[Kabar-indonesia] Analysis: Asia Liquidity Downturn Drives Markets and Economies [+Roach]

[Joyo at aol.com]

3 Reports from Morgan Stanley Economists 

- Asia/Pacific: Liquidity Downturn Drives Markets and 
  Economies

- Global: Scale and the Chinese Policy Challenge 
  (By Stephen Roach, Chief Economist)

- Currencies: Don't Blame the BoJ for the Bloated
  Global Asset Prices

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Morgan Stanley Economists 
June 20, 2006

Asia/Pacific: Liquidity Downturn Drives Markets and
Economies

Andy Xie (Hong Kong)

Summary & Conclusions

Central banks have buffered the global economy against
deflation shocks repeatedly since 1998 by releasing
more money into the global financial system. The
liquidity has kept the global economy strong by
inflating financial assets. This unique episode is
ending as deflation shocks end and the
deflation-exporting economies begin to export
inflation.

The sell-off since mid-May is to retrace the
overshooting between November 2005 and April 2006. The
boom of emerging markets and commodities during this
period took place despite the sluggish liquidity
environment due to reallocation of liquidity out of
big markets.

Inflation is likely to remain a problem for central
banks over the next two years, as the excess liquidity
in the financial system turns into inflation in the
absence of deflation shocks. As central banks fight
inflation, liquidity could decline significantly,
which would cause re-pricing of all assets. The global
economy could experience a period of all assets
depreciating.

Economies that have become addicted to portfolio
inflows to fuel consumption would suffer most in the
process. Their virtuous cycle of buoyant stock
markets, strong currency, low interest rates, and
rapid consumer credit growth could turn into the
vicious cycle of declining stock markets, weak
currency, high interest rates, and consumption
recession.

A soft landing for land prices in the US and China is
a necessary condition for the global economy to avoid
a recession in 2007. If investors can be convinced to
accept lower returns on capital than they hope for
today, the soft landing is possible. The hard-landing
risk is quite significant.

It Is Not Just a Correction

I have been visiting Asian equity investors in the
past two weeks. The mood among investors is sombre.
The sell-off is a painful surprise. Most have a hard
time digesting what has happened.

Most investors believe that the sell-off is a
correction. However, not many want to buy now, as they
fear redemption. Indeed, many are hedging through
futures market and, if liquidity comes back, would
like to sell high beta stocks.

I shared my view with investors (1) that the sell-off
was due to the liquidity cycle turning down, (2) that
the sell-off so far was just adjusting for the
overshooting since November 2006, and (3) that global
liquidity would decline due to inflation, which would
cause a bear market.

I did not get much feedback on my view that the world
was headed for a bear market. Instead, most investors
wanted to discuss with me what other investors were
doing. Apparently, many investors have gone into
survival mode and are interested in technical details
of the market to help them make decisions.

It appears that fear has taken over from greed. More
redemption is quite likely in the coming days. It
would take very good news on inflation for greed to
come back. I doubt that the news on inflation will
turn benign within the next 12 months. That is why I
think any market bounce will not last.

The Sell-off Corrects Overshooting since Nov. 05

Emerging markets and commodities took off in November
2005 and kept rising until April 2006. It happened in
an environment of sluggish global liquidity. The G-3
free liquidity (short-term money growth rate minus
nominal GDP growth rate for the US, Euro-zone, and
Japan) was growing at a 1.1% annual pace between
2004-05 compared to 8.1% in the previous two years.

The boom was due to liquidity reallocation out of big
markets, or rising risk appetite. The bond market has
been in a bear market for two years. The property
market has rolled over in all major economies. The US
big-cap stocks have not performed in the past 18
months. Essentially, the performance of big asset
markets has reflected the sluggish liquidity
environment.

The boom of emerging markets and commodities between
November 2005 and April 2006 was against the global
liquidity tide, not part of a rising tide lifting all
the boats. The 'rising risk appetite' could not be
sustained in a sluggish liquidity environment. It
would not take much to trigger a reversal.

Liquidity Could Decline

The global economy has experienced a 'deflation boom'
since 1998. There have been a series of deflation
shocks. A string of emerging market crises, China's
SoE reform, and Japan's banking reform raised
deflation fears. Central banks around the world turned
on the monetary spigot. Financial speculation has been
the main source of demand for money and rising asset
prices due to financial speculation have led to rapid
global economic growth.

The tech bubble of 1999-2000 and the global
property/emerging market/commodity bubble since 2000
belong to the same liquidity cycle, I believe. As long
as inflation is not a problem and speculative appetite
strong, the global economy will just cruise from one
bubble to another.

However, inflation has become a problem. Global free
liquidity is about 60% higher than ten years ago. So
much more money is not inflation only if the world
continues to receive deflationary shocks.

However, wages are rising in China, land prices are
rising in Japan, and emerging economies that went into
crises have big foreign exchange reserves now. Indeed,
the economies that sent deflation shocks to the global
economy are exporting inflation now.

The 60% extra money in the global financial system has
become inflationary in the new environment. It does
not matter if it works through oil prices, wages in
China or the US. If the money is not taken back by
central banks, it will cause inflation.

This inflationary pressure will not let up even if the
US economy slows down significantly. Again, it is a
monetary phenomenon. The technical transmission
channels are not important. I can see two that will
persist even in a US downturn.

First, oil price is likely to remain high. I believe
that the commodity bubble is bursting, with the
exception of oil. Oil exporters have made so much
money in the past two years that their selling
eagerness has declined dramatically. Most oil
exporters are enjoying their newfound global status.
They would not mind cutting production to sustain high
prices.

Second, China is raising production costs regardless
of global economic strength. China is to cheap
manufacturing products as Saudi Arabia is to oil.
China is in a position to raise export prices. The
world wants China to raise its export prices also by
putting pressure on China to revalue. China is doing
it through removing export subsidies, which benefits
domestic consumption, rather than through currency
revaluation.

These two forces should keep inflation on an upswing
even if the global economy cools in 2007. This is why
central banks cannot cut interest rates even if the
global economy dipped into recession in 2007, I
believe. Virtually all investors that I met in the
past two weeks believe otherwise.

A Multi-year Bear Market Could Lie Ahead

The amount of liquidity reduction, considering that
liquidity relative to real economy is 60% higher than
10 years ago, could be dramatic. Even if half of the
liquidity increase in the past decade is sustainable
due to the permanent disinflationary effect of
globalization, it would still cause the prices of all
assets to decline by about 20% on average.

When asset prices decline, the global economy could be
quite sluggish, in my opinion. More importantly for
equity markets, the share of corporate earnings in the
global economy could decline. Two trends have
exaggerated corporate earnings. First, rising
commodity prices have increased corporate earnings
through inflation tax on consumers. As the commodity
bubble bursts, such earnings are given back.

Second, financial speculation has exaggerated the
financial sector's earnings. The real estate bull
market, for example, has increased the earnings for
financial institutions dramatically. Part of the asset
inflation in the global economy has become the
earnings of the financial sector.

Third, the high-end consumer market could suffer
severely from the negative wealth effect. The positive
wealth effect in the past has exaggerated the demand
for high-end consumption goods and services. There has
been much more inflation in the high-end consumption
segment, which has boosted corporate earnings in this
market.

This is why it I believe it is wrong to look at the
current earnings to judge how expensive the market is.
The asset inflation-driven global economy has
exaggerated corporate earnings substantially. A more
meaningful indicator is to look at the stock market
capitalization to GDP ratio. It has gone up
dramatically in the past 10 years. A big chunk of the
increase could be given back in this bear market.

Some Economies Could Go Into Crises Soon

Several economies have been supporting their
consumption by attracting foreign portfolio inflows.
The inflows have kept their currencies strong,
inflation low, stock markets high, and consumer credit
buoyant. As foreign portfolio inflows stop, their
currencies begin to weaken, inflation accelerates,
interest rates rise, and consumer credit turns down.
The vicious cycle could in my view lead to a currency
crisis.

In addition, some emerging economies have run current
account surpluses on high commodity prices. As the
commodity bubble bursts, their currency accounts could
turn into deficits again. They are also vulnerable, I
believe.

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Morgan Stanley Economists 
June 21, 2006

Global: Scale and the Chinese Policy Challenge

Stephen Roach (Chief Economist, New York)

For the second time in two years, the Chinese economy
is overheated. Yet once again, the Chinese authorities
are taking an incremental approach in addressing the
problem. While this strategy has worked reasonably
well in the past, that may no longer be the case. The
bigger China becomes and the further down the road of
reform it travels, the tougher it will be to use
incremental policy adjustments to steer the economy.
China needs a new approach to stabilization policy --
before it's too late.

Scale effects pose an increasingly serious challenge
to Chinese macro policy strategy. That wasn't always
the case -- especially when China was a small and
largely undeveloped economy. But those days are long
gone. While China still accounts for only about 5% of
world GDP in 2005 (in dollar-based market exchange
rates) -- its overheated sectors now have a much
bigger weight in its own economy, as well as in the
broader global economy. That's especially the case for
China's white-hot fixed investment sector. In 2006,
fixed asset investment is likely to surpass US$1.3
trillion, or more than 50% of total Chinese GDP. This
is astonishing by any standards. Even in their
heydays, investment shares in Japan and Korea never
rose much above the low 40% range; by contrast, in the
United States, the world's largest economy, fixed
investment is likely to be around $2.3 trillion, or
17% of GDP in 2006. In other words, while China's GDP
is only about 18% the size of America's, Chinese fixed
investment outlays are running at nearly 60% of those
in the US. Putting it another way, China's investment
"delta" -- the growth in its investment spending --
dwarfs anything the world has seen in recent years.
>From 2000 to 2005, Chinese fixed investment surged
from about $400 billion to $1.1 trillion -- a $680
billion increase that was nearly 70% larger than the
US investment delta of about $400 billion realized
over the same period.

Similar comparisons are evident in China's export
sector -- the other overheated piece of its economy.
In 2005, total Chinese manufactured exports hit US$762
billion -- fully 84% of the level of goods exports in
the US, the world's largest trading engine. As a
result, goods exports rose to 34% of Chinese GDP in
2005 -- nearly five times the 7% share in the US.
Here, again, the growth delta is nothing short of
astonishing. Over the 2000 to 2005 period, Chinese
goods exports have tripled, whereas those from the US
have increased only about 15%. That outsize disparity
puts China's export delta over the most recent
five-year period ($512.9 billion) at 4.2 times that of
America ($121.3 billion).

The repercussions of China's investment- and
export-led growth surge are global in scope.
Significantly, it's not just an export and investment
story and the implications on employment and real
wages in the developed world. It's also a story of
increasingly powerful impacts on industrial materials
and other commodity markets. Driven by
commodity-intensive activities such as urbanization,
infrastructure, and industrialization, China has
emerged as the dominant force in shaping global demand
for most strategic materials. As I noted recently, in
2005 alone, China accounted for 50% of total global
growth in the consumption of aluminum; for other
industrial materials, the comparisons were literally
off the charts -- 84% for iron ore, 108% for steel
products, 115% for cement, 120% for zinc, 307% for
copper, and well in excess of that latter amount for
nickel. I have argued that with protectionist
pressures mounting and the risks of capacity excesses
growing, China is now nearing the end of its
"commodity-heavy" industrialization model and is about
to embark on a major rebalancing toward consumer-led
growth that would lower the commodity content of its
GDP (see my 2 June dispatch, "A Commodity-Lite
China"). If anything, the investment- and export-led
growth blow-out in early 2006 makes such a transition
all the more urgent.

All this poses an increasingly vexing problem to
Chinese policy makers. In a normal market-based
economy, fiscal and monetary tools are the primary
means by which the authorities temper the excesses of
the business cycle. China, however, is far from a
normal economy. Despite over a quarter century of
impressive reforms, it remains very much a "blended"
economy -- a mixture between state- and
privately-owned enterprises. While the ownership
balance continues to shift dramatically away from the
state, the latest statistics put state-owned
enterprises at about 35% of Chinese GDP. Moreover,
that share undoubtedly understates the degree of state
control in the newly privatized -- or "corporatized"
in Chinese parlance -- segment of the economy. Even
after public offerings, the state still maintains
sizable majority ownership stakes in most of its
so-called publicly-listed, privately-owned companies.
Moreover, there can be no mistaking the limited impact
that internal market forces have had in driving
China's two overheated sectors. For example, in 2004,
state-owned and collective units still accounted for
fully 50% of total fixed asset investment in China. In
addition, nearly 60% of total Chinese exports are
generated by "foreign-invested enterprises" -- Chinese
subsidiaries of foreign multinationals and joint
venture partners, who rely on Chinese sourcing as a
critical part of their global efficiency solutions.

The blended Chinese economy is also supported by a
relatively undeveloped financial sector. Despite
recent reforms, China is still a long way away from
having a fully functioning banking system and capital
markets. Two of its "big four" policy banks are now
listed companies, but the transition to
commercially-based lending practices is only in its
infancy. Nor does China have a well-developed
corporate bond market that enables newly emerging
private businesses to secure funding from capital
markets. That means the bulk of China's credit
allocation continues to rest on the shoulders of a
still very fragmented banking system -- with decisions
made more at the provincial and local level rather
than by head offices in Beijing. Moreover, local bank
branches are still closely aligned with local
communist party politicians, whose main priority is
social stability and project-driven employment growth.
As such, monetary policy at the central government
level -- especially recent adjustments in nationwide
lending rates and reserve ratios -- do little to shape
Chinese investment spending. Instead, the Chinese
authorities have opted for "administrative" controls
to fine-tune investment flows on an industry and
geographic basis. As a consequence, the modern-day
counterpart of China's central planning bureau -- the
National Development and Reform Commission -- has more
to say about the allocation of capital than the market
or fiscal and monetary authorities.

A big risk for China is that it now gets trapped in
the inherent contradictions of its blended economy.
The excesses of a domestic and global liquidity cycle
compound the problem. Not only have Chinese banks been
especially aggressive in pushing out new loans
recently -- RMB lending in the first five months of
2006 was up 80% y-o-y -- but China's tightly managed
currency "float" links its money supply to an
explosive build-up in foreign exchange reserves. Last
year, Chinese FX reserve accumulation topped $200
billion, and this year, China's stock of such holdings
will easily exceed $1 trillion -- surpassing Japan as
the largest reservoir of FX reserves in the world. The
problem for China is that its currency regime still
requires massive recycling of these reserves into
dollar-based assets. Lacking a well-developed domestic
debt market, it is difficult for China to "sterilize"
all of those dollar purchases, meaning excess
liquidity spills over into domestic economy. Not by
coincidence, broad M-2 was surging at a 19.1% y-o-y
rate in May 2006 -- fully three percentage points
above the central bank's 16% target. Needless to say,
this is ultimately quite problematic for inflation
control in either goods or asset markets, or both. In
my view, China's investment bubble -- especially the
excesses in its coastal property markets -- is
undoubtedly linked to the nexus of the global
liquidity cycle and its currency policy.

Chinese authorities are now scrambling to regain
control over a runaway economy. But the response is
almost a carbon copy of the approach last used in the
overheating of 2004 -- incremental adjustments in
monetary policy and administrative measures aimed at
controlling industry-by-industry excesses in
investment spending. The basic problem with this
approach is that it has been overwhelmed by scale --
China's growth dynamic is now so powerful that its old
style of policy management cannot achieve the traction
required for effective macro control. Two overheating
alerts in two years underscore the pitfalls of the
current approach. And the most recent moves to raise
bank lending rates by 27 bp (an April 27 action) and
required reserve ratios by 0.5 percentage point (a
June 16 action) may simply not be enough to contain
the domestically-led excesses of its bank lending
cycle. Similarly, a continuation of grudging
adjustments to its currency policy may not be enough
to contain the globally-led excesses of its liquidity
cycle. Even though foreign central banks are now
tightening, expectations of RMB appreciation continue
to drive capital inflows into China.

In short, scale effects alone suggest that Chinese
policy makers need to do more if they are to succeed
in containing the excesses of their overheated
economy. In nominal terms, the economy is fully 35%
larger than it was in 2004 -- the last time Chinese
authorities were faced with a similar problem. The
experience of the past two years -- ongoing investment
and export excesses, in conjunction with China-led
spikes in energy and other industrial commodity prices
-- underscores the pitfalls of incrementalism in
guiding China's blended macro policy strategy. Fearful
of triggering a boom-bust cycle should policy tighten
too much, and concerned about the imbalances that can
only mount should policy remain overly-accommodative,
Chinese authorities are caught in the middle.

Current circumstances in China scream out for a
tighter macro policy stance. At the same time, the
shift from investment- and export-led growth to a
consumer-led growth dynamic has never seemed more
urgent. It's entirely China's choice in how to proceed
-- how to tilt the mix in its macro policies between
fiscal, monetary, and currency adjustments, and how
fast to push reforms ahead. But the longer China
avoids a more meaningful shift to macro policy
restraint and the longer it leans on investment and
exports at the expense of private consumption, the
greater the chance of the dreaded hard landing.

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Morgan Stanley Economists 
June 21, 2006

Currencies: Don't Blame the BoJ for the Bloated Global
Asset Prices

Refuting a false notion

Stephen Jen (London)

There is a popular notion among investors that the
BoJ's QE and ZIRP have been the main factor behind the
inflated asset prices in the world, and therefore
prospective tightening by the BoJ in the coming
quarters will have detrimental effects on all
financial asset prices. This note is my latest attempt
at dispelling this false notion. While I believe that
continued tightening of global liquidity will
ultimately be bad for risky assets and possibly all
financial assets, I am not persuaded by the
'JPY-carry-trades-holding-up-the-world' argument.

The popular notion I am trying to refute

This notion has been embraced by many investors for
several months, and is well-articulated in a recent
editorial by Mr Anatole Kaletsky (Why Japan Will Keep
Rates Ultra Low, The Times, June 12, 2006. According
to this thesis, even though the Fed began to tighten
two years ago, global liquidity did not diminish
because Japan's ample supply of liquidity
'substituted' for the withdrawn liquidity from the US,
thereby perpetuating and even exacerbating the asset
bubbles in the world. Conversely, when the BoJ starts
to tighten, the impact on global asset prices will be
more severe than that in response to tightening by the
Fed and the ECB.

This thesis is seriously flawed

While the latest round of risk-reduction coincides
with the talk of BoJ tightening, this thesis of
'JPY-carry-trades-fuelling-global-asset-prices' is
seriously flawed, in my view.

We need to understand first how QE worked

I apologize if I sound presumptuous; but based on the
argument that some of the massive money printing by
the BoJ somehow 'leaked out' of Japan and found its
way to other markets, I suspect that some investors
may not understand that all of the excess reserves
were bottled up at the BoJ anyway, and were not even
available for the Japanese economy, not to mention
other markets.

The BoJ has guided the CAB lower by allowing the
corresponding size of its bills purchased from banks
to mature without rolling them over. Both the assets
and the liabilities of the BoJ's B/S as well as the
banking systems' B/S decline in synch. These
'accounting' changes have minimal real effects on
either the monetary condition or the economy.

It is important to understand several features of QE.
(1) QE was never true 'money printing' in the sense
that the expansion in base money meant nothing for
broad money or bank credit. With interest rates
already at zero, there was no constraint on bank
borrowing, and the excess liquidity was 'trapped' on
the banks' deposits with the BoJ. (2) The QE regime
had primarily a psychological effect that ZIRP will
remain in place for a long time, and such an effect
may have helped to depress a good portion of the yield
curve (up to 5-Y), not just the very short-term rates.
(3) The dismantlement of QE, therefore, had zero
impact on the amount of 'money' or bank credit
available for use by Japanese or non-Japanese
borrowers.

Three types of JPY carry trades

Let's assume that there are three types of 'JPY carry
trades': (1) Japanese borrowing in JPY and investing
in higher-yielding foreign assets; (2) Japanese or
foreign investors borrowing in short-term JPY funds
and investing in longer-term JPY assets; and (3)
foreign investors could have had massive borrowing in
JPY from Japanese banks and held foreign securities as
a carry trade.

• Type 1 carry trades: Capital outflows from Japan.
Since the adoption of QE in early 2003, total Japanese
portfolio outflows have been around US$170 billion a
year. Compared to the US' gross annual securities
inflows of US$7 trillion a year, Japanese outflows
should not be so important that they have supported US
or global asset prices. However, with cumulative flows
since the first introduction of ZIRP in early 1999
totalling close to US$1 trillion, there are reasons to
be concerned about the JPY crosses and the prices of
smaller markets, if Japanese repatriation were to
become an issue. In any case, I believe that the BoJ's
policy per se should not dictate the trend of global
asset prices, unless it triggers a wholesale
repatriation by Japanese investors, which is unlikely.

• Type 2 JPY-carry trades: JPY-JPY carry trade. The
biggest investors of this type of carry trades, I
suspect, are the Japanese banks: their taking
short-term deposits (borrowing short) and holding JGBs
(lending long) is the type of JPY carry trade in
question. After the introduction of QE in spring 2003,
we indeed saw a massive rise in JGB holdings, as
Japanese commercial banks not only took maximum
advantage of the zero short-term deposit rate, but,
more importantly, also reacted acutely to the virtual
guarantee by the BoJ that interest rates would remain
low for a long time. However, what is more important
for our discussion here is that, during the last two
years when asset prices in the world really took off,
and the Fed began to tighten, there is no indication
that Japanese banks bought more JGBs to drive the
yield lower so as to offset the liquidity withdrawal
by the Fed.

• Type 3 JPY carry trades: Foreign investors running
JPY carry trades by borrowing from Japanese banks. On
further inspection of the scant data I could find, in
my view, evidence is not supportive of the claim that
there has been an increase in Type 3 JPY carry trades
in recent years.

In the BIS' latest quarterly report, it was suggested
that there was tentative evidence of JPY carry trades.
The BIS reports that the stock of outstanding
JPY-denominated claims, held by both Japanese and
non-Japanese banks, rose noticeably in 4Q05. However,
JPY loans from Japanese banks have declined steadily
since 1995. While outstanding overseas loans in JPY
rose in 2004, they declined again in 2005, reaching
US$181 billion by year-end. Since banks don't usually
take large currency risks, i.e., have large open
positions on currencies, non-Japanese banks' JPY loans
should in theory be offset by their liabilities in
JPY. In other words, Type 3 JPY carry trades should
show up only in JPY-denominated cross-border loans
extended by Japanese banks. Furthermore, the total
stock of loans in JPY accounts for only 5% of all
cross-border bank loans. Also, the total change in the
stock of cross-border JPY loans in 2005 was also 5% of
all cross-border loans. In other words, there is no
indication from these data that large new cross-border
JPY loans were extended by Japanese banks in recent
quarters at a pace that is out of line with the
historical average. Finally, in 2005, there were an
additional US$1.2 trillion worth of cross-border USD
loans and US$1.3 trillion of cross-border EUR loans
extended. Does that mean that there were USD and EUR
carry trades? In other words, there are many reasons
why cross-border bank loans are extended.

What I am not saying

I am not arguing that the BoJ policy has no effect on
global asset prices. Rather, I am refuting the view
that there is something extra special about JPY carry
trades. When interest rates rise in Japan, capital
outflows from Japan would clearly be adversely
affected, ceteris paribus, and some risky assets could
be hurt. I do not challenge this point. But it is
unreasonable, in my view, to think that BoJ tightening
would trigger a collapse in global equities, most
commodity prices, etc. Even massive money printing by
the BoJ failed to support the Nikkei for years and so
I don't see how money from Japan could have such a big
impact on the world. Monetary tightening by the BoJ
will have no more and probably less of an effect on
asset prices than if the Fed or the ECB tightens.

Bottom line

There is an increasingly popular view that the BoJ's
QE and ZIRP have played a critical role in supporting
the global asset prices, particularly after the Fed
began to tighten in June 2004. Conversely, any
tightening by the BoJ could severely undermine global
asset prices. I strongly challenge this view. Global
asset prices will remain vulnerable for many reasons,
but not just because of the BoJ's intention to
tighten.

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Joyo Indonesia News Service
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