The Influence of Foreign Investors

[Investor]

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.

 

[Investor]

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.

 

[Investor]

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.

 

[markrmau]

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.

 

[Investor]

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.

 

[Investor]

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.

 

[Investor]

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.''

 

[Investor]

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)."

 

[Mofra]

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

 

[Investor]

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.

 

[Investor]

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.

 

[ob1kenobi]

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.

 

[TjamesX]

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

 

[excalibur]

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.

 

[Investor]

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.

 

[DTM]

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?

 

[Mofra]

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.

 

[Investor]

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.

 

[Investor]

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.

 

[Investor]

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.