Archive for October, 2007

What is driving the latest bout of surging gold, stock and oil prices?

Tuesday, October 30th, 2007

If you have been reading the mainstream press recently, you will find reasons such as these for the recent surge in oil price:

  1. Tensions in northern Iraq
  2. Supply concerns in Mexico due to tropical storms
  3. Violence in Nigeria’s oil producing region
  4. Falling US dollars
  5. Lack of credibility in OPEC to raise oil production

Likewise, you will find news reports saying that gold price has been surging due to the weak US dollar, stock prices are rising due to the market’s anticipation for interest rates cuts, price inflation is growing due to overheating economy, food prices are swelling due to climate change, and so on.

What is the common denominator for all these surge in prices?

As you would have guessed by now, the common theme among all these explosion in prices is monetary inflation (aka ?printing? of money). We said before in How is inflation sabotaging our ability to measure the value of things?,

Now, let come back to measuring the value of oil. Since oil is priced in US dollars and if the supply of US dollars can be expanded and contracted at will by the Federal Reserve, how useful do you think it is as a calibration for measuring the value of oil?

Thus, in the context of monetary inflation, explaining the movement of prices via the traditional supply-demand analysis only can produce nonsensical ?explanations.? No doubt, some of the rise in prices are justifiably due to supply-demand fundamentals. But when monetary inflation is thrown into the mix, all these price movements will be severely distorted. Such distortions create false price signals, resulting in widespread economic miscalculations and perceived dissonance between what the prices should be and what it is. When that happens, you will see the likes of asset managers (or money shufflers) shifting money from one asset class to the other (see Analysing recent falls in oil prices?real vs investment demand).

Now, gold and oil are the current fashion rage of the money shufflers. Therefore, we would not be the least surprise if the winds of fashion rave changes direction.

Contradictions in the red hot Chinese economy

Saturday, October 27th, 2007
The China growth story is a fascinating story. The swelling Chinese economy is the envy of much of the developed nations, who are struggling with either economic stagnation or lackluster economic growth (for example, Japan is now faced with the danger of falling back into recession). Indeed, there has been talk that China will soon supplant the United States to become the engine of global economic growth. That argument says that the world should not fear the United States falling into severe economic recession because China (along with India) is there to save the global economy.Again, we would like to express our skepticism with this argument.No doubt, in the very long run (when we say ?long run?, we do really mean a very long time measured in terms of decades), this is true. But that does not preclude harrowing setbacks in the short term. As you may recall in our metaphor (see Crisis and the China growth story), China is like the fit young bloke falling into serious injuries because he is running too fast for his own good. The United States is like the weak and elderly grandfather who is also running too fast for his own good and fell into serious injury too as a result. But in the long run, which of the two is better able to cope with such a crisis?As we look at China, we find many contradictions. These contradictions are warnings to us that the outcome may turn out ugly at least in the interim:

  1. As we mentioned before in Why is China printing so much money?, the supply of money is expanding very rapidly in China, resulting in price inflation. Inevitably, mal-investments are building up in the Chinese economy, which will eventually result in a bust (see What causes economic booms and busts?). Already, as this article in the Sydney Morning Herald (SMH) says,
  2. …many experts believe China has entered a new inflationary era because its pool of surplus labour, which once seemed limitless, is drying up in large tracts of the country.

    Hence, if this trend continues and everything else remains equal, we can expect to see many projects in the Chinese economy to fail due to labour shortages. Such labour shortage will manifest itself in the form of surging wages, price inflation, which will force the liquidations of many unprofitable and unfinished projects. When the Chinese economy enters such a liquidation phase, it will be recognised as an economic bust.

  3. As this article in the SMH says,
  4. Central bankers are also watching whether China can drive the world economy through a US downturn. Whether China succeeds depends on how its politicians view and manage the three contradictory objectives of slowing growth to reduce inflation, keeping growth sufficiently strong to soak up redundant state enterprise workers in depressed areas like A’cheng, and holding food prices high enough to improve peasant incomes.

    What are the chances of the Chinese authorities being able to achieve these contradictory objectives simultaneously? It looks that they have hardly any wriggle room to do so.

  5. Despite bringing economic prosperity to vast segments of the Chinese populace, the gap between the rich and poor in China had actually widen over the years. The root cause of this is uncontrollable monetary inflation (see How to secretly rob the people with monetary inflation?), which resulted in the transfer of wealth from the asset rich to the asset poor. This is a potential social crisis waiting to happen.
  6. With rampaging asset price bubbles in the property and stock market, what will happen when those bubbles burst? As history shows, all price bubbles eventually burst? We are hearing stories that many Chinese people are transferring their savings (some doing so recklessly with complete disregard to their financial safety) into the stock market.
  7. Rampant economic growth had resulted in severe degradation of the environment. As history has shown, no nations can destroy their environment and remain viable in the long run. In China’s case, there is a need to sacrifice short term economic growth for long term sustainability of the environment. The question is whether there will be political will to do so (see China to pull the plug?).

So, is China at turning point? If so, what are the consequences? Stay tuned!

Crisis and the China growth story

Wednesday, October 24th, 2007

Our long time readers will have known by now that we are skeptics of the China growth story (i.e. that China will pull the world’s economic growth, independent of the United States). We are skeptics not because we have doubts about the probable coming rise of China. Rather, our skepticism, as expressed clearly in Will the China boom go in a straight line?, was one of expectation on how the story will run. We reckon a metaphor is best used to explain our opinion on the China growth story…

Imagine a weak and elderly grandfather and a fit and young bloke are running together. Obviously, the young bloke is going to run much faster than the grandfather. Both are running as fast as they can, in fact too fast for their own safety. Predictably, both of them eventually tripped, fell and suffered painful fractures. For the grandfather, due to his advanced age, took an awfully long time to recover. Even then, the recovery could not restore him to his previous state of health. Sadly, he is confined to a wheelchair for the rest of his life. As for the bloke, due to his optimal health at the prime of his age, that injury proved to be only a temporary setback in his life. Before long, he is fit and fine again, back to his previous self again.

But at that point in time when both of them first got injured, who would you place your faith and optimism on? Obviously, you would choose the bloke. But it is not that easy when it comes to looking at the macro-economic big picture at the heat of the action in the chaotic market.

Is Australia facing economic crunch time soon?

Monday, October 22nd, 2007

Australia had it lucky for so long. So far, there had been 16 years of uninterrupted economic growth and various media reports are indicating that the trend looks set to continue. This is thanks to the rise of China and her voracious appetite for Australian resources., resulting in a commodities boom that will help power the Australian economy even further. The assumption is that China will continue to grow and grow, forever and ever, pulling the rest if the world up with her into perpetual prosperity. As we said before in Will the China boom go in a straight line?,

We agree with the generalities of this story. True, we believe that China still has plenty of room to grow and its demand for natural resources on planet Earth will have to increase in the decades to come.

However, the market always latches on to the generalities of a story and takes a simplistic projection of the story too far into the indefinite future. What do we mean by that? Put it simply, we do not believe that the rise of China will take on the path of a straight line. Instead, there will be ups and downs, booms and bust and progress and setbacks. Anytime when the path does not look like a straight line upwards and take a temporary dive, the market will flip to the other extreme of this story and project extreme pessimism into the indefinite future.

Looking at China soberly, we can see that behind such amazing growth, there are enormous challenges and serious problems that can lead to economic crisis. According to the Bank for International Settlements (BIS), China is now repeating the same mistakes that Japan committed in the late 1980s. As the article, Stephen Roach on China?s ?Unstable? and ?Unsustainable? Economic Model said,

?There?s a broad consensus in Beijing that what has worked very successfully for nearly three decades will not work going forward. And while the economy certainly performed very impressively last year, there is a growing sense of concern in official China that may not be the case for much longer.?

As we said before in China at turning point?, the dis-inflationary (and even deflationary) effects of Chinese manufacturing has come to an end. Therefore, the seemingly low inflation environment that Australia and much of the Western world were experiencing is coming to an end. Thus, what are the implications for Australia?

Barring any catastrophic financial meltdown in the global financial markets (see Spectre of deflation), price inflation will be on an upward march again. This means that interest rates will be rising (see Have we escaped from the dangers of inflation?). What will rising interest rates do to the Australian economy?

If you look at Professor Steve Keen’s DebtWatch charts, Australia’s frightening high levels of debt makes her highly vulnerable to rising interest rates. Already, as we can see from the political election campaigns in Australian, a frequent theme is often being heard: working families are struggling due to price inflation and debt. Already, there are news reports of soaring bad debts among finance firms. At the fringes, we are seeing signs of the Australian economy under stress (see Investors beware! Signs of economy under stress).

Therefore, we believe Australia is inching one step closer towards a recession as each day goes by.

Why are food prices rising?

Wednesday, October 17th, 2007

Reading the financial press lately, you would have noticed that there are numerous reports of food price inflation over the past year. For example, the price of pork is rising in China and wheat prices are going up, along with the price of corn and other industrial commodities. Why is this so?

We have identified 3 broad global macro themes that will shed light to the answer to this question:

  1. Rise of bio-fuels (ethanol) production As we said before in Prepare for more food price inflation, producing bio-fuels divert agricultural resources away from food production and consumption, thus contributing to rising prices both directly and indirectly. Corn is the best example of this.
  2. Climate change This is the dominant reason for rising food prices. Many parts of the agricultural world are in prolonged drought, which resulted in reduced agricultural commodity output. Global warming has been blamed for it. It is unclear whether such climate change is permanent or not.
  3. Rise of China As China becomes wealthier, its people begin to consume more meat. More consumption of meat means more consumption of grains for livestock, which compete against the demand for human-consumed food.

Thus, as much as you believe that these 3 macro themes will remain, food price inflation looks set to continue.

Unrepentant? Creating a securitisation “super-middleman”

Monday, October 15th, 2007

We read this article, Banks seen readying $100B bailout,

A consortium of the world’s biggest banks, led by Citigroup, is working to create a fund to back up to $100 billion in shaky mortgage and other securities, according to published reports Sunday.

As we said before in Consumers paying for the implosion of dumped risk, it is such unsound lending practices that led to such risk in the first place. Now, they are taking steps to enable the continuation of such nonsense (which is re-branded as a ‘solution’)?

Wait a minute! Isn’t such reckless securitisation the cause of the problem in the first place?

Another rally to record high… before a fall?

Wednesday, October 10th, 2007

Yesterday, the Dow rallied to yet another record high. Presumably, the reason was because the market, after looking at the previous Fed meeting’s minute, concluded that more rate cuts will be on the way.

As we said before in Drugged up stock market,

.. bad news is good news because a deteriorating economy will induce the Fed to flood the financial system with even more cheap money.

But don’t you notice that the flood of bad news has seemingly abated and the crisis in the credit market had been all but forgotten. If that is the case, wouldn’t such a lack of bad news induce the Fed to hold off more interest rate cuts? If the Fed take a pause in meddling with the interest rates after its next meeting (at the end of October), would that induce the stock market to fall again?

Hold your breath.

Australian mortgage sales slump: buyers’ nerves or tightening credit standards?

Monday, October 8th, 2007

Today, this news article caught our attention: Mortgage sales slump as buyers’ nerves fray. In this article, it reported that,

THE number of mortgage sales across Australia fell by 21.2 per cent month-on-month during September, according to an industry survey.

In the past two years, the same index has recorded a seasonal downturn of 8.5 per cent in mortgage sales during September.

Mark Hewitt, AFG’s sales and operations general manager, said last month’s downturn represented a decline of two-and-a-half times the established seasonal average.

Basically, the value of mortgage sales fell 20% in the month of September. Mark Hewitt, who is the sales and operations general manager of AFG, Australia’s largest mortgage broker, was reportedly saying that ?There’s no doubt that concerns about global debt markets and the unknown potential impact of sub-prime difficulties is making property buyers hold off?

We doubt the reasoning of Mark.

No doubt, there were some negative media coverage about the sub-prime crisis in the US and the havoc being wrecked in the global financial markets. But generally, this storm is still largely confined to the financial universe in Australia and has yet to be spilled over to the Australian Main Street. Therefore, to the average potential Australian mortgage borrower contemplating buying a house, will that be a good enough reason to run away?

We suspect the more likely reason is that the havoc in the financial universe led to banks and lending institutions being more wary of lending money i.e. lending standards being tightened.

Another interesting paragraph in the article:

Despite the fall in volume of mortgage sales in Victoria, the average mortgage size broke through the $300,000 barrier in that state for the first time to hit $304,000, up from $289,000 in August.

If the volume of sales fall and yet the average mortgage size had risen, what does that mean? It means that mortgages of lower values had been dropped off compared to the previous month. Does that mean that the purchases of cheaper homes had decreased in September? Who would be buying those cheaper homes? Probably those who are on lower income. Would lending standards be first tightened on those who are on lower income?

These are interesting questions. What do you think?

Danger of China leaking money to overseas stock

Saturday, October 6th, 2007

In our previous article, China considers leaking money to overseas stock, we mentioned that it is possible that by opening the outward investment channels, it may result in disaster. Today, we will talk about how it may happen.

This policy works when China has a lot of foreign currency reserves and a lot of foreign money flowing in through the trade surplus (that is, a lot of RMB is being printed in exchange for these foreign currency inflows?see Why is China printing so much money?). Opening outward investment channels will result in the depletion of China?s foreign currency reserves.

But let?s say an economic crisis hits China. Foreign speculative money that flowed in easily will then flow out just as easily. As foreigners redeemed their RMB for foreign currencies, the Chinese central bank will have to fork out those currencies from their reserves in order to maintain the exchange rates. Hence, the Chinese foreign currency reserves will dwindle in supply.

Devaluing the RMB will exacerbate the problem. By devaluing the RMB, the Chinese central bank is in effect exchanging less foreign currency for every unit of RMB. In that case, foreigners? holdings of assets denominated in RMB will decrease in value in terms of their foreign currencies. This will prompt foreigners to withdraw their money from China to cut their losses. When foreigners withdraw their money, this means they have to sell assets, which will worsen the asset price deflation in China (e.g. stock market crash), which in turn will give them a stronger reason to cut loss and withdraw more money from China.

Therefore, when capital flight (from China) happens, China?s foreign currency reserves will be drained out. Of course, the Chinese authorities would probably implement capital controls to prevent capital flight to preserve their reserves. But that is akin to a bank preventing cash withdrawals in order to protect its cash reserves. Either way, if the situation should come to such a stage, serious loss of confidence in the Chinese economy and financial system will result in an ugly state of affairs.

If China should open the way for outward investments, then we will expect their foreign currency reserves to be reduced, which will result in their reduced ability to deal with a capital flight in future (assuming that the RMB is still not freely floating).

Popular topics

Friday, October 5th, 2007

For your convenience, we have grouped together articles of popular topics at this page. This page is a work in progress. So, please visit it often for updates.