naked capitalism

It’s easy for Americans to pooh-pooh bearish talk about the dollar. Yet the sterling was once the reserve currency, and has fallen, what, by 80% since it lost its standing.

With increasingly dubious accounting and lax enforcement, the US capital markets no longer stand out by virtue of being better regulated. Yes, they still may be deeper and more liquid. But overseas buyers have to look hard at foreign exchange risk. The direction for the dollar in the long term is certain to be down. Overextended debtors trash their currencies (see the Great Depression, the Nordic and Swedish banking crises, and the Asian crisis for a few of many examples).

What is interesting about the Xie piece is that even the stalwart Chinese retail investor has become leery of the dollar. Despite th logic of “oh if you sell, you only hurt yourself”, the flip side is if you become certain you are indeed holding a depreciating asset, it makes sense to exit. You want to be early, not late, out.

And that logic, if it starts to take hold, in classic run on the bank fashion, could lead to a disorderly fall in the dollar. It isn’t clear what the trigger might be, but Bob Shiller contends that sudden flights from markets don’t necessarily require an event to kick them off. And given that Willem Buiter, who though fond of colorful writing, is hardly an extremist, foresees a collapse in dollar assets if the US fails to contain its fiscal deficit, talk of a dollar plunge isn’t a a radical view.

From the Financial Times:

Emerging economies such as China and Russia are calling for alternatives to the dollar…Because the magnitude of the bad assets within the banking system and the excess leverage of its households are potentially huge, the Fed may be forced into printing dollars massively, which would eventually trigger high inflation or even hyper-inflation and cause great damage to countries that hold dollar assets…

….emerging economies…have amassed nearly $10,000bn (€7,552bn, £6,721bn) in foreign exchange reserves, mostly in dollar assets. Any other country with America’s problems would need the Paris Club of creditor nations to negotiate with its lenders on its monetary and fiscal policies to protect their interests. But the US situation is unique: it borrows in its own currency, and the dollar is the world’s dominant reserve currency. The US can disregard its creditors’ concerns for the time being without worrying about a dollar collapse.

The faith of the Chinese in America’s power and responsibility, and the petrodollar holdings of the gulf countries that depend on US military protection, are the twin props for the dollar’s global status. Ethnic Chinese, including those in the mainland, Hong Kong, Taiwan and overseas, may account for half of the foreign holdings of dollar assets….

The Chinese love affair with the dollar began in the 1940s when it held its value while the Chinese currency depreciated massively. Memory is long when it comes to currency credibility. The Chinese renminbi remains a closed currency and is not yet a credible vehicle for wealth storage. Also, wealthy ethnic Chinese tend to send their children to the US for education. They treat the dollar as their primary currency.

The US could repair its balance sheet through asset sales and fiscal transfers instead of just printing money. The $2,000bn fiscal deficit, for example, could have gone to over-indebted households for paying down debts rather than on dubious spending to prop up the economy. When property and stock prices decline sufficiently, foreign demand, especially from ethnic Chinese, will come in volume. The country’s vast and unexplored natural resource holdings could be auctioned off. Americans may view these ideas as unthinkable. It is hard to imagine that a superpower needs to sell the family silver to stay solvent. Hence, printing money seems a less painful way out.

The global environment is extremely negative for savers. The prices of property and shares, though having declined substantially, are not good value yet and may decline further. Interest rates are near zero. The Fed is printing money, which will eventually inflate away the value of dollar holdings. Other currencies are not safe havens either. As the Fed expands the money supply, it puts pressure on other currencies to appreciate. This will force other central banks to expand their own money supplies to depress their currencies. Hence, major currencies may take turns devaluing. The end result is inflation and negative real interest rates everywhere. Central banks are punishing savers to redeem the sins of debtors and speculators. Unfortunately, ethnic Chinese are the biggest savers.

Diluting Chinese savings to bail out America’s failing banks and bankrupt households, though highly beneficial to the US national interest in the short term, will destroy the dollar’s global status. Ethnic Chinese demand for the dollar has been waning already. China’s bulging foreign exchange reserves reflect the lack of private demand for dollars…

America’s policy is pushing China towards developing an alternative financial system. For the past two decades China’s entry into the global economy rested on making cheap labour available to multi-nationals and pegging the renminbi to the dollar. The dollar peg allowed China to leverage the US financial system for its international needs, while domestic finance remained state-controlled to redistribute prosperity from the coast to interior provinces. This dual approach has worked remarkably well. China could have its cake and eat it too. Of course, the global credit bubble was what allowed China’s dual approach to be effective; its inefficiency was masked by bubble-generated global demand.

China is aware that it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects China’s anxiety over relying on the dollar system. The year 2020 seems remote, and the US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate its reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.

The Financial Times reports that the freeze on depositor withdrawals at Russian bank Globex is leading to high levels of withdrawals at other Russian banks, which doesn’t qualify as being a run…..yet.

From the Financial Times (hat tip reader Michael):

Globex on Wednesday banned depositors from withdrawing their money as confidence in the Russian banking system began to show signs of evaporating.

Globex, a mid-sized retail bank with assets of $4bn (€2.95bn, £2.32bn), is the first Russian bank to experience a run on deposits during the crisis. It lost 13 per cent of its deposits last month, according to Maxim Raskosnov, an analyst at Renaissance capital, and a further 15 per cent this month according to Emilya Alieva, Globex’s vice-president.

At least a dozen other Russian banks have reported a sharp rise in withdrawals and account closures.

An economist with a leading western bank in Moscow said Globex was probably the first in what could be a number of bank panics, if the government did not take concerted action soon. “I think there are a large number of small and medium sized banks that are in the same situation,” she said.

Despite a Kremlin promise of $200bn in relief funds – $87bn this week – the fall-out of a stock market plunge and the global credit crunch appears to be worse than anticipated, analysts say.

So far, the crunch has not affected the living standards of ordinary Russians, but a rash of bank failures could.

Banks across Russia have faced a rise in outflows as depositors have begun to lose trust in all but the biggest state banks, VTB and Sberbank, which have received most of the government’s liquidity support.

Tatyana Sadovskaya, the director of a branch of Khnati Mansisk Bank in the city of Nizhnevartovsk, on Wednesday told Interfax news agency that in response to rumours of her bank’s insolvency: “People have formed long lines at cashiers and at bankomats, people are taking their deposits and closing their accounts.”

From a later FT article “The East is in the red“:

Across central and eastern Europe, the global crisis is biting hard, albeit very unevenly. In Russia, the authorities have set aside nearly $200bn (£116bn, €149bn) for a financial market rescue, Ukraine is in talks with the International Monetary Fund over emergency loans of up to $14bn, Hungary was on Thursday bailed out with a €5bn ($6.7bn, £3.9bn) loan facility from the European Central Bank.

Latvia and Estonia are suffering the region’s first recessions in a decade, while growth in oil-rich Kazakhstan has slowed to a crawl. Even in Poland, where Donald Tusk, the prime minister, insists his country is “an island of stability”, the crisis has raised doubts about Warsaw’s euro entry plans.

Stock markets have plunged accordingly, with Polish shares trading at less than half their peak levels and Ukraine’s down by three-quarters. Property markets have slowed, even if developers are still trying to hold up prices. After riding high earlier in 2008, some currencies have come under pressure, notably the Hungarian forint. In Ukraine, where the central bank has intervened to support the hryvnia, the credit default swap rate, a risk measure, has soared 1,400 points to 1,900, among the world’s worst.

The financial whipsaw has cut billionaires down to size, not least Oleg Deripaska, the Russian metals oligarch, who has sold valuable stakes to raise cash. Others are grabbing opportunities to buy cheaply: Mikhail Prokhorov, the Russian nickel investor, acquired 50 per cent of Renaissance Capital, a Moscow bank, for $500m – about one-quarter of its value of a year ago.

With the global crisis still raging, despite the calming effects of this week’s support moves in the US and the European Union, it is impossible to predict how events will play themselves out in a region increasingly important to the west as an export market and low-cost production base. But hopes it might escape unscathed have evaporated. Apart from corporate casualties, some countries could run into difficulties funding current account deficits. Erik Berglof, chief economist of the European Bank for Reconstruction and Development, says: “There is enormous uncertainty right now . . . These countries could deal with rising borrowing costs and an economic slowdown coming from the US and western Europe, but a complete shutdown of international borrowing – nobody can withstand that.”

Griping Online? Comcast Hears You and Talks Back New York Times

Economists’ new research shows positive effects of minimum-wage increases PhysOrg

A Turkish theater for World War III Chan Akyam, Asia Times. I have no idea how likely the author’s scenario is, but the piece does suggest, if nothing else, that Turkey is going to become a flash point.

It’s NOT international trade. Don’t be fooled Econospeak. The last paragraph swings and misses, but the rest of piece presents an underexamined line of thought.

TNK-BP chief executive Robert Dudley quits Russia Times Online, plus a different example of the same phenomenon, An Investment Gets Trapped in Kremlin’s Vise The New York Times. The number one issue in investing in countries that lack proper due process even for the natives is you are at risk of having your assets expropriated. China enthusiasts take note.

US Banks: The Good, the Bad and the Ugly Institutional Risk Analytics. This article says that the majority of banks in the US look to be in good shape and then looks at BankAtlantic, CapOne, and WaMu. This newsletter is the past has been more downbeat about about the banking industry, I wonder if it felt the need to distance itself from the bloggers that Shiela Bair said were “out of control”.

Antidote du jour:

Bond maven Bill Gross has raised his estimate of losses from the credit crunch to $1 trillion. One has to note that his firm is a large holder of Freddie and Fannie debt and he issued this pronouncement the day after the GSE rescue bill passed the House and looks certain to become law.

Note also that this is far from the gloomiest view on record. Well respected analyst Frank Venerose now predicts $2 trillion in credit related losses; Hedge fund Bridgewater, whose research is read by central banks, expects $1.6 trillion in markdowns; hedge fund manager John Paulson, who bet aggressively and successfully on the subprime debt debacle, anticipates $1.3 billion.

From Gross’ August newsletter:

The deflating U.S./global asset markets are much like Churchill’s Russia: a riddle wrapped in a mystery, inside an enigma. “Who is driving delevering?” asks the Financial Times, and the answer comes back, “all of us;” yet it is hard to see it except in the headlines or to fix it, given a lineup of 6.8 billion suspects….

Yves here. This is a tad disingenuous. The “who” question implies the deleveraging may not be warranted. As Veneroso stresses, it is necessary, inevitable, and long overdue. US debt totals nearly $50 trillion. GDP is a tad over $14 trillion. That gives a debt to GDP ratio of 350%. That is vastly in excess of anything this economy has seen, excluding the parabolic rise to this level. The previous peak was around 260% of GDP during the Depression, when Roaring Twenties debt reached unprecedented levels and then (in relation to GDP) spiked higher as GDP fell dramatically but the loans were slower to be written off..

Back to Gross, who compares capital to the mother’s milk of capitalism and then uses bovine metaphors:

Let’s blame it on the barn, or if you must, home prices. Here is one asset that all observers can agree is going down in price for justifiable reasons….

Yet housing, unlike other asset classes, carries with it an aura more like a bad dream than a fairy tale. Unlike the frog that when kissed turns into a handsome prince, housing can morph a froglike economy into something resembling Godzilla. That is because it is the most levered asset class and the one held by more “investor” citizens than any other. U.S. homes are market valued at over 20 trillion dollars with nearly half of the value supported by mortgage finance of one sort or another. At first blush that appears to be reasonably levered, but at the margin, homes purchased in 2004 and beyond are now at risk of turning upside down – negative equity – and there are some 25 million or so of those. The “upsidedownness” in many cases results in foreclosures, or outright abandonment and most certainly serves as an example of what not to do for millions of twenty-somethings or new citizens choosing between homeownership and renting. The dominoes fall month-by-month…. An asset deflation in turn becomes a debt deflation, as subprimes, alt-As, and finally prime mortgages surrender to the seemingly inevitable tide. PIMCO estimates a total of 5 trillion dollars of mortgage loans are in risky asset categories and that nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble. The problem with writing off 1 trillion dollars from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a “negative feedback loop.”

A trillion dollars is a lot of money, but in this age of photoshop wizardry it seems that experts can make just about anyone or anything look good. Lose a trillion? Well, just write it off a little more slowly, or suggest that mark-to-market accounting is not applicable to banks and investment banks. As a matter of fact it may not be. GaveKal’s Anatole Kaletsky points out that “the whole point of a bank is to exchange short-term, liquid liabilities for long-term illiquid assets whose value is hard to gauge. This liquidity and maturity transformation, in fact is the main social function that a banking system provides.” I and others on PIMCO’s Investment Committee wholeheartedly agree. But the reluctance to remark rancid mortgage loans rests on the heretofore inevitable conclusion that home prices will bottom and then reflate within a reasonable period of time. If they go down even more, and stay down, well then Washington – Wall Street – and ultimately, Main Street – we have a problem. That is why Hank Paulson and in turn Christopher Cox are waving their independent but coordinated wands in an effort to 1) prevent a market run on the price of bank and investment bank stocks until there is enough time to reflate the U.S. housing market, and 2) ultimately recapitalize our primary mortgage lenders – FNMA and Freddie Mac. An interesting press release by the CBO on July 22nd, by the way, points out that the GSEs are barely solvent (9 billion dollars) when their assets are valued at current market prices. Housing’s cow needs to turn into a bull real quick.

Make no mistake, the current conundrum that must be solved is: how to make the price of 120 million U.S. barns stop going down in price and then to make them go up again. That, however, is easier said than done. One of the wisest men I know has this serious but admittedly impractical solution: have the government buy one million new/unoccupied homes, blow them up, and then start all over again. Absent that, he’s not quite sure what to do, nor am I, with the exception of the next paragraph’s proposal.

Up until this point, the joint efforts of the Fed and the Treasury have been directed towards maintaining the stability of our major financial institutions, recapitalizing their balance sheets in “current form,” and lowering the cost of mortgage credit. All are crucial to any solution, but it is this third and last point where markets have failed to cooperate. With Fed Funds having been lowered from 5¼% to 2%, it would have been logical to assume that the price of mortgage credit would go down as well and that the price of homes would at least slow their current descent. Not so. As Chart 2 points out, the yield on a 30-year agency mortgage-backed loan has actually risen since the Fed somewhat unexpectedly began to lower Fed Funds in early September of 2007. Add to that of course, the increased fees, points, and total spread that an actual homebuyer pays to finance his purchase now as opposed to then, and it is obvious that homes are not the bargains that starving realtors claim they might be. Financial asset prices, as well as those for homes, are really the discounted present value of what investors believe those assets will be worth far into the future. When the discount rate – in this case a 30-year mortgage – rises faster than the expectations for home prices themselves – then the price of a home falls. 7% + “all in” yields for current home financing, in contrast to prior periods of monetary easing, are lowering, not raising the discounted present value of an existing home. Blow them up? Well, yes, I suppose if we could. But absent that, lowering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy.

To return the housing, cow milking, asset price deflating metaphor to its broader context, the increasing price of credit is a common denominator worldwide in the delevering process which it drives, or in turn, is driven by. If the cost of credit – the discount rate for present value – would go down, then asset prices would be better supported. Stocks wouldn’t sink so fast, commercial real estate wouldn’t wobble so, and Donald Trump wouldn’t have to exaggerate as often about how rich he is (make sure to buy T-Bills or GSE mortgages with that $95 million, Donald – if it closes). But the cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability. In addition to home prices, $130 a barrel oil and their resultant distortion of global wealth and financial flows head that list. For now, investors should remain in high quality assets – until – until, well…until the prospect for home prices points skyward or until the cows come home, whichever one’s first.

Readers will no doubt note the curious failure to acknowledge the delevering as the result of mounting insolvencies, which makes the idea of stopping the fall in loan prices an exercise in fantasy.

We’ve cribbed the title of a provocative post by Satyajit Das at Eurointelligence. He argues that the US’s days of continuing to borrow abroad with little worry as to the consequences may be nearing an end.

A good companion piece is Menzie Chinn’s Implications of adjustment to riskier dollar assets in a portfolio balance framework, illustrated in three steps . Great minds are working alike.

The key issue with US debt, which not enough analysts have focused on (Brad Setser being a noteworthy exception) is that our creditors are not merely lending to us to fund their exports. They are also lending us the money to pay interest on money they lent us in the past to buy their exports. At some point, the debt service component becomes too high relative to the portion that goes to fund current exports. Or the economies over time develop more robust consumer sectors and the importance of funding exports is less pronounced.

Here is the beginning of the Das post, which I recommend reading in its entirety:

High levels of debt are sustainable provided the borrower can continue to service and finance it. The US has had no trouble attracting investors to date. Warren Buffett (in his 2006 annual letter to shareholders) noted that the US can fund its budget and trade deficits as it is still a wealthy country with lots of stock, bonds, real estate and companies to sell.

In recent years, the United States has absorbed around 85% of total global capital flows (about US$500 billion each year) from Asia, Europe, Russia and the Middle East. Risk adverse foreign investors preferred high quality debt – US Treasury and AAA rated bonds (including asset-backed securities (”ABS”), including mortgage-backed securities (”MBS”)). A significant portion of the money flowing into the US was used to finance government spending and (sometimes speculative) property rather than more productive investments.

The real reason that the US actually has not experienced a sovereign debt crisis is that it finances itself in it own currency. This means that the US can literally print dollars to service and repay it obligations.

The special status of the US derives, in part, from the fact that the dollar is the world’s major reserve and trade currency. The dollar’s status derives, in part, from the gold standard that once pegged the dollar to the value of gold. The peg and full exchangeability is long gone. The aura of stability and a safe store of value based on the strength of US economy and military power has continued to support the dollar. In 2003, Saddam Hussein, when captured, had US$750,000 with him – all in US$100 bills. The dollar’s favoured position in trade and as a reserve currency is based on complex network effects.

Many global currencies are pegged to the dollar. The link is sometimes at an artificially low rate, like the Chinese renminbi, to maintain export competitiveness. This creates an outflow of dollars (via the trade deficit that in turn is driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flow back to the US to finance the spending. This merry-go-round is the single most significant source of liquidity creation in financial markets. Large, liquid markets in dollars and dollar investments are both a result and facilitator of the process and assist in maintaining the dollar’s status as a reserve currency.

The dominance may be coming to an end. There is increasing discussion of re-denominating trade flows in currencies other than US$. Exporters are beginning to invoice in Euro or Yen. There are proposals to price commodities, such as oil and agricultural goods, in currencies other dollars. Some countries have abandoned or loosened the linkage of their domestic currency to the dollar. Others are considering such a move.

Foreign investors, including central banks, have reduced investment allocations to the dollar. The dollar’s share of reserves has fallen from a high of 72% to around 61%. Foreign investor demand for US Treasury bonds has weakened in recent times. Low nominal (negative real) rates on interest and dollar weakness are key factors.

Foreign investors may not continue to finance the US. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. This would expose the US to currency risk but most importantly it would not be able to service its debt by printing money. The US, like all borrowers, would become subject to the discipline of creditors.

For the moment, the US$ is hanging on – just.

The post continues here.

As he is often wont to do, Ambrose Evans-Pritchard worries, in dire terms, about the poor prospects for growth and stability, It would be easy to dismiss him as histrionic were it not for the fact that some commentators who have been right so far about the progress of the credit crunch, are also hyperventilating. Witness Nouriel Roubini’s latest offering, “The Coming Systemic Bust of the U.S. Banking System: ‘Dead Stocks Rallying’“. By comparison, Evans-Pritchard is almost cheery.

In truth, this piece isn’t Evans-Pritchard’s best work (he and others have covered parts of this ground before), but some observations were nevertheless interesting and likely to elicit reader reactions. so I’m providing extracts.

From the Telegraph:

The world’s two biggest financial institutions have had a heart attack. The global currency system is breaking down. The policy doctrines that got us into this mess are bankrupt. No world leader seems able to discern the problem, let alone forge a solution.

The International Monetary Fund has abdicated into schizophrenia. It has upgraded its 2008 world forecast from 3.7pc to 4.1pc growth, whilst warning of a “chance of a global recession”. Plainly, the IMF cannot or will not offer any useful insights.

Its “mean-reversion” model misses the entire point of this crisis, which is that central banks have pushed debt to fatal levels by holding interest too low for a generation, and now the chickens have come home to roost. True “mean-reversion” would imply debt deflation on such a scale that would, if abrupt, threaten democracy.

The risk is that these same central banks will commit a fresh error, this time overreacting to the oil spike. The European Central Bank has raised rates, warning of a 1970s wage-price spiral. Fixated on the rear-view mirror, it is not looking through the windscreen.

The eurozone is falling into recession before the US itself. Its level of credit stress is worse, if measured by Euribor or the iTraxx bond indexes. Core inflation has fallen over the last year from 1.9pc to 1.8pc

The US may soon tip into a second leg of this crisis as the fiscal package runs out and Americans lose jobs in earnest. US bank credit has contracted for three months. Real US wages fell at almost 10pc (annualised) over May and June. This is a ferocious squeeze for an economy already in the grip of the property and debt crunch…..

The awful reality is that Washington has its back to the wall. Fed chief Ben Bernanke thought the US could always get out of trouble by monetary stimulus “à l’outrance”, and letting the dollar slide. He has learned that the world is a more complicated place.

Oil has queered the pitch. So has America’s fatal reliance on foreign debt. The Fannie/Freddie rescue, incidentally, has just lifted the US national debt from German ‘AAA’ levels to Italian ‘AA-’ levels.

China, Russia, petro-powers and other foreign states own $985bn of US agency debt, besides holdings of US Treasuries. Purchases of Fannie/Freddie debt covered a third of the US current account deficit of $700bn over the last year. Alex Patelis from Merrill Lynch says America faces the risk of a “financing crisis” within months. Foreigners have a veto over US policy…

My view is that a dollar crash will be averted as it becomes clearer that contagion has spread worldwide. But we are now at the point of maximum danger. Britain, Japan, and the Antipodes are stalling. Denmark is in recession. Germany contracted in the second quarter. May industrial output fell 6pc in Holland and 5.5pc in Sweden.

The coalitions in Belgium and Austria have just collapsed. Germany’s left-right team is fraying…

This is the healthy part of Europe. Further south, we are not far away from civic protest. BNP Paribas has just issued a hurricane alert for Spain….

China, India, East Europe and emerging Asia have all stolen growth from the future by condoning credit excess. To varying degrees, they are now being forced to pay back their own “inter-temporal overdrafts”.

If we are lucky, America will start to stabilise before Asia goes down. Should our leaders mismanage affairs, almost every part of the global system will go down together. Then we are in trouble.

Before you break out the champagne on the news that international investors like the US (or more accurately, hate its stocks less than those of other nations), the article does not address the weighting of equities relative to other asset classes (ie, total allocations could still be down due to shifting more capital to commodities, bonds, or even plain old cash). The relative allocation to the US could be up with the absolute amount invested down.

The article also does not say what proportion of the funds surveyed hedge their currency exposure (certain . Many of these investors presumably do, either on a fund by fund basis, or across all funds (some, of course, take a point of view in their currency overlays). I’ve always wondered how well hedging works for equities in practice, given that the portfolio value changes frequently due to changes in market prices and investor withdrawals/contributions, and that the timing and amount of dividends can change based on trading within the portfolio.

From the Telegraph:

Fund managers across the world are dumping stocks and retreating to cash in a mood of extreme pessimism, fearing that the looming economic crunch is an even greater threat than inflation.

The latest survey of investors by Merrill Lynch shows that an unprecedented 41pc now think that a world recession is either likely or very likely. The majority dismiss hopes of double-digit earnings growth next year as “fantasy”.

“People are a lot more scared about the macro-outlook. The survey has never seen anything like this before since it began a decade ago,” said David Bowers, the organiser of the report.

“Recession risk has taken over from inflation risk. Fund managers believe the global economy is deteriorating so fast that a wage-spiral is never going to happen, at least in developed markets,” he said. The survey is based on 191 funds managing assets worth $610bn (£305bn).

The US is emerging as the one bright spot in the global gloom, despite the credit mayhem. A net 7pc of investors are overweight in US equities, clearly betting that most of the bad news is already in Wall Street prices. The figure was negative in May…..

“The US has now become the country of cheap manufacturing. You’ve got 20pc wage inflation in emerging markets so FDI (foreign direct investment) is flowing back there,” said Karen Olney, Merrill’s chief European equity strategist.

The investor love affair with India, China, and Asian markets over the last nine months has turned sour.

“That trade is off,” said Mrs Olney. A net 75pc are underweight Indian equities as the country’s inflation reaches double digits. Chile (-69), Taiwan (-50), Korea (-50), Malaysia (-44) are not far behind.

Mr Bowers said investors had woken up to the nasty reality that emerging markets have let rip with inflation and will now have to jam on the brakes.

Those with dollar pegs or dirty floats like China have, in effect, been “destabilised” by the US Federal Reserve’s rate cuts….

Russia (+75) remains the darling of the emerging universe, but for how long? Almost two thirds of investors say oil is fundamentally overvalued…..

A net 42pc think the Bank of England has kept interest rates too high given the housing slump and the consumer squeeze…

Europe is not faring much better. Some 96pc think the economy will get worse over the next year, up sharply from the June survey. A majority believe inflation will fall, and a net 24pc say the European Central Bank is engaging in overkill. Not surprisingly, a record 32pc are now underweight eurozone equities…

Japan is sneaking back into favour after years in the wilderness, if only by default. “Japanese banks are the winner from the credit crunch. Japan now has the capacity to be the monopoly supplier of capital to the world once again,” said Merrill Lynch.

Ambrose Evans-Pritchard appears to be trying to corner the market in apocalyptic financial news. But his sources aren’t evangelicals, survivalists, or even goldbugs. The experts he cites are with respected financial firms, meaning they don’t sound alarms casually. Even more significant, the terms they are using to describe what might be coming are uncharacteristically dire.

The latest bad tidings in that the Fannie/Freddie turmoil may lead our favorite foreign credit sources to dial down their purchases of Treasuries and agencies a tad. We’ve become so dependent on foreign credit that a mere tightening of the spigot would have significant consequences.

Tim Price, a UK based investment manager, gives a long-form treatment of a theme I’ve mentioned: we are way way outside known historical patterns. That is troubling to anyone, but it is particularly unnerving to the order-liking mindsets of analysts and central bankers:

That stock market price action has been so consistently dreadful with such little evidence of a sustainable floor despite flurries of ostensibly positive news (Santander / Alliance & Leicester; some form of formal pastoral care for Fannie Mae and Freddie Mac) could be interpreted as a sign that many investors remain trapped at the “denial” stage of this particular market disaster. Or perhaps many investors, institutional and individual alike, are now mulling their deliberative options. And some, presumably, have already reached the decisive phase, and already pulled the plug on much of their market exposure and initiated the dash for cash. This may or may not prove to be the prudent strategy; only time will tell. It certainly seems to show the merit in the advice that if you’re going to panic, panic early. We would merely hazard the following suggestion: the current market environment is flushing out those investors (supposedly “professional” and individual) who are congenitally unsuited to be making substantial portfolio allocations to the equity markets. The fiendish difficulty for those who decide to be out of the market entirely will be when to decide to get back in.

Classic Buffettology advises us to get greedy when others are fearful. This would ordinarily be sound advice, if somewhat difficult psychologically to execute. But if that blanket exhortation proves to be deficient or at least premature this time around, it will be because the nature of the problems facing financial markets, central banks and commercial banks is off the charts. It feels difficult because many of us have never been here before: only part-way through the historic bust of an extraordinary credit boom, only part-way through a property market correction that could yet last for months if not years, and only part-way through probably the gravest systemic crisis facing the banking system since the 1970s, if not indeed the 1930s. What accelerates and amplifies the downwave in stock markets is the state of our brave and newly inter-connected world where all investors are effectively neurons firing in a vast collective brain. And the global investment brain has suffered a stroke, an ischemic shock triggered by a sudden catastrophic lack of confidence mixed with heady deleveraging.

Now to Evans-Pritchard (hat tip reader Dwight):

Merrill Lynch has warned that the United States could face a foreign “financing crisis” within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world.

The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700bn (£350bn) current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst. Britain and other Anglo-Saxon deficit states could face a similar retreat by foreign investors.

“Japan was able to cut its interest rates to zero,” said Alex Patelis, Merrill’s head of international economics.

“It would be very difficult for the US to do this. Foreigners will not be willing to supply the capital. Nobody knows where the limit lies.”

Brian Bethune, chief financial economist at Global Insight, said the US Treasury had two or three days to put real money behind its rescue plan for Fannie and Freddie or face a dangerous crisis that could spiral out of control.

“This is not the time for policy-makers to underestimate, once again, the systemic risks to the financial system and the huge damage this would impose on the economy. Bold, aggressive action is needed, and needed now,” he said.

Mr Bethune said the Treasury would have to inject up $20bn in fresh capital. This in turn might draw in a further $20bn in private money. Funds on this scale would be enough to see the two agencies through any scenario short of a meltdown in the US prime property market…..

Yves here. The problem is that the Treasury lacks statutory authority to do so, and despite going to the trouble to announce a plan on a Sunday before markets opened in Asia, there is no sign that anything concrete has been done to advance the ball.

Roughly $1.5 trillion of Fannie and Freddie AAA-rated debt – as well as other US “government-sponsored enterprises” – is now in foreign hands. The great unknown is whether foreign patience will snap as losses mount and the dollar slides.

Hiroshi Watanabe, Japan’s chief regulator, rattled the markets yesterday when he urged Japanese banks and life insurance companies to treat US agency debt with caution. The two sets of institutions hold an estimated $56bn of these bonds….

But the lion’s share is held by the central banks of China, Russia and petro-powers. These countries could all too easily precipitate a run on the dollar in the current climate and bring the United States to its knees, should they decide that it is in their strategic interest to do so.

Mr Patelis said it was unlikely that any would want to trigger a fire-sale by dumping their holdings on the market. Instead, they will probably accumulate US and Anglo-Saxon debt at a slower rate. That alone will be enough to leave deficit countries struggling to plug the capital gap. “I don’t see how the current situation can continue beyond six months,” he said.

Merrill Lynch said foreign governments had added $241bn of US agency debt over the past year alone as their foreign reserves exploded, accounting for a third of total financing for the US current account deficit….

Global inflation is now intruding with a vengeance as well. Much of Asia is having to raise rates aggressively, drawing capital away from North America. This may push up yields on US Treasuries and bonds, tightening the credit screw at a time when the US is already mired in slump.

Russia’s deputy finance minister, Dmitry Pankin, said the collapse in the share prices of Fannie and Freddie over the past week was irrelevant because their debt has been effectively guaranteed by the US government under the rescue package.

“We don’t see a reason to change anything because the rating of the debt of those agencies hasn’t changed,” he said.

Foreign policy experts doubt that the picture is so simple. Russia is likely to use its $530bn reserves as an implicit bargaining chip in high-stakes diplomacy, perhaps to discourage the US from extending Nato membership to the Ukraine and Georgia.

Vladimir Putin, now Russia’s premier, has stated repeatedly that his country is engaged in a new Cold War with the United States. It is clear that Moscow would relish any chance to humiliate the United States, provided the costs of doing so were not too high for Russia itself.

China is regarded as a more reliable partner, with a greater desire for global stability….

Yves here. Partner maybe, only in the way Ambrose Bierce defined it in the Devil’s Dictionary:

When two thieves have their hands so deeply plunged into each other’s pocket that they cannot separately plunder a third party.

If we think China is a friend, we will be disappointed.

Brad Setser, from the US Council on Foreign Relations, said the Chinese have a stake in upholding Fannie and Freddie, not least to ensure that their loans are “honoured on time and in full”.

David Bloom, currency chief at HSBC, said fears that regional banks could start toppling after the Fed takeover of IndyMac last week were now the biggest threat to the dollar.

“We have a pure dollar sell-off,” he said. “It’s a hating competition: at the moment the markets hate the dollar more than they hate the euro, even though German’s ZEW confidence indicator was absolutely atrocious.”

Ambrose Evans-Pritchard in “Monetarists warn of crunch across Atlantic economies” in the Telegraph points to a troubling development: a fall over last few months in M1 and M2 in the US, UK and EU.

Many have criticized the Fed for “printing money” of late. But the evidence suggests otherwise. First, all of the cash injections that the central bank has undertaken via its alphabet soup of new lending facilities have been met with roughly equal withdrawals though open market operations. Thus the new facilities themselves have not led to monetary expansion.

Second, critics like to point to the Fed’s negative real interest rates as lax monetary policy. In the dot-bomb environment, which was not a credit crisis, that charge is accurate, and that policy helped create our current mess.

But we now have credit contraction. Deleveraging is deflationary. Somewhat loose monetary policy is appropriate. Unlike 2002, banks or securities firms are not going out to create new debt, which is the mechanism by which low interest rates lead to inflation or asset bubbles. Mortgage lending has become dependent on the Federal government via Freddie, Fannie, and the FHA (and the future of that support is now in question). Consumer credit of all sorts is being reined in. Dow Chemical had to go to Warren Buffett to borrow to acquire Rohm & Haas because it could not get funding from banks. Our credit intermediation system is barely functioning.

And oil is now playing a role that is weirdly parallel to gold in 1931. England abandoned the gold standard, which was tantamount to a devaluation. The US stayed on it at that juncture and raised interest rates even though the economy was very fragile. Countries that stayed on the gold standard in 1931 on average suffered a 15% fall in real GDP in 1932.

But gold was not an essential economic input. Oil is, and thus constrains the Fed’s ability to lower rates further (not that it has much leeway at 2%, since most economists regard going below 1% as risking falling into the zero interest rate trap that has enmeshed Japan).

From the Telegraph:

The money supply data from the US, Britain, and now Europe, has begun to flash warning signals of a potential crunch. Monetarists are increasingly worried that the entire economic system of the North Atlantic could tip into debt deflation over the next two years if the authorities misjudge the risk.

The key measures of US cash, checking accounts, and time deposits – M1 and M2 – have been contracting in real terms for several months. A dramatic slowdown in Britain’s broader M4 aggregates is setting off alarm bells here.

Money data – a leading indicator – is telling a very different story from the daily headlines on inflation, now 4.1pc in the US, 3.7pc in Europe, and 3.3pc in Britain.

Paul Kasriel, chief economist at Northern Trust, says lending by US commercial banks contracted at an annual rate of 9.14pc in the 13 weeks to June 18, the most violent reversal since the data series began in 1973. M2 money fell at a rate of 0.37pc.

“The money supply is crumbling in the US. There was a very sharp lending contraction in the second quarter lending. If the Federal Reserve is forced to raise rates now to defend the dollar, it would be checkmate for the US economy,” he said.

Leigh Skene from Lombard Street Research said the lending conditions in the US were now the worst since the Great Depression. “Credit liquidation has begun,” he said.

The Fed’s awful predicament does indeed have echoes of the early 1930s when the bank felt constrained to tighten into the Slump in order to halt bullion loss under the Gold Standard. Investors – notably foreigners – dictated a perverse policy. Over 4,000 US banks collapsed. This time a de facto “Oil Standard” is boxing in Ben Bernanke. Benign neglect of the dollar has started to backfire. It is pushing up crude, with multiple leverage.

The monetary picture is highly complex. The different measures – M1, M2, M3, M4 – have all given false signals in the past. Each tells a different tale, and monetarists fight like alley cats among themselves.

The Federal Reserve stopped paying much attention to the data a long time ago. It has abolished M3 altogether. The US economic consensus is New-Keynesian (dynamic stochastic general equilibrium model). Delving into the money entrails is derided as little better than soothsaying.

That attitude, retort monetarists, is the root cause of the credit bubble. The money supply almost always gives advance warning of big economic shifts. Those who track the data are now calling on central banks to move with extreme caution. If the rate-setters overreact to an inflation spike caused by oil and food – or confuse today’s climate with the early 1970s – they may set off an ugly chain of events.

“The data is pretty worrying,” said Paul Ashworth, US economist at Capital Economics. “US lending is shrinking dramatically in real terms, and we know from the Fed’s survey that banks want to tighten further. People are clamouring for higher rates but we think deflation is now the biggest threat. The idea that the Fed should tighten with unemployment soaring is preposterous,” he said. The jobless rate jumped from 5pc to 5.5pc in May.

In Britain, the Shadow Monetary Policy Committee – hosted by the Institute for Economic Affairs, and a refuge for UK monetarists – issued its own alert this week. The focus is on “adjusted M4″, which covers loans to “private non-financial corporations” and may offer the best insight into the health of British business.

The growth rate has dropped from 16.1pc a year ago to minus 0.5pc in April. It is the suddenness of the decline that matters most. The data reeks of recession. Professor Patrick Minford from Cardiff Business School called for an immediate rate cut, arguing that the credit crunch is a more powerful and long-lasting force than the oil inflation.

Professor Tim Congdon from the London School of Economics said the UK was lurching from boom to bust. “Real money growth is virtually nil. The British economy is taking a thrashing and it is going to get worse. Corporate money balances have contracted 3pc over the last three months, which is double digits on an annualised basis. This is a serious squeeze for companies,” he said.

Mr Congdon warned three years ago that surging M4 would lead to a “dangerous” bubble, which is what occurred. He now fears the MPC will react too late as the process goes into reverse.

Roger Bootle from Capital Economics said Britain could be facing a “real economic crisis and a financial collapse. The MPC does not have the luxury of waiting until all is absolutely crystal clear. By that time the bird will have flown.”

The eurozone is at a later stage of the credit cycle. Even so, house prices are collapsing in Spain, and falling in Germany and France. German industrial orders have dropped for the last six months in a row. A joint IFO-INSEE survey said eurozone growth had stalled to zero in the second quarter.

“Consumer lending has fallen off a cliff. It is contracting in real terms,” said Hans Redeker, currency chief at BNP Paribas. Core inflation has fallen from 1.9pc to 1.7pc over the last year.

Unlike the Fed, the European Central Bank keeps a close eye on money data (though not on real M1, now shrinking). It looks at the broader M3 figures. There is a raging debate in Europe over the signals now being sent by this indicator.

The M3 growth is still 10.5pc, down from 11.5pc in January. However, the data has been badly distorted by the closure of the capital markets. Firms have been forced to draw down existing credit lines from banks, which shows up as M3 growth. (It is the same story with America’s M3 since the collapse of the Commercial Paper market).

“The credit lines are expiring. Companies cannot roll over loans. We are going to see the entire private credit multiplier go into a slowdown,” said Mr Redeker.

Jean-Claude Trichet, the ECB’s president, said last week that the M3 data “overstates the underlying pace of monetary expansion”. The ECB nevertheless pressed ahead with a rate rise to 4.25pc, setting off a storm of protest. This may go down as one of the most unwise monetary decisions of modern times.

The strain on eurozone banks is growing by the day. They bid a record $85bn (£43bn) at the ECB’s last auction for dollars. Only $25bn was available. The spreads on Euribor interbank lending are still at extreme stress levels.

Few disputes that “global inflation” is taking off. Over 50 countries now face double-digit price rises. Ukraine (29pc), Vietnam (27pc), and the Gulf states are out of control, with Russia (15pc), and India (11pc) close behind. China (7.1pc) is on the cusp. Interest rates are still below inflation across much of the emerging world. This is the driving force behind spiralling commodity prices.

The oil spike is already squeezing real wages in the Atlantic region. The debate is whether the Fed, Bank of England, and ECB should squeeze them further, trying to off-set energy rises with a deflationary bust in the rest of the economy. If and when oil peaks in this cycle, they may find inflation crashing faster than they dare to imagine.

The 9th Circle in Dante’s Inferno – starring Judas and Brutus – is a frozen lake. Cold can be more frightful than heat. “Blue pinch’d and shrined in ice the spirits stood,” (Canto XXXIII). Such awaits the victims of debt deflation.

Blomberg columnist William Pesek plays out a line of thought that may have occurred to some readers: what if the resolution of the credit crisis and global imbalances isn’t a nasty recession or punishing inflation but Japan-like protracted low growth, with stagnant to deteriorating living standards?

This idea may not be as much of a stretch as it sounds. Policy makers, in trying to avoid the depression/entrenched inflation extremes, may steer themselves into the Japan solution.

In the US, despite the brave talk of free markets, we have been socializing losses right and left and trying to shore up plummeting asset values. Although inflation is running at high rates in many countries, it is the product mainly of commodities price increases due to developing economy demand. If the banking system in the US, UK and Europe are in as bad shape as I think they are, demand for imports will slacken further, which will reduce growth, and in some cases, reduce consumption. Reader DownSouth reminded us that from 1979 to 1983, oil consumption fell from 67 million barrels per day to 58 million bpd. And high fuel price act as a tariff, again hurting exporters. We have already discussed that factories near Hong Kong are being shuttered at a rapid pace, and this is before the expected post-Olympics slowdown.

Similarly, the strain on food prices is due to biofuels, increased consumption of meat in third world, and poor harvests in Australia, have put pressure on foodstuffs. Biofuels subsidies may get undone (one can only hope) and similarly, higher food costs will have us all, not just people in developing countries, being more sparing of our meat consumption. A near-global slowdown will intensify that trend.

And there is the bigger question of whether we really have reached a crisis of capitalism, whether a system whose raison d’etre is growth and increasing standards, can adapt to a world of resource constraints. The optimists at the Milken Institute Global Conference felt that technology would provide and answer. But new technologies take time to be developed and implemented, particularly on a broad scale, while the needs appear urgent.

From Bloomberg:

Count Hong Kong real-estate mogul Ronnie Chan firmly among those who think Japan’s 1990s experience is highly instructive. The reason: Lost decades may become the rule, not the exception.

“What if the lost decade in Japan becomes the global norm?” Chan, chairman of Hang Lung Properties Ltd., said at the Asia Innovation Initiative conference in Fukuoka, Japan, on July 8. “Can you imagine that? Perhaps we should. Perhaps people should get used to slower growth, or no growth.”

It’s not that Chan, who runs Hong Kong’s fourth-largest real-estate development company by market value, is a pessimist. Property developers don’t often relish 10 years of lost growth here and 10 years of declining asset values there. Chan sees a rare confluence of economic and demographic trends that bode poorly for a global rebound.

No one should be surprised by the rapid pace of economic expansion after World War II…. It began from a low base, following the devastation of economies in Europe and parts of Asia. Next came rapid population growth and a boom in innovation. Then there were new social and institutional paradigms as democracy spread and organizations such as the United Nations and the World Bank offered support.

Today, the picture looks vastly different. As everyone tries to stabilize growth, things are hardly at a low base. Population growth is fueling demand for commodities, driving up inflation and increasing poverty rates. Innovation may slow as investment dries up. And institutions such as the International Monetary Fund hardly seem up to today’s challenges.

Oddly, one of Asia’s potential failures is democracy, Chan says. It simply isn’t proving to be the panacea that leaders in the U.S. and Europe promised. Poverty rates remain stubbornly high in many Asian democracies, and so does corruption. The former is often a result of the latter.

It’s certainly not that democracy is bad. Yet there’s something to be said about what Chan calls “premature democratization” in Asia.

Elections matter only when nations build strong institutions such as independent courts, ministries, a free press, credible central banks and ample systems of checks and balances. Their absence means many governments don’t operate as transparently or successfully as expected.

Yves here. That is not a trivial point. My Communist college roommates would remind me that Russia and China were the only economies to industrialize in the 20th century (for the record, I was apolitical then and previously had a someone who appeared in the Ivy League Playboy issue and later a brilliant but highly wound poet as roommies).

Similarly, Japan with its one party system is not exactly a Western-style democracy. Singapore, an island with just about nothing going for it, and some serious disadvantages at the time of its independence, prospered under a far sighted nation-builder who bordered on being a benevolent dictator, Lee Kwan Yew. Yew in particular was concerned about corruption, and early on created tough watchdog agencies and implemented the policy that top bureaucrats would earn the same level of pay as top private sector professionals, both to make sure the government would attract good people and reduce the incentives to cheat.

Back to Pesek:

All this may be a problem for the region as it tries to avoid the worst of the credit-market crisis. Chan wonders if the type of prosperity during the decade before the 1997 Asian crisis will be more unusual in the future.

“Those 10 golden years of rapid growth and high returns may well have been an aberration,” Chan says.

The combination of surging energy and food prices will challenge economies with political rifts, such as Thailand and Malaysia. Nor does it bode well for high-poverty ones such as Indonesia and the Philippines, or those trying to compete amid China’s boom — South Korea, Singapore and Taiwan, for example.

Slower growth is absolutely necessary, of course. Economists, including Kenneth Rogoff of Harvard University, argue that accelerating inflation is a clear sign the global economy needs to cool to let commodity supplies and fuel alternatives catch up. Yet a sharp slowdown in Asia may be devastating.

Take China, which needs to expand about 10 percent annually to raise the living standards of 1.3 billion people. Slowing growth will place dangerous pressure on Asia’s second-biggest economy. For a nation at China’s level of development, 5 percent growth is essentially a recession…

Policy makers are merely putting off the inevitable and treating the symptoms of what ails the global economy. If they aren’t careful, Japan’s experience during the 1990s will become a familiar one.

“It’s not a scenario many expect for the West or for Asia,” Chan says. “But I’m not sure it can be ruled out.”