Waiting for the Global Financial Drama

Philip Bowring

02 March 2007

The two-day global equities market meltdown may well signal a much bigger future disaster

The script is complete. The dress rehearsal has been held. But the curtain has yet to go up on the first night of the Great Global Asset Price Collapse.

Markets have recovered some composure after the last two days of February. The steep drops can now be described as a correction, not a collapse. But the payback from sustained overindulgence still awaits. That is not to argue that every index from Dow Jones to Topix via silver futures and Singapore property is going to suffer the same fate. There are elements of the local as well as the global in every national market. But make no mistake: the global liquidity bonanza is the pre-condition for almost every asset market excess.

Don’t read too much into the fact that the recent wobble spread from China. The Chinese market remains among the most closed in the world. What the 9 percent Shanghai shock did was simply remind investors in other markets of how much they had risen in the past year. The Asian ones to suffer most, in addition to China and India, were those which have risen most steeply in recent months -- Malaysia and Singapore. Whatever the macro economic and corporate outlook, profit-taking was overdue. Indeed Asian markets including Korea and Thailand, Malaysia and Singapore look relatively less vulnerable to sustained declines than most.

Top of the worry list remains Mumbai. So it is no surprise to find that it has now fallen 12 percent from its high last month, and with lots more to come. Not only had the market risen fourfold since 2003 but the macro conditions in India are abysmal, with inflation at over 6 percent, the current account deteriorating sharply, bank lending excessive and, to cap it all, the government has just raised the tax on dividends.

Shanghai has better macro-economics to support it for the time being and the rise of the past year has been driven by an abundance of cash not credit to punters. But China’s investors are notoriously skittish and could well defeat any government efforts to stem price falls. Price earnings ratios are even higher than in India and profit growth looks likely to disappoint.

The rest of the world need not worry itself with either Mumbai or Shanghai, both primarily driven by local factors. Falls of even 50 percent would cause barely a ripple elsewhere. The world has plenty of other issues to worry about and the recent correction has pointed at the two major ones but without coming to a definitive conclusion as to if and when they will hit.

The first is the US consumer. Has the bonanza of the real estate cash-out come to an end? House prices have finally begun to slip and interest rates show no signs of falling – though real rates remain well below historical norms. Companies in the US, as almost everywhere, are cash-rich but showing little desire to increase investment – and household incomes are barely rising faster than inflation. Two things will happen when the US consumer-led boom stalls. Most obviously, imports will tend to fall, with a consequent knock-on effect for Asian exporters, China more than most because of the Chinese economy’s exposure to US-bound exports. Contrary to some current belief, it will not be question of the world catching cold when China sneezes, but of China catching a cold from the US.

Quite how much damage that will do to China’s own growth rate remains to be seen but given that China (and India) have been growing at unsustainably high rates, the downward shift could be severe. It will anyway be accompanied by a politically driven continued gradual appreciation of the yuan against the dollar which will squeeze Chinese corporate revenues and profits – and also those of US retailers like Wal-Mart which source heavily from China.

That brings up the secondary impact of the US consumer retreat: the narrowing of the current account deficit, which would reduce the pace of global liquidity creation. Growth of base money has been fuelled by a 15 percent plus increase in global reserve assets, still mostly held in dollars.

A weak US economy would have the secondary effect of causing most currencies, particularly the Asian ones which are conspicuously cheap (headed by the yen) to rise. In turn this would further contract the local liquidity expansion effects of the US deficit. The impact would be particularly felt by China, for whom the trade surplus is a key to over-rapid credit growth.

It would likely be less marked in countries such as Malaysia and Taiwan. Both seem candidates for currency appreciation and reduced current account surpluses. But the liquidity expansion effect of their huge current surpluses has been significantly offset by capital outflows, while China has had large net capital inflow in addition to its current surplus.

Apart from the US consumer, the other global party pooper will be Japan. Whether led by a change of heart by Japanese institutions or by fear replacing greed in the hearts of investment bankers and hedge fund gamblers, the huge outflow of yen will come to a halt. Indeed, for many with leveraged positions in the carry-trade it will be dramatically reversed.

The importance of a sudden rise in the yen, back to say 105 to the US dollar, would not be so much on its trade surplus or domestic profit, which is super-competitive at current low exchange rates. It is the sudden increase in the exchange-rate cost of borrowing Japanese savings. That will mean a sharp pullback in the global liquidity expansion by which Japanese savers have been financing consumer booms in the US, UK, Australia, New Zealand etc and driving interest rates in sickly emerging markets such as the Philippines to rock bottom levels.

Quite how fast all this happens is impossible to tell, if only because of the opaque nature of the credit derivatives business and the sheer size of currency hedging books. But once markets get a whiff of trouble, rout could follow and take some big institutions and funds down with it. There was a hint of panic this week even though the US consumer’s retreat is not yet a sure bet in the near term, and Japan’s weak-willed central bank has appeared to extend the life of the yen carry trade and by implication the Taiwan dollar and Swiss franc equivalents (both have been unnaturally weak despite huge current account surpluses).

So what does this say to investors? Will it take commodity markets down with stock markets as demand stalls simultaneously with the contraction in liquidity? Some impact in inevitable at least on base metals such as copper. But the overall impact on commodities may well be modest as investments in new production have lagged demand and new mines come on stream only slowly. Food commodity prices will be kept under upward pressure by demand from ethanol and biodiesel plants. Precious metals may even benefit as investors seek refuge from currencies as well as stocks.

But don’t rush out and buy Australia. Australian consumption and property prices are likely to suffer badly as the cost of sustaining its huge current account deficit increases just as commodity markets falter. Avoid the Aussie and NZ dollars which have been buoyed up by the carry trade.

The euro will probably get even stronger against the US dollar as the ECB keeps monetary policy quite tight even as the US heads for recession. But it has already risen so steeply since its nadir five years ago that a major new move seems unlikely. Ditto the Canadian dollar, which would also suffer from a commodity decline.

The currency action is going to be mostly in Asia and the yen will be the key. The NT dollar will not be far behind and may well strengthen against the yuan as well as the US dollar. Ditto the ringgit. Further appreciation against the US dollar is likely for the won, Singapore dollar and baht, but having led the way in Asian currency appreciation they will now likely lag.

So what does this scenario do for Asian stock, property and bond markets? Clearly exporters’ margins will be squeezed by weak US demand, a possibly faltering China and by currency appreciation. Reduced global liquidity should put upward pressure on interest rates but commodity-driven inflation is falling and stronger currencies will deter authorities from raising rates. So bond markets may be quite stable (except for the weaker countries like the Philippines and Indonesia). Stock markets can expect to suffer broadly but domestically-oriented issues including banks in most of Asia should not be badly hurt. (China and India excepted)

Indeed, Taiwan and Japan may well see repatriated funds invested in the property market. Hong Kong’s property market should also benefit from a weak currency vis-à-vis China.

As for Wall Street, the end of the consumer and property booms will see some horrendous casualties in the credit sector, retail and real estate. But some boring old manufacturing outfits would do really well out of a declining dollar and continued, if slower, growth in foreign markets, especially in Asia.

Perhaps the overriding question is not what the trend is going to be but how fast it will happen and hence how destabilizing. The impact of interest rate and currency adjustments has so far been gradual and un-alarming. If continued there will be no crisis but a slow but sure shift to a new trade and market equilibrium.

However, experience suggests that after such a long period of monetary expansion there will be a catharsis, not as severe as the 1997 Asian crisis but on a scale that spans the whole globe.