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June 15, 2014

Investors continue to whistle in the dark

Investor attitude means that the next financial crisis could be worse than 2007-09 in some ways.

Things are moving fast on the world political stage. Now, Islamic insurgents are threatening to overrun the elected government in Iraq. IF press report are correct, Iran and the US are on the same side of the fence, in the battle against Islamic insurgents. In the meantime, tensions in Asia between China and other nations has not simmered down. Vietnam and Philippines played soccer and volleyball in the disputed islands with China. China was not amused. Japan, in turn, was not amused that China was working on the Nanjing massacre being included in the UN list of atrocities. In addition, according to Bloomberg, Japan lodged a “strong” protest with China after a pair of its fighter jets flew within tens of meters of Japanese surveillance planes in the East China Sea, the second incident in less than a month.

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China’s release of a white paper on the mainland’s control over Hong Kong, coming soon after the 25th anniversary of the Tiananmen Square protests celebrated with gusto in Hong Kong, has set the people of the Special Administrative Region on a collision course with the Chinese government. All these have taken Russia and Ukraine off the front pages for now. The American President has seen his domestic popularity-rating decline and these developments clearly indicate that many nations are vying to be one of the superpowers since America’s writ does not seem to be quite running large on many matters, these days.

China’s economic data might have improved a bit but it is hard to say that they are reliable and that they signal a sustained turnaround. Export growth was better than expected but export numbers in recent months have been swinging wildly. We do not know whether they are capital inflows or payments for exports. Further, better readings in official indices of Purchasing Managers’ Confidence both in manufacturing and non-manufacturing have been offset by disappointing readings in the same indices compiled and reported by HSBC PMI. In any case, the collapse in imports by China (-1.6 percent Y/Y in May) should keep alive concerns over real economic growth in China. The World Bank has downgraded China’s growth estimate for 2014 to 7.6 percent from 7.7 percent but, in the meantime, the International Monetary Fund (IMF) has urged China to target 7 percent growth for 2015 and continue with reforms and restructuring, as it began a new round of Article IV consultations with China.

Bankers who have lent money based on collateral of copper inventory in China are searching for them since, it appears that the borrower might have pledged them for multiple loans. It is an old trick in the book but 21st century banks do not seem to be immune to it. It reminds one of what one banker told Alastair Darling, the then Chancellor of the Exchequer in the UK in 2009 that henceforth they would lend only when they understood the risks involved! Evidently, they have not yet understood the risks involved in operating in China.

Morgan Stanley Capital International seemed to know better. They have not included China A-share indices in the MSCI global indices. China’s capital markets have always been several steps behind its stellar economic performance. Communist Party apparatchiks had scant consideration for profits as opposed to market share. Hence, investors have rarely made money in China. In the meantime, China is stockpiling crude oil and that is helping to keep the price of crude oil well above USD100 per barrel. It is an interesting story put together using informal sources since China does not publish official oil reserves data.

In the United States, the Federal Reserve is appearing to be rejecting calls to reduce its balance sheet. An interesting news-story in Bloomberg claims that the Federal Reserve is abandoning plans (a three-year old strategy) for an exit from unprecedented easing. They will continue to taper but they will not shrink their balance sheet actively. Hence, if they decide to increase interest rates (2016?), it would be the first time the Federal Reserve would do so with such a large balance sheet.

This is par for the course with what the European Central Bank decided last week. The ECB decided to throw everything but the kitchen sink into the problem of confronting disinflation and poor credit growth. It stopped short of announcing outright quantitative easing. But, it mixed a liberal dose of carrots and sticks in trying to persuade banks to lend. The Euro has not exactly weakened against the US dollar, one week after ECB decisions. So, the market is looking for more easing from the ECB and is pushing ECB to do so, actually. EURUSD is at 1.357 as we write this, not too different from 1.36 that prevailed before the ECB meeting. Quite justifiably, there has been stiff opposition in the German media and in public opinion to the latest ECB moves. President of ZEW, well-known think-tank that surveys German economic sentiment monthly had some harsh words to say on ECB decisions

Policymakers on either side of the Atlantic have no clue about the consequences of what they are dong and yet, they are pursuing them with vigour and with a false sense of bravado. They have evidently chosen to ignore the law of unintended consequences. Since they have not learnt this particular lesson from the 2008 crisis and several others that went before it, history will teach them a harder lesson the next time. I am sure of it.

In the meantime, China’s response to American charges of cyber-espionage and European response to America’s unprecedentedly large fines on European financial institutions need to be watched. Christian Noyer, the governor of the Bank of France, has warned that this might lead to reduced usage of the US dollar in international transactions. Quite interestingly, the fines on European institutions has also resulted in more investment banking deals for American financial institutions. The Trade protectionism is creeping up on us silently.

The world is simmering with disputes with potentially adverse economic consequences for movement of resources globally and for global trade, in general. As usual, global investors prefer to whistle in the dark. Credit spreads remains tight and equity markets have barely budged.

More than anything else, investor attitude means that the next financial crisis could be worse than 2007-09 in some ways.

Photo: Indenture


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