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.

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