Sailors are famously more wary of fire than wind. They are well trained to
handle the odd typhoon or five but find it much more difficult to battle a fire
on board, especially while carrying flammable cargo. This is roughly the
situation facing Asia over the course of 2008, with the region's business
community braced for the likely recession in the US that threatens to worsen
before any improvement can be discerned, even as they have to look around for
dangers much closer to home.
In my review for 2007 (Annus
financialitis Asia Times Online, December 22, 2007) the scope of the
damage to the global financial system was laid out, with a conclusion that
Asian
economies could perhaps push through the difficult period if their central
banks or governments changed the excessive dependence on exports to domestic
consumption. While volatility in economic performance is a given, there were
enough reasons to presume elemental shifts that engender positive results.
Some of that may have changed in the last few days of 2007. Firstly, the damage
to global investment banks is worse than previously assumed, as extrapolation
of current market levels on difficult-to-value securities (Level 3 assets in
the bromide parlance of accountants) at the end of 2007 implying that some
investment banks have wiped out their entire capital base. Their capital
raising with Asian central banks and investment companies highlight their
desperation, but the joke may eventually be on the Asians as they realize that
they were suckered into buying assets that are in essence worthless rather than
merely being worth less (ah, the wonders of semantics, which allow a simple
space bar push to determine the difference between a company with 30 billion in
capital and one without any capital at all). I will come back to this point
later.
Secondly, rising security risks have assumed greater urgency in light of events
in Pakistan and Russia over the past few weeks. Make no mistake the
assassination of Benazir Bhutto is part of my central hypothesis of Pakistan’s
nuclear weapons falling into the hands of rabid fundamentalists
(Playing South Asia's World War III game Asia Times Online, November
17, 2007). Tied to a president who has unfortunately cried wolf too many times
[1], strategic options for the US are severely limited at this stage.
Yes, the American public is generous in its accommodation of flawed presidents
in their last year in office, but even they may choke at the possibility of a
war on Pakistan. That limits options to either letting the unpopular President
Pervez Musharraf continue in power or endorsing the more Islamist-democratic
option of Nawaz Sharif as premier. A classic Devil vs Deep Sea choice, and one
entrusted to a lame duck president to boot. The sole winners are the Islamic
fundamentalists, whose ability to recruit will improve dramatically in coming
months even as they become kingmakers in Pakistan over the near term.
As if the US economy and Pakistan weren't enough to worry about, Russia has
wandered into the geopolitical chessboard like a bear nursing one hangover too
many. President Vladimir Putin appears keen to open a last strategic front
against the US before he leaves office - at least formally - this year. This is
most likely to be in the parts of Russia bordering restive Asian states such as
Iran and Afghanistan, even if the immediate strategic priority should be
westwards towards Europe. The entry of Russia into the quagmire would
immediately elicit responses from other regional powers including China and
India, not to mention the suitcases filled with gold coins (no US dollars,
thank you) that will leave Riyadh airport almost immediately.
Japan and Asia
What I described at the beginning of December as an emerging trend quickly
cascaded into the central capital-raising plan for US investment banks by the
end of the month. As results for the year ended December 31 are being prepared
by major commercial banks, it is quite likely that more capital raising will
follow, especially given the rock-bottom prices recorded on some securities
during December.
There is another disturbing aspect to the financial meltdown being seen by the
various US commercial and investment banks. This pertains to the potential for
one of these firms to actually go bust in coming weeks, in turn triggering a
failure to pay on various derivative contracts. Now, these contracts have been
cited as the major reason for many banks to claim their "net" exposure is
small, therefore if any link in the chain fails, the entire chain may collapse.
Imagine that you have a billion dollars of loans to a housing developer, and
you bought credit protection from one of your competitors. The net exposure to
the housing developer would then be shown as nothing, therefore meaning that
you have no danger of losing money if that developer goes out of business. Now
if your counterparty fails, you have that exposure straight back on your books,
with nowhere to hide as other firms will probably now refuse to provide default
protection on this developer.
Bank audit committees can no longer pretend that many of their vaunted "triple
A" securities are anything of the sort, or that they are fully hedged on some
assets just because they bought protection from another firm that looks just
like them across the street. At best, the assets are worth between 20 and 30
cents on the dollar based on the trades seen in December [2], while
calculations for net exposure will have to rise sharply. This erosion of
capital is perhaps the reason why a number of investment banks rushed to shore
up their capital by entering into capital structure deals with their
accommodative Asian friends. As I wrote in my year-end review cited above, the
capital injections will prove insufficient and it is quite likely that Asian
investors will lose billions.
Parallels can be drawn to the surge of Japanese investments into the United
States during the late 1980s and early 1990s, in deals that led to the
acquisition of large tracts of prime real estate and Hollywood studios by
Japanese conglomerates. In pretty much every one of these situations, Japanese
investors lost money and some even had to file for bankruptcy. Ironically
enough, one of the largest Japanese banks that funded such foreign acquisitions
eventually fell into the hands of a US private equity firm.
The "pioneering" work of Asian central banks buying stakes in American banks
and investment houses thus will come to naught as the real depth of the crisis
takes hold. Without capital, these banks will have to offload billions of
non-core assets. These include strategic stakes in a number of Chinese banks
that will probably flood the stock market before Chinese New Year celebrations
can begin in earnest in February.
That set of stake sales will probably be the first blow to regional stock
markets this year. Following from there, I would expect other technical factors
including the potential for currency regime changes, US economic weakness and
reduced earnings multiples to cause further declines in stock markets.
Still, there is enough domestic money chasing stocks in China and India, while
foreign investors remain committed to the region. This trend argues for quick
reversals of share price declines for these markets over the course of 2008.
Minnows suffer
In the context of economic weakness in the US and Europe, it is likely that
investors will continue to increase their exposure to emerging markets,
especially as the strategy produced rich returns in 2007. In that light, much
of the preceding discussions on the weaknesses of the US financial system
appear to strengthen the case for further improvements in the Asian story this
year.
That view however ignores what is known as the crowding-out effect, wherein the
presence of an attractive and large asset causes the diminution of other assets
in its class. Thus, if a liquid government bond were available at 5% yield, no
one would really care to buy a company bond at 5.1% as the incremental yield
does not compensate for credit quality and liquidity differences. This would
push the yield on the latter to perhaps 6% before anyone bothers to be
interested. I wrote about this in a previous article (Vanishing
minnows Asia Times Online, December 1, 2007).
This is a central risk for Southeast Asian stock markets, as well as others
around the region such as Pakistan over the course of 2008. Why should
investors have to deal with political turmoil such as what is being seen in
Thailand and Pakistan when they can make similar returns without the drama in
larger (and hence more liquid) markets such as China and India? Herein lies the
major story for 2008, which is increased separation of asset performance across
Asian markets and economies. By the end of this year, I very much doubt that
anyone will have a unified story to tell about the region.
Notes
1. Crying wolf: first, Afghanistan, where the "war on terror" was started in
earnest some seven years ago with the ostensible intention of flushing out
terror luminaries such as Osama bin Laden and Mullah Omar, has gone really
nowhere. Second, the mess in Iraq with respect to weapons of mass destruction,
and we all know how that's going. Third, the fracas over the course of 2007
with respect to Iranian nukes, until the CIA buried that story.
2. Readers with spare time should take a look at the acquisition of E*Trade by
Citadel, a hedge fund, at the beginning of December. A number of collateralized
debt obligations (CDOs) owned by E*Trade were bought at around 27 cents on the
dollar, and while investment banks may well have better quality collateral and
structures, they will find it difficult to argue that their CDOs are still
worth over 80 cents on the dollar given this transaction.
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