|
|
|
|
SPEAKING
FREELY
The coming
crisis
By Rohit Chawdhry
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click here
if you are interested in
contributing.
NEW DELHI - In the
past few years, expanding global liquidity has
fueled global economic growth. The global economy
expanded at an annual average of 4.5% for the
period 2003-2004, representing the fastest growth
rate since after the Iranian revolution, in the
early 1980s. This period saw growth outpacing the
United States's productivity boom phase of
1994-1999. Not surprisingly, growth in global
corporate profits accelerated, resulting in a
synchronized rally in world financial markets.
However, the party may just be coming to
an end as global growth is likely to decelerate
significantly this year. Why? It's US Federal
Reserve Board chairman Alan Greenspan again, who
is tightening the tap on global liquidity through
interest rates that will eventually result in
slower growth for the world this year. Evidence
for this can be seen from the shape of global
yield curves that imply slower growth rates ahead.
Further, the lagged impact of crude oil prices was
not felt in 2004, but will be in 2005. Overall, a
simple regression model based on the above
variables would not yield world growth of more
than 3% - which represents a sudden deceleration
in economic as well corporate earnings growth
rates this year. Noteworthy is the 35% drop in 256
MB DRAM prices (a good proxy for semiconductor
prices as well as economic activity) since the
start of the year. It is getting increasingly
evident that the global growth environment is
deteriorating faster than most market participants
imagine.
How does a deceleration in global
growth impact emerging markets? Historically, Asia
and Latin America tend to show higher volatility
in the event of global slowdowns as their economic
growth rates decelerate at a faster pace than
developed ones. A 3% global growth rate is
unlikely to yield a gross domestic product (GDP)
growth rate of more than 6.5% for India for 2005.
On the same count, Asia minus Japan, which grew at
7.3%, is not expected to register more than 6%
growth in 2005. Further, if China were to land
hard, then one arrives at 5% for Asia sans Japan.
China's effort to cool down its economy
has been a topic of debate among policymakers and
analysts. The Chinese economy has been growing at
a spectacular pace for more than a decade,
registering an average growth rate of 9.6% from
1991 to 2004. While the consensus among market
participants has been that the Middle Kingdom
would indeed be able to engineer a soft landing,
the fact is that it is unusual for a country with
such growth rates for long periods not to crash
land now and then.
The economic history of
China suggests two earlier episodes of
crashlanding: one in the early 1980s and the
second in 1988-1990. The second was more prominent
as the growth rate collapsed from 11% to 4%. Both
episodes followed the end of the commodity cycles
- in 1977-1980 and in 1987-88. While event risk
models are largely useless, a simple model based
on the spread between HIBOR (Hong Kong Inter Bank
Offered Rate) and LIBOR (London Inter Bank Offered
Rate) may just do the trick.
A discount
for HIBOR over LIBOR would indicate an investment
rush in China due to which HIBOR gets to a
discount over LIBOR. However, if this discount
were to become closer to zero, it would imply that
the investment bubble is deflating. This indicator
did a terrific job in predicting the crashlanding
of 1988-90. The current status of the indicator
suggests a similar pattern as it has moved quite
significantly from being negative to being close
to zero - signaling a likely crashlanding, most
likely in the second half of 2005.
Economists and investors could argue that
such a phase seems unlikely this year as China is
looking to re-accelerate, with industrial
production growth hitting double digits for the
first two months of 2005. While the quality of
data coming out of China is highly questionable,
evidence from other data sets taking into account
regional shipping rates and activity, industrial
production from leading trading partners such as
the US, Japan and Korea suggests otherwise. A
simple leading indicator for China drawn from the
leading indices for the above three countries
would show that export growth is indeed slowing
down and soon the existing excess capacity will
balloon, a situation leading to overcapacity and
crashlanding for Asia as a whole.
The
greatest threat to the emerging markets is China,
where a crashlanding would have far-reaching
implications beyond Asia. We could then expect
global risk appetites to plummet, emerging market
currencies to fall and interest rates to rise -
and the dollar to strengthen. A number of factors
tend to precipitate emerging market crises. A
slowdown in the global economy, falling global
liquidity, rising interest rates in the US and a
crisis in a specific country that spills over to
other emerging markets. Conditions for such a
market dislocation are now falling into place.
Historically, all significant interest
rate tightening cycles by the Fed (of 150 basis
points or more) have been accompanied by market
dislocations. The table below illustrates
tightening cycles, along with market dislocations.
Interest rate
tightening
periods |
Amount
of
rate hikes (bps) |
Corresponding
event/crisis |
Date |
| Sep '68-Sep '69 |
325 |
Penn Central |
Jun '70
|
| Feb
''71-Oct '71 |
150 |
Bretton
Woods Collapse |
Aug
'71 |
| Dec
'71-Jun '74 |
700 |
Franklin
National |
Jun
'74 |
| July
'77-Mar '80 |
1175 |
First
Penn |
Apr
'80 |
| Aug
'80-Feb '81 |
650 |
LDC debt
crisis |
Aug
'82 |
| Feb
'84-Aug '84 |
350 |
Continental Illionis |
May'84 |
| Oct
'86-Sep '87 |
150 |
Stock
market collapse |
Oct
'87 |
| Feb '88-May '89 |
325 |
S&L crisis
Mexican peso crisis
Asian crisis |
Jun '90
Dec '94
Jun
'97 |
| Jan '94-Jun '95 |
300 |
Russian debt crisis
LTCM collapse |
July '98
Sep
'98 |
| May '99-Nov '00 |
175 |
Nasdaq collapse |
Mar ''00 |
| Jun-Feb '05 |
150 |
Mortgage
finance/
homebuilders |
2005? | 
Source: Allianz
Securities Ltd Estimates
While
it is difficult to decipher where the next market
disclocation could be, one can handpick a few
potential ones. Recent breakdowns in stock prices
of leaders like General Motors (whose debt is
trading at 450 basis points above treasuries - a
seemingly junk status), Citibank and Fannie Mae do
not provide much confidence. The multi-year
bull-run for the housing finance
firms/homebuilders may finally be coming to an end
this year. Hedge fund activity has also gone up
significantly since the Long Term Capital
Management blow-up and it is only logical to
assume that the probability of at least one of
them going bust due to their bets on any of these
(and/or China) may prove to be a systemic risk for
the rest of the world. The point is, there are
phases when financial markets become asymmetric to
bad news or event risks (when all the good news
has been priced in while bad occurrences result in
an expansion in volatility). Event risks can
easily result in a substantial outflow from
emerging markets, more so if the dollar were to
appreciate significantly.
The consensus
seems to be further dollar weakening from this
point. However, history shows that there is a
significant lag between the bottoming of interest
rates - whether measured by market prices or Fed
actions - and the strengthening of the dollar.
Studies suggest that the median span between the
low in US Treasury yield and the reversal of the
CRB index or the dollar index is 18 months. With
the low in yields occurring in June 2003, it would
be likely for the dollar to have bottomed out in
December 2004, and this seems to have occurred.
Further, out of seven monetary cycles with a
tightening of 150 basis points or more (from 1977
till date), the dollar appreciated by an average
of 7% in real terms. It seems conditions are in
place for a significant rally in the dollar. The
sentiment reading - a great contrarian indicator -
for the US currency has also reached a nadir, with
Newsweek and The Economist putting out bearish
dollar cover page illustrations in March. It seems
more likely than not that the dollar has at least
bottomed out for an intermediate term. Emerging
market currencies may see some kind of
consolidation or depreciation over the next six to
12 months. However, most of the appreciation for
the dollar is likely to be against the euro and
the yen - the regions where economic fundamentals
are much worse than in the US.
A rising
dollar is likely to have negative ramifications
for both gold and emerging markets over the same
period. Further, the likely increase in downside
volatility for emerging markets could be expected
on account on unwinding of "reflation carry
trades" by hedge funds as well. A significant
portion of these market participants has funded
their investments in emerging markets - stocks,
bonds and currencies - along with commodities by
borrowing at low interest rates in the US. The
primary assumption is that the underlying asset
for this trade (emerging market stocks) would give
superior returns and this along with emerging
market currency gains would provide a healthy
carry (after netting out the cost of funding) as
profit. Unfortunately, a likelihood of dollar
appreciation, a poor environment for commodities
and emerging markets and rising interest rates in
the US are forcing these funds to have a re-look.
While an appreciating dollar is a big
enough reason for commodities to decline, it is
not the only one. Interest rates and import of
primary raw materials from major consumers also
have significant power in explaining commodity
movements. One such attempt to explain commodity
movement is a plot between the metals lead
indicator along with the growth in the CRB metals
index.
It
is evident from the chart that the leading
indicator does a fair job in predicting the growth
in the metals index with a lead time of six to 12
months (see the shaded regions). The lead
indicator takes into account global monetary
conditions, global exchange rate policy and the
import of primary raw materials by China.
It is evident from the chart that metals
look set for a significant setback as global
growth slows. Analysis of the CRB-raw materials
index suggests similar results. Further, an
increase in spreads in US high-yield bonds over US
Treasuries by more than 50 basis points over the
past month is suggestive of increasing risk
aversion. The bottom line: investors are finally
starting to dump riskier asset classes such as
commodities and emerging markets in favor of much
safer assets. Does the downward trend in
commodities signal an end to the rise in crude
oil, at least cyclically? Most likely. With rising
crude oil inventories in the US and elsewhere, and
potential increases in the same due to a global
slowdown in growth, it is likely that crude oil
has peaked for some time till financial conditions
become more sanguine for a pickup in global
demand.
Doesn't a decline
in crude oil merit another round of rallies in
stocks worldwide? Sounds logical, but unlikely.
Studies suggest that a rise in crude oil prices is
driven primarily by increasing demand, as supply
remains relatively static (as global oil
production has more or less peaked in 2005).
Therefore, a slowdown in global demand is likely
to result in a setback for both stocks and oil.
Historically, the most important peaks in the
S&P 500 have coincided with peaks in crude oil
as well. Sounds counter-intuitive but true. This
is bad news for Middle East stock markets, which
looked set to peak in the first half of 2005.
The world economy has been kept afloat by
the aggressive expansion of the US budget deficit
and Chinese investment growth. Any reversal in
these two trends has pretty serious outcomes for
the rest of the world. A likely slowdown in global
growth rates and an appreciating dollar in 2005 on
the back of it are reasons enough for potential
setbacks in emerging markets (stocks, debt and
currencies) and commodities. This coupled with any
potential market dislocations (China, US or
elsewhere), will mean that the already worsening
financial environment may become even worse.
Rohit Chawdhry is senior vice
president of Allianz Securities Ltd, New Delhi.
(Copyright 2005 Rohit Chawdhry)
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click here
if you are interested in
contributing.
|
|
|
|
|
|
|
|
 |
|
|
|
|
|
All material on this
website is copyright and may not be republished in any form without written
permission.
© Copyright 1999 - 2005 Asia Times
Online Ltd.
|
|
Head
Office: Rm 202, Hau Fook Mansion, No. 8 Hau Fook St., Kowloon, Hong
Kong
Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
|
|
|
|
