Summit season is upon us

I’m off to the APEC CEO Summit in Lima, Peru and so in a bit of a rush. So I’ll just dump the good stuff that’s crossing my desk this Monday morning without too much editorial.

In short, I’m looking for signs of de-coupling of the real economy from the financial smoke and mirror factories - the ‘zombie’ Wall Street banks. I’m also looking for global triage and think it possible that we’ll see some economies (that’s you Japan, China, Brazil, India and Saudi Arabia) break away from the de-leveraging black hole and via fiscal stimulus sustain each others’ growth and credit needs in a manner similar to Malaysia’s course in the ‘98 crisis. For the time being, I’ve given up on the US (too much debt, too little industry), and Europe looks neutral at best. Iceland, of course, is toast, and the UK is wobbly.

Illargi:

Paulson throws your money at the one sector of the economy that doesn’t do anything useful, money that could have been used to support those sectors that provide your jobs and produce things that are actually useful.

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Is it just me, or does the US dollar remind you of frequent flyer points that can only be spent on a rapidly dwindling catalog of increasingly shonky goods? It looks like China may be wishing to cash in some of theirs on parts for a railroad, and they should.

Comstock Partners summarises the situation for the US:

We have a budget deficit of about $455 billion this fiscal year and as we have warned in many of our weekly comments, we expect a deficit of $1 trillion or more in the next fiscal year. The incoming administration is also inheriting a $10 trillion government debt… We don´t expect the current global recession to end until the end of 2009 or beginning of 2010. The record U.S. total debt of over $50 trillion on an economy of almost $15 trillion is what we would call very onerous. For a period of about 20 years from the 1960s through 1970s it took $1.50 of increased debt to generate each additional $1 of GDP, but that ratio has trended up consistently in the last 28 years. In recent years it has taken about $3.50 of increased debt to generate an incremental $1 of GDP… Now that the deleveraging process of debt unwinding is in full swing world-wide, what do you think is going to happen to global economic conditions?

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US data last week set more records:

U.S. workers drawing jobless benefits hit a 25-year high this month… Consumer spending fell 1.5 percent last month, after a 2.4 percent drop in September that was the largest since SpendingPulse started the data series in 2003… U.S. imports from China hit a record $33.1 billion in September, but imports from the European Union fell 3.8 percent and imports from the Organization of Petroleum Exporting Countries slumped 27.1 percent as the cost of imported oil fell by a record $12.41 per barrel in September… imports of consumer goods fell nearly 7.9 percent in September… U.S. exports fell at the fastest pace in seven years… U.S. goods exports fell by a record $10.4 billion, with all major categories showing a decline.

Ecinya doesn’t expect much from the G-20 conference:

The world cannot begin to resolve the systemic and economic problems that have derived from the American fiscal and monetary policy malaise UNTIL George W Bush departs the global stage. This weekend George W is hosting the G20 Summit.

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Everyone has advice for the summiteers. VoxEu published a short book (pdf). Dani Rodrik had a good go at pre-drafting the inevitable communiqué as leaders agree to agree, except “The Bush administration opposes any regulatory agency with cross-border authority”. His summary:

There is no coordination in the fiscal arena, the promises made to emerging markets are vague, and even though there is a clear statement on protection and export subsidization, there is no monitoring or enforcement mechanism.

Jean-Claude Trichet (president of the European Central Bank) would like to fix three things: incentives, transparency, and pro-cyclicality.

Modern financial systems have favoured instruments and intermediaries that promise large returns in the short term. Institutions come under pressure to follow the strategies of those able to show high short-term profits. This process tends to lead to herding behaviour, in which risk controls easily become a secondary issue. We need to counter these mechanisms and establish the right incentives for achieving a balance between short-term and long-term investors and intermediaries. Incentives for market participants need to be strengthened in this respect, including through revised internal compensation schemes…

The second point concerns transparency. Despite all regulatory advances and progress in information technology, the financial system has been characterised by a lack of transparency about the ultimate allocation of risks. Two examples are the sheer complexity of structured financial products, which even sophisticated investors are not able to assess properly, and the lack of regulation for certain financial institutions. Regulators therefore need, in particular, to tighten up requirements for markets in which structured financial products are traded and strengthen reporting requirements for formerly unregulated institutions…

Finally, pro-cyclical behaviour is pronounced in financial systems. But in the present global financial system there are mechanisms that intensify fluctuations. The challenge is to preserve an efficient financial system as an engine for economic growth and at the same time ensure its stability. For example, capital regulations and provisioning rules as agreed by the Basel committee on banking supervision, and industry governance structures, especially in the area of risk management, need to restrain excessive risk-taking in upturns and discourage excessive conservatism when credit to companies and households is most needed…

Spiegel surveyed Nobel prize economists

Lucas: The public needs a conveniently provided medium of exchange that is free of default risk or “bank runs.” The best way to achieve this would be to have a competitive banking system with government-insured deposits.

Stiglitz: To too great extent, there has been a race to the bottom in accordance with the myth that deregulation breeds innovation. Instead, the innovation was greatest when it came to getting around the regulations designed to ensure good information and a safe and sound financial system… Financial market regulators, at both the national and international level, have failed… Even countries which have done everything right — those which have managed their economy with far better regulation and better macro-economic prudence than the US — will suffer as a result of America’s mistakes… The sources of liquid funds are in Asia and the Middle East. But why should they turn their hard earned money over to an institution with a failed track record; one which pushed the deregulatory policies that have gotten the world into the mess where are in now; one which continues to advocate the asymmetric policies which contribute to global instability; and one whose governance structure is so flawed?

Phelps: A good life requires a rewarding workplace — one of change and challenge — and that requires some sort of well-functioning capitalism… That the banks chose to take on ever-greater levels of risk, with no end in sight until the collapse, was an effect of employee compensation: Fortunes could be made for each additional day that the bank could operate. There was no claw-back provision that would pay bonuses only for performance over the long term… Unfortunately, the banks for the most part appear to have lost the expertise to make business loans and investments, which they once had…

Samuelson (age 93!): Based on my observations of economic history, both short run and long run, I believe that there is no satisfactory alternative to market systems as a way of organizing both economically poor and economically rich populations. However, using markets is not the same thing as unregulated capitalism so beloved by libertarians. Such systems cannot regulate themselves, either micro-economically or macro-economically… President George W. Bush will figure in the history books as the worst president in the 234 years of US history…

In a sign that they are prepared to sideline the outgoing US president, Mr Medvedev backed the call from President Sarkozy for a follow-up summit in February once Barack Obama has taken over.

The world simply has to hold its breath for 60… more… days…

A new world financial order

Much discussion on the inter-tubes post the Obama/Dem landslide about the need to get the global economy going and at the same time resolve the clear problems with the de-facto Bretton Woods II arrangement in which the poor emerging economies finance consumption in the rich US, UK and EU.

Martin Wolf does a good job laying out the background, since the original Bretton Woods in 1944:

…what is happening lies at the intersection between global macroeconomics – money, the exchange rate and the balance of payments – and global finance: capital flows, financial fragility and contagion…

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US Election Recap

Well, Barack Hussein Obama is in - the 44th President of the Unite States - with a solid Democratic majority in the Congress and the Senate, and the right to appoint 2 or 3 new Supreme Court justices for life. When Ohio voted Democratic for the first time since Lincoln the race was all but over.

Bush, characteristically, told him to go out and party

‘What an awesome night for you, your family and your supporters. You are about to go on one of the great journeys of life. Congratulations and go enjoy yourself.’ - George W Bush

Luckily, Obama appears to have more of a grip on reality…

For even as we celebrate tonight, we know the challenges that tomorrow will bring are the greatest of our lifetime — two wars, a planet in peril, the worst financial crisis in a century. Even as we stand here tonight, we know there are brave Americans waking up in the deserts of Iraq and the mountains of Afghanistan to risk their lives for us. There are mothers and fathers who will lie awake after the children fall asleep and wonder how they’ll make the mortgage or pay their doctors’ bills or save enough for their child’s college education. There’s new energy to harness, new jobs to be created, new schools to build, and threats to meet, alliances to repair. - Barack Obama victory speech

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There’s an election on

In anticipation of my time freeing up in 24 hours or so, here’s some last-minute analysis from the best election site I’ve come across (and they keep on getting better): http://www.fivethirtyeight.com/

McCain, to win, absolutely HAS to win Florida, Georgia, Missouri, Indiana and Montana; and almost certainly both Ohio and North Carolina.

Obama will win if he wins Colorado, and ANY of Pennsylvania, Ohio or both Virginia and Nevada.

At this point the only poll that counts is being taken in the voting booth. Now get out there and make sure your vote gets counted!

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Cash is King

For example, Charles I of England. There is no doubt that cash has been good to hold over the past year, US dollars and yen especially as everyone squared their accounts.

But Morgan Stanley doesn’t believe in deflation, and neither do I.

Although headline prices likely will decline sharply in coming months, underlying inflation over the past three months is elevated at between 2.7% and 3.3%. Surveys of one-year ahead inflation expectations are still over 4%… We think more fiscal stimulus is coming soon, most likely totaling $150-200 billion, and possibly before the turn of the year…

Cash rates around the world (except Iceland) are dropping as authorities cut official rates and flood the system with easy money. Long rates are going to rise so you don’t want to be holding long term bonds, unless you can get 14% for 10 years (in Barclays) like the Gulf SWF’s. Don’t want property for another 3 years, commodities in a recession or equities as earnings fall. But your hard-earned and harder-saved cash is about to compete with Gutenberg.

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Watch the yield curve

We’ve moved from the imminent collapse of bank balance sheets and trade credit to the work-out phase, both in the real economy and for the national debt now underpinning the banks.

Tim Duy via Economist’s View says:

Once the deleveraging is complete, foreign investors will realize they are now awash in Dollar denominated assets at a time when the US Treasury is expected to unleash an unprecedented quantity of such assets on global financial markets. The Dollar and commodities will reverse direction accordingly… I admit to being sympathetic to this story, but would note that sufficient slack looks to be opening up in the global economy to absorb these assets (especially if China continues to backstop the US economy). I assume this is the Fed’s view as well. If the Fed is in error, the yield curve should steepen dramatically in coming months.

Some amusing graphics - the first on who is going to rescue whom…

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The great carry trade unwind

Kedrosky has a chart of major currencies showing only the Yen is holding it’s own, indeed rising, against the USD over the past two months.

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Update, an even better chart:

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Brad Setser also notes that this dollar strength was not global investors fleeing to a “safe” currency.

Net TIC flows in August (line 30) were essentially zero (-$0.4b). Foreigners (apparently led by official investors, but the data here is deceptive) were net sellers of US long-term assets, selling about $9b… Net long-term flows were essentially zero. And so were net short-term flows… The story is simple, at least in my view. Most foreign demand for US assets over this period came from central banks. And they increasingly only wanted to buy Treasuries.

JPY and USD were the two currencies most involved in the carry trade, in which levered hedge funds borrowed at low rates to invest around the world. Now that funds (hedge, pension, bank, SIV) are forced to permanently reduce their leverage they have to get the borrowed currency back to square their books, just when the liquidity in markets has evaporated.

Anybody who thinks that the USD is strong for fundamental reasons is due for disappointment once this unwind is over.

Drive by looting

Greg Ip quantifies the level of intervention thus far, and warns that there could be far more to come.

Before the crisis began, the Fed had $868 billion of assets, 91 percent of them in innocuous Treasury bills and bonds. Now it has $1.6 trillion in assets, with less than 30 percent of them in Treasuries… $1.8 trillion in assets is equal to just 12 percent of America’s gross domestic product… At its peak, the Bank of Japan’s balance sheet amounted to 30 percent of GDP…

Paulson has managed to take the UK inspired (perhaps by Buffet) recapitalisation plan and weaken the impact while increasing the benefits to bank management. Willem Buiter, always good, points out that Paulson is screwing US taxpayers on the terms he is dictating with the banks.

The US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks… In the case of the Fortunate Nine, the injection of capital is through (non-voting) preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injection into Goldman Sachs). Without voting shares, the government has no voice in the running of these banks. It also has no seats on their boards… The UK preference shares have a 12 percent yield and come with government-appointed board members… In addition, in the the case of the Fortunate Nine, there are no attractively valued warrants (options to convert, at some future time, the preference shares into ordinary shares at a set price or at a price determined by some known formula). Quite the opposite, the preference shares purchased by the US state, can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks… That, I would argue, is scandalous, both from a fairness perspective and from the point of view of the moral hazard this creates, by boosting the incentives for future reckless lending…

Stiglitz thinks the same.

Paulson figured he could reshape the UK approach in a way that was even better for America’s banks than his original cash strategy. The fact that US taxpayers might get trashed in the process is simply part of the collateral damage that has been a hallmark of the Bush administration…

It’s almost as if Paulson cares more about his friends and business associates than he does about the average taxpayer…

Update 13 Nov 08

Washington Post reports the Bush administration has taken no action to fill congressionally-mandated independent positions to oversee how the bailout is used. A deadline for the first bailout monitoring report has already passed. The Treasury has committed $290 billion in taxpayer money so far. Eric Thorson, the Treasury Department’s inspector general, said, “It’s a mess. I don’t think anyone understands right now how we’re going to do proper oversight of this thing.”

ASEAN Leadership Forum

While they are still fresh, here are some immediate thoughts on the ASEAN 100 Leadership Forum which I was indeed fortunate to be invited to attend…

First off, it’s pretty clear that ASEAN as a project is a shared journey, not any particular destination. Pulling together a group of 520 million people as diverse as this – financial, political, cultural, ethnic, linguistic, historical – was always an ambitious thing to undertake. The bold approach was to just begin the search for consensus, 41 years ago. This year will see the ASEAN Charter ratified, forming an international legal entity, but while an important milestone this document is clearly more of a platform to build upon than an end in itself. To the extent the project succeeds in geo-political and economic integration ASEAN will become a force to be reckoned with in the same way that the EU has made Europe more powerful and wealthy as a whole than the individual countries would have been. One of the debates was whether ASEAN was getting far enough, quickly enough; but this mistakes the nature of the enterprise in my view. It is where it is, at every point along the way, and each point is better than the one before provided everyone is still content to be engaged. To pre-judge the outcome would be to defeat the purpose of the exercise.

Some of the speakers I was most impressed by…

  • President Macapagal-Arroyo - Philippines leader, ex economics professor, daughter of a former President
  • Shaukat Aziz - ex Citibanker, finance minister (1999) and PM (2004-2007) of Pakistan
  • Timothy Ong - forum convenor, chair of Brunei Economic Development Board
  • Jamaludin Ibrahim - CEO of TMI Malaysia, a local, now regional, mobile telco
  • John Prasetio - ex Andersen Asia Pacific managing partner, Chair of CBA in Indonesia
  • Azman Mokhtar - chair of the Malaysia SWF
  • Senator MAR Roxas - leader of the Philippines opposition

Along with these headliners there were many keen students, business people and salsa dancers (you know who you are) from around the Asia Pacific; all working to understand one another’s views and experience. A great thing.

Investment implications

These countries on the whole – while still facing the huge development challenges of wealth inequality, bureaucracy, corruption, and political turmoil – have been very cautious financially since the Asia Crisis in the late 90’s and so are ‘cashed up’ going into the US/Europe led global recession; and they ultimately have demographics and latent productivity gains on their side. If they can somehow keep their foreign exchange reserves and trade surpluses out of the hands of the US government and/or Wall Street they may be able to use the crisis period to strengthen their real economies and set the conditions for a period of transition from the US/EU debt-funded binge to an Asia-led recovery.

My advice during my 30 seconds of fame was to advocate the following priorities in order to prevent Wall Street’s follies from dragging down the real economy here, as they are already in the USA and Europe:

  1. act fiscally to keep poor people in jobs, and food, by investing in infrastructure, education, health;
  2. keep the ‘plumbing’ connecting savers and borrowers intact, either by offering a government alternative or nationalising the operations (but not the balance sheets) of failing banks, SWF’s and intact banks could possibly coordinate on the lending side;
  3. come back to assessing legacy financial balance sheets and leverage once the real economy has stabilised, simply writing off equity and converting debt until solvent balance sheets are achieved, without any government subsidy;
  4. come up with a plan to provide liquidity for whatever troubled assets are still left without a market, if any.

It won’t escape close readers that this is exactly the opposite of the priorities the US administration has chosen to pursue, sacrificing the real economy and fiscal budget to preserve the management who made the mess. It is this that Main Street suspects, and so has no confidence. It is not just the cost, but the opportunity cost, of doing the wrong things first.

If approached from the bottom up, the real economy – Main Street – will be preserved so taking pressure off of assets and without the game of playing favourites or rewarding folly. There will then be plenty of time to make regulatory and personnel changes to ensure the banking industry returns to its historical function of connecting borrowers and savers rather than running a rigged casino on behalf of management.

On the road

I apologize to regular readers (if any) but I’ve been on the road for more than a week. Meetings and keeping up with the game of musical markets combined with some too-good-to-miss leisure activities to keep me from putting finger to keypad.

I’m currently in Manila for an ASEAN workshop/conference which was meant to be about globalisation, global warming, expensive oil, challenges to democracy, politics of Islam and such; but I have a feeling the conversations in the corridors will be mostly about the banks, central and otherwise, and those pesky bi-modal markets and nasty hedge funds.

From my conversations with all manner of investors in Sydney I came away with a couple of new thoughts on the crisis. For one thing, I thought back to a year or so ago, when Citibank and some others started purchasing equity stakes in the Chinese banks. I’ll bet most observers at the time were like me in expecting these banks to look a lot more like Western banks by now. Instead, we have many Western banks government owned, with balance sheets full of non-performing loans and increasingly permissive “cosmetic” accounting. This world is funny, isn’t it?

On that question of what (if anything) governments should do, I’ve been trying to come up with a framework for thinking about why banking should be treated any differently than any other industry (autos?) that is close to failure. Because banking is ubiquitous it does deserve some special status, like telecoms or electrical utilities. The closest analogy I can come up is a scenario in which all of the power companies world-wide have leveraged up and blown their all of their equity and most of their borrowings on a speculative technology (cold fusion?), and are now no longer able to operate the grid connecting generators (savers) to consumers (borrowers). My conclusion is that the government should nationalise the grid. The grid cannot be allowed to fail or the economy will grind to a halt. But the government should NOT be buying up the dud cold-fusion investments, or shoring up the balance sheets of the leveraged entities. The government should be buying the operating assets - people, buildings, infrastructure - and leaving the balance sheets with those who created them.

In contrast, the Treasury efforts still seem primarily directed at preserving the banking management, both financially and leaving them in control. Incredibly, the only authority that Paulson even has to begin to do the right thing and recapitalise banks is a question and answer in the House before the vote clarifying that this power was included in one of the catchall “and whatever is necessary” phrases. But he is still resisting triage and attempting to cover up the actual damage. Hopefully the rest of the world will move on.

I couldn’t help picking up some great snippets through the week, and will add more to the comments on this post as I do some catching up. I’ve been getting my daily news feed on the iPod - RSS is the best newspaper in the world - and am posting on a 14″ iBook rather than my usual 2×24″ gear…

From 2008 Nobel Prize laureate Paul Krugman:

The only thing we have to fear is fear itself. Fear and negative equity… The two things we have to fear are fear itself and negative equity. And the depleted capital of financial institutions… Amongst the things we have to fear are fear itself, negative equity, and the depleted capital of financial institutions…

From Jeremy Grantham:

We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.

The New York Review of Books has an extensive review of Soros’ new book. Apparently the chaos has coaxed him back into the markets to make another billion or two. The stupidity must be irresistible.

The Milken Institute has a collected overview of the train wreck in slides. It is comprehensive, and devastating to expectations of a miracle recovery. download the original (pdf)

Stiglitz, with a modest plan:

A unique combination of ideology, special-interest pressure, populist politics, bad economics, and sheer incompetence has brought us to our present condition.

I almost missed this Warren Buffet interview, but it is amazing. He is ancient, absolutely without reservations in speaking the truth as he sees it, and seriously worried. His key points: TARP must use market pricing, and we must stick to reporting market values. I only wish he hadn’t likened the crisis to a “financial Pearl Harbour” quite so many times… In a world where the US may be relying on Japanese savers (and many others) for support of a coordinated bailout this struck a jarring note. Why not a “financial Three Mile Island”? It was self-inflicted, after all.