Rich banks to benefit from loans to poor nations ~ says academic Buckley

MARK COLVIN: As leaders from the world's 20 biggest economies meet in Pittsburgh, one of the issues they are confronting is the plight of the world's poor.

Even though many poorer nations' own emissions are low, climate change is having a big impact on them.

And the global financial crisis has caused a collapse in trade and capital flows. It threatens poorer parts of the globe with poverty and hunger.

The G20 has committed hundreds of billions of dollars to the International Monetary Fund to help the hard hit emerging nations but critics argue that the IMF will only make their situation worse.

Among them is Ross Buckley, a professor of law at the University of New South Wales and an expert on global trade and finance.

He spoke to our economics correspondent Stephen Long.

ROSS BUCKLEY: A year ago nobody wanted to know the International Monetary Fund. Now it's the organiser for the international stimulus package which has been sold as a stimulus package for poor countries - but I don't really think it is.

STEPHEN LONG: Why not?

ROSS BUCKLEY: Because what it is is loans. Stimulus packages are usually grants. These are loans that are made by the G20 countries through the IMF to poor countries.

They have to be repaid and what they're going to be used for is to repay the international banks now. So it's really a stimulus package for the rich countries' banks.

STEPHEN LONG: So you think that the International Monetary Fund which has garnered what, somewhere between $US500 billion and $US750 billion to supposedly help the poor countries is actually in a sense a stalking horse for the big global finance houses.

ROSS BUCKLEY: I think that's precisely what's going on. And the reason it's going on is not enough people understand it. There's a democratic deficit if you like at the international level. I don't think rich countries' media or population would allow this but at the international level that's exactly what's happening.

STEPHEN LONG: Well explain why you think that that is the case.

ROSS BUCKLEY: Well because these loans, there's certainly over $500 billion, as you say, of loans. These loans are made by the rich countries to the IMF. They will be conditioned upon the poor countries using them to repay the debt that's due.

So these loans will be used to repay loans that are currently outstanding by poor countries to commercial banks. So the money won't really touchdown in the poor countries. It will go straight through them to repay their creditors.

The IMF lends the money to the countries. The countries use it to repay loans they have to the banks. But the poor countries will spend the next 30 years repaying the IMF.

In a way, if you'd like to see it this way, it's really an increase in seniority of the debt. At the moment the debt is owed by poor countries to banks and if the poor countries had to they could default on that.

The bank debt is going to be replaced by debt that's owed to the IMF which for very good strategic reasons the poor countries will always service.

STEPHEN LONG: How have we arrived at a situation then where as a result of the global financial crisis the International Monetary Fund has come out on top with so much of an increase in its resources?

ROSS BUCKLEY: I suppose because the rich countries need an intermediary to broker and channel the intervention that they want to have for their own interests. The rich countries have made this $500 billion available to stimulate their own banks and the IMF is a wonderful party to put in between the countries and the debtors and the banks.

STEPHEN LONG: Can we be that cynical about it? I've heard the head of the International Monetary Fund speak passionately about this crisis as the Great Recession and the terrible toll it will wreak amongst poor people in poor countries.

ROSS BUCKLEY: When you're adding $500 billion to the long-term debt of the poor countries, many of which are struggling under absolutely intolerable debt burdens already, yes I think we can be that cynical about it.

It's simply not in the, if we really wanted to act in the benefit of these poor countries we would cancel their interest for two years. We would, you know, do something that improves their cash flow now.

STEPHEN LONG: Before the last meeting of the Group of 20 in London earlier this year there was a push from some quarters, from Australia, from the former Reserve Bank official Stephen Grenville, the former prime minister and treasurer Paul Keating to, in effect, decapitate the IMF, take out its governing structure and put the G20 in its place to run the IMF.

Do you think that that would have been a worthwhile reform?

ROSS BUCKLEY: It's difficult to say, you know, the G20 is a broadly representative organisation. If the breadth of those diversity of views can get a voice in the G20 that might be a worthwhile thing.

But I think part of the problem with the IMF is the culture that's right the way through the organisation which is a very naive belief in the power of unfettered markets.

MARK COLVIN: Professor Ross Buckley from the University of New South Wales with Stephen Long.

http://www.abc.net.au/pm/content/2009/s2693454.htm

Appointment in Yekaterinburg ~ Hudson

The Ending of America's Financial-Military Empire

By MICHAEL HUDSON

The city of Yekaterinburg, Russia’s largest east of the Urals, may become known not only as the end of the road for the tsars but of American hegemony too; as the place not only where US U-2 pilot Gary Powers was shot down in 1960, but where the US-centered international financial order was brought to ground.

Challenging America is the prime focus of extended meetings in Yekaterinburg, Russia (formerly Sverdlovsk) today and tomorrow (June 15-16) for Chinese President Hu Jintao, Russian President Dmitry Medvedev and other top officials of the six-nation Shanghai Cooperation Organization (SCO). The alliance is comprised of Russia, China, Kazakhstan, Tajikistan, Kyrghyzstan and Uzbekistan, with observer status for Iran, India, Pakistan and Mongolia. It will be joined on Tuesday by Brazil for trade discussions among the so-called BRIC nations --Brazil, Russia, India and China.

The attendees have assured American diplomats that it is not their aim to dismantle the financial and military empire of the United States. They simply want to discuss mutual aid – but in a way that has no role for the United States, for NATO or for the US dollar as a vehicle for trade. US diplomats may well ask what this really means, if not a move to make US hegemony obsolete. After all, that is what a multipolar world means. For starters, in 2005 the SCO asked Washington to set a timeline to withdraw from its military bases in Central Asia. Two years later the SCO countries formally aligned themselves with the former CIS republics belonging to the Collective Security Treaty Organization (CSTO), established in 2002 as a counterweight to NATO.

Yet the Yekaterinburg meeting has elicited only a collective yawn from the US and even European press despite its agenda -- nothing less than the replacement of the global dollar standard with a new financial and military defense system. A Council on Foreign Relations spokesman has said he hardly can imagine that Russia and China can overcome their geopolitical rivalry, suggesting that America can use the divide-and-conquer that Britain used so deftly for many centuries in fragmenting foreign opposition to its own empire. But George W. Bush (“I’m a uniter, not a divider”) built on the Clinton administration’s legacy in driving Russia, China and their neighbors to find a common ground when it comes to finding an alternative to the dollar and hence to the US ability to run balance-of-payments deficits ad infinitum.

What may prove to be the last rites of American hegemony began already in April at the G-20 conference, and became even more explicit at the St. Petersburg International Economic Forum on June 5, when Mr. Medvedev called for China, Russia and India to “build an increasingly multipolar world order.” What this means in plain English is: We have reached our limit in subsidizing the United States’ military encirclement of Eurasia while also allowing the US to appropriate our exports, companies, stocks and real estate in exchange for paper money of questionable worth.

The artificially maintained unipolar system,” Mr. Medvedev spelled out, is based on “one big center of consumption, financed by a growing deficit, and thus growing debts, one formerly strong reserve currency, and one dominant system of assessing assets and risks.” At the root of the global financial crisis, he concluded, is the fact that the United States makes too little and spends too much, particularly its vast military outlays, such as the stepped-up US military aid to Georgia announced just last week, the NATO missile shield in Eastern Europe and the US buildup in the oil-rich Middle East and Central Asia.

The sticking point for all these countries is the ability of the United States to print unlimited amounts of dollars. Overspending by U.S. consumers on imports in excess of exports, U.S. buy-outs of foreign companies and real estate, and the dollars that the Pentagon spends abroad all end up in foreign central banks. These banks then face a hard choice: either to recycle these dollars back to the United States by purchasing US Treasury bills, or to let the “free market” force up their currency relative to the dollar – thereby pricing their exports out of world markets and hence creating domestic unemployment and business insolvency.

When China and other countries recycle their dollar inflows by buying US Treasury bills to “invest” in the United States, this buildup is not really voluntary. It does not reflect faith in the ability of the U.S. economy to enrich foreign central banks for their savings. Nor does it represent any calculated investment preference. It is simply a matter of a lack of alternatives. U.S.-style “free markets” hook countries into a system that forces them to accept dollars without limit. Now they want out.

This means creating a new alternative. Rather than making merely “cosmetic changes as some countries and perhaps the international financial organisations themselves might want,” said Mr. Medvedev at the end of his St. Petersburg speech, “what we need are financial institutions of a completely new type, where particular political issues and motives, and particular countries will not dominate.”

When foreign military spending forced the US balance of payments into deficit and drove the United States off gold in 1971, central banks were left without the traditional asset used to settle payments imbalances. The alternative was to invest their subsequent inflows of US dollars in US Treasury bonds, as if these still were “as good as gold.” Central banks now hold $4 trillion of these bonds in their international reserves. These loans have financed most of the US Government’s domestic budget deficits for over three decades now! Given the fact that about half of US Government discretionary spending is for military operations – including more than 750 foreign military bases and increasingly expensive operations in the oil-producing and transporting countries – the international financial system is organized in a way that finances the Pentagonand also US buyouts of foreign assets expected to yield much more than the Treasury bonds that foreign central banks hold.

The main political issue confronting the world’s central banks is therefore how to avoid adding yet more dollars to their reserves and thereby financing yet further US deficit spending – including military spending on their borders.

For starters, the six SCO countries and BRIC countries intend to trade in their own currencies so as to get the benefit of mutual credit that the United States until now has monopolized for itself. Toward this end, China has struck bilateral deals with Argentina and Brazil to denominate their trade in renminbi rather than the dollar, sterling or euros, and two weeks ago China reached an agreement with Malaysia to denominate trade between the two countries in renminbi. Former Prime Minister Tun Dr. Mahathir Mohamad explained to me in January that as a Muslim country, Malaysia wants to avoid doing anything that would facilitate US military action against Islamic countries, including Palestine. The nation has too many dollar assets as it is, his colleagues explained. Central bank governor Zhou Xiaochuan of the People's Bank of China put an official statement on the bank’s website, explaining that the goal is now to create a reserve currency “that is disconnected from individual nations.” This is the aim of the discussions in Yekaterinburg.

Aside from no longer financing the U.S. buyout of their own industries and the U.S. military encirclement of the globe, China, Russia and other countries would no doubt like to enjoy the same kind of free ride that America has been getting. As matters stand now, they see the United States as a lawless nation, financially as well as militarily. How else to characterize a nation that proclaims a set of laws for others – on war, debt repayment and treatment of prisoners – but flouts them itself? The United States is now the world’s largest debtor yet has avoided the pain of “structural adjustments” imposed on other debtor economies. U.S. interest-rate and tax reductions in the face of exploding trade and budget deficits are seen as the height of hypocrisy in view of the austerity programs that Washington forces on other countries via the IMF and other Washington vehicles.

The United States tells debtor economies to sell off their public utilities and natural resources, raise their interest rates and increase taxes while gutting their social safety nets to squeeze out money to pay creditors. And at home, Congress blocked, on grounds of national security, China’s CNOOK from buying Unocal, much as it blocked Dubai from buying US ports and blocked other sovereign wealth funds from buying into key infrastructure. Foreigners are invited to emulate the Japanese purchase of white elephant trophies such as Rockefeller Center, on which investors quickly lost a billion dollars and ended up walking away.

In this respect the US has given China and other payments-surplus nations no alternative but to find a way to avoid further dollar buildups. To date, China’s attempts to diversify its dollar holdings beyond Treasury bonds have not proved very successful. For starters, Hank Paulson of Goldman Sachs steered its central bank into higher-yielding Fannie Mae and Freddie Mac securities, explaining that these were de facto public obligations. They collapsed in 2008, but at least the U.S. Government took over these two mortgage-lending agencies, formally adding their $5.2 trillion in obligations to the national debt. In fact, it was largely foreign official investment that prompted the bailout. Imposing a loss for foreign official agencies would have broken the Treasury-bill standard then and there, not only by utterly destroying US credibility but because there simply are too few Government bonds to absorb the dollars being flooded into the world economy by the soaring US balance-of-payments deficits.

in late 2007, seeking more of an equity position to protect the value of their dollar holdings as the Federal Reserve’s credit bubble drove interest rates down, China’s sovereign wealth funds sought to diversify. China bought stakes in the well-connected Blackstone equity fund and Morgan Stanley on Wall Street, Barclays in Britain, South Africa’s Standard Bank (once affiliated with Chase Manhattan back in the apartheid 1960s) and in the soon-to-collapse Belgian financial conglomerate Fortis. But the US financial sector was collapsing under the weight of its debt pyramiding, and prices for shares plunged for banks and investment firms across the globe.

Foreigners see the IMF, World Bank and World Trade Organization as Washington surrogates in a financial system backed by American military bases and aircraft carriers encircling the globe. But this military domination is a vestige of an American empire no longer able to rule by economic strength. US military power is muscle-bound, based more on atomic weaponry and long-distance air strikes than on ground operations, which have become too politically unpopular to mount on any large scale.

On the economic front there is no foreseeable way in which the United States can work off the $4 trillion it owes foreign governments, their central banks and the sovereign wealth funds set up to dispose of the global dollar glut. America has become a deadbeat –a militarily aggressive one -- as it sruggles to hold onto the immense power it once earned by economic means. The problem for the rest of the world is how to constrain its behavior. Yu Yongding, a former Chinese central bank advisor now with China’s Academy of Sciences, suggested that US Treasury Secretary Tim Geithner be advised that the United States should “save” first and foremost by cutting back its military budget. “U.S. tax revenue,” he said, “is not likely to increase in the short term because of low economic growth, inflexible expenditures and the cost of ‘fighting two wars.’”

At present foreign savings are what finance the US budget deficit by buying most Treasury bonds. The consequence is taxation without representation for foreign voters as to how the US Government uses their forced savings. It therefore is necessary for the financial diplomats to broaden the scope of their policy-making beyond the private-sector marketplace. Exchange rates are determined by many factors besides “consumers wielding credit cards,” the usual euphemism that the US media cite for America’s balance-of-payments deficit. Since the 13th century, war has been a dominating factor in the balance of payments of leading nations – and of their national debts. Government bond financing consists mainly of war debts, as normal peacetime budgets tend to be balanced. This links the war budget directly to the balance of payments and exchange rates.

Foreign nations see themselves stuck with unpayable IOUs under conditions where, if they move to stop the US free lunch, the dollar will plunge and their dollar holdings will fall in value relative to their own domestic currencies and other currencies. If China’s currency rises by 10 per cent against the dollar, its central bank will show the equivalent of a $200 million loss on its $2 trillion of dollar holdings as denominated in yuan. This explains why, when bond ratings agencies talk of the US Treasury securities losing their AAA rating, they don’t mean that the government cannot simply print the paper dollars to “make good” on these bonds. They mean that dollars will depreciate in international value. And that is just what is now occurring. When U.S. Treasury Secretary Geithner assumed an earnest mien and told an audience at Peking University in early June that he believed in a “strong dollar” and China’s US investments therefore were safe and sound, he was greeted with derisive laughter.

Anticipation of a rise in China’s exchange rate provides an incentive for speculators to seek to borrow in dollars to buy renminbi and benefit from the appreciation. For China, the problem is that this speculative inflow would become a self-fulfilling prophecy by forcing up its currency. So the problem of international reserves is inherently linked to that of capital controls. Why should China see its profitable companies sold for yet more freely-created US dollars, which the central bank must use to buy low-yielding US Treasury bills or lose yet further money on Wall Street?

To steer round this quandary it is necessary to reverse the philosophy of open capital markets that the world has held ever since Bretton Woods in 1944. On the occasion of Mr. Geithner’s visit to China, Zhou Xiaochuan, minister of the Peoples Bank of China, the country’s central bank, said pointedly that this was the first time since the semiannual talks began in 2006 that “China needed to learn from American mistakes as well as its successes” when it came to deregulating capital markets and dismantling controls.

So an era is winding to its end. In the face of continued US overspending, de-dollarization threatens to force countries to return to the kind of dual exchange rates common between World Wars I and II: one exchange rate for commodity trade, another for capital movements and investments, at least from dollar-area economies.

Even without capital controls, the nations meeting at Yekaterinburg are taking steps to avoid being the unwilling recipients of yet more dollars. Seeing that U.S. global hegemony cannot continue without the spending power that they themselves supply, governments are attempting to hasten what Chalmers Johnson has called “the sorrows of empire” in his book by that name – the bankruptcy of the US financial-military world order. If China, Russia and their non-aligned allies have their way, the United States will no longer live off the savings of others in the form of its own recycled dollars, nor have the money for unlimited military expenditures and adventures.

US officials wanted to attend the Yekaterinburg meeting as observers. They were told No. It is a word that Americans will hear much more in the future.

Michael Hudson is a former Wall Street economist. A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) He can be reached via his website, mh@michael-hudson.com

Emerging market De Nile strikes home

The parallels between U.S. policymaking and what we see in emerging markets are clearest in how we've mishandled the banking crisis. We delude ourselves that our banks face liquidity problems, rather than deeper solvency problems, and we try to fix it all on the cheap just like any run-of-the-mill emerging market economy would try to do. And after years of lecturing Asian and Latin American leaders about the importance of consistency and transparency in sorting out financial crises, we fail on both counts: In March 2008, one investment bank, Bear Stearns, is bailed out because it is thought to be too interconnected with the rest of the banking system to fail. However, six months later, another investment bank, Lehman Brothers -- for all intents and purposes indistinguishable from Bear Stearns in its financial market inter-connectedness -- is allowed to fail, with catastrophic effects on global financial markets.

In visits to Asian capitals during the region's financial crisis in the late 1990s, I often heard Asian reformers such as Singapore's Lee Kuan Yew or Japan's Eisuke Sakakibara complain about how the incestuous relationship between governments and large Asian corporate conglomerates stymied real economic change. How fortunate, I thought then, that the United States was not similarly plagued by crony capitalism! However, watching Goldman Sachs's seeming lock on high-level U.S. Treasury jobs as well as the way that Republicans and Democrats alike tiptoed around reforming Freddie Mac and Fannie Mae -- among the largest campaign contributors to Congress -- made me wonder if the differences between the United States and the Asian economies were only a matter of degree.

On Wall Street there is an old joke that the longest river in the emerging-market economies is "de Nile." Yet how often do U.S. leaders respond to growing signs of economic dysfunctionality by spouting nationalistic rhetoric that echoes the speeches of Latin American demagogues like Peru's Alan Garcia in the 1980s and Argentina's Carlos Menem in the 1990s? (Even Garcia, currently in his second go-around as Peru's president, seems to have grown up somewhat.) But instead of facing our problems we extol the resilience of the U.S. economy, praise the most productive workers in the world, and go on and on about America's inherent ability to extricate itself from any crisis. And we ignore our proclivity as a nation to spend, year in year out, more than we produce, to put off dealing with long-term problems, and to engage in grandiose long-term programs that as a nation we can ill afford.

A singular characteristic of an emerging market heading for deep trouble is a seemingly suicidal tendency to become overly indebted to foreign creditors. That tendency underlay the spectacular collapse of the Thai, Indonesian and Korean currencies in 1997. It also led Russia to default on its debt in 1998 and plunged Argentina into its economic depression in 2001. Yet we too seem to have little difficulty becoming increasingly indebted to the tune of a few hundred billion dollars a year. To make matters worse, we do so to countries like China, Russia and an assortment of Middle Eastern oil producers -- none of which is particularly well disposed to us.

Like Argentina in its worst moments, we never seem to question whether it is reasonable to expect foreigners to keep financing our extravagance, and we forget the bad things that happen to the Argentinas or Hungarys of the world when foreigners stop financing their excesses. So instead of laying out a realistic plan for increasing our national savings, we choose not to face up to the Social Security and Medicare crises that lie ahead, embarking instead on massive spending programs that -- whatever their long-run merits might be -- we simply cannot afford.

After experiencing a few emerging-market crises, I get the sense of watching the same movie over and over. All too often, a tragic part of that movie is the failure of the countries' policymakers to hear the loud cries of canaries in the coal mine. Before running up further outsized budget deficits, should we not heed the markets that now see a 10 percent probability that the U.S. government will default on its sovereign debt in the next five years? And should we not be paying close attention to the Chinese central bank governor's musings that he does not feel comfortable with the $1 trillion of U.S. government debt that the Chinese central bank already owns, let alone adding to those holdings?

In the twilight of my career, when I am hopefully wiser than before, I have come to regret how the IMF and the U.S. Treasury all too often lectured leaders in emerging markets on how to "get their house in order" -- without the slightest thought that the United States might fare no better when facing a major economic crisis. Now, I fear time is running out for our own policymakers to mend their ways and offer real leadership to extricate the United States from its worst economic calamity since the 1930s. If we insist on improvising and not facing our real problems, we might soon lose our status as a country to be emulated and join the ranks of those nations we have patronized for so long.

http://www.washingtonpost.com/wp-dyn/content/article/2009/03/25/AR2009032502226.html?referrer=emailarticle

Roadmap To Inflation And Sources Of Cheap Insurance

by James Montier

As Albert and I regularly point out during meetings, we have never been more unsure on the inflation/deflation outlook. I have previously said I was torn between the deflationary impact of the bursting credit bubble, and the inflationary pressures of the policy response. When we read something by the deflationists we sit there nodding our heads in agreement, then we pick up something by the proponents of a return of inflation and we find ourselves agreeing with that as well. The respective sides seem deeply entrenched in their positions.

In contrast, we are trying to keep an open mind on the subject. Albert is biased towards a Japanese style outcome, and I am biased towards an inflationary outcome, but neither of us has any strong conviction.
Fisher and the debt-deflation theory of depressions

In the face of this uncertainty I decided to return to history and see what it has to say about the way out of a depression. My first point of call was Irving Fisher's "The debt-deflation theory of Great Depressions" published in 19331. Fisher is probably most infamous to those in finance for his pronouncements of a new era of permanently high stock prices in 1929. But in the wake of his disastrous calls he turned to trying to understand the experience of the depression. Incidentally, he also invented the Rolodex.

In his debt-deflation theory, he posits "two dominant factors" in driving depressions "Namely over-indebtedness to start with and deflation following soon after... In short, the big bad actors are debt disturbances and price-level disturbances". He continues "Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed." That is to say, debt-deflation spirals can easily become self-reinforcing.

The good news is that Fisher is also very clear on how to end a debt-deflation spiral: "It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors... I would emphasize... that great depressions are curable and preventable through reflation and stabilization". The irony of Fisher's route out of deflation is that, probably only the Fed - after helping lead us into this mess2 - can now get us out of it.
Romer's lessons from the Great Depression

After reading Fisher's analysis of the 1930s, I came across a recent speech given by Christina Romer, who is now the head of the Council of Economic Advisers, and who made her name in academic circles studying the events which ended the Great Depression. In the speech, Romer offers six lessons from the Great depression for the current juncture.

Lesson 1 – Small fiscal expansion has only small effects

Romer wrote a paper in 19923 arguing that fiscal policy was not the key driver in the recovery from the Great Depression. Not because fiscal expansion is ineffectual per se, but rather because the fiscal stimulus that was conducted wasn't large. As Romer notes "When Roosevelt took office in 1933, real GDP was more than 30% below its normal trend level... The deficit rose by about one and a half percent of GDP in 1934".

Lesson 2 – Monetary expansion can help heal an economy even when interest rates are near zero

Romer notes that actually it was the Treasury rather than the Federal Reserve that drove the monetary expansion (a peculiarity of the system under the Gold Standard). In April 1933, Roosevelt suspended convertibility to gold on a temporary basis, and the dollar depreciated. When the US returned to gold at the new higher price, gold flowed into the US, allowing the Treasury to issue gold certificates which were interchangeable with Federal Reserve notes. As Romer notes "The result was that the money supply, defined narrowly as currency and reserves, grew by nearly 17% per year between 1933 and 1936". Romer argues that this "Devaluation followed by rapid monetary expansion broke the deflationary spiral" - empirical evidence to support Fisher's hypothesis outlined above.

Lesson 3 – Beware of cutting back on stimulus too soon

The monetary expansion seems to have produced remarkable results in terms of real growth: the US economy grew by 11% in 1934, 9% in 1935 and 13% in 1936 in real terms. This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the deficit was reduced by approximately two and half percent of GDP. Monetary policy was also tightened, as Romer notes "The Federal Reserve doubled the reserve requirement in three steps in 1936 and 1937". She concludes "taking the wrong turn in 1937 effectively added two years to the Depression".

Lesson 4 – Financial recovery and real recovery go hand in hand

Romer points out the inseparable nature of the real and financial recoveries. This meshes with our analysis that the banks aren't really the problem in a debt-deflation environment, rather they are a symptom of the problem. The current policy in the US seems to be aimed at "fixing the financial system", witness Bernanke's recent comments "Recovery is not going to happen until the financial markets and the banks are stabilized". This appears to be a misperception, as, Romer notes "Strengthening the real economy improved the health of the financial system. Bank profits moved from large and negative in 1933 to large and positive in 1935, and remained high through the end of the Depression".

Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn't post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn't make them solvent. If you were starting a business today, then setting up a bank would be a very attractive option. However, history - as represented by the balance sheet - cannot simply be ignored when it is inconvenient. As John Hussman noted "The excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term "operating profit." Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet."

Lesson 5 – Worldwide expansionary policy shares the burdens

Given the worldwide nature of the current slump, Romer makes an interesting point on the effectiveness of competitive devaluations, "Going off the gold standard and increasing the domestic money supply was a key factor in generating recovery... across a wide range of countries in the 1930s... These actions worked to lower world [real] interest rates... rather than just to shift expansion from one country to another".

This is something that Albert and I have been discussing of late. We have been pondering the possibility of competitive devaluation (obviously ultimately a zero sum game in terms of exchange rates) having enough of an impact on local monetary creation to increase inflationary expectations, thus helping countries reflate. It appears as if Romer has sympathy with this view.

Lesson 6 – The Great Depression did eventually end

The final lesson that Romer offers may be of use to investors at the current juncture. She makes the point that the Great Depression did finally end. As Romer puts it "Despite the devastating loss of wealth, chaos in our financial markets, and a loss of confidence so great that it nearly destroyed American's fundamental faith in capitalism, the economy came back. Indeed, the growth between 1933 and 1937 was the highest we have ever experienced outside of wartime. Had the U.S. not had the terrible policy-induced setback in 1937, we, like most other countries... would probably have been fully recovered before the outbreak of World War II" This is a reminder that the current obsession with no scenario being too pessimistic is probably ill advised.


Bernanke and the policy options

The final source for signposts to watch comes from a speech given by Bernanke in 2000 to Japanese policy makers. As I wrote in Mind Matters 6 January 2009, in this speech Bernanke clearly acknowledged the greater threat that deflation poses in a highly leveraged economy, "Zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer-term credit, than the economies of the nineteenth century."

Bernanke clearly believes that monetary policy is far from impotent at the zero interest rate bound. In essence his argument is an arbitrage based4 one as follows "Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero."

In the speech, he laid out a menu of policy options that are available to the monetary authorities at the zero bound. First, aggressive currency depreciation, as per Romer's analysis of the end of the Great Depression. Second on Bernanke's list is the introduction of an inflation target to help mould the public's expectations about the central bank's desire for inflation. He mentions the range of 3-4%!

Third on the list was money financed transfers. Essentially tax cuts financed by printing money. Obviously this requires co-ordination between the monetary and fiscal authorities, but this should be less of an issue in the US than it was in Japan. Finally, Bernanke argues that non-standard monetary policy should be deployed. Effectively, quantitative and qualitative easing. Bernanke has repeatedly mentioned the possibility of outright purchases of government bonds - as the UK is now doing.

This menu should provide us with a roadmap of policy options to watch for. If (and when) the deflationary pressure builds, we should expect to see more and more of these options wheeled out. Note that we aren't talking about trying to 'fix the system', to reflate the bubble (which would be the equivalent of giving crack cocaine to a heroin addict trying to deal with withdrawal). Rather, the suggestion from Fisher is that inflation erodes the real value of debt; it is the most painless way out of our current mess. Whether the authorities can create just a little inflation remains to be seen, as does their ability to actually create inflation in any way. Such imponderables are beyond my ken.
Investment implications – Cheap insurance

Howard Marks recently suggested that today's investment decisions must focus on "value, survivability and staying power". These factors lie at the heart of the three-pronged approach that I have been suggesting since the end of October last year.

The first prong is cash. This is a legacy from the lack of opportunities that characterised markets in the last few years. But it is also a hedge against outright deflation. The second prong is deep value opportunities in both debt and equity markets (as detailed for the equity markets most recently in Mind Matters, 4 March 2009). The third element is sources of cheap insurance. The idea behind this element of the portfolio is to prepare for a wide variety of outcomes by buying cheap insurance (which ideally, although not always, pays off in multiple states of the world). Of course, it should be noted that the purchase of cheap equities also contains an inflation hedge element.

Inflation/deflation insurance I – TIPS

The first and most obvious source of inflation/deflation protection when I first started thinking about this subject was US TIPS. These bonds have a deflation floor on the principal, so in the event of deflation I receive my cash back - representing a real rate of return equivalent to whatever the deflation rate is. In the event of inflation, I get whatever the yield is on the TIPS when I purchase them plus the inflation, of course (buying the new issue TIPS avoids the problem of accrued inflation).

When I started looking at TIPS, the yield was over 3.5%. This has dropped since then, resulting in the 10 year TIPS delivering a 9% return since the end of October. The 10 year TIP is currently yielding 2.1%, against the 10 year nominal bond yield of 3%. This implies that the market expects US inflation to be a mere 1% p.a. over the next decade - this strikes me as an exceptionally low rate.



Inflation/deflation insurance II – Gold

The second inflation/deflation hedge I suggested in late October was gold. Now, gold concerns me for a variety of reasons, not least of which is that it has no intrinsic worth: I can't really value gold - beyond extraction cost.

However, it has some attractive features from an insurance point of view. Most obviously, in a world of competitive devaluations, gold is the one currency that can't be debased. Thus it provides a useful hedge against the return of this sort of beggar-thy-neighbour policy. In the event of significant prolonged deflation, what is left of our financial system is likely to collapse, thus holding a money substitute isn't such a bad idea against this cataclysmic outcome.

Of course, recently everyone has been talking about gold (not hugely surprising given that it is up some 30% since late October) - something that makes me nervous. However, gold is institutionally massively under-owned, so whilst it may have been moving up the list of attractive assets of individual investors (if the EFTs are anything to go by) and sensible hedge funds (such as the likes of Greenlight, Paulson, Third Point, Eton Park and Hayman), the mainstream institutional appetite for it has remained depressed.



Inflation insurance I – Dividend swaps

As we noted in Mind Matters, 2 February 2009 the European and UK dividend swap markets are pricing in an outcome that implies greater dividend declines than witnessed in the US during the Great Depression. The pricing then implies that essentially the dividends won't recover, pretty much forever. This strikes me as excessively pessimistic.

In addition, dividends have a relatively close relationship with inflation (as detailed in the aforementioned Mind Matters). Thus dividend swaps look like a deeply distressed asset fire sale, with the added advantage of offering inflation insurance if I buy the longer dated swaps (up around 7% from my original note in February). The most common rebuttal to my fondness for dividend swaps is counterparty risk. However, the European dividend swaps have an exchange listed future, which obviously doesn't have any counterparty issues.



Inflation insurance II – Inflation swaps

The second of the pure inflation hedges comes via the inflation swap market. The charts below show the zero-coupon fixed rate necessary to build a swap against zero-coupon CPI appreciation over 10 years. When I first looked at the US version in January (see Mind Matters, 6 January 2009) the rate was a mere 1.5%. Today it has risen, although not dramatically, to 2.3%.

However, the cheapest inflation swaps in the world seem to be Japanese swaps. They are available for -2.5%! Both the US and Japanese inflation swaps strike me as cheap ways of buying inflation insurance at the moment. Although counterparty risk is obviously a significant factor in these long duration swap transactions.







Eurozone break-up insurance: Spanish and Portuguese CDS

The final element of the insurance policy concerns the risk of a euro break-up. In a world of competitive devaluation, it isn't clear that the Eurozone will be able to stand the pressure. The one area of the world which has anything like the gold standard in place is the Eurozone. As Albert opines during our meetings with clients, this is less a function of economic realities and more a function of political expediency (I'll leave a detailed exposition of this logic to Albert in a future note).

To protect against this risk (or even rising perceptions of this risk) the natural insurance is provided by the CDS market. If even one country was to publicly contemplate leaving the Eurozone then these CDS spreads would explode. I find it hard to believe that Portuguese and Spanish CDS are below those of the UK - where we have the ability (and have used it) to print our own money.



Footnotes:

1 Available from http://www.fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf This is one of few articles published in Econometrica that I have ever read!

2 See Bill Flecksenstein's excellent book, Greenspan's Bubbles or John Taylor's insightful paper The Financial Crisis and the Policy Responses: An empirical analysis of what went wrong, available from http://www.stanford.edu?~johntayl/FCPR.pdf, or any of Albert Edwards' myriad of rants on Greenspan.

3 Romer (1992) What ended the Great Depression?, The Journal of Economic History, Vol 52

4 As Stephen Ross once said, to turn a parrot into a learned financial economist it needs learn just one word: arbitrage. To my mind economists are far too happy to rely on arbitrage assumptions to rule out solutions. Indeed the second chapter of my first book, Behavioural Finance is spent detailing failures of arbitrage (both causes and consequences thereof, including the ketchup markets!).

link

Truth Beauty and Russian Finance ~ (Yet another) Year of Living Dangerously Russia in the Global Crisis

Recently, we were asked to contribute a paper on the impact of the global economic crisis upon Russia. Whilst T&B sees a number of signs of stabilization in Russia – a phenomenon painfully missing virtually anywhere else – both the speed and the severity of the global meltdown is simply breathtaking. Russia is climbing back up the rock-face, but it is climbing up through an avalanche…

It is thus a risky business issuing bullish calls for any economy – we see growing evidence for a gradual stabilization in Russia – most recently, at 40.6 the VTB Purchasing Manager Index (PMI) while still clearly recessionary, has improved for the second month running – from 33 in December to 35 in January; inventories of finished goods have declined quite substantially, one of the conditions for a resumption in manufacturing activity. As of this writing, the rouble has stabilized, and after the spectacular recovery in the Eurobond market, the rouble bond market is now steadily improving, with bids for first and second tier assets at yields around 20%.

Life lacks spice if not spent far out upon a limb, so we will risk making fools of ourselves with a series of predictions: the S&P will hit our target of 650 (now just 50 points away) sooner rather than later – but will then stabilize (hope, not evidence). Oil prices have probably bottomed. Chinese resource demand is coming back. The RTS equity market bottomed around 500 last October and

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does not want to go any lower (current quote: 540) but we would expect it to trade within a reasonably narrow range for the immediate future. The best near term investment opportunities now include Russian Eurobonds, and for the adventurous, selected rouble bonds.

In brief – we have seen a fair number of swallows – we begin to suspect that they may a springtime make. That said, the downside risks are obvious: if we are faced with a true meltdown of the global economic, financial and trading systems, then any predictions regarding Russia in isolation should not be relied upon. If the disaster scenario were to eventuate, we suspect that our readership would have other, more immediate preoccupations – the procurement of food, water, and a dry cave in which to sleep – rather than blaming us for a missed call or two.

(Another) Year of Living Dangerously – Russia and the Global Crisis

Whilst the economic impact upon Russia of the initial phases of the global economic crisis exceeded rational expectations formulated based upon the secular shift in economic activity towards the emerging markets, in fairness, the sheer havoc triggered by the collapse of the serial US asset bubbles is unprecedented; in retrospect, the current crisis will be seen to have represented the fundamental inflection point in secular shift in the global balance of economic power away from the old economies of the West.

For now, innocent bystanders need beware. As in every financial crisis, the initial disruption was both panicked and non-selective; both babies and bathwater were pitched out of windows as financial entities went into survival mode. Then, as the crisis matures, markets begin to increasingly differentiate between those companies or countries faced with the threat of imminent demise, as opposed to those which have become oversold beyond any rational valuation, and thus, offer compelling opportunities for the adventurous. We think that the contagion effect in Russia was front-loaded, i.e. that the worst effects were felt in late 2008, and that a period of stabilization is now at hand.

The Three Horsemen of the Apocalypse – and the Missing Stallions

Three principal mechanisms account for the transmission of the global economic crisis to the Russian economy; in order of decreasing importance, these are the global credit contraction, the collapse in commodities prices, and the reversal of investment flows. These shocks have been of a magnitude unprecedented in modern economic history, and especially, occurred with extraordinary rapidity, with in particular credit going from bounteous to almost non-existent virtually overnight.

For structural reasons, the emerging markets – not excluding Russia – were highly exposed to a sudden failure of global capital markets. Since conditions will almost certainly continue worsening during the course of 2009-2010, legitimate questions can be asked regarding the economic survivability of several emerging countries, in particular of Eastern Europe. As regards Russia, on the other hand, it appears that most of the damage has already been felt, and absent a complete collapse in the global trading system or commodities markets, we would expect to see stabilization not far from the current levels.

We will first consider the three essential factors driving the crisis, as well as the near-term outlook for each, before turning to the mitigating factors, i.e. those areas where Russia is relatively immune to contagion effects.

1. Credit While Russia was initially able to shrug off the first phases of the global crisis, the disastrous decision to allow a disorderly failure of Lehman Bros sent global financial markets spiralling into crisis mode. The desperate rush by banks to repatriate capital led to the sudden withdrawal of all credit – regardless of the ultimate creditworthiness of the borrower. The Russian corporate sector, largely funded in the international capital markets, proved to be dangerously exposed.

© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -2 -

This fragility was a direct consequence of the “Kudrin System” whereby, so as to forestall the development of “Dutch Disease” and hyperinflation driven by massive commodity export revenues, under FM Kudrin Russia moved to capture the windfall profits of the oil producers, accumulating massive Forex reserves while reducing the sovereign debt load to trivial levels. Given the perceived limits to the ability of the Russian financial system to absorb and allocate investment capital, the government invested oil export revenues into G7 assets, essentially leaving it to the global investment banks to intermediate these reserves back into the Russian economy.

Deprived of domestic options for financing business expansion, working capital or Capex, the Russian corporate sector by necessity turned to the global banks and capital markets for funding. Given that until October 2008 the international banks were both highly liquid and increasingly desperate for credit-worthy borrowers, they willingly provided increasing volumes of finance; the counterpart to burgeoning sovereign Forex reserves was thus the rapidly-growing indebtedness of the Russian corporate sector.

Had the onset of the global crisis been delayed by a further 24 months, it is likely that the Russian private sector would have found itself disastrously over-indebted. In the event, whilst the gross indebtedness of the Russian corporate sector has been rather alarmingly estimated at some $500 billion, this ignores the huge offsetting foreign assets held by the corporate sector. Estimated debt service and redemptions for 2009 are approximately $110bn, the vast majority of which have already been funded by issuers purchasing USD on the local market; indeed, many of the obligors, in particular the banks, have been actively buying back their outstanding Eurobonds, which have performed very strongly over the past few months.

The Washington Consensus Strikes Again…

We would argue that the crisis was exacerbated by the premature, politically-motivated decision to fully integrate Russia into global financial markets, embracing total liberalisation just as the Western system spiralled into an asymptotic bubble trajectory, asserting Russia’s newfound economic stability by dismantling all capital controls. Unfortunately, whilst controls are relatively ineffective in preventing outflows, at the time outflows were not the problem; the problem was an excess of hot money looking for short term trading opportunities and where controls had been relatively effective was in discouraging the inflow of foreign hot money.

In the event, with the capital account thrown open, the “global carry trade” got underway in earnest; hedge funds piled into short-term rouble assets, given the perceived one-way rouble exchange rate risk, as well as local interest rates which, while negative in real terms, were well above the dollar cost of funding. These inflows, coupled with a strongly positive trade account, obliged the Russian Central Bank to run an inappropriately easy monetary policy so as to slow rouble appreciation; along with torrential capital inflows, this pushed domestic real interest rates into deeply negative territory – resulting in inflation, excessive currency valuation, and a serious misallocation of resources. Furthermore, since virtually all of the currency inflows were short term, they made no useful contribution to much-needed infrastructure investment or Capex; of course, when global risk tolerance collapsed, there was a violent reversal of capital flows, leaving the CBR to a desperate and ultimately unsuccessful attempt to preserve popular confidence in the currency and banking system by seeking to hold the rouble at an unsustainable level.

Perspectives –

Despite the occasional public calls for capital controls by hardliners in the Russian government, the Central Bank is fully aware that the time for currency controls is when the money is pouring in – when the cash pours out, controls prove extremely porous. Indeed, by triggering precautionary capital flight, they generally prove counterproductive, especially in a country as skilled as is Russia in the evasion of administrative controls. As recently affirmed by Mr. Putin himself, for now, the game will continue to be played by the old rules.

Perhaps the most successful aspect of the anti-crisis package has been the shoring up of the Russian banking system. There have been no disorderly bank failures; the level of popular and corporate bank deposits has been broadly maintained; and while NPLs are rising (and recent

© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -3 -

changes in CBR bank reporting regulations certainly have not enhanced clarity), their absolute levels do not threaten Russian macroeconomic stability.

At present, global credit markets have begun to recover, and indeed, a few top-rated Russian entities have managed to raise substantial new finance, while a larger number have successfully negotiated roll-overs of their existing credit lines.

By cutting back on the systematic official (non-bank) support for Russian companies faced with foreign debt maturities, the government is encouraging these to continue to seek negotiated arrangements with their foreign creditors – who may find it in their own best interests to maintain a cooperative relationship with their solvent but illiquid borrowers. Given that those companies able to do so took advantage of the stepwise rouble devaluation to purchase foreign currency sufficient to meet their 2009/2010 obligations, any defaults on foreign bonded debt will likely be confined to a couple of very minor issuers. On the other hand, we would not expect Russian corporates to gain meaningful access to global capital markets in the foreseeable future.

2. Commodities Although the Russian government has long been cognizant of the risk posed by excessive dependency upon the global commodity cycle, in practice, this dependency has proved exceedingly difficult to break. Russia is by nature a major exporter of energy, minerals, as well as an increasingly important force in the global agricultural commodities market. Thus, during the commodity up-cycle, cash pours in, driving currency appreciation, inflation, and crowding out non-commodity economic activity. The down-cycle of course is marked by rapid economic deceleration, credit squeeze, and deflation.

To date, the most successful attempts at industrial diversification have involved Russian exporters moving up the commodity value-added chain, e.g. from export of iron ore and slab steel to high- value added speciality steels; from natural gas to fine chemicals; from pulp and lumber to coated paper and furniture.

Tacit the occasional nanotechnology fantasy, the development of domestic manufacture has been most successful as regards import substitution – including food products, building supplies, and especially, the domestic manufacture of foreign automobile marques. For the latter sector, Russia’s politically-motivated exclusion from the WTO has proved a blessing in disguise, sheltering the domestic market for foreign car manufacturers established in Russia.

Perspectives -

For the foreseeable future, Russia’s relative correlation with the commodity cycle should be taken a given. There is no clear consensus as regards medium-term price trends in global commodity markets, although we suspect that market participants may have swung from excessive bullishness to unjustified pessimism. While economic activity in the West will almost certainly continue to decline, this will be at least partially offset by resource-intensive government mandated infrastructure spending.

Nevertheless, the continuation of the Chinese growth miracle now constitutes the sole realistic hope for avoiding a prolonged recession/depression. Quite fortunately, one would do well to discount much of the pessimism in the press as regards the ability of China to reflate. Whilst China is faced with the daunting task of reorienting export-driven manufacturing activity towards a huge and deeply undersupplied domestic market, it benefits from a high degree of political centralization and is thus able to rapidly implement radical policy directives; after a decade of contracyclical fiscal and monetary policy, China has a huge stock of ammunition – a combination of a deep budget surplus and the world’s largest currency reserves.

The first, encouraging signs of resumed Chinese demand include a modest rebound in global iron ore, coke and steel prices. Similarly, having collapsed by an unprecedented 90% last year, the Baltic Dry Index, the primary index for global bulk shipping costs, has more than doubled on growing Chinese demand. With agricultural production having collapsed in numerous geographical locales

© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -4 -

due to accelerating climate change as well as the drying up of agricultural credit, export grain prices should rebound within the next 18 months.

The key question is, of course, the oil price. It seems likely that a bottom was found in late 2008, with Brent repeatedly bouncing off of the $40 level on Brent since last December. Whilst the market has focused on demand destruction, destruction of supply has been neglected – at current prices, numerous marginal oil sources, from Canadian oil sands to deep-water offshore drilling, US stripper wells, much Kazakh production, and most alternatives including biofuels become economically unsustainable. OPEC is showing remarkable discipline, and there are modest signs of cooperation among some non-OPEC oil producers.

Meanwhile, the great oil fields are declining at variable rates – Indonesia is now a net importer, Mexican production is collapsing, and whilst the terminal phase in North Sea production has been delayed, the final slope of this decline will be extremely sharp. Although new oil sources will continue to be found, the easy oil has already been drilled, and marginal production will be feasible only at prices closer to the 65-85$ range where we see oil prices ending the year.

As regards the demand side, although it is a fair bet that the United States will never again import as much oil as it did in 2007, the US is no longer the top source of incremental demand. Amazingly, in January – for the first time in history – Chinese consumers bought more cars than did Americans (and it should be noted that American automobile sales are net-net replacement purchases, while Chinese sales represent new cars on new roads).

3. Capital flows Foreign investment capital has flowed out of all emerging markets, with global capital markets closed to Russian (indeed, to all EMEA) equity offerings since October 2008; they look to remain so for the foreseeable future. As regards debt markets, only the top-rated borrowers can raise new money – and this is considerably more expensive than in the past.

While some very alarming numbers have been reported for Russian capital flight, in fact, much of this has simply been Russian entities purchasing dollars/Euros, either to fund upcoming debt maturities and bond buy-backs, or simply for wealth preservation. Correspondent accounts with the Central Bank of Russia have surged as the Russian corporate sector has switched reserves into foreign currencies; despite the currency shift, these reserves remain available to their Russian owners.

As regards FDI, at least until recently, the vast majority of foreign companies doing business in Russia have been highly profitable – when polled, a majority confirmed their intention to maintain or increase their investments in what remains a secular growth market. We would contrast this with the situation in China, where despite a more charitable treatment in the press, one would be hard- pressed to name 5 Western companies making money on their domestic operations.

Perspectives –

The best news here is that the situation cannot further deteriorate – capital raising simply cannot fall below zero! Indeed, it could be argued that, unlike long-term foreign direct investment which has clearly been beneficial, the opening of the Russian market to speculative foreign capital flows has reliably proved disastrous; Russia may well do best when forced to rely primarily upon her own internal resources.

And the Missing Horsemen:

Unlike many of its emerging market peers, Russia is relatively immune to miscellaneous scourges facing the developing economies, and which threaten a number of Latin American (Mexico, Argentina), EMEA (Ukraine, Georgia, the Baltics, Hungary) and Asian (Indonesia, Thailand, Philippines, Korea) countries with economic collapse:

• Plunging global demand for manufactured goods © Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -5 -

Russian exports are primarily in the commodities sector – and the main driver here is likely to be Chinese industrial activity. Manufactured exports are limited to military (a growth sector in troubled times), nuclear power generation, and relatively cost-effective heavy industrial machinery (turbines, power generation, etc.) suitable for the needs of the developing countries – where at least some infrastructure spending is likely to be maintained.

• Inability to fund the current account deficit due to collapse in remittances/bond markets/exports Russia has no indispensible import requirements, being self-sufficient in all major commodities and basic foodstuffs. In a worst-case scenario, Russia could survive without Mercedes motorcars and French cheese for an unlimited period. Remittances are a negative item on the balance sheet, and the Federal government has virtually no foreign debt to refinance.

• Political instability With due respects, reports of Russian political unrest are laughable. Whilst a number of EMEA governments are breaking under the stress, Russia remains remarkably quiet. We would note that the Western press, always desperate for bad news as regards Russia, has been recycling a single demonstration by Vladivostok used car dealer for nearly three months now… Those of us who lived through the 1998 crisis were stuck by the total absence of popular protest – as the crisis worsened, people returned to their dachas to plant potatoes. Perhaps the experience of seventy years of collectivist rule durably chilled the popular enthusiasm for revolution.

As regards the international context, the crisis has diminished any Western ardour for confrontational politics, the opening of new military fronts, or expensive missile systems; a substantial improvement in US-Russian relations is thus to be expected. Similarly, some of Russia’s neighbours, previously fixated upon comprehensible but perhaps outmoded historical grievances, will now have far more important matters to attend to – in the current climate, even modest Russian investment capital flows will likely receive a warm welcome.

• Economic fragility Despite claims by the western kommentariat that the Russian politico-economic system lacks flexibility, in fact, it is far more flexible than that of most developed economies. Downward adjustment of wages and staffing levels can occur virtually overnight, with production simply halted until inventories are reduced to the desired level – as indeed happened during the January 2009 period (resulting in industrial production numbers which were dramatic but quite misleading).

In summary, while our readers are undoubtedly familiar with the inefficiencies of the Russian economy, this does have a silver lining: no manufacturer in his right mind would attempt to set up a just-in-time supply chain in Russia. After 20 very eventful years, like an old Lada automobile, much of the local industrial fabric is relatively inefficient, but at least, admirably fault-tolerant.

© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -6 -

Although we would expect to see further discouraging numbers through the first half of 2009, the period of maximal stress was apparently reached in October-November 2008; after a sharp rouble devaluation, successful support for the banking sector, and the recycling of official Forex reserves into the corporate sector, the increase in non-payments which mushroomed out in Q4 2008 has been almost entirely reabsorbed.

Although our view is temporarily unfashionable, we continue to expect a gradual differentiation between the potentially high-growth BRICs countries and the old economies of the West. Those wishing to predict the timing of a Russian rebound would do well to keep a close eye on Chinese growth trends. Whilst the financial disruption in Russia has been severe, the financial system has survived the stress test, and policy of both the Central Bank and the finance ministry are broadly appropriate. Over the next couple of years the opportunities in financial markets will likely match those enjoyed by investors in the 1998 post-crisis period.

This message is provided for informational purposes and neither the information nor any opinion expressed herein constitutes an offer, or an invitation to make an offer, to buy or sell any investment funds, securities or any options, futures or other derivatives related to such securities.

Investment in emerging markets bears a high degree of risk, and is not suitable for all investors. This report is based upon information we believe to be reliable, however it is provided solely as an intellectual exercise, and no investment decisions whatsoever should be based upon it, in full or in part. In particular, investing in securities, including Emerging Markets securities involves a great deal of risk and investors should perform their own due diligence before investing.

Currency crisis is gathering storm

In the last few weeks, the currency market is where the action has been. We have witnessed massive moves in every major currency and in some not so major ones. To my mind, all of this is a prelude to some sort of currency crisis.

This crisis has been sneaking up on us as most of us have been transfixed by the US subprime crisis and the subsequent credit crisis. For some currencies, it has been a sickening ride. The US Dollar plunged to 1.60 to the Euro only to snap back viciously down to 1.25. The US Dollar plummeted to below 2.10 to the British Pound but is now above 1.60. All of this in the space of a few months.

But, it is in commodity and emerging market currencies where the trouble is brewing. First, we saw a nightmarish plunge of the Australian and Kiwi Dollar as commodities plummeted. This all out assault on commodity and emerging market currencies then widened to include the Icelandic Krona, the South African Rand, the Polish Zloty, the South Korean Won, the Hungarian Forint, and the Mexican Peso amongst others.

This speaks to hot money fleeing emerging markets wholesale as the carry trade started to unwind. And I have slowly started a drumbeat of concern regarding these events. However, today, I caught two interesting perspectives on this debacle that made me blanch. One was the cover story in the Economist.

A few months ago, many emerging economies hoped they could take mass casual leave from the credit crisis. Their banks operated far from where the blood was being shed. The economic slowdown evident in America and Europe was regrettable, but central bankers in many emerging economies, such as India and Brazil, were busy engineering slowdowns of their own to reverse high inflation. They were more interested in the price of oil than the price of interbank borrowing.

This detachment has proved illusory. The nonchalance of the RBI’s staff, for example, is not shared by the central bank’s top brass, who, a day before the strike, cut the bank’s key interest rate from 9% to 8%, having already slashed reserve requirements earlier this month. Their staff’s complaint about pensions looked quaint on the day that Argentina’s government said it would nationalise the country’s private-pension accounts in what looked to some like a raid to help it meet upcoming debt payments. The IMF, which has shed staff this year because of the lack of custom, is now working overtime (see article). The governments of South Korea and Russia have shored up their banking systems. Their foreign-exchange reserves, $240 billion and $542 billion respectively, no longer look excessive. Even China’s economy is slowing more sharply than expected, growing by 9% in the year to the third quarter, its slowest rate in five years.

The emerging markets, which as the table shows enter the crisis from very different positions, are vulnerable to the financial crisis in at least three ways. Their exports of goods and services will suffer as the world economy slows. Their net imports of capital will also falter, forcing countries that live beyond their means to cut spending. And even some countries that live roughly within their means have gross liabilities to the rest of the world that are difficult to roll over. In this third group, the banks are short of dollars even if the country as a whole is not.

-A taxonomy of trouble, Economist


This article makes a compelling argument for expecting emerging markets to be the next leg down in this metastasizing credit crisis. And the Economist devotes much more space to this emerging problem (pun intended).

But, the analysis penned by Ambrose Evans-Pritchard is what really caught my eye. He makes the case for us to worry about a full-scale currency crisis worse than the 1931 currency crisis of the Great Depression. The link: Bank credit. You can think of Sweden in the Baltics, Austria in Central Europe, Spain in Latin America -- and you begin to picture the interconnectedness that will imperil Europe's banking system much more than either Japan's or America's.


The financial crisis spreading like wildfire across the former Soviet bloc threatens to set off a second and more dangerous banking crisis in Western Europe, tipping the whole Continent into a fully-fledged economic slump.

Currency pegs are being tested to destruction on the fringes of Europe’s monetary union in a traumatic upheaval that recalls the collapse of the Exchange Rate Mechanism in 1992.

“This is the biggest currency crisis the world has ever seen,” said Neil Mellor, a strategist at Bank of New York Mellon.

Experts fear the mayhem may soon trigger a chain reaction within the eurozone itself. The risk is a surge in capital flight from Austria – the country, as it happens, that set off the global banking collapse of May 1931 when Credit-Anstalt went down – and from a string of Club Med countries that rely on foreign funding to cover huge current account deficits.

The latest data from the Bank for International Settlements shows that Western European banks hold almost all the exposure to the emerging market bubble, now busting with spectacular effect.

They account for three-quarters of the total $4.7 trillion £2.96 trillion) in cross-border bank loans to Eastern Europe, Latin America and emerging Asia extended during the global credit boom – a sum that vastly exceeds the scale of both the US sub-prime and Alt-A debacles.

Europe has already had its first foretaste of what this may mean. Iceland’s demise has left them nursing likely losses of $74bn (£47bn). The Germans have lost $22bn.

Stephen Jen, currency chief at Morgan Stanley, says the emerging market crash is a vastly underestimated risk. It threatens to become “the second epicentre of the global financial crisis”, this time unfolding in Europe rather than America.

Austria’s bank exposure to emerging markets is equal to 85pc of GDP – with a heavy concentration in Hungary, Ukraine, and Serbia – all now queuing up (with Belarus) for rescue packages from the International Monetary Fund.

Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain. The US figure is just 4pc. America is the staid old lady in this drama.

Amazingly, Spanish banks alone have lent $316bn to Latin America, almost twice the lending by all US banks combined ($172bn) to what was once the US backyard. Hence the growing doubts about the health of Spain’s financial system – already under stress from its own property crash – as Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall.

Broadly speaking, the US and Japan sat out the emerging market credit boom. The lending spree has been a European play – often using dollar balance sheets, adding another ugly twist as global “deleveraging” causes the dollar to rocket. Nowhere has this been more extreme than in the ex-Soviet bloc.

The region has borrowed $1.6 trillion in dollars, euros, and Swiss francs. A few dare-devil homeowners in Hungary and Latvia took out mortgages in Japanese yen. They have just suffered a 40pc rise in their debt since July. Nobody warned them what happens when the Japanese carry trade goes into brutal reverse, as it does when the cycle turns.

-Europe on the brink of currency crisis meltdown - Ambrose Evans-Pritchard, Telegraph


When the markets open on Monday, I expect the crisis in Emerging markets to take top priority. Iceland was the first victim of this crisis. The dreadful events there should be a warning to policy makers to address this now or else we could see some awful writedowns at European institutions in the very near future -- not to mention the potential economic destruction this turmoil could cause.