Sailors are famously more wary of fire than wind. They are well-trained to handle the odd typhoon or five but find it much more difficult to battle a fire on board, especially while carrying flammable cargo. This is roughly the situation facing Asia over the course of 2008, with the region’s business community braced for the likely recession in the US that threatens to worsen before any improvement can be discerned, even as they have to look around for dangers much closer to home.
In my review for 2007 (Annus financialitis Asia Times Online, December 22, 2007) the scope of the damage to the global financial system was laid out, with a conclusion that Asian economies could perhaps push through the difficult period if their central banks or governments changed the excessive dependence on exports to domestic consumption. While volatility in economic performance is a given, there were enough reasons to presume elemental shifts that engender positive results.
Some of that may have changed in the last few days of 2007. Firstly, the damage to global investment banks is worse than previously assumed, as extrapolation of current market levels on difficult-to-value securities (Level 3 assets in the bromide parlance of accountants) at the end of 2007 implying that some investment banks have wiped out their entire capital base. Their capital raising with Asian central banks and investment companies highlight their desperation, but the joke may eventually be on the Asians as they realize that they were suckered into buying assets that are in essence worthless rather than merely being worth less (ah, the wonders of semantics, which allow a simple space bar push to determine the difference between a company with 30 billion in capital and one without any capital at all). I will come back to this point later.
Secondly, rising security risks have assumed greater urgency in light of events in Pakistan and Russia over the past few weeks. Make no mistake the assassination of Benazir Bhutto is part of my central hypothesis of Pakistan’s nuclear weapons falling into the hands of rabid fundamentalists (Playing South Asia’s World War III game Asia Times Online, November 17, 2007). Tied to a president who has unfortunately cried wolf too many times , strategic options for the US are severely limited at this stage.
Yes, the American public is generous in its accommodation of flawed presidents in their last year in office, but even they may choke at the possibility of a war on Pakistan. That limits options to either letting the unpopular President Pervez Musharraf continue in power or endorsing the more Islamist-democratic option of Nawaz Sharif as premier. A classic Devil vs. Deep Sea choice, and one entrusted to a lame duck president to boot. The sole winners are the Islamic fundamentalists, whose ability to recruit will improve dramatically in coming months even as they become kingmakers in Pakistan over the near term.
As if the US economy and Pakistan weren’t enough to worry about, Russia has wandered into the geopolitical chessboard like a bear nursing one hangover too many. President Vladimir Putin appears keen to open a last strategic front against the US before he leaves office – at least formally – this year. This is most likely to be in the parts of Russia bordering restive Asian states such as Iran and Afghanistan, even if the immediate strategic priority should be westwards towards Europe. The entry of Russia into the quagmire would immediately elicit responses from other regional powers including China and India, not to mention the suitcases filled with gold coins (no US dollars, thank you) that will leave Riyadh airport almost immediately.
Japan and Asia
What I described at the beginning of December as an emerging trend quickly cascaded into the central capital-raising plan for US investment banks by the end of the month. As results for the year ended December 31 are being prepared by major commercial banks, it is quite likely that more capital raising will follow, especially given the rock-bottom prices recorded on some securities during December.
There is another disturbing aspect to the financial meltdown being seen by the various US commercial and investment banks. This pertains to the potential for one of these firms to actually go bust in coming weeks, in turn triggering a failure to pay on various derivative contracts. Now, these contracts have been cited as the major reason for many banks to claim their “net” exposure is small, therefore if any link in the chain fails, the entire chain may collapse.
Imagine that you have a billion dollars of loans to a housing developer, and you bought credit protection from one of your competitors. The net exposure to the housing developer would then be shown as nothing, therefore meaning that you have no danger of losing money if that developer goes out of business. Now if your counterparty fails, you have that exposure straight back on your books, with nowhere to hide as other firms will probably now refuse to provide default protection on this developer.
Bank audit committees can no longer pretend that many of their vaunted “triple A” securities are anything of the sort, or that they are fully hedged on some assets just because they bought protection from another firm that looks just like them across the street. At best, the assets are worth between 20 and 30 cents on the dollar based on the trades seen in December , while calculations for net exposure will have to rise sharply. This erosion of capital is perhaps the reason why a number of investment banks rushed to shore up their capital by entering into capital structure deals with their accommodative Asian friends. As I wrote in my year-end review cited above, the capital injections will prove insufficient and it is quite likely that Asian investors will lose billions.
Parallels can be drawn to the surge of Japanese investments into the United States during the late 1980s and early 1990s, in deals that led to the acquisition of large tracts of prime real estate and Hollywood studios by Japanese conglomerates. In pretty much every one of these situations, Japanese investors lost money and some even had to file for bankruptcy. Ironically enough, one of the largest Japanese banks that funded such foreign acquisitions eventually fell into the hands of a US private equity firm.
The “pioneering” work of Asian central banks buying stakes in American banks and investment houses thus will come to naught as the real depth of the crisis takes hold. Without capital, these banks will have to offload billions of non-core assets. These include strategic stakes in a number of Chinese banks that will probably flood the stock market before Chinese New Year celebrations can begin in earnest in February.
That set of stake sales will probably be the first blow to regional stock markets this year. Following from there, I would expect other technical factors including the potential for currency regime changes, US economic weakness and reduced earnings multiples to cause further declines in stock markets.
Still, there is enough domestic money chasing stocks in China and India, while foreign investors remain committed to the region. This trend argues for quick reversals of share price declines for these markets over the course of 2008.
In the context of economic weakness in the US and Europe, it is likely that investors will continue to increase their exposure to emerging markets, especially as the strategy produced rich returns in 2007. In that light, much of the preceding discussions on the weaknesses of the US financial system appear to strengthen the case for further improvements in the Asian story this year.
That view however ignores what is known as the crowding-out effect, wherein the presence of an attractive and large asset causes the diminution of other assets in its class. Thus, if a liquid government bond were available at 5% yield, no one would really care to buy a company bond at 5.1% as the incremental yield does not compensate for credit quality and liquidity differences. This would push the yield on the latter to perhaps 6% before anyone bothers to be interested. I wrote about this in a previous article (Vanishing minnows Asia Times Online, December 1, 2007).
This is a central risk for Southeast Asian stock markets, as well as others around the region such as Pakistan over the course of 2008. Why should investors have to deal with political turmoil such as what is being seen in Thailand and Pakistan when they can make similar returns without the drama in larger (and hence more liquid) markets such as China and India? Herein lies the major story for 2008, which is increased separation of asset performance across Asian markets and economies. By the end of this year, I very much doubt that anyone will have a unified story to tell about the region.
1. Crying wolf: first, Afghanistan, where the “war on terror” was started in earnest some seven years ago with the ostensible intention of flushing out terror luminaries such as Osama bin Laden and Mullah Omar, has gone really nowhere. Second, the mess in Iraq with respect to weapons of mass destruction, and we all know how that’s going. Third, the fracas over the course of 2007 with respect to Iranian nukes, until the CIA buried that story.
2. Readers with spare time should take a look at the acquisition of E*Trade by Citadel, a hedge fund, at the beginning of December. A number of collateralized debt obligations (CDOs) owned by E*Trade were bought at around 27 cents on the dollar, and while investment banks may well have better quality collateral and structures, they will find it difficult to argue that their CDOs are still worth over 80 cents on the dollar given this transaction.