This week, Barak Obama was inaugurated as the 44th President of the United States and the de facto Global Head of the World Economy. Mr. Obama had promised “change” through out his campaign and he told the America people in his inauguration speech that “We must change because the world is changing around us”.
Little did we know that within just a couple of days, the world would be on the verge of a fundamental change that could destabilize the world’s economy and the global financial system.
PIIGS
All over Europe and Asia, governments are trying to battle the economic slowdown and the banking crisis by pouring enormous amounts of money into their banking systems. This flood of money is raising deep concerns of whether the Governments will be able to finance this infusion. The numbers for some European countries seem out of proportion to their economic size. For example, Ireland has guaranteed all the deposits in that country even though the total amount of deposits is 5 times the size of Ireland’s GDP. How can Ireland do so without printing amounts of money that could destroy its currency?
In Europe, this problem is most acute for “PIIGS” – Portugal, Ireland, Italy, Greece and Spain. This week S&P downgraded the Sovereign ratings of Portugal, Spain, Greece and hinted that Ireland could be next. This has led CDS levels for European Sovereign Debt to reach record levels.
If that were not enough, over the weekend, England ended up taking steps to increase its equity stakes in major UK banks leading to fears of nationalization. This is not a theoretical or a social concept. Nationalization means the debts of the Banks end up as Sovereign obligations of UK. This led to a run on the pound which reached levels against the dollar last seen in 1985. The European currency, Euro, has also sold off because of the perceived threat to the united European Monetary Union, with the PIIGS and Eastern Europe in open revolt against the economic policies supported by Germany and France.
Anxiety about credit risks of sovereign nations, especially major European nations, would be a huge escalation of the global credit crisis that, so far, has been limited to the commercial and investment banks.
All this has happened before President Obama’s announcement of his massive bailout package. Clearly, the amount of the “stimulus” plan would be far smaller to those of UK and Europe as a percentage of GDP. But, the concerns about the total size of what might be necessary has begun to concern investors. That is why the premium paid to insure against default on US Treasuries reached a record high of 74.9 basis points on Friday, January 23, 2009, merely 3 days after Mr. Obama’s inauguration.
Let us be clear. Serious concern about the safety of US Treasuries would be catastrophic for America. The unquestioned creditworthiness of US Treasuries is the bedrock of US Bond markets and the global bond markets. This is what keeps the US Dollar as the world’s reserve currency and gives America its unique status. This is why China, Russia and Middle Eastern countries keep a vast amount of their reserves in US Treasuries.
So far, the US dollar has been strong. The rest of the developed world is so much worse off than the USA that the dollar is the best of a very bad basket of currencies. This may be changing before our very eyes. This week, the 30 year Treasury fell by 10 percentage points and Gold exploded upwards. Other commodities also firmed up providing the first signal that global investors are beginning to get worried.
We fervently hope that the Obama Administration is viewing these events with concern. Because, if the PIIGS slime slithers into America, it would be game over for the Global Economy.
DraGle – The Dragon & The Eagle
Our confidence in the caution and indeed, sanity of the Obama Administration was shaken when Tim Geithner, the nominee for the Secretary of Treasury, said explicitly in his Congressional Testimony that President Obama believed that China was “manipulating” its currency.
If this was politics to sooth the nerves of organized labor that put Mr. Obama in the White House, it was utterly foolhardy and dangerous. If Mr. Obama really believes this and if Mr. Geithner goes along with it, then we are looking at the first serious protectionist salvo of the Obama Administration.
The latter would be the 2009 equivalent of Confederates firing on Fort Sumter, the beginning of the US Civil war. A trade war between the US and China would be as devastating to the world as the Civil war was to the USA.
The twin engines of world growth this decade have been US and China. The twin forces of US Consumer spending and Chinese Capital Expenditure – joined at the hip like Siamese twins with each supporting the other, powered global economic growth. Today, both US and China are experiencing a deep slowdown. Economists believe that it will take 3-5 years for the US Consumer to regain a reasonable level of spending. It is getting increasingly clear that China is in the midst of a virulent slowdown and could actually face a recession. “Demand is falling in China, they are over-invested in capacity and there’s a global supply glut” said Nouriel Roubini in an interview to Bloomberg.com, ‘It has very, very important implications”.
Our own & similar views about China were discussed in our January 9 “Jim Cramer – Balanced Thinker But Wrong On China” – https://cinemarasik.com/2009/01/09/jim-cramer–balanced-thinker-but-wrong-on-china.aspx
In today’s economic minefield, any attempt by the Obama Administration to force China to appreciate its currency would be like playing with nuclear dynamite. In our opinion, the Chinese currency is very overvalued and has been propped up to present an illusion of resilience and strength to the world. Chinese Banks are in terrible shape, far worse than the European Banks. Any attempt by China to raise its currency further would hollow out its economy and create a deflation far worse than Japan’s.
Frankly, we expect things in China to get far worse before they get better and we expect deflation to hit China regardless of what the Chinese Government does. In an article in Newsweek International, a noted Chinese expert stated his (extreme?) belief that 2009 could be China’s 1929 (1929 was the start of the depression in America).
This is not the time to sound trumpets of a Protectionist War, especially on utterly flimsy and false grounds of currency manipulation. Every country manipulates it currency for its purposes and the USA is one of the more active manipulators. Witness the standard “A Strong Dollar is in the US National Interest” proclamation of every US Treasury Secretary. The reason they keep proclaiming it is that no one in the financial world believes they really think so.
Many commentators have pointed out that it took America’s entry into World War II to finally get the country out of the 1930s depression. Hardly any commentator has discussed the fact that the USA had established a virtual trade embargo against Japan for most of the 1930s and one of the compulsions for the Japanese attack in WWII was to break out of the US naval embargo.
China is already feeling threatened militarily. Last week, the Chinese Military, the real power in China, released a white paper arguing that China was facing serious military and political threats. China has escalated its military spending to levels that deeply concerns the USA and its neighbors. Historically, authoritarian societies have begun military adventures during hard economic times to deflect the attention of their restive populations. Wars do tend to focus societies and military spending does tend to create inflati
on and end a deflationary spiral.
For all of these reasons, we think it would be a highly dangerous step to begin a protectionistic attack on China. President Obama could start it easily; the Congress and the American public would support him enthusiastically. But, once begun, wars are hard to control as President Bush found out. He also found out, that if the war goes bad, the overwhelming support from the same Congress and the American People first evaporates and then changes into virulent opposition.
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Two Dangers For America & The World – PIIGS & DraGle
