FYI | Sep 19 2007
Let’s start this week’s editorial with a question: what do you think is the core problem behind the global liquidity crunch?
I am sure you will be as surprised I was when you’ll read the answer to this question provided by Mike Milken, one of many larger than life characters in the global finance industry who was once credited for revaluing inhouse research at Wall Street brokerages.
The problem behind today’s global liquidity crunch, says Milken, has at its core nothing to do with leverage, lack of regulation, predatory lending, sophisticated investment products, lenders seeking growth or market share, or globalisation (did I miss any of the things you were thinking of?).
At the core of today’s problem lies the same misconception that has been plaguing the finance industry probably since its early days of inception, says Milken, and that is the sheer universal perception that any loan that is backed up by real estate collateral is a good and solid loan.
And about once in every generation people come to the conclusion that this perception is a misguided one. Says Milken: “we saw it in the 1960s and the 1980s and we’ll probably see it again in another 20 years”.
Milken started working on Wall Street four decades ago. He studied, among many other things, two hundred years of credit history. He says if people would look into the causes of major disasters such as the US savings and loan industry bust in the 1980s they will discover the same basic premise at the core of the problem: losses on real estate loans.
Milken says it’s always important to remember most real estate loans are non-recourse to the borrower and the underlying credit is based on the value of the collateral. Of course, the fact that the value of the collateral can actually decline is never taken into account by either party on both sides of the contract. So every time it happens… (I am sure you can fill out the next few steps yourself). The end result is always: crisis – it’s just the format that changes with the times.
You would think that after two hundred years, and on average one financial crisis per each generation, we would have learned our lesson, wouldn’t you?
Milken used his speech as one of the key note speakers at CLSA’s annual Investors’ Forum in Hong Kong a few days ago to enlighten the spirits of the attendees. The public relations department of CLSA was so amenable as to send me a copy of the speech. Unfortunately, I did not receive copies of speeches given at the same Forum by Andy Rothman, CLSA’s China macro strategist, and by CLSA’s chief economist Jim Walker. I am therefore relying on other media reports to summarise their thoughts.
The reason for including Rothman and Walker in this week’s editorial is a very straightforward one: all three speeches are linked through today’s global liquidity problem but, most of all, I have seldom seen more extremely opposing views between two experts working for the same investment bank as between Rothman and Walker. Put together with Milken I think it makes for a nice CLSA Forum triangle.
Let’s continue with Walker. Contrary to the general view that China will continue growing its domestic economy while most developed economies are struggling with tighter lending and funding conditions, Walker is of the view that the world is in for a shock as China will be impacted as well, and quite severely so.
Globalisation has turned into a phenomenon whereby capital intensive industries have become the beneficiaries of US monetary policies, says Walker. China is simply the biggest beneficiary of the Fed’s easy money policy since the dot com bust.
The global credit created in the past five years has been unprecedented in history, he points out. Walker believes we’re now experiencing the unwinding of this debt and this process will play itself out over the next six to twelve months.
The repercussions won’t be nice. GDP growth for the US is forecast to fall to 1.4% for 2007 and to 0.2% in 2008. I assume both figures mean Walker is of the view that a recession for the US can no longer be avoided. He sees the Federal Reserve as “only chasing the market”.
For China his GDP growth forecast is for more than 11% this year, but Walker believes it could slow to 5% in the second half of next year. For China, this would equal a recession.
At its core, Walker believes the credit crunch we are about to see playing out will be the biggest in history, and the economic wonder of China is too reliant on demand elsewhere while domestic investments are fuelled by abundant easy money flowing into the country.
His colleague, Andy Rothman, CLSA’s China macro strategist, doesn’t seem to share this somber view at all. In fact, Rothman doesn’t see any major problems occurring in China. He doesn’t think the economy is growing too fast. It seems the authorities are doing all the right things.
The only problem he can think of is that China is still exporting predominantly very low value items. Borrowing a quote from trade minister Bo Xilai, Rothman says for every US$700 computer that China exports only US$15 goes to the Chinese manufacturer.
With the notable exception of the iPod, most high-value items are still imported into China before being assembled there. As such, net exports, which are calculated by stripping out the value of the import components that go into making export products, still only represent about 7% of China’s GDP.
However, if the US and the rest of the world will be squeezed by the global liquidity crunch this is likely to play in China’s favour, Rothman says, as consumers in developed economies will turn to cheaper goods to buy, and guess who is the number one manufacturer of such products?
With these thoughts I wish you all the best for the next two weeks. I will be taking sort of a mini-break which in essence means I will be around and about but not at full strength and not all the time. As a result there won’t be any Weekly Analyses or Rudi on Thursdays for the next two weeks.
I’ll be back before you start missing me.
Your editor,
Rudi Filapek-Vandyck
(As always supported by the Fab team of Greg, Chris, Grahame, George, Joyce and Terry)
