THE TYRANNY OF OPAQUE MARKETS

By the nature of our profession, we are naturally obsessed by what we see daily on our screens. However, in the last several years I have become fascinated by what we do NOT see there. With so much risk capital now captured by the South and the East, unfortunately for us, the opacity of the dealings will only increase. There are three, interrelated reasons for this:
1. East of Istanbul, some 75% of all deals are done in the private market
2. The experience of 2008 led to a breach of trust and much higher dependence on stocks, to the detriment of flows
3. As a result of this obsession of physical inventory control, coupled with low interest rates, contango has evolved in certain commodities, most durably in some metals

Yet, this realization is relatively new. Some three years I traveled from Charlotte NC, where I worked for a multistrat hedge fund, to New York to listen to a number of UBS strategists and analysts. I do not remember the exact date, but this must have taken place sometime between May 2008 when the commodity equities turned sharply down in London and July 2008 when Hank Paulson’s memorable speech reversed long commodity/short financials trade.

The UBS strategist was quite flippant in his dismissal of the weight represented by the emerging markets. He complained about the pressure on him to learn Mandarin and reassured everyone that the proverbial fatso from Costco would have to save the planet as he or she is ultimately irreplaceable. The argument went like this: America with 300m population consumes 11.5 tr worth of goods and services, whereas Europe with twice as many people consumes half of that figure. Japan is a distant third with $4tr worth of consumption and China, well, not in our lifetime shall we see it carrying the weight of responsibility for global growth.

But even if that UBS strategist spoke with a British accent, his view of global economy was strongly embedded in the “consumption” school of thought. In this view, consumption, or end-demand, is what propels this planet around the sun. But then, the end of the world appeared on our Bloomberg screens. Very slowly did we begin to understand that while consumption does matter, consumption on borrowed dime would eventually end in tears.

So what happened since those momentous events three years ago? Closer to home, we dusted off the Austrians. Today angry Congressmen spit out one-liners from Henry Hazlitt’s adorable paperback and Michelle Bachman carries with her a volume penned by von Mieses on a holiday break. And the rest of us? Well, we are all a notch closer to Schumpeter’s view that the way to expand the economic wealth of a nation is not to:
• use fiscal policy and liquidity injections in order to "stimulate demand"
• incur huge fiscal and monetary cost to defend holders of bad debt
• risk long-term slowdown by obstructing the restructuring of excessive debt burdens

No, from a macro perspective, living standards can be increased only in two, but diametrically different ways:
• through capital consumption, i.e. dis-saving and massive borrowing, something we avidly tried (and succeeded) during the Clinton-Bush era, or
• through capital accumulation, i.e. savings and capital investment, a model arduously pursued today by many emerging markets.

We all know that the demand for capital dropped among the developed economies, with FAI/GDP falling from 25% to 18%. At the same time, it has grown in the emerging markets. In India it stands at 33% to GDP and in China 47% and STILL growing at 25% yoy. The question remains, of course, how “productive” (from the Schumpeterian perspective) the growth in the East and the South has been. I believe that the picture there is somewhat mixed. The quality of growth in emerging markets has been uneven and with rising current account deficits and rocketing credit intensity of GDP growth (quadrupling fourthfold in China) may have even deteriorated in the last three years,. But the persistent growth differential between “us and them” is undeniable and should correspondingly affect our thinking about the commodity space across asset classes: the physical, the futures and even the equity.

PHYSICAL COMMODITIES

Commodity professionals, we can give themselves credit that, at least since 2003-04, they have been paying a lot of attention to China. Indeed, I am sometimes amused when I hear about China being “over-dependent” on exports. It was back in 2003 that the leadership of the Chinese Communist Party (CCP) began to question a development model based on exports and on co-opting private entrepreneurs into the Party Congress, a process that had flourished in the late 1990s. 2003-04 was also the time when a decade of Zhu Rongji’s financial reforms had already borne fruit, China had become a WTO member and was in a build-up mode for the Olympic coming out party. In order to bolster the position of the state-owned enterprises, a shift from exports to fixed asset investment became a priority.

A decision was taken that the "pillar" industries, including energy, mining, steel manufacturing, automotive industry and telecom would be dominated by companies under government control. Granted, private enterprise was there to stay, but tolerated only as providers of jobs, foreign exchange and technology. In December 2003, PBOC established Central SAFE investments (Huijin), which later helped recapitalize state-owned banks using foreign exchange reserves, thus entrenching a growth model based on state-owned banks offering loans to SOEs and the same banks coming back to the market every couple of years to recapitalize themselves. The ensuing lending binge unleashed a tsunami of construction activity which durably transformed many commodity markets. In response, Sir Bob Wilson, upon his retirement as Executive Chairman of Rio Tinto, cautioned against commodity markets’ excessive dependence on China.

But dependent we became. The observation of overdependence has been particularly glaring in the commodities that China is net short: metallurgical coal, copper, iron ore, oil, platinum group of metals, soybeans.

We are often victims of our own wishful thinking, expecting the world to become somewhat more Anglo-Saxon, more free-market-ish and more democratic in general. Meanwhile, despite the trappings of (our) modernity, the Chinese Communist Party’s model still has a lot more in common with the Soviet system than with ours. Unlike the pre-Gorbachev Soviet system, which tried hard (and eventually failed) to control the flows and volumes of products, components, subcomponents and commodities throughout the value chain, CCP devised a system in which it controls not the widgets, but the supply of economic factors, and consequently their price. As most of us still remember from the economics class, there are three basic economic factors: land, capital and labor. This is how CCP achieves this in a state-controlled economy with Chinese characteristics:
• land supply control, through state-ownership and land registry at municipal level (I will return to this later),
• capital control, which remains underpriced through capital account controls and distributed through lending quotas,
• labor supply control, with the two-tier population registry (hukou) system: the locals and the migrants and the central guidelines for provincial decisions regarding the minimum wage.

This system may be bursting at its seams now, but it is still firmly under CCP’s control, with the possible exception of underground lending.

Now, if you control all the factors, then regardless of your personal make-up (which may be highly technocratic and pragmatic, rather than ideological), you and your organization will develop a Leninist control culture around it and will be pretty upset if there are ANY inputs whose supply you do NOT control.

The iron ore market is a case in point. China Iron Ore and Steel Association (CISA) is a bureaucratic entity mandated to protect the interests of the country’s steelmakers. If you meet CISA’s officials in Beijing and overcome their initial “we won’t tell you ‘cos you’re a foreigner” (我不告诉你，因为你是外国人) you will soon learn that Western governments, (yes, “governments”) have devised a perverse plot to deprive China of access to iron ore resources and thus to strangle its birthright growth rate.

Much has been said about iron ore market’s high Herfindahl index of supply concentration. However, Sir Bob Wilson was not entirely wrong. Today as much as 25% of global seaborne iron ore of about $1bnt p.a. is destined for just one market: long steel products used in Chinese construction. And when asked about how sustainable this is, most analysts point to the continued “urbanization”.

Contrary to the claims of such reductionist commentators, urbanization itself is NOT a market phenomenon, but a process driven by a confluence of institutional decisions in China, whose sustainability depends largely on the durability of the system based on three pillars:
1. the Constitution of PRC, which turned all land into the property of the State
2. the lopsided structure of provincial budgets, responsible for 77% of expenditure but entitled barely to 46% of federal tax transfers, which turns these budgets dependent on land transfers. As much as 70% of the provincial budget relies on land transfers (leases below cost, sales tax, spec sales).
3. the capacity of local officials to single-handedly transform the value of land by re-allocating land from “rural” (whereby rural land can only accrue value from 30-year leases) to “industrial” or “residential” (where 70-year ‘lease’ is possible).

Urban Development Investment Corporations or UDICs (城市发展投资公司) and other many similar entities (6600 of them nationwide) have been structured to bypass the inability of municipalities to sell bonds directly. The existing products often showcase a glaring mismatch between maturity and revenue generation. However, UDIC bonds (and infrastructure loans) do not have principal payments until years after the communist officials in charge of the province are long gone. Meanwhile, the interest payments are being satisfied with land sale proceeds. Today, the system is saddled with an estimated $RMB11tr (or nearly $2tr) of debt, representing some 42% of China’s GDP. The system’s cheerleaders tend to profess high level of comfort with this number (given the value of assets potentially offsetting this burden), conveniently forgetting that under conditions of uncertainty, the duration of a financial institution’s liabilities shortens and the duration of its assets lengthens.

This process of forced urbanization, embedded in this institutional framework does not affect commodity markets in which China functions as a significant primary producer, e.g. zinc with its global surplus of 256kt this year. But it certainly does matter for iron ore, where the problem is compounded by the dropping exports from India, as illustrated by the recent political and legal wrangle in Karnataka and Orissa. China’s iron ore reserves are of low quality and despite $1bn annual exploration spending, the aggregate reserve depletion is among the fastest on the planet. Looking at the data from US Geological Survey, the 60mt per month importer may run out of domestic sources of iron ore within 9 years.

This is a linear, finite view of the emerging market commodity phenomenon, but cyclicality and seasonality are of equal importance.

SEASONALITY

Since most humans evolve in a climate characterized by regular changes – four seasons in temperate climates, dry and wet seasons in the tropics, near permanent darkness and midnight sun in the Arctic – most of us also come to expect some form of recurrent patterns. Some traditions have even injected such hopes into religious thinking, thus avoiding the eschatological destiny of much of the Western heritage. By the virtue of climate, tradition AND the related credit subcycles, seasonality imposed by the emerging markets has begun to trump such well-respected recurrent references as the US driving season, European winter heating season, US hurricane season or sometimes even northern hemisphere corn planting season. In fact, as we could observe in the last several years, the industrial metal demand dances around the Chinese credit cycle.



The Chinese credit market is directed with an annual, rather than Japanese fiscal or Australian calendar. As the state owned banks have, by government fiat, guaranteed 3% spread loan/savings rate ratio on some $2 trillion worth of savings, they are keen to open their loan books as early as possible after the beginning of the calendar year and earn maximum interest within the official quotas permitted by the regulators for that particular year. Much of that credit goes to builders, contractors and manufacturers. But a lot of this lands with legal, quasi-legal and illegal underground lending system, starting with the commonly tolerated Minjian Jiedai 民间借贷 – or “civil borrowing”, through mutual assistance societies Huzhuhui (互助会), all the way to subterranean loan sharks Gaolidai (高利贷), who would later use this liquidity throughout the year at interest rates we can only remember from Vito Corleone movies.

As a result, the builders are in a position to contract new projects and the commodity import machine is set in motion, with the concomitant impact on the seasonality in China’s current account. Every year, depending on when exactly the Spring Festival falls, sometime between February and April it becomes fashionable for a wave of Western analysts (and some politicians) to express a collective sigh of relief that “Chinese surplus is shrinking and the problem of undervalued renminbi will soon go away”. Consequently, it would be highly improper, impertinent and uncivil of us to dub the Chinese government as a “currency manipulator”. And so it goes. China continues to intervene in forex markets at $1.4bn a day, and Chinese trade surplus is indeed shrinking (from $295bn in 2008 to $183bn last year), but not necessarily in terms of bilateral exchanges with the US as our soybeans exports (even coupled this year with our corn exports) prove insufficient to quench Chinese thirst for inputs, much of which remains very seasonal.

NO PERPETUM MOBILE

The law of structural dynamics means that every self-reinforcing loop will eventually encounter sufficient constraints to slow down the process. Such constraints are already present in the Chinese economy. Robert Mundell was right. If you do not want to realign your prices in relative terms through exchange rate, you will sooner or later pay for this with real price adjustment. This is exactly what happened in China with 87% increase in M2 over the last three years. It is now frequently quoted that this is a country with a third of US GDP and a monetary mass 30% higher than the US. I find it intriguing to compare China of today not with the US of today, but with the Nixon era. The 1970s show how long the lag could be between the M2 avalanche and the onset of inflation.



However, too many of us get carried away by this obsession with inflation and commodities. Not even gold, a financial product par excellence, is perfectly correlated with inflation. Others argue that the value of gold is simply a mirror image of the trade-weighted dollar, but this conveniently dismisses the fact that most other currencies are also losing their purchasing power, not in terms of CPI-related indexes, but in terms of their capacity to acquire assets. As real buying of gold occurs also outside of the USD currency zones, gold represents a useful yardstick of value for all of those currencies, not just the dollar.

No, where gold truly reacts against the extremes, it is in terms of how we connect future and present prices. And we do it via interest rates, in real terms. Gold perfoms well when the expectations become entrenched that real yields will crawl in the gutter for a while. The main exception is the period 1994-95, marked by a Greenspan interest rate hike that panicked the bond market.

FUTURES

Let us move now to the impact on the futures market. Here too, the institutional framework in the emerging markets, and particularly in China is actively shaping the global marketplace.



A critical juncture came in 2008, when the ultra-capital intensive system designed by the Chinese Communist Party and described above was severely tested and then further enhanced. Half a decade into the fixed asset investment binge that made China a linchpin for all the commodity markets with the exception of oil, the 800 pound gorilla trader was still sitting on a 19th trading infrastructure. As China slowly integrated into the world economy, the letter of credit (LOC) system remained key element in its dealings with overseas trade partners. The growth was extraordinary. By 2007, almost 70% of China’s exports were financed with LOCs. But 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 understandable (at least for sinologists) that pre-payment schemes are not very “Chinese” culturally speaking, but 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 30 years of reforms.

As many remember, the sudden collapse of China’s LOC system in late 2008 led to a catastrophic slump in most commodity prices. One day I could be sitting with a CFO of a mid-size Australian iron ore company, who professed his confidence in the future, and the next day his panamax vessels were floating idly in Southwest Pacific in search of a willing customer. What did this lesson mean for the buyers? Do not trust the flows, trust only the stocks. So a quarter of a century after the Just in Time system thinned out the value chains, upstream commodity business went in the opposite direction as if we were all in perpetual preparation for a war or, at the very least, for a collision with a large asteroid. China’s Strategic Reserve Bureau began its frenetic buying spree: becoming the world's top importer of copper, soybeans, iron ore, cotton and natural rubber and among the largest buyers of coal, vegetable oil, sugar and potash. Importantly, this hoarding behavior coincided with record low interest rates globally, and it was no different in China.

Two years into the great credit-lubricated party, inflation expectations had become so pervasive that multiple increases in reserve requirement ratios proved insufficient to cool the economy. In October 2010 China officially entered the “tightening mode”. On that day, commodities blipped, but nobody remembers that. By the second hike in December 2010, the commodity market shrugged it off completely. Although some argue that any increase in domestic interest rate exposes its central bank to sterilization losses, the PBOC is not really an independent policy bank. Rather, it is a ministry subjected to the decisions of the State Council, where so-called “stability” is paramount and the commercial considerations secondary. Yet this is a ‘stability’ where food price inflation is in double digits and rents in Beijing shoot up 100% yoy. Someone got scared and the screw had to be tightened.

For the rest of us, the story that has unfolded since then is one of copper.

In January this year a friend announced to me: “this year I am going to short gold and go long copper”. I asked ‘why would you do that?’. Well, “gold is a bubble, but copper has real demand, Chinese really buy it”. I asked: do you know what they do with this when they buy it? He was not interested: “supply and demand”.

In fact, all we usually know about demand in China is the so-called “apparent demand”, i.e. production plus net imports plus/minus changes in Shanghai exchange stocks. When in 2009, Chinese net imports rocketed from 1.360 million to 3.112 million tonnes, it was hard not to see the hidden hand of hoarders: legitimate commercial restocking, strategic moves by SRB, and speculative stockpiling. Conversely, strong end-use and low apparent demand in 2010 pointed to destocking.

By comparison, what has happened since the tightening of interest rates at the end of 2010? Since then, Chinese copper importers have become… bankers. Unfortunately for my buddy the investor, they did not import copper to consume it. And the difference matters. They exploited the system to obtain – and provide - renminbi.

With new official loans in the first five months of this year falling 12% to 3.55 trillion renminbi ($549 billion), it was only a matter of time till the loophole was filled with typically Chinese ingenuity. Already in 2010, letters of credit issued by Hong Kong-listed Chinese banks jumped 70 percent, faster than the nation’s overall trade growth of about 25 percent.

It is useful to review the cat and mouse game between the importers and the regulators and to see what the impact on copper market has been, especially in Asia.

Companies could apply for a 90-day or a six-month dollar-denominated letter of credit to import refined copper, but not really to consume it. The only price was a requirement to put down 20 percent of the value of the imports as a deposit to the bank for the LOCs.

First, copper was imported into China by speculative investors for resale in China. They would sell the metal domestically once it arrived and lend out the earned (renminbi) cash at higher (unofficial) rates before repaying the letter of credit at maturity.

However, because Chinese copper prices have maintained discounts (up to nearly $200/t) to the London Metal Exchange prices since 2010, it forced the speculators to put contracted imports into bonded warehouses, most of which are located in Shanghai area. By March 2011 this shadow stockpile reached a reported 1mt. From here on, there were two ways to obtain renminbi. Investors could either:
1. use the bonded inventory to borrow collateralized loans at 90% or even 100% of the stored material and most frequently re-lend this capital at higher interest rates, or
2. re-export the copper.

Why would re-exports be of interest to investors? First, remember that in an economy with the closed capital account, exporters have to exchange their dollar inflows into renminbi. Secondly, following some successful lobbying by importers, the regulators scrapped the rule whereby these stocks had to pay 17% VAT in order to be re-exported.

However, last April, the Chinese authorities tightened rules on repatriating foreign currency from re-exports. Now, the Chinese firms were required to leave such foreign currency earnings in pending accounts and were not allowed to convert them into renminbi until they received receipts of import payments and re-export incomes. Financial intermediaries also had to cut their advance payments from foreign importers and delayed payments to exporters to 20 percent of the total foreign exchange they sold or bought over the past year. That naturally affected all those who carried several outstanding letters of credit at the same time.
But the demand for renminbi credit continued to outstrip the official lending quotas and the cat-and-mouse game continued. Enter offshore renminbi. To much fanfare, some 20 months ago Beijing had opened up Hong Kong as an offshore venue for investors willing to gain access to renminbi-denominated assets, allowing foreign companies and banks to raise funds in Chinese currency for cross-border trade and investment. Some 67,000 Chinese companies were allowed to participate in the offshore renminbi business. Now, investors trying to resell their bonded copper overseas began to ask foreign buyers to settle trades in the “offshore” renminbi (CNH), remitted from offshore banks in Hong Kong. This summer, however, PBOC moved to tighten the screws on offshore trading and notice No. 145 stressed that the onshore market had not been liberalized and the capital account remained closed. Widespread CNH selling has intensified since and continues to date (late September 2011).

More importantly for the copper market, it soon became possible to deliver the material from the bonded warehouses against Shanghai Futures Exchange contracts. Previously, imports were subject to VAT payments in advance of the delivery against exchange contracts. There are two consequences of this change. First, it removed one hurdle to trading the arbitrage between the Shanghai bourse and the London Metal Exchange. Secondly, in case backwardation appeared in Shanghai, you could now deliver physical against it. For futures traders it could be a way for the shorts to cover their exposure, instead of buying back shorts. The outcome would be reduced volatility.

What does this opening mean for the copper curve? A copper-collateralized loan costs an importer 6 to 8 percent, but the renminbi obtained this way is then re-lent in the “underground” market at rates 3x that much! What is the significance of this? It’s an alchemist’s dream. We turn copper into gold.

One of the reasons why the cost of borrowing base metals, such as copper were generally higher than prevailing interest rates (i.e. µ<λ) was that unlike gold, they usually responded strongly to physical supply-and demand fundamentals. When demand was strong, inventories were depleted and the metal came at premium, putting an even greater upward pressure on prices. As the metal prices rose, the lease rates rose as well in response to the scarcity of the metal. Similarly, when the demand was weak, inventories would build up, making the metal more abundant and pushing prices lower. Not surprisingly, high lease rates were associated with high spot prices and low lease rates with low prices.

However, as long as µ>λ there is an implied rate of return (interest rate less lending rate) on holding the metal. Gold usually provided such an implied rate of return, but base metals did not. Global gold inventory does not matter because the metal is plentiful. In fact, this is how Indian jewelers finance their gold inventory, through gold lease rates, thus avoiding currency risk. And even though gold lease rates generally have a negative correlation with spot prices, the calculated base rates do not ultimately matter.

Gold may have been in contango since Lucy left Olduvai Gorge, but in the case of Chinese copper, if 民间借贷 or 互助会 interest rates remain above the LOC interest rates, then we end up with gold-like characteristics:



Not surprisingly, contango appeared in Shanghai despite all we know about the tightness of copper concentrate, labor activism in Chile, winters in Atacama desert, strikes at Grasberg, low TC/RCs and high merchant premia. This contango would be here to stay, if the futures market in Shanghai was not so jittery about the maze of potential regulatory changes concerning:
• LOCs deposit, interest rates and associated currency exchanges
• offshore renminbi repatriation
• bonded warehouse taxing

Indeed, State Administration of Foreign Exchange has introduced rules to make it harder to use the metal as collateral and in late August People’s Bank of China required banks to place a part of the original collateral held against LOC in low yielding reserve accounts, instead of using it to make further loans. That means that it is going to become more expensive to issue the LOC.

Interestingly enough, the dearth of renminbi credit led not only Chinese investors and merchants to use dollar-denominated LOCs. Even Chinese producers of semi-finished copper products have begun to use letters of credit to purchase USD-priced bonded copper in Shanghai, rather than in the CNY-denominated spot market, for which they do not have cash. Bonded metal in Shanghai can be delivered to buyers in two days after stock owners pay the VAT. Banks in Jiangsu and Zhejiang have been advised not to issue LOCs to purchase bonded copper from Shanghai warehouses, arguing that these only applied to imports and not to the metal already stored in the country. But local banks would continue to provide credits if their bonded copper purchases are resold in the domestic market, rather than re-exported.

Assuming the symmetry in terms of CNY/USD preference, the above pyramid build on copper (or soybeans, or any other) collateral could potentially crumble the moment capital flees towards USD, as it is commonly the case during the episodes of global liquidity stress. This could explain some of the vicious Chinese selling of metals (including copper) throughout most of last week. But more ominous signs could be just around the corner. There are reports of letters of credit refused for imports. The sensitivity of Chinese trade to global credit woes has not diminished.

FINAL WORD

It is time we abandoned the dream that global markets, including financial markets, will somehow lead to homogenization of the world exchanges. Capital and goods move freely precisely BECAUSE of differences between localities, their institutions and their cultures. It’s Asia’s fears that drive its demand for gold, its quest for liquidity and fresh credit or the taste for the control of the physical inventory.

At a conference in Oxford 10 days ago someone was stunned that a decade of global growth delivered a zero return in the US stock market. I find this tunnel vision baffling. It is irrational to expect that Asians would put their wealth in pension funds which, in turn, will efficiently allocate capital to underpriced US stocks. What do we know about their economic behavior, obsession with land ownership, real asset control, inter-generational wealth transfers, seasonal consumption patterns and underground lending structures indicates that commodities, thanks to their fungibility, still remain the best bet we have in the public markets to participate somehow in the waves triggered by China’s and India’s fears.

FIRST TIME IN 79 YEARS

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.



GLOBAL TRADE THROTTLES BACK
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?

EMPTY LECTURING
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…



FROM DEEP DEFLATION TO SHARP INFLATION?
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.



IT’S NOT ONLY THE ECONOMY, STUPID
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.

BEGGAR THY BARBARIAN

CHINA AND THE WORLD IN CRISIS
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.

THE END OF THE CHINESE BUBBLE
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).



HOW DO WE KNOW THAT CHINA IS SLOWING?
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.



HOW IS IT POSSIBLE THAT THE WORLD IS CHANGING ITS VIEW ON CHINA SO QUICKLY?
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?



NOT ONLY CHINESE PROBLEM
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”.



CERTAIN THINGS NEVER CHANGE
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.



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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.

TAUT AND FRAUGHT – THE PARABLES OF THE GLOBAL ECONOMY (part 3)

It has been over six months since the world markets wobbled uncertainly into the New Year. With comfortable hindsight bias overlooking multi-billion dollar losses, it is now time to refresh our view on what to expect during the period which separates us from resinous aroma of Christmas pines.

Investors of All Nations Unite! No amount of diversification has protected you thus far. Year-to-date losses have been remarkable. Shanghai Index has dropped 47%, India 40%, Hong Kong 23%, London 15%, US market (S&P500) 13%, Tokyo 11%. The Pakistani investors eventually decided to ransack the stock exchange in Karachi, and in all candor, other temples of greed deserve commensurate thrashing. Interestingly enough, commodities, so far insulated from the cascading erosion of wealth, have recently joined other asset classes in this broad sell-off.

Alas, the same commodities have now infected the global economy with an epidemic which, along with smallpox, seemed to have been eradicated from the surface of this planet: Inflation.

INFLATION – OR HOW TO TELL MASALA QUESADILLAS FROM SUSHI TORTILLAS

I meet two types of economists among those who have miraculously maintained their jobs on Wall Street. They can be broadly categorized into two tribes - the White Tribe and the Red Tribe. The Whites focus on the industrialized OECD economies and mostly see a prolonged slowdown precipitated by debt market excesses and graying populations. The Reds, on the other hand, concentrate on the commodity prices and over-accommodating monetary policies in the emerging markets. The two tribes do not really speak the same language, even though they believe that they do. When the White Tribe uses the signifier “CPI” (consumer price inflation), it mentally visualizes an American fatso in front of his oversize family mansion which houses a loud shrew and a couple of spoiled kids. When the Red Tribe uses the signifier “CPI”, it imagines cute and skinny Filipino kids who have not seen their mother in a year (she works as a domestic helper in the Middle East) and their dad for six months (he works on a Greek ship). In the former case, food accounts for some 4% of inflation “basket”. In the latter case, it accounts for 50% of inflation “basket”. But the disparity is even larger. Filipino food is basically a commodity – rice and vegetables, protected partly by government subsidies. Meanwhile 82% of the food value consumed by an obese American is derived from packaging, distribution, processing and labor. The differential impact of commodity price swings is heavily lopsided to the disadvantage of the orphaned family.



The Whites are cold, callous cynics. The Reds are passionate, pugnacious alarmists. The Whites usually see no inflation and ridicule the naïve Western consumer whose perception is skewed by the prices of seven daily products, instead of a scientific, multi-factor inflation model. The Reds have been crying inflation wolf for months, panicked by galloping food and energy prices.

THE LAND OF THE WHITE TRIBE

First, are the Whites really wrong? How can one reconcile the recession-prone US economy with persistent inflation pressures? Dismissing outright the global impact of the US demand slowdown has proven to be premature. Indeed, the congenial American fatso is practically irreplaceable. Aggregate US consumer demand is worth over $10 trillion per year. By comparison, Europe and Japan combined represent some $8.5 trillion. For all its swagger, China is a minnow ($900 billion) and India still has a long way to go ($500 billion).

The global economy has over the last 15 years benefited hugely from the disinflationary impact of globalization, facilitated by international labor arbitrage. It is the production of apparel, computers, toys, video and audio equipment - assembled by Chinese girls’ nimble fingers - that has seen the retail prices fall in the developed markets. Alas, these are low-frequency purchase items and they hardly affect the perception of inflation, most impacted by the runaway prices of gasoline, eggs, bread and air fares.

The White tribe continues to ridicule this “inflation perception” as the figment of consumers’ poor understanding of their spending patterns. This is a questionable form of scientism (people do act upon their own perceptions and modify their economic behavior accordingly), but the White tribe does have a point indicating another factor that damps the momentum of the inflationary groove: average wage growth in developed economies.

Indeed, it is only recently that the discussion of increased wages reappeared in the EU’s political discourse. American workers have been deprived of collective bargaining rights during the Reagan administration when Lane Kirkland’s AFL-CIO was more interested in fighting communism in Europe than supporting moribund industries at home. Today, unemployment expectations in the US are at a 28-year high and the precarious character of the (still existing) jobs will not allow the workforce to formulate wage demands that would offset price pressures and entrench inflationary expectations.

Meanwhile, Japan is veering off into a class society. I have two sorts of friends there. One group works for established corporations, with a guarantee of lifetime employment, not unlike their fathers (not mothers) did. Their main risk is karooshi (death from overwork) rather than lifestyle changes. The second group tries hard to make ends meet and maintain their lifestyle by taking unstable weekend jobs combined with part-time employment elsewhere. Culturally and economically, they remain hatarakibachi (busy working bees) and also risk karooshi, but are unlikely to achieve any wage growth before that. It probably did not matter in the recent years so much because your yen tomorrow was always worth more than your yen today, but these days will be over when inflation expectations re-enter Nippon psyche.



With OECD countries having reached wage growth peak in 2006, the current weakness of the workforce’s bargaining power all but disembowels the inflation apparition. But the economic well-being suffers nonetheless, regardless of the economists’ triumphalism.

THE LAND OF THE RED TRIBE

The Red Tribe focuses a lot more on the commodity prices and the mechanisms through which they affect emerging market economies. But why are emerging markets more exposed to inflationary shocks from commodity prices? Is it just oil and food? Well, not quite, as those who suffer most from price increases often happen to be oil exporters - Venezuela, Russia and Saudi Arabia among them.

Rising food and energy prices only translate into persistent inflation if monetary mass and/or credit grow faster than the gross national product. If India’s or China’s money supply has expanded by 20% year over year, Saudi Arabia’s has grown by 72%! Negative interest rates (i.e. interest rates less inflation) have reached nearly 5% in Russia and 8% in Egypt.

Loose monetary policies have created a liquidity shock in emerging markets fuelling demand for raw materials. The manipulation of the exchange rates and subsidized domestic commodity prices shifted the burden of price adjustment upstream, to dollar-denominated commodities. Given the potentially unstable nature of many of these countries’ political structures, their governments have been obstinate in implementing the plethora of non-market mechanisms. Price controls, emergency supply increases, VAT rebates, export taxes and quotas, or outright export bans have all been destined to dampen the impact of commodity prices on privileged industries or potentially restive urban populations. The demand for raw materials thus continues unabated and the resulting price increases are exported to the developed nations which carry the burden of demand adjustment.

Nevertheless, with the increased rigidity of local labor markets (thanks partly to China’s new labor law), there is a risk that food and energy price increases eventually seep into the “core” inflation. Most Asian and Middle Eastern governments may have little choice but to eventually raise interest rates and let their currencies appreciate. Ample foreign reserves and improved terms of trade with the developed countries give emerging markets enough room to allow their currencies to appreciate incrementally. When this happens, their hitherto “cheap” currency will no longer dis-intermediate the commodity price inflation for the Western end-user. These appreciations, unless corrected by the developing nations’ runaway inflation, would prolong the dollar’s depressive lows.

WHERE THE REDS MEET THE WHITES

Lauded by technocrats and demonized by populists, globalization has for the last two decades played a decisively disinflationary role, shielding comfortable western consumers from the shrinking pressure on their wallets.



One of the hugely underestimated side-effects of this cross-border process has been successful labor cost arbitrage. If cheap labor was not allowed to move to the existing industrial installations, then the installations moved to the labor. Since at least 2000, massive shifts in low-skilled labor endowment have been doubly beneficial. They ensured expanding margins for global companies and provided disinflationary safety valve for consumers’ economies. Mexican delivery boys in New York, Polish baggage handlers at Heathrow Airport and Pakistani workers in the Persian Gulf have all combined their forces to slow down the inexorable cost pressure that accompanies economic growth. For as long as the exchange rate differentials flattered their mental anchoring in home countries’ financial realities they willingly filled the labor market niches long abandoned by host economies’ local populations.

We should hope that the remaining pools of inexpensive labor and affordable, non-Western capital will partly offset the inflationary pressures unleashed by the commodity prices. Alas, many of the sources of this politically incorrect and often illegal “cheap labor” may now have seen its peak. Latinos have been the first to suffer from the construction industry shake-off in the US. The pool of Eastern Europeans entering Western Europe’s job markets is not unlimited, although it could potentially be offset by culturally alienated youth from Middle East and Africa. Coastal China has been suffering from rising labor costs for two years as the supply of female labor has peaked. Further flows are still possible into urban India and the Gulf countries.

The globalization of labor flows does and will continue, but is unlikely to directly benefit the profit share of Western, or Western-listed companies. Nor are he recent labor flows positive for the dollar. To protect the value of their remittances, ship crews are now demanding that their wages be paid in Euro. Foreign construction workers in the Persian Gulf will eventually force these economies to break the dollar peg. Japan’s exports are now invoiced in the yen. And China finds it difficult to stem capital inflows drawn by the perception of the unsustainability of the current exchange rate. All these trends bode ill for the dollar, the denominator of most commodity prices.



As the Red Tribe and the White Tribe debate the inflation “decoupling”, they might need to take into account that the burden of commodity prices shifts ineluctably towards dollar economies. Some of the Red blood will then be spilled onto the White Tribe’s clean shirts.

TAUT IN A KNOT – THE PARABLES OF THE GLOBAL ECONOMY (part 2)

INFRASTRUCTURE AND COMMODITY DEMAND

Emerging markets are often characterized as primarily exporters of commodities. This is an over-simplification. On an aggregate basis, they are both exporters and importers of raw materials. India and China are net importers of commodities, while Australia and Canada are important exporters of commodities, including to customers in emerging markets.

These days, numbers of interplanetary magnitudes are published, illustrating projected “infrastructure development” in the emerging markets. These are staggering figures. Of the $22 trillion earmarked for infrastructure spending over the next decade, some $1.3 trillion is being disbursed this year. Beyond Brazil, Russia, India and Russia, the main multi-billion infrastructure investors will be Indonesia, Mexico, Saudi Arabia, South Africa and United Arab Emirates. Despite of all the wailing about a “bubble”, this infrastructure expenditure has so far proved largely price insensitive.

A closer look at these projects reveals that “only” slightly above 30% of the overall expenditure will transform into commercial and industrial infrastructure. The rest will be spent on what mankind always had to fork out – shelter. And for a good reason. In China, which comprises 34% of all new urban residents among these economies, as much as 63% of all construction is residential. During the next decade 11% of all Chinese, 10% of all Brazilians and 9% of all Indians will relocate to the cities. Only Russia has a negative urbanization rate, offset by the gradual replacement of old Soviet building inventory. All together, the world will experience relocation of 2.4bn people into the cities of Asia, Latin America and Africa. The move dwarfs the magnitude of Western and Japanese urbanization of the 1950s and 1960s which involved one tenth of that number.



IS THIS REALISTIC?

Although they are still minnows in terms of final consumer demand, emerging markets now represent some 30% of the world’s economy and 60% of incremental growth. The massive infrastructure spending plans have connected these economies more strongly among themselves. As the global trade flows have registered the lowest growth in several years, the trade among the emerging market economies has been booming. In the process, the US-centric supply chain pattern of the 1990s has given way to a new structure in global trade. These shifts are illustrated by unprecedented spreads between commodity indexes (up) and industrial production in the developed economies (down).

How was this massive realignment possible?

After the 1998 debacle, most governments in emerging markets dodged the pressure to develop internal consumer and financial markets. Instead, since at least 2002, these nations have embarked on major developments of infrastructure, in part to serve new export markets, and in part to address the needs of modern urbanism. This, in turn, reinforced the trade networks among these countries, making them less directly vulnerable to periodic economic slowdown in the US and other developed economies. Not surprisingly, in the early 2008, their overall export growth was maintained, despite falling demand in the US. With 80% of its commodity demand destined for the domestic consumption, China, rather than US, often emerged as the ultimate destination of exports from other Asian and African countries.

Following several years of capital accumulation through trade account surpluses, emerging market nations are now holding 75% of the world’s foreign reserves. Over the last five years, they have been growing annually by 39% in China, 57% in Russia, 32% in India and 33% in Brazil. China has a closed capital account and export earnings are essentially trapped within the Chinese economy. Owing to appreciation pressure on Chinese renminbi, there has been little incentive for illegal capital flight since at least 2001. The Chinese State continues to control not only interest rates and cross border capital flows. It controls asset supply and asset transfers. And it remains the chief banker for infrastructure and property development in the country. Only in the first half o this year, additional $52bn flew into China in the form of foreign investment. This wealth has been largely re-directed into urbanization and re-industrialization of these economies.



The common misconception is that the infrastructure spending (and, by extension) commodity demand will collapse the moment the export industry stumbles. This is misguided for at least two reasons.

First, the contribution of net exports to Chinese gross domestic product, while growing in the recent years, has not exceeded 7%. This is dwarfed by 43% ratio of investment (both public and private) to gross domestic product and the ratio of consumption (46%). Even if the American consumers turned their backs tomorrow on Chinese goods, the impact on China’s growth would be limited. Most of Chinese exports go to Asia (46%), followed by Europe (24%). Only 21% of Chinese exports are destined for North America. And that is less than 1.5% of China’s gross domestic product. At a recent Canton Fair, order volumes were dominated by Europe, followed by the Gulf countries, and only then US. This is understandable given that Chinese currency has actually depreciated 4.4% versus Euro over the last year.

Secondly, the slowdown in Chinese exports will not defeat the building and infrastructure boom because it has occurred already. Since the beginning of the year, roughly 20% of Taiwanese and Hong Kong-invested businesses have closed in Pearl River Delta. While the new French-style Labor Law was the final straw, the maquiladora-type of operations had already been losing competitiveness for some 18 months. Friends in the region are telling me about the same Taiwanese businesses opening in Vietnam (60% of China’s wage level) or Cambodia (40%). While there could be a lagging impact on the local property market, the deceleration in maquiladora activity is unlikely to have a lasting impact on China’s infrastructure spending ambitions.



All this will require materials necessary for property development (aluminum, copper, cement and steel, i.e. iron ore and metallurgical coal), power generation (thermal coal, natural gas, uranium, cement, steel), power transmission (aluminum, copper, steel) and transportation (oil, steel, cement). But what may slow down this urbanization process, is a phenomenon unthinkable just several years ago – insufficient supply of basic commodities.

NO SUPPLY TO THE RESCUE

The main reason for the stubbornly high commodity prices should be sought in their inelastic supply. All the four groups of commodities – agricultural, energy and industrial – have been affected by several, mutually reinforcing factors that bottlenecked supply to the market. The most important among these are access to capital and technology, physical constraints, volatile weather conditions and explosion in capital costs.

Regardless of the potential return, capital and technology find it much more difficult to flow towards the sources of raw material wealth in the conditions of the progressive erosion of what the Western Culture labels “the rule of law”. With long-term security of tenure under threat, resource nationalism on the rise, bureaucratic rent-seeking behavior, ideologically motivated support for social and industrial disturbances – it is not surprising that both risk-averse debt and allegedly risk-tolerant equity markets appear reluctant to lock in capital for considerable periods of time in far-flung, inherently unstable destinations. Despite all the self-satisfied and politically palatable blabber that “the world is flat” the hurdles for capital flows are often insurmountable. Examples are aplenty. Equity investors are unable to prop up the world’s largest copper company. The most technologically advanced oil companies may no longer access bookable reserves in the ground. In turn, Arab oil sheiks are not allowed to invest their resources in North America’s agricultural land, instead of artificial ski slopes in the Persian Gulf. In these cases, and many others, capital will lie fallow, or will be redirected into lower return projects elsewhere.

Nor can resource companies fully leverage the potential of tax arbitrage. Most major companies now have their emerging market subsidiaries attached to holding companies in tax-free jurisdictions, but the subsidiaries themselves are taxed more aggressively by host governments. This has taken an extreme form in upstream industries, where a combination of royalties, export quotas, domestic pricing, equity transfers, beneficiation levies and windfall taxes has reduced incentives to pursue investments. In extreme cases (as in Africa), this is due to state bank-backed competition from China (mostly Exim Bank) which carries promises of large-scale infrastructure projects and local power perpetuation, neither of which are acceptable to Western shareholders.



In one Latin American country, I once assisted in a meeting of “stakeholders” – colorfully clad activists interested more in robust projection of their agendas rather than dialogue with potential employers and tax payers. As much of the increasingly acrimonious debate was couched in terms of racial self-victimization (“Spaniards came here 500 years ago, brought us shards of glass and took our gold”), the most interesting moment came when the attention of the attacks was redirected from the well-trodden path of anti-Western and anti-Anglo Saxon bashing. To rowdy ovation from the class-conscious crowd, a speaker lashed out again a dangerous new beast – “las Multilatinas”, successful Latin American companies in search of growth opportunities in neighboring countries. Latin “capitalists” were deemed unwelcome, just as other “foreigners” and their local allies.

Physical constraints are gradually becoming a barrier to capital flows as well. In agriculture, mining and energy, the low-hanging fruit has been largely harvested. The available agricultural land in South America and Eastern Europe is not adequately linked to major market thoroughfares and it will take years before adequate infrastructure is developed. In the US, much of the protected federal land could be released, but due to soil quality, it cannot be instantly transformed into fertile corn or soybeans acreage. Meanwhile, oil, gas and metal exploration efforts are forced move to increasingly remote locations in the Arctic Circle, sudorific jungles or off the continental shelf, only to tap into deposits of lower quality than those that are currently being depleted.

It is extremely difficult to attract and maintain a committed workforce in those inhospitable, boring and often dangerous places. The fact that so few schools prepare new generations of geologists and engineers further exacerbates this problem. And although the global transportation links may have spread out a single company’s asset web around the planet, the increased transportation costs make even these value chain decisions questionable. The strain on international logistics contributes to increased costs as too few sources with too few linkages carry massive volumes of products to too few end-point destinations. The resulting costly delays lead to further dislocations in the trade system.



All commodity production is, to certain extent, dependent on weather conditions. As the recent floods in Eastern Australia have proved, a global 850mt seaborne coal market may suffer disproportionately from a knock-on effect caused by excessive downpour in one, key region. But more surprises may be on the horizon. The unusually cold winter over a landmass stretching from Iran to Korea, wet weather conditions in Japan, floods in Southern Africa and North America and cooler, wetter summers in Europe, have all an impact on economic activity, and nowhere is this influence stronger than in the agricultural markets. It just could be that the sun spot activity cycle will usher the planet into several cooler years. It could also be that the melting Arctic ice cap has poured so much fresh water into the North Atlantic that the Gulf Stream is trapped much further to the south, leaving American northeast and European west colder than usual. It could also be that we are entering an uncharted era in which anthropogenic factors begin to interact with (poorly understood) climate effects of ultraviolet and cosmic rays. Whatever the causes, the weather volatility at this new stage of Holocene will continue to impact the already tight global commodity markets and the low inventories.

Finally, the illiquid debt markets and the underperforming stock markets do not make it any easier for resource companies to increase the supply of raw materials. Huge delays in permitting process deserve part of the blame. It now takes up to 4 years to finalize a feasibility study, up to 10 years to obtain the necessary permitting in certain Western countries, and up to 48 months to have the critical equipment delivered. Even if some of these periods overlap – it does go a long way in explaining why the commodity boom has NOT been followed by a swift production response.

Because of exploding capital costs and expensive, but chronic delays, mining companies are not developing brand new “greenfields” projects, nor can they enter profitably many countries due to the afore-mentioned resource nationalism. They can and do redeploy their cash either in mergers and acquisitions, which are supply-neutral, or in “brownfields” developments nearby their existing operations. The latter choice may actually be supply negative – the mining companies move to lower grades, extending the life of the mines and improving their net asset value, often effectively lowering the volumes of payable product.

21st CENTURY'S ZENO PARADOX

With the supply side so constrained – the only solution lies in the adjustment of global demand patterns. But the much-talked about “demand destruction” could be a short-term phenomenon. In any case, it has not occurred yet. Unfortunately, the main emerging market economies carry a statist legacy, are not fully market-driven and often introduce various price distortions that make price transmission more opaque. Regulated energy prices in China and in India reallocated capital away from utilities and pushed energy demand too high, now leading to accelerated energy imports of oil and coal. Similarly, India froze cement prices between 2006-07, leading to shortages and increased imports. Last May, despite 59% increase in the prices of raw materials and energy imports, China increased the volume of key imports of resources by another 13%.

It appears that neither conservation nor substitution offer a durable demand solution and more radical technological solution should be sought – both on the demand- and supply side.



In 5th c BC, Greek philosopher Zeno formulated a notorious paradox. If the tortoise is given a head start over Achilles, the Greek warrior will never catch up with the turtle if he always halves the distance between the carapaced reptile and himself. It took 24 centuries for human thought to solve this paradox.

We are slowly reaching the conclusion that, at the current level of technological advancement, this planet’s resources will not allow China and India to reach the level of wealth attained by the Western economies and Japan. This is a sobering thought for the world and a challenge for non-linear technological breakthroughs in alternative energy, agribusiness and material science. Let us hope that mankind’s cerebral power finds solutions before we enter a collision course with these new players’ frustrated ambitions.