FYI | Sep 12 2007
If you are getting tired of reading more developments and potential scenarios about the ongoing global liquidity squeeze, imagine being in our shoes.
When the Tech Wizard visited me last week and asked me about what I thought was the real problem in today’s global financial markets, I told him the problem is that this crisis we have is like an invisible assassin; we all know it is there, somewhere, but we have no idea about its precise location or even what it looks like.
It’s like being afraid of the dark.
Last week I read what I thought was a very interesting approach to the problem by GaveKal. It reminded me about why those GaveKal reports are held in such high esteem across the globe: it’s all about the ability to think outside the box and to transplant the key issue into a completely different framework, allowing others to gain a better understanding of what the core of the matter is all about.
A liquidity squeeze, says GaveKal, is like dynamite fishing. After the underwater explosion you first see the little fish come up to the surface. Next you see the bigger fish. Ultimately, and this is a long while after the explosion, you’ll see the whales coming to the surface with their belly up.
Identifying the little fish is always the easy part. GaveKal says last time around in 2000 it was boo.com, pets.com, and Hikari-Tsushin. This time around, the names have been New Century Financial and Astroc Mediterraneo.
We have already seen some bigger fish too with Goldman Sachs having had to bail out at least one of its hedge funds and with UK-headquartered Barclays expected to reveal the true extent of its losses over July-August sooner rather than later.
There will be more small fish casualties. For instance, Victoria Mortgages in the UK has gone into administration and by doing so the company has officially become the first British casualty of the US sub-prime crisis.
More interesting, however, is the question: who will be the big whale that will ultimately come to the surface, belly-up, gasping for oxygen?
In the previous bust, says GaveKal, we found out after some time the whales were named Enron, MCI, Argentina and, to some extent, Vivendi.
So who will it be this time?
Market consensus seems to point into the direction of the world’s investment banks. But will it be some private equity player? Or will it be the US consumer? Or US real estate?
GaveKal points out that the now widespread expectation of a slowdown in US consumption will have one very important side-effect: a serious improvement in the US current account deficit (because US consumers are exporting less US dollars, in effect).
This, in turn, means that anyone who is running negative cash flows (i.e., big current account deficits) and needs cheap and plentiful US dollars to thrive, gets cut off from the easy money. GaveKal reminds us all this is what happened to Mexico in 1994, Southeast Asia in 1997 and Argentina in 2001, to name just a few.
While not dismissing that one of the whales may include an investment bank somewhere, the outside the box thinkers have become increasingly wary that one of the whales may turn out to be one of the countries where the government has in recent years papered over economic cracks with easy and plentiful US dollars.
Candidate number one would seem to be Venezuela where an increasingly isolated, and disliked, President Chavez has become almost desperately dependent on a high oil price to remain in control of the country.
To make matters worse, some experts have already pointed out the global credit crunch has hit Venezuela hard with short term money market rates jumping higher, similar to what we have seen over the past two weeks here in Australia. One of the problems with this is, of course, that countries such as Venezuela do not have a financial infrastructure that is as healthy and as balanced as in Australia.
To add to the government’s worries, reducing global risk appetite is expected to see foreign funds flow out of the country.
As analysts at Danske Bank highlighted in a recent report, this story is not an isolated Venezuela story, but rather a developing trend across the globe. Money markets in developed countries are not functioning well at the moment and the same holds true for the money markets in many emerging economies.
The difference between the two is, however, that developed economies in general have a strong banking sector. This makes the risk of banking and financial distress much larger in emerging markets.
Venezuela is only one example. A recent report by credit rating agency Standard & Poor’s identified eight countries where a combination of high foreign debt, current account deficits, and dependence on foreign direct investment suggested a high vulnerability to rising interest costs.
Topping the list were Latvia, Iceland, and Bulgaria. Eastern Europe in particular seems to be one of the regions with a high concentration of potential “whales” as several governments have spent heavily on infrastructure but were disappointed later as they didn’t receive as much in funds from the EU as they expected. But there’s more to it, as GaveKal points out “all over Eastern Europe, consumers have borrowed Euros, or CHF [Swiss francs], to purchase cars, appliances, etc. What happens if domestic currencies start to weaken?”
According to S&P, much of the credit expansion in Eastern Europe has come through relatively short-term cross-border bank lines. As such the leverage of the private sector externally has risen sharply, easily outpacing the accumulation of foreign reserves.
If you’re looking for a reason to worry about next year’s global economic growth, then look no further. Many of these countries have grown at double digits over the past few years. Alas, that could now be well at risk because of rising credit costs.
Latvia’s economy, for instance, grew 12% last year, but the country’s external debt is forecast to hit 140% of current account receipts by 2008, while Bulgaria and Romania have current account deficits of 14.8% and 10%, respectively.
GaveKal believes one should include Turkey among the potential casualties as well, with the country currently mixing a precarious current account situation with rising inflation (August CPI at 7.4%) and a tense political situation.
While it remains far from certain whether we will see any of these countries ending up as one of the whales in the current global crisis, many an expert is convinced the risks for casualties of such caliber have increased significantly over the past few weeks. And those risks are mounting with each passing day the global liquidity squeeze remains unresolved.
Till next week!
Your I personally hope we don’t see too many whales editor,
Rudi Filapek-Vandyck
(as always supported by the fabulous team of Greg, George, Grahame, Joyce, Chris and Terry)
