A World Awash in Dangerous Liquidity
It should perhaps be no surprise that given that the US Treasury Secretary was until recently head of one of the world’s most highly leveraged financial institutions. Leverage is king in the world of funny money promoted by Hank Paulson and the vastly overpaid glitterati of Goldman Sachs and its ilk.
But in all the hype about the record US$21 billion IPO of Industrial and Commercial Bank of China on the Shanghai and Hong Kong markets this month, almost no one has bothered to comment on what should surely by the most extraordinary aspect of the event, and one which is an alarming illustration of how successful the Wall Street masters of the universe have been in creating the monetary conditions which underwrite their own greed – and pave the way for future shock and awe for the rest of us.
This is just the same financial never-never land in which Enron grew up. That is not to suggest that the bosses at Goldman are dishonest in the way of Jeff Skilling. Crooks we always have with us. The lesson from Enron that has yet to be learned is that with or without fraud, massive leverage via opaque newfangled instruments is the danger. Collapse can be sparked as much by arrogance, stupidity or innocent ignorance as crookedry.
CLSA economist Dr Jim Walker reports that there are few surer signs of excess money in a system than prices of un-raced racehorses, an investment even more certain to lose money than taking up residence in a Macau casino. Turnover at the recent yearling sales at Newmarket, Britain’s major bloodstock sale, was up 60 percent on a year ago. Average prices for the untried nags rose 20 percent after a 75 percent increase in 2005. Run for your life.
The ICBC was so oversubscribed that funds committed to the IPO were in the region of half a trillion US dollars. Half a trillion wagered on a dodgy state bank in China! That in itself was testimony to the amount of cash and credit sloshing around the world. To put it in perspective: it is roughly $100 for every individual on the planet – and more than the average loan made by the Grameen Bank, the micro-credit lender created by Nobel prize-winner Muhammad Yunus.
It is true that only retail investors had to put up the cash. The institutional insiders, as ever rigging the system to their own advantage, could apply for as much as they liked in the expectation that the worst they could suffer was limited by the greed of their fellow institutions. But presumably they should have made some provision for having to come up with cash rather than their usual IOUs.
Under any even half-normal circumstances, a sudden $100 billion, let alone $500 billion increase in demand for money, even if only needed for a few days between IPO application and repayments, would spark a steep rise in short-term money rates in dollars if not also in euros, etc.
But this huge demand caused nary a blip. The low cost of speculation and investment bank and broker sales hype of Chinese banks generally has enabled early investors to show gigantic paper profits -- US$3 billion in the case of Goldman and ICBC. Well done Hank. The racket lives.
At the bottom of all this is the rise in global liquidity – foreign exchange reserves. Now around US$4 trillion, they are rising at roughly the same rate as the US current account deficit -- US$700 billion a year. Of course there have been benefits. Countries from Russia to Korea to Malaysia, which teetered on the edge of international bankruptcy in 1998 and 1999 now have big excess reserves and don’t need to worry about expanding domestic demand.
The excess international reserves (i.e., the amount not required for prudence) are now well over US$2 trillion (according to former US Treasury Secretary Lawrence Summers) ensuring that interest rates remain very low by historical standards and providing the multiplier platform for the expansion of domestic money supply in many countries and for commercial loans expansion by international banks.
But from a global perspective those reserve are that is just the tip of the debt iceberg. Total US dollar assets held by the rest of the world now total US$11.6 trillion and are growing at around 15 percent a year.
On top of that there is the almost unquantifiable impact of new instruments such as Collateralised Debt Obligations (CDOs) which cannot be tracked through bank balance sheets. Institutional (insurance companies, hedge funds etc) purchases of such assets and the myriad of derivatives have soared. Does that mean that banks are safe so there will be no meltdown if things go wrong? Banks may be safer, but no one knows how many of the non-bank instruments will ultimately become dud bank assets. Even S&P, so often behind the curve, has warned that banks could face problems if they are suddenly unable to offload the leveraged loans they have booked onto the shoulders of other institutions.
Anyway, it is much easier for central banks to stem a bank crisis because bank numbers are few and they are subject to continuing (even if inadequate) regulation. That cannot be said of the myriad of non-bank institutions which have been investing other peoples’ money, whether your pension or some oil sheikh’s windfall.
Much is made of the increase in US interest rates since Greenspan lowered them to almost zero to combat a non-existent deflation. But with the federal funds rate at 5.25 percent the real level – even if one is silly enough to believe the manipulated US inflation data – is around 2.5 percent which is still cheap by historical standards. The same applies to the euro area and sterling. Rates are only high relative to recent lows, not to historic norms, the reasonable expectations of lenders or the actuarial computation of pension funds.
Even higher rates may do little to curb monetary growth given international trade and currency imbalances. The EU has money growth of 7-8 percent, the UK and Australia in double digits and in developing countries such as China and India growth remains high, and even in laggards such as Southeast Asia. This has all pushed global GDP, now running at 5 percent growth helping offset the negative impact of high oil prices. But outside India and China, which have attracted so much speculative capital, the global liquidity surge has done more to boost asset prices in developed countries than spur growth more broadly.
Under the circumstance it is perhaps surprising that stock markets have not been more bullish than has been the case. Yes, the Dow is at a new record, European markets are back to 2000 levels and emerging markets are re-rating to bring price to earnings ratios close to developed country levels. That relative caution (the whole Indian market and Chinese banks excepted) is probably more due to popular memories of the dotcom crash and the Asian crisis. Some excess liquidity has clearly flowed into commodities, whose prices have also been sustained by rising physical demand and the lack of new investment in the decade preceding this boom.
The place to look for the excess money is not equity valuations but two types of debt – mortgage debt, reflected in record (till recently) prices in a very wide range of locations from China to Dubai, Spain and LA and private equity and management buyouts. These seem a no-brainer because interest costs are low but earnings yields are still strong and after several years of earnings growth, there is plenty of optimism of future growth. Like the yen carry trade (borrowing yen at near zero interest rates to invest in US, Australian etc higher yielding debt) it seems simple.
The top 10 private equity funds now have US$100 bn of equity at their disposal, which can be leveraged by at least 50 percent to threaten almost any company the world over with a bid from a bunch of Paulson-trained manipulators who know nothing about running real, non-financial businesses.
Nor is this just private equity. The current bid by listed Tata Steel for a much bigger listed steel maker, Corus, is in effect a leveraged buyout, not an equity deal. This offer is more than 60 percent debt-financed, which is great for the investment and other bankers who get outrageous fees up front, and a disaster in the making for those who are the ultimate buyers of this debt.
But it was always thus. Think how much the corrupt lenders to the Asian corporate darlings of the mid-1990s made from deals, and how much the banks and bondholders subsequently suffered. History repeats itself in the world inhabited by Hank Paulson and his ilk – commission up-front and to hell with the creditors and small investors.
But that all sounds like stale bear talk. This stuff can go on, and on -- until conditions change. Will they change? There is only one answer, yes. The issue is when. For that there is no answer. The likelihood is that things will carry on much as they are for a while longer as very lax monetary policies and rigged exchange rates seems to suit most governments for now. There seems little near-term chance of the US deficit sharply declining, even with lower oil prices, little chance of interest rate rises in Japan, China or the EU putting the skids under the dollar.
Almost everyone in this market, the trillions in the hedge funds, the skeptics in the investment banks who believe – or have to believe – that they will get out before the music stops. But of course that is possible only for a small minority. The majority must stay in the game and at risk. Get out of the game they may preserve their capital, but their earnings will collapse.
But if you are a small investor, you have no need to stay in any game. It is not your career or your bonus which is at stake. It is your life savings.
So the advice is to follow the words of the original Rothschild who made his fortune by “always selling too soon”. Low-yielding cash is an unattractive asset. It is cheap and at best only just holding on to its real value. It is an ugly looking asset. But it is now better than most of the alternatives.