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FRIEDBERG'S COMMODITY
AND CURRENCY COMMENTS
Prepared by Friedberg Mercantile Group
The Re-Pricing Of Risk
“The global speculative orgy is slowly coming apart, literally fraying at the edges.” We wrote these exact words a little over six months ago (“Fraying at the edges,” Friedberg's Commodity & Currency Comments, April 20, 1997); tragically, they are patently more evident today than they were then, when only Thailand and South Korea were experiencing gut-wrenching bear markets.
Long before the Hang Seng October dive unnerved Wall Street and the financial centers in Europe, we warned that “the fraying at the edges of the globe is the first sign that more troublesome times like ahead.” Immodestly, we quote ourselves to direct your attention to the true significance of recent events. That these events could have been foreseen in the calmer spring days us testimony to the true financial and economic malaise that is affecting the globe.
The Southeast Asian crisis is not an accident, but the product of cancerous disease that is spreading with alarming speed and threatens to engulf, to one degree or another and in one form or another, emerging and developing countries alike. Official reassurances that all is well come thick and fast. Respectable analysts and economists pronounce that the fundamentals of this or that economy remain bright, that exports to Southeast Asia represent only a minuscule portion of total exports and that therefore GNP in the U.S. and other developed economies will be shaved by only 1/4% or at most 1/2%, that, unlike some multinationals, domestic companies will continue to prosper, and so on. These are but another demonstration that the patient has not been properly diagnosed.
The world economy, through permissive central banking, has been fed for a long time steady and excessive doses of cheap money. As is always the case, the initial effect was pleasurable. Insolvent financial institutions were bailed out, financial assets rose in price, good feeling spread and politicians and the media sang the praises of capitalism. With time, successes bred further successes. Emerging/developing economies, which putatively adopted free-market policies, began to experience substantial speculative inflows, lulled by the siren song of global diversification. Investors could do no wrong. Fear began to disappear form their vocabulary.
Unbeknownst to them, (shouldn't they have known?), these funds, after being skimmed by politicians, cronies of the rulers and those in the seat of power, inflated domestic credit, going mostly to the borrowers with the most clout. The damage had been done; the fatal virus had entered the body and there was no way to extricate it except through painful surgery.
And so it was that central banks around the world caused caution to be thrown to the wind, promoted irrational exuberance, financed wasteful projects and excessive consumption and, when occasionally the market appeared ready to teach the fearless a lesson or two, they rode to the rescue, solemnly pledging “conditional help,” unaware (or, unwilling to be aware) of the continuing moral hazard they were creating.
The spreading Southeast Asian crisis is not about slight or large declines in exports, nor about necessarily eroding profit margins or multinationals competing with Asian producers, nor even about deflation, as some observers have suggested. It is about fear and about liquidity, or rather, the evaporation of liquidity. It is about re-pricing risk globally and ubiquitously. It is about what will happen to borrowers when credit will be granted only at some astronomic price that will ensure their ruin or, equally bad, when it dries up at any price.
The lethal and rippling effect that fear and the accompanying withdrawal of liquidity can have is best appreciated by dissecting the case of a major borrower. Take Brazil. Coming into the Asian crisis, its prospects looked, to most observers, stable. Admittedly, the deficit on current account had widened to about $30 billion for the year. Nevertheless, the Brazilian central bank was expected to add $4 billion to its $60 billion of international reserves by the end of 1999. How? Through the massive privatization program contemplated for this year (which has already raised over $17 billion) and the next two years (estimated to bring in $40 billion), plus foreign direct investments and portfolio investments, and the assumption that trade lines, leasing, and factoring remained almost unchanged from last year's $17 billion. At the same time, despite ongoing fiscal deficits, privatization proceeds were going to reduce net debt by almost 4% of GDP, to 28.9% from 32.7% in 1997.
Castles built on air. Privatizations and portfolio investments depend crucially on stock market behavior and sentiment. With the stock market in Brazil down more than 34% from the July peak, privatizations will become more difficult, if not impossible, to carry out, and portfolio investments will turn–if they have not done so already–into outflows. For each of the next two years, these two items alone can represent failures to receive and/or outflows of anywhere between $20 and $50 billion.
Now consider that Brazil needs to amortize $20 billion of bank-issued Eurobonds and to roll over short-term foreign debt of between $40 and $60 billion annually on top of a current account deficit of $30 billion, and pretty soon the central bank reserves are insufficient to meet the run. To make matters worse, Brazil's domestic public debt, equivalent to $180 billion, is extremely short, with an average maturity of just 7 months.
The central bank's attempt in recent days to prop up the currency had the effect of hoisting interest rates to over 36% per annum from under 15% as recently as July. An increase of 20 percentage points on this debt represents the not inconsiderable sum of $36 billion, or 4.5% of GDP, tearing to shreds the remains of the plano real. Voila. For Brazil, the difference between global liquidity and illiquidity is the difference between life and death, between solvency and bankruptcy.
The market has begun to perceive this problem, and in its time-honored fashion, it has begun to discount it. The market will not wait to see if the 1998 privatization program will succeed. It has been infected by fear. In much the same way as the '30s witnessed systemic bank runs, we are about to witness systemic country runs. None of these emerging country borrowers is solid enough to withstand a drying up of liquidity. Brazil is not. Neither is Russia. Nor the Eastern European countries. Nor even Greece, Turkey or South Africa.
Still, the question is not whether the North American and European economies will be able to withstand the fall in exports to the developing world. That, they probably will. The question is how fear will affect their own economies. The answer is remarkably simple: The fear-induced re-pricing of risk will adjust, i.e., lower, asset prices, which, in turn, will affect net worth, which in turn will affect consumption, and which in turn will affect corporate profitability and investments. The net effect: A global recession of indeterminate depth and duration.
November 2, 1997Friedberg Mercantile Group
181 Bay Street, Toronto, Canada
Copyright 1997, by Consensus Inc. All American and Pan American rights Reserved. editor@consensus-inc.com
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