economic behavior of investors. The population is generally risk and debt averse. Consumer loan to savings ratio is 24% and 80% of banks’ funding comes from retail deposits. Still, some youngsters who use corporate credit cards are beginning to apply for revolving credit. Remarkably, there has been a credit growth expansion this year (up 5% year on year), with expected loan growth of $0.5tr this year, with total loan portfolio of $4.18tr. The government does not encourage revolving credit. As usual, the expectation is that if something goes wrong, the government will ‘save’ them.

A sizable 3 bedroom house in suburban Shanghai may cost as much as $430k. Debt aversion is so high among Chinese homeowners that when uncertainty grows his/her economic behavior will be exactly the opposite to the American model. Rather than refinancing the mortgage, the Chinese homeowner will accelerate the repayment schedule. Until last week, with a 35% down payment and 5.4% interest rate, it was not uncommon to see these mortgages repaid within 4 or 5 years. Importantly, the price of such a piece of property is still up 80% over the last 5 years, which not only increases labor mobility but also leads to wealth concentration high net worth in the areas determined by school quality, where “emperor moms” tend to congregate.

The buyers of a second unit face steeper hurdles. It is very difficult to obtain a loan for the second apartment. Such buyers need to put 40% down payment and have to pay higher interest premium (7.7%).

The subprime problem is a distant abstraction for the Chinese. Buyers of their first apartment pay a 30% down payment and mortgage is only offered to clients whose income is above $10.5k pa per person (one needs to earn at least 6000 renminbi per month in order to service repayments of 3000 renminbi per month). These figures apply to second tier cities.

Although interest rates were cut by 0.27% in early September and again a month later, the transmission of this measure makes it little more than a symbolic measure and no impact on residential investment. The recent relaxation of lending applies only to a 10bp reduction in reserve requirement among the smaller banks (which account for 40% of the market). Lending quotas were increased by 5%, applying to all state-owned banks and their JVs. The government’s priority is to target small and mid sized enterprises, energy saving businesses, green technology and Sichuan rebuilding, not the property market. The government dissects the prospective loan recipients into 3 categories: “actively promoted” (renewable energy, transportation, grid, rail, ports), “prudently promoted” (health care, power generation), and “restricted” (highly polluting, energy-intensive, overcapacity – like glass, steel, aluminum, cement).

Capital growth could even become negative. Although loan to retail deposit ratio is 57%, as profits are fall and unemployment rises, non performing loans (NPLs) would return as a feature of China’s financial system. An 8% GDP growth (official) translates into 4% NPL. A 6% GDP growth (official) would lead to NPL expansion to 6.8%. Disposable income growth trails GDP growth by 2%, so losses could be made worse.

With asset prices falling (depressing artificial price earnings ratios), price competition will intensify again in the conditions of overcapacity (assuming continued slow demand overseas). Production costs may appear less flexible than in the past (labor, energy, quality control, environmental costs) and capacity utilization rates are bound to fall. Production scale-backs are possible and bankruptcies would spread among small and midsize enterprises with low working capital.

Friday, October 17, 2008


I promised to focus on China's property bubble this week, but other important events are approaching fast and the planned feature will be delayed by several days

When fear and uncertainty spread their repulsive tentacles, many humans react by displacing and even personalizing the elusive object of such emotions. A similar phenomenon of projective blaming is now underway among sections of the American electorate. At a time of unprecedented wealth destruction, many Americans are obsessed with a myth of dark, menacing Otherness. According to the myth’s organizing principle an Indonesian Muslim Communist from a Radical Black Church could actually be a Kenyan Weatherman Arab Terrorist. And yes, the real danger is that this person, with his un-American name, is getting perilously close to be the next President of a country which, until two months ago, was still a beacon of free market capitalism.

The despair runs deep. So deep that these frustrated groups of the American voters have placed their hopes with an occasionally electrifying, though often syntax-challenged personality of an admittedly handsome woman who prides herself with her utter disdain for the intricacies of the global economy and the world affairs. Supreme in her fiery harangues, the Republican VP candidate has been unable to properly construct subordinate clauses when speaking of that country we are in of which one state she is the executive of where Putin rears his head and we send them out to keep an eye on. Ok?

Palin was handpicked by McCain’s entourage to ‘shore up’ his credentials among the powerful Evangelical voters. Although many foreign observers see the Evangelicals’ influence through the prism of their support for Bush’s failed foreign policies or their biblically sealed alliance with Israel’s right wingers, the group’s impact on the quality of American political debate has been much more pervasive and wide-ranging. On talk radio shows earlier this year, John McCain came under assault from Evangelicals who castigated him for opposing torture in Guantanamo. “He is anti-torture”, yelped with high-pitched indignation an obviously deeply religious woman, “but I am pro-torture!” It was not until McCain’s campaign organizers increased the frequency of his interaction with the Evangelical “base” that the sectarian reaction became less strident (“he is one of us”). But some have remained reserved, noting that McCain never quite captured the wisdom of George W. Bush, the wisdom of finding all the right answers in the Scriptures. Astonishing as it might seem, the hapless Mr Bush will be sorely missed by that orphaned 30% of the US electorate and by their allies from one small country in the Middle East.

Palinism is arguably more than a daily fodder for late night comedy show chuckle. The real risk for America’s value system lies in the fact that as many as three Supreme Court judges could be confirmed by the new President. The country’s direction could thus be durably affected by these choices and the fears about the very sustainability of the ‘value crusade’ contribute to the hysterical anti-Obama atmosphere at many of Palin’s rallies. The reactions have become so hostile that some opponents likened Palin to segregationist George Wallace. Suddenly it is the Democrats who had to apologize for the comparison; the organizers of the anti-Obama rallies did not have to. And yet, the emotions among the ignorant mob run high. Calls to “kill him” reflect the fear displacement of small town America. It is bemusing to relive it during interviews with white youngsters from the Deep South, who threaten to “relocate to a Communist country” if Obama wins. I concur that North Korea could actually be good for their eating habits.

Meanwhile, the American media remain puzzled. Accused of uncritical approach to the excesses of Bush’s first term, most mainstream networks find it hard not to betray their pro-Obama sympathies. It leaves the Fox TV as a lone conduit of rather farcical right-wing propaganda. But the spin feels tired and worn out. When four years ago John Kerry won another TV debate against the incumbent, the Fox TV proclaimed that although Kerry was “glib” and probably a better debater, Bush was “a better President”. Four more years of war and trillions of dollars of lost wealth later, that argument is markedly less airborne. Besides, arguing that Palin would make a “better” President could prove risqué outside the avidly sectarian circles.

The spin doctors are, therefore, at pains to turn ignorance into virtue and mediocrity into value. Instead, they have tried to undermine the opponent’s appeal by further stressing his Otherness. After Obama’s triumphal tour of the Middle East and Europe, I received emails with some astonishing accusations of the Democratic candidate’s betrayal of America. According to the slur, Obama proved that he was not truly American because he…. “spoke to 200’000 screaming Germans”. This sticks. After all, Kerry was accused of being fluent in French. Palin’s oversize flag pin, and her sub-Bush distaste for anything foreign plays well with this audience. And, unfortunately for Obama, his daughters are still too young to “proudly serve the nation” in Iraq.

The race card and the anti-Muslim innuendos are a frequent motif in these mailings. In one such email, sporting the picture of Obama’s poor, wrinkled Kenyan grandma, the outraged caption read: “do you want the First Family of the United States of America to look like THAT?” Obama’s absent father’s ethnic roots are also dragged out as a proof of Barack’s own radical leanings

With the economic situation dire and the real life consequences of the financial meltdown too complex for even well informed people to grasp, the “it’s economy, stupid” argument can only drive home the message through anecdotal or better yet first person experience. The 401k checks, which most Americans receive monthly are a home run “free mailing” for the candidate who has crafted a message of ‘change’, even if his program, as much as his opponent’s, will be at pains to incorporate the fiscal and financial constraints within which the future administration will have to operate.

The new inhabitant of the White House will inherit a country diminished abroad after 8 years of shameful unilateralism, and severely hobbled economically after the last 16 years of bubbly hubris. Cleaning up the mess left over by the Clinton/Bush era will be a task of Herculean proportions. The new administration will have to deal with mounting public debts, bad assets and corporate failures. In such circumstances, it will not be easy to re-ignite the nation’s energy without the (tempting) handout of easy credit. Instead, America will have to enter the unpleasant era of deleveraging. And with half a trillion dollar of annual deficits - something will have to give. The unenviable choice will fall somewhere between reflation, tax increases and spending cuts.

Reflation makes one shudder at the thought about the potentially disastrous, long term consequences for the savers. It is difficult to believe that the application of openly reflationary measures would signify a full circle in the economic orthodoxy. Still, your best protection against the potential ravages of debt reflation would be… gold. Purchase of gold should be facilitated by its subpar performance during the initial deflation and aided further by the artificially strong US dollar which depresses the value of the dollar-denominated gold price. Dollar’s strength is ‘artificial’ because it is supported by three, temporary events: European banks’ unwinding of their short dollar positions in the wake of the CDO breakdown, US-based hedge funds’ closing out their dollar-denominated debt after selling their large positions overseas, and US corporations benefiting from IRS tax breaks for repatriation of profit from overseas. The relative weakness of the yellow metal (in dollar terms) could, therefore, provide an excellent entry point to secure future insurance against reflation.

During electoral campaigns, no one’s lips will read “more taxes”. But the unpleasant reality for either candidate is that the deficit will force such increases in some form, as soon as the immediate recession has passed. The proper timing of such fiscal rebalancing will be tricky and, if implemented prematurely, it could suffer from the so-called Hashimoto Effect. Ten years ago, the Japanese Premier managed to smother a recovering economy by showing that low interest rates are a necessary, but insufficient condition to offset the weakness in growth indicators. Regrettably, I have little advice for Americans who are bound to face a heavier tax burden. But one obvious choice would be to swap your US passports for the passports of Burundi, Bhutan or Barbados.

Finally, the most appealing solution of all, i.e. spending cuts. In the last televised debate, both presidential candidates were patently vague as to which public program should be trimmed – health? Education? Social security? Tough to build new America without them. The wars in the Middle East and Central Asia could be one target, but this is not instantly achievable. Should such a pull-out, if implemented for fiscal, rather than strategic reasons, could lead to seriously destabilizing consequences. But you could still make money on it, for example by investing in burqa stocks.

One thing is certain. After the unilateral (and misguided) decision to go into Iraq and the equally unilateral (and misguided) decision to let Lehman Brothers fall, the costs of Washington’s solitary adventures are now more obvious than ever. These expensive blunders have led not only to multibillion losses but also to an extraordinary loss of America’s geopolitical and financial power. This is because much of that power was predicated on counterparties’ and rivals’ critically important perception of power.

All those valuations – from net present value to earnings multiples to cash burn rate to liquidation value - are in fact highly dependent on the thin layer of trust in what constitutes “fundamental value”. Only now do we realize how much of America’s power lied in its addictive optimism. And without optimism, Uncle Sam is worth a lot less.

Yet for as long as America continues to attract talent from around the world and continues to create favorable conditions for hard-working people, the promise of this land of opportunity will tower high above many others. The next four years will be crucial. The challenge to wean the economy of its addiction to credit supported by property values should not be underestimated by even the most skilled motivational speaker of his generation.

Saturday, October 11, 2008


Another week of market panic. Another long, damaging week for all those who borrowed short term liquidity in order to invest or lend in the long term. No end in sight for the unprecedented, convulsive seizing of interbank and money markets. No counterparty is trusted, no credit history adequate. But the worst could be yet to come. And it will come if trade partners refuse to conduct physical transactions with each other. Such a threat, meted out last week by China’s state owned enterprises to one of Australia’s iron ore producers induced Kevin Rudd, Australia’s Mandarin speaking Prime Minister to pick up the phone and call China’s Premier. The necessity for such government interventions illustrate just how fragile the global trading system could be. The unraveling of the hitherto flourishing trade routes could make the recovery of our decimated savings so much more difficult if not entirely impossible.

As the dramatic events of global market meltdowns and banking collapses are unfolding, some commentators are still holding on tight to the hope that the savings accumulated in current account surplus countries will somehow save the planet’s economy. After all, the central banks of Asia and Middle East have for years been gobbling up US Treasuries and agency bonds, helping to suppress US interest rates and facilitating America’s housing bubble. This seemingly unquenchable appetite for the single staple meal of US debt kept afloat the over-leveraged American ‘consumer of last resort’. Some are now hoping that the trillions of dollars worth of US government paper accumulated in the East could be somehow unlocked to unfreeze the clogged LIBOR and see the lending resume globally.

But such a scenario could now prove overoptimistic as the ‘savings-surplus’ economies are slowing down as well. The precipitous drop in the oil prices is draining the wealth of Petrodollar economies at a record pace. Just this week, we have learned that the Russian oligarchs had registered a combined loss of $230bn over only four months. Last week I wrote about China’s exports predicament. With China’s largest export market – Europe – now tipping into recession, further contraction in this sector should be expected. But there are other, even more potent drivers leading to an unpleasant screech in the Chinese brakes. The mid-cycle, downward trend in China’s real estate market, although not directly related to America’s credit problems, is highly worrying. And what makes China’s economic deceleration worse is that all the three endowment factors have over the last year seen coincidental sharp price increases: coastal labor (due to legislation), capital (caused by tight lending quotas) and land (owing to land hoarding and speculation).

When the Chinese government moved to reinvigorate domestic economy back in 2002/2003, much of the internal growth came through unprecedented expansion in fixed asset investment (FAI). As a result, FAI rose to 41% of Chinese GDP. The relative magnitude of this contribution is apparent when compared to the importance of domestic consumption (36%) and net exports (8%). As much as 50% of urban GDP growth comes from FAI. Critically, real estate represents a quarter of fixed asset investment (compared to 30% manufacturing and 11% transport). At its cyclical peak, 10% GDP growth has been associated with 20% FAI growth, translating into unprecedented demand for steel and raw materials. It is in the consumption of energy and basic raw materials that we can now detect just how severe China’s slowdown really is. Year on year rate of growth in fixed asset investment has fallen by 6%, construction output by 10% and residential property by 16%. As of last month, annual decrease in growth was 6.2% in energy, 4.6% in iron ore, 3.5% in cement. Coal consumption growth has fallen 4%. Previous troughs in those subsectors occurred between 2001 and 2005, but did not coincide. This time they do.

Power demand in particular is a good indicator of real GDP numbers, even though the ratio is falling slowly with the phase-out of the most energy intensive industries. In 2000, the ratio of electricity consumption to GDP was 1.5:1, but it is now closer to 1:1. And if so, this particular indicator looks scary; China’s electricity demand growth was barely above 4% in August, and sharply down from spring. Some of this breakdown could be caused by insufficient coal deliveries to power plants and cash flow problems of electricity generators unable to pay for the fuel.

Optimists point to increased infrastructure development, but even if accelerated, it is unlikely to substitute for the material hyper-intensity of real estate development of the recent years.

The realization of just how serious China’s problem is has dawned on us late, very late. Indeed, until my recent trip to China I had been holding out a hope that the negative stream of data could be attributed to several one-time, seasonality-distorting events. “Excuses” for the pause in apparent growth indicators were aplenty. Olympic priorities had apparently trumped the need to keep the economy racing, resulting in large-scale absenteeism in favor of ‘patriotic’ TV screens or the net surfing. Despite the aspirations of traditional numerology, 2008 has been hardly a “lucky” year with its earthquakes, snowstorms, floods and recurrent health scares and, at least officially, “disasters led to the slowdown in the economy”. Year on year comparisons were also complicated by the twin impacts of renminbi appreciation and the introduction of the new, rigid Labor law.

There is little doubt that at least some of these factors added to the economy’s cyclical maturity and weak external environment, but there are more disturbing, structural reasons as well.

The 2005-07 excesses in construction and property investment were caused by low or negative real interest rates, which led to capital misallocation, excessive capital expenditure and speculative investment in stocks and property. Having failed to develop a proper social security system, the government relied on pump-priming to keep the labor-intensive machine going. It is worth remembering that each time the Chinese administration is overhauled on the occasion of a new 5-year plan, fiscal pump-priming boosts fixed asset investment. Such economic stimuli are in China functional equivalents of pre-election spending by incumbent governments in democratic countries. Even though no one gets elected by the Chinese population, the mobs have to be pleased.

Such big fiscal boosts last between 6 and 9 months. Importantly, the last one was introduced in October 2007 and this means that capacity growth in some manufacturing sectors significantly lagged the (falling) demand cycle. Whereas demand peaked late 2007, capacity expansion continued into the second quarter of 2008, further distorting the perceptions of China’s allegedly unstoppable growth.

Finally, there is the stock market. Having lost 67% over the year, Shanghai index is occasionally propped up by the government in effort to re-establish confidence in the market, but the aggregate price to earnings ratios are still at multiples of around 20 times, hardly a bargain for bottom feeders. More ominously, some 30% of the 2007 earnings of the listed companies were in cross-investments. When Ping An Insurance announced its results for the first half of 2008, its losses were 20% higher than its (negative) income, due to additional investment losses.

It is also a good testimony of the magnitude of the slowdown that the typically flow-boosting natural disasters (snowstorm and earthquakes) did little to stimulate the economy. The data on Sichuan reconstruction is curiously sporadic, as if it was another state secret. Or are they all rebuilding their lives with local bamboo?

At the height of China’s property bubble, the cost of construction was about 1/3 of the value of a new house. The remaining 2/3 were divided into the profit, taxes and permitting. The price of land used to constitute 30% of overall costs in 2005, but its share doubled in the last three years. Such supply side constraints led to low concentration of urban construction, absurd valuations and cheap execution. Construction quality is generally very shabby and ‘cutting corners’ was the way for the developers to absorb the costs of land, labor, cement and steel.

The growth of Chinese investment and its role as the marginal consumer of all sorts of raw materials was largely responsible for the huge increase in commodity prices globally. The dragon’s ferocious collapse is now taking a toll on the resource sector of the global economy, pulling in its wake the economies of Latin America, Africa and Australia. Although the liquidity problems of Chinese construction firms and steel producers could be the main reason for the slowdown in physical transactions, we could be at the cusp of something much more ominous. Since the massive market sell-off began, almost a quarter of the global wealth has been wiped out – in savings, assets and other forms of capital. When the extinction of wealth is so widespread, so deep and so fast as this time, cooperation to stem the ravages may be more difficult to achieve. Instead, we are facing the classic dilemma of the tragedy of Commons. And so, for about two weeks now, Chinese customers have been refusing to pay their bills and honor purchase commitments signed with counterparties from India to Indonesia to Australia.

Some ten years ago, I learned this lesson myself. At that time, my firm decided to sign a contract with a Chinese transportation company. We happily returned from Beijing, with a document officially signed by Mr Wang, a senior official of that company. Over weeks and months we found communication with the Chinese partners increasingly difficult and there were no signs of delivery on the contract. When we finally intervened, it turned out that Mr Wang had left the company. Back in Beijing, we eventually managed to see his replacement, Mr Hu. We sat down in oversize armchairs arranged side by side, sipped green tea and exchanged pleasantries. When I finally asked Mr Hu about the contract, he glanced at me with a look of a bored anteater and snapped: “but this paper signed by Mr Wang. Mr Wang no longer work here. You should not think this paper important”.

As the first news came about Chinese state owned enterprises breaking long-term contracts with Australian suppliers, I was reminded of the 18th century letter that the Chinese emperor wrote to King George of Britain. Here’s what he wrote:

“You, O King, live beyond the confines of many seas, nevertheless, impelled by your humble desire to partake of the benefits of our civilization, you have dispatched a mission respectfully bearing your memorial. To show your devotion, you have sent offerings of your country's produce. In consideration of the fact that your Ambassador and his deputy have come a long way with your memorial and tribute, I have shown them high favor and have allowed them to be introduced into my presence.

Swaying the wide world, I have but one aim in view, namely, to maintain a perfect governance and to fulfill the duties of the State: strange and costly objects do not interest me. If I have commanded that the tribute offerings sent by you, O King, are to be accepted, this was solely in consideration for the spirit which prompted you to dispatch them from afar. Our dynasty's majestic virtue has penetrated unto every country under Heaven, and Kings of all nations have offered their costly tribute by land and sea. As your Ambassador can see for himself, we possess all things. I set no value on objects strange or ingenious, and have no use for your country's manufactures. It behoves you, O King, to respect my sentiments and to display even greater devotion and loyalty in future, so that, by perpetual submission to our Throne, you may secure peace and prosperity for your country hereafter”.

As Chinese real estate slump impoverishes realtors, construction companies, cement and steel producers, it can be expected that the losses will be pushed further up the value chain, even if that creates potential legal or diplomatic ripples. With the global depression looming, ‘beggar thy neighbor’ tactics may yet become our daily staple. The age-old traditions of business conduct in China will be of no help in trying to save international, rule-based cooperation. Instead, one should wonder why the Chinese state has not yet embarked on a buying spree of its own. If Russia can purchase Iceland, why couldn’t Australia be sold to PRC? Such a realignment of relative power in the Pacific basin could yet prove to be the ultimate outcome of the free markets’ current seizures.


Next week, I’ll probe the intricacies of the system which underpinned the extraordinary tale of real estate bubble in China and took the global markets for an unprecedented ride.