Archive for November, 2007

Tightening noose around business’s neck

Friday, November 30th, 2007

In our previous article, How money & credit can shrink (i.e. deflation)?, we explained how money and credit can shrink in the economy. Today, we will show you a graph of this happening in the US economy, courtesy of the New York Times:

Tightening Business?s Financial Lifeline

Is Chinese growth ‘de-coupled’ from the US economy?

Wednesday, November 28th, 2007

One of the most well-known economic adage is that “when the US sneeze, the rest of the world catches a cold.” According to that adage, that means that in general, should the US economy falls into a recession, the rest of the world will follow suit.

On the other hand, another theory has been gaining in popularity: China’s growth is ‘de-coupled’ from the ailing US economy. According to this new theory, China should continue to grow and power the global economy regardless of what happens to the US economy. This is the ‘de-coupling’ theory. Proponents of this theory sees that so far, China had ‘de-coupled’ (both in real and financial terms) the most from the US. As we can all see, so far, despite the slowdown in the US (due to the credit crunch and housing slowdown), China’s growth had so far been unaffected. Proponents of the ‘de-coupling’ theory sees that if Chinese growth is dependent on the health of the US economy, we should see signs of the Chinese economy slowing as well. Since there are no signs of this happening, then the conclusion is that the Chinese economy is independent from the health of the US economy.

There are skeptics of this ‘de-coupling’ theory. Most notably, Nouriel Roubini, one of the most prominent bear and contrarian economists believes that China will be the “first and most serious victim of a US led recession.” He believes that as the US economy turns over from the current ‘soft-landing’ to a very serious recession in the months and years to come, it will expose the weaknesses in the Chinese economy. This is his theory:

  1. The current US slow-down is mainly concentrated in the housing and financial sector. So far, the US consumers have not cut back severely on their spendings. It is a matter of time before US consumers will feel the pinch and begin to tighten their wallets. When that happens, Chinese exports of consumer goods to the US will be affected.
  2. A Chinese slow-down from the low double digits growth to mid single digit growth will be considered a ‘hard-landing’ for the Chinese. Due to the political and social environment in China, such a slow-down can have dire consequences.
  3. There is a myth that trade between East Asian nations will save their economies from the US slow-down. Previously, East Asian nations exports their goods directly to the US. But today, the arrangement is different- China is now the receiving point of goods in the primary and intermediate stages of production from East Asian. It is in China that the final stage of production is being completed before export to the US.
  4. There is another myth that if the US consumers slackens, then Chinese and non-US consumers will rise to take up the slack. The problem for China is that its economy is heavily structured towards export (“…exports are 40% of GDP; where investment is 50% of GDP and, leaving aside housing investment, most of such investment is directed towards the productions of more exportable goods”). Thus, the Chinese consumers can do very little to plug the gap of collapsing export-oriented demand. There is also some research that points out that the “there is a very low probability of major improvements in domestic demand or non-US external demand.”

What is the implication of this for Australia?

It is clear that once China slows, its demand for Australian commodities will slow dramatically as well. When that happens, we can expect the Australian economy to be severely affected as well.

Annual lending freeze in China?

Monday, November 26th, 2007

In our previous article, Is China about to crash?, we mentioned about the lending freeze that the Chinese government had edicted. Apparently, from our Chinese sources, this is hardly surprising because such lending freeze often happen annually at the end of the year.

We shall see how it goes this time.

Is China about to crash?

Friday, November 23rd, 2007

The rampaging Chinese stock market had fallen about 18% from its record high in mid-October. Is this just a correction in an ongoing bull market, a slow-motion deflation or a precursor to a crash? This is an interesting question. As usual, despite the title of this headline, we will not be trying to predict the future in this article. But what we do offer is to show you some warning signs of such a possibility:

  1. Anecdotal experience- From one of our contacts in Shanghai who is involved in an export business, the frantic pace of work seemed to have abated significantly. This is hardly surprising, given that the slowdown of the US economy will curb its consumer demand for imported goods. Assuming that this situation is representative of the Chinese companies involved in the export business, it means that Chinese economic growth will slow as well. What will this do to the Chinese stock market, which had awarded ridiculously high P/E to many businesses? As this news article, US slowdown threatens Chinese export growth says:

    China?s commerce ministry warned on Thursday that a slowing US economy would trigger a drop in Chinese exports that would mark a ?turning point? for China?s rapid economic growth.

  2. Lending freeze- Recently, we saw this news article, China Freezes Lending to Curb Investing Frenzy:

    Even a temporary lending freeze, however, could cast a chill on important segments of the Chinese economy, including the stock market, whose steep run-up over the past year has given rise to fears of a speculative bubble. Though off their highs, Chinese share prices have nearly doubled since late 2006.

    The Chinese are walking on thin ice. They started off with absurdities like price controls (see Result of Chinese price controls) and now, they are resorting to lending controls, which is akin to throwing a spanner into a red-hot running machine- the result is unpredictable. Lending controls can accidentally result in a deflation (see How money & credit can shrink (i.e. deflation)?) by hastening the demise of businesses who have their lifeblood (i.e. funds) cut off, resulting in cascading bad debts. We hold our breath on that one. Gulp! On second thoughts, this may as well be, in order to clean up the excesses and mal-investments in the Chinese economy.

  3. Credit crunch contagion- As if the lending freeze is not enough, this time round, the credit crunch has spread to China. This news article, Credit crisis sweeps Asia reports,

    THE global credit crisis hit Asia with a vengeance this week, triggering a massive flight to safety as investors across the region pull out of risky assets.

    Pay attention to this phrase: “…triggering a massive flight to safety…” As we said before in Danger of China leaking money to overseas stock

    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.

    When this happen, imagine what will happen to the US dollar and price of commodities as China’s US dollar reserves get drained out and repatriated back into the US? Imagine what will happen to the supply of RMB in China when this happen?

It’s time to put on your seat-belts and hope for the best, folks.

Supplying never-ending drugs till stagflation

Friday, November 23rd, 2007

Recently, fear and panic about the credit-crunch is resurfacing again. When the US Federal Reserve started cutting interest rates a few months ago, the market suddenly found a new wave of optimism, believing that the worst is over. Consequently, stocks bounced back. But today, the market is realising that the credit crunch is worse than initially thought.

That wave of optimism was based on nothing but a hope (or wishful thinking). In reality, in this world of globalised maze of inter-connected finance, nobody truly understands how it all works (see Financial system?messy, tangled ball of yarn) or where the risks truly are. Therefore, any declaration of victory (in the belief that the worst is over) is premature and foolhardy. As we said before at the end of August (see Is the worst over yet?), the worst is not over. In fact, it was just the beginning. There are still serious questions on to the solvency of some of the major US financial institutions (see How solvent are some of the major US financial institutions?). There are too many unanswered questions.

Our feeling is that there are many more losses worth billions of dollars (possibly hundred of billions) yet to be confessed. The next question is, can this malaise spread? There is no doubt about this- it will definitely spread. The question is how far and wide.

What can happen, looking forward? We explain…

Traditionally, to gain access to money (which is the lifeblood of businesses), one has to go to the bank. Recall that we said in Collateral Debt Obligation?turning rotten meat into delicious beef steak,

Back in the old days, the nexus between lenders and borrowers was strong. Before the bank lends you money, it has to know your financial health intimately and ensure that you are credit-worthy enough for a loan. You had to dress in a suit to impress the bank managers enough to convince him or her to give you credit. Indeed, in the old days, accumulating bad debt was bad business.

Today, through the financial ?innovation? of securitisation, the link between lenders and borrowers were broken. It has developed to the point whereby the one who is lending you the money is not the one who has to bear the loss or clean up the mess when you default on the loan. As the loan travels down the chain from the lender to the ultimate owner, intermediaries along the way collect fees and charges. Thus, lenders make profits the moment they make a loan. After that, they pass the risk of bad debt down the chain like a hot potato.

That’s where the trouble starts. Securitisation seems to reduce risk for the individual lender. But overall, it does not reduce risks for the financial system. Instead, it spreads the risks further and wider over a larger area. Since securitisation makes it far too easy to borrow and lend money, the global financial system ran amok on an overdrive of debt and credit creation, escalating the overall level of risks to dangerous toxic levels.

Now, the trouble with credit and debt is that it is like a drug. The more you abuse it, the more dependent you are on it for ever decreasing amount of kicks. We believe that much of the global growth is dependent on this drug. What if the supply of this drug is cut off? There are two options:

  1. Go cold turkey and suffer now for the future benefit of being drug free.
  2. Get more drugs, by hook or crook to avoid as much pain as possible.

From what we know, the world would rather choose the second option. As we said before in A painful cleansing or pain avoidance at all cost?,

But will the Fed follow the Austrian recommendation?

We believe it is highly unlikely. Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

Central bankers have the power to open the floodgates of never-ending supply of drugs (i.e. fiat money). Students of the Austrian Schoolof economic thought will understand that indiscriminate ‘printing’ of money (i.e. lowering of interest rates) will worsen the plague of mal-investments and structural damage in the economy. Like drugs, the more you ‘print’ money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively anymore no matter how much money is being ‘printed.’ That is the nightmare of stagflation (low or negative real growth with sky-rocketing price inflation- look at Zimbabwe).

We believe that in the days ahead, you will see increase in volatility in the market as each threat of cold turkey (e.g. recession, collapses, deflation) is being soothe by even more drugs (e.g. injection of liquidity, bail-outs, cutting of interest rates) from the central banks.

The only sensible thing that Greenspan said

Wednesday, November 21st, 2007

We are no fans of Alan Greenspan. Lately, he had been saying a lot of things to the media and even wrote a book. Some of the things he said and wrote are true and some are sheer nonsense. We have issues with some of the things that he said that are true because he was not practicing them when he was head of the Federal Reserve. Take for example his interview with FOX Business Network:

Fox News: “So why do we need a central bank?”

Greenspan: “Well the question is a very interesting one. We have at this particular stage a fiat money which is essentially money printed by a government and it’s usually the central bank which is authorized to do so. Some mechanism has got to be in place that restricts the amount of money which is produced, either a gold standard or currency board or something of that nature because unless you do that, all of history suggests that inflation will take hold with very deleterious effects on economic activity. … There are numbers of us, myself included, who strongly believe that we did very well in the 1870-1914 period with an international gold standard”.

Very true.

But he was the one ‘printing’ copious amount of money when he was the chief of the Federal Reserve.

How money & credit can shrink (i.e. deflation)?

Monday, November 19th, 2007

Recently, Goldman Sach warned that (see $2 trillion lending crunch seen)

… mortgage wipeout could result in a $2 trillion cutback in lending and have dramatic implications for the U.S. economy.

When that happens, the supply of money and credit will contract in the economy. This is, according to the definition of the Austrian School of economic thought, called a deflation (see Cause of inflation: Shanghai bubble case study for understanding the true meaning of inflation). The symptoms of deflation include falling asset (e.g. property, bonds, stocks) prices. In severe cases, even prices of consumer goods can fall as well (see The mechanics of deflation- increase in demand for holding cash).

Now, how does Goldman Sach comes up with the figure of $2 trillion? As the above-mentioned article said,

A bank that aims to maintain a capital ratio of 10 percent would need to shrink its balance sheet by $10 for every $1 in credit losses.

Therefore, given that Goldman Sach’s estimate that half of $400 billion of loans in the US financial system will go bad, then banks will have to shrink their balance sheet b $2 trillion.

How does this work?

Recall that in our earlier article, 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?, we said,

Today, we live in a time of fractional reserve banking system. Put it simply, if you deposit $100 into a bank account, the bank is going to lend out a large proportion of your $100 and keep the rest as reserves, in case you decide to withdraw some of your money as cash. The proportion that the bank is going to keep as reserves is the reserve ratio. Let?s say the reserve ratio is 10%. After depositing $100, the bank is going to keep $10 and lend out $90. The $90 that someone borrowed from the bank will again be deposited, resulting in $81 being lent out and $9 keep as reserve. At this point time, how much money has you original $100 multiplied into? In terms of the amount of bank deposits, there are now $100 + $90 + $81 = $271 of ?money? in the financial system. This can go on and on, until the quantity of money swell to the theoretical limit of $1000 (based on reserve ratio of 10%). Thus, for example, a ratio of 5% can swell the quantity of money up to the theoretical limit of 20 times.

The original $100 in cold physical cash forms part of the monetary base (or M0). Technically, these physical cash and banks’ deposit on the central bank (yes, banks have accounts in the central bank for them to ‘store’ their money too) forms part of the monetary base. Thus, given a 10% reserve ratio, every $100 of monetary base will result in up to $900 of loans (i.e. credit). That is, the original monetary base is being multiplied up to $1000 worth of money and credit.

Now, what happens if $50 worth of loans has gone bad (i.e. the borrower defaults on the loan)? This time, the multiplication works in reverse. When that happens, you can see that in order to maintain a 10% reserve ratio, $500 worth of money and credit has to be withdrawn from the financial system, by hook or crook. When that happens, banks have to stop lending or recall back their existing loans. If this happens en masse in the financial system, you can imagine what a disaster it will be!

Now, look at how vulnerable Australia is. In September 2007, money and credit (M3) is Australia is worth $910.6 billion. The monetary base is $38.9 billion. Therefore, the overall reserve ratio is only 4.27%. That is, every $1 of physical cash deposit, on average, resulted in $23.40 worth of money and credit added into the financial system. Therefore, every dollar that has gone bad can potentially result in the withdrawal of around $23.40 worth of money and credit from the financial system.

The seriousness of this situation will depend on the quality of debt. If you look at the amount of private debt relative to GDP in Australia (see Steve Keen’s DebtWatch report), you will appreciate the high level of debt risk that Australia is facing right now. Any unfavourable economic shock can easily unravel Australia’s debt bubble, resulting in a serious case of deflation. Right now, we are hearing disturbing news report of mortgage stress and business debt stress (see Debt stress for Australian businesses) in Australia. With the likelihood of sustained interest rates rise, the problem is going to get worse.

Be warned.

Fighting for resources in the mining industry

Saturday, November 17th, 2007

In our previous article, Rising metals price=rising mining profits? Think again!, we mentioned that

… What this means is that the Australian economy is running out of resources to continue every project and production growth in the economy.

Today, we saw this article in the mainstream media: Fortescue ups ante by challenging Pilbara rail access. It says,

FORTESCUE Metals Group’s battle for third party access to railway lines in Western Australia intensified yesterday, as the iron ore explorer sought rights to a network near a massive new deposit.

As economic resources becomes more scarce, we can expect to see some companies that own valuable resources to hoard them for their own profitable benefits. Others which do not have these vital resources will get into cat-fights to get them.

Mainstream chatter about recession in the US

Saturday, November 17th, 2007

More than a year ago, in Tide turned, we warned that the

US economy is very sick and by implication, the stock market will eventually follow. For us, we are hedging our financial well-being with gold.

At that time, most of the mainstream consensus was that either there would not be a recession in the US or there would only be just a ‘soft-landing.’ Today, the mainstream tune is different. They are talking about the high probability of a recession in the US (e.g. Goldman Sees Subprime Cutting $2 Trillion in Lending in Bloomberg and America’s vulnerable economy in The Economist).

In the months to come, after it is confirmed that there is indeed a recession in the US economy, the mainstream chatter will be on how severe it will be. Our view stands with the Bank for International Settlements, a pre-eminent global financial institution that is sometimes known as the central banker’s central banker (see Bank for International Settlements warns of another Great Depression).

The consequences of a Greater Depression (assuming that it will happen) will be globally felt. We feel that China (and by extension, Australia), will not escape unscathed in such a scenario. The question is whether such a Greater Depression will follow the severe deflationary pattern of the 1930s or the hyper-inflationary pattern of Weimar Germany.

Please note that we are not predicting that the Greater Depression will come to us in the near future. Rather, we are warning that the risk and impact of such a happening is sufficiently great enough (i.e. a Black Swan) for us to be greatly concerned.

Myths on the Australian housing/rental crisis & its implications

Thursday, November 15th, 2007

When reading the mainstream press in Australia, one would get the impression that the housing/rental crisis in Australia can be ‘solved’ simply by building more housing. The logic of this mainstream belief is simple: there is a housing/rental crisis because there is a shortage of housing in the face of rising demand; therefore, the only way to ‘solve’ this problem is to increase the supply of housing. As a result of such beliefs, ‘solutions’ such as (1) increasing the government release of land for home building and (2) encouraging investments in home building are proposed.

This is where we differ from mainstream opinion. While it may be true that there is a rental/housing crisis in high demand areas, we doubt it is true for Australia as a whole. Hence, in this article, we will question some of the beliefs in mainstream thinking (we need to thank the people discussing at Steve Keen’s Debt Deflation blog site for shedding light on these issues):

  1. Is there really a shortage of housing? Let us turn our attention to the census data at the Australian Bureau of Statistics (ABS):
      2001 2006 Growth
    Number of Total Private Dwellings 7,790,079 8,426,559 8.17%
    Number of Unoccupied Dwellings 717,877 830,376 15.67%
    Number of Households 6,744,795 7,144,097 5.92%
    Population 18,769,249 19,855,288 5.78%
    Number of Dwelling/Household 1.15 1.18 2.60%

    As we can see, from 2001 to 2006, the growth in the number of dwellings far exceeded the growth in the number of households. In addition, the growth in the number of dwellings also far exceeded th population growth. As the average number of persons per household in both the 2001 and 2006 census is 2.78 (i.e. remained the same) this could not be explained by the decrease in the size of households. This hardly looks to be a shortage situation!

  2. Is there hoarding of housing? According to the census data, the proportion of dwelling that was unoccupied during the census night in 2001 and 2006 was 9.22% and 9.85% respectively. Looking at it another way, the number of dwellings exceeded the number of households by 15% in 2001 and 18% in 2006! Furthermore, the rate of increase of unoccupied dwellings increased almost 3 times the increase in population. Some of these unoccupied dwelling could be due to temporary factors, but it would be fair to say that a significant proportion of unoccupied dwellings are surplus vacant dwellings (i.e. hoarding).
  3. Are rental price sensitive to interest rates? Whenever the RBA decides to raise interest rates, those with vested self-interests will scream that this will result in another surge of rents, thereby ‘exacerbating’ the rental ‘crisis.’ We believe this is a myth. The real cost of rents is impervious to real interest rates, as shown by these graphs:

    Graph to real rental cost versus real interest rates

    Source: Discussion forum at Global House Price Crash (RBA, APM June newsletter, Abelson 2004, ABS)

So, given these findings, here are our theories on what may happen when interest rates rise:

Given that there are expectations of further interest rates rise in the near future, there will be declining hopes for favourable and economical capital appreciation of residential properties for investment purposes (see Australian property good investment? Part 3?prospects of capital appreciation). This is especially true in Sydney where property prices are expected to remain flat. For western Sydney, property prices can even fall.

Since a significant number of dwellings are vacant, interest rates rise will increase the real costs of holding those dwellings as investment properties (i.e. non-productive assets). Since investors cannot count on capital appreciation to make such investments worthwhile, they have two choices:

  1. Liquidate those properties.
  2. Put up those properties for rent.

Such outcome will put further downward pressure on property prices and rental yields.

For properties that are currently being rented, are landlords able to increase rents easily to cover higher interest costs? Perhaps so in high demand areas, but we doubt they can easily do so everywhere else. As the above-mentioned graph has shown, the majority of landlords will probably find it difficult to raise their rents. Even if they could do so, would that be enough to cover higher interest costs? Since they have to face competition from investors who are hoarding vacant properties, it is even harder for them to jack up the price of rents.

Thus, with flat property prices, increasing interest costs and flat real rental returns, investors will find themselves squeezed. This will further encourage the liquidation of investment properties, resulting in further downward pressure on property prices. When property prices deflate, what will happen to the rental market? As we said before in Australian property good investment? Part 2?Rental & affordability crisis,

Because housing is largely unaffordable to a large segment of society, it serves as an impediment for them to leave the rental market through the acquirement of their own property. If they cannot leave the rental pool, it can only lead the pool getting larger as more and more people enters the pool.

That means that when property prices deflate sufficiently, renters who previously could not afford to buy their own homes can now do so. This in turn will shrink the rental pool and thus, reduce overall rental demand. This will put further downward pressure on rent prices, which will further put pressure on property prices, resulting in a vicious feedback cycle.

In short, these are our findings:

  1. There is no overall housing shortage. The increase in the number of dwellings far exceeded the population growth and household formation. Furthermore, the increase in unoccupied dwellings is almost triple the increase in population growth.
  2. Hoarding could be the reason for housing ‘shortage’
  3. Overall, real rental costs are resistant to changes in real interest cost.

As a result, many of the conventional solutions to the housing/rental crisis will not work. Therefore, the only sustainable solution is to introduce/change policies that will encourage a sustained decline in property prices (e.g. remove Capital Gains Tax exemption, close negative gearing loophole)- we recognize that such solutions are politically costly (nobody wants to see the value of their property fall). If the government will not make such a move, then sustained interest/mortgage rates rise will have to step in to do the job. Given that this is a highly probable outcome (see Interest rate rise in Australia- be prepared for more to come), we believe that Australian residential properties are bad investments at this stage of the economic cycle. For first-time home buyers, this will be good news.