The decline of US credibility is complete after the humiliating death of Saddam Hussein and the sharp escalation of violence in Iraq that followed it. News editors of US television channels describing the situation as “the United States is losing the war in Iraq” clearly failed English grammar at school, by mixing up their gerund-participle in place of the appropriate past participle, ie, “the United States has lost in Iraq”.

The fact that America’s moral obligations have not kept pace with its technological capabilities has been brought to the fore once again, by the country’s attack on Somalia’s apparent sanctuaries for al-Qaeda this week, even as the US forsakes any responsibility toward the innocent victims of Sudan’s genocidal leaders. It is a matter of some wonder to observers that a US administration can practice non-intervention in the same breath as active bombardment.

The malaise is not only American, as other countries such as Britain appear equally culpable, albeit of other offenses. The suspension of an investigation into alleged bribing of members of the Saudi royal family by a British defense contractor was explained as a measure to safeguard English jobs. That economic interest has been at the forefront of all societies’ cultural, religious and moral evolution has already been covered in a previous post; [1] I only bring this story up to highlight the more generic disease prevalent across the Western Hemisphere.

It isn’t only in the area of foreign policy that such hypocrisy is evident. Environmental concerns have also caused Western leaders to leap headlong into denial, adopting the same strategies of pseudo-science that tobacco companies used in past few decades to pooh-pooh links between smoking and cancer. I wrote in a previous article [2] that Islamic terrorism may produce the unintended consequence of reducing global warming, in essence by scaring over-consuming Western societies into actually changing their habits.

None of this would matter but for the fact that North America and Europe are hopelessly addicted to cheap financing and rising import demand (respectively) from emerging superpowers. It would be erroneous to assume that the latter group needs the former; instead it is the other way around. Why then are global financial markets showing less risk than would otherwise be prudent?

The emperor has no clothes, darling

Eloquence can be defined as the ability to describe the balloon-smuggling star of Baywatch, Pamela Anderson, without using one’s hands. In much the same way, watching a number of financial news channels, I am struck by the inability of any commentators to explain the low returns in US financial markets without using their hands to draw elaborate castles in the air. Seeing as most of these channels are US-owned, perhaps they are not permitted to utter the obvious truth, which is that US bonds and stock values are inflated.

With even ill-tempered minnows such as Venezuela thumbing their noses at American officials, it is almost surreal to observe the continued stability of financial markets, which observation brings into focus the role of the biggest holders of US debt. Rather than being beholden to the stability of the US economy, countries such as China and those in the Middle East are merely withdrawing air from the bubble ever so slowly.

The expected rise in bond yields this year, and concomitant expectations for a decline in US stock valuations, are already being reflected in financial markets, which currently show surging enthusiasm for all things non-American. There has been no need thus far to effect a “zero-sum” approach of selling one group of financial assets to buy another, because of ample global liquidity. The decline in oil prices of late is actually negative for that liquidity as it reduces the surpluses.

Smart money, though, is chasing returns away from the US and even the European Union. While that strategy by itself leaves much to be desired, at least it proves more defensible than the air of resignation that surrounds anyone forced to invest in the US economy.

The catalyst

Chinese banks pay their depositors less than what US banks pay theirs. Even so, the former cannot keep away their surpluses, which eventually wind their way back through the financial markets to the US. But this calculation only works as long as the returns on US assets exceed the currency-adjusted return for Chinese banks. In the past two years, that was certainly not the case, as the Chinese currency appreciated more than the nominal yield differential between the two classes of assets.

While this loss may have been bearable a few years ago when China had less than US$150 billion in foreign-exchange reserves, its current position of more than $1 trillion means that even a 1% loss as described above translates into a mind-boggling figure of $10 billion. In practice, the Chinese government loses more than that every year to keep the peace with the Americans and Europeans.

On the benefits side of the equation, China gets to keep manufacturing jobs that could otherwise be lost – albeit not to North America or Europe, but rather to other Asian economies lower down in the manufacturing value-addition scale, such as India and Vietnam. The forsaking of domestic demand for this purpose is going to look, at some stage, like an overly high price to pay. I expect that between a sudden decline in property or stock prices and continued pressure from the US administration, China will push through a staggered revaluation of its currency against the US dollar this year and next.

Market reaction

Financial markets are already signaling this eventuality, as the rising prices of Chinese financial companies now show. The country’s largest bank and its largest life-insurance company are, respectively, the third- and second-largest by market capitalization in the world. Behind this creditable achievement lies the expectation of foreign investors to benefit from significant currency appreciation, rather than any overt trust in the fundamentals of such companies.

Chinese banks continue to face huge challenges, ranging from their excessive deposits to their large and growing book of problem loans. Meanwhile, Chinese insurance companies face the threat of a staggeringly quick demographic decline, which, when measured against the poor returns on less risky assets in the country, implies that growth in overall income is likely overstated.

Thus the primary reason for investors to partake of such assets, at inflated prices, is the expectation that they can profit from the rise before any downturn. Investors in US or European assets can hardly complain on this front, seeing as the assets they are holding appear equally subject to overoptimistic valuations. At one stage during the emerging markets crisis of the late 1990s, the value of one US company exceeded the combined market capitalization of all emerging markets. It is the natural order of things that the boot is now on the other foot.

In summary

If the sting of a scorpion surprises a burglar, he is caught between the need to scream, risking capture, or silently bearing the pain before gingerly withdrawing into the night. Much the same logic rules the financial markets these days, where the poor returns to be had in the US markets have driven many investors to search for alternatives, even if these appear overvalued themselves.

This global epidemic of pseudo-logic will end in tears for many investors, but at least the people with the real savings have the ability to recover, which the US economy appears to lack.

1. See It’s the money, honey, Asia Times Online, December 22, 2006.
2. See Eco-friendly terrorism, Asia Times Online, September 30, 2006.