Why did the foreigners bail out cash-starved financial institutions?

January 28th, 2008

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Recently, many cash-starved banks and financial institutions (e.g. UBS, Citigroup) that were stung by huge amount of bad debts were being infused with cash ‘investments’ by foreign Sovereign Wealth Funds (SWF) to rebuild their capital base. If not for such bailouts, many people would not have heard of some obscure names like Abu Dhabi, Temasek, GSIC, etc.

Why are SWFs propping up these financial institutions?

We do not really know for sure, but we can only guess at what is going on inside their dark minds. The common understanding of the purpose of SWFs is, as this Times Magazine article says,

 At a time of extreme stress in global-equity and credit markets, many governments have surplus foreign exchange to play with–and because of the falling U.S. dollar, they are increasingly interested in investing their cash where it can earn greater returns than it would from U.S. Treasury debt, the traditional haven.

But that still does not answer one question- why are they propping up financial institutions specifically? Are investments into troubled financial institutions the best use of their money? We doubt so. If the answer is no, then there must be a deeper reason why they are suddenly so ‘charitable’ towards the financial companies. Today, we are attempting to venture into the deeper recess of their minds…

As we said before in Awash with cash?what to do with it?,

… foreign countries that account for the vast majority of US imports (namely the oil-producing Middle Eastern nations, Russia, China and Japan) are sitting on so much US dollars that they do not know what to do with it.

Their problem is not just that they have too many idle and unproductive dollars, as implied by the above-mentioned quote from Times Magazine. This is because the interests of nations are not confined to just commercial profits the way corporations are. Rather, we believe what they are beginning to fear is that their dollar reserves are turning out to be an increasingly unreliable store of value in the long term. With the way the US is debasing their dollar, we cannot help but agree with Iranian President Mahmoud Ahmadinejad (we are no fans of him, by the way) when he said, “They [the US] get our oil and give us a worthless piece of paper.”

Take the example of China. As we said before in Can China really ?de-couple? from a US recession?, with China at a very resource intensive phase of their development, any insufficiency of resources and capital goods can result in the stoppages and delays of their capital investment projects in the current pipeline. When that happens, the current trajectory of their economic growth will be shot down, resulting in the mass in-completion of half-finished projects. Such an outcome will be dire, as their banks will then be piled with massive bad debts. That will be what we call a “crash.” That explains why China is buying up political and economic influence in Africa in order to secure African raw materials. China’s trillions of US dollars reserve is a form of savings that will be used to acquire their future needs for resources to power their economy in the long term. Therefore, any threat to the long-term value of their savings will be a long-term threat to their economy.

If this is the case, then why did these SWFs choose to prop up financial institutions instead? Why don’t they spend their US dollar reserves to buy up as much resources that they need, as soon as possible?

Well, they cannot do that all in one shot. With such a gargantuan amount of US dollars, such actions will severely upset the global price equilibrium of the things they buy, and the value of the US dollar. For example, if China is to do that, you can see the price of commodities shooting up and the US dollar plunging. That is a great recipe for fostering global instability.

Well, then why don’t they invest their US dollars on more worthwhile enterprising businesses, for example, Microsoft, NTT DoCoMo or some other resource companies? Why did they use them to prop up those financial institutions that deserve to die?

We can only guess and speculate. This is our take on why: by bailing out those undeserving financial businesses, they are helping to prop up confidence in the global financial system, in which the majority of financial assets are denominated in US dollars. If the global financial system collapses, then the value of US dollars will not be worth much any more. If the US dollar really becomes worthless pieces of paper, then the vast savings of countries like China will go up in smoke. If their savings goes up in smoke, their economy will follow soon.

In other words, the vast majority of the world is ‘long’ on the US dollars. There is too much for too many to lose from a falling US dollar. Therefore, if you believe that the death of the US dollar (and all the other fiat currencies) is inevitable, then the wisest thing to do is to take a position on the other side- ‘short’ the US dollar (and all the other fiat currencies). To do that, you will have to ‘long’ gold (see Why should you invest in gold?). The up-trending gold price is telling us that there are more and more people who are ‘shorting’ the US dollar (and all the other fiat currencies).

  • Nice argument and hypothesis.

  • Nice argument and hypothesis.

  • Jackie

    How does China “long” US dollars? Do they dump gold into the market to balance those who “short” the dollars? Or they absorb all the extra money printed by the Fed? Either way, this cannot go on for long, or can it?

    I am just wondering when the whole world is trying to hold the roof up (prevent the US from recession), they may be quite successful for a while before the market dives. Now it seems China is just buying time (by bailing out US financial institutions so the problems do not surface) to prepare for the Black Swan Day. So what does China do during this “extended” time? Just continue to suck wealth from US until US becomes an empty shell? Would China try to quietly acquire gold as well?

  • Jackie

    How does China “long” US dollars? Do they dump gold into the market to balance those who “short” the dollars? Or they absorb all the extra money printed by the Fed? Either way, this cannot go on for long, or can it?

    I am just wondering when the whole world is trying to hold the roof up (prevent the US from recession), they may be quite successful for a while before the market dives. Now it seems China is just buying time (by bailing out US financial institutions so the problems do not surface) to prepare for the Black Swan Day. So what does China do during this “extended” time? Just continue to suck wealth from US until US becomes an empty shell? Would China try to quietly acquire gold as well?

  • Hi Jackie!

    The words ‘long’ and ‘short’ is borrowed from stock trading terminology. When you ‘long’ a share, you buy it- profit when the share price goes up. When you ‘short’ shares, you borrow stock to sell and buy it back later- profit when the share price goes down.

    So, when we say China is ‘long’ the US dollars, it’s an euphemism for meaning that China ‘profits’ (‘loss’) from a rising (falling) US dollar as its US dollar reserves will rise (fall) in value.

    >”I am just wondering when the whole world is trying to hold the roof up”

    That feels like it. More specifically, it is the central bankers and Wall Street who are trying to hold the roof up.

    >”So what does China do during this “extended” time? Just continue to suck wealth from US until US becomes an empty shell? Would China try to quietly acquire gold as well?”

    Good question. China’s hands is probably tied right now. They must be pretty nervous now. Yes, if we were China, we will be quietly acquiring gold.

  • Hi Jackie!

    The words ‘long’ and ‘short’ is borrowed from stock trading terminology. When you ‘long’ a share, you buy it- profit when the share price goes up. When you ‘short’ shares, you borrow stock to sell and buy it back later- profit when the share price goes down.

    So, when we say China is ‘long’ the US dollars, it’s an euphemism for meaning that China ‘profits’ (‘loss’) from a rising (falling) US dollar as its US dollar reserves will rise (fall) in value.

    >”I am just wondering when the whole world is trying to hold the roof up”

    That feels like it. More specifically, it is the central bankers and Wall Street who are trying to hold the roof up.

    >”So what does China do during this “extended” time? Just continue to suck wealth from US until US becomes an empty shell? Would China try to quietly acquire gold as well?”

    Good question. China’s hands is probably tied right now. They must be pretty nervous now. Yes, if we were China, we will be quietly acquiring gold.

  • Jackie

    Hi Editor,

    Thanks.

    China’s hands are tied, but maybe only until Olympics in August. China would not want a global recession before it runs the show.

    I lived in Hong Kong in 1997. Before the handover in July, Chinese govt flooded Hong Kong with excessive money. (Some said it was by the Communist party’s order) The intention was to paint a rosy picture in Hong Kong to show the world (especially Taiwan).

    Of course, this cannot go on for long. By October 1997, the stock market peaked and the Asian Economic Crisis followed. Hong Kong entered a 5-6 year deflation period and any rescue attempts were only lip service. But the media control (secret ones) means that the very painful deflation is not discussed too extensively with the western media.

    So what will happen after Beijing Olympics? Will China stop bailing out US banks and let it fall into recession? I read your article on decoupling theory not long ago and I agree that the world economy is not yet decoupled from the US economy. But if China can create a positive image of “capital refuge” in a global recession by maintaining moderate growth, then a US/global recession would be quite desirable for China wouldn’t it? The capital inflow flooded in China is probably enough to keep their projects going and the Chinese spending. So it may be better for China if the rest of the world are in financial hell then?

    Hong Kong was such a “capital refuge” after the Second World War to Shanghai bankers; whenever China was in trouble, Hong Kong boomed by the flood of capital. The key question is : Is China likely to become such a “capital refuge”?

    Would appreciate your view on that.

  • Jackie

    Hi Editor,

    Thanks.

    China’s hands are tied, but maybe only until Olympics in August. China would not want a global recession before it runs the show.

    I lived in Hong Kong in 1997. Before the handover in July, Chinese govt flooded Hong Kong with excessive money. (Some said it was by the Communist party’s order) The intention was to paint a rosy picture in Hong Kong to show the world (especially Taiwan).

    Of course, this cannot go on for long. By October 1997, the stock market peaked and the Asian Economic Crisis followed. Hong Kong entered a 5-6 year deflation period and any rescue attempts were only lip service. But the media control (secret ones) means that the very painful deflation is not discussed too extensively with the western media.

    So what will happen after Beijing Olympics? Will China stop bailing out US banks and let it fall into recession? I read your article on decoupling theory not long ago and I agree that the world economy is not yet decoupled from the US economy. But if China can create a positive image of “capital refuge” in a global recession by maintaining moderate growth, then a US/global recession would be quite desirable for China wouldn’t it? The capital inflow flooded in China is probably enough to keep their projects going and the Chinese spending. So it may be better for China if the rest of the world are in financial hell then?

    Hong Kong was such a “capital refuge” after the Second World War to Shanghai bankers; whenever China was in trouble, Hong Kong boomed by the flood of capital. The key question is : Is China likely to become such a “capital refuge”?

    Would appreciate your view on that.

  • Jeremy

    It’s interesting that this discussion has focused on China,
    which has played only a small role in “bailing out” U.S. financial institutions. China did inject $5 billion into Morgan Stanley.
    Wealth funds from other countries have been playing a much larger role in this process, notably the UAE, Kuwait and Singapore.

  • Jeremy

    It’s interesting that this discussion has focused on China,
    which has played only a small role in “bailing out” U.S. financial institutions. China did inject $5 billion into Morgan Stanley.
    Wealth funds from other countries have been playing a much larger role in this process, notably the UAE, Kuwait and Singapore.

  • @ Jeremy

    China was used just as an example.

  • @ Jeremy

    China was used just as an example.

  • Hi Jackie!

    Very interesting questions. We are not sure whether we can answer your question adequately. Here are some of our thoughts:

    1. Capital (as in foreign money and credit) can flood in, but mal-investments (in higher-order productive goods) cannot be disguised forever. The short-term effect of capital flood would be even more price inflation. Given that China is now already battling price inflation, they may not want to welcome that.

    2. Our guess that a US recession is ‘desirable’ as long as there is still some semblance of confidence in the US dollar. If not, China would be in trouble too.

    3. In the meantime, the obvious thing China would do is to diversify their US dollar reserves away. But whether they have enough time to do that is another matter.

    Anyone else have any ideas to contribute?

  • Hi Jackie!

    Very interesting questions. We are not sure whether we can answer your question adequately. Here are some of our thoughts:

    1. Capital (as in foreign money and credit) can flood in, but mal-investments (in higher-order productive goods) cannot be disguised forever. The short-term effect of capital flood would be even more price inflation. Given that China is now already battling price inflation, they may not want to welcome that.

    2. Our guess that a US recession is ‘desirable’ as long as there is still some semblance of confidence in the US dollar. If not, China would be in trouble too.

    3. In the meantime, the obvious thing China would do is to diversify their US dollar reserves away. But whether they have enough time to do that is another matter.

    Anyone else have any ideas to contribute?