01-Jul-2005

>Global Nuggets-1

BIS: "Time might well be running out"

By now quite a few people have noticed the truly impressive annual report from the Bank for International Settlements, the world's central bankers. So far, so good was published on Monday to coincide with its Annual General Meeting. If you have time to read only one report a year on the state of global financial markets, this surely is it.

The good news is that the world economy is on track to deliver another year of
-> subdued inflation and
->robust growth, approaching 4%.
->But there is also "a growing sense of unease that it might not last.

Imbalances are the central theme of the report: "there has been little progress in tackling internal and external imbalances." These imbalances "could unwind with a potentially disruptive impact", and "time might well be running out" to tackle them:

One simply cannot ignore the number of indicators that are now simultaneously exhibiting marked deviations from historical norms. Among the internal imbalances that compel attention, real policy rates in many industrial countries and in emerging Asia continue to hover around zero. Nominal rates on long bonds, as well as credit spreads and measures of market volatility, are remarkably low. The household saving rate in many industrial countries has been trending sharply downwards, and debt levels are at record highs. House prices in many countries have never been higher. And in China, the investment ratio has risen to a startling 50% of GDP. Finally, external imbalances have never been larger in the postwar period. Any or all of these numbers might well revert to the mean, with associated implications for global economic growth. Such an unwinding might be gradual, and possibly benign, but it could also be rapid and disruptive. In large part, what happens will be determined by real-financial interactions that we should not pretend to fully understand.

Both Calculated risk and Macroblog have highlighted the report's call for a smaller US budget deficit, by cutting expenditure and raising taxes. Meanwhile the ever-widening US current account deficit:

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“US recession much closer than imagined”

The chances of a United States recession or even a decline are closer than imagined warned Bill Gross, an influential financial guru who manages the largest mutual fund in the world with assets of 450 billion US dollars.

“US officials are close to running short of fiscal and monetary fuel (cutting taxes and interest rates) which they have been using to promote growth”, and when options run out, a general softening can be expected.

“Assets could cease to expand at two digits, scarce inflation and meagre economic growth could wither and Rome will be up in flames”, anticipates Mr. Gross adding that if “Rome is up in flames yields of long term bonds will predominate, and that day can be much closer than we expect”.

Mr. Gross believes that United States low interest rates, lower taxes and the overall weakness of the US dollar have caused the real estate and stock exchange markets to soar, as well as boosting consumption.
But there has been no investment or jobs, which have gone instead to Asia.

“The legs of this US recovery are weak because they are based on an appreciation of assets and the appreciation of future assets is intrinsically vulnerable given the debilitated stimuli from interest rates”, argues the mutual fund guru.

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A little thought:

EXCERPT FROM THE US CONSTITUTION, Article I, section 10: No State shall ... coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts....

FROM THE US TREASURY WEBSITE: "Federal Reserve notes are not redeemable in gold, silver or any other commodity, and receive no backing by anything. The notes have no value for themselves, but for what they will buy."

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Too Much Money
A global savings glut is good for growth -- but risks are mounting


Savings. It's an almost mystical word for economists -- the Holy Grail of growth. The more a country saves, the more it has available to invest. And the more it invests -- in computers, factories, or infrastructure -- the more productive its economy becomes and the faster it can grow.

The U.S. seemed to be setting itself up for years of (really??)
->rising interest rates,
->subpar investment, and
->sluggish economic growth.


But that's not what is happening.

->Long-term interest rates are falling and have now dipped below 4%.
->The total of residential and business investment has been rising and now stands at 16.5% of gross domestic product, well above the average for the 1990s.
->And there are few signs that the economy is stalling.


These surprising events are forcing economists, investors, and policymakers to think more globally than ever before.In just the past few months, they've begun to consider seriously two intertwined and heretical notions:

What really matters for interest rates is the global economy, and there the problem may be too much savings, rather than too little.

->Look around the world, and extra money is piling up in all sorts of places.
->Japanese corporations are recording record profits, but not doing much spending.
->Chinese companies are on an investment tear, but the country is getting so much money from exports that it has billions to spare, including $18.5 billion that China National Offshore Oil Corp. (CNOOC) bid for Unocal.
->The surge in oil prices -- now about $60 a barrel -- is giving oil-producing countries such as Russia and Saudi Arabia far more money than they can use right away.
->And the aging workers of Europe are building nest eggs for an uncertain future.
->Even in the profligate U.S., businesses have been accumulating huge sums as undistributed corporate profits -- running at a record annual rate of $542 billion in the first quarter -- have almost doubled in the past two years.

The International Monetary Fund predicts that in 2005 the worldwide savings rate should hit its highest level in at least two decades.

This unexpected surge of savings is like a rose with thorns.
->Low interest rates have the potential to power productivity, build wealth, and raise living standards throughout the world.
->As more and more workers in developing countries join the global economy, cheap money makes it easier to provide the equipment and infrastructure they need to prosper.
->Access to global savings has also enabled the U.S. private and public sectors to fund a big increase in housing construction and health-care spending in recent years, while simultaneously ramping up military outlays.
->The result: guns and butter -- all without boosting inflation or pushing up interest rates.

Skittishness
But the savings glut is creating new risks for the global economy, which is having a tough time absorbing the unanticipated flood of funds.
->Instead of going into productive investments, cheap money may be overheating spending and sending asset prices soaring too high, setting the stage for a future bust.
->"The odds of a catastrophic scenario have gone up," says Kenneth S. Rogoff, former chief economist at the IMF and a professor at Harvard University.
->A unexpected rise in inflation or interest rates could tank the bond market and burst the global housing bubble, which now stretches from Barcelona to Shanghai to San Francisco.
->Doubt about the U.S. ability to finance its huge trade deficit could trigger a steep downturn in the dollar and a monetary crisis.
-> China's factory-building spree may leave it saddled with excess capacity for years to come.
-- Prices for cold-rolled steel and ethylene have already dropped sharply, and auto prices have fallen as much as 20% in the past 12 months.

"It's going to be very tough for those guys who own factories," says Morgan Stanley (MWD ) economist Andy Xie, "and a lot of them won't pay the banks."

History shows that excess liquidity can disappear overnight if investors start getting skittish and lose confidence, causing severe disruptions to markets that have gotten used to cheap money.

The global savings glut also forces investors to operate without many of the signposts they used to depend on.
->In the past, they could afford to concentrate their attention on what was happening in the U.S. If the Fed tightened credit or if the federal budget deficit swelled, long-term interest rates tended to rise in response.
->But now, in a global economy awash with savings, investors have to be much more aware of what's happening outside the U.S.
->If China revalues its currency, that could push up U.S. rates because it would mean that Beijing would eventually have a smaller surplus to invest in Treasury securities.
->If the European Central Bank eased credit, that could lead to lower U.S. bond yields -- even if the Fed were raising rates at the same time.

Global savings -- which the IMF estimates at roughly $11 trillion in 2005, almost the size of the whole U.S. economy -- is the excess of the combined income of the world's nations over their combined consumption.
That excess has grown fast in recent years, freeing up resources for investment.
What's more, the increased globalization of capital markets has unlocked national savings, making for an easier flow from one country to another.

But for many investors, the question is not whether there is a global savings glut, but how long it will last.
And on that score, there are plenty of reasons to expect it to continue for a while.
->First, the rise in oil prices worldwide is causing a massive transfer of wealth to oil-producing countries.
->Russia's trade surplus, for example, is running at $100 billion annually, up from $65 billion a year ago.
->Similarly, most of the Arab stock exchanges are at or near record levels. The UAE market, a combination of the Dubai Financial Market and Abu Dhabi Stock Market, is up 105% on the year. The Saudi stock exchange is up 65%. "High oil prices are producing huge liquidity," says Mustafa Abdel-Wadood, CEO of EFG-Hermes (UAE) investment bank.
For now, most of this money is being recycled to the global financial markets as savings rather than as investments in oil exploration and production or other productive uses.

Holding Back
->Demographic shifts are driving up savings as well, as aging societies in Japan and Europe accumulate funds for retirement. That's holding back both consumption and business investment, as many European and Japanese companies are cautious about committing much capital to expand their domestic operations.
->In Japan, the combination of weak wage growth and strong exports have boosted corporate profits, with a much smaller increase in business investment.
->The same story also holds in Europe. "Balance sheets of European companies are strong. Cash flow is strong. Everything is fine," says Herbert Lohneiss, CEO of Siemens Financial Services (SI ), the finance arm of the MunichWhat is not fine is that they do not invest enough."
->The reluctance to consume and invest is fueling enormous trade surpluses in Japan and Germany, in particular. The latest data from Japan show a current-account surplus of $171 billion for the year ended April, 2005. That's up from a surplus of $157 billion a year earlier. Germany, where domestic demand is flat and unemployment is in the double digits, is running a current-account surplus of over $100 billion over the past year. electronics and engineering giant. "


Surprisingly, the lag in business investment extends to parts of Asia as well, outside of China.
->For example, a Bank of Korea survey of 5,400 of the country's companies found that they were sitting on a record cash pile of $65 billion at the end of 2004.
->Yet there are no signs that spending on new plants and equipment, up a so-so 3.1% in the first quarter of this year, is accelerating. Indeed, South Korea hasn't recovered from a two-year slump in domestic demand. Household spending inched up 1.3% year-on-year in the January-to-March period, and the savings rate is still rising.

And then there are the staggeringly large Chinese trade surpluses. For years, economists reassured themselves that China's trade with the whole world was pretty well balanced, even if the country had a big surplus with the U.S. Those days are over. Now, China's trade surplus has more than tripled, to an annual rate of about $70 billion a year.

That $70 billion surplus is exactly that -- the extra income that China takes in from exports and that isn't used at home.
-> It's all recycled as savings into the global economy, in the form of purchases of U.S. Treasury bonds
-> and, lately, as stepped-up direct investment in U.S. companies. Analysts say CNOOC's bid for Unocal could herald a wave of Chinese takeovers of U.S. companies.

So far, the total impact on the world economy of all the savings sloshing around has been benign.
While demand is weak in some countries, cheap money is working its magic in other places, pumping up everything from investment in Chinese factories to the explosion of housing construction in Spain.

Mortgage rates in India, historically a country with a high cost of capital, have plummeted from 15% five years ago to 7.5% today. In fact, the world economy racked up its fastest growth rate in three decades last year with only a small rise in inflation rates.

"Unstable Equilibrium"
In the future, cheap money also could provide potent fuel for spending on new technologies, as soon as the next wave of innovation gets juices flowing again.

Already venture capital funds, flush with cash, are putting more money into alternative energy startups, an increasingly attractive investment in a world of high oil prices.It's easier for companies to spend money on research and development when the cost of capital is low.And the boom of the 1990s shows just what can happen when a technological breakthrough -- in that case, the Internet -- arrives in a period when there's ample savings.

Economists, though, worry that the good times are built on shaky foundations and wonder when they will end. "We're in a highly unstable equilibrium," says Martin Barnes, managing editor of The Bank Credit Analyst. "There are so many things that are three standards of deviation from normal."

What worries economists is that most of the savings is going to one country.

U.S. alone is soaking up as much as three-quarters of the excess global supply of savings.

The result: a current-account deficit totaling $668 billion last year, or 5.7% of the country's GDP. And a further rise this year looks likely. Economists fret that at some point foreign investors and governments may tire of putting big sums into the U.S., triggering a steep decline of the dollar and a jump in U.S. interest rates.
So far, of course, that hasn't happened. Indeed, the dollar has risen 7% against a basket of major currencies this year, in part aided by Europe's woes.But New York University's Stern School of Business professor Nouriel Roubini says that is only delaying the day of reckoning and sees a danger of a bumpy landing for the dollar and the U.S. economy in 2006.


It's not only the sheer size of the U.S. borrowing that could be a problem. It's also what the money is being used for.
Unlike in the late 1990s, when the U.S. was tapping foreigners to help finance productivity-enhancing investment,
->much of today's borrowing goes to pay for the federal budget deficit and
->to fund a surge in house prices that many experts believe can't last.

Fueled by ultralow interest rates, house prices jumped a record 12.5% in the first quarter from a year ago.

The surge in prices has put homes out of the reach of the first-time buyers who are the lifeblood of the housing market.
"We have real problems in the housing sector that will [eventually] cause the economy a great deal of stress," writes University of California at Los Angeles professor Edward E. Leamer in a new report.

"The deterioration in credit quality in 2003 and 2004 could well show up in increased defaults in 2006 and 2007," says Martin Fridson, head of FridsonVision, a bond research service.

If global savings is channeled in the right ways, it can be a great boon for the world economy, enabling the sort of investment and risk-taking that fuel growth. But there's far too much evidence right now that low rates are encouraging behavior that could cause trouble. Hold on to your hats.

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TOP 25 QUESTIONS

What is the Universe made of?
What is the biological basis of consciousness?
Why do humans have so few genes?
To what extent are genetic variation and personal health linked?
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Are we alone in the Universe?
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What genetic changes made us uniquely human?
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How far can we push chemical self-assembly?
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Do deeper principles underlie quantum uncertainty and non-locality?
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How hot will the greenhouse world be?
What can replace cheap oil — and when?
Will Malthus continue to be wrong?

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