Posts Tagged ‘currency crisis’

Why central banks are forced to raise interest rates in a currency crisis?

Tuesday, May 25th, 2010

We will continue from the currency crisis theme today. As we mentioned in our previous article, the threat of a currency crisis in Australia is not something we will dismiss out of hand. We rather be prepared for one and for nothing to happen than be unprepared and be caught with our pants down.

Now, what can the government do if currency speculators launch an assault on the AUD?

For one, the Reserve Bank of Australia (RBA) can use its foreign currency reserves to buy up its domestic currency in order to ?support? the AUD. This strategy works until the reserves are used up. Australia, being a chronically current account deficit country, does not rank well in terms of quantity of reserves for an advanced country. As you can see from this list, Australia has less than US$40 billion of reserves. Even tiny Singapore has 5 times as much as Australia.

But what if the speculators? assault prove to be too strong for the RBA to intervene? In that case, it would be forced to raise interest rates. As we quoted the Bank for International Settlements (BIS)?s 79th Annual Report in Bank for International Settlements (BIS) warning on stimulus spendings,

External constraints could also bind for some countries. Particularly in smaller and more open economies [e.g. Australia], pressure on the currency could force central banks to follow a tighter policy than would be warranted by domestic economic conditions.

When a currency is rapidly depreciates, it is a tempting target for hedge fund to short it. This can be done by borrowing large amount of money in that currency and selling it. In the absence of capital controls, the central bank, in its attempt to defend its currency, will have to raise interest rates to make shorting as expensive as possible.

How does this work out in reality? For that, we managed to find this old 1997 article from the South China Morning Post.

Why hedge funds cheer as Asian rates explode

If central bank wins, funds make money in lending market and if it buckles they make hay in currency market, says Larry Wee

If there were any doubts that hedge funds had a big part in East Asia?s currency chaos, the word in the market is that at least one major fund was behind the carnage in Hong Kong last Thursday when the key Hang Seng Index plummeted 10.4 per cent.

The story goes that one fund professional?George Soros?s name is inevitably mentioned?had let it be known that he was heavily short on HK$. The reaction of the Hong Kong Monetary Authority (HKMA) was predictable: determined to defend Hong Kong?s peg to the US$, it forced interest rates sky-high.

What the HKMA did not realize, however, is that this hedge fund had borrowed massive amounts of Hong Kong dollars in the money market. On top of this, it also shorted the Hong Kong stock market in a big way. So when overnight interest rates skyrocketed to 250 per cent, and stocks collapsed, the fund was overjoyed.

The cruel irony is that, when HKMA governor Joseph Yam spoke with bravado last week that he would charge HK$ short-sellers punitive rates, the funds that had already loaded up with HK$ laughed all the way to the bank.

This story explains just how the multibillion dollar hedge funds?the vast pools of money managed by the likes of Mr. Soros?have operated to get the best returns. Their blitzkrieg starts behind the scenes, in the money market where funds are borrowed and lent.

The strategy is simple: Well before they mount an assault on a currency, the hedge funds borrow huge amounts of the very currency they want to bring down. Often they borrow as much as ten times the amount they intend to sell. When they start selling the currency, they know for sure that interest rates will spike up as a result?often from below 10 per cent to well past 100 per cent. Lending at, say, 150 per cent when you borrowed at 7-8 per cent is a nice business; it yields huge profits when you?re lending in the billions.

Often these funds?apart from Mr. Soros Quantum Fun, other big ones include the Tiger and Omega funds?corner all available liquidity in the money market, so they become the only major lenders of the currency they have attacked.

The art in this strategy is this: Even if the central bank succeeds in defending its currency and inflicts forex losses on speculators, the hedge funds would have made many times more in the lending market. What if the central bank buckles and allows the currency to fall? Then the funds hit a double jackpot, and wins in the currency market too.

When the baht was attacked this way in June-end?again said to be led by Mr. Soros?the major funds walked away with profits of up to US$1 billion (S$1.58 billion) each, sources say. Not bad for a couple of months? work. Four months later, it?s the turn of the Hong Kong dollar. The question on many people?s minds is whether the peg to the US dollar will be broken. But whether or not it does, the hedge funds have already made a pile by now.

Sources say the big funds entered the money market a month ago to borrow Hong Kong dollars at around 7 per cent; they are now on-lending those dollars at sky-high rates. Last Thursday, when the speculative attack was at fiercest, overnight HK dollars cost as much as 250 per cent to borrow. The benchmark three-month HK interbank offered rate (Hibor) was fixed at 17.3 per cent, while six-month HK dollars funds cost 33 per cent. So the hedge funds will surely wind up this Christmas with record profits for the year. But they leave in their wake Asian economies with mountains of bad debt, crippled stock markets and surging inflation.

When interest rates explode with the force witnessed in Asian markets, the first to plunge are the stock markets. The next to come under pressure are the real estate markets. And if interest rates stay high, the whole economy slows down as companies hold back expansion plans and individuals cut back on spending. Inflation inevitably rises and we get what economists call ?stagflation??a sticky combination of economic stagnation and inflation.

What comes next?as Malaysian Premier Mahathir Mohamad warned over the weekend?is the threat of recession, where economic activities not just slow down but actually shrink. There is a good reason why economies are invariably left wrecked: the hedge funds target economies with serious and often hidden structural imbalances. Their currencies are usually most vulnerable to a sell-off and will topple with a hard shove.

And before they launch their currency attack, they short-sell the stock market too, knowing that other, less agile, market players will have to sell stocks to get their hands on local funds. This stock sell-off frightens genuine foreign investors into selling out too; when foreigners sell off, preferably in a frenzy, they have to convert their foreign currency for repatriation?which only starts another round of selling on the besieged currency.

That?s how it all snowballs. That?s how currencies collapse. And that?s how hedge funds like Mr. Soro?s Quantum make megabucks.

One thing to note: hedge funds don?t wake up one day and decide to attack currencies out of the blue. They prepare beforehand.

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Serious vulnerability in the Australian banking system

Sunday, May 23rd, 2010

Last week, we witnessed one of the most rapid falls on the Australian dollar (AUD). In a matter of a couple of weeks, the AUD fell around $0.10 relative to the US dollar (to a low of above US$0.80).

There were many reasons offered for this rapid depreciation- one of them blames the Rudd government?s resource super-profit tax (see Why Rudd?s mining super-profit tax will encourage more commodity speculation). In reality, there?s probably no specific reasons why AUD fell so quickly for this specific instance. As we wrote in our report, How To Foolproof Yourself Against Salesmen & Media Bias, the desire to pin-point a specific reason is part of the human trait of falling for the narrative fallacy. The simplest explanation laid the blame on ?hedge funds? and ?speculators.?

In any case, in the minds of most lay-people, the AUD is seen as a barometer for the health of the Australian economy. If the AUD goes into a free-fall, many people will see it as a sign that the Australian economy is in trouble. Conversely, if the AUD appreciates strongly, it is seen as a sign of a ?strong? economy. In reality, the foundations for the strength/weakness of the economy has been set long before the currency appreciate/depreciate. Nowadays, with the rise of lightening-speed money, the currency exchange rate is more as a result of capital inflows/outflows from money shuffling and less as a result of the fundamentals of the economy.

For Australia, we are getting more and more nervous about a currency crisis someday (see Will there be an AUD currency crisis?). Jimmy Rogers concurs with our worry. As he said in a recent interview,

If the Australian economy keeps taking on debt, the next time there’s a bear market, the Australian dollar will collapse. And he sees a bleak future for any currency backed by massive debts. Top of his list of bad currencies is the once mighty greenback.


The only disappointment I’ve had is that your politicians are as bad as the ones in America. If the Australian government keeps running up such gigantic debts, the lucky country is going to run out of luck.

However, he reiterates his belief Australia will not be prepared for the next economic shock and for a commodities bear market if it keeps taking on debt.

One thing you have to note is that Jimmy Rogers is probably not talking about Australia?s government debt. Relative to basket case countries like US, UK, Japan and the PIIGS in Europe, Australia?s government debt is tiny. The problem for Australia is its private debt, which is reflected in the foreign debt. As long as foreigners wants to invest in Australia, it will be fine. But the moment foreigners change their mind, Australia will be in trouble (a crashing AUD will be one of the symptoms).

We believe Australia has a serious structural problem that can easily turn this lucky country into an unlucky country very quickly. Recently, we saw this presentation (that explains the problem) making its round around web sites:

How to Profit From the Coming Aussie Property Crash (and Banking Crisis)

Please note that we:

  1. Are not making any investment advice based on this presentation.
  2. Are not making any predictions based on this presentation (see Failure to understand Black Swan leads to fallacious thinking to understand what we mean).

There?s one point made in this presentation that we have not covered in this blog- there are AU$13 TRILLION worth of off-balance sheet liabilities in Australia?s banking system (you can see the figure yourself from the link to RBA?s web site). Inquiring minds should be asking questions about what these liabilities are all about. Does the Australian regulators and central bank (and perhaps the banks themselves) fully understand what sort of hidden risks the Australian economy is subjected to from these ?off-balance sheet? liabilities?

For us, the basic point to take away from this presentation is that:

  1. There is a serious vulnerability in Australia?s banking system.
  2. This vulnerability is simply too colossal to be bailed out by the Australian government (hence the threat to the AUD).

We are not trying to scare anyone here. But these are the sorts of questions investors have to ask.

What if China crashes?

Sunday, May 9th, 2010

Regarding the current drama in Europe, if the European authorities does nothing (or stoically refuse any thought on moral hazards), the world will get a GFC II, in which Australia may not be so lucky this time round. Our guess is that when push comes to shove, the Europeans will eventually print money and kick the can further down the road. After all, with the nightmare of the Panic of 2008 still fresh in their minds, they will not repeat the ‘mistake’ of acting too slowly. The outcome will be more moral hazards and monetary inflation, which is something we and our children will pay down the road.

Meanwhile, as the global financial markets are fixated over the current sovereign debt crisis in Europe, contrarian investors (especially Australian investors) should look at another part of the world for any potential mishaps- China. Starting from January this year, the Chinese government had been tightening the supply of credit. Measures include turning off the credit tap to increasing bank reserves requirements. Recently, unlike 2008, the Chinese government seemed to be getting really serious about cracking down on property speculation, even to the extent that it is giving the impression that it wants the property bubble to burst (see Is China’s Stock Market Crashing?).

As we wrote in Marc Faber: Beware of investing in Australia (as it follows the Chinese business cycle), with all these tightening measures, China will slow down this year. The question is, will the Chinese government accidentally over-tighten cause a crash instead? Remember, its objective is a soft-landing (which they managed to pull off in the 1990s under ex-premier Zhu Rongji). But will they end up going too far, resulting in a hard-landing?

Only time will tell.

But if it happened, you can sure that Australia will have a very ride. As we warned our readers a few months ago in Hazard ahead for Australia- interim crash in China,

Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.

The first effect of an economic slow-down in China will be a fall in base metal prices. Already, there are some signs that base metal prices are cooling off. For example, copper prices are approaching the lows made in January this year. If China crashes, we can expect base metal prices to crash too.

Next, given that the Australian dollar (AUD) is seen as a commodity currency, it will fall. This is to be expected as Australia’s terms of trade and business cycle is closely tied to Chinese demand for commodities, which in turn is tied to the business cycle in the Chinese economy. A crashing Chinese economy will be likely to test the AUD as it was tested in 2008. Mining companies in general will not do well in such an environment. In fact, speculators like Jim Chanos will be shorting the Australian mining stocks (see How is Jim Chanos going to short China? (Australia: take note)).

Then, with the deteriorating terms of trade (due to falling Chinese demand), the Australian economy will slow down. With that, there will be speculations (and hope) that the Reserve Bank of Australia (RBA) will be cutting interest rates.

If China’s coming slowdown is just a soft-landing, then the story may end here. But if it’s a hard-landing, then there will be more complications. In that case, Australia is very likely to have a hard landing too. This is where we are getting nervous. The critical thing to watch out for is Australia’s unemployment rate. As we wrote in RBA committing logical errors regarding Australian household finance,

Given Australia?s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises. As unemployment rises, it will eventually reach a critical mass of prime debts turning sub-prime.

Given that Australia’s highly leveraged banking system is heavily concentrated on mortgages (Black Swans lurking around Australia?s banking system), there will be a tipping point in the unemployment rate that will trigger a banking crisis. That in turn may trigger a currency crisis (see Will there be an AUD currency crisis?).

How to buy and invest in physical gold and silver bullion
If there is an AUD currency crisis, the RBA will be in a quandary. Should it cut interest rates further to support the domestic economy (and condemns the AUD)? Or should it raise interest rates to defend the AUD (and condemn the domestic economy)? This was what Iceland faced in 2008- high inflation, collapsing currency and rising unemployment. The Icelandic central bank had to raise interest rates to defend its currency. Remember, a collapsing AUD implies that the price of oil imports in AUD will sky-rocket (limited to the extent that oil prices are falling due to reduced Chinese demand). As you can read in Five potential emergencies- energy crisis, this will be extremely disruptive to the Australian economy.

Of course, the scenario that we painted is extreme. But after having read and understood Nassim Nicholas Taleb’s The Black Swan, we learnt not to say “never.” Hopefully, the outcome will not be that bad. But for those who want to be prepared, we highly recommend How to buy and invest in physical gold and silver bullion.

Will there be an AUD currency crisis?

Tuesday, April 20th, 2010

A few weeks ago, in Black Swans lurking around Australia?s banking system, we expressed our nervousness about Australia?s banking system:

We must confess, we are getting more and more nervous about the potential for a Black Swan hitting the Australian economy. Particularly, we are looking at a vulnerability in the banking system.

As we wrote in that article, the solvency of Australia?s highly leveraged banking system is concentrated too much on mortgages. It is bad enough for the entire banking system to be so highly leveraged. It is even worse for the leverage to be concentrated on a particular type of loan- mortgages.

In other words, any one of the Big 4 banks are too big to fail because if one fails, it is likely that the others will follow. That implies that the Australian government will have to act quickly to nationalise the entire banking system in such an event.

Will that be the end of the story?

No, our fear is that the biggest casualty in this story will be the Australian dollar.

Firstly, Australia?s gross foreign debt (at December 2009) is AU$1.2 trillion. Correspondingly, the net foreign debt is AU$648 billion. It is highly unlikely that foreigners will continue to lend money to an already highly indebted Australia with a broken banking system. In fact, it is likely that the great Aussie carry trade will reverse, causing a rapid depreciation of the AUD. Should the implosion of the Australian banking system cause a panic, we can easily see the Australian dollar crash.

Secondly, nationalisation of the entire banking system will be prohibitively expensive for the Australian government. The asset column of Commonwealth Bank?s balance sheet alone is around 60% of Australia?s GDP. In the context of a banking crisis, the Australian government will have to guarantee bank deposits. As we wrote in Australian government?s contingent liability to exceed AU$1 trillion, that is a contingent liability of over AU$1 trillion. That means Australia?s relatively small budget deficit can easily balloon to dangerous levels very quickly.

In short, we can?t see how the Australian dollar will retain value in a banking crisis. An AUD currency crisis may not happen, but as we get more and more nervous, we find it more and more imperative to be prepared. As we wrote in Protecting yourself against currency crisis,

Personally, we feel that the best way to protect yourself from a currency crisis is to leave the country before TSHTF. If not, stock up some physical cash (both foreign and local), physical gold and silver (see our book, How to buy and invest in physical gold and silver) and supplies- these will tide you over while the sh*t is hitting the fan. For the longer term, you may want to move some of your savings overseas- you may not be able to use them in the midst of the crisis, but when it is all over, the local currency may no longer exist (e.g. you may have to convert the old currency to a new one at unfavourable rates).

Hedging against currency crisis with electronic gold

Thursday, March 18th, 2010

Back in January this year, we talked about protecting yourself against currency crisis in Protecting yourself against currency crisis. The basic idea of that article is that the time to prepare for such an eventuality is before TSHTF. Once it happens, it is too late.

For our Australian readers, this seems to be less of a worry because there is still an air of optimism (relatively) among the population. But for our American readers, the nagging feeling of fear and brooding seems to be permeating among the masses. As the author of this book, The Ultimate Suburban Survivalist Guide: The Smartest Money Moves to Prepare for Any Crisis, wrote in the introduction,

Do you have a pervasive sense of anxiety, as if our modern world is on thin ice? Do you have an uneasy feeling that Wall Street seems to be collapsing under the weight of bad debts and bad decisions- and dragging your job along with it? Or, maybe you feel our society is coming apart at the seams, and that our civilization could actually break down and collapse.

You are not alone. A lot of people are worried. In fact, there is a growing movement of people who are preparing for the end of the world as we know it (TEOTWAWKI).

That book is written in an American context. If you are an American reader, please let us know how true or accurate this is in the comments below.

Now, for this article, we will stick to the original point (currency crisis) and not venture to the theme of TEOTWAWKI (survival skills/gears, self-sufficiency, guns, supplies stockpiles, etc). We hazard a guess that the TEOTWAWKI theme is of more interest to our American readers than to our Australian readers. But if enough readers express their interests in TEOTWAWKI, we may do more research and write more about it. If not, let’s stick to the topic. (By the way, contrarians like Marc Faber are alluding to the TEOTWAWKI theme).

Okay, back to currency crisis. There are two components to hedging yourself against currency crisis:

  1. Diversify your assets overseas.
  2. Prepare a cache of physical monetary assets (e.g. physical cash and physical gold/silver).

For the second component, our book How to buy and invest in physical gold and silver bullion would cover it very well. But for this article, we will look at the first component.

One of the ideas (and note, they are ideas- nothing in this blog should be taken as financial advice) that is floating around in our mind is electronic gold. We first touched on this idea two years ago in What is the future of silver?,

Today, we have a very powerful technology that can solve the convenience and sub-divisibility problem (see Properties of good money) associated with [using] gold [as] money- computers. All we need is a trusted central repository of gold (perhaps today?s central bank can change its institutional role for this purpose) and let computer systems keep track of ownership and transfer flow of gold money. In other words, the gold is physically kept in a secure central location while the finer sub-divisions and change of ownership of gold money is recorded as bookkeeping entries on computers. No physical movement of gold is necessary.

This passage was written to refute some of the views that gold can never ever function as money again because it will be physically inconvenient (or beyond imagination) to carry minuscule amount of physical gold as money to buy small items (e.g. bread).

Well, two things against this argument:

  1. In Zimbabwe, people were already used flakes of gold to buy bread (see the video at Rural Zimbabweans are desperately panning for gold powder to ward off starvation).
  2. The same problem of inconvenience existed two hundred years ago and that’s why mankind invented the use of warehouse receipts for gold as a proxy for money (the history of money is written in more detail in our book, How to buy and invest in physical gold and silver bullion). Warehouse receipts for gold are the precursor to the paper money we have today.

In this current age of information technology, this problem can be easily solved with electronic gold. In fact, there are quite a few electronic gold solutions currently implemented today. One of them is (which we disclose that we have an affiliate interest with them).

One very important thing to remember: the whole point of owning gold is to own an asset that is nobody’s liability (if you want to understanding the reasoning behind it, please read How to buy and invest in physical gold and silver bullion). That will eliminate most gold ETFs, gold futures, gold CFDs, etc because they are basically financial assets disguised as ‘gold’ as they exist as a liability in someone else’s balance sheet. As for other types of gold that you do not take physical possession for yourself (e.g. kept in vault storage on your behalf), you have to look at them on a case-by-case basis to ensure that

  1. You own the legal title to the gold (i.e. your gold is really yours and not belong to the liability column of someone else’s balance sheet), and
  2. Trust that they are able to physically deliver your gold to you on demand.

So, if you trust, then they fulfil these two criteria. But do not let us tell you who to trust or not to trust- seek advice, do research and decide for yourself.

When we first heard of, we imagine a world whereby gold becomes money and payments can be made back and forth electronically as conveniently as PayPal. If you have a full-holding account in, you can certainly do that with their patented technology. We don’t see why it can’t be done.

But we talked to those guys and found out something interesting. Apparently, most of their clients do not use as electronic gold money (as we imagined in our fantasy). In reality, most of them link their full-holding account with their bank accounts all over the world. Why would someone do that? Here is what we think (bear in mind, this is just our opinion)…

Remember, back in Protecting yourself against currency crisis, we wrote

Personally, we feel that the best way to protect you from a currency crisis is to leave the country before TSHTF.

If you believe that all paper fiat currencies will eventually depreciate significantly against gold, then it makes sense to hold gold. Let’s say you have a cache of physical gold and you decide to leave the country? That means you have to lug your physical gold to that country where there’s always a danger of loss in transit from bandits, thieves, corrupt officials, ship-wrecks, air-crash, etc. Or maybe the custom officers in both the source and destination country may not look in favour of anyone bringing in physical gold. Whatever the reason, you may not feel comfortable having so much valuables in your physical possession while you’re on transit to another country. For a big fat filthy rich person, it is physically too demanding to lug around his large stash of gold.

GoldMoney. The best way to buy gold & silver So, here come the folks at Since you have already set up links between your full-holding account and the various overseas bank accounts all over the world, you do not have to worry about hauling physical gold around. (Of course, having some physical gold coins in your pocket will always be useful for things like paying for a space on a leaky boat to travel to that country- jokes aside, we mean it is not wise to completely do away with having some physical gold in your physical possession).

So, the next time you visit a foreign country, you may want to open a bank account over there!

Meanwhile, please vote on the poll below:

Protecting yourself against currency crisis

Friday, January 29th, 2010

Today, we will continue from the final question asked at Next phase of GFC is when governments go bust,

When governments go bust, we will have currency crisis. How do you protect yourself against this?

First, let us begin with understanding what a currency crisis is. From the Wikipedia,

A currency crisis, which is also called a balance-of-payments crisis, occurs when the value of a currency changes quickly, undermining its ability to serve as a medium of exchange or a store of value…? Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country’s own currency reserves or its foreign reserves (usually in euros, US dollars or UK pounds).

Basically, a currency crisis occurs when there is a problem in a country’s balance of payments (see Understanding the Balance of Payments). The currency will depreciate very rapidly and as a consequence, cannot be used as money and cannot function a store of value effectively. This usually manifests itself as sky-rocketing price inflation, which undermines everyone’s standard of living. When Hugo Chavez recently announced the planned devaluation of the Venezuelan currency (that’s not technically a currency crisis, but this is just an example to show you its effects), people rushed out to buy consumer goods in anticipation of price inflation.

From this, you can see that obviously, the key to protecting yourself from a currency crisis is to diversify your savings away from the affected currency (e.g. foreign currency, gold, silver, etc). Does it mean that all we have to do to hedge ourselves is to go to our local bank branch, open a foreign currency account and then transfer some of our savings to that account?

Unfortunately, that’s true only in a perfect world. In reality, when there’s a currency crisis, there’s a high chance that a banking crisis will come along with it. For example, in Argentina’s currency crisis (1999-2002), the government froze bank accounts in an attempt to prevent a run on the banks. In some cases, governments may even impose capital controls (especially in pegged currencies), which basically means your money will be stuck.

In such an environment, Black Swans abound, which means the financial system may be dysfunctional. That means your foreign currency stored in your local bank’s foreign currency account can be, for all intent and purposes, useless. In today’s modern economies, since exchange of physical cash forms a tiny percentage of commercial transactions, a dysfunctional financial system will affect most commercial transactions in the economy, which in turn implies that the economy will be paralysed. Even if the financial system is working, price inflation will make life miserable for most people.

In such a bleak environment, we can imagine people resorting to barter, physical cash (both foreign and local) and even physical silver and gold. Hopefully, local governments and communities will take the initiative and come up with complementary currencies so that the economy can still function (otherwise, everyone will be reduced to primitive bartering). In Argentina, a spectrum of complementary currencies had emerged, in such a large scale that some of them are even called “quasi-currencies.”

Personally, we feel that the best way to protect yourself from a currency crisis is to leave the country before TSHTF. If not, stock up some physical cash (both foreign and local), physical gold and silver (see our book, How to buy and invest in physical gold and silver) and supplies- these will tide you over while the sh*t is hitting the fan. For the longer term, you may want to move some of your savings overseas- you may not be able to use them in the midst of the crisis, but when it is all over, the local currency may no longer exist (e.g. you may have to convert the old currency to a new one at unfavourable rates).

Note: All these are NOT personal advice- they’re just ideas for you to consider.

Currency crisis: UK, Japan and US

Tuesday, January 26th, 2010

Continuing from Currency crisis: first countries in the line of fire- PIIGS, we will discuss more on the next sequence of events to happen. As we said before, we are not ?predicting? or forecasting the future- what we are presenting is just a rough sketch of what may possibly happen.

After the PIIGS countries, the next country to be in danger of public debt default or currency crisis is the United Kingdom. At the current rate of deterioration of its public finance, the national debt of UK will reach 17% of GDP in 2010 and 100% by 2013. Niall Ferguson, author of the famous The Ascent of Money series, said

We?re not Iceland or Ireland, but we?re closer to them than we are to the U.S.

The reason why the UK is in a more vulnerable than the US is because,

The big difference between the two countries is that the U.S. issues the world?s No. 1 currency and is regarded, partly for that reason, as a safe haven,? Ferguson says. ?The U.K. used to be, but we?re not anymore. That means we have much more currency risk here.

Of course, this does not mean that the UK government will default or that the pound will face a currency crisis. But certainly, the risk is increasing as shown by the increase in price for the credit default swaps (CDS) of UK government debt. The time-frame for a currency crisis in UK is around the vicinity of 3 to 5 years.

The next country in the line of fire is Japan. We all know about the demographic time-bomb in the United States (see How is the US going to repay its national debt?). But Japan’s population is ageing earlier than the US. Worse still, they’re ageing at a time when their government debt is twice the size of their GDP. The reason why Japanese government debt could get so high in the first place is because Japan is a nation of savers. Currently, only 6% of their national debt are held by foreigners, whereas it is 57% for the United States. However, the problem for Japan is that as their population ages, their savings rate will have to fall. That implies that buyers of Japanese government debt will turn to sellers. That means that the Japanese government will have to look to borrowing from foreigners. Time-frame: say, 5-10 years time.

Finally, the next in the line of fire is the United States. We had already mentioned about them at How is the US going to repay its national debt?, Is the GFC the final crisis? and America?s balance sheet. The time-frame is around 10 to 12 years. Others believe it is 5 to 10 years time. That’s why President Obama is pursuing health care reforms. As he admitted on TV, if the US does not solve its health care issues, the Federal government will go broke (see Ladies and Gentlemen, the US Is Insolvent).

On that note, Australia is not in better position either. As PM Kevin Rudd warned recently (see Work harder to support ageing Australians: Rudd), Australia’s time-frame is around 15 years time onwards.

Currency crisis: first countries in the line of fire- PIIGS

Thursday, January 21st, 2010

In our previous article (Next phase of GFC is when governments go bust), we wondered how can someone protect their savings in the event of currency crisis. Since the word “currency crisis” is a very broad term that can cover all kinds of scenarios, there is no one-size-fit-all solution to this problem. Hopefully, our musings will give you a better idea of where to start investigating and seek professional advice.

As we mentioned before in our previous article, there is a downward trend in many governments’ credit rating. The next stage of the GFC will see governments going bust. The main thing to understand is that this event need not necessarily be imminent. Also, you must not make the mistake of seeing that as a singular event- in reality, it will be a sequence of events punctuated by calm in between, as each country is at different stages of the fiscal cycle. The reason why we say that is because there are plenty of investment tip-sheets, newsletters and reports persuading people to buy their wares by giving the impression that government defaults are imminent events that will happen all at once. The mainstream media is not too helpful too. As investors, you have to be clear that there are time-frames and order of sequences in these events. Not only that, some of these events may not happen at all.

With that, we will continue. Please note that we are not ‘predicting’ or forecasting the future. What we are presenting is just a rough sketch of what may possibly happen.

Currently, the most vulnerable countries to default are the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain). It does not mean that all of them will blow up tomorrow. Marc Faber reckons that a couple of them will blow up within the next two years. Even though we do not know which ones and when exactly it will happen, one thing is clear- since these countries uses the Euro, the viability of the Euro as a currency will be put in question. As we said before in Is this a bear market rally or a turning point?,

The European Union is an economic union but not a political union. Therefore, the European Central Bank (ECB) does not have the same level of authority and political support as the US Federal Reserve. Individual nations using the Euro as their currency cannot simply print money to bail out their financial system because they have surrendered their economic sovereignty to an intra-national authority. To do that, there can be a situation whereby taxpayers of say, Germany, are asked to bail out the taxpayers of say, Spain. Politically, this is too much to ask.

This is where the uncertainty lies. There will be political and legal wrangling on what to do with these wayward PIIGS nations. Will the Euro survive the wrangling? No one knows. Since financial markets hates uncertainty, the Euro will continue to face downward pressure (which is happening right now). Of course, if it is suddenly clear that the Euro will not survive, then its value will be zero straight away. Should that happen, there will be a currency crisis, derivative meltdown (as an effect of PIIGS default or implosion of the Euro) and another global financial panic this very second. Since it is not clear yet, the Euro will continue its orderly descent. In the meantime, the financial markets will keep on guessing while the European authorities will not reveal much of what’s happening in the discussions behind closed doors.

Now, the question is, against which currency will the Euro depreciate against? Someone once said, if currencies are in a beauty contest, the winner will be the least ugly one. The US dollar, even though it is flawed and may not survive as a currency in the long run, has more time on its side. It is less ugly than the Euro. As far as the eye can see, it is more likely to survive longer than the Euro. Therefore, we will see the US dollar ‘strengthening’ against the Euro.

If you are one of the citizens of the PIIGS countries and if it so happen that it is your country that is going to blow up, then there’s no better time to prepare than right now.

In the next article, we will turn our eyes to the next sequence in the time-line.

Next phase of GFC is when governments go bust

Tuesday, January 19th, 2010

10 months have passed since the Panic of 2008 brought global stock markets to a low in March 2009. Since then, we had the “green shoots” of recovery (where economies were getting from worse to bad) and hopes of recovery. By today, we have some semblance of ‘recovery.’ But this ‘recovery’ is very uneven. For example, unemployment is not turning around yet in the United States. Much of Europe and Japan are still in the doldrums. Australia, on the other hand seems to be recovering and China is roaring ahead with an expected growth of 10% in 2010.

During the Panic of 2008, we had financial institutions and businesses going bust like dominoes, threatening to pull the world down into a Greater Depression. Governments all over the world suddenly became Keynesians and switched on their massive money printing press to bailout, rescue and spend, spend, spend in the name of ‘stimulating’ their economies. But as we said before in Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven?t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ?stimulating??.

So, with economies seemingly on the path to ‘recovery’ (especially in Australia and China) from a near death experience, this looks like a free lunch from the government isn’t it?

Unfortunately, the answer is “No!” Then what is the risk of governments putting economies on a crutch for an extended period of time?

As we quoted the BIS in July 2009 at Bank for International Settlements (BIS) warning on stimulus spendings,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly.

As we said before, during the Panic of 2008, we had financial institutions and businesses going bust like dominoes. This time round, governments will be going bust like dominoes. Today, if you read the financial press, you will find this disturbing trend: credit rating agencies are downgrading and threatening to downgrade the credit ratings of government debts.

While we do not trust credit rating agencies (since they are the ones who gave sub-prime CDOs triple-A ratings), we will treat their ratings as overly-optimistic in the first place. For investors, what is significant is not the ratings themselves. Rather, it is the pervasive trend of more and more downgrades that is much more indicative. As this article compiled a non-exhaustive list of news excerpt of sovereign debt downgrades, we noticed a very disturbing fact- a large number of countries (some of them are major countries) are involved.

Can this trend turn around (i.e. governments become more prudent in their fiscal management)?

We doubt so. As we said before, the word “stimulus” is a weasel word that is misleading and deceptive. Economies suffering from debt deflation cannot be ‘stimulated’ into self-sustaining growth. A better word is “crutch.” The problem with using crutches to prop up economies is that the longer they are in place, the more dependent economies are on them. Eventually, if they are in place for too long, the economy will descend into stagflation (see Supplying never-ending drugs till stagflation). Once you understand this, you will be able to read between the lines of this BBC article,

The International Monetary Fund head has warned that the global economy could experience another downturn – a so-called double dip recession.

Dominique Strauss-Kahn said countries should not exit from stimulus packages that have bolstered growth through huge amounts of government spending.

The longer governments delay from removing economic crutches, the bigger government debts will become. That, along with Medicare and social security liabilities for the growing ranks of retirees and shrinking rank of workers means that eventually, governments will become insolvent (not technically because they can resort to printing money).

Consider these countries:

  1. Japan, the world’s second largest economy, is a welfare superpower with a rapidly ageing population. Twenty years of economic ‘stimulus’ under debt deflation has resulted in government debt of almost 200 percent of GDP.
  2. The US government is the next to arrive, as they are currently where Japan is 20 years ago, with an unfunded Medicare and social security liabilities looming (see America?s balance sheet).
  3. As this Financial Times article warned,

    After crunching the data, McKinsey estimates that the gross level of British private and public debt is now 449 per cent of GDP ? up from 350 per cent at the start of the decade.

    And even excluding the liabilities of foreign banks based in the UK, the ratio still runs at 380 per cent ? higher than any country except Japan (closely followed by Spain where debt has also spiralled dramatically, according to a McKinsey report issued today.)

  4. Then we have the PIIGS countries, namely Portugal, Ireland, Italy, Greece and Spain, where Marc Faber warned that one or more of these governments will likely blow up in the next couple of years. This will plunge the viability of the Euro as a currency in grave doubt. Will a default trigger a derivative meltdown?
  5. Then we have the other European countries like Latvia and Ukraine…

When governments go bust, we will have currency crisis. How do you protect yourself against this? Keep in tune!

Which asset class for the next financial markets panic?

Thursday, November 19th, 2009

If you still have lots of spare bullets in your investing arsenal (i.e. lots of spare cash free for investment), it is very tempting to use them up in fear of missing out on further rally. But if your over-riding concern is to preserve your capital in real terms, this is a very difficult market to invest.

For value investors, the proportion of undervalued stocks is decreasing as the stock market continues to trend upwards. Recently, a highly prominent banking analyst, Meredith Whitney has turned the most bearish for over a year:

If you are a technical analyst, you will see that stocks are at an extremely overbought territory. According to the Market Club Trade Triangle, the trend for the S&P500 is still at a very strong up-trend. Statistically, this is the point whereby the risk of a major correction is very high. The previous one is too mild to be counted as a correction (see Aborted correction?).

In terms of property prices, Hong Kong luxury apartments are bubbling away. Base metal prices (especially copper) have recovered strongly from the Panic of 2008. Chinese fly-by-night bidders are reportedly appearing in Australian residential property auctions. The Aussie dollar is approaching parity with the US dollar.

It looks very much like bubbly 2007 all over again.

We are not prepared to use our spare bullets in such a bubbly environment. But if you are based in Australia, we do see a silver lining. The price for gold is rising rapidly in terms of US dollars. But in terms of Aussie dollar, it has hardly risen. In fact, even though it is at a record high in USD, it is down 20% from the March 2009 record high in AUD.

Let’s say there’s going to be a short covering in the USD (see Currency crisis ahead? Part 1- Potential short squeeze on the US dollar) due to some deflationary threat. Chances are, gold price (along with commodity and stock prices) in USD will come down. At the same time, stocks worldwide will be down as well, along with the depreciation of the AUD. A falling gold price in USD will be mitigated by the depreciation of the AUD. As a result, Australian holders of gold may not suffer as badly as gold prices in AUD may not fall as much, perhaps even rising should the AUD depreciates very rapidly.

But even in this scenario, there will be a limit to a fall in gold price in USD. As we wrote before in Has gold moved on to a secular shift?, central bankers have crossed the line from being a collective seller of gold to a collective buyer of gold (e.g. Mauritius central bank is now buying gold). The Chinese will see any temporary strengthening of the USD as an opportunity to get rid of them to buy gold.

On the other hand, if there’s going to be a currency crisis, our guess is that gold prices will soar in USD. If the AUD depreciates against the USD as well, we will get soaring gold prices in AUD.

Our speculative view is that (and this is NOT financial advice) if you want to be on the other side of the trade in the next panic (i.e. on the winning side, not on the panicking herd’s side), the currently high AUD may prove to be a stroke of good luck for Australian investors because it gives them a wonderful opportunity to buy gold on the cheap. Not only that, if you are planning to buy physical gold, it helps that Australia is a gold producing nation (you may want to read our book, How to buy and invest in physical gold and silver bullion).

Only time will tell whether this idea will be a winning Black Swan trade.