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).