Global De-Coupling? Let's Hope So!

NEWS FLASH: The United States is not the only country suffering from significant financial imbalances. Neither is it the only country where underwriting standards were thrown overboard as a result of many years of rising collateral values. Even if these factors were not at play it would be debatable whether world economies could emerge unscathed from a U.S. consumer slowdown. With the attitude towards aggressive lending changing markedly, some of the heretofore benignly neglected bubbles could pop.

Now that I have your attention, let's go country by country (through both developed and emerging markets) and catalog some of the problem issues.....my bet is that there are many more cases than I have overturned in the rather cursory (yes, I'm admitting it myself folks) investigation I have done for this article. Why are there all these imbalances? Easy money. Those of you who have attended the asset cycle 101 class already know that money hates a vacuum and that investors will leverage up appreciating assets until the asset prices start to fall or someone raises the price of leverage. Usually both of these happen at the same time. The rest of the story ain't pretty. Here is the list of problematic issues worldwide, that could be made worse by a wholesale change in sentiment towards aggressive lending. I'm not predicting that they will, I'm just letting you know they are out there and you may hear more about them in the future.

British Consumer Debt Crisis & London Commercial Real Estate Debacle

With regard to how a worldwide slowdown would impact the country, The Observer notes: "Since Britons are some of the most indebted people in the world, that puts us in a particularly vulnerable position. Per capita, Britons borrow more than twice as much as other Europeans. The average family pays 18 per cent of disposable income servicing debt. If the world economy slumps, the bailiffs will knock at British doors first."

As we have chronicled here before, there has been a run on British REIT's by investors seeking to pull their money out of the investment partnerships. While it is reflective of somewhat indiscriminate risk aversion, according to The Guradian, "Commercial property has proved one of the most popular investments of recent years, with billions of pounds pouring into the sector. Investors, keen to enjoy double-digit returns, maintained their attachment to the sector last year despite many analysts arguing it was already hugely overvalued. Warnings that commercial property was an asset bubble ready to burst went unheeded."

With regard to London in particular, which has possibly benefited in a business sense even more than New York City from Wall Street's credit derivatives and related hedge fund trading, The Evening Standard notes, "The faltering economy has left the City of London office market braced for its worst crisis since the recession of the early 1990s. Demand for office space is falling as firms slash thousands of jobs and stop hiring new staff. But supply levels are rising dramatically - not just from space freed up by redundancies but also from a wave of new offices being built with completion dates this year and next. Around five million square feet of office space yet to be let is due to open in the City this year and next - room for some 40,000 people."

Spain - Residential Property Bubble Extraordinaire

According to a quote by David Owen of investment bank Dresdner Kleinwort, cited in the blog Seeking Alpha, "Spain could face serious difficulties this year as the excesses of a decade-long boom finally catch up with the country. The size of the Spanish corporate sector's financial sector is truly really scary. It rose to 14.5% of GDP in the third quarter of 2007 from 10% in the first quarter. This must be a record for a relatively large economy. Clearly this is not sustainable. Cost imbalances have a nasty habit of unwinding quickly and very painfully." The article goes on to note that Spanish direct investment in residential construction (ex mortgages and other related businesses) is 18% of the economy versus 6% in the U.S. Diana Choyleva, an economist at Lombard Street Research in London, is quoted as saying "Spain is like the U.S, on speed when it comes to the housing market. It is highly likely there will be falls in nominal prices." It also cites Moody's as saying that Spanish loan delinquencies may rise 15 fold by the end of 2008 due to increasing interest rates.

China Potential Stock Market Unwind + Corporate Bad Debt Bomb:

Zhong Wei, an economist with Beijing Normal University, was recently quoted regarding the U.S. sub prime crisis in the central bank's newspaper saying "The non-performing loan ratio in the banking industry and risks of volatility in the capital market are both rising". Why should the central bank be worried about this? It's not just the $7.9 billion of U.S. sub prime exposure the Bank of China has admitted to. According to aMay 2006 Ernst & Young report, the country had $911 billion of domestic bad debt. This is the $1 trillion of bad debt number you may recall hearing about now and again. At the time this was equal to nearly 40% of China's gross domestic product. Ernst & Young also believed there were $225 billion of additional pending low quality loans that would eventually go non-performing. However, Ernst & Young reportedly "corrected" their report a short while later to be more in keeping with the government's official tally of $133 Billion in non-performing loans for the four largest banks. When these figures were reported, worries about China being vulnerable to a liquidity shock were well publicized. While not much has been written since then, these bad debts didn't just disappear in 18 months. The Chinese government has reportedly been transferring bad loans to "special asset management companies" at least in part, with the use of $500B of government funds, over the past decade. Last Friday, China's banking regulator put out a report on its priorities for the country's banks; it didn't mention bad loans, but focused on improving innovation and strategic planning. The silence was somewhat deafening. In fact, the agency's chairman, Liu Mingkang, was quoted as saying: "Five years ago, the state banks were technically on the verge of bankruptcy, but now they are large commercial banks with international recognition." The economy was booming for 15 years and the banks were nearly bankrupt, it's still booming and now everything is fine? Somehow I am not sure that underwriting standards have done a 180 degree turn in the last 18 months. Interestingly, about 21% of loans are to exporters, who are reportedly already seeing their U.S. customers become slow in paying their bills. This may be why Yu Yongding, director of the Chinese Academy of Social Sciences and a former adviser to the central bank, was recently quoted as saying: ``If there is weakness in the world economy, the impact on the Chinese economy will be very serious.'' The Shanghai Composite Index was up over 125% last year and 132% in 2006, individuals; corporations and, yes, banks have all been making significant profits in the stock market, which has now fallen 30% or so from the peak.

India Potential Stock Market Structural Issues & Real Estate Valuation Problems

According to an article in the blog Seeking Alpha, 2 bedroom condos in New Delhi, are now selling for $200,000, or about $200 per square foot, this compares with $400 per square foot for a similar condo in Chicago. The only problem is, per capita income in Chicago is 50 times that of New Delhi. Additionally, New Delhi has room to grow geographically in 4 directions so there is no reason for a scarcity premium versus Chicago which can only grow in two directions. Additionally, while it is true that India's overall population density is much higher than the U.S., it is reportedly less densely populated than your run of the mill northeastern U.S. state like New Jersey.

In 2007, India's stock market rose a record 47.1%. Recently, sentiment has shifted markedly regarding the future market outlook. Much attention has been paid to the cooling of a smoking IPO market, particularly after Monday's 17% drop and flop of the biggest ever Indian IPO, Reliance Power.

According to Jigar Shah, head of research in India for Kim Eng Securities, as quoted in the Wall Street Journal, "As I see it, we are likely to go down further, primarily because investor sentiment has declined quite significantly." One analyst's opinion, but if it reflects public sentiment in this retail driven market; it may not be a good omen. Alok Vajpeyi, a VP and MD with Dawnay Day AV Financial, told the Economic Times of India, "The stock market reacted with great speed to redress the short-term valuation imbalances that had arisen as a result of exceptional liquidity — both domestic and overseas, by reversing perhaps 20% of the index gains from the peak. It hurt! It does not matter to most how much you made in the past. Even those, who earlier made a multiple of the money that they lost in recent weeks, have temporarily receded into their shells. For the time being investment sentiment is changed from the secularly bullish outlook on the market that shares will only go up, and that IPOs will list at massive premiums." Note that according to a recent Business Week article, due to an under-developed bond market - where new issues are less than 1% of GDP vs. 112% in the U.S. and 10% in China, the equity market is more critical to funding businesses' day-to-day funding needs. Another structural issue that has already been a problem during periods of frenetic trading is that, according to the Wall Street Journal, the stock exchange does not allow electronic funds transfer and relies on payments made by check. Retail investors have trouble acting quickly on changes in the stock market because they often mail checks to brokers and the checks then have to clear. This has reportedly caused some clients with margin accounts to be "bought in" before they could deliver funds against margin calls.

On the plus side. I am hopeful that this may be one of the last articles we have to write about risks in the financial system that people aren't talking enough about yet. I really hope so, because the sooner we can qualify and quantify all the things that could go wrong, the sooner the markets will discount these factors and governments and central banks can start working to offset their corrosive effects on money creation.

From the Blogosphere:

Is Europe's Housing Market Next

Will That Great Bubble Be Full of Hot Air

Spanish Economy Dominates Eelection

Decade of The Dragon

Timing the Chinese Bubble

PHOTO SOURCE: Answers.com

• Add to del.icio.us
• Digg this!
• Add to Technorati
• Add to Reddit