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Global economy headed for danger
By John Berthelsen

HONG KONG - The precipitous falls in equities markets across the world this week are raising concerns whether, after years of central-banker complacency, the global economy could be headed for a real crisis. They could be simply hiccups, but if they are, they are vicious ones. The entire year's gains in almost every world equities market have been erased in less than a week.

On Wednesday, the London market registered its biggest one-day percentage loss in three years; Germany's DAX index fell 3.4%; France's CA lost 3.2%; the Dow Jones Industrial Average fell 1.8%; the Nasdaq Composite fell 1.5%; and the broader Standard & Poor's 500 sank 1.7%. Compounding the gloom, prices for US Treasuries fell along with stocks, with yield on the benchmark 10-year note rising to 5.15%. Bond prices and yields move in



opposite directions. Though most bourses seemed to regain ground in early trading on Friday, the ominous signs remain.

At issue are fears that while the world's biggest central banks - the US Federal Reserve Bank, the Bank of Japan and the European Central Bank - have been watching out for interest rates and money growth, they have been ignoring, or at least been complacent about, the rapid proliferation of derivatives and the soaring price of gold and other commodities such as oil and copper. The Indian and Chinese governments, both of which have tame central banks and concerns about restive populations, have kept monetary policy relatively loose as well. Now, some economists believe, the sharp global market falls in both commodities and equities over the past few days could be the start of an economic nightmare. The central banks may have waited far too long to try to control inflation.

For instance, Dr Jim Walker, the Hong Kong-based economist for CLSA Asia-Pacific Markets, told investors in a private newsletter this week, "We are possibly in the most dangerous period for global financial markets in my working life."

Walker is not alone. "The Fed is grappling with two risks: (i) that it has already tightened too much and that a sharp economic slowdown is in the works and (ii) that it has tightened too little and an acceleration of inflation is on the way," write Ethan Harris, Drew Matus and John Shin, economists with Lehman Brothers, in their May 12 Global Economics Monitor.

Geoffrey Barker, economist and macro-fund manager at Ballingal Investment Advisors in Hong Kong, says central banks have forgotten the lessons of the early 1980s, when Fed chairman Paul Volcker applied historic and painful brakes to inflation, driving up interest rates to the point where US five-year T-bills were commanding rates as high as 20% annually.

Until just this week, when the markets have started to come apart, a tidal wave of liquidity generated by rising commodity prices and derivatives has swamped financial markets, not only in Europe but emerging markets as well. Even a country as disastrously managed as the Philippines has experienced a stock-market surge to record peaks. Markets in Australia, South Korea and Hong Kong have hit equally giddy heights as hot money has washed in from a global economy in which far too much money is chasing far too few financial instruments.

This liquidity has charged into commodities, emerging-market debt and equities, Asian currencies and particularly Chinese assets. Cross Border Capital, a financial advisory service, estimates total global financial assets now at US$74 trillion - $36 trillion in equities, $18 trillion in bonds and $20 trillion in liquid assets, looking for places to park on low interest rates.

Sean Darby, Asia strategist for Nomura, depicted one aspect of the phenomenon in April - a Sotheby's art and ceramic auction in which a painting of a pink lotus by Chang Yu sold for HK$28.12 million (US$3.62 million), more than five times the HK$5 million offer price. "Ironically, Chang Yu spent most of his life inventing games rather than painting, believing the former would make him rich and famous," Darby wrote. "We think the auction represents further anecdotal evidence that the financial economy is still flush with money."

Darby described what he called a "cocktail of global demand and excess liquidity ... helped by low real short interest rates and a lack of desire by corporates to replace inventory or reinvest in [capital expenditures]". He warned that central banks had left monetary policy too relaxed for too long, that the market underestimated growth, and that inflation signals that had emerged so far from the long bond market were misleading.

Alan Greenspan, previously everybody's favorite central banker, may have exited the stage just in time, leaving his successor, Ben Bernanke, with a series of seemingly intractable problems. Investors, particularly concerned about rising inflation, are watching anxiously to see how the Fed will react at the next Federal Open Market Committee meeting in late June (the FOMC is the Federal Reserve body that sets monetary policy). The consensus is increasingly that interest rates must go higher. They have reached neutral in the United States, and in Japan the central bank is steadily withdrawing excess liquidity - printing less money - in preparation for a rate rise.

But raising interest rates in the United States would have several consequences, none of them appetizing. At a time when the US - and world markets - are seemingly welcoming a cheaper dollar to try to control the country's huge and growing current-account deficit, a rise in interest rates means a flood of new money into US Treasuries to take advantage of the higher rates and adds to the deficit. Just on the growing belief that the Fed would have to raise interest rates, the US dollar rose overnight against the euro, the won, the New Taiwan dollar and the yen, among other currencies.

Second, rising interest rates in the US mean an automatic rise in mortgage rates as well. The average American family's debt load, which would be further exacerbated by any interest-rate rise, risks lower income growth and outright declines in home prices, Geoffrey Barker says. In a word, a rise in mortgage rates risks puncturing the already precarious US housing bubble, which is keeping the country's economy afloat. Millions of Americans have refinanced their homes and taken out the equity to spend for other possessions.

The average American now carries $10,000 worth of credit-card debt. Nor is the US alone. Mortgage rates, particularly in Hong Kong and other areas, parallel what happens in the United States, and homeowners - or in Hong Kong's case, apartment owners - are going to have to get used to sharply rising mortgage payments. Without a steady income stream and stability in the price of their largest asset - their homes - debt may become unbearable. Foreclosures once again will be a bank headache.

"Stagflation" is a word that came into the English language during the final years of president Jimmy Carter's administration in the US. The term refers to a period when rising commodity prices and previously lax monetary policy cost central bankers the ability to control inflation through interest-rate rises, and economies start to stagnate. A new nightmare for the US may be a new bout of stagflation - the combination of a stagnating economy and soaring interest rates that undid the markets in the final years of the Carter administration. It also undid the Carter administration itself.
Puru Saxena Ltd, a Hong Kong-based wealth manager, in a press release this week predicted oil would hit US$200 a barrel and gold would rise to $2,000 an ounce. It remains to be seen how long the current downturn in commodity prices will last. Demand in China and India and other newly industrializing economies does not appear to be about to abate. US President George W Bush may have a long two and a half years before he leaves office.

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