Wealth International, Limited

Finance Digest for Week of November 22, 2004


The financial community at large, with regard to China’s growth, is assuming two fundamental premises. The first is that China had its slowdown in the third quarter with government now intent on reinvigorating the economy. And the second is that the explosive growth of the last two years is the start of a new trend towards faster growth. Both are wrong in my view.

Until two years ago, I was consistently bullish about China and its economy. Now I worry. Here is why. It is common knowledge that China’s financial sector is fragile, so much so that some policy makers in Beijing believe that the currency is overvalued when account is taken of this fact. Less well known is how so much of the manufacturing sector has been financed, which is a cause of concern for the central bank. There is, what I call, the unholy triangle of local company, local government and local bank. The company approaches the local government and acquires land cheaply. It then goes to the bank, in which local government has an equity stake, if not wholly owned, and is given 20-30 year money on concessionary terms that in many cases are the equivalent of zero cost capital. The company puts up the factory, installs the equipment, often state-of-the-art, inflates its asset value and repeats the process with the bank. This is how so many companies have grown from producing just a few thousand widgets of indifferent quality five or six years ago to now having a capacity a hundred times that volume, in some cases millions, depending on the sector. By 2007, China will have the capacity to supply the entire global demand of air conditioners.

The problem is that everyone else in the same sector is playing the same game with the result that there has been built a gross surplus capacity at virtually every stage of the manufacturing process. Conversion and product prices have, thus, been driven down to levels that many companies are not, in reality, even covering their operating costs. So the friendly local bank is providing them with working capital in addition to the long-term loans. A month or so ago a senior official from the PBOC stated that as much as 60% of bank loans were for working capital! The problem for the manufacturing sector is that there is no pricing power, but input costs are rising rapidly from raw materials, to electricity, diesel, water and now even labour. Where are the real profits, as opposed to so many that are published? It is why a senior investment banker in Hong Kong described China as buying expensively and selling cheaply.

In 2007 China must open up its banking sector to foreign financial institutions for RMB business, which, in turn, means that the banks must be cleaned up by then or else the authorities run the risk of depositors switching to foreign banks. The leadership is determined to keep to this WTO commitment. Hence, action to reform the banking structure is being stepped up. In the process, the authorities must also try to change the Chinese business model, which has been used by these companies that have grown so rapidly, away from the creation of critical mass, with no regard to either profitability or return on investment, towards making real profits. The PBOC and the Bank Regulator understand the problem and are moving gradually to address the issues. Monetary policy is becoming more restrictive. The fear is that as the authorities move to bring order to the financial system there will be a lot of casualties in the manufacturing and real estate sectors.

In summary, by implication, reforming the financial system implies a massive restructuring of the manufacturing sector. The next two years will be interesting to see how these changes play out and whether the authorities are prepared to take them to their ultimate conclusion. In our view, the rapid growth of the last two years is an aberration. Aberrations consist of excesses. Excesses must be purged to return to stable growth. This will take around two years. Thus, we should see below trend growth in 2005 and 2006, followed by slower but more sustainable growth than seen in these last two years. I maintain my long-term faith in China’s ability to grow faster than the West. For it is a fact that the center, or powerhouse, of the world is inexorably shifting back to Asia led by China. Demographics, savings and history are driving this shift of power. Herein, lies the real problem.

Link here.


The record of Lord Lawson, Tory Chancellor of the Exchequer in the late 1980s, was marred, in the eyes of his critics, by the way his policy of low interest rates and easy money refuelled inflation at the end of that decade -- and it took the recession of the early 1990s to cure it. What they forget is that his easy-money policy was praised at the time because it came after the 1987 stock market crash. The crash, though it scared everyone rigid at the time, did not destabilize the wider economy. Indeed, with hindsight it is possible to see that the economy rode the shock with barely a quiver.

What Lawson did then is an almost exact precedent for what Alan Greenspan, chairman of the US Federal Reserve, has been doing for the past three years. His equivalent of the 1987 crash was the bursting of the stock market dotcom bubble, and his policy was to slash rates to just 1% and keep them there. Only in the last few months has he started marching them back up again -- and even now, after four increases, they are still a very low 2%. More to the point, they were kept artificially low long after the U.S. economy had begun to pick up again, and they stay low despite the fact that it continues to roll along.

This ought to cause an upsurge of inflation. It is, of course, fashionable to believe inflation is dead. Indeed, Roger Bootle, one of London’s best economists, continues to argue very cogently that there is little chance of its return, and most people go along with him. There is a touching belief too, built on the past decade’s experience, that central bankers now know what they are doing and will act promptly to nip any inflationary pressures in the bud. It is debatable whether central bankers deserve this much intellectual respect and it certainly ignores the possibility, as with Greenspan, that central bank policy might be the cause of the problem.

But, say the doves, if Greenspan’s policy is inflationary, why has there been no sign of it, given that the Fed has been deluging people in credit for years? The possible answer to this is China. Because Chinese labor is about a tenth the cost of American labor, this has delivered a massive one-off reduction in costs as the goods come back in as cheap imports. This has masked inflationary pressure for the past few years but is now reaching its natural limits. In a few years, today’s optimism that inflation has been forever squeezed from the system could prove seriously misplaced.

Link here.


In the months leading to the collapse of WorldCom Inc., its shares were in a nose-dive, traders were selling its bonds at junk levels and its chief executive was forced out. But not until investors lost several billion dollars did Congress and others begin to rivet attention to a little-known player in this unfolding drama: the credit raters. WorldCom rose to prominence through voracious acquisitions, including the bold 1998 purchase of MCI, the District-based long-distance telephone company. And it could not have done it without the rating companies. WorldCom borrowed money through the sale of bonds, which the rating firms approved by giving them good grades, a signal that they were relatively safe investments.

As it turned out, nothing could have been further from the truth. But the rating firms were among the last to recognize it. It was not until weeks before WorldCom disclosed massive fraud and filed the biggest bankruptcy in U.S. history in 2002 that the credit raters finally cut the firm’s debt to junk status. The rating companies say they are not in the business of detecting fraud; rather, they say they give an opinion of the creditworthiness of a company, municipality or nation. But some critics say the WorldCom case highlights a broader problem: that the world’s big three credit raters -- Moody’s Investors Service, Standard & Poor’s and Fitch Ratings -- have become some of the most important gatekeepers in capitalism without the commensurate oversight or accountability.

From their Manhattan offices, they can, with the stroke of a pen, effectively add or subtract millions from a company’s bottom line, rattle a city budget, shock the stock and bond markets and reroute international investment. Without their ratings, in many cases, factories cannot expand, schools cannot get built, highways cannot be paved. Yet there is no formal structure for overseeing the credit raters, no one designated to take complaints about them, and no regulations about employee qualifications.

The big three ostensibly function as a disinterested priesthood. But at the heart of the increasingly profitable business is a conflict: The rating companies get the bulk of their revenue from the fees they charge to the very entities they are rating. Industry insiders say the desire of a rater to hold on to a paying client -- or recruit a new one -- at times has interfered with the objectivity of a rating. Dozens of current and former rating officials, financial advisers and Wall Street traders and investors interviewed say the rating system has proved vulnerable to subjective judgment, manipulation and pressure from borrowers. They say the big three are so dominant they can keep their rating processes secret, force clients to pay higher fees and fend off complaints about their mistakes.

Link here.


Now 92, the global value investor still manages his investments and oversees the activities of his foundations. Sir John is positive about the long-term future but very cautious about current valuation levels for stocks, bonds, the dollar and real estate. When asked to explain his concern aboout U.S. Housing prices, he said that, “Prices of houses in all nations for centuries have fluctuated above and below cost of reproduction. In the United States now, in most major cities, homes can be sold for far higher prices than reproduction costs. Several times in my lifetime, house prices have been far below reproduction costs and such cycles are likely to continue.”

Asked to suggest alternatives to equities, his reply was that, “Because both share prices and bond prices are high this year, many wise pension managers invest in open-end mutual funds that try to maintain short positions in stocks about equal to their long positions. In this way, a pension fund can benefit from a wise security analyst while waiting for the time when either stocks or bonds can be bought at bargain prices.” Also on equities: “It is normal for voters to elect politicians who promise to spend too much. This increases the rate of inflation, and so after adjusting for inflation, return on stocks over the next market cycle may average only 3 percent.”

Hedge funds? “There will be a scandal because the cost burden is so great. In mutual funds it is unusual for a fund to be ahead more than 2 percent or 3 percent. The typical hedge fund is charging 2 percent to 3 percent, plus 5 percent to invest, and 20 percent to 25 percent of profits.”

Link here.


Eliot Spitzer, the New York attorney general, has already exposed insurance industry secrets like bid-rigging and hidden commissions. Now he is training his spotlight on an even murkier part of that universe: the buying and selling of insurance policies that artificially bolster companies’ financial statements. The policies in question are known as finite insurance or financial reinsurance. They are sold as ordinary insurance policies, which allow companies that buy them to receive favorable accounting treatment -- smoothing out losses on their books, for example.

To critics, however, the policies are structured less like insurance and more like loans. At heart, they say, finite insurance is simply a form of financial engineering that masks the strength or weakness at the companies that buy them. As such, its use has probably had a much greater impact on investors and customers than other industry practices that Mr. Spitzer has singled out. The deals offer an especially rich vein for investigators to mine, industry analysts say. And last week, Mr. Spitzer sent out a flurry of subpoenas to insurers about policies they may have sold to help customers eliminate or offset losses that would have hurt their financial results. The S.E.C. and the Justice Department are also scrutinizing financial engineering products sold by insurers.

By far the biggest customers for such policies are insurers themselves, so investigators will be looking at how these companies may have used these contracts to make their books look better. As regulators unravel these arrangements, industry analysts say, they are likely to discover a labyrinth of deals among insurance companies that are often routed through tax havens in Bermuda or the Caribbean. No one knows for sure how large the market is for such policies.

Link here.


The coming recession is no one’s fault, and especially the President’s, just like Clinton did not cause the boom of the 90s. It is part of the normal business cycle, but the Dem’s will call it the Bush Recession no matter what. Now you and I know that there is very little government can do about the business cycle. Congress cannot repeal it. All they can do is try and reduce regulations and laws that hurt business and then get out of the way. The good news is that right now 2005 looks like it will be O.K. for the first three quarters at the very least. We may be able to dodge the bullet until mid-to-late 2006, but any longer is problematic. That is not being a Cassandra. That is being realistic. The market will probably anticipate a recession and turn into a real bear, cutting down the time to act. That gives “us” one year in which to effect fundamental changes that will make the world better for our kids.

Social Security must be reformed. Now. Let us be realistic. If we do have a serious recession, it is quite possible we will see a Democrat in the White House in 2008. That means 2012 at the earliest for any real reform, and it will cost hundreds of billions (if not a few trillion) more. This is one we must do for the kids. The think tanks you and I trust suggest true Social Security reform is going to cost about $1 trillion. Privatization is not cheap, but it lets our kids have a chance to retire in a world where the government will not be bankrupt and gives them actual cash for their retirement.

On employment, it is time to pull out all the stops now. As an example, there is a real telecom reform bill winding through Congress. Put it on the front burner. It is a jobs bill, as long as you can keep the old dinosaur telecoms from watering it down. Tort reform and litigation control would bring down costs and allow business to hire more people. Everything that can be done to better the employment picture should be done now. How many free trade zones can we get done in the next two years? I know there is one under way with Thailand, but we need to expand the concept. Free trade is good for U.S. jobs. Why not do something radical and help the world at the same time? Why not propose a free trade zone with all of Africa and the next 20 poorest countries who will reciprocate?

This is the time to deal with the national deficit. Putting an absolute hold on increased spending is a no-brainer. Run fixed, no increase budgets for a few years and the deficit drops quickly. In a recession, tax receipts are going to go down. If we do not simply clamp down on spending now, then deficits will explode in during a recession. We do NOT want to be running a campaign of four more years of eye-popping deficits in 2008. The only way we are going to get control of healthcare is by wider use of Medical Savings Accounts. Expand the program.

Link here.


The presidential elections were an interesting distraction, but, in the weeks since then, the news has obviously refocused on the stuff that truly matters: sex, sports, and violence. Question: Which clip ran longer in the perpetual video loop of recent days -- Monday Night Football’s desperate housewife getting naked with a player in the locker room, or, Friday night’s knock-down-drag-out between basketball players and fans in Detroit? Answer: Both clips got more than the zero airtime allotted to Saving Private Ryan by the ABC affiliate here in Atlanta on Veteran’s Day. Children might have been watching, for heaven’s sake!

Absurdities duly noted, please consider a few points that may not be as obvious as they should be: 1.) This trend should not be a surprise. In a culture that has an ever-increasing desire to be entertained, sex, sports, and violence are bound to collide at “intersections of the extreme”. 2.) The distinction between actors and audience is distinct no more. Wasn’t reality TV supposed to blur that line?

3.) Inhibition is bad; ruthless ambition and self-expression are good. Just today, no less an authority on sex, sports, and narcissism than Donald Trump himself reminded us that even bankruptcy is not “a failure” but “a success”. If you say otherwise, well, “You’re Fired!” 4.) It will get worse before it gets better. We cannot always know ahead of time what “it” is, since the combinations of sex, sports, and violence are virtually limitless -- nevertheless, you will know “it” when you see “it”. All these points (and many others) flow from the same premise, namely that the trends in popular culture spring from the same source as the trends in the stock market.

Link here.


Stephen Roach, the chief economist at investment banking giant Morgan Stanley, has a public reputation for being bearish. But you should hear what he is saying in private. Roach met select groups of fund managers in Boston last week. His prediction: America has no better than a 10% chance of avoiding economic “armageddon”. Press were not allowed into the meetings. But the Herald has obtained a copy of Roach’s presentation. A stunned source who was at one meeting said, “it struck me how extreme he was -- much more, it seemed to me, than in public.”

Roach sees a 30% chance of a slump soon and a 60% chance that “we’ll muddle through for a while and delay the eventual armageddon.” The chance we will get through OK: one in 10. Maybe. In a nutshell, Roach’s argument is that America’s record trade deficit means the dollar will keep falling. To keep foreigners buying T-bills and prevent a resulting rise in inflation, Federal Reserve Chairman Alan Greenspan will be forced to raise interest rates further and faster than he wants. The result: U.S. consumers, who are in debt up to their eyeballs, will get pounded. Less a case of “Armageddon”, maybe, than of a “Perfect Storm”.

Roach marshalled alarming facts to support his argument. To finance its current account deficit with the rest of the world, he said, America has to import $2.6 billion in cash -- every working day. That is an amazing 80% of the entire world’s net savings. Sustainable? Hardly. Twenty years ago the total debt of U.S. households was equal to half the size of the economy. Today the figure is 85%. Nearly half of new mortgage borrowing is at flexible interest rates, leaving borrowers much more vulnerable to rate hikes. Americans are already spending a record share of disposable income paying their interest bills. And interest rates have not even risen much yet.

Roach’s analysis is not entirely new. But recent events give it extra force. The dollar is hitting fresh lows against currencies from the yen to the euro. It has farther to fall, especially against Asian currencies, analysts agree. A source who heard the presentation concluded that a “spectacular wave of bankruptcies” is possible. It is undeniable that America is living in a “debt bubble” of record proportions. But some argue there may be an alternative scenario to Roach’s. Greenspan might instead deliberately allow the dollar to slump and inflation to rise, whittling away at the value of today’s consumer debts in real terms. It may be the only way out of the trap. Higher interest rates, or higher inflation: Either way, the biggest losers will be long-term lenders at fixed interest rates. You would not want to hold 30-year Treasuries, which today yield just 4.83 percent.

Link here.

Others predict an “avalanche”.

Are we going to be drowned in an avalanche of cheap dollars? How worried ought we to be about the recent exceptional weakness of the dollar? The reason for the weakness has been the continuing rise in the external deficit of the United States, now nearly 6 per cent of the U.S. GDP. Alan Greenspan warned that the U.S. current account deficit is unsustainable. Mr. Greenspan thinks that foreign investors may go on strike because they have too many dollars already. He would like to see a reduction in the U.S. budget deficit in order to reduce the external deficit. That, however, would mean deflationary policies, and President Bush does not like deflation.

The problem is not a new one. It is based on the structural weakness of the world’s leading currency, whichever that might be. In the 1920s the key currency was sterling, but the pound had been weakened by Britain’s financial losses in the First World War. London was still the centre of the world exchange system, and Britain still had great, though declining, power to borrow. Eventually, Britain could not take the strain and had to abandon the gold standard in 1931. The slump of the 1930s followed. As early as the 1960s the French were complaining that the dollar was following the same track. The Bretton Woods system of dollar-gold convertibility did break down. President Nixon ended the U.S. commitment to exchange dollars for gold. There followed the great world inflation of the 1970s and early 1980s.

Since 1971 the dollar has been in an unusual and vulnerable position. It is a dominant, but inconvertible, currency. The politicians of the dominant country can behave with relative irresponsibility, and they usually do. For this reason, a dominant currency tends to become cumulatively less competitive. A dominant currency is likely to become a weak currency as there will be too much of it -- the position of the dollar today. The dominant nation is also likely to accumulate debt, on an horrific scale. At some point, which cannot be predicted exactly, the appetite for the dominant currency is sated, and people want to sell. Then fear sets in; the avalanche is upon us.

The dollar was restored by aggressive deflation in the period around 1980, but it is again in serious decline. It is not clear how the present exchange system of floating non-convertible currencies can be restructured. Without confidence in the dollar, the world has no valid reserve currency. The euro lacks political strength, if nothing else, and itself seems overvalued; the Chinese renminbi is tied to the dollar. If confidence is not restored, there will be pressure for the familiar false remedies, for competitive devaluation or protectionism. Yet the world exchange crisis is being treated as everybody’s problem and therefore nobody’s.

Link here.


Are foreign investors souring on Wall Street? The data say yes. In September and August, foreign investors were net sellers of $5.9 billion of American stocks, according to the latest Treasury data available. These two monthly declines highlight a sharp slowdown in inflows from abroad since the beginning of the year, when the 12-month total through February was $58 billion. In September, the 12-month inflow had dropped to $18.7 billion. While there have not been negative consequences for the American stock market so far, a steeper decline in the dollar could increase the net outflows and make American equities less attractive. The net selling of American stocks by foreigners has probably continued since September, said Ian Scott, a global equity strategist with Lehman Brothers in London, “because the dollar has continued to fall, and I think that is one of the motives behind the outflow.”

Bob Froehlich, chief investment strategist at Deutsche Asset Management, said that fear that the United States’ current-account deficit would continue to grow, along with the belief abroad that the federal budget deficit will be difficult to reduce because of the war on terror and President Bush’s promises to make his tax cuts permanent, “has spooked some investors outside the United States.” Such fears have yet to have any impact on the recent performance of the United States stock market. Indeed, as William E. Rhodes, chief investment strategist of Rhodes Analytics in Boston, noted, “It is an old rule of thumb that foreigners are the last in and the last out.” So it is possible that this outflow is a contrarian signal for the stock market.

But many analysts think that the dollar, which is down 2.7% this year against a broad index including the U.S.’s trading partners and much more against some individual currencies, will fall sharply in the months ahead. Such a decline, they argue, would not be good for stocks here.

Link here.


Is the gold price giving us a repeat performance of October’s fake-out in the oil market? My suspicion is that gold is acting a lot like crude did last month... running up to fresh highs -- and making headlines all the way. But this is not the main event. Not yet. The day of reckoning for America, her deficits and her dollar, is surely on its way. Investors who have not yet bought gold as protection could be forgiven for thinking they have missed their chance. But we may see gold make the inevitable run up to $450 -- as early as next week -- and then experience a serious correction and consolidation. For that, investors still not holding gold should read, “Last chance to buy before the bull is untethered...”

First, note that as gold has screamed up since the summer, gold mining stocks have failed to confirm the move. Just as it happened with the Oil Sector in October, the underlying commodity has gotten way ahead of its producers. Why? The answer is “earnings’ gravit”. If you want to buy Newmont Mining at P/E of 50, be my guest... and many investors will. But until the bullion price moves much higher -- and starts making its way onto the income statements of the gold producers -- the dearth of gold shares means you have too many investors chasing too few gold stocks, and paying too much for them.

With paper gold, like GLD, the New York listing for the World Gold Council’s bullion backed gold fund, and GBS, its London-list equivalent, accepted and flourishing, “earnings’ gravity” on gold stocks may no longer be a check on making money in the yellow metal. With GBS and GLD, so the theory goes, you get more liquidity in the equity side of the gold market. I made the enhanced liquidity argument myself -- about a year and a half ago, when gold was much less popular. Today is different. Gold is “hot”. But is gold warming up because it is truly at the center of a major shift in investor sentiment about asset allocation and the need for diversification?

With gold making 16-year highs, and the dollar making fresh lows in euro and yen terms, I am more inclined to take recent developments as a sign of a near-term top in the gold price. In contrarian terms, whenever the crowd is all on the same side of the trade, the trade is nearly over. In this scenario, GLD launches... goes a-Googling its way up briefly... and then plummets to earth at the rate of 32 feet per second per second when the luster of the first buy tarnishes. That is when we should buy it. And that is when you should go hunting for gold stocks again -- buying them at a much lower price.

Link here.


The rise in household net worth in recent years has largely resulted from inflating prices of corporate equities in the late 1990s, and residential real estate in the past four years. But this rise in household wealth is illusory. Just because an existing house goes up in value does not necessarily mean that the more expensive house “produces” more actual housing services. Does a rise in the price of the house enable more people to live in it? Does the increase in the price of an existing drill press necessarily mean that the drill press is now capable of drilling more holes in an hour? The economic wealth of a nation is related to an increase in the number of drill presses, not the nominal value of the existing stock of drill presses. The more drill presses an economy has, the more holes can be drilled in the production of other goods. The greater the capital stock of an economy, the more productive is its labor force to be. In short, the greater the capital stock of an economy, the more goods and services that economy is likely to be able to produce.

Some forms of capital imply faster future economic growth than others. Does a physically bigger house (more square footage) with granite kitchen countertops enable the occupants to produce more widgets? Does a massive SUV driven by the suburban soccer mom make her or anyone else to produce more widgets? Bigger houses and bigger household vehicles add to the nation’s capital stock. But I would submit that increases in business equipment and business structures are more reflective of a nation’s wealth than increases in consumer durables and houses.

In fact, McMansions and SUVs are gaining as a share of the total capital stock. In the past four years, not only has the growth in the nation’s capital stock slowed, but the growth in the truly productive part of that capital stock -- the business capital stock -- has slowed even more. Fed Chairman Greenspan can crow about the continued rise in household net worth as percent of after-tax income if he wants. And, indeed, he has helped bring about an increase in household net worth through his easy money policies, first inflating the value of corporate equities, and then the value of residential real estate. But his measure of wealth is illusory. The growth in the true wealth of this nation is slowing, despite the Fed’s best efforts to “paper” over it.

Link here (PDF file).


Most of us have been talking and writing about China for some time now. Yet it seems that those who have traveled there and witnessed with their own eyes what is going on become more impressed. Jim Rogers, the famed Adventure Capitalist author and investor, has spent some time in China. He is a long-term enthusiastic China bull (though he sees a hard landing in the near term) and even recommends people learn to speak Mandarin. The New York Times, in a piece titled “China’s Reach”, notes the growing influence and affluence of the Chinese, and with it a confidence about the future of their country. The burgeoning middle class has some money to spend and some appetites to satisfy. Not only for food and drink, but for travel as well.

Investment analyst Anatole Kaletsky, notes that, “Today, for a rapidly growing Chinese middle class, the daily struggle for subsistence is over and the new struggle of trying to catch a glimpse of China’s glorious past (in Beijing or Xian) or its shining future (in Hong Kong or Shanghai) is on.” This trend could have enormous investment implications as the world caters to the Chinese and their spending patterns. It does not take a lot of imagination to picture how traveling Chinese with money burning holes in their pockets will benefit hotels, for example. This brings me to an interesting point. Emerging market investing is cyclical and fraught with peril. While China presents enormous opportunities, it also brings specials risks as well. Emerging markets can experience gut-wrenching peaks and valleys.

In 1997, the Russian stock market soared 200%, only to fall by more than 50% the following year. Russia captivated the imagination of investors, but it has been a very bumpy ride to date. All of the world’s mature markets had to pass through these kinds of phases. The explosive growth in the United States during the 19th century was punctuated by booms and busts in canals, railroads, bank stocks, real estate and more. China will likely be no different. China’s boom is being fueled in part by monetary and credit expansion. According to economist Krassimir Petrov, “Money supply for 2001, 2002 and 2003 grew respectively 34.2%, 19.3% and 18.1%. Thus, during the last three years, money supply in China grew approximately three times faster than money supply in the United States during the 1920s.”

All that money sloshing around is bound to cause problems, namely, by creating a massive bubble -- and you see it in Chinese real estate and in certain Chinese stocks. So we have to tread carefully in China, which is why I favor gaining exposure in a sort of oblique way. Mobius, in dealing with this problem in Russia, used the concept of establishing a beachhead where you could gain exposure to a promising market without gaining exposure to its problems. It is a way to take advantage of global trends without assuming as much of the risk. That is the challenge.

Link here.


It was Edward R. Dewey, a famous cycles analyst, who first observed that the tallest buildings are built at the end of economic booms. He called it the “skyscraper indicator”. In the past few months, Munich residents passionately debated a new plan proposed by city fathers. It called for the construction of three skyscrapers that would dwarf Munich’s current tallest building, the 480-year-old Church of Our Lady. Residents were divided so evenly on this issue that a local newspaper poll found “equally strong voices for both sides”. Finally, it was decided that the only way to resolve the dispute was with a citywide referendum. And last Sunday, November 21, Munich residents took the vote.

Now, let us remember that optimism about the future has been weak among Germans. Since 2000, Germany has been a bear market leader among the EU nations. With social mood this bleak, what do you suppose was the outcome of the “skyscraper” referendum? Right -- the negative social mood prevailed and the skyscraper plans were scrapped. However, the decision won by only a 50.8% margin. Such divisiveness among voters is another sign of bear market psychology that has taken hold of Germany. In fact, trends towards polarization, separatism and restriction can be seen across the globe these days: in the close results of the U.S. and Ukrainian elections, in the violence by and against Moslems in the Netherlands, in the recent speed limit proposals for German autobahns, and in this fight for Munich’s skyline.

But there is another way to look at the razor-thin margin that won the referendum. The fact that an almost equal number of Munich residents voted in favor of the skyscrapers indicates that after four years of dire pessimism, Germany’s social mood may finally be changing. What would confirm this change? The German stock market.

Link here.

German confidence evaporates in face of euro, oil prices.

Surging oil prices and the runaway strength of the euro, currently at an all-time high around 1.32 dollars, are undermining industrial confidence in Germany, a key survey showed. And with confidence also fading fast in other eurozone countries, such as Belgium and Italy, the German data are likely to increase pressure on the European Central Bank to step in and prevent the stronger euro from choking off recovery altogether, analysts said. The widely watched business climate index calculated each month by Ifo, the Munich-based think-tank, fell to 94.1 points -- its lowest level in 14 months -- in November.

Link here.


Who believes in a strong dollar? Robert Rubin, Bill Clinton’s treasury secretary, most certainly did. John Snow, his successor but two, says he does but nobody believes him -- if only because he wants other countries’ currencies, in particular the Chinese yuan, to go up. Mr. Snow’s boss, President George Bush, in one of his mercifully rare forays into economics last week, also said he wants a muscular currency: “My nation is committed to a strong dollar.” Again, it would be fair to say that this was not taken as a ringing endorsement. “Bush’s strong-dollar policy is, in practical terms, to maintain a pool of fools to buy it all the way down,” a fund manager was quoted by Bloomberg news agency as saying.

It does not help when the chairman of your central bank, Alan Greenspan, whose utterances on the economy are taken rather more seriously than Mr. Bush’s, has said the day before that the dollar seems likely to fall: “Given the size of the current-account deficit, a diminished appetite for adding to dollar balances must occur at some point,” were his exact words. The foreign-exchange market immediately decided that it was sated, and the dollar fell to another record low against the euro. Mr. Greenspan’s words were of huge moment, and not just because he spoke clearly, unusual though this was, nor because the Federal Reserve rarely comments on foreign-exchange movements. No, Mr. Greenspan’s words were significant because he was tacitly admitting what right-thinking economists the world over have long believed: that the emperor has no clothes.

Mr. Greenspan’s previous line had been that America’s ever-expanding current-account deficit was not a problem when capital could flow so freely around the world; and that, in effect, it would continue to flow to America because the country is such a wonderful place in which to invest. Now he is saying that it will not, or at least that investors will demand a cheaper dollar, or cheaper assets, or both, to carry on financing America’s deficit. But I suspect that the deeper significance of Mr. Greenspan’s admission is that the game that has been played since the collapse of the Bretton Woods system in the early 1970s is drawing to a close. The dollar’s status as the world’s reserve currency -- its preferred store of value, if you will -- is gradually coming to an end. And, ironically, the fact that it has become so popular in recent years will only hasten its demise.

One man who undoubtedly believes in a strong dollar is Japan’s prime minister, Junichiro Koizumi. Unlike America, Japan has been putting its money where its leader’s mouth is. On behalf of the finance ministry, the Bank of Japan has bought more dollars than any other central bank has ever done. At last count, it had the equivalent of $820 billion in foreign-exchange reserves, most of it denominated in the American currency. As goes Japan, so goes the rest of Asia. Li Ruogu, the deputy governor of China’s central bank, the People’s Bank of China, said that his country would not be rushed into revaluing the yuan, and that America should put its own shop in order. Mr. Ruogu’s bank, too, has been a huge buyer of dollars in recent years. China and the rest of developing Asia now have $1.4 trillion of reserves, mostly dollars. This is more than the combined reserves of the rest of the world (excluding Japan). In effect, they are trying to peg their currencies in order to keep their exports competitive; China’s peg is explicit. Huge foreign-exchange reserves are the result.

The upward pressure on Asian countries’ currencies stems either from their saving too much and consuming too little, or from America saving too little and spending too much. Mr. Greenspan’s most recent comments show that he recognizes the problem is more home-grown. Personal saving in America, as a percentage of household income, slumped to just 0.2% in September, close to a record low. Indeed, the savings rate has been declining remorselessly since 1981, when it reached a high of 12.5%. This lack of saving shows up in the current-account deficit, which is a record near-6% of GDP and rising. In effect, foreigners are saving on America’s behalf.

The question is whether foreigners will be happy to carry on financing America’s growth with the dollar and asset prices at their present level. The private sector is already voting with its wallet: it has been financing an ever smaller percentage of the deficit, and there has been a net outflow of direct investment. That leaves the public sector, i.e., central banks -- and those, in particular, of Asia. At the heart of the central banks’ calculations is a trade-off: intervening to keep your currency down can be costly, but it is good for exports. Though the costs of intervention are hard to quantify, they are potentially big.

The biggest risk, of course, is that lenders would lose pots of money were the dollar to fall. As the printer of the world’s reserve currency, America can pass on foreign-exchange risk to the lenders because, unlike other indebted countries, it can borrow in its own currency. The incentives to flee the Asian cartel (to give it its proper name) thus increase the bigger the game becomes. Why take the risk that another central bank will leave you carrying the can? Better to get out early. Because the game is thus so unstable it will come to an end, and probably a messy one. And what will then happen to the dollar? It is hard to imagine its hegemony remaining unchallenged when so many will have lost so much. And doubly so given that America has abused the dollar’s reserve-currency role so egregiously that its finances now look more like those of a banana republic than an economic superpower.

Link here.


Asian countries are getting worried because their export growth is waning, and countries in that region are highly dependent on exports. Exports account for more than half the GDP in a number of smaller ones, such as Vietnam (52%) and Thailand (55%). In Singapore, Malaysia and Hong Kong, the ratios exceed 100%, as their airports and harbors turn imports into exports. These countries worry that high-energy prices and other forces are cooling the U.S. economy and, hence, demand for their exports. They also worry about the effects of high-energy costs on Asia and, more broadly, exports within the region.

Asian countries are also concerned about the strength of their own currencies against the dollar and the resulting negative effects on their exports-specifically, their exports to the United States since the lion’s share of their exports, directly or indirectly, end up in America. Nevertheless, currency values and real imports have almost no correlation; the same is true of real exports and currencies. So if currency movements do not alter trade flows very much, what does? Economic activity. When an economy is growing, consumers and businesses buy more of everything, especially imported goods and services. There is a close correlation between real imports and GDP in the U.S. Statistical work shows that U.S. imports rise 2.9% for each one percent increase in GDP, but only 0.2% for each one percent rise in the dollar. Other major countries have similar relationships

Asian concern over dollar weakness, then, is overblown, but worries over U.S. growth and American imports are well founded. The immense fiscal stimuli from earlier tax cuts and jumps in defense and Homeland Security spending are now fully absorbed. So, too, are the effects of the decline in interest rates, which spurred housing activity and cash-out mortgage refinancing. With further big leaps in housing and consumer spending unlikely, many hoped that business outlays would surge and seamlessly continue robust U.S. economic growth. But those hopes have not been fulfilled. So, the U.S. economy lacks meaningful growth stimuli.

At the same time, three negative forces are at work: First, the recent jump in crude oil prices is cutting about 1% off U.S. GDP growth. It is sobering to note that the last five oil price spikes were associated with recessions. Second, the Fed is in the midst of a rate-raising campaign, and Fed rate hike efforts almost always end in recessions. And lastly, in the postwar era a recession has occurred in the first or second year after 10 of the 15 presidential elections. So if the United States is no longer the destination for much of the world's exports, who will be able to step in?

China has become a big player on the global stage, and therefore important to the worldwide economic outlook. But now China is trying to cool her overheated economy, and last month the central bank raised its benchmark interest rate for the first time in nine years. The likelihood that China can let the superheated air out of her soaring economic balloon without a crash-landing is very low. A recession in China would wreak havoc on the rest of Asia, even Japan, which is just emerging from over a decade of deflationary depression and remains dependent on exports for growth. Japan’s recovery has been export-led, much of it due to China. If the U.S., China and Japan have weak economies, so does the rest of the world.

So, will another country replace the U.S. as the economic engine that absorbs the globe’s excess goods and services? Maybe, but none have yet volunteered for the job. Ironically, the import-wary Japan may end up being the world’s next big importer. All major countries have rapidly aging populations, but Japan’s is the most extreme. Due to decades of saving more than was needed for domestic investment, Japan has been exporting capital. Those outflows have cumulated into huge holdings of U.S. Treasury obligations, foreign real estate and other assets around the globe. Japan, in the decades ahead, can simply sell those piles of foreign assets and use the money to buy the imports needed to supply her retirees.

While Japan may replace the U.S. as the globe’s importer, developing countries like China are unlikely to fill that role. I believe that China, India, the Asian Tigers, Latin American lands and other developing countries are probably decades away from achieving big enough middle classes to eliminate their dependence on exports for growth. Many see the growing U.S. trade and current account deficits as menacing problems. I see the reverse, the dependence of the rest of the world on America to buy its excess goods and services, which can only be good for us in the long run.

Link here (scroll down to piece by Gary Shilling).


The recent announcement that Edward C. Prescott and Finn Kydland had received the 2004 Nobel Prize in economics has put business cycle theory front-and-center again in economic discussion. Whether or not one agrees with all of what Prescott and Kydland have said -- and Austrian economists do not -- does not cloud the larger importance of this subject and why it is important to understand the nature of business cycles.

In my graduate economics class for MBA students, I frequently employ case studies that look at business failures and mistakes. More often than not, a statement like “at the same time, a deep recession further clouded Company X’s business fortunes” or something like that. I find such statements to be rather interesting; the downside of the business cycle is treated in the same way that one would view a hurricane or an earthquake: a simple force of nature. A business that is hit hard during a recession is not unlike a business whose building is flattened by a tornado. Such a view is short-sighted, of course. Storms and earthquakes are a force of nature that no person can control; business cycles, on the other hand, are the sole creation of people.

Austrians see the business cycle first and foremost as occurring because of monetary decisions made by central bankers and others in policy-making capacities, as opposed to the introduction of new technologies, which is the central theme of Prescott and Kydland. In other words, business cycles, as Murray Rothbard pointed out in America’s Great Depression, have the common thread of monetary inflation, which leads to capital malinvestment, and ultimately culminates in the boom and bust routines that we have come to know so well.

As I work through the various case studies in which bad business decisions were exacerbated by overall economic downturns, I ask whether or not the knowledge of an Austrian view of business cycles would be useful for business decision makers. I assume that it is useful for those in government who make decisions on taxation, spending, and monetary policies, although one doubts that even good theory would induce politicians and bureaucrats to change their ways.

Would be that all business owners and investors knew and understood the Austrian Business Cycle Theory (ABCT). (Yes, I know that Alan Greenspan knows the theory -- and, apparently, it has not done him any good.) Would it prevent government from acting in the way that it does? Perhaps not. However, the ABCT tells us this truth most clearly and plainly: the emperor has no clothes. That bit of wisdom always is worth knowing.

Link here.


New disclosure rules help understand the problem: the franchisees are hurting.

Krispy Kreme makes doughnuts that people line up to buy, at least when a store opens in a new market. It was this that made Krispy Kreme’s stock hotter than its products when it burst onto the investment scene a few years ago. But now reality is setting in. The important thing about Krispy Kreme is not that it reported a quarterly loss this week. Nor is the crucial issue an investigation by the S.E.C., or the unwillingness of the company’s auditors to sign off on its quarterly filings until that investigation is over. What is important is the evidence that the Krispy Kreme empire, as a whole, cannot make money.

What has gone wrong? When things started to slow down this year, the company blamed the Atkins diet. But other doughnut makers are not suffering to the same extent, and some companies say that sales of high-carbohydrate snacks are rebounding. “There is no doubt,” said William R. Johnson, the chief executive of H. J. Heinz, in announcing an increase in his company’s earnings, “that the low-carb phase has played itself out.”

Krispy Kreme’s company-owned stores report an operating profit, but not one large enough to cover corporate overhead. The real profits have come from the company’s dealings with its franchise vendors. The franchises pay royalties of 4.5% to 6% of sales, plus 1% for advertising and public relations. And they must buy all their supplies from the parent -- paying hefty markups that provide 20% profit margins for Krispy Kreme.

All that would be fine if the franchises were doing well. But many are not, and some are turning to Krispy Kreme as the lender of last resort. Some of these borrow from the parent and others sell their franchises back to it. One lucky operator had a deal that forced Krispy Kreme to buy at a price set in more optimistic times. In other cases, the parent bought for reasons the S.E.C. may be looking into, since its insiders held stakes in franchises the company purchased. Krispy Kreme emphasized that those insiders sold at cost, and thus did not profit. For a time that satisfied investors, who might have been better off had they asked why the insiders wanted out.

Until recently, it had been hard to tell how the franchises were doing. But the combination of additional investments in franchises and new accounting rules -- imposed as a result of the Enron scandal -- has forced the company to disclose more. In the quarter ended in October, the joint ventures lost $2.1 million after coming close to breaking even a year earlier. What this really looks like is a fad that faded.

The lesson of Krispy Kreme is simple, and it is not that Americans are suddenly devoted to healthier food. It is the same one that too few investors heeded in the 1990’s when Coca-Cola was improving its profits by squeezing its bottlers: If the people who actually sell the product are suffering, the enterprise is not a success.

Link here.


Mexico’s central bank lifted interest rates for a 5th time since July to halt rising inflation and “quickly” bring it back to target. Banco de Mexico raised the amount commercial banks must borrow overnight at higher rates to 63 million pesos ($5.6 million) daily from 57 million pesos, it said on its Web site. Mexican authorities adjust interest rates by reducing or increasing the amount it lends at a rate that is double the going market rate.

Central bank Governor Guillermo Ortiz, 56, must keep raising interest rates to show his commitment to the 3 percent inflation target after consumer prices rose 5.4% in the 12 months to October, said economists such as Neil Dougall from Dresdner Kleinwort Wasserstein. “Given the magnitude of the overshoot, there’s still work to be done,” said Dougall, in an interview from London before the interest-rate announcement. “As long as inflation expectations start to come down, that would allow the central bank to ease off.”

Link here.


(Originally published October 15, 1999)

I left Baltimore last night and took a cab down to Dulles Airport in Virginia. The following is the actual conversation with the cabdriver. It began as the cab crossed the Baltimore beltway, and the driver suddenly remarked ...

Link here.


Dear Mr. Dollar:

I have for some time expounded your shortfalls and frailties. And now, with your soundness and future status having been elevated to the crucial issue in global markets and economics, it is appropriate that I address my heightened concerns to you directly. There are some critical issues that I want to ensure you are aware of. As much as I have criticized you in the past, I today fear for your future.

First of all, there is great confusion and misinformation as to who you really are and what role you play. Some believe -- and many would like to perpetuate the myth -- that you are the “currency” created and managed by the Federal Reserve. I think even you would admit that this is an expedient and false impression. Federal Reserve liabilities are but a small and shrinking portion of dollar-denominated claims, and the Fed has quite limited capacity to support you during episodes of faltering confidence and market tumult. The Fed’s previous effort to support you by increasing the attractiveness of U.S. securities is at this point a largely spent force. And while the consensus view holds that the Federal Reserve and Administration have advantageously used your devaluation as a policy tool -- the Fed to “fight deflation” and the Bush team to buoy U.S. manufacturers and employment -- it is more accurate to recognize that the actual policy mechanism has been to incite the (mindless) creation of additional dollar claims (Credit inflation), thereby stimulating expenditures and asset inflation (real estate, bonds and equities, in particular). The policy has been to perpetuate Bubbles, and only talk as if they were concerned about your strength and welfare. “Strong dollar” blather has similarly lost efficacy.

Many confuse you with dollar “bills” -- Federal Reserve Notes -- and Treasury debt. Others commonly mistake you for numerous Credit instruments issued by various types of institutions that can be used these days to consummate transactions in the real economy or financial markets. Some erroneously presume that scores of previous gross financial transgressions and policy derelictions -- not to mention the consequent deep structural economic maladjustments and endemic inflated asset prices -- will somehow be forgiven if only the federal budget is balanced. If it were only that easy, Mr. Dollar. I wish it were true.

Many refer to you as “fiat”, insinuating that you are authorized or sanctioned by the U.S. government. This is inaccurate. The Fed enjoys no dollar “monopoly power,” while Secretary Snow and the Department of the Treasury today possess virtually no power. The issuance of dollar debt is open to virtually all, while the size and nature of the dollar trading market -- dominated today by derivative trading, “hot money” speculative flows, and foreign central banks -- is massive and unlike anything in history. ... [T]oday, in a Fancy-Free Marketable Securities-Based Financial New World Order -- with myriad institutions creating liquid dollar-denominated liabilities, and securities playing such an instrumental role in the global system’s payments settlement mechanism -- the term “Global Wildcat Finance” is much more legitimate than “fiat currencies”.

Mr. Dollar, it is today more factual and certainly analytically advantageous to think of you in the context of a “unit of account” in the global pricing of U.S. assets. Your value is determined in the marketplace (currency futures trading), and then is used to impute value for a vast array of claims throughout the global “ledger” of financial assets and liabilities. As a unit of account your intrinsic value would generally move inversely with the quantity of financial claims created. However -- and we will return to this crucial issue -- any chasm that develops between market perceptions and reality creates fragilities and potential for dislocation. Your market value will always be relative to other units of account (currencies) and, at times, to perceived superior stores of value (gold, precious metals, crude and energy).


Mr. Dollar, no one knows better than you how present-day notions of monetary and fiscal policies -- along with New Age Finance, have left you unguarded and vulnerable. Considering your role as the “world’s reserve currency” and the eminent “unit of account” for global prices -- to not assiduously guard your wellbeing is an outrage. The complacent consensus view nonetheless takes comfort from the historical ebb and flow in your relative value to other currencies. I would, instead, suggest that the ongoing saga of contemporary finance and its recurring currency crises and collapses leave zero room for complacency.

And as you know, there is a consensus view that holds that your value is being somewhat sacrificed by the Fed as it sticks with its accommodative monetary policy (“peg” interest rates low and let your value “float”). Few in the U.S. see much risk, with most in Washington and Wall Street content to enjoy the seductive “debtors’ blessing” delusion of devaluation and inflation. This is a quagmire. And if I had any hope that low interest rates and the status quo would rectify acute U.S. financial and economic fragilities I would not be writing to you this evening. But I fear the worst: the Fed is immersed in a trap of runaway Credit and asset inflation. Global players -- including central banks -- are coming to recognize there is no way out. Almost anything non-dollar is viewed as a superior store of value to investors and the massive speculating community. And perhaps others see dollar vulnerability as a potential countervailing force to aggressive U.S. foreign policies. Things don’t look good. Confidence is faltering, and I fear we have passed the point where a dollar crisis is unavoidable.

I wish you the best in what will likely be a difficult and tumultuous period. And I do sincerely hope you can muster all your strength and surprise us with your resiliency. It certainly did not have to be this way. I hope the Greenspan Fed (and the “inflationists”) will be held accountable. Too much lunacy has been spoken and written, while the scourge of financial folly worked furtively to destroy you. The world’s preeminent currency was a terrible, terrible thing to waste. There will be huge costs to pay, and I am saddened and sorry it happened.

Link here (scroll down to last section of page body).
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