DABERIAM XXXIX

May 2008

Since March, visits to both the East and West coasts of the US and Asia, including Ulaan Baatar, have highlighted to me the divergence in the Western and Asian economies. My theme last year that inflation was going to be the major problem is playing out with a vengeance. Central Bankers now have a dilemma, they cannot continue to push interest rates down to deal with the West’s financial crisis as convention requires them to push interest rates up to deal with inflation. The single lever of interest rates is, however, unlikely to have much impact on inflation as it is being imported from Asia. The same trade mechanism that enabled the Governments of Western countries to claim credit for the benign inflation as consumer goods rolled off the new and modern production lines of Asia at low prices, is turning as those product prices along with commodity prices rise rapidly, as discussed in my March comments. 

The interest rate dilemma is going to make the Western economy very uncomfortable, with the worst consequences in Britain and Europe. The more pragmatic Federal Reserve Bank and the far less rigid economy of the US means that probably the slow down will be less and the recovery quicker. The rigidity of the Euro area and the overarching bureaucracy stifles enterprise and makes economic change slow, but at least enterprise can evolve albeit slowly within this environment. Britain, however, has in the last eighteen months developed a whole new paradigm of Government incompetence of Third World proportions. The Government, under the Brown leadership, a rabid Socialist Scot with minimal knowledge of commerce and industry, has managed to create fiscal and legal uncertainty of monumental proportions. The tax system is in chaos, both for the poorest in the land and right up to the huge numbers of wealthy non-British who reside here. Rafts of changes are announced and then withdrawn or amended, leaving total uncertainty in both the personal and corporate tax areas. 

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 30 April 2008	USD	2.00%	EUR	4.00%	GBP	5.00%
MSCI World Equity Index	30/04/2008	309.223	31/12/2007	299.916	YTD %	3.10%
Gold (PM London Fix $ per ounce)	30/04/2008	971.00	28/12/2007	833.75	YTD %	16.46%
Oil (WTI Crude $ per barrel)	30/04/2008	113.46	28/12/2007	96.01	YTD %	18.18%

Added to the tax and fiscal chaos, the announcements of rafts of legislation destabilising the rules for employing people, are hugely discouraging business and industry from taking on employees. A depressing picture that is going to greatly exacerbate the economic difficulties over the next year or so in Britain. 

This rather depressing view has been triggered by a lot of travel over the last few months which over-rode my intention to confine my comments to a more backward looking view of some of the causes of the Western financial crisis, which follows:- 

As we look back over the financial turmoil of the last six months it is worth thinking about some of the causes of these man-made disasters. Most industries are self-regulatory and where monopolies start to appear they are easily identifiable. If they are not being encouraged by the Government, then they are relatively easily curtailed. In other words, market forces in most areas tend to stop excesses, but this does not apply to the financial sector. 

The finance industry, a vital part of modern economics is highly regulated as well as being the product of Government’s delegation to the sector of the responsibility of creating “money”. The finance industry like any other needs to be looked at from an evolutionary point of view. Humans, like any other life form, will take advantage of any nook or cranny that will sustain life or make money. 

Conceptually, human ingenuity therefore will evolve strategies to take advantage of any profitable activity. In a regulated environment where legislation is inevitably put in place as a reaction to the latest crisis, the legislative process will be confused and of itself create inconsistencies that can be exploited. 

Looking back, it is interesting that the crisis of the 1930s created the Glass Steagall Act of 1933 separating conventional banks from Merchant or Investment Banks and Brokers. Two regulatory environments developed as a consequence, the Federal Reserve to deal with Bankers and the Securities and Exchange Commission to deal with stock broking and investment banking. 

The separate evolution of these two different regulatory authorities enabled a great deal of banking activity to be taken over by broking houses which for example led to the growth and collapse of Enron, and many other institutions. The legislative consequence here was the creation of the Sarbanes-Oxley Act, the bizarre consequence of which was to create an explosion in off-balance sheet finance. The commonly called Structured Investment Vehicles (SIVs) - this is paper that distances the Finance Vehicle from the Company issuing, was encouraged by the Act. It is these instruments that the Finance Industry created over the last few years in abundance that are, as Warren Buffet called them, instruments of mass financial destruction. 

Created to get between the cracks of legislation they encouraged companies to parcel up debt and sell it. The buyers of the paper in its various forms are banks, insurance companies, pension funds, mutual funds, etc. To give purchasers comfort with the strange instruments, the rating agencies, Moody’s etc., extended their mathematically systematic method of evaluation, which typically gives great weight to the historic record of defaults for any particular type of paper and categorising it Triple A down through the alphabet. This method of rating encouraged buyers to forget to look at the underlying structure of the instrument and familiarity bred complacency. 

More recently, the banking regulators implemented, with effect from January ’08, a regime called Basle 2, which uses part of the same rating system to categorise bank liquidity to the simplistic rating of paper between being Prime, i.e., A rated, and Sub-Prime - B rated; ignoring the possibility that the rating agencies will change the ratings as experience evolves with the consequence that the banks’ reserve assets can be wiped out by a change in rating category without looking and taking into account the real underlying asset value of the paper. This uncertainty has led to the breakdown of trust between banks, investment banks and brokers in large parts of the financial system, and it is going to take some time for managements to work through the ‘books’ to figure out what they are really holding! These dislocations will not be fully cleared up until we get through the next year-end ’09. 

Still shocks to come. 

Damon de Laszlo 
May 2008

DABERIAM XXXVIII

March 2008

Visiting China two weeks ago, to see companies around Shanghai and Chonqing, one was constantly reminded of the incredible progress made in the last fifteen years, bringing an enormous increase in living standards to hundreds of millions of people. The consequences for some are awful, Tibet being much in the headlines, but the old moral dilemma remains - how to reconcile the benefits that the regime has brought to half a billion people with the downside for relatively few.

The consequence for the West, however, of the Chinese Government’s strategy is worth constantly reiterating. We have benefited from ten years of Chinese industrialisation, which has produced huge amounts of innovative goods as well as reducing the cost of products that contribute to the West’s high standard of living. Western Governments have taken credit for the low inflation that this has brought. 

We will not be so happy with the next phase. Chinese wages are rising; amazingly there is a shortage of labour. The Chinese people are benefiting from the products that used to go only to the West. They are also enjoying more and better food and the other material benefits that come with rising prosperity. The RMB is also rising inexorably as the Chinese Government increase interest rates to dampen down the economic expansion and is encouraging industry to look inward as the US and other western countries bring pressure on China to reduce its trade surpluses. China’s increase in consumption of food and raw materials for the enormous infrastructure - building programme is putting huge upward pressure on commodities. The combined pressure of increases in the cost of Chinese products and the continuing increase in commodities is going to bring in a new inflationary era.

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 27 Mar 2008	USD	2.25%	EUR	4.00%	GBP	5.25%
MSCI World Equity Index	29/02/2008	284.474	31/12/2007	299.916	YTD %	-5.15%
Gold (PM London Fix $ per ounce)	29/02/2008	971.50	28/12/2007	833.75	YTD %	16.52%
Oil (WTI Crude $ per barrel)	29/02/2008	101.85	28/12/2007	96.01	YTD %	6.08%

The good news from the China story, which also applies to India, is that there will be a movement of industrial production back to the West. This, however, is only of small comfort as the US, in particular, has got to digest an enormous pile of debt. The impact of this on US GDP is likely to be several percentage points over the next few years. 

Looking at Europe, Britain is in the same position. While UK private borrowing is probably not as extreme as in the US, the Government borrowing requirement is far, far worse. The UK position is further exacerbated by an apparent lack of understanding of what has been the successful part of the UK economy, i.e. international financial services and the specialised manufacturing and chemicals industry. By creating tax rises and more importantly tax uncertainty and confusion, these parts of the economy are being destabilised by political mismanagement. 

In February, it looked as though there were still some downdraughts in the world’s financial sectors. We are now fairly certainly at the bottom. Going forward, everyone now knows that there is a financial crisis; this probably means that while there will be turmoil, things will start to get better. The speed of recovery in the US will be slow for a year or two; as I have said the general level of debt that needs to be reduced will impact GDP. Europe, which as a whole was growing more slowly, will also gradually turn round, but the future does not look exciting. 

The biggest dangers to world stability this year will come from the political efforts to destabilise China, with the Olympic Games acting as the lightning conductor. While the Chinese government may not be “nice”, it is effective, and the Chinese economy is critical to the West’s economic stability. If China were collapsed, the economic consequences would be very serious.

Damon de Laszlo 
March 2008

DABERIAM XXXVII

February 2008

On the first of February I wrote in irritation to the Financial Times criticising the bureaucratic and box-ticking regulations of Basle II and observing that it is the regulators that are partly to blame for the present problem, an old theme of mine. It has been interesting to see the flurry of correspondence and editorial that subsequently appeared. 

It’s also fascinating to see the different response to the breakdown of control in two different companies. Northern Rock, ostensibly a very straightforward bank, ex Building Society, borrowing money in the short term inter-bank markets to lend out as mortgages, failed as a result of its inability to continue borrowing as the markets noticed its deteriorating credit worthiness. The failure and its aftermath showed the glaring incompetence of the regulatory environment to spot the very old fashioned and simple risk of unmatched borrowing and lending. There is also a complete failure to point out the lending practices of Northern Rock were racy and unsustainable. 

Nevertheless, in spite of the total failure of the management to appreciate the straightforward risks it was running, there seems to be a likelihood that the UK Government, having put in place a huge rescue operation, is going to hand the company back to most of the old management. Indeed none of the old management seems to have sustained any serious criticism or questioning. 

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 11 Feb 2008	USD	2.25%	EUR	4.00%	GBP	5.25%
MSCI World Equity Index	31/01/2008	264.919	31/12/2007	299.916	YTD %	-11.67%
Gold (PM London Fix $ per ounce)	31/01/2008	923.25	28/12/2007	833.75	YTD %	10.73%
Oil (WTI Crude $ per barrel)	31/01/2008	91.76	28/12/2007	96.01	YTD %	-4.43%

Compare this with Société Generale where the failure in an enormously complex area of the bank has caused a public outcry and the pillorying of the management from the Chairman downwards, and set off a raft of investigations by the regulatory authorities from New York, through London and back to Paris. No public money has been lost or public rescue been mounted; while the events appear to have generated a loss of some $5 billion or so, this is sustainable and now under control.

The difference between the two seems to be that one was an abject failure of the establishment system; the other was an internal failure of controls in an immensely complex part of the bank’s operations. While Governments, Regulators and the Press have had a field day pillorying Société Generale Chairman Daniel Bouton, an enormously sophisticated and successful banker who has built an immensely impressive company, he has handled the crisis in his organisation impeccably with great speed and efficiency; the handling of Northern Rock has been a complete shambles in virtually every aspect. 

On a different tack, it is worth observing in the context of the present economic crisis that we are probably nearing the bottom of the cycle. The world and his dog now knows there is a financial crisis and the unanimity of downward pointing forecasts indicates the turn is not too far away. We still have to get through the publication of the history of 2007 in the form of year-end accounts. Every Chief Financial Officer and auditor will be throwing the kitchen sink into the last few months of the year so as to have some hidden reserves to go into 2008. Clearly there is always a risk of systemic failure but it is now less likely than it was a month or two ago. 

The US Government, in an unusual and highly impressive flash of unanimity, has created a financial stimulus to the US economy that will add a good 1% to the GDP of America in the second half of the year. The Fed has acted dramatically and impressively to address the situation. The Sovereign Funds of the Middle East and China are moving in an impressive fashion to take advantage of the confusion in the West, buying discounted assets, so putting liquidity back into the system. 

The not-so-bad news is that markets will continue to be volatile and could continue to go down for a while, but the really bad news is that inflation rather than deflation is going to be the order of the day going forward. 

The extraordinary phenomenon of Chinese industrialisation is slowing, but the price of its exports is rising along with the value of its currency, pushing up prices in the West. Oil in particular, and energy in general, will continue to rise in price as the political systems of the West continue to fail to address the energy needs of their economies as they are fearful of the green movements. 

Unfortunately, the slow down needed to unravel the huge pile up of Government and private debt that has created a large part of the economic growth of the last few years will not push down inflation as it has done in the past because of the growing demands and successful management of the Chinese, Indian and other rapidly developing economies. 2008 will be “interesting times” but by the end we will be entering into a new world order, with China, India and Russia becoming clearly major players on the world stage. The “West” will have to be more conciliatory.

Damon de Laszlo 
February 2008

DABERIAM XXXVI

December 2007

It is unusual for me to put pen to paper twice within four weeks but having just re-read the Daberiam of December ’06, when I observed that ’07 would probably be as benign as ’06, with clouds gathering in ’08 - the storm arrived a little early! 

The storm raises some real concerns about the ability of Central Banks to cope with the complexity and linkages in the global economy. The world’s economy today is much more akin to weather system and the famous butterfly effect. This makes the individual economic models that Central Banks use dangerous. Bankers that over-indulge in models use them as a substitute for thinking, time is spent arguing about modifying the model rather than looking at the events that are unravelling in a complex world. 

In the last few months, the Fed has misjudged the severity of the financial crisis and still appears to be looking at it as a liquidity problem rather than a credit crisis. The unravelling of the structured debt market is causing downward pressure on asset prices that have been inflated by the expansion of credit. This downward pressure itself is causing more of the structured debt to be downgraded. Many of the financial institutions that hold this paper do not understand how the structures work and how the ratings work. Indeed I believe there are many bank directors who don’t understand either. The asset price inflation that has been driven by the creation of these vehicles will now become deflation. Banks do not trust each other and are still not even sure what they have in their own engine rooms, unravelling this problem will last certainly through the first quarter of next year.

Global Economic Indicators

World Economic Growth  (World Bank figures)	2006	4.00%	2005	3.60%	2004	3.40%
Base rates: 18 Dec 2007	USD	4.25%	EUR	4.00%	GBP	5.50%
MSCI World Equity Index	30/11/2007	284.33	29/12/2006	235.243	YTD %	20.87%
Gold (PM London Fix $ per ounce)	30/11/2007	783.50	29/12/2006	635.70	YTD %	23.25%
Oil (WTI Crude $ per barrel)	30/11/2007	88.72	29/12/2006	61.06	YTD %	45.30%

Compare this with Société Generale where the failure in an enormously complex area of the bank has caused a public outcry and the pillorying of the management from the Chairman downwards, and set off a raft of investigations by the regulatory authorities from New York, through London and back to Paris. No public money has been lost or public rescue been mounted; while the events appear to have generated a loss of some $5 billion or so, this is sustainable and now under control. 

The difference between the two seems to be that one was an abject failure of the establishment system; the other was an internal failure of controls in an immensely complex part of the bank’s operations. While Governments, Regulators and the Press have had a field day pillorying Société Generale Chairman Daniel Bouton, an enormously sophisticated and successful banker who has built an immensely impressive company, he has handled the crisis in his organisation impeccably with great speed and efficiency; the handling of Northern Rock has been a complete shambles in virtually every aspect. 

On a different tack, it is worth observing in the context of the present economic crisis that we are probably nearing the bottom of the cycle. The world and his dog now knows there is a financial crisis and the unanimity of downward pointing forecasts indicates the turn is not too far away. We still have to get through the publication of the history of 2007 in the form of year-end accounts. Every Chief Financial Officer and auditor will be throwing the kitchen sink into the last few months of the year so as to have some hidden reserves to go into 2008. Clearly there is always a risk of systemic failure but it is now less likely than it was a month or two ago. 

The US Government, in an unusual and highly impressive flash of unanimity, has created a financial stimulus to the US economy that will add a good 1% to the GDP of America in the second half of the year. The Fed has acted dramatically and impressively to address the situation. The Sovereign Funds of the Middle East and China are moving in an impressive fashion to take advantage of the confusion in the West, buying discounted assets, so putting liquidity back into the system. 

The not-so-bad news is that markets will continue to be volatile and could continue to go down for a while, but the really bad news is that inflation rather than deflation is going to be the order of the day going forward. 

The extraordinary phenomenon of Chinese industrialisation is slowing, but the price of its exports is rising along with the value of its currency, pushing up prices in the West. Oil in particular, and energy in general, will continue to rise in price as the political systems of the West continue to fail to address the energy needs of their economies as they are fearful of the green movements. 

Unfortunately, the slow down needed to unravel the huge pile up of Government and private debt that has created a large part of the economic growth of the last few years will not push down inflation as it has done in the past because of the growing demands and successful management of the Chinese, Indian and other rapidly developing economies. 2008 will be “interesting times” but by the end we will be entering into a new world order, with China, India and Russia becoming clearly major players on the world stage. The “West” will have to be more conciliatory.

Damon de Laszlo 
December 2007

DABERIAM XXXV

November 2007

The general press has now caught up with the banking world and it is clear to everyone that we are going through a crisis in the financial markets. It has sometimes been observed that no plan of battle survives the first shot being fired; until the smoke clears the outcome is uncertain. We are at the moment when virtually all pundits have joined in on the game of predicting a stream of potential disasters as contagion spreads through the financial system, but the outcome is not certain. 

The structured debt unwinding still has some way to go. In general financial institutions are probably not through the write offs of their positions and there is still another six months to go before company auditors and the rating agencies have cycled through the portfolios and captured all the write-downs. 

The unravelling of the structured debt market is causing major problems in the inter-bank market, and causing banks to distrust each other. This is turn is causing a huge reduction in liquidity in all the financial markets in the West, that could possibly in turn lead to a deflationary spiral. 

To return to the military analogy: under the pall of smoke that is obscuring the banking system, the financial institutions are fighting their individual battles to sort out the carnage in the structured debt market. The weaknesses in some of the institutions have and will continue to appear but the overall battle for liquidity is likely to be subsiding by the third quarter of ’08. 

Global Economic Indicators

World Economic Growth  (World Bank figures)	2006	4.00%	2005	3.60%	2004	3.40%
Base rates: 29 Nov 2007	USD	4.25%	EUR	4.00%	GBP	5.75%
MSCI World Equity Index	30/10/2007	299.601	29/12/2006	235.243	YTD %	27.36%
Gold (PM London Fix $ per ounce)	30/10/2007	789.50	29/12/2006	635.70	YTD %	24.19%
Oil (WTI Crude $ per barrel)	30/10/2007	94.54	29/12/2006	61.06	YTD %	54.83%

The prognostications of disaster are based on historic experience but there is today a major difference. While the banking situation is causing the markets to be very nervous, the underlying economies in China and the rest of Asia remain exceedingly strong and are producing enormous amounts of liquidity. Europe is still suffering from its highly rigid economies, but USA’s more flexible economy is responding to the dollar depreciation as already the downturn in imports and upturn in exports is starting to correct the burgeoning trade deficit. 

The Fed is highly likely to reduce interest rates and this is forcing the other Central Banks to either hold or reduce interest rates in turn in order to stop their currencies appreciating against the dollar, so reducing the pressure on the system. 

It is also worth noting that while volatile commodity prices are still at the high end of the charts, this does not indicate a major weakness in the global economy. Indeed the high commodity prices, in particular food and oil, are feeding inflation in China and the rest of the world. The upward pressure on the RMB will also inevitably feed into US inflation. While half of the economic community that are looking at historical statistics see no inflationary problems, those that look forward, including the Central Banks, are making nervous noises. 

One can predict that interest rates in two years time will be higher than today, but where they go in the meantime is the key question, to which the answer is almost certainly lower. 

We are at the point where it seems that the pessimists have it all their own way, but it is probably the turning point. While corporate profitability and global growth will certainly slow, the lower interest rates are likely to enable growth to be rekindled by the end of next year. Stock markets tend to anticipate and there is a high probability that they could take off in the run up to Christmas. There is also a high probability that in post-Christmas gloom, there will be another financial institutional train wreck. 

I have to end on an optimistic note as we run into Christmas and conclude the world is not coming to an end just yet.

Damon de Laszlo 
November 2007