The Influence of Foreign Investors

[Investor]

.... 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.

 

[Investor]

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.

 

[Investor]

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.

 

[Smurf1976]

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.

 

[markrmau]

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.