The decline of US credibility is complete after the humiliating death of Saddam
Hussein and the sharp escalation of violence in Iraq that followed it. News
editors of US television channels describing the situation as "the United
States is losing the war in Iraq" clearly failed English grammar at school, by
mixing up their gerund-participle in place of the appropriate past participle,
ie, "the United States has lost in Iraq".
The fact that America's moral obligations have not kept pace with its
technological capabilities has been brought to the fore once again, by the
country's attack on Somalia's apparent sanctuaries for al-Qaeda this week, even
as the US forsakes any
responsibility toward the innocent victims of Sudan's genocidal leaders. It is
a matter of some wonder to observers that a US administration can practice
non-intervention in the same breath as active bombardment.
The malaise is not only American, as other countries such as Britain appear
equally culpable, albeit of other offenses. The suspension of an investigation
into alleged bribing of members of the Saudi royal family by a British defense
contractor was explained as a measure to safeguard English jobs. That economic
interest has been at the forefront of all societies' cultural, religious and
moral evolution has already been covered in a previous post; [1] I only bring
this story up to highlight the more generic disease prevalent across the
Western Hemisphere.
It isn't only in the area of foreign policy that such hypocrisy is evident.
Environmental concerns have also caused Western leaders to leap headlong into
denial, adopting the same strategies of pseudo-science that tobacco companies
used in past few decades to pooh-pooh links between smoking and cancer. I wrote
in a previous article [2] that Islamic terrorism may produce the unintended
consequence of reducing global warming, in essence by scaring over-consuming
Western societies into actually changing their habits.
None of this would matter but for the fact that North America and Europe are
hopelessly addicted to cheap financing and rising import demand (respectively)
from emerging superpowers. It would be erroneous to assume that the latter
group needs the former; instead it is the other way around. Why then are global
financial markets showing less risk than would otherwise be prudent?
The emperor has no clothes, darling
Eloquence can be defined as the ability to describe the balloon-smuggling star
of Baywatch, Pamela Anderson, without using one's hands. In much the
same way, watching a number of financial news channels, I am struck by the
inability of any commentators to explain the low returns in US financial
markets without using their hands to draw elaborate castles in the air. Seeing
as most of these channels are US-owned, perhaps they are not permitted to utter
the obvious truth, which is that US bonds and stock values are inflated.
With even ill-tempered minnows such as Venezuela thumbing their noses at
American officials, it is almost surreal to observe the continued stability of
financial markets, which observation brings into focus the role of the biggest
holders of US debt. Rather than being beholden to the stability of the US
economy, countries such as China and those in the Middle East are merely
withdrawing air from the bubble ever so slowly.
The expected rise in bond yields this year, and concomitant expectations for a
decline in US stock valuations, are already being reflected in financial
markets, which currently show surging enthusiasm for all things non-American.
There has been no need thus far to effect a "zero-sum" approach of selling one
group of financial assets to buy another, because of ample global liquidity.
The decline in oil prices of late is actually negative for that liquidity as it
reduces the surpluses.
Smart money, though, is chasing returns away from the US and even the European
Union. While that strategy by itself leaves much to be desired, at least it
proves more defensible than the air of resignation that surrounds anyone forced
to invest in the US economy.
The catalyst
Chinese banks pay their depositors less than what US banks pay theirs. Even so,
the former cannot keep away their surpluses, which eventually wind their way
back through the financial markets to the US. But this calculation only works
as long as the returns on US assets exceed the currency-adjusted return for
Chinese banks. In the past two years, that was certainly not the case, as the
Chinese currency appreciated more than the nominal yield differential between
the two classes of assets.
While this loss may have been bearable a few years ago when China had less than
US$150 billion in foreign-exchange reserves, its current position of more than
$1 trillion means that even a 1% loss as described above translates into a
mind-boggling figure of $10 billion. In practice, the Chinese government loses
more than that every year to keep the peace with the Americans and Europeans.
On the benefits side of the equation, China gets to keep manufacturing jobs
that could otherwise be lost - albeit not to North America or Europe, but
rather to other Asian economies lower down in the manufacturing value-addition
scale, such as India and Vietnam. The forsaking of domestic demand for this
purpose is going to look, at some stage, like an overly high price to pay. I
expect that between a sudden decline in property or stock prices and continued
pressure from the US administration, China will push through a staggered
revaluation of its currency against the US dollar this year and next.
Market reaction
Financial markets are already signaling this eventuality, as the rising prices
of Chinese financial companies now show. The country's largest bank and its
largest life-insurance company are, respectively, the third- and second-largest
by market capitalization in the world. Behind this creditable achievement lies
the expectation of foreign investors to benefit from significant currency
appreciation, rather than any overt trust in the fundamentals of such
companies.
Chinese banks continue to face huge challenges, ranging from their excessive
deposits to their large and growing book of problem loans. Meanwhile, Chinese
insurance companies face the threat of a staggeringly quick demographic
decline, which, when measured against the poor returns on less risky assets in
the country, implies that growth in overall income is likely overstated.
Thus the primary reason for investors to partake of such assets, at inflated
prices, is the expectation that they can profit from the rise before any
downturn. Investors in US or European assets can hardly complain on this front,
seeing as the assets they are holding appear equally subject to overoptimistic
valuations. At one stage during the emerging markets crisis of the late 1990s,
the value of one US company exceeded the combined market capitalization of all
emerging markets. It is the natural order of things that the boot is now on the
other foot.
In summary
If the sting of a scorpion surprises a burglar, he is caught between the need
to scream, risking capture, or silently bearing the pain before gingerly
withdrawing into the night. Much the same logic rules the financial markets
these days, where the poor returns to be had in the US markets have driven many
investors to search for alternatives, even if these appear overvalued
themselves.
This global epidemic of pseudo-logic will end in tears for many investors, but
at least the people with the real savings have the ability to recover, which
the US economy appears to lack.
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