# The Influence of Foreign Investors



## Investor (2 May 2005)

At the start of 2003, foreign investors held 33% of the ASX market capitalisation. 

The hedge funds and "international hot money" became aware of the value buying in Australia and started buying big. This group started the bull market run from the trough of the current cycle. 

By the end of 2004, foreign investors held 40% of the now increased market capitalisation of the ASX.

Hedge funds have extracted over $200 million of capital gains from the WMR (WMC) takeover play. This is at the expense of local investors.

Hedge funds sold some ASX shares in March 2005 and started the decline in the market.

What am I getting at?

Never underestimate the power of this group to move market pricing. I try to keep track of their movements as best as I can.

Currently, there are around 10,000 hedge funds (around 7,000 are American) across the world with assets estimated at around USD 1 trillion. They operate on huge leverage with the attendant financial risks. I forecast that some will collapse over the process of time when the next major dislocation in global financial markets occur. 

Hedge funds thrive on volatility and exploit market mispricings or arbitrage.

Anyone wanting to know what happened when the most famous hedge fund in the world's history collapsed in 1998, can type in Long Term Capital Management (LTCM) on Google and read about the debacle. The Masters of the Universe that crashed down to earth. Alan Greenspan had to engineer a "cushion" to prevent contagion.


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## TjamesX (3 May 2005)

Investor said:
			
		

> Anyone wanting to know what happened when the most famous hedge fund in the world's history collapsed in 1998, can type in Long Term Capital Management (LTCM) on Google and read about the debacle. The Masters of the Universe that crashed down to earth. Alan Greenspan had to engineer a "cushion" to prevent contagion.




I've actually read the book about it all 'how genius failed - rise and fall of LCTM' 

It is an amazing story, they had the nobel prize winners for finance/economics and when it can down to it all - they failed in one of the most simple aspects of trading..... money/capital management.

They actually distributed I think $1 billion in profits to equity holders, only to become insolvent a year later!!!

TJ


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## TjamesX (3 May 2005)

Investor said:
			
		

> At the start of 2003, foreign investors held 33% of the ASX market capitalisation.
> 
> The hedge funds and "international hot money" became aware of the value buying in Australia and started buying big. This group started the bull market run from the trough of the current cycle.
> 
> ...




Where were you able to obtain this information from???

After reading LTCM story you definitly get the feeling that hedge funds are the X factor for the financial markets at the moment. But I was also under the assumption that true hedge funds only dabble in the equities market - because there aren't many true arbitrage opportunities??

Cheers
TJ


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## Investor (3 May 2005)

TjamesX said:
			
		

> Where were you able to obtain this information from???
> 
> TJ




From reading. 

Combination of The Economist (an international economics journal); BRW; The Bulletin; Financial Review.

Never assume anything about hedge funds. They are opaque in their modus operandi, have limited reporting requirements, do not have capital adequacy requirements and are unregulated.


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## Investor (11 May 2005)

I read the following on the internet this morning. It confirmed my suspicions about the hedge funds selling shares to cover losses on bonds held:

"In New York last night markets fell on concerns about a fifth consecutive day of oil price rises and worries over US hedge fund exposures to risk The markets decline came as oil reached US$53 per barrel amid concerns about supplies of fuel ahead of an expected rise in demand, while rumours abounded among traders that hedge funds were selling stocks because of trading decisions gone bad this year."


Some hedge funds also lost some money on the PRK takeover offer for VBA. It remains to be seen how extensive the issue is with some hedge funds going awry. Time will tell.


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## Investor (11 May 2005)

In 1994, John Meriwether, a previous Salomon Brothers bond trader, founded a hedge fund called Long-Term Capital Management. He assembled a team of traders and academics to create a fund that would profit from the combination of the academics' quantitative models and the traders' market judgement and execution capabilities. 

Investors, including many large investment banks, invested $1.3 billion at inception. But four years later, at the end of September 1998, the fund had lost substantial amounts of the investors' equity capital and was teetering on the brink of default. 

To avoid the threat of a systemic crisis in the world financial system, the Federal Reserve orchestrated a $3.5 billion rescue package from leading U.S. investment and commercial banks. In exchange the participants received 90% of LTCM's equity. 

LTCM had Nobel-prize winning economists Myron Scholes and Robert Merton, as well as David Mullins, a former vice-chairman of the Federal Reserve Board who had quit his job to become a partner at LTCM. These credentials convinced 80 founding investors to place the minimum investment of $10 million apiece. Merrill Lynch purchased a significant share to sell to its wealthy clients.

LTCM's main strategy was to make convergence trades. These trades involved finding securities that were mispriced relative to one another, taking long positions in the cheap ones and short positions in the rich ones. There were four main types of trade: 

- Convergence among U.S., Japan, and European sovereign bonds;
- Convergence among European sovereign bonds;
- Convergence between on-the-run and off-the-run U.S. government bonds;
- Long positions in emerging markets sovereigns, hedged back to dollars.

Because these differences in values were tiny, the fund needed to take large and highly-leveraged positions in order to make a significant profit. At the beginning of 1998, the fund had equity of $5 billion and had borrowed over $125 billion ”” a leverage factor of roughly *thirty to one*. LTCM's partners believed, on the basis of their complex computer models, that the long and short positions were highly correlated and so the net risk was small. 

What LTCM had failed to account for is that a substantial portion of its balance sheet was exposed to a general change in the "price" of liquidity. If liquidity became more valuable its short positions would increase in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk factor. 


Fast forward to the recent 8 weeks....... I am reading increasing warning signs about Hedge Funds.

In recent months, the world has seen an increase in the "price" of liquidity.

To use sensitivity analysis;

The hedge funds have assets around USD 1 trillion (highest ever). 

A 10% loss of assets would be sizeable and could cause a financial tremor. 

A 20% loss could cause a severe financial dislocation. 

A 30% loss (highly unlikely, I think) could bring a global financial earthquake.

I cannot estimate the probability of occurrence of each risk level. I do not know whether anyone can??? 

I hope the eventual losses (which I think is already occurring in real time, but is yet to be quantified) will be less than 3% of assets. 

I do not know how much more (if any) selling pressure the hedge funds will bring to the local ASX market, as they unwind some of their positions, but I sense that it is still happening.


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## Investor (13 May 2005)

I think (could be wrong) that the wave of selling this morning, is primarily being done by foreign investors.

The profit downgrade by Wal Mart in America was another warning sign of an economic slowdown.


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## markrmau (13 May 2005)

What do you think of the hedge fund rumours (from a few days ago).

Is it possible that a few hedge funds really have blown up and had to liquidate thier positions on the LME? - and have been pulling out of BHP and RIO over recent weeks.

Offshore selling could also be coming because of the depreciation of the aussie dollar (and cause more depreciation).

Also, I assume the wal-mart sales are looking over the last 3-4months, whereas US had strong sales figures last night.


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## Investor (13 May 2005)

markrmau said:
			
		

> ....Offshore selling could also be coming because of the depreciation of the aussie dollar (and cause more depreciation).
> ....




Yes. I had expected this as well. See the following in the news today:


"Yesterday, Westpac Bank predicted the local dollar would plunge back below US70 as commodity prices come off highs and foreign investment into Australia slows, according to Westpac Bank.

Westpac has forecast the local dollar will fall to US72 cents by December 2005 and to US64 cents by December 2006. 

"The Australian dollar looks set for a fall in the second half of this year," said Westpac in a research report. 

"The fundamentals do not improve in 2006 either. In fact, the unfavourable trend accelerates."


It is logical that some foreign investors would sell. What I could not estimate is how much that selling would be offset by some of the placement of cash by the local fund managers into the ASX. If the former is "bigger" than the latter, clearly, the market would fall.


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## Investor (14 May 2005)

markrmau said:
			
		

> What do you think of the hedge fund rumours (from a few days ago).
> 
> Is it possible that a few hedge funds really have blown up and had to liquidate thier positions on the LME? - and have been pulling out of BHP and RIO over recent weeks.
> 
> ....




Here are some snapshots from the internet:

May 13 (Bloomberg) -- All week, there's been a not-so-subtle undercurrent in financial markets of potential hedge fund losses; of popular General Motors trades (long the bonds, short the stock) gone sour, courtesy of Standard & Poor's and Kirk Kerkorian, respectively; of untoward responses in the riskiest tranches of collateralized debt obligations; and even of ``correlation trades'' becoming uncorrelated. 

The Tick, Tick of GM in Hedge Fund Derivatives: Mark Gilbert 

May 13 (Bloomberg) -- The aftershocks from the drop to junk by General Motors Corp. and Ford Motor Co. are rippling through the credit markets, testing the theory that derivatives redistribute rather than exacerbate risk.

Hedge Fund Losses in April Spark Stock Market Drop 

May 11 (Bloomberg) -- Hedge funds declined 1.75 percent in April, the worst monthly performance since September 2002, according to Hennessee Group LLC, a New York-based consulting firm that tracks industry returns. 

U.S. Stocks Fall on Oil, Hedge Funds; 

May 10 (Bloomberg) -- U.S. stocks fell as oil prices climbed for a fifth day and speculation increased that hedge funds may be taking on too much risk.


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## ob1kenobi (14 May 2005)

Interesting point.  The ABC had an item on their Sunday morning Business Show about Hedge Funds and their place in the scheme of things. The issues raised were: the apparent ease in setting up a fund, the variety of players in the market and whether or not the hedging is actually driving the market in some dangerous ways (which runs contrary to why you hedge in the first place!). Whilst I'm not into conspiracy theory, given how eratic the domestic market has been and its apparent preoccupation with commodity prices on the back of GM & Ford being downgraded by S & P, I suspect you might be onto something.


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## Investor (15 May 2005)

Fresh from the internet, I bring you today's 'harvest':

"*City hedge funds head for domino collapse* 

BAD investments by some of the biggest hedge funds in London have triggered unprecedented losses, record demands for money back and talk of a death spiral weighing heavily on stocks and bonds. 

GLG, a hedge fund started in 1995 by a group of former Goldman Sachs bankers, has in recent weeks had demands for more than $500m (£270m) from investors wanting to pull out of its $4 billion market-neutral fund. 

The predicament of GLG, the biggest group in Europe, with $13 billion under management, highlights the stress being felt at many hedge funds in Europe and America after four months of deteriorating results. 

Prime brokers and the credit departments in investment banks have been calling clients to check their capital strengths as rumours of a big hedge-fund blow-out grip the industry. 

London-based Cheyne is thought to be down by at least 10% in its credit fund after the downgrading of debt at General Motors and Ford. Ferox, another of London’s most successful funds, is thought to be down nearly 20%. Bailey Coates, Polygon, Rubicon, Vega, Moore Capital and Brevan Howard are all nursing heavy losses of about 5% each in April. Bailey Coates, whose losses reported in The Sunday Times three weeks ago first alerted the wider market to the industry crisis, has had yet more redemption calls. 

“What you’re seeing is like a run on the bank,” said Narayan Naik, director of hedge-fund studies at the London Business School. “Selling forces more selling and there’s a cascade effect.” 

Although industry experts said there was no hedge-fund blow-out on the scale of Long Term Capital Management in 1998, many are concerned that the worst might not be over. 

“There’s not a panic like when LTCM nearly went bust,” said Naik, “but prices will keep dropping until excess money is squeezed out of the hedge-fund industry and a new floor is established.” 

After performing well in the fourth quarter last year, funds have run into increasing difficulty this year as a downturn in consumer spending has sparked fears of a broader slowdown. 

While GLG reported that one of its key funds was down 5.2%, a Man Group scheme suffered a 3.1% decline and Madrid-based Vega told investors one of its leading funds was down 6%. 

May has also started rockily. Some hedge funds were wrongfooted when Standard & Poor’s downgraded General Motors and Ford bonds to junk levels, and US investor Kirk Kerkorian used the opportunity to buy shares. Bond prices fell and share prices rose, *the opposite of what fund managers thought would happen. * 

Hedge funds that specialise in convertibles ”” bonds investors can exchange for shares ”” have also had a hard time. Funds had bought up nearly 80% of all convertibles, so when their prices fell it turned into a stampede."


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## Investor (15 May 2005)

The following article was in The Age a few weeks ago. It provides another indication of the current state of uncertainty with the extent of problems with Hedge Funds.


"The critical question raised by the abrupt fall in world equity markets over the past month is whether it is, in Peter Costello's terms, the markets taking a "breather" after a massive run in the preceding 11 months, or more fundamental forces at play.

The answer is almost certainly the latter, with a combination of economics and developments in the structure of financial markets exerting considerable downward pressure on equity markets.

It is no coincidence that the major equity markets peaked last month, just after the US Federal Reserve raised US official rates by a quarter of a percentage point - the seventh such rise in this cycle. The release of the minutes of the Federal Open Market Committee meeting on March 22, which showed increasing anxiety over the outlook for inflation, increased the markets' nervousness about the outlook for rates.

Within the US, weaker employment and retail spending, falling factory output and slowing corporate profits have undermined the expectations of future profitability that had been built into US share prices. Outside the US, slowing growth in Europe and Japan has also tempered world growth. The 70 per cent increase in crude oil prices in the past two years and soaring commodity prices are starting to impact on growth and inflation.

With Western consumers over-leveraged, the US running unsustainable trade and budget deficits, signs of global supply-demand imbalances, Asian countries maintaining undervalued currencies and trade tensions rising, there are also some potentially destructive global structural imbalances to unsettle markets.

Those issues alone would be sufficient to explain why the US market has fallen about 7 per cent since peaking on March 4 and why our market - where some, although not all, of the US settings are replicated - has fallen almost 5 per cent over that same period.

The market's response to the signs of a weakening in the US economy even as the Fed hints at an acceleration of its rate-raising program - which raises the threat of stagflation - has, however, been quite dramatic.

After the 2000 dotcom and telecommunications bubble burst, one of the easier opportunities in history to make money opened up. Big investors were able to borrow in US dollars at negative real interest rates and invest those funds in assets generating real returns elsewhere. The so-called "carry" trade fuelled the explosive growth of hedge funds, which added massive leverage to the basic investment proposition.

Even households seized on the classic arbitrage opportunity, albeit in a somewhat less sophisticated fashion. Consumers in most of the developed countries took advantage of historically low rates to invest in income- or capital-gain producing housing, as well as going on a massive consumption binge.

Not surprisingly, the surge in investing powered by cheap money was reflected in similar surges in asset prices. Since its post-bubble nadir in early 2003, the US market has risen almost 100 per cent. Our market (which didn't fall as far when the bubble burst) is up almost 60 per cent over that period.

From shares to houses to oil, the prices of assets and commodities exploded, helped by the China phenomenon but leveraged in the financial markets by the hedge funds.

The global addiction to cheaply funded risk peaked last month but really started after the Fed's earlier rate rise in February, which triggered a large-scale sell-off in emerging market assets. Capital has been withdrawn from emerging Europe, Latin America and Asia (excluding China and Japan). Bond yields started to rise, volatility in equity and commodity markets soared and investors started switching from riskier asset classes to less vulnerable investments.

In our market it is notable that the ASX 200 is down 4.85 per cent over the past month, while the "Small Ordinaries" is down 7.5 per cent - there has been a flight away from the small caps towards quality. There has also been a shift from cyclical stocks to defensive stocks.

That broad trend away from riskier asset classes potentially carries with it the seeds of something unpleasant, given the extraordinary growth of the hedge fund sector and its latent combustibility as a result of the levels of leverage in many of the funds.

After 2001, when real rates in the US became negative, company profits and cash flows were swollen by the cheap funding and the consumption boom triggered by low interest rates. With inflation not an issue, investors were prepared to pay more and more for future earnings because they weren't discounting those earnings for either inflation or high nominal rates. Not surprisingly, price/earnings ratios expanded and the risk premiums assigned to financial assets were compressed.

With rising rates and inflation, a stronger US dollar, increasing volatility in financial markets and US real rates having just surpassed the spreads available in euro-denominated funding, the appeal of the carry trade has waned and the positions it funded are being unwound. Hence the sharp rise in volumes and volatility in the major markets.

Future earnings no longer look as rosy and will now have to be discounted by a rising real rate.

That is why there is no certainty that our market will be able to hold its ground, despite its statistics looking defensible at current levels - or at least not expensive by historical standards.

There has been a worldwide bubble of sorts in financial assets and commodities which has developed a leak. The opacity of the hedge fund activity and their condition means it isn't possible to state with any precision either the size of the bubble or the gravity of the leak.

It is possible that the past month has just been "the correction we needed to have," or the "pause that refreshes", or Costello's "breather". It is equally possible, however, that the vague threat the hedge funds were seen to pose to the stability of financial markets and real economies may be materialising, with unpredictable but presumably fairly unpleasant consequences."


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## Investor (16 May 2005)

Uncertainty in global markets goes up a notch. See the following article from today's The Australian:

CURRENCY markets are bracing for volatile trading ahead of China's move on Wednesday to allow the yuan to be traded against eight extra currencies, including the Australian dollar.

The reform is being viewed as a precursor to the much-awaited upward revaluation of the yuan, which would hamper China's export competitiveness to the benefit of the US. 

While China's central bank on Friday dismissed reports of an imminent change to its policy of pegging the yuan-$US rate, the Government has also said it intends to surprise the market with such an announcement. Wednesday's forex market reform is seen as a step towards China's currency liberalisation by boosting the yuan's liquidity. 

"There will be nervous traders watching their screen on May 18 (Wednesday)," AMP Capital Investors chief economist Shane Oliver said. "The market was pricing (a revaluation) in, but that reversed in the last couple of days. If sentiment reverses again, you might see big swings." 

A revaluation would most likely involve a widening of the narrow 0.3 per cent band in which the yuan is allowed to vary against the $US. US-led pressure for a revaluation has been mounting, given the nation's current account deficit, which has been fed by cheap Chinese imports. 

A stronger yuan, in contrast, would boost China's internal consumption by making exports cheaper. 

Australian exports would also become cheaper for Chinese buyers, while Chinese imports to Australia would become become more expensive, creating inflation and interest rate pressures, but improving out current account deficit. 

"We expect China's authorities will broaden the yuan's trading band tenfold to 3 per cent, which will allow the yuan to appreciate 1.5 per cent," investment bank JP Morgan said in a report. 

"JP Morgan expects a further 5 per cent yuan appreciation by the end of 2005 and total appreciation of 10 per cent within 12 months." 

After Wednesday's reforms, the Australian dollar can be directly tradeable with the yuan, through interbank dealings with seven authorised foreign banks. 

The yuan currently can be traded only against the $US, the Hong Kong dollar, the Japanese yen and the euro. 

Westpac Bank economist Huw McKay said the $A inclusion was not likely to have near-term implications for the $A, but could reduce costs for Australian companies dealing with China. "It will reduce risk to importers by taking out third currencies," he said. 

Mr McKay said most Sino-Australian trading was in $US-dominated resources, such as iron ore and coal. "But, as we export more sophisticated goods ... we may well have the power in the relationship to say 'please pay us in Australian dollars'." 

JP Morgan economist Stephen Walters agreed. "Convertibility won't open the drawbridge but it might make things a little bit easier," he said. "The real impact is when China revalues its currency." 

But economists said the Chinese were unlikely to move on a revaluation this week, despite the X-factor of surprise. 

"My guess is it will be some time in the next three months," Dr Oliver said. 

Mr McKay warned that such a move would weaken China's banking system, which relies on a vast pool of captive local savings. 

The Australian newspaper.


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## Investor (16 May 2005)

May 16 (Bloomberg) -- Japanese resource stocks fell, led by Dowa Mining Co. and Nippon Oil Co., after a slump in commodity prices raised concern that slowing global growth may cut demand for raw materials. 

``Excess money that people made when the global economy was booming was put into commodities and now that growth is being questioned, the money is starting to be taken out,'' said Takashi Miyazaki, who helps oversee about $20 billion in assets at UFJ Partners Asset Management Co. in Tokyo. 

``Almost inevitably, commodity stocks will face some tough times'' as a result of the recent slump in raw material prices. 

Investors could be reluctant to take any large bets before Japan's gross domestic product report due tomorrow, analysts including Yutaka Miura at Shinko Securities Co. in Tokyo said.


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## Investor (16 May 2005)

In the Financial Review:

Miners hit as hedge funds unwind
May 16 12:50

Falling commodity prices dragged the resource sector down heavily on Monday to kick off a weak start for the Australian sharemarket amid talk that troubled hedge funds are unwinding their big bets of recent years.

An ex-dividend ANZ and heavy losses by blood products group CSL, after a broker downgrade, added to the downward pressure on the local market, as did weakness in steelmakers and market-sensitive wealth managers.

The benchmark S&P/ASX-200 was down 0.6 per cent at 3989 in afternoon trade. After hitting five-month lows early this month, the market has rebounded by 1.6 per cent, but remains 6.5 per cent off the record highs of mid-March.

The big theme, say analysts, is one of risk aversion. Global hedge funds, having placed major bets on commodities and other assets leveraged to the economic cycle, are suddenly unwinding those positions to cover losses elsewhere.

"Screen chatter on potential issues in the hedge fund sector has continued to percolate through the market," Deutsche Bank analysts said in a morning note.

"This appears to be driving a climate of risk reduction, with investors looking to exit the consensus trades that are perceived to be the darlings of the hedge funds or even put on the reverse trade on the prospect of forced hedge fund unwinding."

Resource stocks were the biggest weight on the market on Monday after another decline in commodity prices on Friday. Copper eased 3 per cent, bringing its losses to 7 per cent over three days, as the US dollar extended its rebound.


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## Investor (17 May 2005)

Some good news out of Japan, which has been in economic stagnation for over a decade since the bursting of the bubble. 

If it is sustainable and not another false dawn (only time will tell), it will take some of the "burden" for world economic growth out of America. 

Japan is the world's largest creditor nation, owning 1/3 of the world's credit supply (including a chunk of Australia's net foreign debt of around $422 billion).

Its companies like Toyota, Sony, Panasonic, Honda, Mitsubishi and Nissan are still formidable on a global scale.

See the following article released today:

Japan Economy Grows at 5.3% Pace, More Than Expected (Update3) 

May 17 (Bloomberg) -- Japan's economy, the world's second- largest, grew at more than twice the rate economists forecast as rising wages prompted consumers to increase spending on clothing and food. Stocks and the yen gained. 

Gross domestic product rose at an annual 5.3 percent pace in the three months ended March 31, a report by the Cabinet Office in Tokyo showed today. The median forecast of 28 economists surveyed by Bloomberg was for a 2.4 percent rate of growth. The economy grew a revised 0.1 percent in the fourth quarter. 

Consumers are shopping more at retailers including Aeon Co. and Matsuzakaya Co. as employers raise wages and hire more workers, helping Japan extend its recovery from a fourth recession since 1991. Spending by households, which accounted for more than half of growth, is helping Japan withstand a slowdown in overseas demand. 

``We're seeing increasing signs that the economy is on the path to a stable recovery,'' Eishi Yokoyama, an economist at AIG Global Investment Corp., said before the report was released. ``Consumers are more willing to spend.'' 

The yen rose to 106.69 to the dollar at 9:36 a.m. in Tokyo from 106.74 late yesterday in New York. The Nikkei 225 Stock average advanced 0.9 percent to 11,042.35, led by Toyota Motor Corp. 

Japan's growth compares with a 3.1 pace of expansion in the U.S. in the first quarter, the slowest in two years. The 12 nations sharing the euro grew 0.5 percent from the previous quarter. 

Employment Rises 

Quarter-on-quarter, the economy grew 1.3 percent in the three months to March 31, compared with economists' expectations of a 0.6 percent gain. From a year earlier, growth was 1.2 percent in real terms, today's report showed. 

Consumer spending rose 1.2 percent from the previous three months, the first gain in a year, more than the 1.1 percent increase forecast by economists. 

Japanese companies are hiring more workers and paying them better after reducing excess capacity and cutting debt since the nation's asset-price bubble burst in 1991. 

Aeon, Japan's largest retailer, said on April 6 that net income rose 12 percent to 62.1 billion yen ($577 million) in the year ended Feb. 28 and sales rose 18 percent to 4.2 trillion yen. It expects sales to increase 3.4 percent this year. 

Executives at retailers including Matsuzakaya say they are hopeful about the outlook. 

Bonuses 

``I'm not pessimistic about consumer spending at all,'' Kunihiko Okada, president of Matsuzakaya, a Nagoya-based department store chain, said in an interview on May 13. ``The composition of the Japanese population is changing now as baby boomers and their children are leading consumption, and we think this is a big business opportunity for our industry.'' 

Twice-yearly bonuses, which usually amount to several months' salary, rose for the first time in eight years in December to 430,278 yen ($4,026). 

The number of full-time workers in Japan rose in January for the first time since 1997, and the unemployment rate fell to 4.5 percent in March, matching a five-year low. 

Household spending rose a seasonally adjusted 2.2 percent in the three months to March 31, the biggest gain in eight years, the government said on May 10. Retail sales rose 0.1 percent in the first quarter from a year earlier, the first gain in four quarters, the government said on April 28. 

Capital Spending 

Companies including Sharp Corp. and Elpida Memory Inc. are planning to spend more on factories and equipment as they prepare for a rebound in overseas demand for electronics after companies built up excess stockpiles last year. 

Capital spending rose 2 percent from the previous quarter, today's report showed, and accounted for more than a fifth of the economy's expansion. Economists expected capital spending to rise 0.6 percent. 

Machinery orders, which point to spending in three to six months, unexpectedly rose 1.9 percent in March, the government said on May 13, suggesting that gains in corporate investment will continue. 

Tokyo-based Elpida Memory, the world's fifth-largest memory- chip maker, will increase spending to 143.6 billion yen in the fiscal year started April 1, more than the 100 billion yen it initially planned, President Yukio Sakamoto said on April 25. 

Osaka-based Sharp, the world's biggest maker of liquid- crystal display televisions, said on April 26 it will raise spending 3.3 percent to 220 billion yen. 

Overseas Sales 

Sumitomo Metal Industries Ltd., Japan's third-largest steelmaker, said this month it will spend 100 billion yen to boost annual capacity at its Wakayama mill. 

``Manufacturers are replacing old furnaces and that means we can expect capital spending to increase into next year and the following year,'' Nobusato Suzuki, chief financial officer at Osaka-based Sumitomo Metal, said in an interview on May 10. 

Overseas sell fell 0.2 percent, and imports rose 0.5 percent in the first quarter. Net exports, or the difference between exports and imports, subtracted 0.1 percentage point from growth. 

Export volumes, which don't take into account price fluctuations, rose for the first rose for the first time in three months in March, government data on April 21 showed. 

``Exports are improving considerably,'' Kakutaro Kitashiro, head of the Japan Association of Corporate Executives, said on May 10. ``The inventory adjustment in the information technology sector has made a lot of progress.'' 

Nominal GDP, which isn't adjusted for price changes, rose at an annual 2.3 percent pace, today's report said. Quarter-on- quarter, it expanded 0.6 percent, more than the 0.2 percent growth predicted by economists. 

Seven years of deflation have taken a toll on the economy. Prices as measured by the GDP deflator fell 1.2 percent from a year earlier, compared with the 0.7 percent drop predicted by economists.


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## Investor (18 May 2005)

In The Australian today, comments by Robert Gottliebsen (a very experienced and seasoned business commentator, the previous editor of BRW):

Hedges trim the dollar, shares
May 18, 2005

"SPECULATIVE money, often administered by hedge funds, is playing a big role in the latest fall in the Australian dollar and share market.

If the exodus to the US dollar were to gather momentum, it might even affect our apartment market because all Australian asset classes have delivered bonanzas to speculators via increases in value and a higher dollar. 

Now they are jittery, although some of the forces currently boosting the US dollar are good for Australia. 

*It's worth following at least some of the money trails, although I must emphasise that these trails are far more complex and numerous than I portray.* 

The big US deficits have created large buckets of US dollar capital sloshing around Asia. A significant amount of this money has found its way into China and represents a big portion of China's foreign exchange reserves. 

Often the Chinese speculative money was parked in real estate and this is why Shanghai has large numbers of unoccupied apartments and empty hotels are common in some parts of China. 

If the Chinese currency were sharply increased in value, this money would stop flowing into China and much of it would attempt an exit that would explode the Chinese capital investment bubble. 

Commodity prices would fall, so Australia would be affected. 

The US is putting great pressure on China to increase the value of the yuan but the Chinese are resisting, partly because they know the dangers. 

Small steps are likely. But in recent weeks there has been a significant directional change in the speculative money flows. 

For over a year many speculators have been switching out of the US dollar into the euro and other currencies. But America is again sucking in large sums and the US dollar has been rising despite the deficits. 

One of the reasons for the sudden return to US popularity is that its relatively low interest rates are attracting huge real estate speculation. 

Americans are even more skilled at creating real estate mania than Australians, and global speculators have joined the game. 

In addition, reports from big companies around the US show that it is becoming much easier to lift prices and in the process this is making the corporate profit outlook much stronger. This is being reflected in higher earnings projections by analysts and this increases the value of US stocks and sucks money into Wall Street. 

Suddenly Federal Reserve chief Alan Greenspan is potentially facing both an inflationary problem and a real estate asset bubble. 

Accordingly, the pressures on him to maintain the current higher interest rate momentum will be intense and short-term rates of 4 per cent to 4.5 per cent by the end of 2005, or early next year, look highly likely.

There is no doubt that such a rate increase would slow the US economy in 2006 and this would quickly spill over into China, commodity prices and Australia. 

Those projected budgetary surpluses would be severely trimmed. So the speculators betting against the Australian dollar basically have two tickets in the raffle -- a slowdown in China because of a currency move and a US slowdown because of higher interest rates. 

But timing is important and the current stronger corporate US outlook will not suddenly disappear and we could see a period of global strength which would see strong share prices and the local currency hold its ground. 

What we are really looking at is the realisation by both the Chinese and Americans that there is a need for a slowdown. 

The debate is about who takes the brunt of any reverse. But either way Australian commodities will be affected. 

We should not forget that underpinning the commodity market is very big long-term basic demand from China and India, which will not go away. But China is encouraging Brazil and others to lift production."

The Australian newspaper.


My comments - to me, the global financial / equity / property markets are currently in disequilibrium, to use economic jargon. The adjustments have been happening and will continue to happen for some time, while markets move back towards equilibrium. 

I will explain further as I go along, but I emphasise that no one has to agree with anything I say, i.e. do not take any cheap shots for the time being.


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## Investor (18 May 2005)

May 17 (Bloomberg) -- U.S. 10-year Treasury notes rose after the Federal Reserve said April industrial production unexpectedly fell, a sign the economy may be struggling to pull out of a first- quarter slowdown. 

The gains kept the notes' yields, which are a guide for corporate and consumer borrowing rates, near a three-month low. The drop in production follows a report yesterday from the central bank's New York branch that showed manufacturing in its area declined this month. 

``Demand, especially for the 10-year note area, remains very strong,'' said David Brownlee, who manages $7 billion of debt securities at N.L. Capital Management in Montpelier, Vermont. ``There's a bid in the Treasury market that simply does not go away,'' said Brownlee, adding that ``there's very little value'' in Treasuries at these yields. 

The benchmark 4 1/8 percent Treasury note maturing in May 2015 gained 1/16, or 63 cents per $1,000 face amount, to 100 1/32 at 4 p.m. in New York, according to bond broker Cantor Fitzgerald LP. The yield fell almost 1 basis point, or 0.01 percentage point, to 4.12 percent, and is down from this year's high of 4.69 percent in March. 

The note rose as much as 1/4 of a point before a late rally in benchmark stock indexes sapped demand for government debt. The Standard & Poor's 500 index gained 0.67 percent. 

Industrial production declined 0.2 percent in April, the Fed said. A rise of 0.2 percent, half last year's monthly average, was forecast, according to the median estimate of economists surveyed by Bloomberg. The New York Fed's Empire index yesterday fell to minus 11.1, from a revised 2 in April. 

`Soft Patch' 

``It definitely points towards the soft patch we're currently probably in,'' Kevin McNair, who oversees $7 billion in bonds at BB&T Asset Management Inc. in Raleigh, North Carolina, said of today's production report. Yields will still rise later in the year as the Fed will add to its eight interest rate increases since June 2004, he said. 

The economy expanded at a 3.1 percent annual rate in the first quarter, the slowest pace in two years. Debt yields will likely remain low for the time being, McNair said. He declined to be more specific. 

Also today, a Labor Department report showed prices paid to factories and other producers rose 0.6 percent in April. The median forecast in a Bloomberg News survey was for an increase of 0.4 percent. Excluding food and energy, producer prices rose 0.3 percent, compared with a median forecast of 0.2 percent. 

Some investors said the report wasn't all bad for Treasuries because excluding food and energy, the cost of intermediate goods, those used in earlier stages of production, rose 0.2 percent, the smallest rise since December 2003. 

There is evidence the longer-term inflation risk ``is still very controlled if the Fed continues to be a staunch fighter of inflation, which the market believes them to be,'' said Sadakichi Robbins, head of proprietary fixed-income trading at Bank Julius Baer & Co. in New York. Quicker inflation erodes the purchasing power of fixed-income payments. 

Real Yields 

``The ability to stay below 4.25 (percent on 10-year yields) despite pretty bullish surprises on the economy -- that gives some comfort'' to bond bulls, Robbins said. 

Treasury yields adjusted for inflation are low by historical standards. The 10-year note's yield as of yesterday was about 1.8 percentage points higher than the rate of core consumer inflation. Over the past decade the so-called real yield averaged about 3 percent. 

``Tomorrow's CPI report will give a better indication if there's inflation in the system or not,'' said Jay Bryson, a global economist at Wachovia Corp. in Charlotte, North Carolina, and a former economist at the Fed. 

The Labor Department may say tomorrow that core consumer prices rose 0.2 last month, half the 0.4 percent gain in march, according to the median estimate of economist surveyed by Bloomberg. 

``The inflation uptick doesn't seem to be getting through the consumer, so it doesn't worry us much,'' said Barry James, who manages $1 billion in bonds and stocks for James Investment Research in Dayton, Ohio. 

Fed Outlook 

Fed policy makers on May 3 raised their target for the overnight lending rate between banks for the eighth time since June, to 3 percent, and indicated they are likely to raise it further in the coming months. The rate probably will rise to 4 percent by year-end, according to the median forecast in a Bloomberg survey of 63 economists taken from April 29 to May 6. 

The Fed ``still need to rise'' to keep inflation contained, Fed Governor Donald Kohn told the Australian Business Economists Conference earlier today. There is still a risk of prices rising further, he said. 

``Kohn gave the impression that he'll certainly be voting for more rate rises at upcoming meetings,'' Michael Thomas, a Sydney- based economist at ICAP Australia Ltd., said before the report. ``The Fed seems to be more worried about inflation upside risks than growth downside risks.'' 

TIPS 

A drop in energy and commodities prices led traders in recent weeks to pare expectations that inflation will accelerate, as measured by yields on Treasury Inflation-Protected Securities, or TIPS. 

The gap by which 10-year Treasury yields exceed yields on 10- year TIPS shrank to 2.46 percentage points last week, the least since February. It was little changed today at 2.50 percent. 

The difference represents the expected average inflation rate over the life of the notes and is down from the high this year of 2.78 percentage points in March. 

Investor Sentiment 

Treasury investors are less bearish, according to a weekly poll of clients by JPMorgan Chase & Co. The share of investors betting on lower prices fell to 44 percent from a record 66 percent. The percentage betting on rising prices increased to 17 percent from 8 percent. The rest expected no change. 

A separate survey by Merrill Lynch & Co. shows 25 percent of investors believe government bonds are ``fairly'' or ``under'' valued, the poll, which was conducted at the start of the month, showed. The percentage compares with 83 percent for equities. The survey of 339 money managers, who together oversee more than $1 trillion, took place between May 6 and May 12. 

Interest-rate expectations have fallen with a net balance of 80 percent of investors forecasting global short interest rates will be higher a year from now compared with 94 percent in March. 

Demand for Treasuries has also risen over the past week amid concerns about losses at hedge funds, causing a flight to the relative safety of government debt. *One or two hedge funds may have ``notable failures'' because on credit investments*, Martin Fridson, a New York-based analyst who publishes Leverage World, a high-yield bond research service, said yesterday in an interview


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## Investor (18 May 2005)

The event on Sept 11 shocked the world in many ways. The subsequent wars in the Middle East also led to considerable uncertainties. 

From my reading, it seemed to me that the world's major central bankers (West and East) did everything that they could to ease monetary policy to prevent global recession. The end result was the biggest creation of M3 money supply the world had ever seen (this was later to be called the carry trade - money at nil 'real inflation adjusted' borrowing costs). Whether this huge supply of liquidity has averted or merely delayed a global recession remains to be seen. 

The carry trade (free ride on the yield curve) ended earlier this year, after many 0.25% interest rate rises by Alan Greenspan. The world is now adjusting to the effects. Bond markets are in adjustments. Global equity markets are in adjustments. Property markets are starting to adjust, but still patchy depending on location. As in all property cycles, Sydney led on the way up and leads on the way down. The downturn in Sydney is now evident and falling (it has to - the city is facing net interstate outward migration due to the absurd prices - reported in the newspapers this week). The downturn in Melbourne has started but is patchy (not broad based like Sydney) but will probably become more evident before the year is out - apartments in the CBD and South Melb. are recording falls of around 20% from peak. Brisbane's prices might have started a reversal. As in all previous cycles, the other capital cities will soon follow the decline after the time lag effect, as happened when prices were on the way up. Refer to the latest aireview issue no. 59 released a short while ago for another indication.

Economic history provides some guidance that after a period when there has been excess liquidity, some of that liquidity eventually is lost through some investments going awry. Any of the previous local or global recessions (including the spectacular bursting of the bubble in Japan over a decade ago that Japan has yet to recover from) would be instructive.

The following is an article (of some depth in macro economics) that might explain what has happened with the carry trade.

How Japan financed global reflation
By Richard Duncan
FinanceAsia February 2005  

In 2003 and the first quarter of 2004, Japan carried out a remarkable experiment in monetary policy – remarkable in the impact it had on the global economy and equally remarkable in that it went almost entirely unnoticed in the financial press. Over those 15 months, monetary authorities in Japan created  ¥35 trillion. To put that into perspective,  ¥35 trillion is approximately 1% of the world's annual economic output. It is roughly the size of Japan's annual tax revenue base or nearly as large as the loan book of UFJ, one of Japan's four largest banks.  ¥35 trillion amounts to the equivalent of $2,500 for every person in Japan and, in fact, would amount to $50 per person if distributed equally among the entire population of the planet. In short, it was money creation on a scale never before attempted during peacetime. 

Why did this occur? There is no shortage of yen in Japan. The yield on two year JGBs is 10 basis points. Overnight money is free. Japanese banks have far more deposits than there is demand for loans, which forces them to invest up to a quarter of their deposits in low yielding government bonds. So, what motivated the Bank of Japan to print so much more money when the country is already flooded with excess liquidity? 

The Bank of Japan gave the  ¥35 trillion to the Japanese Ministry of Finance in exchange for MOF debt with virtually no yield; and the MOF used the money to buy approximately $320 billion from the private sector. The MOF then invested those dollars into US dollar- denominated debt instruments such as government bonds and agency debt in order to earn a return. 

The MOF bought more dollars through currency intervention then than during the preceding 10 years combined, and yet the yen rose by 11% over that period. Historically, foreign exchange intervention to control the level of a currency has met with mixed success, at best; and past attempts by the MOF to stop the appreciation of the yen have not always succeeded. They were very considerably less expensive, however. It is also interesting, and perhaps important, to note that the MOF stopped intervening in March 2004 just when the yen was peaking; that the yen depreciated immediately after the intervention stopped; and that when the yen began appreciating again in October 2004, the MOF refrained from further intervention. 

So, what happened in 2003 that prompted the Japanese monetary authorities to create so much paper money and hurl it into the foreign exchange markets? Two scenarios will be explored over the following paragraphs. 

In 2002, the United States faced the threat of deflation for the first time since the Great Depression. Growing trade imbalances and a surge in the global money supply had contributed to the credit excesses of the late 1990s and resulted in the New Paradigm technology bubble. That bubble popped in 2000 and was followed by a serious global economic slowdown in 2001. Policy makers in the United States grew increasingly alarmed that deflation, which had taken hold in Japan, China and Taiwan, would soon spread to America. 

Deflation is a central bank's worst nightmare. When prices begin to fall, interest rates follow them down. Once interest rates fall to zero, as is the case in Japan at present, central banks become powerless to provide any further stimulus to the economy through conventional means and monetary policy becomes powerless. The extent of the US Federal Reserve's concern over the threat of deflation is demonstrated in Fed staff research papers and the speeches delivered by Fed governors at that time. For example, in June 2002, the Board of Governors of the Federal Reserve System published a Discussion Paper entitled, "Preventing Deflation: Lessons from Japan's Experience in the 1990s." The abstract of that paper concluded "...we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus-both monetary and fiscal- should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity." 

From the perspective of mid-2002, the question confronting those in charge of preventing deflation must have been how far beyond the conventional levels implied by the base case could the economic policy response go? The government budget had already swung back into a large deficit and the Federal Funds rate was at a 41 year low. How much additional stimulus could be provided? A further increase in the budget deficit seemed likely to push up market determined interest rates, causing mortgage rates to rise and property prices to fall, which would have reduced aggregate demand that much more. And, with the Federal Funds rate at 1.75% in mid- 2002, there was limited scope left to lower it further. Moreover, given the already very low level of interest rates, there was reason to doubt that a further rate reduction would make any difference anyway. 

In a speech entitled, "Deflation: Making Sure 'It' Doesn't Happen Here", delivered on November 21, 2002, Federal Reserve Governor Ben Bernanke explained to the world exactly how far beyond conventional levels the policy response could go. Governor Bernanke explained that the Fed would not be "out of ammunition" just because the Federal Funds rate fell to 0% because the Fed could create money and buy bonds of longer maturity in order to drive down yields at the long end of the yield curve as well. Moreover, he said, "In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices." 

He made similar remarks in Japan in May 2003 in a speech entitled, "Some Thoughts on Monetary Policy in Japan". He said, "My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt-so that the tax cut is in effect financed by money creation." These speeches attracted tremendous attention and for some time financial markets believed the Fed intended to implement the "unorthodox" or "unconventional" monetary policy options Governor Bernanke had outlined. 

In the end, the Fed did not resort to unorthodox measures. The Fed did not create money to finance a broad-based tax cut in the United States. The Bank of Japan did, however. Three large tax cuts took the US budget from a surplus of $127 billion in 2001 to a deficit of $413 billion in 2004. In the 15 months ended March 2004, the BOJ created  ¥35 trillion which the MOF used to buy $320 billion, an amount large enough to fund 77% of the US budget deficit in the fiscal year ending September 30, 2004. It is not certain how much of the $320 billion the MOF did invest into US Treasury bonds, but judging by their past behavior it is fair to assume that it was the vast majority of that amount. 

Was the BOJ/MOF conducting Governor Bernanke's Unorthodox Monetary Policy on behalf of the Fed? There is no question that the BOJ created money on a very large scale as the Fed would have been required to do under Bernanke's scheme. Nor can there be any question that the money created was used to buy an increasing supply of US Treasury bonds being issued to finance the kind of broad-based tax cuts Governor Bernanke had discussed. Moreover, was it merely a coincidence that the really large scale BOJ/MOF intervention began during May 2003, while Governor Bernanke was visiting Japan? Was the BOJ simply serving as a branch of the Fed, as The Federal Reserve Bank of Tokyo, if you will? This is Scenario One. 

If this was globally coordinated monetary policy (unorthodox or otherwise) it worked beautifully. The Bush tax cuts and the BOJ money creation that helped finance them at very low interest rates were the two most important elements driving the strong global economic expansion during 2003 and 2004. Combined, they produced a very powerful global reflation. The process seems to have worked in the following way: 

US tax cuts and low interest rates fuelled consumption in the United States. In turn, growing US consumption shifted Asia's export-oriented economies into overdrive. China played a very important part in that process. With a trade surplus vis-Ã -vis the United States of $124 billion, equivalent to 9% of its GDP in 2003 (rising to approximately $160 billion or above 12% of GDP in 2004), China became a regional engine of economic growth in its own right. China used its large trade surpluses with the US to pay for its large trade deficits with most of its Asian neighbors, including Japan. The recycling of China's US Dollar export earnings explains the incredibly rapid "reflation" that began across Asia in 2003 and that was still underway at the end of 2004. Even Japan's moribund economy began to reflate. 

Whatever its motivation, Japan was well rewarded for creating money and buying US Treasury bonds with it. Whereas the BOJ had failed to reflate the Japanese economy directly by expanding the domestic money supply, it appears to have succeeded in reflating it indirectly by expanding the global money supply through financing the sharp increase in the MOF's holdings of US Dollar foreign exchange reserves. There is no question as to if this happened. It did. The only question is was it planned (globally coordinated monetary policy) or did it simply occur by coincidence, driven by other considerations? 

What other considerations could have prompted the BOJ to create  ¥35 trillion over 15 months? A second scenario is that a "run on the dollar" forced the monetary authorities in Japan to intervene on that scale to prevent a balance of payments crisis in the United States. This is Scenario Two. 

During the Strong Dollar Trend of the late 1990s, foreign investors, both private and public, invested heavily in the United States. Those investments put upward pressure on the dollar and on US asset prices, including stocks and bonds. The trend became self-reinforcing. The more capital that entered the US, the more the dollar and dollar denominated assets rose in value. The more those assets appreciated, the more foreign investors wanted to own them. Because of the large sums entering the country, the United States had no difficulty in financing its giant current account deficit, even though that deficit nearly tripled between 1997 and 2001. 

By 2002, however, with the US current account deficit approaching 5% of US GDP, it became increasingly apparent that the Strong Dollar Trend was unsustainable. The magnitude of the current account deficit made a downward adjustment in the value of the dollar unavoidable. At that point, the Strong Dollar Trend gave way and the Weak Dollar Trend began. Foreign investors who had invested in US dollar denominated assets during the late 1990s naturally wanted to take their money back out of the United States once it became clear that a sharp correction of the dollar was underway. Moreover, many US investors, and hedge funds in particular, also began selling dollar- denominated assets and buying non-US dollar-denominated assets to profit from the dollar's decline. 

The change in the direction of capital flows can be seen very clearly in the breakdown of Japan's balance of payments. 

The preceding chart shows the balance on Japan's current account and financial account, the two principle components of Japan's balance of payments, going back to 1985. Traditionally, Japan runs a large current account surplus and a slightly less large financial account deficit, with the difference between the two resulting in changes (usually additions) to the country's foreign exchange reserves. 

Beginning in 2003, however, there was a startling change in the direction of the financial account. Instead of large financial outflows from Japan to the rest of the world, there were very large financial inflows. For instance, in May 2003, Japan's financial account reflected a net inflow of $23 billion into the country. The net inflow in September was $21 billion. These amounts increased considerably during the first quarter of 2004, averaging $37 billion a month. 

The capital inflows into Japan at that time were massive, even relative to Japan's traditionally large annual current account surpluses. But, why did Japan, which normally exported capital, suddenly experience net capital inflows on a very large scale in the first place? The most likely explanation is that very large amounts of private sector money began fleeing the dollar and seeking refuge in the relative safety of the yen. 

When the Strong Dollar Trend broke, had the BOJ/MOF not bought the dollars that the private sector sold in such large quantities, the United States would have faced a balance of payments crisis, in which, in addition to having to fund a half a trillion dollar a year trade deficit, it would have had to find a way to fund a deficit of several hundred billion on its financial account as well. 

Any other country facing a large shortfall on its balance of payments would have experienced a reduction in its foreign exchange reserves. The United States, however, maintains only a limited amount of such reserves; only $75 billion as at the end of 2003, far too little to fund the private capital outflows occurring at that time. 

Once those reserves had been depleted, market-determined interest rates in the US would have begun to rise, in all probability, popping the US property bubble and throwing the country into recession. Under that scenario, a reduction in consumption in the United States would have undermined global aggregate demand and created a severe world-wide economic slump. 

The US current account deficit more or less finances itself since the central banks of the surplus countries buy the dollars entering their countries to prevent their currencies from appreciating and then recycle those dollars back into US dollar-denominated assets in order to earn interest on them. 

Large scale private sector capital flight out of dollars presented the recipients of that capital with the same choice. The central bank of each country receiving the capital inflow had the choice of either printing their domestic currency and buying the incoming capital or else allowing their currency to appreciate as the private sector swapped out of dollars. The European Central Bank chose to allow the euro to appreciate. The Bank of Japan and the People's Bank of China chose to print yen and renminbe and accumulate the incoming dollars to prevent their currencies from rising. If some central bank had not stepped in and financed the private sector capital flight out of the dollar, then sharply higher US interest rates most likely would have thrown the world into a severe recession. It is quite likely that this consideration also played a role in influencing the actions of the Japanese monetary authorities during this episode. 

The BOJ/MOF stopped intervening in March 2004. By that time, the Fed had indicated that it planned to begin tightening interest rates. That put a stop to the private sector capital flight out of the dollar. Therefore no more intervention was required. At the same time, by the end of the first quarter of 2004, it was becoming clear that strong economic growth in the US was creating higher than anticipated tax revenues. That meant a smaller than expected budget deficit. In July, the President's Office of Management and Budget revised down its estimate of the budget deficit from $521 billion to $445 billion. The actual deficit turned out to be $413 billion. Thus less funding was required than initially anticipated. 

So, what did motivate the monetary authorities in Japan to create the equivalent of 1% of global GDP and lend it to the United States? Was it simply, straightforward self interest to prevent a very sharp surge in the value of the yen? Was it globally coordinated monetary policy designed to pull the world out of the 2001 slump and prevent deflation in the United States? Or, was it necessary to stave off a US balance of payments crisis that would have produced a global economic crisis? 

Perhaps it was only straightforward foreign exchange intervention to prevent a crippling rise in the value of the yen. Intentionally or otherwise, however, by creating and lending the equivalent of $320 billion to the United States, the Bank of Japan and the Japanese Ministry of Finance counteracted a private sector run on the dollar and, at the same time, financed the US tax cuts that reflated the global economy, all this while holding US long bond yields down near historically low levels. 

In 2004, the global economy grew at the fastest rate in 30 years. Money creation by the Bank of Japan on an unprecedented scale was perhaps the most important factor responsible for that growth. In fact,  ¥35 trillion could have made the difference between global reflation and global deflation. How odd that it went unnoticed.


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## Investor (20 May 2005)

In today's Financial Review, on page 37:

"The current high risks and potentially high returns from putting money into hedge funds mean that investors may as well bet on horses instead, according to a report published yesterday.

The Centre for Economics and Business Research (CEBR) estimates that the *hedge fund sector worldwide is 8 per cent poorer* now than 3 months ago. 

The financial services research company believes life will remain tough for hedge funds as economic conditions are likely to be average at best, causing some 1600 funds to close over the next 2 years.

The CEBR says "For investors looking for high risk, high yielding investments, may we recommend horse racing?"

"The tendency for hedge funds to take on excessive risk is exacerbated by reward structures for managers that are asymmetric - there is heavy gearing on high returns, while if a loss is made, the manager merely fails to collect a bonus."

The CEBR also says hedge funds are virtually unregulated. 

When hedge funds were relatively few in number, the combination of skilled managers and the availability of arbitrage possibilities meant that they outperformed conventional investments.

"But... their scale now means that the returns from finding unrealised arbitrage opportunities have largely disappeared".

The CEBR estimates the number of hedge funds has grown from 2,000 in 1990 to 8,000 in 2004, managing assets of USD 1.1 trillion, with USD 154 million managed through London."


My comments - a few months ago, I was surprised to read that Australian Superannuation funds had around 2% of total assets invested in hedge funds. I did not consider it to be appropriate, but that is merely my view. Wonder whether they invested in the right hedge funds or the wrong ones or whether anyone can actually knows the difference? The investors in LTCM did not know they had already lost money, until it was too late (a bit like reading about it in the newspapers). Of course, I have read recent reports that people are now "smarter" than back then. Hmmm.... time will tell.


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## Investor (20 May 2005)

Overnight (Australian time), the EU warned that it would follow America and impose trade barriers against China.

Here is China's response:

May 20 (Bloomberg) -- China raised export tariffs on textiles, seeking to avoid U.S. government and European Union quotas on shipments of Chinese shirts, trousers and underwear. 

China's textile exporters will have to pay a tax of as much as 4 yuan (48 U.S. cents) per item to sell their goods abroad, up from a maximum of 0.3 yuan, the finance ministry said on its Web site. The new tariffs, imposed on 74 types of textiles from June 1, are five times higher than previous taxes for most products, Xinhua news agency reported. 

``It's a gesture of goodwill from China,'' said Qu Hongbin, an economist at HSBC Plc in Hong Kong. ``Everything is symbolic because China's exports are very competitive.'' 

The curbs may not be enough to stop the U.S. and EU imposing quotas on some Chinese textiles, less than five months after a four-decade-old system of global quotas on textile trade ended. China's textiles exports surged 29 percent in the first quarter, aggravating trade tension with the U.S., which reported a record $162 billion trade deficit with China last year. 

``It means that in this little round of arm wrestling that pits the Americans and the Europeans against the Chinese, the Chinese have decided to slow their exports of textile products,'' said Pascal Lamy, nominated on May 13 to be the next director-general of the Geneva-based World Trade Organization. ``The bottom line is that the Chinese are slowing their exports to avoid the Americans and Europeans slowing their imports,'' he said in an interview on the French radio station Europe 1. 

External Pressure 

The U.S. Commerce Department on May 18 said it would cap imports on $914 million of Chinese clothing and yarn, a move following less than a week after it announced quotas on three other textile products. The U.S. imposed safeguard measures for men's and boys' shirts, trousers, knit shirts and combed yarn, allowing it to set a 7.5 percent limit on import growth of those products this month. 

The EU has also escalated threats to act against China since Feb. 24, when Trade Commissioner Peter Mandelson urged ``moderation and caution'' during a trip to Beijing. Two weeks later, he said the EU would take ``appropriate action'' in response to the increase in garment imports. 

On April 6, Mandelson rejected appeals from Euratex, which represents clothing manufacturers such as Marzotto SpA and Chargeurs SA, for immediate curbs. The EU's probe began about three weeks later. 

`Encouraging' 

``This is an encouraging step,'' said Claude Veron-Reville, a spokesman for the EU. ``This is an important element to take into account before the formal consultations are launched.'' 

The EU is keen to get more details on the move, she said. European national government experts will meet next week to decide whether to endorse the European Commission's proposal to open a formal period of consultations with China at the WTO. 

``The Chinese government is making a gesture to the world that it is taking active measures to curb textile exports, and it will help the government in its future talks to the EU and US to deal with the current trade disputes,'' said Long Guoqiang, a senior trade researcher at the State Council Development and Research Center. 

The move may be followed by more steps, depending on its effectiveness said Liang Yanfeng, a senior researcher at Chinese Academy of International Trade and Economic Cooperation. ``It will take some time for the government to see the result of the measure before they decide whether to expand the scale,'' she said. 

Wal-Mart, Oriental 

The tariff increase, while modest in dollar terms, will squeeze profits for China's exporters, said Zhang Hanlin, a senior trade professor at the University of International Business and Economics. 

Wal-Mart Stores Inc., the world's biggest retailer, said the tariff changes are unlikely to have much effect on their business. 

``We did not significantly increase imports from China when the quotas were eliminated,'' Xu Jun, a Wal-Mart spokesman in Beijing. ``Consequently, the re-imposition of tariffs, on certain types of apparel, will have relatively minimal impact on our business.'' 

Exporters including Orient International (Holding) Co., China's largest textile and clothing exporter in 2003, will be hurt by the tariff increase. 

``This kind of increase will particularly hit processing companies that depended on processing fees. Customers will shift their orders elsewhere and avoid China,'' he said. ``We will have to give up some orders that generate poor profits.'' 

Tariffs 

Items with tariffs raised by 400 percent include men's cotton or woven suits and shirts. Tariffs for women's cotton suits have been raised to 4 yuan from 0.2 yuan per item, and those for women's overcoats have risen to 4 yuan from 0.3 yuan. 

``On some products, tariffs will see a 20-fold increase and this should bring, on average, a half a euro tariff on each product,'' said Giuseppe Maraffino, a Milan-based economist covering Asia at UniCredit Banca Mobiliare SpA. ``However, China's competitive advantage comes from cheaper labor and I don't think this measure alone will be strong enough,'' he said, referring to today's announcement by the Chinese government. 

China's total exports were worth $97.4 billion last year, according to figures from the China National Textile & Apparel Council. The U.S. accounts for 24 percent of global textile and clothing imports, while the EU accounts for about 20 percent.


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## Investor (20 May 2005)

From the internet:

*Domestic threats to China's rise*

The general consensus is that China will gradually emerge as a power in East Asia able to challenge the United States for regional dominance. In preparation, every country facing the prospect of Beijing's wake is reassessing its strategic options in order to gain the best position possible after China sails ahead. Japan is looking for methods to challenge China's rising military power in the region and may amend its constitution in order to see this through. The 10 Association of Southeast Nations states are pursuing a strategy of interlocking their economies with China's, while looking to the US and India for balance and leverage. South Korea is moving closer to Beijing, though it will continue to rely on its special relationship with Washington. Washington's current National Security Strategy sees about a decade of opportunity for the US to act in order to achieve permanent security dominance in the region before China will be able to block such an effort. 

In the meantime, China's foreign policy has largely been driven by immediate needs - access to economic markets and energy resources. Knowing that its geopolitical power is directly tied to China's economic rise and the perception that it will continue for the midterm, Beijing has limited its other geopolitical ambitions for the moment and has pursued the "waiting game", sensing that its hand will increase in value as the game continues, as long as it is able to get its domestic cards in order. While the US, India, Russia and Japan may maneuver to limit China's expanded reach, there are several domestic liabilities that could potentially limit Beijing's ability to gain its presumed position in the region. 

The division between the rapid economic rise of China's east and the slow growth of the west has left the country divided. The environmental destruction caused by the centrally planned economy, and that the market economy has ignored or made worse, may cap China's economy before it reaches its full maturation. The social havoc that centrally planned birth control and an aging society may produce in the near future could force huge changes in the government's role in private life, or worse it could create a backlash against the government. Generational and ideological unrest could boil over as new technologies link disparate groups together. 

Perhaps the gravest threat is the rapid growth of the eastern coast, generated by cheap loans from poorly managed state banks, which could potentially undermine the booming economy. Any one of these liabilities could slow China's growth; all of them could sink China's rise. How China deals with these challenges in the near future will be a better determinate of its future role in the world than Beijing's current geopolitical maneuvering as it continues to play the "waiting game". 

*Holding China together to protect its 'peaceful' rise*

While China's coastal cities have experienced meteoric economic expansion for the past 20 years, the interior's growth rate has not been enough to maintain a balance between the agrarian economy of the interior and the manufacturing economy of the east. Urban incomes have roughly tripled in the past decade, while growth in rural incomes has lagged behind at two-thirds that rate, creating a widening disparity between the coastal region and the remainder of China. 

This imbalance has caused one of the largest migrations in the world's history as peasants from China's western and central provinces relocate to the booming economies of Shanghai, Beijing and Guangzhou. More than 40% of China's population now live in cities or towns, up from 18% in 1978 - nearly 1% of the country's population make the move every year, despite regulations such as household registrations that discourage migration. Recent statistics indicating a shortage of skilled labor in some coastal regions will do little to alleviate the problem. The interior is largely unable to fill this void, and the shortage will only drive up incomes for the coastal workers facing increased demand, further enlarging the income gap. 

The reason so many are abandoning the western, rural areas has everything to do with economic opportunities, but Beijing has moved to narrow the disparity by increasing the rate of urbanization in the west. In recent years, Beijing has begun to ease the restrictions on switching a rural household registration to an urban one - a necessity for a migrant worker to gain access to state services; still, this remains a burdensome process for many. Beijing is also pouring huge amounts of investment into infrastructure projects to the interior. While hundreds of billions of dollars have been spent to build the interior into an attractive location for private firms to invest, there has, so far, been little movement from the private sector to follow the lead. However, the environmental costs of these investments may prove to be too much for the economy to bear, injecting a potentially disastrous risk to any private investment in China's interior. 

The Three Gorges Dam will be the single largest source of hydroelectric power in the world (the equivalent of 15 nuclear power plants), and its reservoir will allow ocean-going ships to access China's interior for six months of the year, according to engineers working on the project. It will also displace more than 1 million people. The 265 billion gallons of raw sewage and 700 million tons of sediment deposited in the Yangtze River annually will no longer be carried out to sea and will back up in the reservoir. Over 1,000 mines and factories containing potentially hazardous materials will be submerged. But the largest risk is the catastrophe that could occur from an error in construction, which has been so plagued by corruption that even the state-controlled media has criticized the loose financing of the project. This project, on a colossal scale, highlights the looming environmental risks to China's rise. 

China continues to struggle with energy efficiency. Its oil use is currently about double the average of other Asian countries - approximately three-quarters of a barrel per US$1,000 of gross domestic product (GDP). Energy production is heavily reliant on domestic coal (75% of the country's energy production comes from coal-burning plants for which demand still outstrips supply, even as China has begun moving to alternative sources) and is subject to frequent outages - in turn, causing an increase in oil use as companies turn to generators to keep production lines running. The problems of energy production grow progressively worse as one travels west into China's interior, increasing the social divisions in the country. While China has clearly put energy security at the center of its foreign policy, its progress at tackling domestic inefficiencies is troubling at best. 

Environmental damage may not be the only legacy of China's centrally planned economy. China's "one child" policy may have created a society with far fewer workers than necessary to care for a population that will be dramatically weighted toward the elderly in the coming decades. In order to maintain social cohesion, Beijing will be forced to spend a greater percentage on caring for retirees than ever before. However, the effect of this policy may not simply be limited to economic costs. Under the "one child" policy, male children were favored over females, especially in rural and isolated provinces. Soon there will be an abundance of young men in China with no prospects for marriage in their country. 

This could prove to be a destabilizing factor if these young men direct their anger toward the state. As mass protests become more and more common throughout China, it is possible to imagine disaffected young men linking up to display their shared outrage - should this be directed at the government, it could limit China's ability to maneuver on the world stage. 

The recent string of protests directed at Japan demonstrated Beijing's ability to control (and manipulate) mass crowds in China for foreign-policy goals. However, they have also exposed some of Beijing's weaknesses on this front. Short message service messaging and e-mail were used to organize complicated protests. As organizers develop their skills, it is possible they will teach others not so keen to use the crowds for Beijing's benefit. This threat is more likely considering the current environment of wide-scale protests aimed at local officials and governments. 

It is estimated that there were 60,000 protests in 2003, a number that has increased 17% annually over the past decade; in some inland areas, protests are becoming a daily occurrence. This could be viewed as an opening of China's political system if it were not for the harsh measures that Beijing has employed to squash dissent in recent years. Forty-two of those partaking in the recent state-sponsored protests against Japan were arrested; when the cause goes against the government's political aims, the numbers are much higher. Even though they risk arrest and "reeducation" internment, Chinese citizens are publicly voicing complaints across vast areas of the country. 

These protests tend to be focused at local officials and stem from complaints about insufficient compensation for land confiscation, inadequate welfare payouts and official corruption at the local level. As Beijing began to shift state assets to the private sector, the unprofitable state industries of the interior were the first to be dumped and were the last to be granted access to state bank loans. This led to vast areas plagued with unemployment. Often, the residents too old to migrate to the urban centers but too young to draw a state pension, have little left to do except protest.

The state banks may have only added to the woes of China's interior, but they have become, perhaps, China's biggest liability if it is to emerge as a great power in the east. Some estimates have put the amount of "bad" loans in the system as high as $800 billion (China's GDP is close to $1.6 trillion). While this number may be inflated, the actual amount is certainly enough to cause great damage to China's economy. As a condition of joining the World Trade Organization, China must open its banking sector to foreign competition in 2006. When this happens, it is likely that accounts in good standing will flee to the newly introduced banks with better financial footing. While preparations are being made to raise cash for the state banks in order to better absorb this shock, there is little time for Beijing to finish its reforms. 

The current leaders have focused a great deal of their energy on resolving the banking issues that could undermine the coastal economies, if for no other reason than they know this is where China's leverage with other states is deposited. For instance, $200 billion in "bad" loans and other non-performing assets have been transferred to other institutions, cleaning up the banks' balance sheets. It is very unlikely that Beijing will allow its state banks to collapse or be undermined by the coming competition; in fact, the threat of competition has helped to transform the banking sector controlled by the state into a more transparent system in line with other developed countries' financial sectors. However, this has and will continue to require much of Beijing's energy, which could have been spent in other areas. 

*Conclusion*

China has recently begun to emerge as a great power, but much of this power is derived from the perception that its rapidly expanding economy will continue to raise the boats of its neighbors. Should China's economy begin to sputter, this newfound power could rapidly dry up, leaving Beijing's future ambitions marooned in the East China Sea. While much has been said about the possibility that certain sectors of China's economy could overheat and burden the rest of the country's economy, Beijing has, so far at least, demonstrated its ability to contain this problem with both heavy-handed and market-based approaches. 

Still, there are many other domestic liabilities that could bring China's economic expansion to a halt. The vast division between the booming economies of the coastal cites and the stagnation of the interior, environmental and social problems derived from centrally planned projects and the "bad" loans that continue to plague China's state-controlled banks could still sink the tremendous growth of China's economy. Actions from Beijing demonstrate that it is taking these problems seriously, enough at least to put its foreign policy ambitions not linked to energy security and access to markets on hold. It remains to be seen if Beijing will be able to do enough to stave off the domestic threats to its presumed assumption as regional hegemon.


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## markrmau (21 May 2005)

Perhaps the strengthening USD over the last few months is a flight to safety with expectations that the Chinese 'miracle economy' is about to derail.

I guess it will end spectacularly. When the wheels fell off Japan Inc., the strong domestic consumption 'propped up' the system allowing a decade long slide. China hasn't the domestic wealth and consumption, so when things pop, it could be a bit more of a dislocation.

Doesn't look good for aussie markets on monday.


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## Investor (21 May 2005)

*Greenspan Calls Home-Price Speculation Unsustainable * 

May 20 (Bloomberg) -- Some regions of the U.S. housing market show signs of unsustainable price speculation and ``froth'' from rapid sales, Federal Reserve Chairman Alan Greenspan said. The surge may ease as homes become less affordable, he said. 

``It's pretty clear that it's an unsustainable underlying pattern,'' Greenspan said in response to a question after a speech on energy to the Economic Club of New York. ``People are reaching to be able to pay the prices to be able to move into a home.'' 

``There are a few things that suggest, at a minimum, there's a little froth in this market,'' Greenspan said. While ``we don't perceive that there is a national bubble,'' he said ``it's hard not to see that there are a lot of local bubbles.'' 

Greenspan's comments represent some of his strongest language to date on rising home prices. Fed Governor Donald Kohn said in an April 22 speech that rising home prices now ``raise questions.'' 

Combined sales of new and existing homes, townhouses and condominiums set four records in each of the past four years, aided by low mortgage rates. The median price of a previously owned home in March rose 11 percent from a year earlier, the biggest 12-month gain since December 1980, according to the National Association of Realtors. Sales of new and previously owned homes are expected to total 7.87 million this year, trailing only last year's record, the group predicts. 

Investors 

A national bubble is unlikely because the U.S. real estate market is composed of individual regions with different pricing trends, making a collapse that damages the overall economy unlikely, Greenspan said. Home purchases and sales also have high transaction costs, making it hard to speculate, and most people buy homes to live in, he said. 

Even so, Fed economists have determined that second home purchases are partly responsible for driving up the ratio of sales to the existing housing stock, Greenspan said. Because buyers could sell without facing relocation costs, the Fed chairman said the more rapid pace of second home purchases may reflect speculation in some markets. 

A survey of the Realtors group released March 1 found that 23 percent of homes sold in 2004 were purchased by investors. Nearly 4 in 10 Americans said it is at least somewhat likely the housing bubble in their market will burst within three years, according to a May 13 Experian/Gallup Personal Credit Index poll. 

``When you get speculation, there are only a couple of ways for it to end, and they are not good,'' said Jay Mueller, senior portfolio manager at Wells Capital Management, a Menomonee Falls, Wisconsin-based division of Wells Fargo & Co. ``We are nowhere close to income growth matching house price appreciation.'' 

`Simmer Down' 

There's a risk that consumer consumption may decline if the housing market slows, Greenspan said. ``If it occurs, and eventually it will, it will reduce the fairly large and still accelerating degree of extraction of equity from existing homes,'' he said. ``This has been a major force in financing consumption expenditures.'' 

While Greenspan didn't explain why he expected the surge in home prices to ``simmer down,'' he noted that buyers have to resort to unusual financing techniques, such as interest-only loans, to afford homes now. 

There is ``considerable unlikelihood of a major decline'' in prices because that's ``very rare'' in the U.S., Greenspan said. 

``Even if there are declines in prices, the significant run- up to date has so increased equity in homes that only those who have purchased just before prices literally go down are going to have problems,'' he said. 

`The presumption that there are a lot of bankruptcies out there doesn't seem credible to any of my associates and myself,'' Greenspan said. 

Fed's Role 

Earlier this week the Fed and other banking regulators warned banks that they should tighten controls on home equity loans that they said are too often offered with no documentation of a borrowers assets. 

``That kind of moral suasion approach should probably have been done two years ago,'' said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina. ``It is very hard for them to jack up interest rates to deal with this, but they can get tougher on their guidance.'' 

Economists such as Stephen Roach of Morgan Stanley have said the Fed helped cause housing and other asset prices to soar by keeping its policy rate at 1 percent for the year ending June 2004, the lowest since 1958, and then raising rates slowly. 

One result of the Fed's ``measured'' pace of rate increases is that long-term bond yields, which set the basis for many mortgages, have stayed low. Yields on 10-year Treasury notes are about 4.12 percent, down from about 4.7 percent a year ago. 

The rate on a 30-year fixed mortgage this year has averaged 5.78 percent, close to the four-decade low of 5.21 percent that was reached in 2003, according to mortgage purchaser Freddie Mac. 

Regional Prices 

David Berson, chief economist at Fannie Mae, said in a report this week that the affordability of homes in some regions is at its lowest level since the mid-1980s because of huge price increases. Nationally, housing affordability, a function of prices, mortgage rates and income growth, is in the middle of its 10-year range. 

The median selling price of a previously owned home rose to a record $195,000 in March, the latest statistics from the Realtors group showed. Previously owned homes account for 85 percent of the residential real estate market. 

Three metropolitan regions in Florida led the nation in price growth, according to the group. The strongest price increase was in Bradenton, where the first-quarter median price of $275,000 was 46 percent higher than the same period in 2004. 

`Hot Spots' 

In the San Francisco Bay area, the nation's most expensive region for homes, the median price was $689,200. 

``The housing market doesn't have a regional problem; it has localized hot spots,'' said Robert Brusca, president of Fact & Opinion Economics in New York. 

The Standard & Poor's Supercomposite Homebuilding Index, which rose 64 percent in the past 12 months, fell 0.7 percent today. Shares of builders Meritage Homes Corp., Toll Brothers Inc. and KB Home have all more than doubled in a year. 

Greenspan's housing comments came after a speech on energy prices. The Fed chairman said businesses and consumers are already changing investment and purchasing plans to adapt to higher energy prices and will eventually increase energy efficiency in the U.S. 

``With energy prices again on the rise, more rapid decreases in the intensity of use in the years ahead seem virtually inevitable,'' Greenspan said.


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## Investor (21 May 2005)

May 20 (Bloomberg) -- China's decision to raise textile export tariffs is unlikely to have much effect in stemming the surge in trade or dampening calls by foreign producers to cap clothing imports from China, U.S. and European businesses said. 

``We are past the point where we can rely on promises from the Chinese to act,'' said Lloyd Wood, a spokesman for the American Manufacturing Trade Action Committee in Washington, which represents U.S. textile makers. 

China's finance ministry said yesterday in Beijing that textile producers must pay a tax of as much as 4 yuan (48 U.S. cents) per item, up from a maximum of 0.3 yuan. The new duties on 74 products including shirts, pants and underwear take effect June 1 and come amid a groundswell of attempts in the U.S. and Europe to punish China for what some call unfair trade practices. 

Francesco Marchi, director of economic affairs at Brussels- based Euratex, which represents companies including Marzotto SpA and Chargeurs SA, said the change falls short of expectations. 

``The overall impact remains marginal and limited,'' Marchi said. ``Clearly they should go even higher. It's something but it's not enough to correct the situation.'' 

China is the world's largest clothing exporter, shipping about $97.4 billion of apparel worldwide last year, according to the China National Textile & Apparel Council in Beijing. Prices for Chinese apparel in 2004 were 58 percent below those offered by suppliers in Bangladesh, India and other countries, the U.S. industry estimates. There aren't enough details to show that yesterday's decision will affect that difference, Wood said. 

Price Advantage 

Only two categories of products were assigned the maximum tax, women's polyester pants and cotton women's overcoats, and two were given a tax of 3 yuan, flax yarn and men's wool pants, according to the ministry's Web site. T-shirt exports, one of China's largest, were assessed a levy of less than 1 yuan. 

``China's subsidies are just going to overwhelm these increases,'' Wood said. ``It's too little, too late.'' 

Marchi says that the 4-yuan tariff amounts to about 8 percent of the total cost of some of the items concerned. 

``If we want the measures to work you have to have at least 30 percent tax which clearly is impossible, a increase to 7 percent or 8 percent doesn't make a difference.'' 

Textiles exporters in China including Orient International (Holding) Co. agreed that the tariffs may not be enough to stop the U.S. and EU restrictions, less than five months after a four- decade-old system of global textile quotas ended. 

China's higher levies probably won't erode the price advantage of its clothing, both producers and importers say. 

China's decision ``is going to be too little, too late to affect our people,'' said Laura Jones, president of the U.S. Association of Importers of Textiles and Apparel in New York. 

U.S. Consultations 

Within hours of China's announcement, Brazil said it planned to implement restrictions on textile imports from China. 

China's worldwide textile and clothing exports rose 29 percent in the first quarter, aggravating tensions with the U.S., which reported a record $162 billion trade deficit with China last year. The Bush administration this month imposed quotas on more than $2 billion in apparel imports from China, and is considering more caps that could go into place next month. 

The U.S. will hold meetings with Chinese authorities in the coming weeks to discuss the quotas, said Dan Nelson, a spokesman for the Commerce Department in Washington. ``The consultations will represent an opportunity for discussion with the Chinese government of the measures just announced,'' he said. 

In addition to recent Commerce Department actions, there are several bills before Congress aimed at China's currency and trade policies. A bill was introduced in the U.S. Senate this year to impose a 27.5 percent tariff on Chinese imports unless China revalues its currency, and legislation was proposed in the House of Representatives last month to broaden the definition of exchange-rate manipulation to include China as an offender. 

European Union 

In Europe, the French government urged the European Union about three weeks ago to curtail a 60-day investigation into a surge in clothing imports and instead move toward immediate measures against China. The European Union responded May 17 with a demand for immediate action by China to pare growth in T-shirts and flax yarn or risk having quotas imposed. 

Former EU trade commissioner Pascal Lamy, who was nominated on May 13 to be the World Trade Organization's next chief, said China's move represents progress in the ``round of arm-wrestling that pits the Americans and the Europeans against the Chinese.'' 

``The bottom line is that the Chinese are slowing their exports to avoid the Americans and Europeans slowing their imports,'' Lamy said in an interview on Europe 1 radio station. 

Claude Veron-Reville, a spokeswoman for current EU Trade Commissioner Peter Mandelson, called the move ``an encouraging step.'' 

``This is an important element to take into account before the formal consultations are launched,'' he said. 

Seeking Details 

European national government officials will meet next week to decide whether to endorse Mandelson's proposal to open a formal period of consultations with China at the WTO. 

``The Chinese government is making a gesture to the world that it is taking active measures to curb textile exports, and it will help the government in its future talks with the EU and U.S.,'' said Long Guoqiang, a senior trade researcher at the State Council Development and Research Center in Beijing. 

More steps may follow the move announced yesterday, said Liang Yanfeng, a senior researcher at the Chinese Academy of International Trade and Economic Cooperation. ``It will take some time for the government to see the result of the measure before they decide whether to expand the scale,'' she said. 

Wal-Mart 

Wal-Mart Stores Inc., the world's biggest retailer, said the changes are unlikely to have much effect on its business. 

``We did not significantly increase imports from China when the quotas were eliminated,'' Xu Jun, a Wal-Mart spokesman in Beijing. ``Consequently, the re-imposition of tariffs on certain types of apparel will have relatively minimal impact on our business.'' 

Still China's largest exporters agreed that the momentum in the U.S. and EU to impose safeguard and retaliatory measures against China is strong. 

China's ``government will increase its room for negotiation, but the U.S. and the EU will still carry out their procedure,'' Jimmy Zhang, trading manager of Orient International, China's largest textile exporter in 2003, said by telephone from Shanghai.


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## Investor (21 May 2005)

markrmau said:
			
		

> Perhaps the strengthening USD over the last few months is a flight to safety with expectations that the Chinese 'miracle economy' is about to derail.
> 
> .... Doesn't look good for aussie markets on monday.




I think (could be wrong) that the USD rising, was partly due to interest rate rises for the USD, hence increasing its relative yield (interest rate on a currency is one of 6 major factors affecting FX) and partly due to the repatriation of funds from unwinding of overseas investments by hedge funds and some private American investors.

See the following article. Foreign investors who agree with the outlook for the AUD would probably consider withdrawing (if they have not already done so) some AUD investments after calculating potential FX losses. 

A 10% reduction from 40% to 30% foreign ownership of ASX market capitalisation is over $90 billion.

May 21 (Bloomberg) -- The Australian dollar had its third weekly decline on concern falling commodity prices will weigh on the currency and the country's interest rate and yield advantage over the U.S. will narrow. 

The prices of metals such as copper and gold that Australia exports dropped over the week, raising speculation the country's revenue from overseas sales will decline. The Reuters-Commodity Research Index of 17 commodities futures has fallen 9 percent from its March 16 all-time high. Over the same period the Australian dollar has depreciated 4.7 percent. 

``Commodity prices and the direction of the U.S. dollar will drive the Australian dollar lower,'' said London-based Monica Fan, global head of foreign exchange at RBC Capital Markets from the firm's Sydney office. She recommended selling the currency next week. 

Australia's dollar fell to 75.60 U.S. cents in late New York trading yesterday from 76.14 cents at the close a week ago. The currency slid to a four-month low of 75.32 cents on May 18. 

Australia's dollar may slide to 70 U.S. cents by year-end, said Stephen Koukoulas, chief strategist at TD Securities Ltd. in Sydney. The currency is influenced by metals prices because almost 60 percent of the country's exports, which make up a fifth of the economy, are raw materials. 

``There has been a clear softening of commodity prices,'' said Koukoulas. ``This component of currency support for the Australian dollar is very quickly unwinding.'' 

Copper futures for July delivery rose 1.2 cents, or 0.9 percent, to $1.375 a pound on the Comex division of the New York Mercantile Exchange yesterday. Prices were up 29 percent from a year earlier, while the Australian dollar has gained 8.6 percent over the same period. A futures contract is an obligation to buy or sell a commodity at a set price by a specific date. 

Australia is the world's third-biggest producer of the metal, which had a correlation of 0.81 with the Australian dollar in the past year. A reading of 1 would suggest the two move in lock step. 

Rate Gap 

The currency is also being sold because some traders are betting that rising U.S. interest rates will lure investors away from Australian financial assets such as government bonds. 

Australia's target interest rate for lending to banks overnight is 5.5 percent compared with the Fed's comparable rate of 3 percent. The Reserve Bank of Australia has raised rates just once in the past 17 months. The Federal Reserve has lifted rates by a quarter percentage point eight times since June to 3 percent. 

Thirteen of 22 economists surveyed by Bloomberg News on May 6 forecast Australia's interest rate will remain unchanged for the rest of the year. U.S. borrowing costs will rise to 4 percent by year-end, according to the median estimate of 63 economists surveyed by Bloomberg from April 29 to May 6. 

``One of the core reasons behind our expectations that the Australian dollar will underperform through 2005 and 2006 is that higher rates and yields in the U.S. will see spreads narrow versus Australia,'' Westpac Banking Corp. currency strategists, headed by Robert Rennie in Sydney, wrote in a note to clients. 

The currency will decline to the low 70 cent area by year- end, the bank predicts. 

The gap in yield, or spread, between Australian two-year government bonds and comparable U.S. Treasury notes has narrowed to 1.60 percentage points from 2.92 percentage points a year ago. The gap has averaged 2.23 percentage points in the past year. 

`Risk Environment' 

Australia's dollar also weakened on concern hedge funds, which helped drive the currency higher last year, may sell after incurring losses, said Simon Stevenson, a currency strategist at Merrill Lynch Investment Management in Sydney. 

The funds, loosely regulated investment pools that oversee more than $1 trillion for investors, declined by an average 1.75 percent in April, their worst monthly performance since September 2002, according to Hennessee Group LLC, a New York-based consulting firm. 

``The risk environment isn't positive for the Australian dollar,'' said Stevenson, who helps manage about $8 billion of investments. ``I'd be a seller of Australian dollars.''


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## Investor (21 May 2005)

Greenspan raises yuan inflation risk
May 21, 2005

US Federal Reserve Chairman Alan Greenspan today said he expected a revaluation "at some point" of the Chinese yuan and warned the move could impact inflation in the United States.

"I will accept the premise that the (yuan) will be at some point revalued," Mr Greenspan said in response to a question after a New York speech.

The powerful US central bank chief then warned it might have unintended consequences for those in the United States who blame China for global trade imbalances.

A revaluation would likely mean higher prices for imports, stoking inflation. Manufacturers might simply shift out of China to other low-cost nations, he added.

"The effect will be a rise in domestic prices in the United States and as a consequences of that there will be other impacts," Mr Greenspan said. 

Following a revaluation, Mr Greenspan said, "the price of imports in the United States from China will rise ... it does not follow that it will lower our overall trade balance".

Mr Greenspan pointed out that in the global market companies could shift elsewhere if the Chinese currency got too high.

"China competes significantly with Thailand, etc," he said. "Essentially what we will find is that we will import from a different area (if the yuan rises significantly)."


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## Mofra (22 May 2005)

Investor,

Thanks for all the info, been reading your posts with great interest.

Just on the revaluation of the yuan, there will obviously be some benefit to Australian commodity exporters, is there any way of estimating or calculating the benefit to the sector as a whole or to the economy?  I imagine some estimates may exist, but if so where would be a good place to start researching?

Cheers


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## Investor (22 May 2005)

Mofra said:
			
		

> Investor,
> 
> Just on the revaluation of the yuan, there will obviously be some benefit to Australian commodity exporters, is there any way of estimating or calculating the benefit to the sector as a whole or to the economy?  I imagine some estimates may exist, but if so where would be a good place to start researching?
> 
> Cheers




Take a look at my latest post in the BHP / Rio Tinto thread for a start.


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## Investor (23 May 2005)

Latest writing from Stephen Roach (who has had a bearish view for some time, but he is more of a global big picture type of analyst) from Morgan Stanley:

Stephen Roach (from Beijing)

Over the years, I have made probably ten visits to the Temple of Heaven in Beijing.  But this time it literally took my breath away.  Built in the 15th century, it is one of Ming China’s greatest monuments ”” an extraordinary complex of sacrificial buildings that is three times the size of the Forbidden City.  The centerpiece ”” the magnificent three-level white marble Altar of Prayer for Good Harvest ”” was the scene for the major social extravaganza of the just-completed Fortune Global Forum.  Staged by the Beijing municipal government, the Temple of Heaven was magically transformed by lights, music, opera, and traditional costumes and dancing into what had to be a preview of the opening ceremony of the 2008 Olympics.  It was a truly spectacular event.  On the surface, the China boom never looked more glorious. 

Beneath the surface, however, there is a growing sense of unease in China.   Don’t get me wrong ”” the backward looking data flow still looks terrific.  GDP growth continues to soar ”” gains in 2003 were just revised upward to 9.5% (from 9.3%) and the Chinese economy was estimated to be holding at that pace in the first period of 2005.  The latest update of the more reliable industrial output figures paints an equally impressive figure ”” a reacceleration to 16% y-o-y growth in April versus somewhat more subdued year-end 2004 comparisons of 14.4%.  Growth is not the issue in China.  There has been plenty of it in recent years and there is an ample reservoir of considerably more growth to come in the pipeline.  The issue is the consequences of that growth.

Two considerations are especially critical in that regard ”” China’s own efforts to maintain the internal stability of its economy and the world’s response to the China growth juggernaut.  Recently, Chinese officials have taken dead aim on the nation’s over-heated property sector with a new series of tough administrative measures.  This is the third such action this year, but this one seems to have real teeth in going after excesses on both the demand and supply sides of the property.  There is a new tax on any “property flipping” that will be imposed on transactions taking place within two years of a purchase and there are new penalties for excess developer’s profits and the restriction of land supply.  These actions were jointly issued by seven agencies within the central government ”” underscoring a deep sense of determination on the part of China’s senior leadership to come to grips with the major internal excess of the Chinese economy.  This is clearly a much tougher message than I picked up in late March, when I met with senior officials at the annual China Development Forum (see my 22 March dispatch, “China Goes for Growth”).   That could finally mean “game over” for the Shanghai property bubble.

Meanwhile, back home, the US government has unleashed a multi-pronged assault on Chinese trade.  The Commerce Department has imposed “surge protection” quotas on the imports of several categories of textile products made in China.  The Treasury Department has issued the functional equivalent of an official ultimatum on the currency issue ”” making it crystal-clear that China is on the brink of being found guilty of manipulating the renminbi.  And the US Congress is moving full speed ahead in the consideration of a more broadly based scheme of stiff tariffs on all Chinese-made products shipped to the United States.  Reflecting the confluence of lingering angst in a tough US labor market and a China-centric trade deficit, the scapegoating of China has now become the favorite political sport in Washington (see my 9 May dispatch, “Politicization of the Trade Cycle”).  Never mind, the flawed macro logic behind this potentially tragic outbreak of protectionism.  US politicians seem increasingly united in their efforts to blame China for America’s massive foreign trade and current-account deficits. 

The real test for China comes from the potential interplay between these two sets of forces ”” internal measures aimed at containing the property bubble and external measures aimed at constricting Chinese trade.  This could be an exceedingly difficult set of circumstances for an unbalanced Chinese economy, whose growth dynamic is powered by two major drivers ”” exports and export-led investment.  Collectively, exports and fixed investment now make up about 80% of total Chinese GDP.  By going after the property bubble, Beijing is attempting to squeeze the biggest piece of that ”” domestic investment ”” whereas Washington is taking aim on the export component.  This potential double whammy is especially disturbing in that China lacks the backstop of internal private consumption; in 2004, household consumption fell to a record low of 42% of Chinese GDP ”” the smallest consumption share of any major economy in the world.  (Note: While investment, exports, and private consumption collectively account for more than 100% of Chinese GDP, a negative offset of some 34% of GDP comes from imports, while another 12% shows up in the form of government consumption). 

This could well be modern-day China’s toughest macro challenge.   Time and again ”” but especially over the past eight years ”” the Chinese economy has had to cope with very tough external and internal circumstances.  The Asian financial crisis of 1997-98, the synchronous global recession of 2001, and the SARS outbreak of early 2003 were all formidable threats that most in the West thought would derail the Chinese economy.  Yet China barely skipped a beat on all of those occasions.  This time the challenge is very different and potentially much more significant ”” ironically, coming just when the world has become convinced that the Chinese growth miracle is here to stay.  If Beijing gives on the currency front after having just taken actions to pop the property bubble, the risk of a major shortfall of Chinese economic must be taken seriously.

But the real problem is political: China and the United States are on very different pages when it comes to assessing the reactions to these tough macro circumstances.  The Chinese leadership is filled with indignation over Washington’s protectionist leanings.  But it seems unwilling or unable to recognize the political aspect of this threat.  Instead, senior Chinese officials are very focused on the macro origins of America’s external imbalances as being deeply rooted in an unprecedented shortfall of domestic US saving ”” a case that I have made repeatedly in my own presentations in Beijing and around the world over the past several years.  What Beijing seems to be missing is that Washington politicians could care less about macro ”” they are focused are pinning the blame on someone else.  Today, that someone else, unfortunately, is China. 

What worries me most is that both nations ”” China and the US ”” are painting themselves into political corners from which there are no easy exits.  Chinese officials speak repeatedly of the currency issue as a matter of “national sovereignty” ”” stressing that any external pressure to change will be counter-productive for a nation that places great emphasis on its newfound pride.  At the same time, Washington seems increasingly convinced that the US body politic is finally prepared to say, “enough is enough” on the trade deficit.  At the late March China Development forum, I warned Chinese officials that 2005 was shaping up to be the worst year for US-China trade relations in a decade (see “China’s Rebalancing Imperatives” published as Special Economic Study on 21 March).  I was wrong.  This year has turned out to be the worst outbreak of Washington-sponsored China-bashing on record.  Political stalemates are resolved when one or both parties blink.  China and the US are unflinching in their political resolve. 

Recent actions in Washington offer little hope of compromise from the US side.  At the same time, my conversations this week in Beijing left me increasingly concerned about China’s willingness to compromise.  Don’t get me wrong ”” the air is buzzing with speculation of an imminent shift in RMB currency policy.  But a new wrinkle has just entered the political equation ”” an escalation of efforts to contain an increasingly worrisome property bubble.  Given its long-standing focus on stability, I get the strong sense that the Chinese leadership believes that there is a tradeoff between actions on the property and the currency fronts.  Faced with worrisome downside risks to economic growth if it acts on both fronts, from Beijing’s perspective, it may boil down to a choice between these two options.  Having played its hand on property, the odds of China moving on the currency may well have declined.  And that could mean that the political quagmire with the US may only deepen, as a result.

Like most things in China, there is more to the Temple of Heaven than meets the eye.  The Imperial Vault of Heaven is surrounded by the so-called Echo Wall.  If you stand at one part of this circular wall and whisper, your voice can be heard with perfect clarity by someone situated at the opposite portion of the wall.  That’s pretty much sums it up today.  The echoes of Beijing are growing louder by the moment.  The cacophony of US and Chinese politicians speaks of a debate that is working at cross-purposes ”” charges and counter-charges that offer little possibility to resolve the mounting build-up of macro tensions between the two nations.  For an unbalanced global economy and ever-complacent world financial markets, the echoes of Beijing left me with a deep sense of trepidation.


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## ob1kenobi (24 May 2005)

Re: China. As one with a major in Anthropology and Sociology, we are witnessing the waking of a giant. The world largest population, slowly moving from an agrarian economy to a more industrialized one, wanting to engage the world whilst protecting the rich heritage that it has from the ravages of external cultural influences that often arrive with foreign trade. It is forseeable that China in the process of transition could become an economic giant, It is also reasonable to fear the turmoil (political, legal, economic, technological), that could enguld it in the process. Time will ultimately decide this but the influences could be profound.


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## TjamesX (24 May 2005)

This probably has significance for this thread and the general Chinese situation everyone is trying to understand - usefulness is ????, its more just interesting reading....

I read a book a couple of years ago called _Lords of the Rim_ written by Sterling Seagrave. Anyone interested in China's history, present and where its going - it is truly a great read, worth adding to the bookshelf.

The book may seem to be a bit prophetic as it was written in 1995, but it is essentially about the legions of migrants that have settled in the pacific rim over many 100 of years, some leaving of their own will, some expelled - but all having a common root to the South of China... also referred to as the overseas Chinese. I guess its a tale of how years of dictatorships and communism within Chinese culture breed a certain type of capitalist - now they are poised to shape their former countries future with their amassed wealth.

Here's the blurb from the the back cover;



> A community of 55 million expatriates. Up to 2 trillion dollars in assets. A highly integrated network of influence and favour. A firm base on the Pacific Rim. Ambitions to influence the West. Imagine the potential power of such an organisation. You don't have to. This is the empire of the Overseas Chinese.




A couple of extracts from the last few pages, that upon reading them now seem eerily relevant;



> With their tradition of evangelism, and the conviction that they have the mandate of heaven, Americans are in the habit of forcing their vanities down the gullets of other people. Much of Lee Kuan Ywe's advice to the West about China has to do with letting the Mainland have its own particular nationalism, and ceasing to press China to bahave according to what the West sees as 'universal' moral principles........
> 
> Lee Kuan Yew urged the United States to befriend China, rather than trip it up with threats of trade war. Would the West really prefer it if Beijing lost control, China disintegrated, and the chaos of the warlord years resumed? The Japenese learned that there are many Chinas, not just one...... A Beijing preoccupied with prosperity is much less likely to make trouble. The Wests best interest therefore lies in encouraging China's propsperity. And prosperity there will be, whether the West encourages it or not, co-operates or not, plans for it or not. The age of Sun Tzu has returned. It is sunrise on the Rim.




remember this was written in 1995... at the time it didn't really hit me the significance of the expat Chinese. Then a couple of things that stuck with me simply because I had read the book - talked to someone about Vancouver (where she lived) she mentioned that nearly all the signs in the city have Chinese dielect as well as english. Also someone from Auckland mentioned there were hole suburbs in the City were owned/occupied by overseas Chinese.  (two cities specifically mentioned in the book)

TJ


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## excalibur (24 May 2005)

Chinese Intention
Moving 4 million people from west to east, building streets, cities and housing as well as future factories, lets me remember the US in the industrial boom.
It scares me a bit. It`s like giving a kid  machine-gun.
Till the americans started to realize how they should manage their monetary system, took quite a while. Many mistakes were made. We all know the consequences...
As soon as chinas currency  be strong enough, there could be first a tug of war.
And that could be bad news for everybody.


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## Investor (24 May 2005)

Here is another instalment of my epic posts from the internet. It aims to explain the global macro economic settings and outline some of the risks that lie ahead.

I enjoy analysis because it helps me understand what is happening and what is likely to happen. It assists me in risk management. I prefer to know in advance what might happen and if a serious fall in markets occur, I already know why, rather than having to wake up and ask "What happened?"    :

*The Strange Tale of the Bare-Bottomed King
By Bill Gross
May/June 2005 - Investment outlook  * 

They say never sell America short and with good reason. Any country whose equity market has been able to crank out 6.8% real returns annually over the past century stands as a formidable obstacle for any speculator willing to bet the "don't come" line. The odds of winning a long-term wager laid against the U.S. "house" have been about as bad as heading out to the track and betting on your favorite color of jockey silks. Even when the bear gets his facts right, the timing and the wait often spell his doom; the "house" has more chips, especially a house with reserve currency status like the U.S., so a wager must be done prudently in order to conserve capital for that prospective rainy day. 

Our recent PIMCO Secular Forum, held over a 3-day period in mid-May, discussed this cautionary and historical framework within the context of a U.S./global economy that clearly had begun to resemble a casino, but nonetheless appeared to have ample chips or reserves to keep the game going for awhile. Speakers such as Michael Dooley, conceptualizer of the current Bretton Woods II arrangement, and Jonathan Wilmot of CSFB, presented their bullish and in some cases bearish arguments for economic growth and investment returns over the next 3-5 years. Over 100 PIMCO professionals actively participated in the discussions and decision-making, which by its heritage has a long-term secular orientation. In the end, while the gambling metaphor and betting against the house advice was more than apropos, we chose instead to weave our tale around the story of the Emperor who had no clothes and the solitary boy who in his innocence cried out that this sovereign was indeed - naked. Not wanting to sell America short just yet however, and being mindful of our country's dynamic past and the lessons that its history inevitably has taught wayward doubters, we decided to modify the parable just a tad. We agreed that the U.S. was indeed King of the World and was indeed outfitted in a grand set of clothes. Biggest economy, most powerful military, best universities, highly productive, freest capital markets, bearer of the world's reserve currency status - these are all characteristics that describe our current King, and any little boy or bear who shouts that they can't see them is close to blind. So our monarch has some spiffy threads indeed. Still, after analyzing not only the U.S. in 2005, but the global kingdom that it rules, we had legitimate concerns as to how well those threads were put together. They look good, but can they hang tight without shredding during a storm, or will they come undone, leaving our ruler bare-bottomed in the wind? The answer, we decided, was dependent on the quality of the cloth and its stitchery - how well they were put together - and of course, the probability of a storm epitomized in our cartoon by the terrier of Coppertone fame. But lest we give too much away in this reality-show fairytale let us recap the past and begin as they say at the beginning. 

Secular Review and Current Update
One day sometime in the early 21st century, there was a global economy that was growing at what appeared to be a decent enough rate but which was suffering from a strange malady - something economists describe as a lack of "aggregate demand" - in essence an inability to make use of available global capacity to produce. Now that was a condition that most citizens could hardly comprehend because mankind's desires/demands appear to forever be insatiable. We always want more of everything so how could there ever be a lack of "aggregate demand" in this magic kingdom? The historical textbook example of this malady probably first appeared during the depression of the 1930s when what Keynes labeled as capitalism's "animal spirits" were so dampened that corporations and consumers sat out the dance, preferring to hide their money in a mattress instead of risking it in a transaction during a deflationary spiral. In their place, government became the buyer of last resort. The world's most recent example has unfolded in Japan over the past decade, but scores of other instances now abound centering around either 1) mercantilistic or 2) demographic secular influences. The mercantilistic draining of global demand has its most recent origins in the Asian crisis of nearly a decade past when South Korea, Malaysia, and others left themselves exposed to the seemingly whimsical liquidity injections - then withdrawals - of global bankers and investors. Whispered vows of "never again" placed an increasing emphasis on exports/production as opposed to imports/consumption and the result was massive increases in Asian and selected emerging country reserves as the U.S. current account deficit helped build the war chests shown in Chart I.   

"If you don't have enough reserves it can cost you a lot. We learned that (in the late 90s)," ex-Korean official Hong-choo Hyun warned recently. Asia's mattress in the past few years, then, has taken the form of massive recycling of reserve surpluses into U.S. Treasuries instead of reinvestment in infrastructure or government sponsored business ventures. To make this arrangement possible, a fixed currency in China and "dirty floating" currencies in the bulk of Asia have mirrored an image reminiscent of the Bretton Woods era of reserve management during which the U.S. dollar was fixed to gold and the remaining currencies were fixed to the dollar. Our new arrangement is being labeled Bretton Woods II even though the dollar no longer has any such anchor and currencies such as the Euro are free to float. China itself is expected to institute a freely floating currency within the context of existing WTO plans during the next 3-5 years, but for now, BWII and its currency fix is standard operating procedure. 

Supporters of this process such as Forum speaker Dooley, argue that its informal yet semi-regulated structure is helping to generate sufficient global demand for goods and services by flowing money from those countries that want to produce (Asia) to countries that still want to spend (the U.S.), and they have a point. Yet to focus on currently attractive global growth rates under the umbrella of Bretton Woods II misses the broader and overarching point. The global economy needs more consumers, but because of prior financial crises and advancing demographic influences that focus on savings for retirement, shown in Chart II, the primary willing spenders reside in the U.S.   

Newly prosperous emerging market countries are the world's natural deficit countries - instead they are building surplus reserves. Together this combination of American shoppers and Asian/emerging market/European savers are exchanging dollars, and goods and services in what for now appears to be an OK arrangement for both parties. But because it is so consumption one- sided, there are risks - increasing risks - that this apparent equilibrium is rather unstable and may at some point tip over. Unless Asia and Europe can join the consumption party, there may come a time when the U.S. Viagra wears off. Because of Bretton Woods II, the recycling of reserves into U.S. Treasuries has allowed Americans to finance their imports at exceedingly attractive interest rates. Yields on U.S. Treasuries and corporates may be as much as 100 basis points below prior equilibrium levels, so if the U.S. is King, then we undoubtedly have purchased for ourselves a fine set of clothes on cheap credit. The new threads, however, have been secured on the back of rapidly increasing debt, resulting in a 6% of GDP balance of trade deficit, and that debt has been extended to consumers only because of asset appreciation in the financial and housing markets. Can this King continue to reign over a seemingly prosperous yet imbalanced global and U.S. economy? 

We advised in prior pages that the King's clothes and their ability to cling to his bod were dependent on two things - the quality of the stitchery and the potential for a storm. Let's put ourselves first of all in the role of royal seamstress to get a behind-the-scenes look at how these clothes have been put together. We acknowledge once more that the finest cloth has been purchased due to productivity advances, leading technologies, superb higher education, free-flowing capital markets, and a military dominance that allows the U.S. to exert its will in supranational agencies such as the U.N., World Bank, IMF, and the WTO. But in recent years, America's growth has been stitched together more from the iron fist of government policies than the invisible hand of a dynamic free enterprise economy. (In a world deficient in aggregate demand, the case for free markets and the invisible hand grows weaker as PIMCO's Paul McCulley has pointed out.) Its budget surpluses of the late Clinton years are a distant memory due to tax cuts and Iraq-related defense expenditures. Without them however, and the resultant deficits, our recovery from the stock market "bubble popping" of 2001 might never have occurred. In turn, reflationary monetary policies of global central banks, especially our Federal Reserve, have fostered a low nominal and much lower still real interest rate environment that has remarkably failed to stimulate normal domestic investment as in prior business cycles. *Instead it has led to higher levels of U.S. consumption due to housing appreciation/equitization which have provided the ability to buy goods with money that can only be described as near "costless." Without this government intervention, which in some ways is reminiscent of the 1930s depression - differing for the time being primarily in its earlier and more efficient implementation - the U.S. and global economy might be sinking instead of floating. * 

What's New
But there are limits, both fiscal and monetary, and the monetary limit - what we will describe on the next few pages as the "Pump," as well as our recognition of the still developing Bretton Woods II policy arrangement - stand as PIMCO's primary 2005 additions to our ongoing secular outlook. While Bretton Woods II is odds-on in PIMCO's book to be with us during the bulk of our 3-5 year secular timeframe, and therefore continue the 100 basis point interest rate subsidy to our financial markets, there undoubtedly are risks that must be monitored. It isn't prudent for U.S. citizens to continue to expect to consume 6% more than they produce, nor is it rational for investors to expect foreign central banks - primarily the Chinese and Japanese - to invest that 6% surplus and other direct investment monies into the U.S. Treasury market forever. At some point it comes undone, either through a massive revaluation and dollar decline, a Treasury buyer's boycott, or a whimpering U.S. consumer beaten down by the cost and/or amount of their burgeoning leverage - much of which is housing related. Geopolitical risks abound as well with North Korea, Taiwan, and Iran serving as potential flash points. Since the Bretton Woods II arrangement currently seems to satisfy giver and taker, consumer and maker, it should survive for a few years. Cross those fingers, though. 

Because that conclusion nearly mandates a continuation of our artificially low U.S. and global interest rates fostered at the expense of the yield insensitive Chinese and Japanese Bretton Woods II (BWII) "cartel," it might seem that all we as bond investors have to do is to head for the bar to get a tall cool one. But that would neglect the potentially reflationary impact of this artificially low yield environment. Surely, near 0% real short-term rates here and abroad have got to stimulate an inflationary resurgence. Au contraire. *China has opted into BWII for one reason only - to employ hundreds of millions of unemployed workers in its interior. And it is those same workers, requiring only 5-10 cents per U.S. wage dollar that have kept inflation competitively low nearly everywhere in the global economy. What inflation we do have - 3% in the U.S., 2% in Euroland, 0% in Japan - is due to asset inflation - higher commodity prices, higher housing prices, and higher stock prices - creating artificial wealth and immediate purchasing power through what we described at our Secular Forum as the "Pump." In some secular stretches, real, not artificial wealth is generated by productivity surges and the advancement of new technologies. The 1990s was such an example, but during the past five years wealth has come more from finance- based miracles than those based on productivity. * 

*Nearly everyone knows that oil prices, housing prices, and even stock prices are up in the past few years and in some cases spectacularly. Not everyone knows why. Enter the "Pump." The pump in its purest sense - sans the risk premium, and the P/E, P/Rents multiple changes of stock and home prices - can best be explained via the price action of a good old inflation protected Treasury, a 5-year maturity TIPS shown in both yield and price terms in Chart III.* 

This asset has been "Pumped" over the past 4 years to the tune of 14% price appreciation by the low interest rate policy of Alan Greenspan. Its 4% real yield has been lowered to 1% real yield with a resultant 14% price pop. That increase is reflective of the wealth creation pump for more well known asset classes - our homes, our stocks, our corporate bonds with their CDO structures and so on, except in these cases, the asset pop has been more than 14% because they are risk assets and in many cases levered ones. 

*Now this concept of the "Asset Pump" (which in combination with fiscal deficit spending and associated tax cuts has been the primary U.S. induced policy to keep consumption up and the recovery going) is important to understand because it gives us a strong hint about our economic and investment future and allows us to describe our King's seamstress as having done a rather poor job of sewing. That seems evident because her creations have been put together not based on savings and domestic investment but on finance-based consumption fed from asset appreciation based on the Pump. * 

Future finance-based consumption, however, is limited by our ability to keep pumping lower and lower yields, which in the past have led to higher and higher TIPS, home, stock, and associated asset prices. Let me do the TIPS math for you and then you can draw the implications for other asset classes. The 14% 5-year TIPS capital gain over the past few years that Alan Greenspan has been able to manufacture probably can only go up by 5 more points, because a 0% real yield for a 5-year maturity TIPS serves as a practical limit that investors will tolerate during deflationary, and most low inflationary environments. A 5-year TIPS moving lower in yield from 1% to 0% goes up 5 points. Even if the Fed continues to "Pump," then, we are  ¾ of the way complete in terms of the Fed's ability to continue to stimulate asset prices, because its 21st century journey started at 4%, we are now at 1%, and 0% is the practical limit. That doesn't mean that the housing "bubble" can't keep going because it likely will if the Fed "Pumps" real yields closer to 0%. But there are limits, and we are heading down the home stretch of this U.S. race towards prosperity based on asset price appreciation. 

Our point on the "Pump" then, is to suggest that in combination with a globalized free trade-based economy exhibiting a surfeit of cheap Asian labor, it will be difficult to generate U.S. inflation higher than our current 3% even if interest rates fall further. If 3% inflation is all we can get from the past 5-years' asset inflation, it's hard to believe that we get more from what's left. The potential to reflate via interest rates is nearly over. We draw the same conclusion for Euroland and Japan. Japan, of course, is the primary example of how 0% nominal yields can fail to generate any inflation whatsoever, is it not? Continued disinflation not reflation, then, will rule our fragile future kingdom, with the potential for 1-2% CPI prints in most years between 2006 and 2010 throughout much of the global economy. Readers may remember our past few years' Secular Forum descriptions of the tug-of-war between disinflation and reflationary forces. We have proclaimed a winner based on our observation of massive fiscal and monetary global stimulation described above, the limited inflationary response, and the lack of further ammunition. Long live our disinflationary King. 

Investment Implications
The risk to bond markets going forward, therefore, will not be from having too much high quality duration, but too little. The demand for Treasuries should continue at high levels from foreign central banks due to the continuation of Bretton Woods II and from private global bond investors who will sense no threat from accelerating inflation over our secular 3-5 year timeframe. In addition, as our Secular Forum speaker Olivia Mitchell described, private and public sector pension fund changes are underway which will likely mandate increased allocations to long-term bonds in order to accommodate many nations' demographic surge towards old age and retirement. The change is even further advanced in Euroland based on UK and Dutch pension accounting modifications. If we had to forecast (and we do), we believe a range of 3 - 4 1/2% for 10-year nominal Treasuries will prevail during most of our secular timeframe and that yields on Euroland bonds will be slightly lower due to their structural unemployment problems, disinflationary incorporation of new Central and Eastern European countries into their existing family of nations, and more growth-inhibiting demographics. This bullish scenario is not without its risks, be they geopolitical, trade, oil, or internal budget popping related in the U.S. or Euroland. In addition, anything that threatens BWII or resembles a "helicopter money" monetary response described by Ben Bernanke could ultimately be bond market destructive. 

Furthermore, the inherent leverage throughout the global financial system will pose a danger to risk-oriented markets (stocks, high yield debt, CDO structures, real estate) as owners gradually realize their returns can no longer be pumped anywhere near double-digit expectations. Whether this can be accomplished gradually as central bankers maintain or happen quickly as others believe is an important question, and points to the potential storm referred to in previous pages. We would suggest that although financial innovation and derivative products allow for diversification and a spreading of risk across more market players, the increased liquidity of our modern day system has also allowed for increased leverage, quicker exits, and therefore more systemic, system-wide risk. If institutional and retail investors in levered products become increasingly disenchanted with quarterly/annual returns, an unwind of levered structures could take place even in the face of continued economic growth, much like we've seen in recent weeks. 

Well our reality-based fairytale must now come to a close. The one reality we are sure of is that we at PIMCO are most fortunate to be entrusted with the management of your assets. The responsibility, while heavy, is the reason we are in business. Thank you. As to happy endings in the global economy and financial markets? Well some assets - high quality bonds, and certain commodities in limited supply among them - may continue to do well; other risk-oriented holdings can be pumped only a little bit further. And then? Well, given appropriate steps from government policymakers that attempt to rebalance our decidedly imbalanced global economy, we can still continue to prosper, but as with most fairytales, the wicked witch lurks. For now we at PIMCO will be content to acknowledge our reigning King's clothes, the poor quality of the stitchery, and the partial exposure of his bare-bottom displayed on our front cover. Stay tuned in future years. This may yet turn into a reality show that resembles not the Coppertone Girl but Uncle Sam with a crown on his head and not much else to show for his/our years of profligate consumption based upon Bretton Woods II and the leveraging of near costless finance.


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## DTM (24 May 2005)

Would be a funny story but its scary how similar our story is in comparison with the Americans.  Either way, any fall out would be like a world wide Tsunami.

How much more of an economic boom can there be if consumption is dependant on our real estate and our record mortgages?


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## Mofra (24 May 2005)

Have been reading with interest the possible implications of a worldwide economic meltdown, however two things have struck me:

*a.   Can governments worldwide exert some artificial influnce to halt such a catastrophie during such an event?* 
Investor mentioned in a previous thread that quick measures were taken by the US Federal reserve when a large hedge fund collapsed. Governments generally hold countless contingency palns for all manner of eventualities (economic, social and military), so surely some measures must be planned.

*I also remember reading a while ago that the US government had been "borrowing" out of 401k holdings (US equivalent of our supeannuation). Does anyone know if this is correct?* 
Surely this would increase the pressure of governments to establish some artifical safeguard in the event of a massive drop capital.

By no means do I advocate these government plans as a way of shirking our own responsibilities for prudent financial management, but I would like to ask the questions in the interests of providing balance to the discussion - overwhelmingly foreign influence is portrayed as a dark financial shadow cast accross domestic markets when they are also responsible for some of the spectacular rises on local bourse enjoyed over the past two years.


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## Investor (25 May 2005)

*Australia's Economy Will Grow 2.5% in 2005, OECD Forecasts * 

May 24 (Bloomberg) -- Australia's economy will probably slow as consumer spending and home building cool, while exports will fuel a pickup in 2006, the Organization for Economic Cooperation and Development said. 

The economy will expand 2.5 percent this year, the Paris- based OECD said in a report on the world economic outlook. Australia's A$798 billion ($607.4 billion) economy, the fifth- largest in the Asia-Pacific region, will grow 3.4 percent in 2006, the 30-nation organization said. 

The Reserve Bank of Australia will probably keep interest rates unchanged after raising the cash rate target in March to 5.5 percent, the OECD said. March's increase in borrowing costs has damped consumer and business confidence and cooled home building and retail spending, according to recent reports. 

``Private consumption growth is projected to slow and residential investment shrink,'' the OECD said. Growth should pick up in 2006 ``helped by an acceleration in exports.'' 

*The OECD forecasts exports will increase 8.1 percent in 2006, almost double its 4.6 percent forecast for this year. * 

``Supply constraints and transport bottlenecks seem to have held back commodity exports,'' the organization said. Exports account for about one-fifth of the Australian economy, with more than half of those made up of commodities such as iron ore, coal, copper and gold. 

The government's May announcement of A$21.7 billion in income-tax cuts over four years is likely to be ``mildly supportive'' of economic growth, it said. 

``Because of tighter monetary conditions and slowing growth this year, inflation is expected to stay below 3 percent,'' the OECD said. Consumer prices, the key gauge of inflation, rose 2.4 percent in the first quarter from a year earlier. The central bank tries to keep annual price increases between 2 percent and 3 percent.


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## Investor (25 May 2005)

We're on brink of ruin, OECD warns
By Tim Colebatch
Economics editor
Canberra
May 25, 2005

If governments do not steer economies back on course to correct imbalances, the markets will eventually do it for them.

The chances are increasing that the global economy will suffer a hard landing, with currency markets savagely dumping the US dollar and throwing much of the world into recession, the OECD has warned.

In its latest economic outlook, issued last night, the Organisation for Economic Co-operation and Development implies that one scenario could have the Australian dollar jump to $US1, putting the economy under huge pressure when the brakes slam down on global growth.

But the Paris-based think tank offers some reassurance. It says most likely the world will muddle through 2005 and 2006 while not resolving its huge current account imbalances.

It forecasts strong debt-financed growth continuing in the US and Australia, and weak growth in Japan and the euro countries. Output growth in the OECD as a whole would slow from 3.4 per cent last year to 2.6 per cent in 2005 and 2.8 per cent in 2006. Its forecasts for Australia resemble the Government's. Output would grow by 2.5 per cent this year before stronger exports lift it to 3.4 per cent in 2006.

Investment would stay high, while high export prices trimmed the current account deficit. But the OECD says Australia must accelerate reform in a range of areas, not only those the Government has tackled, but also to improve training and education, and strengthen competition. The report warns that if governments do not steer their economies to correct the widening imbalances, the markets will do it for them, with a big currency shift that would bring world growth to a screeching halt.

"These continuing divergences in domestic demand . . . cannot be treated with benign neglect," it said. "Given the unsustainable US current account position, pressures for correcting existing imbalances will become ever larger."

"At some point, they may take the form of an abrupt weakening of the dollar, with adverse consequences for the OECD area as a whole. Although not the most likely outcome at present, such an unpleasant scenario is gradually looming larger."

The OECD said the crisis could be set off by "a large adverse credit event, a realisation that the desired currency composition of central bank and/or private financial institutions' portfolios is shifting, an unexpectedly large rise in long-term interest rates, or yet some other factor.

"A large drop in the dollar would substantially damp the modest expansion projected for the euro area and Japan, especially if accompanied by falls in bond, share and house prices."

As an example, the OECD estimates that a 30 per cent greenback devaluation would throw Europe and Japan into recession, reducing their growth to roughly zero for two years, and wipe 10 per cent off the value of Wall Street stocks.

The report does not estimate the potential impact on Australia, but its methodology suggests it would also be severe. It assumes that China and other developing countries would maintain their dollar exchange rate, leaving the West to take the full impact.

The report comes as ANZ Bank chief economist Saul Eslake has warned that the US current account deficit is unlikely to be fixed without a recession.


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## Investor (25 May 2005)

One of many explanations as to why the super mining cycle has stalled: 

Higher Oil Prices Send Resource Stock Investors into "Analysis Paralysis" 

By Bill Ridley April 8,2005 
OnlineInvestorsNews Volume M 10-7, April 8, 2005 
a free supplement of The Growth Stock Report www.jameswinston.com

With crude oil prices breaking new highs on Monday, trading as high as $58.28, alarm bells are starting to ring around the world as economists pondered slower economic growth, accelerated inflation, and even global recession.

The higher price for crude was helped along with Goldman Sachs announcement last week that oil could hit $105. This week, CIBC World Markets warned that oil prices could hit $100 or higher. The result of this furor over oil evaporated the liquidity on many non oil resource stocks as investors contemplated what higher oil prices will mean to their portfolios.

The probability of even higher oil prices is a mix a many factors not the least of which include OPEC's limited ability to crank up production, a lack of tanker capacity, and limited refinery capabilities. 

Given that the risk in the oil market is already at an unprecedented high, an oil price spike is a real possibility particularly given a major natural disaster, or an act of terrorism centered on an oil producing area.

Last year the International Energy Agency stated that with every $10 increase in the price of oil, world GDP would fall by .5% or $255 billion. Other studies show a strong link between crude oil prices and inflationary trends that can lead to global recession.

So with this scenario, resource investors are at once frozen into an analysis paralysis - neither buying nor selling - but just watching for signs of how the global economy will react to higher oil prices. Many eyes are focused on the world's newest big resource consumer - China.

As I mentioned in my article, China and the Final War for Resources, "You name the commodity and China's buying it and consuming it in HUGE quantities. Last year they consumed nearly half of the world's cement, twice the world's consumption of copper, and nearly a third of the world's coal, 90% of the world's steel plus nearly every other commodity you can think of has been in greater demand by China." 

So far this year demand for raw materials in China is still very strong. 

Growth in China's economy for the first two months of this year shows exports are up 37%, industrial production up 17%, retail sales up 14% and investment in factories and infrastructure are up 24.5%. 

This bodes well for resource stocks across the board.

Specifically with copper, world-wide inventories are low, and all other things being equal with the global economy, this should continue the current bull market in copper. 

Zinc is another interesting situation where LME inventories are 580,000 tonnes, above average but are expected to drop to 250,000 tonnes by year end. Five refineries have shut down over the last three years (one in Australia and four in Europe) which is a major reason for higher projected prices over the coming months.

And over the next 12 months coal producers will also see record breaking revenues as new contracts are locking in huge profit margins due to a lack of supply. 

For example, British Columbia is the second biggest producer of coal in the world right behind Australia and the province just announced two huge coal deals with Asian steel mills for more then $100 U.S. per tonne - an increase of $54 tonne over last year!

One B.C. based company, Elk Valley Coal Partnership just announced a five year deal that should expand steelmaking coal output by 30%. Elk Valley Coal Corp., owned jointly by Fording Coal Trust and Teck Cominco, is the second-biggest player in the coking coal field, providing an estimated 21 per cent of global supplies.

In February, Fording Coal Trust announced that Elk Valley Coal had negotiated prices averaging $122 a tonne for the 2005 coal year, compared with an average $52 a tonne for 2004.

So in summary, with China still showing signs of strong buying of raw materials and with the global economy showing solid GDP growth of 3.5% I would have to conclude any decrease in demand for resources not on the horizon - at this point in time at least. 

The wild card, as I have been mentioning for the last few years, is the ever widening U.S. trade and budget deficits. That's a topic for another report but needless to say, I am continuing to monitor that situation closely.


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## stockGURU (25 May 2005)

Investor said:
			
		

> With crude oil prices breaking new highs on Monday, trading as high as $58.28, alarm bells are starting to ring around the world as economists pondered slower economic growth, accelerated inflation, and even global recession.
> 
> The higher price for crude was helped along with Goldman Sachs announcement last week that oil could hit $105. This week, CIBC World Markets warned that oil prices could hit $100 or higher. The result of this furor over oil evaporated the liquidity on many non oil resource stocks as investors contemplated what higher oil prices will mean to their portfolios.
> 
> ...




Investor - A very interesting article, thanks for posting it. I was wondering what you think about companies such as Lihir Gold, that have produced geothermal power facilities... will this give them an edge in a world where the supply of oil is diminishing and prices over the medium term can only increase due to continuing high demand?


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## Investor (25 May 2005)

stockGURU said:
			
		

> Investor - .. that have produced geothermal power facilities... will this give them an edge in a world where the supply of oil is diminishing and prices over the medium term can only increase due to continuing high demand?




Yes. A very interesting and promising new technology. I saw the documentary on TV (news). 

Exactly what the world needs, because of depleting non-renewable energy sources.

I am hoping it will eventually prove commercially viable in a big way. As with all new technology, it needs to pass the "test of time."

However, I also think the world will have to go "nuclear plants" and hydro electric power, in a very big way, asap because as Margaret Thatcher once said ...... T.I.N.A. (there is no alternative).


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## Investor (25 May 2005)

Mofra said:
			
		

> ...*a.   Can governments worldwide exert some artificial influence to halt such a catastrophy during such an event?*
> 
> *I also remember reading a while ago that the US government had been "borrowing" out of 401k holdings (US equivalent of our supeannuation). Does anyone know if this is correct?*
> .. - overwhelmingly foreign influence is portrayed as a dark financial shadow cast accross domestic markets when they are also responsible for some of the spectacular rises on local bourse enjoyed over the past two years.




Answer to your first question - at the extreme situation, liquidation of over USD 2 trillion by Asian Central Banks - no way known can there be any solution. The world moves into global depression. It is because of this potential outcome that there is a "Mexican stand off" for so long. 

How to resolve it? The G7 nations are trying to come up with an answer. Hitherto, no one knows. Global imbalances of this size has been unprecedented and uncharted waters.

Re: 401K funds - they buy Treasury bills as part of portfolio. As such, they have lent to the US government. 

Re: Foreign Investors - all I said was "Do not underestimate their power to move market pricing" - it is a double edge sword that cuts both ways. Upside and downside. Problem is that they usually make profits out of local investors by buying low and selling high. I try to stay one step ahead of them whenever possible.


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## Investor (25 May 2005)

Hedge funds' worst month since 1988
By Richard Irving

THE hedge fund industry in April weathered its worst month since the collapse of Long Term Capital Management in August 1998, according to new performance data published yesterday. 

The average return on a universe of more than 950 individual hedge funds was minus 0.5 per cent, the sharpest fall since the Russian default sent emerging markets into a tailspin seven years ago. 

The grim performance comes after returns of minus 0.16 per cent in March, marking only the second time that the industry has suffered successive negative returns since records began. 

Uncertainties over the long-term creditworthiness of Ford and General Motors ”” which were downgraded to junk this month ”” falling commodity prices and volatile stock markets hit returns across most specialist sectors of the industry. 

Only macro funds, which take big-picture punts on the world economy, US bond funds and specialist arbitrage funds, which seek to profit from volatile markets, generated positive returns. 

The data, published by Eurohedge, a trade magazine, is one of the few sources of performance information on an industry that is notoriously secretive. 

Managed futures funds, which typically make money from exploiting market trends, and convertible bond funds, which play the relationship between bond, equity and stock markets, fared badly, falling 1.57 per cent and 1.18 per cent respectively in April. 

Although the poor performance run is likely to spill over into May following the slump in corporate bond markets, the data suggest that losses in the industry are not as widespread as some analysts had feared. 

According to Neil Wilson, managing editor of Eurohedge, only seven firms in the database generated negative returns running into double digits in April.


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## Smurf1976 (25 May 2005)

Investor said:
			
		

> However, I also think the world will have to go "nuclear plants" and hydro electric power, in a very big way, asap because as Margaret Thatcher once said ...... T.I.N.A. (there is no alternative).



Somewhat off topic    but I wish good luck to anyone who tries to develp hydro these days. Seriously, I wish them good luck but in all honesty I think the Greens and their supporters are so totally opposed to hydro that nuclear is a far easier option. Even burning wood is still vastly preferred by environmentalists to hydro development. ANYTHING would be easier than hydro these days from a politcal perspective. 

The world's first Green political party to actually have members elected to parliament was established for the specific purpose of opposing hydro. It was more than a decade before forests were even considered an issue other than in terms of promoting the use of wood as an alternate power source. 

Nuclear energy, Iraq war, GE crops, greenhouse, pulp mills and all manner of urban planning issues are absolutely nothing compared to the emotion that hydro development stirs up. Been there, seen that.   

Of course, developing hydro in a foreign country is still doable, but forget new large scale hydro in Australia unless there is a MASSIVE change in attitude. Personally I support hydro power as do many, but the politics are something truly amazing to say the least.


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## Investor (25 May 2005)

Smurf1976 said:
			
		

> .... ANYTHING would be easier than hydro these days from a politcal perspective.
> 
> ...  Of course, developing hydro in a foreign country is still doable, but forget new large scale hydro in Australia unless there is a MASSIVE change in attitude. Personally I support hydro power as do many, but the politics are something truly amazing to say the least.




Yes. I am aware of this hurdle. My thinking is when the time comes in many years from now, when it is either that, or water and power shortages of a scale which we have never seen before. 

This latest drought that the country is facing, provides a glimpse of potential problems ahead, bearing in mind that the new immigration numbers are now 150,000 p.a. and water requirements can only increase. Without new supply ...... let us hope the drought breaks before the water supply does.

I tend to read about global climate change as part of my reading, for many years. What I am reading recently and seeing on TV have been alarming, but that is my topic for a new thread, soon.


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## Mofra (25 May 2005)

Investor, 

Firstly thank you very much for answering my earlier questions


			
				Investor said:
			
		

> However, I also think the world will have to go "nuclear plants" and hydro electric power, in a very big way, asap because as Margaret Thatcher once said ...... T.I.N.A. (there is no alternative).



Uranium was a traders buzz word for a few weeks, as iron-ore was before it and anything from oil, gold, zinc, geo-therm etc could be next  (RTM spike anyone?)

Also interesting to read the GM & Ford credit rating slump in terms of the energy crisis - Toyota and Honda seem far more advanced in the hybrid technology stakes, one would have to consider the possibilty of hybrid cars becoming a much greater proportion of the new car market, which doesn't augur well for GM & Ford. At US$100 per barrel, even the Toorak Tractors might be spending a little more time in the garage.


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## Investor (26 May 2005)

May 25 (Bloomberg) -- The European Union set an end-of-month deadline for China to rein in its surging textile exports or face restrictions by the 25-nation bloc. 

EU Trade Commissioner Peter Mandelson will request formal consultations with China over exports of T-shirts and flax yarn if informal talks fail to produce a solution by May 31, European Commission spokeswoman Francoise Le Bail said. The EU could then impose a 7.5 percent cap on growth in exports of those products to Europe if China doesn't do so itself. 

Informal talks between EU and Chinese trade officials ``are ongoing,'' Claude Veron-Reville, Mandelson's spokeswoman, told journalists in Brussels. ``We will launch the formal consultation process unless a settlement, a satisfactory solution, has been found'' by the deadline. 

Mandelson is pushing China to limit exports of T-shirts and flax yarn after the U.S. curbed other Chinese textile imports. The EU and U.S., accounting for almost half of global textile imports, are resorting to the restrictions after Chinese exporters captured market share following the end of a four- decade-old system of global quotas on Jan. 1. 

China, the world's biggest clothing producer, agreed to raise export tariffs on 74 products in response, though the government maintains that threats by the U.S. and EU to impose caps aren't justified. While the increases are five times higher than previous taxes for most of the items, U.S. and European businesses said the duties won't curtail the growth in exports. 

On May 21, China threatened to drop export taxes on textiles should other governments impose caps through quotas. 

Deal `A Possibility' 

Discussions will continue this week ``as necessary,'' Veron- Reville said, adding that a deal by the end of the month is ``a possibility we don't exclude.'' 

Exports of Chinese garments surged 29 percent in the first quarter from a year earlier. The EU imported 187 percent more Chinese T-shirts in the first three months and 56 percent more flax-yarn products. 

China shipped about $97.4 billion of textiles and apparel worldwide last year, according to the China National Textile & Apparel Council in Beijing. Prices for Chinese apparel in 2004 were 58 percent below those offered by suppliers in Bangladesh, India and other countries, the U.S. industry estimates.


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## Investor (26 May 2005)

Hong Kong's richest man, Li Ka Shing (net worth USD 11 billion) is a firm believer of the China juggernaut. The Hong Kong people call him "Superman".

His son, Richard Li, was the guy who took Telstra up the garden path for $4 billion, with the PCCW (Reach) JV. At the time, I was wondering why TLS was mixing it with such astute people, who would not be expected to be giving anything away. Apparently, from what I had read, the local business people in HK knew TLS was getting a raw deal, because the Li Senior was already putting competitive telco deals in China, that would make life difficult for "Reach". 

Glad I avoided T2. 

Li firms sink another $1.5b in China sites 
Raymond Wang
May 26, 2005 

Cheung Kong (Holdings) and Hutchison Whampoa are preparing to invest nearly HK$1.5 billion in property projects in Beijing and Tianjin, even as the central government steps up its efforts to rein in the mainland's runaway real estate market.

In the past six months, the two key companies controlled by billionaire Li Ka-shing have jointly bought 12 mainland development sites, investing more than 10 billion yuan (HK$9.4 billion).

They said Wednesday their 297,694 square meter site in Bei Xin Village, Changping district, Beijing, will be turned into a residential development at a cost of HK$498.08 million, including land costs of HK$173.38 million. Cheung Kong and Hutchison will be 50-50 owners of the project. 

In Tianjin, they will build a commercial and residential complex on a 19,617 sq m site near the Yingkou Dao subway station.

Total investment in the two-phase project is estimated at HK$963 million. The first, commercial phase of the development will cost HK$568 million. The Li companies' partner will be Tianjin Metro General Corp, which operates the city's subway system.

The trio will work through a joint-venture company with registered capital of HK$371 million, of which 80 percent will be contributed by Cheung Kong and Hutchison in cash. Tianjin Metro will fund its part of the investment with land instead of capital.

The subway operator will be entitled to 25 percent of the floor area of the completed buildings, but not to any other share of the profits.

In an effort to curb the overheated real estate sector, Beijing has recently brought in measures designed to curb speculation, such as a 5 percent tax on the value of property transactions and limits on ownership transfers of uncompleted flats. Banks are doing their part too, for example, by insisting that mortages be paid off in full before flats can be sold.

However, Li denied that Cheung Kong and Hutchison were rushing in to the mainland market at a risky time. He said their investments were spread over a number of cities and would generate handsome returns since the land prices involved were not astronomical.

Shares of Cheung Kong fell 1.07 percent Wednesday to end at HK$69.25 per share, while Hutchison shares fell 1.12 percent to HK$66.50.


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## Investor (27 May 2005)

From The New York Times:

Who's to Blame? Hedge Funds
Published: May 27, 2005

EVERY big market decline must have scapegoats to blame for losses. While the timing of the next market collapse is anything but clear, the scapegoat is already in view. It will be those horrid hedge funds.

In recent weeks, the blame for every little market gyration, whether in bonds, commodities or stocks, seems to have been assigned by some commentator or other to a hedge fund strategy gone awry. Memories of Long-Term Capital Management, whose near collapse in 1998 so alarmed Wall Street that the Federal Reserve organized a rescue, are fresh again.

The hedge fund industry is a tempting target, one that has been growing rapidly with minimal public disclosure. Funds will soon have to register with the Securities and Exchange Commission, but there are few rules that apply to them. That will change if and when hedge funds take the blame for whatever financial disaster may await us.

Perhaps they will deserve it. Past scapegoats have rarely been blameless, although finding someone to blame can also be convenient for those who would rather not dwell on their own poor investment decisions. After the 1929 crash, blame was attached to the short sellers and to the use of high leverage to buy stocks. In 1987, it was program traders, who bought and sold baskets of stocks with hedges against stock-index futures. And in 2000, blame was heaped upon analysts who had issued rosy forecasts for overvalued stocks. New rules followed each fall.

There are limited signs that the growth of the hedge fund industry is leveling off. In the first quarter, according to Tremont Capital Management, $24.6 billion went into hedge funds, 36 percent below the level a year earlier. But that was still more than went into such funds in any full year before 2001.

Running a hedge fund can be both lucrative and fun. Management fees are high, and sometimes hedge funds can win arguments, as was shown this year when top executives of the Deutsche BÃ¶rse were forced out. That power angered German politicians, though, and the fund managers face investigations. 

*In the long run, it is unlikely that the returns of most hedge funds will justify the fees. Hedge funds can do well because the managers are geniuses, but there may not be enough of those to go around. Or they can do well by being average performers and using the magic of leverage to multiply the return on equity. But the increase in short-term interest rates has made leverage more costly. * 

THERE is a problem with a fee schedule that gives the decision maker a big cut of the profits but requires others to bear the losses. As in baseball, those swinging for the fences are more likely to strike out. Around 10 percent of hedge funds go out of business each year, Tremont says.

Add in the sharp rise in recent years in highly risky loans to speculative borrowers, some of them packaged into odd securities bought by hedge funds, and the potential is there for significant market disruption if many hedge funds try to bail out of the same things at the same time.

Hedge funds will not be the only scapegoat candidates if there is a meltdown. If it appears that some derivative security allowed hedge fund managers to gamble with little or no real equity invested, calls for regulation of the over-the-counter derivatives market could multiply. 

Whether or not this will matter to ordinary investors is another consideration. In the long run, the systemic impact of Long-Term Capital's collapse was minimal. Any new hedge fund problems could be similar.

But with minimal information available about what hedge funds are doing, it is inevitable that there is fear they are up to something bad.


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## Investor (27 May 2005)

Hedge Funds Are Stumbling but Manager Salaries Aren't
By RIVA D. ATLAS 
At hedge funds, the rich just keep getting richer.

Across Wall Street, fees for businesses from trading stocks to investing in mutual funds have been falling. But at hedge funds, those exclusive investment partnerships for the wealthy and institutions like pension funds, fees have stayed dizzyingly high, even as billions of dollars have poured into the industry and performance, on average, has faltered.

Last year, the top-paid hedge fund manager, Edward S. Lampert of ESL Investments, earned $1 billion, according to a survey to be released today by Alpha, a magazine published by Institutional Investor that follows hedge funds. That is the highest sum in the four years the magazine has been tracking these managers' incomes.

The average hedge fund manager on Institutional Investor's list of the top 25 earners made $251 million in 2004, up from nearly $136 million three years earlier.

The secret to the wealth of hedge fund managers is how they get paid. Instead of receiving a fixed percentage of the funds they manage, as mutual fund managers do, hedge fund managers generally make "1 and 20" - 1 percent of assets under management and 20 percent of profits.

That means that a $1 billion hedge fund manager earns $10 million just for opening the doors, and a lot more if his fund performs well. Investors are willing to pay more for these managers' talents because, at a time when stocks are doing poorly and yields on short-term Treasury securities are low, hedge funds hold out the hope of a better return. 

This promise has become so seductive that the top hedge fund managers can basically name their price. 

"You don't mind paying higher fees if you are getting rewarded properly," said Michael Strauss, chief economist for Commonfund, which invests on behalf of foundations and endowments.

Steven A. Cohen of SAC Capital Advisors, for example, takes as much as 50 percent of all profits his hedge funds earn, netting him $450 million last year, according to Institutional Investor. Even after this big cut, his funds still returned around 23 percent, not bad in a year when the Standard & Poor's 500-stock index rose 8.99 percent.

Another manager on the list, Kenneth C. Griffin, has a novel twist on the fees he charges. His firm, Citadel Investment, which managed some $11 billion at year-end and has close to 1,000 employees - large for a hedge fund - does not charge a fixed fee for expenses. Instead, Mr. Griffin bills investors annually for whatever it cost to run the fund that year, a figure that fluctuates, but has been as high as 6 percent of assets, according to investors.

Last year, Mr. Griffin's largest fund returned 9.87 percent, far below its compound average annual return of 26 percent.

Spokesmen for Mr. Cohen and Mr. Griffin declined to comment. 

Still, some longtime investors in hedge funds worry that the steep compensation may make managers like Mr. Griffin less motivated to perform. Already, overall performance of hedge funds is faltering. Through April, hedge funds were down 0.7 percent, according to an index by Hedge Fund Research, a data firm. That is better than the S.&. P. 500, which was down about 4 percent in the period. But hedge fund investors are bracing for further losses for the month of May, after some complex derivatives trades went against a number of fund managers.

"When managers were earning double-digit returns, high expenses did not matter as much," said Antoine Bernheim, publisher of the U.S. Offshore Funds Directory. "But when you are in a low single-digit return environment, investors can end up breaking even or losing money. This is not a sustainable situation."

Somehow, though, hedge fund managers continue to attract huge sums under ever richer terms. 

Investors were clamoring to get into Eton Park, the $3 billion hedge fund started last November by Eric Mindich, a former Goldman Sachs executive. Investors in the new fund agreed not to withdraw any of their money for as long as three and a half years. Another recent start-up, by the financier Carl C. Icahn, charges a 2.5 percent fee for expenses and 25 percent of the profits.

Many of the 25 managers on the Institutional Investor list of top earners had outstanding returns. Mr. Lampert's estimated $1 billion profit, for example, came after returning some 69 percent to his investors, who benefited from the spectacular rise in the price of Kmart, the discount retailer that Mr. Lampert has merged with Sears, Roebuck.

The second-best performer on the list, James H. Simons of Renaissance Technologies, made $670 million after posting a 24.9 percent return last year, even after deducting his 5 percent management fee and 44 percent cut of the profits. 

A spokesman for Mr. Lampert declined comment; executives at Renaissance did not return calls.

But other celebrated managers had disappointing results, yet continued to earn hundreds of millions. 

Last year, George Soros made $305 million, even as his Quantum Endowment Fund rose just 4.6 percent. Mr. Soros's large earnings reflects the fact that much of the money managed by his firm now represents his own capital. 

Outside investors pulled money from Soros Fund Management in recent years, after Mr. Soros announced that he would be investing more conservatively. His goal is to earn enough to support his charitable efforts, rather than to make big, risky bets like his famous multibillion-dollar gamble against the British pound in 1992.

Mr. Soros is not the only manager aiming for lower, less volatile results. Much of the vast sums flowing into hedge funds these days comes from pension funds and other institutions, which prize predictable performance over outsize returns. 

The average pension fund is looking to make just 8 percent, after deducting fees, on its hedge fund investments, according to a recent study by the Bank of New York and Casey, Quirk & Associates, a consulting firm. That is a far cry from the returns of more than 25 percent generated by celebrated managers like Mr. Soros and Michael Steinhardt at their peaks.

Now that the performance bar has been lowered, there is less incentive for managers to make more aggressive bets, consultants said, especially when they can still charge the same steep fees they did in the past.

Investors in hedge funds say they are resigned to paying dearly for top hedge fund talent. "It's the law of supply and demand," said William Lawrence, chief executive of Meridian Capital Partners, which manages portfolios of hedge funds. "Over time, if the fees are not borne out by performance, the market will react."


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## Investor (28 May 2005)

The latest analysis about the likelihood of rising global trade barriers from Morgan Stanley:

The market and media are spinning a new story on China’s currency: the US is ordering China to revalue by more than 10% or face protectionism.  Do not hold your breath.  China will not buckle.  China does not possess the conditions for a strong currency and will not succumb to foreign pressure and take a decision that may cause economic chaos at home.

The net margins for China’s exports based on the information from the companies listed in Hong Kong and Taiwan are around 5%.  With 50% costs local, 10% currency appreciation could wipe out the profits in the export sector.  The exporters may be able to raise prices, but maybe not.  A big appreciation will trigger some economic instability.  China does not need that.

Some protectionism in the global economy may be coming.  Capital can adjust much quicker than labor in today’s global economy.  The WTO framework can tolerate such protectionist measures.  But this won’t stop, let alone reverse globalization.  Most of the trade today is unambiguously good for both capital and labor among trading nations.  The trade disputes today involve a tiny amount compared to the overall trade volume.

I do not believe that globalization as a whole is under serious threat.  Modern communication and transportation technologies have shrunk the world so much that isolationism is not practical.  Despite the ominous noises in Washington, life goes on.

An Anxious America

I think the United States may be experiencing an anxiety attack.  The high household debt, big fiscal and trade deficits make many Americans, especially the Washington elite, anxious about America’s future.  At the same time, the international media has become obsessed with China, creating catchy titles like ‘China’s century’, ‘the next superpower’, ‘the next biggest economy’, etc.  Many Americans also notice that China has replaced Japan as the country that the US has the biggest trade deficit with.  It is not surprising that many politicians and policy thinkers in Washington link the two and equate China’s fortunes with the US’s misfortunes, and ‘China bashing’ has become popular.

There is also a political element to the issue.  The swing states in the Midwest have heavy exposure to manufacturing.  Sounding tough on China may help win some congressional seats there.

The emotional buildup over China has climaxed with the determination to ‘do something about China’.  The rumor is that the US government is demanding a 10% Rmb appreciation as a down payment or face a protectionist measure, such as a 27.5% tariff on all Chinese goods.  The anti-surge quotas on Chinese textiles have been touted as indicators for what to come.  It looks like a standoff.

I would not worry too much about this.  The United States went through worse with Japan in the 1980s.  It led to Super 301 and voluntary quotas in steel and auto.  The situation is much more benign this time, in my view.  Most Chinese goods do not compete against US domestic industries, and these goods are usually under American brands.  The US may account for three-quarters of the value chain in the China trade.  This is why the social opinion surveys in the US show low negative rating on the China trade.  A majority of the American people in the mid-1980s thought negatively of the Japan trade.

The US economy has boomed for 20 years without a significant downturn.  It may be headed for one soon.  This is why Washington is so anxious, I believe.  Many Americans tell me that they would not want a downturn to deal with the economic excesses.  Nobody does.  But it is ultimately unproductive to fight the force of business cycles at any cost.  When the US economy does go through a downturn to address its imbalances, cheap Chinese goods should become more desirable.  It will decrease the reduction of living standard during the downturn.  Washington will come around to this view, I think.

Blaming China for the US’s problems is unhelpful and groundless.  China’s exports to the US are one-third of the US trade deficit.  If the US were to stop importing from China, it would not solve the trade deficit.  It is even more unrealistic to imagine that moving China’s currency will make a significant dent in the trade deficit.  The US needs to go through a recession to solve its imbalances, I believe.  Asia went through a similar adjustment in 1998.  Eventually, I believe the US will come around to this view.

The United States has an excellent system that can correct itself.  It is fighting the correction now.  But it will go through the adjustment soon enough and boom again.

Limited Impact of Protectionism So Far

There are some areas of competition between the US and China in trade.  Under the MFA quota system, the US textile industry survived, despite high costs.  As the quota system was eliminated this year, the pressure from Chinese imports has inflicted adjustment pain in this sector.  The imposition of the anti-surge quotas would give the industry more time to adjust.  I think that these measures will prove to be temporary, like the steel tariffs a few years ago.

Since the textile quotas limit growth, their impact on the China trade is quite small.  The US’s total imports from China were US$197 billion in 2004, of which US$4.3 billion were textile products.  In the first quarter of 2005, US imports from China rose by 30.2% from last year and the textile portion by 34.9%.  If the textile category was kept at US$2.3 billion by quota as opposed to 35% growth, US imports from China would rise by US$2.3 billion less.  This is a significant amount but is only 1% of the total.

Further, trade is no longer bilateral.  While the US may restrict the imports of pants and shirts from China, some developing countries could still enjoy quota-free access to the US market.  These developing countries are likely to import fabrics from China.  The US will eventually see that such bilateral barriers are not effective.

I seriously doubt that US protectionist measures would spread.  American companies import and distribute goods imported from China.  Most of China’s exports to the US are on an f.o.b. basis.  US companies would have to pay the tariffs that the US government may put on Chinese products.  For example, 27.5% tariffs on China may force American businesses to pay about US$50 billion.  Their impact on corporate earnings would be so severe that the US stock market could fall sharply.  I do not believe that the US government would act to allow something like this.

There is a market view that Washington is not rational at this point and is determined to punish China regardless of the consequences for itself.  First, I doubt it.  The US is a pluralist society.  While a few people in Washington can ratchet up the noise level, the interests of different groups would work into the decision process.  The outcome would result from the trade-offs of different interest groups.  Considering how important China’s production base is to corporate profits in the US, the probability that the US would act in such a way to inflict severe self-damage is low.

Second, if the purpose of US pressure on China is just to damage China, it is pointless for China to compromise.  China is better off to wait for a protectionist bill, such as a 27.5% tariff, which may affect only the one-fifth of China’s exports to the US that belong Chinese companies, or 5-6% of China’s total exports.  The US and other foreign companies own four-fifths of China’s exports to the US and must pay the tariffs.  This would be better than a big revaluation that would affect all of China’s exports and may destabilize the economy.

No Turning Back on Globalization

The noises of protectionism can be deafening these days.  The bottom line for protectionism is that the labor in high-cost economies cannot adjust as quickly as capital to seek out lower-cost production locations.  This asymmetry may justify temporary and selective trade protection to address the mobility difference between capital and labor.  As global companies extend their reach and increase the speed of capital mobility, the cases of targeted protection would increase.  However, this would only affect the growth rate of global trade.  Such protectionist measures do not imply that the trend of globalization is reversing.

Some argue that the labor backlash in the rich economies may stop or even reverse the trend of globalization.  This sort of virulent protectionism did happen in the 1930s.  I strongly disagree that the world could head down this path again.  Today’s world is dramatically different from that in the 1930s when globalization suffered a severe setback.  Modern communications and transportation technologies have dramatically shrunk the world.  The interactions in the world community are rising rapidly.  Politicians will not be able to stop the trend.


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## Investor (28 May 2005)

May 28, 2005 

China has established a new top level task force headed by Premier Wen Jiabao to handle its urgent energy needs, as the country prepares for a new wave of severe power shortages.

The panel, made up of "heavyweights from the country's economic and military sectors,'' will regulate and oversee the unruly and fragmented energy industry, the China Daily newspaper reported.

Assisting Wen will be vice premiers Huang Ju and Zeng Peiyan, both members of China's all-powerful nine-member politburo standing committee, as well as leaders from the commerce and foreign affairs ministries.

The ``leading group'' will be responsible for research into the nation's ramped-up energy needs, including exploitation and conservation, security and emergency systems as well as international co-operation within the sector, the newspaper said.

The fact that the new non-ministerial body is stacked with China's heaviest ruling-Communist Party hitters signals a renewed urgency on the part of Beijing to tackle the sprawling and mismanaged industry blamed for the today's woeful energy shortages.

As China's economy has accelerated over recent years the country has been hit by worsening power blackouts, forcing rationing in all major cities and especially along the industry-heavy eastern provinces.

Adding to difficulties have been redundancies in the building of power plants and bitter fighting between the nation's coal suppliers and electricity providers.

The energy bureau of the National Development and Reform Commission, the current energy regulator, would continue to supervise industrial projects and energy-affiliated activities, the newspaper said.

China has long held off on the establishment of a regular ministry to replace the current energy bureau under the control of Kai Ma, chief of the commission that has a staff of only 20.

Critics insist the bureau has failed to reduce the shortages, especially a lack of electricity nationwide since mid-2003.


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## Investor (28 May 2005)

India digs deep for trade and commerce
By Sudha Ramachandran 

BANGALORE - A century and a half after the idea was first conceived, the decks have finally been cleared for the execution of the Sethusamudram shipping canal project. This envisages increasing the navigability of the waters between India and Sri Lanka, and will involve dredging a channel in the seabed between the  two countries. The canal will run through Indian territorial waters. 

*India's cabinet committee on Economic Affairs has given the green light for the US$550 million project, and work is scheduled to begin next month. The canal is expected to be ready by 2008 for medium-sized vessels to navigate*. 

Currently, the movement of vessels through the Palk Strait is impeded by its shallow waters. Between Pamban island near Rameshwaram in the southern Indian state of Tamil Nadu and Talaimannar in Sri Lanka's Mannar district lies a reef called Adams Bridge, where the depth of the sea is a mere two to three meters. Consequently, ships from the Arabian Sea heading to the eastern ports of India (or vice versa) have to take a circuitous route around Sri Lanka at present. 

The Sethusamudram project will change that. It involves dredging a 167 kilometer, 300 meter wide, 14.5 meter deep canal, which will stretch from Tuticorin port on India's southern coast to Adam's Bridge in the Gulf of Mannar, and extend northward to the Bay of Bengal. 

Once the canal is ready, ships will be able to avoid sailing the circuitous route around Sri Lanka, reducing travel distance by about 400 nautical miles and travel time by at least 36 hours. *The reduction in travel time and distance, fuel costs and docking fees at Colombo will cut maritime transportation costs significantly. This cut in costs will obviously make Indian goods more competitive globally*, and domestic consumers, too, would benefit. India would also gain from toll collections from vessels using the channel. 

The project is to be funded by government-guaranteed debt and equity from the public that that will be listed on stock exchanges. 

Winners and losers
Tuticorin harbor is the biggest beneficiary of the project. The Sethusamudram canal is expected to transform Tuticorin into a transshipment hub that will act as a catalyst for the development of other ports - in Nagapattinam and Rameshwaram for instance - as well as economic activity in the hinterland. 

However, while the project might hold out the promise of profits and seem like a South Asian version of the Suez Canal, to some it spells economic ruin and environmental disaster. 

Notably, there are worrying economic implications for Sri Lanka. Colombo port currently relies on India for about 60% of its transshipment business. This could fall drastically once the canal is operational. 

However, Indian officials are saying that Tuticorin cannot displace Colombo in importance as a port, as bigger Indian vessels would still need to sail around Sri Lanka and dock at Colombo port. Besides, international shipping would continue to take the route around Sri Lanka. 

Environmentalists in India have pointed out that the project threatens the rich marine ecology of the area and that the dredging and marine traffic could destroy the Gulf of Mannar Marine Reserve - one of India's most biologically diverse coastal regions. Environmentalists in Sri Lanka have warned that heavy dredging could disturb the water system of the Jaffna peninsula. It is also feared that the dredging and increased maritime traffic would disrupt sea currents, step up sea erosion and threaten the fragile coastline of the Gulf of Mannar. 

The livelihood of about 500,000 fisherfolk spread across 138 fishing villages along five coastal districts of Tamil Nadu will be severely hit, as there will be restrictions on the waters they can enter and the number of hours they can fish. Entire fishing villages could be displaced to make way for repair yards and other onshore services. 

But not just the environment lobby is opposed to the project. "Comparing the Sethusamudram canal with the Suez or Panama canals is absurd," admits an Indian official in the Ministry of Shipping. "The Suez Canal transports 14% of world trade and reduces navigation time by 24 days. The Sethusamudram Canal cuts navigation time by 36 hours only. The investment might not justify the boost in trade that is expected to accrue," he points out. 

So why is the Indian government steaming ahead with the project? "Reports in the media seem to have exaggerated India's expectations from the project," says the Shipping Ministry official. India does not expect the Sethusamudram project to emerge as an important waterway for international shipping. "We see it as a means to boost coast-to-coast shipping within the country," he says. 

All political parties in Tamil Nadu have been demanding the implementation of the project. It appears that pressure from the Tamil parties in the ruling United Progressive Alliance coalition has speeded up the cabinet committee's green light for the project. 

But there are also defense and security compulsions behind the project. India's Minister of Finance P Chidambaram has drawn attention to the "tremendous externalities" in defense, security and anti-smuggling that the project has. Security analysts have pointed out that the canal would enable the Indian navy and coast guard to deploy larger vessels than they do at present and allow them to deploy faster as well. 

The significance of the project to India's security stems from its proximity to Sri Lanka's Northern province, the bastion of the Liberation Tigers of Tamil Eelam (LTTE). The increasing reach and effectiveness of India's navy and coast guard in the Palk Strait and the Gulf of Mannar as a result of the project is expected to improve India's capacity to check smuggling and movement of LTTE cadres across these waters. 

Analysts such as Professor V Suryanarayan, former director of the Center for South and Southeast Asian Studies at the University of Madras, have been warning that the emergence of the LTTE's naval wing - the Sea Tigers - "as a credible fighting force in India's immediate neighborhood has serious implications for India's security". 

"New Delhi should take up the Sethusamudram project on a top priority basis, so that the navy and the coast guards can freely move around the Palk Bay and the Gulf of Mannar and keep constant vigil on India's maritime borders," he wrote in 2003 in an opinion piece in The Hindu. 

The LTTE has been strangely silent on the project. Sri Lankan sources tell Asia Times Online that this could be because Tamil political parties in India are in favor of the project. And the Tamil LTTE might not want to be seen to be opposing their "dream project". It is possible that the LTTE is content to stand back for now while the environmental lobby and other opponents of the project press their protests. Pro-Tiger websites have been carrying analyses by environmentalists critical of the project and articles that portray India's maritime and geostrategic ambitions. 

When Prime Minister Manmohan Singh lays the foundation for the Sethusamudram canal project next month, India will be taking its first concrete step toward making a 150-year dream a reality. This reality, though, might not turn out to be as rosy as hoped. 

Sudha Ramachandran is an independent journalist/researcher based in Bangalore.


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## Investor (28 May 2005)

The next reserve currency
By Toni Straka 

Oil prices seem to have reversed their recent correction, capital inflows into the United States are falling, and there has been no significant moderation of producer and consumer prices. Under these circumstances, questions are being raised about America's preeminent economic status. Taking into account the slowing in US industrial production, worsening demographics in all Western industrialized nations and the general expectation that the global economy will slow in the second half of 2005, here's some historical perspective about reserve currencies - a status that many say the dollar is perilously close to losing. 

Time-traveling from the Greek to the Roman empire, the British empire, and the young history of the US, one notes that the most widely accepted (reserve) currency always had its home in the political powerhouse of its times. Political power rests on three determining factors: the productive capacity of that nation; its international trade relations; and its capability to defend itself. 

While there were several denominations of silver coins in circulation in the Greek empire that had their origins in the provinces of Byzantine, Macedonia and Peloponnesia, to name just a few, the Roman empire first introduced the silver drachmae in order to facilitate trade with the Greeks. The drachmae was followed by the golden aureus, the silver denarius and the bronze sestertius. One aureus was equivalent to 25 denarii or 250 sestertii. 

Inflation, the beginning of the end
The aureus had a respectable lifespan of more than 400 years before inflation diminished its reputation. Nothing has changed since: whenever a currency loses its value, so does its popularity. First the Roman emperors started chipping away at the edges - the need to prevent this resulted in the edge grooves still seen on many coins now in circulation - and then the purity of the coins was tampered with until they became pieces of lead covered with a thin coat of gold. 

As the Roman empire declined, so did the Roman money as a means of tangible form of payment for goods and services. In medieval times, all forms of money, and their respective strength, were mainly tied to the content of precious metals - a system that continued till World War I. One Swiss gold franc had the same value as one Austrian gold crown or a Dutch gold coin of the same weight. There was no need for a Bretton Woods agreement in these times. 

The reserve currency of the 18th and 19th century was undoubtedly the British pound sterling. As the name says, a one pound note could at any time be redeemed against one pound of sterling (pure) silver at the Bank of England or before that at the treasury of the king. The sixpence stemmed from the custom of cutting a silver penny in six equal pieces for small purchases. 

With the demise of the British empire, which went hand in hand with the outsourcing of its productive capacity to the colonies, where labor was cheap, the pound was replaced by the US dollar in the early 20th century, when the US ascended to the throne of the biggest economy in the world, a place it has held ever since. 

Menzie Chinn of the University of Wisconsin and Jeffrey Frankel of Harvard look at the next 20-30 years and conclude, in their study entitled "Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?" that "under any plausible scenario, the dollar will remain far ahead of the euro and other potential challengers for many years". 

I wonder whether this Western approach will still be valid in 30 years. Under the assumption that the European Union with its strong productive base and its highly developed financial markets - especially once Britain joins the Euro - will come back to the path of stronger growth again, the euro could climb to the number one spot in the line-up of international currencies. But this might be for a transitory period only. Most forecasts see China becoming the biggest economy on the globe by 2020, give or take some setbacks along the way that are inherent with the growth rates that the country has been enjoying recently. 

China is still some distance away from liberalizing its currency controls, not least for the reason that its financial sector is still in its infancy. But China will develop this sector and gain knowledge along the way. With a consumer base of probably more than 1.5 billion people by then, it will have a huge backyard on which it can rely for further growth to fuel its growing international importance. As the country has been on the path to a more liberalized economy for the last 15 years, taking one step at a time, its careful planning for the future will lead to a more prominent role in the capital sector. Those who produce can save, too, and therefore become a supplier of capital needed elsewhere. 

Of course it is premature to speculate about the yuan becoming the reserve currency of the world. But it is not premature to speculate when the resource-rich countries will begin to favor the euro as the preferred means of payment for the riches in their soil. Until now, commodities have been predominantly priced in dollars on the world markets, stemming from the fact that the US is the single-biggest buyer and consumer of energy and has been the biggest buyer of most other commodities. In an age of global redistribution, this might change as the US gives up its number one purchaser position. 

Staying with dollar-based prices - which could mean using the currency of a third country that is primarily known for its huge amount of debt and no plausible recipe for a turnaround - could become too costly a way for others to conduct their bilateral trade. After outsourcing American production, an outsourcing of control of international trade could well be on the way. The race for financial dominance is on. And it will be decided in favor of the country or region that manages to maintain a lead in production, which will inevitably be located in proximity to the world's largest base of consumers. 

Toni Straka is a Vienna, Austria-based independent financial analyst and portfolio manager, who worked as a financial journalist for over 15 years and now evaluates global market trends.


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## Investor (30 May 2005)

Hedge funds 'to blame'
David Nason, The Australian
30May05

LONG Term Capital Management wasn't the first hedge fund to get itself into serious strife but it's the one that is always recalled whenever the market turns choppy.

A choppy market is one that doesn't seem to make sense and is hungry for direction. The uncertainty it produces invariably causes traders, investors, analysts and everyone else in the money game to start worrying about a downturn. When that happens, people want a bad guy to blame for the doom that might be ahead. Nowadays, when there's no obvious candidate, suspicion tends to fall on hedge funds. 

Run by outrageously paid managers, these vast pools of exclusive private capital are used for highly leveraged investments and are a major component of today's market. 

But because hedge funds are largely unregulated and not subject to disclosure rules that apply in other sectors of the market, much of what they do remains a mystery. In unsettled times this makes people nervous. 

Hence the current round of reflection on LTCM, the once state-of-the-art hedge fund founded in 1994 by legendary Salomon Brothers bond trader John Meriwether. 

Meriwether put together a team that included a couple of Nobel Prize-winning finance academics, an ex-deputy of the US Federal Reserve and some of the smartest traders on the street. Eighty wealthy investors, including some of the big investment banks, kicked in a total of $US1.3 billion at inception. 

For a while LTCM seemed invincible, producing returns way above the market average and attracting more and more investment. At the beginning of 1998, LTCM had $US4 billion under management, leveraged to create bond, currency and equity positions worth more than $US100 billion. But when, in August that year, Russia devalued the rouble and declared a moratorium on $US13.5 billion of government debt, it triggered an international upheaval of a kind that Meriwether's geeks, for all their computer models and Harvard degrees, had failed to anticipate. 

LTCM went into a nosedive and in the end the Fed was forced to organise a $US3.5 billion bail-out to prevent its demise from causing a crisis of confidence across the entire market. 

People have been revisiting this history because of the market contradictions currently at play. It wasn't so long ago that increasing interest rates, high oil prices and a struggling General Motors would have had everyone preparing for a recession. 

Instead, growth in the US remains steady, high-yield bond default rates are at record lows and the vast majority of S&P 500 companies have produced first-quarter earnings at or above expectations. 

There's a feeling that something has to give and much of the nervousness has focused on hedge fund plays in the car industry, particularly at GM, traditionally one of the market's biggest issuers of bonds. 

The speculation is that many hedge funds went long on GM bonds (a losing bet now that the bonds have been downgraded to junk status) and covered their positions by going short on GM equities. 

What they didn't expect was billionaire investor Kirk Kerkorian stepping in and buying great chunks of the company, an action which sent the share price north again and left the hedge funds with losses on both sides of the ledger. 

The big questions now are: which hedge funds have lost how much, are there more losses on the horizon and what will be the overall impact on the market? 

But amid all this, the outlook for hedge fund managers remains upbeat with a report last week showing that the top 10 managers all made in excess of $US200 million in 2004. 

Top of the list was Ed Lampert of ESL Investments. His 69 per cent return on investment in 2004 gave him a staggering take-home pay of $US1.02 billion, the highest hedge fund compensation ever recorded. 

This was up from $US420 million in 2003. 

Think of Eddie next time you're trying to find that mortgage payment.


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## Investor (31 May 2005)

The Death of the Federalist Project?
By Anatole Kaletsky
Thursday, May 26th 2005  

Why are the people of Europe so angry? The standard answer, as the Germans, French and Dutch all turn against their governments, is that the European project has gone too far and that political elites have over-reached, losing touch with the ordinary people. Their resentment about the loss of national political control to unaccountable Eurocrats of Brussels has finally boiled over. The French may be voting Non to defend their country against a European Union which they now see as a Trojan horse for ultra-liberal Anglo-Saxon values, while the Dutch (and the Danish and British) rejectionists may be driven by exactly the opposite motive, believing that the EU Constitution is trying to ensnare them in a centralised, over-regulated, Gallic state. But far from discrediting the anti-EU movement, this diversity of opposition actually accounts for the power of the revolt. 

What people are voting against is not just one or other particular clause of the constitution, nor even its general tenor, whether this is too liberal or insufficiently so. The real bugbear is the idea of any unified Constitution which attempts to impose a single system of government on the whole of Europe and purports to harmonise away the political philosophies, economic preferences and social traditions developed in different nations over hundreds of years. 

But before we assume that the federalists will simply give up in desperation, it is worth considering another possible explanation for the popular revolt against European elites. In Sunday's German election, which effectively destroyed Gerhardt Schroeder's government, his recent ratification of the EU constitution was not even an issue and Europe was far from the voters' minds. Two months earlier, the Berlusconi government suffered a similar fate in Italy, a country where Euro-enthusiasm remains undimmed. Why did this happen? In our view the answer is simple: It's the economy, stupid! As regular readers may be aware, we have always argued against economic determinism in British or US politics. But that is because the British and American economies have on the whole been performing well since 1992. Europe meanwhile has become an economic disaster. 

*The people of France, Germany, Italy and Holland may be angry about globalization or ultra-liberalism or immigration, but this anger reflects a deeper malaise. Their living standards are falling, their pensions are in danger; their children are jobless and their national pride is turning into embarrassment and even shame. In sum, they feel that their countries, which numbered among the richest and most powerful nations on earth as recently as the middle of the last decade, have gone to the dogs under the leadership of the present generation of politicians. And, at least in the economic sense, they are absolutely right*. 

*The relative economic decline of "old" Europe since the early 1990s - especially of Germany and Italy, but also of France - has been a disaster almost unparalleled in modern History. While Britain and Japan certainly suffered some massive economic dislocations, in the early 1980s and the mid-1990s respectively, they never experienced the same sort of permanent transformation from thriving full-employment economies to stagnant societies where mass unemployment and falling living standards are accepted as permanent facts of life. In Britain, for example, unemployment more than doubled from 1980 to 1984, but conditions then quickly improved. By the late 1980s, Britain was enjoying a boom, the economy was growing by 4% and unemployment had halved. In continental Europe, by contrast, unemployment has been stuck between 8% and 11% since 1991 and growth has reached 3% only once in those 14 years*. 

This dreadful economic performance is more than enough to explain the political angst among Europeans. But what does it mean for the future of Europe? If Europe's economy remains paralysed, then the federalist project is clearly dead, as are all hopes of further significant EU enlargement. But if the economy recovered, the disillusionment with EU politics might quickly vanish. 

What could bring about this miraculous transformation? The answer is surprisingly simple. European policymakers could kick-start growth and break the spiral of economic and political pessimism by doing exactly what America did in similar circumstances in 2001. They could drastically reduce interest rates and devalue their currency. As in Japan, interest rates could be reduced all the way to zero and the euro could be pushed down through intervention in currency markets. Such an aggressive policy of monetary stimulation could be guaranteed to revive economic growth, whether or not voters could be persuaded to endorse the labour market and pension reforms which Europe certainly needs in the long- run, but which can actually aggravate economic stagnation in the short term, as Chancellor Schroeder has learned to his cost. 

*There is only one obstacle to this monetary solution of Europe's problems. That is, of course, the European Central Bank*. It is no coincidence that Europe's economic underperformance started with the centralisation of monetary policy under the German Bundesbank from 1991 onwards and deteriorated further with the formation of the ECB in 1999. In fact, the behaviour of the ECB has transformed the euro from a giant step towards European integration into the biggest single obstacle to the further development of the EU. 

This is not the place to discuss in detail the ECB incompetence (Charles took a whole book, called Des Lions MenÃ¨s Par Des Anes, to do that) which largely accounts for the economic and political malaise in Europe today. Suffice it to say that all of the major shocks to the world economy since the ECB was created have originated outside Europe - the internet boom and bust, the terrorist attacks of 9/11, the Iraq oil shock, the US corporate scandals, the rise of China... Yet in every case, the euro-zone has suffered more economic and social disruption than America, Britain or Japan. 

If Europe's leaders want to revive any hope of EU integration - or even if they just want to save their own political skins - they have one obvious recourse. The first order of business in any revision of the European Constitution must be to change the objectives of the ECB and bring central bankers under the explicit political control which is taken for granted in Britain, America and Japan. Imposing some political discipline on the ECB would not guarantee popular support for EU integration, but it would at least acknowledge to voters that Europe has now suffered from a decade of economic incompetence bordering on sabotage.


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## Investor (31 May 2005)

The New York Times:
May 29, 2005
An Indicator That's Almost as Good as a Time Machine
By ROBERT D. HERSHEY Jr. 

AN investor's fantasy might be to glimpse stock or bond market prices for a trading session yet to come, perhaps next month or in 2010.

Sorry. That kind of prescience can't be arranged. But there's another forward-looking resource, albeit less certain, to aid in financial decision-making, one that has the virtue of being not only readily obtainable but free as well. 

It is the market's up-to-the-minute forecasts on the future monetary policy of the Federal Reserve. 

Even beginning investors know the Fed's importance, because the interest rates it influences affect the financial markets, the economy - from housing to incomes to tourism - and even national elections. Knowledge of the Fed's likely moves may help you to decide whether to use an adjustable-rate mortgage or a conventional one, whether to shift money into stocks or bonds, and even which kinds of stocks or bonds to buy. 

The course of Fed policy is foreshadowed by various market indicators, the most revealing being the price of futures contracts on federal funds - overnight loans among financial institutions whose rate the Fed itself closely controls.

The futures contracts send clues about what is usually the most important single issue facing the markets: What will the Fed do next? And the specific question on everyone's mind these days is this: Is the Fed, which has been raising rates for nearly a year and has five more policy meetings scheduled for 2005, about finished? 

The answer, judging from the consensus reflected in the futures contract for December, is: We're getting close.

"The funds market is telling us they're going to pause at at least two of these meetings," said John Augustine, chief investment strategist at Fifth Third Asset Management in Cincinnati.

Mr. Augustine points to the current federal funds rate of 3 percent and notes that a quarter-point increase at each meeting - the pattern that has lifted the rate in eight steps from 1 percent in mid-2004 - would put it at 4.25 percent by year-end. The December contract, however, is now trading at 3.72 percent. He said he believes that the Fed is likely to stop its credit-tightening in meetings toward the end of the year.

These contracts, settled on the basis of the average rate for federal funds during the month, are traded on the Chicago Board of Trade. The August contract ended one recent session at 96.60, meaning that the market believed the funds rate for that month would be near the difference between that figure and 100, or 3.40 percent. 

You can follow the action online at www.cbot.com by clicking on "30-day fed funds." 

Sometimes, analysts portray their readings of funds futures prices as odds or probabilities. For example, if you assume that the Fed will raise rates by a quarter point at both the June and August meetings, bringing the level to 3.50, then a reading of 3.72 would imply there was about an 80 percent chance of an increase at the next meeting, in September - 3.72 being about 80 percent of the distance from 3.50 to 3.75. 

Not surprisingly, the shorter the time period, the more accurate these forecasts have turned out to be.

"So far as predicting the funds rate over the next several months, the federal funds futures dominate other instruments," said Brian P. Sack, senior economist for Macroeconomic Advisers in Washington.

Investors can use such readings of market expectations as a benchmark for evaluating the general investment climate as well as predicting movements in the relationship between short- and long-term interest rates.

If, for example, you think the consensus is correct for modestly higher interest rates this autumn, and you have not already made an adjustment, you may want to cut back on your fixed-income investments. If you're in real estate, a conventional mortgage may seem a better bet than an adjustable one. If you are convinced that the Fed will stop raising interest rates by early fall, you may be more comfortable buying longer-term bonds.

The stock market implications are tricky. Rising rates are generally not good for stocks, but if investors become confident that the Fed has inflation under control, they could start pouring money into stocks, setting off a rally. An optimist may want to buy metals or other industrial stocks, while a pessimist may want to consider food or tobacco or other so-called defensive stocks. 

Of course, the futures contracts merely reflect current market sentiment, and if you're a contrarian who thinks that the Fed may have already made its last move, you may want to lock in today's rates and load up on bonds or certificates of deposit. 

In any event, knowing the consensus is a good starting point.

"The federal funds rate serves as an anchor for the financial system and other interest rates key off its current level and expected changes in it," said a 2001 study by Raymond E. Owens and Roy H. Webb of the Federal Reserve Bank of Richmond. "Accurate predictions of changes in the federal funds rate are, therefore, of great value to persons engaged in a wide variety of business activities."

Although Alan Greenspan, the Federal Reserve chairman, and other Fed officials tend to speak opaquely about monetary policy, the central bank since 1994 has increasingly managed to guide the markets along an intended path without surprises.

Thus its formal statements after each of its eight meetings a year are scrutinized for the smallest nuance of intentions, currently whether the Fed sees itself continuing to nudge rates higher at a "measured" pace. The next meeting is June 29-30.

THE funds market can also move sharply on unexpected news about the economy. For example, after the government announced on May 6 a surprisingly big increase in payroll jobs for April, the October funds futures contract jumped to 3.59 percent from 3.49 percent in just a half-hour.

"There had been hopes that the Fed might be able to take a breather" in its persistent credit-tightening since mid-2004, said Ward McCarthy, managing director of Stone & McCarthy Research Associates in Princeton, N.J. "The April employment data, I think, dashed a lot of such hopes."

But while the funds rate is the best predictor in the short run, Mr. Sack and other researchers have found that for periods longer than six months, other market instruments, including Treasury bills, display comparable predictive power.

For this, Macroeconomic Advisers favors eurodollar futures, which trade very actively on the Chicago Mercantile Exchange and pay out at quarterly maturities based on the three-month London interbank offered rate, or Libor.

Movements in Treasury bills can be misleading because yields can be depressed by a panic-driven flight to quality, analysts said. 

For the past year, there have usually been just two realistic choices for the policy makers - raising the funds rate by either one-quarter of a point or one-half a point. 

Sometimes there is a third choice, and when the situation seems complex, analysts at times seek supplementary information from other markets, such as options on funds futures, a relatively new and underdeveloped contract with rich potential as a provider of information. These options are also traded on the Chicago Board of Trade.

The main complication in deriving the expected policy path from the funds futures rates is adjusting for the premiums that investors require for bearing the risks of going long or short the contract.

The size of this premium, which needs to be subtracted from the futures rate, can be big enough to lure speculators with no firm view on the direction of Fed policy. 

(A study by the National Bureau of Economic Research last year found that the Fed itself makes only a minimal adjustment of just six-hundredths of a point for the premium on a six-month futures contract. That compares with an adjustment of 25 hundredths of a point that the bureau's researchers consider more accurate.)

Even without refinements, knowing the likely course of policy is useful, with movements in funds futures especially revealing in reacting to fresh developments. 

"Investors' exposure is not so much to what the Fed does," Mr. Sack said, "but to unexpected things the Fed does - to changes in the market's expectations."


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## markrmau (31 May 2005)

We might have just had a lot of O/S hedge fund selling on close. China has reversed the textile export duties they recently planned to impose, because of US and European noises towards trade-war. Gold being sold off, USD up, and base metals down - all because yuan revaluation is less likely when china feels threatened.

ASX might be a bit rocky tomorrow.


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## Investor (31 May 2005)

markrmau said:
			
		

> We might have just had a lot of O/S hedge fund selling on close. China has reversed the textile export duties they recently planned to impose, because of US and European noises towards trade-war. Gold being sold off, USD up, and base metals down - all because yuan revaluation is less likely when china feels threatened.
> 
> ASX might be a bit rocky tomorrow.




Not just tomorrow. Probably a few weeks at least; a few months more likely.

Time will tell. Enjoy the ride.


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## Investor (31 May 2005)

TjamesX said:
			
		

> .... Chinese culture breed a certain type of capitalist - now they are poised to shape their former countries future with their amassed wealth.
> 
> .....the significance of the expat Chinese. .....




Many of the capitalists in HK, Taiwan and Singapore have already been back in China, as expats, to play a role in nation building and of course, make more money.

From memory, around 10 years ago, China sent a team of policy makers to Singapore to learn about nation building from the then Prime Minister, Lee Kuan Yew, who had taken the small island state of 3.5 million people, to developed nation status in around 30 years.

China knew it could not use the same "blueprint" but modified it to be used in various cities in China (to try to create various "Singapores"). Critical in the blueprint are long term 10 year plans with annual reviews of progress.


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## Investor (1 June 2005)

From the Morgan Stanley website:

Stephen Roach (New York) 31/5/05

When I first wrote of an interest rate conundrum in January, little did I know how deeply this concept was about to become ingrained in the heart and soul of central banks and financial markets (see my 18 January dispatch, “The Real Interest Rate Conundrum”).  But conundrum it is, as real rates remain at unbelievably low levels at the short and long end alike -- in the US, Europe, Japan, and even emerging markets.  Given my concerns over the US current account deficit, I have long in the bearish camp with respect to the US bond market outlook.  A rethinking is now in order.  The likelihood of a China-led slowing of Asia has prompted me to change my view.  I now suspect bond yields will stay low for the foreseeable future, and I wouldn’t rule out the possibility that they might even drift lower. 

Recent trading action in fixed income markets has revealed a lot about the character of the interest rate conundrum.  During the credit scare of early May, the so-called riskless asset -- namely, US Treasuries -- have benefited from a classic safe-haven bid.  Yields on 10-year Treasury notes fell from close to 4.3% to nearly 4.0%.  Yet something strange has occurred as the angst of the credit event faded -- long-term yields haven’t returned to their earlier levels.  As always, there are a multitude of factors bearing down on financial markets that make it difficult to dis-entangle the impacts of any one development.  The mid-May release of a surprisingly benign CPI report -- a core rate of inflation that was unchanged for April on a month-to-month basis and decelerating on a year-over-year basis for the second month in a row -- certainly stands out as a new and constructive piece of information for the bond market.  But I don’t think that was enough to neutralize the typical reflex effect that almost always occurs as the urgency of a flight-to-quality bid fades.  Something else is going on in the bond market.

The asset-allocation flows of a low-return world are obviously an important part of this equation.  The demographic imperatives of funding ever-mounting asset-liability mismatches have put a natural bid under long duration assets.  With the days of heady, late 1990s-style returns on equities long thought to be over, fixed income instruments have become the new asset class of choice for fund managers.  Central banks have encouraged this tilt by holding policy rates near the zero threshold in real terms for the past several years.  The result has been a succession of carry trades that became the icing on the cake for ever-frothy fixed income markets -- also bringing hedge funds and speculators into the game.  The migration of bets along the risk curve has had a stunning logic.  Investors have been vulture-like in squeezing excess returns out of one type of instrument and then moving on to the next.  It started with sovereign bonds and has then spread in rapid succession to investment-grade corporates, high-yield corporates, emerging-market debt, and, more recently, the exotic structured credit products. 

I have been highly suspicious of the staying power of this flow-driven bull run in bonds.  Such momentum-driven buying almost always goes to excess and there is good reason to believe that this will be the case this time as well.  What worries me the most in this regard is the coming US current account adjustment.  *History is devoid of examples where external adjustments are not accompanied by falling currencies and rising real interest rates -- the latter being necessary to compensate the creditors of deficit countries for taking undue currency risks.  With the funding of America’s current account deficit now requiring close to $3 billion of capital inflows each business day and the dollar on a three-year descent -- at least until early this year --- the pressures for some type of interest rate adjustment were mounting.  Timing, of course, is the trickiest part of this call -- especially since the bulk of the recent flows appears to have been driven by the “policy buying” of dollar-denominated assets by foreign central banks*.  But with the buyers at the margin -- namely, Asian monetary authorities -- seriously overweight dollars, the logic of portfolio diversification suggested the day of reckoning was likely to come sooner rather than later.  That one consideration has kept me in the bearish camp on the bond market for most of the past few years.

As strongly as I have felt -- and continue to feel -- about this conclusion, I must also confess to being torn by the other side of the trade.  What concerns me the most in this regard are two major risks for an unbalanced global economy -- a possible growth shortfall and another downdraft on the inflation front.  Nor do I view these concerns as purely cyclical.  The ever-powerful IT-enabled forces of globalization -- now spreading from tradables to once-sacrosanct nontradables -- seem to be imposing new limits on pricing leverage that our traditional inflation models are simply not equipped to handle.  Against this secular backdrop of the globalization of price compression, the impacts on inflation and inflationary expectations could be magnified by any major cyclical shortfalls in global activity. 

That is precisely what I now suspect could be in the offing -- a China-led slowing of the pan-Asian economy that could have a very important bearing on both global growth and inflation.  As I noted last week, *there is now a compelling case for a China slowdown later this year that could last well into 2006* (see my 23 May dispatch, “What If China Slows?”).  Two sets of forces appear to be at work -- domestic policies that bear down on China’s property bubble and external policies that squeeze Chinese exports.  Collectively, fixed asset investment and exports make up 80% of China’s GDP.  There is now good reason to stress the downside risks to this huge piece of the Chinese economy that is currently expanding at nearly a 30% y-o-y rate.  *For the past six years, China’s GDP growth has fluctuated in the 6-9% range.  Currently, it is growing at the upper end of this range.  By the time the China slowdown plays out, I suspect that its GDP growth could be near the lower end of this range*.

If such a slowdown comes to pass, two broader macro impacts are likely to unfold -- the first being a slowing of activity in China’s pan-Asian supply chain.  That would take an especially large toll on Taiwan, Korea, and Japan, but few economies elsewhere in Asia would be spared.  *Collectively, Asia accounts for fully 35% of world GDP (as measured by the IMF’s purchasing-power-parity metrics)*.  That means the direct effects of a two-percentage point slowing of growth in China-centric Asia -- a distinct possibility, in my view -- would knock 0.7 percentage point off world GDP growth.  The second macro impact comes on the inflation front -- namely, in the form of a sharp reduction of Chinese commodity demand.  *With China now accounting for only 4% of world GDP (at market exchange rates) but 8% of crude oil consumption, 20% of world aluminum consumption, and 30-35% of steel, iron, coal, and a broad array of other industrial materials, a slowdown in the pace of Chinese industrial activity is hardly without consequence for commodity inflation*.  The Journal of Commerce spot index of industrial materials has already done a round trip -- moving from a peak rate of inflation of nearly 35% in early 2004 to an outright decline of -3% y-o-y in late May of this year.  In the event of a China-led Asian slowdown, recent downward pressures on commodity prices could intensify.  That could have an important impact on tempering the inflationary expectations embedded in bond markets.

But what about the interest rate implications of America’s coming current account adjustment?  This has been my own personal stumbling block on the bullish call for bonds.  I have thought long and hard about this and have now concluded that I may be guilty of having overlooked a critical aspect of the interest rate piece of an external adjustment.  *In the end, what foreign creditors seek in a current-account adjustment is a relative premium for taking currency risk.  The key aspect of this premium is the word “relative.”  As long as spreads widen between the US and other international interest rates, that may be sufficient compensation for America’s foreign lenders*.  In other words, US interest rates need not rise sharply in the absolute sense in a current-account adjustment.  All that is needed is that they remain attractive in comparison to rates elsewhere around the world.  Interestingly enough, Joachim Fels feels about the same way with respect to European bonds, especially in the aftermath of the French “non” on the EU constitution (see his 30 May dispatch, “Vote No on Eurozone Bonds”).  While I understand the near-term appeal of that call, over time, I suspect that the risks associated with a likely US current account adjustment will be far more important in shaping relative returns in the global bond market than will be the more remote possibility of an EMU breakup.

I must confess to being stuck on one key piece of this macro riddle: In my view, real interest rates -- both short and long -- are still far too low for sustainable growth in the global economy and for stable conditions in world financial markets.  Yet central banks -- especially America’s -- have been reluctant to lead the charge in normalizing the rate structure.  The best we have gotten from the Fed is a policy rate that has gone from negative to zero in real terms over the past year.  I continue to believe this is ultimately a recipe for disaster.  America’s bubble-prone, saving-short, overly-indebted, asset-dependent economy is very much an outgrowth of excessively low real interest rates.  But in the context of what could now be an impending shortfall in global growth, real rates may stay low.  In fact, financial markets may well be correct in pricing a Fed that could go on hold sooner rather than later.  Consequently, given the likelihood of a China-led compression of inflationary expectations, another leg to the secular rally in bonds can hardly be ruled out.  At some point over the next year, I wouldn’t be shocked to see yields on 10-year governments test 3.50% in the US, 2.50% in Europe, and 1% in Japan.

So call me a bond bull for now.  In today’s era of low-inflation globalization, a China-led growth shortfall would be a big deal in shaping the cyclical forces that drive the inflationary premium embedded at the long end of yield curves around the world.  America, with its gaping current account adjustment, should benefit less than surplus countries in riding the next wave of any bull move in bonds.  *But in this climate, the bear case makes less sense -- unless, of course, you want to bet on the dark side of global rebalancing and a potential protectionist backlash.  While I remain quite sympathetic to those concerns, the markets do not -- at least for the time being.  Should that sentiment change and protectionism intensify -- an endgame I continue to fear -- the bond market could then do a quick about-face and come under severe selling pressure*.


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## Investor (1 June 2005)

Also by Morgan Stanley:
Andy Xie (Hong Kong)

The global trade cycle is turning down.  The slowdown to date is due to the high-base effect.  The post-tech burst recovery in 2002 and the weak dollar-inspired surge elevated the trade level to an extraordinary high. 

The trade cycle is slowing on the lack of additional stimulus, i.e., mean reversion is the force at work.  The strengthening dollar is likely to cause trade to correct beyond mean reversion.  Before year end, several Asian economies could show negative export growth from last year, similar to how trade cycles behaved in the past.

*A real trade downturn will happen when US consumption and/or China’s investment turn down.  China’s investment is likely to decelerate substantially in 2006, as leading indicators -- corporate profits and property prices -- are already turning down.  US consumption remains strong, but its housing market may be in a final frenzy.  If the US housing market peaks out this year, 2006 would be a very tough year*.

Mean Reversion So Far

Global trade has slowed by more than half since mid-2004.  The combined imports of the US, Euro 12, and Japan grew at 8% in March 2005 from March ’04, versus 17.6% last year.  The combined exports of Taiwan, Korea, and Japan grew by 8.7% in April ’05 from April ’04, versus 22.7% last year.  The extraordinary trade boom since 2002 appears to be winding down.

The deceleration so far reflects the force of mean reversion.  The combined exports of Taiwan, Korea, and Japan have averaged 6.7% annual growth since 1997.  The combined imports of the US, Euro 12, and Japan have averaged 7.4% annual growth since 1993.  The current growth rates are still close to the averages.

The trade boom began as a recovery from the tech burst in 2002.  A combination of the Federal Reserve’s rate cuts over the deflation scare, the US push for a weak dollar, and Rmb revaluation triggered a dollar liquidity bubble and an emerging market boom.  That took the trade cycle to an extraordinary level.  *The combined exports of Taiwan, Korea, and Japan averaged 13.7% annual growth between 2001 and 2004 compared with 3.4% growth in the preceding 10 years.  For these aging industrial economies, such growth rates are quite unusual*. - _my comments are exports of Plasma/LCD TVs, digital cameras/recorders, etc. were huge._

*China’s trade has risen rapidly in this cycle.  The total value of trade rose by 31.3% per annum between 2001 and 2004, compared with 14.2% annual growth in the preceding 10 years.  Exports registered 32% growth from last year in April, but imports registered marked weakness, rising 12.2% in the first quarter and 16.6% in April from last year*.  Two special factors may have contributed to the import slowdown.  (1) Excessive inventory; China may have over-imported construction equipment last year.  (2) The government has kept gasoline and diesel prices too low, and the petrochemical companies slowed oil imports.  Hence, China’s imports should recover.

Part of the import weakness suggests export weakness later.  Imports led exports by about two quarters over 1993-96.  If history repeats itself, as I expect, China’s exports should decelerate sharply in the third quarter.

China’s trade cycle tends to pick up first and recede last because China is the lowest-cost producer, and the world’s demand growth tends to flow to China first.  The lead or lag may be two quarters.  This dynamic would also put China’s export weakness in the third quarter.

The Correction Beyond Mean Reversion

Some factors are emerging to suggest that the trade cycle would correct beyond the mean reversion.  The immediate headwind is a strengthening dollar.  Weak dollar trade and the subsequent Rmb revaluation trade flooded emerging economies with liquidity, pushing China’s investment cycle to an unprecedented height and lifting the commodity CRB index to the highest level since the Iran-Iraq War two decades ago.  The surging CRB index gave many emerging economies (e.g., Russia and Brazil) the revenues to import.  The commodity boom or bubble has been the main accelerator in this trade cycle.  As the dollar strengthens, the CRB index could turn down from here.

The dollar strength comes from the rising Federal funds rate, the political crisis in Europe, and Japan’s weak economic performance.  The factor that triggered the dollar weakness -- the twin US deficits -- remains.  Thus, this wave of dollar weakness will not be as pronounced as in 1995, in our view.  Nevertheless, a strengthening dollar is likely to deflate the commodity bubble and decrease global trade temporarily.

Such dynamics were present but to a lesser extent in previous cycles.  This is why East Asia’s exports dip into negative growth at the bottom of every cycle.  Such negative growth would not be a cause for alarm.  It is just paying for the froth at the cycle peak.

2006 Could See a Real Downturn

The real trade downturn would come from demand weakness in US consumption and/or China’s investment.  These two economies have accounted for half of global growth in this cycle.  China’s impact on commodity prices and equipment demand could explain a big chunk of the other half.  A real downturn in trade would happen when demand gets into trouble in either or both.

China’s investment boom has peaked, I believe.  Leading indicators -- corporate profits and property prices -- are turning down.  It may take a further two to three quarters for demand to weaken.  China’s fixed investment is still growing at 25% annually.  It could decelerate to 10% or less in 2006.  A slowdown of such magnitude could cause the CRB index to fall by 20% from the current level.  Oil prices may drop below US$30/barrel.

US consumption is still strong.  The key is that its housing market is expanding rapidly in both price and volume.  *Some Americans are paying hundreds of dollars to attend seminars to learn how to speculate in the property market, similar to when many Americans were paying to learn how to be day traders in 1999.   Hence, the short-term risk is that US consumption would surprise on the upside.  However, similar to what happened in 1999, when average people think that they can make a living from speculation (does this sound familiar), the bubble may be about to burst.  2006 could turn out to be a very tough year*.


My Comments

For many months now, I have been expecting 2006 to be a difficult year, economically speaking.


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## Smurf1976 (4 June 2005)

Investor said:
			
		

> At the start of 2003, foreign investors held 33% of the ASX market capitalisation.



Where can I get this information? I'd like to keep track of this over time.


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## markrmau (7 June 2005)

Whats Greenspan trying to do? Engineer a crash so the PPT has something to do?

Greenspan issues hedge fund warning
Jun 07 11:37
Feedback AFR wires

US Federal Reserve Chairman Alan Greenspan has issued a warning of possible downturn for the hedge fund industry as funds take ever greater risks to generate higher returns at a time market interest rates are unusually low.

"After its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy," Dr Greenspan told a bankers conference in Beijing via satellite on Tuesday.

"Continuing efforts to seek above-average returns could create risks for which compensation is inadequate," Greenspan said. "Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming."

The Fed chairman added, however, that the financial system should escape widespread damage from hedge fund woes as long as the banks lending to them manage risks effectively.

Hedge funds are largely unregulated entities that cater to wealthy and institutional investors. Their assets are estimated to have doubled over the last five years to around $1 trillion, although observers think funds suffered perhaps the heaviest redemptions in a decade in the second quarter of this year.
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In his remarks, Greenspan tied the big risks hedge funds have taken on with the unusually low long-term interest rates prevailing around the globe.

As in February, when he termed the low level of long-term interest rates "a conundrum," the Fed chief wrestled with a number of potential explanations for the atypical environment -- but again found them all inadequate.

"One prominent hypothesis is that the markets are signaling economic weakness," he said. "This is certainly a credible notion. But periodic signs of buoyancy in some areas of the global economy have not arrested the fall in rates."

He said stepped-up demand by pension funds for long-term assets was likely no more than "a small part" of the cause.

Greenspan said while foreign central bank purchases of U.S. government debt may have lowered long-term borrowing costs in the United States, Fed staff estimates suggested only a modest impact. Further, he said this would fail to explain the lower long-term rates elsewhere around the globe.

He said the integration of low-cost producers like China and India into global markets likely had lowered the inflation compensation investors had previously demanded for holding long-term debt. But he said that more readily explained trends of the past decade, rather than of the past year.

The Fed has raised overnight borrowing costs by 2 percentage points since June 2004, taking the benchmark federal funds rate to 3 percent. Long-term rates, however, are lower now than when the Fed started.

Greenspan said the abnormal behavior of interest rates had encouraged greater risk-taking.

"Whatever the underlying causes, low risk-free long-term rates worldwide seem to be one factor driving investors to reach for higher returns, thereby lowering the compensation for bearing credit risk and many other financial risks over recent years," he said.

And for high-flying hedge funds, the increased appetite for risk seemed likely to lead to losses, Greenspan said.

"But so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability."

Although warning of hedge fund troubles ahead, Greenspan, who was to speak on a panel with European Central Bank President Jean-Claude Trichet, Bank of Japan Deputy Governor Toshiro Muto and People's Bank of China Governor Zhou Xiaochuan, reiterated his view that the industry had helped increase the economy's resilience.

He said this was important, since economic policy-makers were not always able to head off brewing trouble in time. He urged countries not to become resistant to free trade because it would lessen their economic flexibility.

"In this regard, the recent emergence of protectionism and the continued structural rigidities in many parts of the world are truly worrisome," Greenspan said.


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