Archive for April, 2008

What will be first sign of an impending Chinese economic correction?

Wednesday, April 30th, 2008

In our previous article, Can China really ?de-couple? from a US recession?, we mentioned our theory that China’s economy

may be an epic boom waiting to be a bust.

In that article, there are three major reasons why we have reservations (which may turn out to be unfounded, hopefully) on China’s economy:

  1. “A severe recession in the US economy will crimp US consumption significantly. This will translate into a disproportionate contraction in the higher stages of production, which is China?s job. This in turn will result in yet another disproportionate contraction in yet another higher stage of production- for example, Australian resource production.”
  2. “Does China have enough capital goods, labour and raw materials to continue the current trajectory of capital investment growth in China?”
  3. “To re-tool and re-configure the Chinese economy towards its domestic needs [and away from declining export market] requires a period of adjustment in which capitals are destroyed and built.”

Indeed, Marc Faber did wrote that

Let us assume that the unthinkable happens: China?s economy slows down sharply, or even contracts – and there are reasons why it could.

So, if this unthinkable happens, what will be the warning signs?  Today, we will attempt to answer this question.

Let’s take the above-mentioned reason (2) as an example. Suppose the Chinese economy cannot be supplied with enough raw materials and skilled labour fast enough to maintain the trajectory of economic growth. How will this situation be manifested in real life? Rising and persistent price inflation is a sign that the Chinese economy is running low on ‘fuel’ to keep the economy running at the current speed. During inflationary times, input cost of production rises. For producers of consumer goods, this may mean that their profit margins get squeezed. Some may even go out of business. For major capital projects, rising costs may render them into mal-investments. For example, for the builder of a skyscraper, cost overruns may result in the project being unprofitable. Banks may not be willing to extend further credit for such projects.

For reasons (1) and (3), it is obvious that a lot of businesses will fail.

So, imagine what will happen if all these business and project failures happen en masse? A lot of bad debts will build up in the economy. If there are enough of them, the banking system will be severely threatened. Then the economy will go into a slump.

Therefore, rising levels of bad debts will precede an impending Chinese economic correction. This does not mean that such a correction is imminent. It may possible take a while for that stage to arrive, but we believe that if such breakneck economic growth continues, it is only a matter of time for a bust to arrive.

Pressure on global financial system is still simmering away

Monday, April 28th, 2008

One of the financial veterans you have to respect is Peter Bernstein. As this Wall Street Journal article, One Guy Who Has Seen It All Doesn’t Like What He Sees Now said,

Peter Bernstein has witnessed just about every financial crisis of the past century.

As a boy, he watched his father, a money manager, navigate the Depression. As a financial manager, consultant and financial historian, he personally dealt with the recession of 1958, the bear markets of the 1970s, the 1987 crash, the savings-and-loan crisis of the late 1980s and the 2000-2002 bear market that followed the tech-stock bubble.

Today’s trouble, the 89-year-old Mr. Bernstein says, is worse than he has seen since the Depression and threatens to roil markets into 2009 and beyond — longer than many people expect.

If you look at the financial press today, you will find that the market is ‘optimistic’ that the credit crisis is turning for the better. It has hope that the situation will get better. Consequently, you get to see some recovery of financial stocks and the US dollar. But Peter Bernstein is not so hopeful. As he said,

If China goes into a recession, God knows. The Iraq war and the whole situation with terrorism, we really don’t know where that is going to come out. There are so many things that have got to get buttoned down before you say that the future looks good enough to take a risk.

In other words, there are too many unknown unknown lurking around (see Failure to understand Black Swan leads to fallacious thinking). We share his concern about China and had written a long article about it in Can China really ?de-couple? from a US recession?. Peter Bernstein will only start to get hopeful when he sees that

… housing trouble has to at least flatten out. As long as that is going on, I think the pressure on the credit system is going to persist. It is kind of the leading indicator. It is where the trouble started. We have to underpin the consumer. That is why this is different. That is why this is like nothing we have had before.

This brings us to the Credit Default Swaps (CDS). As we said before in Potential global economic black hole: credit default swaps (CDS),

What happens if these waves of bad debts trigger the contingent obligations of CDS sellers to honour these mass of credit defaults? If these CDS sellers default themselves, what will happen to those who depend on CDS to remain solvent in the event of defaults?

As long as the house price deflation is still under way, the solvency of the financial system will be under pressure, which in turn will lead to further deflation and contagion of credit default. That will test the CDS. As this Economist article said, Swap shop,

However, many market participants were equally reassuring about the health of the CDO market in early 2007?and look how that turned out. Independent observers will not be really reassured until the system survives the test of a big, juicy default. Given the weakness of the American economy and the scale of the credit crunch, it probably will not be long before that test comes along.

If the CDS time bomb explodes (and some will argue that it is a matter of when), the first share market casualty will be the financial stocks. Just as the Germans did not know when and where D-Day will occur (though they knew it was a matter of time), so will the day of CDS reckoning be.

Australia’s monetary growth update?February 2008

Monday, April 28th, 2008

Today, we will show you the latest chart of Australia’s money supply growth from July 1959 to February 2008. Our previous update was at Aussie money supply growth- December 2007 update. Click on the below chart’s thumbnail to see it in full-size:

Australia?s monetary growth (July 1959 to February 2008)

The terms used in this chart was explained in What is money?.

The left axis: The dark blue line represents the growth of the monetary base, while the light blue and red line shows the growth of M3 and broad money respectively.

The right axis: The black line represents the ratio of the monetary base to broad money. As at February 2008, this ratio stands at a wafer thin margin of only 4.37%. As we said before in Australia?s monetary debasement & credit expansion, this means that approximately, every $4.37 of original cash

… in the economy gets lent and re-lent, over and over again until it becomes $100 of credit (broad money)

Please note that in that previous article, we used the currency/M3 ratio. Today’s graph uses the monetary base instead of currency in that ratio, which is more accurate representation.

Finally, the growth of M3 from February 2007 to February 2008 was still at a high level of 21.6%.

What is money?

Friday, April 25th, 2008

This is a deceptively simple question. Last time, money was simply gold and silver. But today, in this modern age of finance, money is far more complicated than what it was used to be. It has come to the point that it is very hard to even define what money is, let alone measure its quantity. Alan Greenspan, the former head of the US Federal Reserve was believed to have said ?We don?t know what money is, any more.? Today, we will explain what money is by explaining the various measures of money supply, according to the definitions of Australia’s central bank, the Reserve Bank of Australia (RBA).

A good way to see money is to think of it as an inverted pyramid, the apex of which is the most liquid form (and most favoured by drug dealers). This most liquid form of money is defined as currency. Currency is the (1) physical notes and coins that can be seen, touched and smelled and (2) held by the “private non-bank sector” (which is basically institutions, companies and individuals that are not banks and governments). Currency is mentioned in the graph in our previous article, Australia?s monetary debasement & credit expansion.

The next broader measure of money is the monetary base, which is (1) physical notes and coins held by the “private sector” (which is anything that is not of the government), (2) banks’ deposit at the RBA and (3) what the RBA owes to the “private non-bank sector.” The central bank (RBA) is the bank of the government and banks. Therefore, your bank will have an account at the RBA where it keeps its money, which is the previously mentioned (2). For (3), an example would be the Medicare rebate that you receive from the Australian Commonwealth government. It will come in the form of a cheque drawn from the RBA. The difference between component (1) of currency and component (1) of monetary base is that the former excludes physical money held by banks (e.g. notes stored inside the ATM machines).

The next measure of money is M1. It is comprised of (1) currency and (2) bank current deposit held by the “private non-bank sector.” In Australia, you may have a current deposit account that pays almost no interest and you can withdraw your money from it at any time. This money will be included in M1.

The next broader measure of money is the M3. It comprised of (1) M1 and (2) other deposits with bank (e.g. term deposits, certificates of deposits, etc).

The broadest measure of money is broad money, which comprised of (1) M3 and (2) borrowings of financial institutions from the private sector. Your money kept in high-yield cash management accounts will be part of broad money.

So, how can there be so many measures of money, from the most limited currency (AU$39.4 billion as at February 2008) to massive broad money (AU$ 1074.5 billion as at February 2008)? Well, you may want to read our earlier article, 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?.

Next article, we will show you an updated graph of Australia’s money supply.

Banking for dummies

Wednesday, April 23rd, 2008

One of the most lucrative business in the world is banking. This is especially true in a world of fiat money and fractional reserve banking system, where money that is backed by nothing can be created from thin air. As we have seen previously in Reserve Bank of Australia entering the landlord business, the central bank can always prevent or prempt a shorter term financial meltdown by pumping liquidity into the system (that is,’printing’ money and then followed by lending them or buying up bad debts or some other tricks- see Recipe for hyperinflation) and introducing moral hazard. But in the longer term, the people have to pay for these moral hazards via inflation.

Today, we will take an introductory look at the business of banking.

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank’s liability but your asset. In accounting technicalities, your money goes into the bank’s balance sheet as an asset with a corresponding liability.

Currently, today’s banking system is a fractional reserve banking system. That means banks do not have to keep all your deposit money in its ‘vault.’ Since it is unlikely that you will recall most of your deposit money at any one time, it can lend out the vast majority of your deposit money while simultaneously maintaining the full balance in your bank statements. Legally, banks have to keep a minimum ratio of deposit money in its ‘vault’ to deposit money. This ratio is the reserve ratio, which is 10% in the US. Countries like Australia do not have formal reserve ratio requirement. The implication is that if every bank customer decides to recall all their deposit money simultaneously, the bank is insolvent instantaneously. That is, there is a run on the bank.

As we said earlier, a bank profits by taking a cut between its borrowing and lending interest rates. If it keeps too much deposit money in the ‘vault,’ it is money that is not put in productive use and thus, have a negative impact on its profits. On the other hand, lending money out entails risks of debt default. Side note: With the rise of securitisation (see Collateral Debt Obligation?turning rotten meat into delicious beef steak), banks (and non-banks as well) are able to lend and re-lend money many times over, spewing out massive amount of credit into the financial system.

As you can see by now, the banking business is a balancing act of managing a portfolio of assets and liabilities. Since the banking industry is a highly regulated one, there are rules for them to follow in this balancing act. For example, there are government regulations that require banks to keep a certain ratio between risky assets (loans and bonds) and equity capital (excess of assets over its liabilities). The upcoming Basel II accord is another such example.

The global credit crisis has thrown many spanners in the works of many banks’ portfolio and by extension, the global financial system. As you can see, bad debts is causing the mayhem in banks’ portfolio (see Is this sub-prime or solvency crisis?). When the financial system realised that the price of money was too low for too long (see Prepare for asset repricing, warns Trichet, which is written back in January last year), banks (as well as non-bank) become very much risk averse and hoarded money as a result. In other words, money suddenly becomes scarce (which implies its price, the interest rates has risen).

So, as we asked before in Reserve Bank of Australia entering the landlord business, what might be the “possible repercussions if the RBA had not [got into the landord business]?” When money becomes scarce and banks (as well as non-banks) become more scared, lending seizes up and credit standards become tighter (see Rising price of money through the demise of ?shadow? banking system). For economies that are drugged up by credit (e.g. Australia, UK and the US), this can cause the economic activity to seize up. The fact that the RBA is temporarily swapping risky assets (mortgage bonds) for thin air money at a bargain price is a very telling sign. And it is not only the RBA that is doing this- it looks that other central bankers are coordinating their efforts in pumping liquidity into the financial system. At least this is the official reason. Since the RBA did not reveal who they get their mortgage bonds from, other conspiracy theorists believe that the RBA are bailing out some financial institutions (which include banks and the non-bank lenders).

For bankers, there is such a thing as free lunch.

Reserve Bank of Australia entering the landlord business

Monday, April 21st, 2008

Last Friday and today, The Reserve Bank of Australia (RBA) got move involved in the landlord business by buying up a total of AU$1.1 billion of mortgages. Effectively, the RBA produced AU$1.1 billion from thin air and lent it at around 7.8% to banks, who in turn lent it to mortgage borrowers at above 9%. Most of that money had to be repaid to the RBA in around a year’s time. Since October last year, the RBA had been buying up around AU$2.64 billion worth of mortgages (source of RBA’s market operations data can be found here).

Let us give you a sense of scale of how big those landlord business transactions were. As at February 2008, there were around AU$218 billion of securitised housing loan (see Rising price of money through the demise of ?shadow? banking system for the meaning of securitisation). Therefore, the AU$2.64 billion of mortgage purchase constitutes 1.2% of the February 2008 securitised housing loan figures.

For now, we are not trying to read too much into this. The RBA is not the only central banking getting involved in the landlord business in the name of providing liquidity. What might be the possible repercussions if the RBA had not done that? Keep in tune!

‘Making’ money or wealth preservation?

Sunday, April 20th, 2008

Over the past year, the many countries in the world had witnessed a substantial synchronised asset price deflation. In the US, the median property price is said to have fallen 10% over the past year. The property bubble in the UK and Spain is said to be bursting too. Stock prices in China had falling 50% since the October 2007 peak (see Chinese stock market overrun by bears). The Indian stock market is also falling. The Chinese property bubble in major cities such as Shenzhen is reportedly to be bursting as well. The Australian stock market had fallen 18% from its November 2007 peak, with its financial stock index falling 32%. The Japanese stock market is also in a bear market.

Back in March last year (when it was still a bull market), we said in How does the US export inflation?,

That is why when the US opens up their spigot of US dollars and engages in a global spending spree, foreign countries have to follow suit by inflating their own money supply so that their currencies will not be overly expensive relative to the US dollar. The result is worldwide synchronised price inflation and asset bubbles.

Today, the reverse process is active. With the US experiencing deflation (see How money & credit can shrink (i.e. deflation)?), liquidity is being withdrawn from the global financial system, resulting in a synchronised asset price deflation (see Marc Faber on why further correction is coming?Part 2).

Yet curiously, at the same time, despite the asset price deflation, the world is experiencing price inflation for gold, oil, metals, food (see Why are the poor suffering from food shortages?) and other commodities.

Dear readers, do you see that this combination of asset price deflation plus general price inflation is the worst possible combination for investors? The whole point of investing is to increase the investor’s purchasing power in the long run. This inflation-deflation combination works together to decrease investors’ purchasing power. In Australia, with its high and rising interest rates, a saver does much better than an average investor (assuming that the official CPI figures is a reliable measurement of price inflation- see How much can we trust the price indices (e.g. CPI)?). The worst off are those who borrow heavily to buy assets that are falling in value in a rising interest rate environment.

As we said before in Is this sub-prime or solvency crisis?,

The problem is that much of the economic boom that we enjoy over the past several years are financed by the explosion of credit (which is debt on the opposite side of the balance sheet). There is such a colossal amount of debt created and scattered throughout the globe that it does not take a genius to see that massive amount of bad debts have to accumulate and build up in the global financial system. Eventually, all bad debts will be exposed as what they truly are.

Now, we have a money-printer in the Fed who is answerable to the Congress, who in turn is answerable to the mob (see A painful cleansing or pain avoidance at all cost?), we have the situation whereby the US is attempting to print its way out of mass bad-debt insolvency. Adding fuel to the fire, we have two (one is already more than enough!) 600-pound gorillas, namely China and India, devouring the earth’s resources at a ferociously unprecedented rate.

Is this sustainable? The sky-rocketing gold, silver, energy, metals and food prices could be an indication that resource mis-allocation and mal-investments is accumulating in the global economy. If so, we cannot rule out at least one of the 600-pound gorilla stumbling, bruising its bloody nose and knocking things all over in the short to medium term (see Can China really ?de-couple? from a US recession?).

Our hunch is telling us that something just do not feel right. Thus, now is not the time to be greedy about ‘making’ money. Wealth preservation is our greater concern (see Why should you invest in gold?).

Chinese stock market overrun by bears

Thursday, April 17th, 2008

Back in November last year, in Is China about to crash?, we wondered,

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.

Today, we can see that the Chinese stock market is firmly in the bears’ territory. From its record high in mid-October high last year till today, the Chinese stock market had collapsed almost 50%. Ever since the beginning of last year (see China paradise for stock speculators) we had been voicing our concerns on the Chinese stock market bubble. The market rose for 9 more months before the bubble finally burst.

But unlike the Western world, the Chinese stock market does not really reflect the Chinese economy. As we said before in What lies ahead for the Australian economy in the coming years?,

… the rot in the global financial system may not affect the real side of the Chinese economy directly. This is because the Chinese financial system is still rather primitive compared to the advanced Wester economies. For example, there are still hundreds of millions of peasants toiling in the countryside. Those who migrated to the cities to toil under the factories are still not plugged into the developing Chinese financial system. Therefore, unlike the Western world, a bearish Chinese stock market does not necessarily forecast doom for the wider Chinese economy.

Those stock speculators deserve to lose their money.

The next financial time bomb- Credit Default Swaps

Wednesday, April 16th, 2008

Today, we were alerted to the fictitious story written by Jacques Attali, who is formerly the top aide to French President Francois Mitterrand and the founding president of the European Bank for Reconstruction and Development: Imagining the worst-case scenario.

One message from this story is clear: the next financial time bomb will be Credit Default Swaps (CDS). As we said before in January this year, Potential global economic black hole: credit default swaps (CDS),

Note: we are not predicting that such a time bomb will explode. But this is another potential Black Swan, which Warren Buffets calls the ?financial weapons of mass destruction.?

That story however, has a happy ending that finishes within a 2-year time frame. We have grave doubts on that ending.

P.S. Note that we are not in agreement with all of Attali’s fictitious story. The CDS part of the story is the one that we want to highlight.

Why are the poor suffering from food shortages?

Tuesday, April 15th, 2008

Recently, there are a lot of news headlines about rising food prices and food-related riots and unrest. As this news article, Food inflation, riots stir concern reported,

Finance ministers meeting in the US to grapple with the global financial crisis have also struggled with a problem that has plagued the world periodically since before the time of the Pharaohs: food shortages.

Surging commodity prices have pushed global food prices up 83 per cent in the past three years, according to the World Bank – putting huge stress on some of the world’s poorest nations.

Is this a fairly recent phenomenon? In February and July last year, we touched on this looming food crisis in Corn as food or as fuel? and Prepare for more food price inflation respectively. Finally, in October last year, we had identified three macro-themes about this looming food crisis in Why are food prices rising?. So, you can see that this food problem has been in the makings for quite a long time already. It is only recently that it has received great attention in the media.

We have been thinking about this food problem for quite a long time, wondering whether there is a root reason for this slow-motioned tragedy. As we read the news media about this problem, the reasons seemed to be quite fragmented. Somehow, our intuition tells us that there must be an underlying force behind all these reasons. So today, we will attempt to come out with a theory to explain how it comes about, while hoping that we do not fall into the narrative fallacy that we talked about in Mental pitfall: Narrative Fallacy.

Today’s journey will begin in China. At the end of 2006, China’s rural population stood at around 737 million. From 1990 till today, we estimated around 230 million rural peasant Chinese migrated from the countryside to the cities (source: China’s rural population shrinks to 56% of total). Our guess is that the majority of the rural migrants are males. Over the past couple of decades, it is this mass migration that provided the vast quantity of labour to propel China’s rise as a major economic power. It is China’s economic power in manufacturing that enabled the debt-induced over-consumption and low inflation of the West, especially in the English-speaking nations (look at the US’s mighty trade deficits). Compared to Western standards, China’s peasant farming is not as efficient and productive per capita. Now, if around 230 million rural peasant Chinese (mostly males, and the males do most of the farming) migrated to the cities’ manufacturing related jobs, it is clear that Chinese farm output has to fall significantly. Also, China as a whole is getting wealthier than before and as a result, consumes more meat, which in turn consume grains for livestock, thus competing against the demand for human-consumed food. Therefore, to feed China’s vast population with significantly reduced farm output, food imports have to rise significantly, which puts upward pressure on the world’s food prices.

Next, China’s rise over the decades raises the consumption of commodities greatly, including energy. As we said before in The Problem that can throw us back into the age of horse-drawn carriages,

In summary, supplying environmentally sustainable energy indefinitely at a rate fast enough is a colossal global problem that must be solved. If not, the latter generations will not live better than the current generation.

With rising energy costs, the US embarked on a foolhardy ethanol program in the name of energy ‘independence’ (see Prepare for more food price inflation). This program resulted in even more diversion of more food production resources into fuel making, reducing the food supply even more.

In the more affluent Western nations, food production takes on a more capital-intensive form. These capitals requires energy. With rising energy costs, food prices have to rise because of the increasing cost of production and distribution.

To make matters even worse, food is tend to be much less income and price elastic, especially for the poor. That is, no matter what, people have to eat even if their income falls or if the price rises. This is unlike the more discretionary items like clothing whereby people can reduce demand in response to falling income or rising prices. As a result, any increase in the cost of producing food is easily passed on to the consumers in the form of higher prices.

When the effects of climate change and drought get thrown in, the situation becomes even more serious.

The more we look at it, the more we feel that the global economic growth of the past decade is not sustainable without serious environmental, food, energy and commodities repercussions. That is why we see that a severe global recession is a necessary evil. Otherwise, more sufferings and permanent damage will occur even for the future generations.