Sunday, June 29, 2008

We're all in this together

It used to be, if US stocks were down, those in Asia were up. Vice-versa, if Asia was down, the US was up. Now, seemingly in sympathy of the US downturn, we see reds in stock markets all over the world. Now it seems, when America sneezes, practically the whole world gets a cold.

More than ever, nations on earth are linked together by globalization. And now more than ever, many nations are dependent on a strong US economy. With the US economy in recession, the resulting slowdown in US demand for world products is causing a recession in other parts of the world.

But more than this, there’s another reason for the global slowdown.


Again because of globalization, many developing countries are building domestic infrastructure to catch up with the standards of the developed countries. And with development came rising incomes, and with it, rising demand for goods.

With more people demanding more products, but with supply of the basic commodities to make these products still at the same level, inflation has gone up. Because demand for is now global, everybody all over the world is now affected by the resulting inflation.

With globalization, everyone is now inter-linked. The merits, therefore, of diversifying portfolio investments across the globe has been diminished. Everybody is now a customer of one another. A decline in a major trading bloc/country will result in a downturn in another. On a bright note though, this should mean that a major pick-up in any one major trading corner of the globe can raise the others.

In the meantime, though, with global inflation at unsupportable levels, demand destruction will have to be global as well. That should be good though.

With everybody sharing the decline, no one country should have to bear the brunt of stagflation. With demand slowing down across the globe, inflation will be tamed sooner.

That should mean, with the correct and coordinated policy moves across the world, a global turnaround could come much sooner.

We just have to make sure global inflation does not give way to global depression. Again, correct and coordinated global policy moves will be key. Another key component of a recovery will be a sharp increase in commodity supply, coupled with milder but more manageable growth world-wide.

Maybe then, we will start seeing stock prices world-wide turn green again. Just don’t expect astronomical price appreciation again.

Well, maybe with stocks of commodity producers….

Wednesday, June 25, 2008

Banks and the spread of risk

How did banks spread more risk throughout the entire system? And how did they do it with so called derivatives? Derivatives are after all instruments to manage risk.

First, let’s examine what a derivative is. A derivative is alike an insurance contract. Let’s take the case of an accident insurance. In the accident insurance scenario, if an actual accident happens, the insurer pays the insurance buyer an agreed payout for such an event. If no accident happens, the insurance company pockets the insurance premium. For as long as the insurance buyer keeps buying insurance and does not incur accidents, the insurance company remains profitable.

Insurance firms manage their risk by selling insurance over a broad spectrum of the population. Here the law of large numbers rules. The larger the population covered, the smaller the percentage of the population that will likely draw on their insurance coverage.

When one bank wants to manage its risk, it buys a derivative product the way a normal person buys accident insurance. Another bank sells the derivative, acting like an insurance company.

The cost of the derivative is like the insurance premium. The risk event for a derivative buyer is normally a credit default, or interest rate or market going against the position of the derivative buyer. If the risk event being insured does not happen, the derivative seller pockets the premium as profit.

If he sells enough derivatives over a broad array of transactions, a derivative seller can become very profitable.

What happens if the insurance buyer and seller are in the same line of business? In the case of commercial banks, they acted both as the buyers and the sellers of derivative products.

In the same way each bank managed its own risk, each also sought to increase profits by selling insurance to other banks seeking to manage their own risk.

In this scenario, what happens when there is a default in one of the banks whose default risk is insured by another bank? There is a cross-default. What happens is the insuring bank re-insured its own default risk by buying derivative somewhere else? Now you’re beginning to see the ramifications of a system-wide credit default contagion.

How did banks manage to delude each other, and sell this garbage to one another? By means of creative packaging. They simply pooled risky loans and assets together with more stable ones, then sliced and diced these pools, then sold the various slices to different investors.

The way they valued these new investment instruments, pooling the risky assets with the good ones diluted the riskiness of the risky assets. Then slicing and dicing these pools, and then distributing these over a broad investor base, created the impression, at least from the eyes of each individual investor, of erasing the risk altogether. Now that risk had been cut, parcelled, and spread over a broad spectrum of investors, the likelihood of default on one parcel of the asset pool, it now seemed, was minimal.

Similarly, just because a master chef cuts and slices a slab of bad meat, and distributes small bits and pieces of it over a large array of dishes, doesn’t automatically mean that the risk of a major food poisoning from any one of the dishes had been averted. The risk of getting food poisoning had simply now been spread throughout all the dishes.

Banks, it turns out, are not only good intermediaries of capital, they are also good intermediaries of risk. The spread of risk looks very much like the spread of AIDS. First the banks were successful in infecting each other with a virus that impedes immunity to infection. Now comes the spectre known as stagflation, which can potentially spread the infection of credit default across several sectors.

What oh what will happen to the most exposed banks?

Update: Similar-themed post here.

US Banks and the perfect storm

US Banks are in for the perfect storm ahead. Never mind the fact that the sluggish economy means there isn’t much new business going the way of banks. I say the prospect of credit defaults alone will cause much more pain for US banks in the months to come.

After the storm, who will disappear, who will be left standing? That’s an interesting question. But who does disappear depends on how heavily their asset base and financial performance are affected by the elements of this perfect storm. Here are those elements:

By now, everybody knows all about sub-prime. This was where the banks’ trouble started. At the beginning, the weakest link always breaks first. Banks who aggressively lent to sub-prime borrowers were the first to swallow asset write-downs and write-offs.

At the same time that US banks and consumers were reeling from the credit crunch brought about the by the sub-prime mess, along came inflation. Brought about by robust growth and infrastructure development in the developing world, basic commodities such as energy, minerals, and food suddenly became scarce.

With inflation, cost inputs rise. So along with the sub-prime sector, the next tier of borrowers will break. The small and medium scale businesses are the most affected by the spectre of inflation. They are the next likely candidates for credit default, if inflation continues inching upwards. Which banks are most exposed to this sector?

If and when more business fail because of inflation, we will see the effects of recession spread towards the greater economy. As more people lose their livelihoods, less consumer spending means less money pumping the general economy, the more businesses will be put at risk, and on back to consumer livelihood risk.

Banks heavily exposed to the consumer segment will suffer most in this stage.

As more borrowers default, credit providers will resort to ever tighter lending standards. Liquidity will further erode, and interest rates will rise. Rates could go so high that even the most credit-worthy borrowers will now feel the heat.

These credit-worthy borrowers are usually corporate and institutional borrowers allowed to borrow heavily on their balance sheet. These are the institutional investors, private equity and hedge funds, as well as the largest cash-generating companies.

Money lent out will be called by the lenders. What happens to money lent that had been re-lent? In these instances, will there be a multiplier effect on margin calls? After all, the beauty of the banking system is to grow the economy by making money available to a greater number of borrowers, right?

So if a margin call by a primary lender results in a call by sub-lenders down the line, will we see more calls than there is money available? What happens when the “coiled spring” of capital expansion ricochets backwards?

The spectre of inflation means that a Fed rate increase is always just around the corner. A rate increase just when liquidity is disappearing? Just when there are more calls than money available?

Also, some government policy advisers are advocating a tax on oil and gas consumption. Is this tax applicable to all users, including businesses already reeling the from already high oil cost? If this tax is indiscriminately applied to all users, prepare for business closures, and perhaps, even more bankruptcies.

Because banks trade with each other all the time, they have numerous ongoing financial contacts with one another. If a major financial counter-party fails, guess what happens to the entire financial system?

And yet with the current environment, a major bank failure seems just around the corner.

Lastly, it always helps if speculators hasten the inevitable by betting on the direction of the perceived inevitable. If enough hedge fund managers believe a bank is likely to fail, large bets that go against the open positions of the bank in question will always ensure that said bank ultimately fails. Remember Long Term Capital.

The hedge fund phenomenon is proof that while liquidity is getting dry in some parts of the market, there is still enough capital in the market flowing to those poised and well-positioned to profit the most from the depressed environment.

Update: Similar-themed post here.

Tuesday, June 24, 2008

A discussion on excess oil profits tax

The Becker-Posner blog is a collaborative blog that discusses a variety of issues, with two different views, from an economist and a tax lawyer/judge, supplied for each topic. Recently, I found there a good discussion on the excess profits tax on oil companies, which is currently being proposed by some government policy advisers.

Becker (the economist) argues rightly that an excess profits tax on oil companies will be an additional hurdle to solving the existing tight supply of oil:

The proposed excess profits tax on the earnings of oil companies would discourage the search for additional oil, and hence would have the opposite effects on this search from a relaxation of the moratorium on offshore drilling. An excess profits tax that is expected to persist for many years discourages further exploration for oil simply because much of the profits on new oil production would be taxed away….

Lower production by American companies would cause a rise in the world price of oil. Moreover, increased production by other countries would tend to offset reduced production by the United States, so that the effect on global warming and global pollution is likely to be modest. However, the increase in wealth transferred from the United States to the Middle East, Russia, Venezuela, and other oil-producing countries could be substantial.

Posner (the tax lawyer) agrees, but adds that a tax should be levied instead on its use, mainly for environmental protection reasons:

But given the high price of oil, increasing our oil production will increase total world production rather than just substitute for foreign production. So there will be more tanker spills and more carbon emissions if offshore and Alaska drilling is allowed, since the supply of oil will be greater….

The problems created by an increased supply of oil can be minimized by an increase in the federal gasoline tax … calibrated to prevent gasoline prices from declining as a consequence of increased production of oil and hence increased supply.

A gasoline or carbon-emissions tax must not be confused with a tax on the profits of oil companies, which, because of the uncertainties involved in exploring for oil, will, as Becker points out, reduce the incentive to find and exploit new domestic oil fields. (In contrast, a heavy tax on gasoline will increase the incentive to find energy substitutes for oil.) In addition, imposing excess profits taxes sends a bad signal to the business community: that success will be penalized.

All throughout, a good and thorough discussion. I encourage you to read their entire post. In addition, I would like to add my own thoughts.

Perhaps there should also be a mechanism to distinguish oil use for industrial and public use vis-a-vis individual private use. Industrial use that benefits a lot of people has a more attractive cost-benefit ratio than private use i.e. for private vehicles, homes, etc. I think more tax should be levied for the latter's use.

By industrial use, I mean oil’s use by business and economic entities that produce goods for the local economy and generate jobs for the local communities. Many of these businesses are already hurting from the high price of oil, and increasing this cost further by taxation will only further erode their business profitability and viability. Given that the economy is already weak at this point, losing additional businesses to bankruptcy through higher taxation will only put more people out of work, and further deteriorate the economic environment.

The continuous increase in oil price can and should be contained by demand destruction. But, in my opinion, destroyed demand should come from low to no value-added use, such as that for private conveniences. It should not come from productive initiatives, especially not from those that support an already floundering economy.

Monday, June 23, 2008

Businesses will again be local

Are today’s high oil prices going to be with us permanently? Everybody’s speculating the answer to this now. If you look at where the price has been going, everybody seems to speculate that yes, it’s going to be with us going forward.

So what are we to make of this new reality? How does this change our lives? How will business de done accordingly? What happens to the global economy?

Well, we are already seeing some loose and fragmented events that suggest what is on the road ahead. Let me summarize in one sentence my own perception into them. BUSINESSES WILL ONCE AGAIN BECOME LOCAL.

Local. Wasn’t it just a couple of years ago when everyone seemed to be talking about globalization? So what is this craziness I’m pointing out now? Business will again be local?

Consider some dose of reality for businesses:

1. Transportation costs are increasingly a large drain on corporate profits.
2. Current economic reality has different effects on different locales – some markets remain healthy, other markets need scaling back.
3. Markets with healthier demand may (in the meantime) have more inflation, which could lead to more currency devaluation, which eats into repatriated income
4. Steeper credit terms means companies can only expand as fast as internal cash flow will afford them. Inflationary environment eats into cash flow, hence less cash flow for growth in the meantime.
5. Airlines are cutting back on destinations, and focusing on just the most profitable routes. What if flights to one of your major markets suddenly was cut off by a major airline? That may mean you have no other choice but the remaining, expensive option.

I have earlier said that today belongs to the larger market players. Now, I say, today also belongs to those closest to the market.

If you are a supplier of a basic good, you can no longer supply your good at uniform prices world-wide. Not when $200 a barrel oil means you have to absorb the transport costs to overseas markets. The farther away the market, the more you have to absorb in transport cost.

If your product can easily be substituted by a local product, manufactured in the overseas market, you’re suddenly going to find yourself the luxury item there. Less people can afford luxuries right now.

It might be different if you’re already a globalized company with global operations.

Your finance is in North America, Marketing in Europe, Production in Asia, and raw materials from Africa? You’ve already established a “beachhead” in many markets? Congratulations. You get to maintain your global operations.

And given that it’s going to be difficult to grow in this stagflationary environment, you’re likely to keep your advantage for some time to come. Not too many competitors can afford to invest in beachhead expenses for now, or have the risk appetite, when the market is this weak.

But more often than not, according to my crystal ball, if you’re a global firm, demand for your products will start to cluster more in the large markets. It is in these markets where a sizeable population exists that can still afford to pay for your increasing costs. Where are these markets? You’ll likely find them in larger cities in the US, Canada, Western Europe, Australia, the BRIC countries (Brazil, Russia, India, China), and the Asian NICs.

The rest of the world? For now, the local markets in the developing world will be owned by local conglomerates - the ones that make and sell their products in the same market. Globalized firms with globalized costs will be too expensive for these markets for the time being.

The demand destruction being talked about right now? Perhaps it’s local demand for the global firm that’s being destroyed. They have too many “beachhead” costs.

But then again, that’s just my own crystal ball. You may have another view. But the way I read it - Right now, businesses will again be local.

Friday, June 20, 2008

Drawback of inadequate regulation: Paying monopoly profits for a privatized public good

Economist Tyler Cowen posted this link today on the Marginal Revolution web log. It is an article wherein he puts forward his views on the privatization of residential water supply in the Third World. He advocates full freedom by the private company to price its good. His argument goes:

And no, I don't mean a water concession with a price regulated by the government, I mean true laissez faire in water supply. No price regulation, no rate of return regulation, no government ownership of assets, no political pressure to keep prices low. Water companies should be allowed to maximize their profits, and because supplying water is nearly always a monopoly, they should be allowed to make monopoly profits. I know the idea sounds crazy--to an economist, water supply is a classic "natural" monopoly--but on closer inspection the other alternatives might be worse…..

….Let's say the new water prices were so high as to capture all the benefits that buyers would receive from the new supply of water. We can expect much lower rates of diarrhea and other diseases, if only because the water supplier can charge more for cleaner and safer water.

I beg to disagree. Granting monopoly profits to private water companies does not mean they will start making drastic improvements on water delivery. This goes against our long experience in many privatized companies granted full laissez faire freedom by government. Allowing monopoly profits does not automatically lead to improved service delivery.

A private, for-profit company’s objective is first and foremost to make a profit. If the company’s shareholders happen to be of the shareholder value maximization school, they will want to maximize profits first and foremost.

On that note, why shouldn't an unregulated private water company use its excess profits instead to buy the local electrical utility, and monopolize that as well? And why not use the excess profit to lobby the government to do away with regulation in electricity as well? Before long, it will have bought everything and monopolized everything. With any luck, it will make up for it by offering bundled discounts to suffering consumers.

Privatization without regulation is worse than no privatization. At least, government can potentially be more accountable to the people, given that the government periodically needs to renew its mandate via elections. This is especially important when the service provided is a public good, like that of water delivery.

The future of capitalism?

This is the work environment of the most powerful allocators of capital today.

Where are the reams of business plans and financing proposals? Where are the rolls of market and feasibility studies?

Large amounts of capital now flow freely throughout the world based primarily on market momentum, which is what the trader above mostly checks for.

If you are a businessman looking to raise new capital, good for you if you are in their radar for the moment. They will cause you to get more money than you know what to do with. But you might want to dissolve your business as soon as your sector or industry becomes their next fallen angel. They can make life hell for you by making the cost of your capital fluctuate more than a diabetic’s blood sugar on a feast-hunger diet.

Thursday, June 19, 2008

The hamster and the spinning wheel

The low interest rates and lax credit standards of the last seven years led to the largest liquidity boom in history. As more banks lent more funds - more investment banks, funds, and investors borrowed to turbo-boost returns on their investments and speculation.

The multiplier effect of the leveraged finance transactions led to huge run-ups in assets that were the targets of these investor/speculators.

With the collapse of the leveraged finance market, many creditors have been demanding money back from the borrowers. This has led to the reverse-multiplier effect, where asset price increases, previously funded by the growth of liquidity, decline in price as margin-called investors sell their portfolio.

This is supposed to be just another example of the intended effects of market correction.

But many regular consumers got caught tied up in this latest credit crunch. Many had bought houses, which was the most visible beneficiary, and then casualty, of the credit boom-bust.

To save these consumers, many of whom suddenly had trouble keeping up with their mortgage payments, the Fed has had to orchestrate a large expansion of money supply.

To save regular consumers caught up in the financial market’s latest bubble, the Fed has had to replace artificial currency (created by the multiplier effect of bank lending), with actual currency. This monetary expansion has been a large component that fuelled today’s inflation.

Now people’s problems have come from an inability to afford paying their debt, to having an inability to afford basic goods. For these people, these measures were just enough to keep staying where they are, much like the running hamster on a spinning wheel.

The people who had benefited from the boom have likely already gotten their money out. Those early leveraged investors, those who sold assets before the fall.

Now, these people hardly need the Fed’s bailout. If anything, the recent government measures could be fuelling their next investment boom. We are already probably seeing this in the current commodities market.

They are making the spinning wheel run faster, and the poor hamster on it is going to get swept up, no matter how fast he runs.

Monday, June 16, 2008

How did the investment banks get so deep in this mess?

How did the investment banks get so deep in this mess?

Many people are asking this right now. Not a bad question. Considering that investment bankers are supposed to be smart, highly paid technocrats, how can they have committed the consecutive mess that have befallen the financial markets in the last decade alone? The Long Term Capital mess, the Enron, Worldcom, and Global Crossing mess, the Internet Bubble mess, the Sub-prime Housing Bubble?

Why is it that everything they get their hands on lately has been subject to maniacal excess, by an obsessive over-shooting of growth followed by spectacular fall? Many experts have tried to put forth their own explanations and opinions. Allow me to put forth some of my own contributions. Warning: this may tend to be one-sided in favour of investment bankers.

Let me list four main factors, and summarize some recent broad trends in these factors, that affected investment banker behaviour, which then led to these consecutive excesses of stupidity and greed.

ORGANIZATIONAL. Starting in the late 1980’s and culminating in the 1990’s, commercial banks have tried to poach into the field of investment banking. Because of ‘80s financial innovations such as securitization, and the increasing ability of commercial bank’s best clients to access the capital markets directly, many commercial banks began to experience margin pressure, and potentially, loss of market share. Thus, they began to look to make inroads in the higher-margin investment banking. Many began to build investment banking subsidiaries. I would say that the culmination of all this poaching was the outright takeover by many large commercial banks of the most successful investment banks by the turn of the century.

This resulted in sudden over-capacity in investment banking. Everyone suddenly was involved in it. Everyone had a unit doing it. Everyone was throwing money towards doing it.

Complicating this was the fact that the top bosses were now commercial bankers, who were used to managing credit for straightforward loans. They were supposed to oversee investment banking transactions, at just about the time when they were starting to get more esoteric and innovative.

The i-banking organizational framework, which used to favour relatively smaller firms ruled by partnerships composed of long-time investment bankers, now was replaced by the large bureaucratic organization. Often, the parent organization was a large publicly-listed entity that was supposed to maintain an increasing stock price by continually delivering above-average returns, regardless of market prospects.

You know what this meant? Whereas before, investment bankers were supposed to chase only after upstanding clients, and structure transaction terms that made sense, for deserving projects and firms - now, they simply had to close transactions. That’s the only way they can pay the public shareholders the returns they expected, to compensate them for the huge premiums paid to the i-banks by their commercial bank acquirers.

I-banking is a cyclical activity. When the economy has overshot expansion, it is supposed to contract a little, before expanding again. Now that i-banks were owned by publicly listed firms, and managed by commercial bankers used to steady interest income, they were now expected to achieve ever-increasing growth targets year after year. The new set of shareholders was not supposed to understand that i-banking can achieve spectacular returns for a couple of years, but then have sluggish returns the next two.

If you’re an i-banker, used to earning up-front fees for closed transactions, how are you supposed to steady income growth? You close more transactions, even after you’ve exhausted the good clients list. You also keep more of your underwritten assets on the books, so you get both recurring interest income from the asset, and possibly, trading gains if you decide to sell the asset later on. You invent more and more esoteric products and transaction structures, to sell more transactions to more clients, and more products to more classes of investors. In other words, you take on more risk.

Who cared if you’re lowering your underwriting standards? As long as your parent bank shareholders are happy, and your corporate banker bosses are too satisfied to understand what you are really doing, then by all means you continued doing anything that achieved your targets, made money for your firm, and kept your job.

MARKET. If you’re an i-banking client, and you knew that you were among an i-bank’s best clients, meaning, you had the best credit credentials, then you constantly demanded better terms than the i-bank’s last transaction. It didn’t matter whether the i-bank’s margin was already pressured to the bone. If a couple dozen other i-banks were chasing after you, you awarded your business to the one willing to bend backwards the most for you.

All clients thought like this. This led to transactions closing with better and better yield for the clients, at the cost of i-banking firms, and increasingly - regardless of client quality.

COMPETITION. As I mentioned, with the influx of more players, there was a sudden over-capacity in investment banking. To keep afloat, many firms started lowering their underwriting standards. Those who could not get the best clients simply took the next tier.

Those who found a profitable niche milked it to the bone by closing more transactions than the amount of deserving clients warranted. And once their competitors realized that they were onto something, it wasn’t long before everybody else was knocking over each other trying to close as many deals as possible, before the door closed on profiting from that particular niche. Often, deals got closed long after the door of opportunity was supposed to have closed. There was just too much capacity chasing after deals.

Often one of the unwritten rules of competition is that, if your closest competitor started lowering his standard, you also lowered yours. Otherwise, the next tier of clients will go to him rather than you. That is not going to bode well with your commercial bank bosses and shareholders, who expect steady, and even, growing income. If the competitor lowers again, you lower yours again. In the end it is a battle of who has the deepest pocket. Again, in an environment of historically high excess liquidity, the potential to lower standards was also historically high.

PEOPLE . If you were a producer in your i-bank, the takeover by the banks put you in the following environment:
- You reported to people who generally did not understand, or did not put as much focus on, what you did as to other units of the bank
- You were appraised much like the other officers of the commercial bank. That meant you had to produce an ever-increasing revenue stream, regardless of the status of the economy.
- You may have started feeling you weren’t paid enough, when compared with other people in the over-all bank, given that you put in longer hours, prospected with more clients, put up with more shit, and sacrificed more to get the job done.
- You may also have realized that you had more specialized skills that nobody else in the bank can replicate, but you were being overlooked in the over-all banking environment.
- You may have found yourself stifled by this new environment. Your best ideas were denied or left by the way-side, and found company resources dedicated to less lofty projects. You also found that the company did not understand i-banking risk, and the bank either avoided initiatives with absolutely-mitigable risks, but put on other risks that you thought were just plain dumb.

If you found yourself feeling any of the above, or perhaps a host of other related grumblings, you left the banking conglomerate and started your own private firm.

Thus, along with the rise of the financial supermarkets, where everybody thought the future belonged to the biggest banks able to offer everything and anything under the financial sun, we also saw the rise of many boutique advisory firms, private equity shops, and private hedge funds. These were peopled by the best traders, analysts, and corporate finance advisors who have decided to leave their now befuddling banking environments.

Thus, the big banks were left with people willing to put up with the unreasonably increasing targets, willing to put up with commercial bank policies that were, more often than not, incompatible with effective investment banking, willing to put up with bosses who treat investment banking as just another item on their menu of financial products.

Yes, many of these people stayed because commercial banks, having the deepest pockets, could finance the most, and biggest, transactions. Staying with a commercial bank meant they could get involved in more transactions, while those colleagues who opted to transfer to the niche, specialty knowledge firms had to content with a much smaller deal flow, and since these speciality firms did not have the resources of the big banks, had to dedicate more time to fewer deals.

The corollary to the choice of staying in the large commercial bank was the mindless mass-manufacture of the latest fad in financing. The faster these were closed, and the more clients were called on, the bigger was the volume of deals, and therefore, the better the bank was able to compensate for any pressure on its margin.

Never mind if the last deal was no longer closed with as much attention to detail as the previous ones. After all, once you’ve done one, you’ve done them all, right? Having the template from previous transactions gave you the license to just cut-and-paste everything, and to minimize any special case considerations, for this particular transaction or that particular deal.

After all, if everybody – the shareholders, the clients, the senior managers, the market, and the general public – thinks that all investment banking activity can and should be commoditized, why not just go about it as if it were, right? If everybody treated investment banking activities as if they were no different than documented and codified bank activities, such as clearing and settlement, then doing more in the exact same way is the right way to go, isn’t it?

Let me end by saying that I believe the right business model for i-banks is – providing clients with intellectual capital as opposed to financial muscle. Less risk, more value added, and more tangible benefit to the client. The commercial banks, along with their commercial banking shareholders, are destroying the investment banking culture and business.

Update: Exposure to a different business model from that that destroyed the US financial system got me looking at it differently. It's actually the other way around - the commercial banks, wanting to act like investment banks, got themselves into the same mess as the investment banks. But the reckless investment bank model is what got them into this mess.

Wednesday, June 11, 2008

What price demand destruction?

“The price of oil will likely stay high or increase unless there is significant demand destruction.”

Most likely, you have heard or read this phrase lately, unless you’ve been living under a rock or simply do not care at all about the ongoing energy crisis.

This phrase is used by many analysts and economists as the only way out of high oil prices. This is mostly used by those who are deflecting blame for the high price of oil from the speculators. The explanation is that there simply is more real and actual demand now than there is supply. There is new real demand from the emerging economies. New real demand from increased world trade. New demand from a resource-hungry populace, especially the American consumers whose vehicles of choice have increasingly been the large gas-guzzling trucks and SUVs. The argument goes that there simply isn’t enough oil being pumped out of the ground to satisfy all this real demand.

Since increasing supply will, most optimistically, be difficult, costly, and take years to effect , price can only go down if demand declines. In other words, existing demand needs to be destroyed. Killed. Annihilated.

In a regularly functioning market, so the theory goes, the most efficient level of supply and demand will eventually be reached. If price goes too high, many market participants will simply buy less, either by looking for close substitutes, or foregoing consumption altogether. In short, the price will eventually settle at a level where the market is able and willing to pay for oil.

Demand destruction will be our salvation from high prices. Are we to be happy about this? Do we all believe that the demand that will be destroyed is that coming from the frivolous consumers of oil? Those who drive when they can easily walk? Those who fly when they can take the bus? Those who use gas and oil aimlessly and wastefully?

In other words, what is the cost of demand destruction? What demand is actually destroyed?

Well, I would start by guessing that the demand that is destroyed is not necessarily that coming from the most frivolous users. The demand that will be first to disappear is that coming from those whose purchasing capability is most stressed by the high price. It is they whose marginal propensity for oil consumption is steepest. In other words, a higher oil price kills demand from them first before killing it from others.

Who are these market participants most stressed by a high price? Here’s my list of those who, I’m pretty sure, are already thinking of ways to decrease oil consumption:
1. The poorest people
2. Companies with the lowest profit margins
3. Organizations that have only a fixed level of money for expenses, i.e., non-profits, NGOs, charitable organizations, etc.

Firstly, the poorest people. Because they are poor, let me make the assumption that their use of oil, if any at all, is not in any way frivolous to begin with. Using diesel oil for heating, for example. Anybody who lives in a place with harsh winter knows that heating is not a luxury. But with oil at its current price, it’s getting to look like it, regardless whether people may die without it or not.

Companies with slim profit margins. Increased global competition may have forced many of them to survive with barely any profit (See previous blog - “Today belongs to the big boys”). Many of these companies may actually be large employers, and their demise will put many people out of work, and some into poverty.

Fixed-expense organizations. These could include those charitable organizations who may otherwise try to help feed and shelter the poor, but can only do so for as long as their sources of incomes (donations) affords them to do so. High inflationary prices constrict their ability to allocate funds to more projects. So you see, demand destruction might actually take away all your possible lifelines, if you happen to be among the newly unemployed, poor, and without heating.

So what price demand destruction? The price is steep, most especially for those lowest on the totem pole of capitalism. They are represented in every nation on earth.

And because of the effectiveness with which capitalism has spread globalization, demand destruction in any one sector, from any place, on earth, can easily escalate to global proportions. To illustrate- higher oil means less industrial production in some countries. Less industrial production means less jobs. Less jobs means even lesser consumption. Even lesser consumption means lesser production for still other countries. And so on.

If governments do not effectively manage the process of demand destruction, we may all end up with no demand at all. And that is just as dire a crisis, if not more, than high inflation brought about by too much demand.

Tuesday, June 10, 2008

Today belongs to the big boys

Now more than ever, size matters. That’s my unbridled belief.

The companies and businesses that will best weather these uncertain times, and get out of it alive, will be those who are the biggest in their industries. Smaller companies, even those that occupy specific niches, are in for wild times ahead.

Stagflation. This term has been used to describe what is happening right now. Stagnant markets coupled with runaway inflation on basic commodities. If you’re a business operator now, you’re being hit on both ends – on the revenue side, and on the cost side. The former is declining, the latter increasing.

Cost-cutting, which had been a paramount focus of many companies in the last decade as a result of increased global competition, has largely cut to the bone. Not much chance of cutting costs further. Not much choice when practically all input costs are increasing. Not when all your suppliers’ costs are also increasing as a result, with them passing the pain onto you.

Increase market share. That’s everybody’s mantra now. When you can’t decrease the cost of doing business, you should increase the value generated by your business. In a stalling economy, with consumer rolling back on spending, this goal gets complicated, and for many, results are dicey.

In tyring times, big is better. Here are my top reasons why:
· Geographic advantage – Bigger companies are likely represented in more markets, have more elaborate distribution networks, and higher penetration in the larger markets. This means that any decrease in consumption in a weaker market may be offset by strong demand in other markets.

· Buyer bargaining advantage – Bigger companies can better afford to use their large bulk orders to force suppliers to accept lower margins. Suppliers, for obvious reasons, will not want to lose their biggest clients. They will likely make up for lost margin by increasing margins to lower bulk orderers – that would be the smaller companies.

· Likely bigger cash pipeline – Bigger companies have greater cushion against runaway inflation. In all likelihood, they have already built a cash hoard that can last them through a longer winter than many smaller rivals. This attribute can be a result of reasons # 1 and 2, and can lead to the next attribute.

· Ability to undercut smaller rivals – Bigger companies can keep reluctant consumers from completely going away by lowering their prices. Smaller companies may not be able to keep up.

· Product diversity – Bigger companies will likely offer a broader array of products and services. Nowadays, occupying small niche markets may not be enough. Niche companies have bets on only one horse. If consumer demand in that niche falls, many firms will fall by the wayside. Larger firms, on the other hand, can fall back on sales of other goods. Not to mention the fact that bigger companies with broader product offerings can bundle their products, thereby offering better value for an ever more demanding consumer.

So you see why these are going to be boom times for the larger firms? Today’s scenario presents them with a long-awaited opportunity to crush the competition. In today’s scenario, it’s simply not enough to be more creative, or faster, or more differentiated. In today’s scenario, you have to be big, strong, and able to withstand the twin blows of stagnation and inflation.

In today’s scenario, smaller players will likely cut back on market share or disappear altogether. Potential new entrants will rethink before they join the fray.

In today’s scenario, consumers will cut back on spending for non-essential items. Non-essential items often include products with specific attributes that, in better times, appeal to only small segment of the population. Large mass-appeal products will likely outlive the niche products. The longer this stagflation lingers, the worse off niche companies will be.

In today’s scenario, the government will try to keep as much of the jobs that it can. To be effective, it will seek to help the largest employers, and those whose fortunes have the largest effects on the over-all economy. Smaller firms will have to be sacrificed as tax dollars are focused on saving the big boys.

In today’s scenario, suppliers, as mentioned above, will offer better terms to their larger customers, thereby effecting a huge transfer of benefits from the smaller companies to the larger ones.

Nowadays, it isn’t the likes of IBM or Intel that are paranoid about the competition. It is the little-known rival or sub-contractor who doesn’t sleep well at night.

Charles Darwin said that nature encourages many varieties of evolution and specialization, as organisms try to find ways to thrive in this world. In the end, most notably when conditions become harsh and inhospitable, only the strongest survive. Yes, certain specialized organisms survive, but for as long as they are not in the way of the big predators, or perhaps, large predators will leave them free, if they can kill the large predators with potent venom.

In today’s environment, these specialized organisms may be the small hedge funds, who can inflict the venom of increasing the large companies’ cost of capital. Certainly, the venom organisms are not the smaller rivals to the large firms. The smaller rivals are the gazelles to the large company lions. Not too comforting, if you’re the small player.

So in these trying times, smaller companies - Merge before it’s too late!

Update: see newer post. Also here And an earlier revision here.

Tuesday, June 3, 2008

a new focus of economic development

2008 has indeed been unravelling much of what globalization had achieved this past decade. This unravelling is being accelerated by the twin forces of economic stagnation and runaway inflation.

The economic stagnation is propagated by the US economic slowdown. For all intents and purposes, globalization has been moved forward more than anything by American consumerism. For decades, the American consumer has fuelled the onward progress of global trade by buying and making a market for the products and services churned out by the world’s efficient production economies.

Now because of the current housing problem and credit crunch in the US, the American consumer is being pinched to the point of exhaustion- economic exhaustion. Previously easily available bank credit is now being rolled back by capital-hit banks and lenders, making consumers unable to fund new acquisitions, or worse, roll over existing debt. Consumers’ net worth and 401K are seriously hit, making the consumers feel a lot less richer, and a loss less prone to conspicuous consumption. The economic slowdown in the American economy is also creating a vicious cycle of less people willing and able to support a precarious economy with their purchases.

The recent run-up in inflation is also catching with what is left of the American consumer’s ability to spend. Inflation has hit the most basic of necessities – food, gas, heating, such that these purchases have been eating into discretionary income. Where before, discretionary income consisted a large bulk of the consumer’s income, nowadays, income for basic necessities has taken the lion’s share for most people.

So with the engine of global trade, the American consumer, severely handicapped, what is to be of the fledgling economic development efforts of the world’s developing countries, much of whom depend significantly on the continued growth of global trade?

Many are already experiencing the bitter reality of greatly decreased orders coming from the US market. And this decline in production orders is affecting not just the developing countries, but virtually all of America’s major trading partners.

For as long as the American consumer remained the principal source of growth for the rest of the world, there was to be no decoupling of the global economy from the American economy. In fact, now more than at any time in the world’ history, if America sneezes, the rest of the world will catch cold. The hardest hit will be the developing countries.

For decades, starting with Japan, and then with Asia’s economic tigers, and with the latest economic dragon, China, the principal strategy of economic development has been to run trading surpluses, and to use this surplus as the fuel for domestic economic growth. Running trading surpluses was such an effective and successful strategy that many countries simply relied on this as their principal source of continued development.

Running trade surpluses, by its very nature, means that countries need to sell more goods than they buy. Therefore, an effective trade surplus program couples an aggressive export growth program with a severely restricted importation policy and program.

Potential growth of consumption has been curtailed by economic disincentives to spending more. High tariffs on imported items and a national collective consciousness focused on ever greater savings, as opposed to growing consumer spending, has prevented many countries that have already achieved NIC (newly-industrialized country) status from shifting their growth strategy towards developing a robust domestic consumer economy.

This is how it's always been in much of the developing world. Years of economic growth may have resulted in constantly improving national accounts, but comparative advantage that comes from maintaining low wages, instead of true value creation, does not a vibrant domestic consumer economy make. So their continued growth have rested on the American consumer continuing to buy their excess production.

Hence, with the fallback in American spending, who is left to plug the gap in orders from these countries. Certainly, it hasn’t been the domestic consumer in these countries. To begin with, many industries in these NICs have been over-specialized and focused more on world-beating production efficiency. They have not been diverse enough, nor focused enough on consumer marketing and consumer R&D, to be able to effectively shift gears and focus on making a market for new and innovative nationally-produced products for their domestic economy.

In many ways, this situation is a result of a primary method whereby these NICs were able to beat other countries in terms of being the lowest-cost producers of many global products. They simply did not pay many of their employees sufficiently enough to be able to afford many modern luxuries enjoyed by the American consumer. Hence, while countries such as Thailand and Malaysia were world-beaters in producing apparel and electronics, their domestic consumers simply did not buy as many of these same goods as the American consumer did.

Not that I am advocating transforming domestic consumers of these NICs into the profligate consumers the Americans were. That would surely lead to the same economic mess that the American economy is currently mired in. But simply, many national economies, particularly, in Asia, may need to re-assess their portfolio of industries.

Many of their biggest companies are global suppliers of particular and specific products. There are not enough small and medium sized companies that achieve enough prominence to take up the slack in the economy if and when there is a significant downturn in the fortunes of these big global suppliers. There aren’t enough sufficiently large enough small companies focused on selling and making a market for an eclectic array of goods to the local consumers. After all, many of the products that are currently produced by these developing nation’s world-beating locally-based global suppliers started out as eclectic products produced by the headquarter companies that have now outsourced their manufacture to these same countries.

In short, many developing and NIC countries need to develop more local entrepreneurs who are focused on developing niche markets in the domestic economy. The goal of becoming the back-end supplier of finished goods for some other global company is now insufficient to guarantee continued economic prosperity. To maintain economic prosperity for all, countries need to diversify away from focusing on specific sectors, being the world supplier for these sectors, and into selling a greater array of products and services FOR DOMESTIC CONSUMERS. After all, if a company succeeds in creating a market for a product that the domestic consumer falls in love with, then there is great likelihood that these products will eventually find a niche market in the global economy as well.

Again, a national economic program that countries might find useful going forward is nurturing local entrepreneurs who know how to make a market for their products, not merely produce goods at lowest cost. A good training ground for these fledgling companies is the domestic economy, so governments need to put up measures to enable and encourage domestic consumers to support these fledgling companies.

In this new economic reality, the biggest advantages, naturally, will go to those companies fortunate enough to be located in countries with large domestic populations. Particularly populations with sufficient disposable income, and no existing heavy debt burden.

As much of the developed world retreats in terms of spending and growth, the world’s best investors are currently looking to China, India, Russia and Brazil as the biggest growth areas of the world, and the most profitable places to invest. It is no coincidence that these are large countries with sizable populations. The market potential of the domestic economies of each of these countries, alone by themselves, can be many times greater than many of the current developed countries.

Much smaller countries, therefore, may be better off forming large regional trading blocs with their closest neighbours. The European Union is the best model for this. If it were not for the increased growth potential of a much bigger European market, many companies located in any of the EU’s member countries may now be finding themselves in much direr circumstances. The much bigger home market in which to make a market for their products significantly offsets any reverse growth from the US market.

Monday, June 2, 2008

A new future for outsourcing?

For the first few years of the new millennium, the business buzzword and main issue of global business was outsourcing - the off-shoring of a lot of jobs from the developed countries to the developing world.

This was the subject of endless discussions, many sleepless nights among workers whose jobs were either in danger of, or already being, outsourced. Many pundits either wrote about it, opined for it, against it, praised it as the saviour of businesses racked by high employee costs, or deplored as the bane the would destroy the livelihood of many hard-working middle class workers.

Clearly, from the vantage point of the developing countries, outsourcing was hailed as their way out of poverty, as a slew of outsourcing companies set up in their homelands signified the start of abundant opportunities, rising incomes, and secure futures.

Outsourcing grew out of corporate strategy that chases after ever-growing shareholder returns on investment by constantly lowering over-all expenses of the firm. As institutional and private investors demanded constantly increasing stock prices, this necessitated constantly increasing earnings growth of the firms, which necessitated both constantly increasing revenue growth and cost reduction. And for many firms, the single biggest cost, and most likely candidate for cost-cutting, was wage and salary cost.

Increasing global proficiency in English, rising quality of education in the developed countries, significant improvements in telecommunications and information technology – all have contributed to making the phenomenon known as outsourcing possible.

At first, the major activity outsourced by many firms was manufacturing. Since the factory entailed the highest number of employee headcount, and since factory work was the most easily broken down into easy, repetitive tasks, this was the first to go out the door from corporate head offices in the developed countries.

As time went on and information technology improved, higher value-added back office processes were next to go. In-bound and out-bound call centers were outsourced to countries that had a sizable population of English-speaking workers. Next to go were other back office work – ticket processing, order handling, forms preparation, various dictation and transcription work, logistical management processes, and manually repetitive computer programming tasks.

The latest round of outsourcing was starting to target high value-added work, the kind of work that was the done by a company’s highest-paid professionals – accounting, tax management, financial and marketing research, legal research, software design, architectural and engineering design, compliance work, even R&D work of major bio-tech firms.

This latest round of planned outsourcing threatened to eradicate the last of the remaining knowledge work jobs from the developed countries, save that of upper management – the management positions of those levels high up enough to enjoy status of becoming project managers, or become relationship officers handling the accounts with the outsourcing service providers. Not in danger of losing their jobs either were those who maintained face to face contact with a company’s actual clients, and secured continuing sales orders. In other words, marketing and sales jobs in developed countries were safe (At least those where sales cannot be made as effectively by telemarketers working out of out-bound call centers).

The road to the virtual corporation seemed to go one way- forward. All companies were expected to eventually have various support units based in different locations across the globe. The main yardstick for choosing which location was which location enabled the corporation to achieve the highest return to its shareholders, in other words, who promised to provide the most seamless service at the lowest cost.

People were sill talking about the outsourcing phenomenon just when the costs of doing business globally started rising, and rising steeply.

These costs are being exacerbated by rising global inflation, rising cost of oil, rising food prices, all of which contribute to rising volatility of global currencies. Ten years ago, global exchange rates were very tame and did not suddenly go in unexpected directions. A country that effectively controlled inflation and kept a balanced budget easily maintained a stable currency.

Not so anymore in this new age of rising inflation; and of more and more hedge fund managers contributing to increased world-wide volatility in all asset prices, including currencies, commodities, and just about all financial instruments you can identify and imagine.

A major assumption of companies seeking to control costs by outsourcing processes was that the cost translation of these outsourcing providers was going to be constantly below the cost of doing the process at home. This was possible for as long as outsourcee countries had tame inflation.

Now hard-charging inflation is threatening to put just about every major outsourcing vendor out of business. The experience of many of these firms nowadays is, their rising over-all cost of providing the service is threatening to wipe out their already razor-thin margins, as rising inflation results in rising local wages, rising financing costs, and rising over-all costs of doing business .

In addition, the recent depreciation of the US dollar by itself completely eradicated the profit margins of many aggressive outsourcing vendors who signed long-term contracts with corporate clients at specified rates denominated in their appreciating home currencies. They had simply assumed currency exchange rates will remain at predictable levels.

In just a matter of a year, the burgeoning outsourcing industry, for some years the bogeyman of many workers from the developed world, suddenly finds itself fighting for its very survival. What does the future hold for these firms? For the outsourcing phenomenon itself?

My guess is that in the next few years, if the current inflationary environment persists and the US dollar maintains its current depreciated value, outsourcing will cease to grow, and may even contract in a big way.

Many previously-outsourced jobs may end up going back to their home countries, as the wage differential between developed countries and developing countries narrows due to inflation. Inflation is getting to be the big equalizer of wages between developed and developing world. Since inflation generally is higher in the developing world, the costs of doing business has increased to a greater extend in those places.

Also, the current economic stagnation in the US economy is resulting in a lot of cutbacks in consumer spending. This is then leading to lower corporate profits for US-based companies, many of whom are leading outsourcers. As they cut back on their operations, to account for decreased b volume, they are likely to decrease, or pull out altogether, from their operations set up in foreign countries.

My best guess is that the first outsourced jobs to go back to the developed countries i.e., the US, are the low skill back office work - the call centers, the ticket processing, order handling, forms preparation, various dictation and transcription work, etc. After all, it is the lower-skill jobs that are easiest to migrate back and forth. Barring low costs of packing up and re-deploying in another location, they can quickly be closed and dispersed.

The manufacturing jobs will probably be scaled down but largely stay in the developing countries, and probably not necessarily go back to the developed countries. It is more costly and time-consuming to pack up an entire factory and its various machinery.

Some companies will still accelerate outsourcing though, specifically in those areas where developing countries have already developed a local infrastructure that can sustain a competitive advantage to developed markets. Processes that would otherwise be done by highly paid staffers in the developed world will continue to be outsourced, i.e., tax and legal back office support, and maybe finance and accounting support, too.

Therefore, the developing world would probably need to quickly upgrade its skills, so that it can compete, pound for pound, in the higher value-added work – the accounting, tax management, research and design jobs. These jobs, however, are done best and most relevantly to a client’s needs, by those on the ground where the client resides. In other words, if the clients are in the developed countries, the workers in these countries will constantly be able to out-maneouver the outsiders.

Hence, we are probably seeing a considerable backlash in the latest manifestation of globalization – the globalization of work processes. We are probably also seeing a fallback as well in a more primary form of globalization – global trade.

I don’t know by how much the developed country workers will enjoy it either, because the entire pie has shrunk anyway, meaning there’s less for everyone to begin with. There’s less for you, that is, if you happen to be one of those with focused and narrow skills, a phenomenon which accompanied the previous decades’ high growth in business volumes. It was overspecialization which largely enabled the outsourcing phenomenon to happen anyway.

So to the narrowly skilled workers of the developed world, now that global business is cutting back, and getting back to basics, are you ready to do more of what you assumed other people were already supposed to be doing?

A new investment metric for a commodities-crazed world

We hear from many pundits that the current food crisis. i.e., the swift escalation in the price of food commodities, is largely caused by speculators and hedge fund managers. How true is this? Let’s start by analysing how they might, and could, effect this increase.

To begin, we all know that any increase in price of any commodity is largely the result of supply and demand interaction. Price increases if supply cannot meet all existing demand at previous levels. We know that global population has been increasing, particularly in the Third World countries. We also know that personal incomes are increasing in these developing countries. These factors can put a partial logical cause to the current demand-supply interaction.

But in our current situation, food prices have been increasing rapidly. Too rapidly. For commodities like wheat, rice, corn, and soybean, prices were doubled in as short a time as a few months. Does this mean world population has doubled in that time? Or the average income of everybody in the world doubled in that amount of time? Likely not. But our current situation is such that it almost seems like for this year alone, we see people suddenly eating who otherwise never ate at all before this year came rolling.

Let’s now summarise how food commodities are priced. Commodities such as wheat and corn are traded on a commodity futures exchange. Futures exchanges exist because many food producers, i.e., corn farmers, wheat farmers, etc. do not want, or cannot afford, to absorb the price volatilities of the good that they produce.

A harvest season takes many months. For some farmers, harvest season may come only once a year. If you’re a farmer, you are weighed by specific, determinable expenses when deciding to plant a crop for an oncoming harvest. Corn seed prices, fertilizers cost, plus all other costs of running a farm or plantation.

Income from all the farmer’s effort and costs, however, cannot be determined with as much certainty. Because of the long lead time between planting and harvest and eventually, getting a crop to the market, many events can suddenly affect supply and demand during the interim. In that amount of time, a bumper harvest may result in much supply for what the farmer has just planted, leading to a decline in price. It is very possible, if a large enough number of farmers had decided to plant, say corn, and all of them, because of favourable weather, experience a bumper crop, corn prices may fall even below each farmer’s cost of planting it. This would wipe out the farmers.

To prevent financial ruin, many farmers prefer to sell their commodities to buyers long before they have harvested their crops. We call their agreements forward contracts, wherein farmers sell a specific quantity of a commodity, for a specific price, for delivery at a specific date in the future. A specific buyer promises to buy the farmer’s output at harvest, at whatever price that crop will have upon harvest time. In short, this buyer has now taken on the risk of a bumper crop. After all, if prices fall below what the buyer had agreed to pay for at delivery of the crops, that buyer will now be potentially in financial ruin.

This buyer may be the large food wholesaler who would be buying the farmer’s output after harvest anyway. Or he could be a purely speculative buyer, someone who’s willing to take a bet that months in the future, the price of the commodity might actually rise. For example, just when harvest time for corn comes, the buyer knows that people will suddenly develop an unrelenting appetite for popcorn, thereby increasing demand for corn in the market.

But since many buyers also want to retain financial flexibility, and since many of them are pure financial speculators who really have no intention of ending up with a harvest of corn at delivery date, they have set up the futures exchange where they can buy and sell these forward contacts with each other. In a futures exchange then, the prices for these forward contracts fluctuate depending on where market sentiment believes the price will be at upon delivery.

Many hedge fund managers have lately been interested in investing in the futures exchange. Why? Well, they mostly believe that demand for most commodities will be firm going into the future, given increasing consumption world-wide.

Other reasons are responsible for hedge fund managers’ current love affair for commodities. Stock prices worldwide are sluggish. The US dollar has been depreciating, with the depreciation eating into potential stock market profits . Investing in bonds are no good either if inflation is expected to be high, as inflation eats into the fixed income stream of bonds. So many fund managers are making an exodus out of traditional stock and bonds fare, and into commodities.

Many have gotten into commodity futures trading such that they have already dwarfed the true and eventual buyers of these commodities in the exchange – the food wholesalers – to a significant extent. In short, hedge fund managers are increasing the cost for these food wholesalers to buy the commodities on the exchange. These food wholesalers have to pass this added cost down onto the consumer eventually.

We can now see a very likely key ingredient of the recipe for today’s food crisis. Hedge fund managers as a group could be the single biggest, most powerful food hoarders the world has ever seen.

They are indeed powerful. Frequently, they are investing not just their own capital, but are in fact investing for the world’s largest pension funds, retirement funds, insurance firms, and wealthiest individuals. And they have been augmenting their investing power with leverage.

Previously, when hedge fund managers limited their investment to the stock market, we saw huge run-ups in stock prices. At the height of the tech bubble, for instance, we saw the price to earnings multiples of many tech stocks go into the hundreds. Price earnings multiple is the multiple that a company’s earning need to be multiplied to, to arrive at the price of the stock.

Given this scenario of high commodity prices, I will even venture into offering a new diabolic multiple. The price to hunger multiple. This might be the multiple whereby a certain commodity price level, where a scandalously large population of the world no longer can afford to buy food, and therefore go hungry, is multiplied to arrive at the price of the commodity.

In a bull market for stocks, a truly interested investor may end up having to buy stock at prices beyond the capability of the company’s level of earnings to earn that investor a return on his investment. In this bull market for commodities, people may have to buy food at prices where they will just end up going hungry. This is very scandalous and unforgivable in the most extreme.

What are we to do?

Why don’t food wholesalers buy the commodities directly from the farmers, by-passing the commodities exchange altogether, which is now possibly infested by too many parasitic hedge fund managers and other speculators of all sorts? Maybe some are already contemplating to. If commodity prices have indeed already been going to unreasonable levels.
Genuine food buyers, if this is indeed already the case, for the sake of the world’s poorest and hungriest, please act now!

Is Dubai set to be a new Global Financial Center?

Is Dubai set to be a new Global Financial Center, in the same league as New York, London and Hong Kong? This question seems timely, given the current chain of events.

With the recent run up in oil prices, Middle Eastern countries that produce oil have been minting money like crazy. Not just Middle Eastern (read: OPEC) countries, but any country that is able to produce and export oil has suddenly found itself once again the darling of the global economy.

The world just can’t have enough of what they are producing. And given that these countries are all finding that demand is much, much stronger than what they can all supply, the price of their oil has been shooting through the roof.

This is not exactly how it was in the 1970’s, the last time the world saw a significant price hike in oil. Back then, only the developed world had an insatiable appetite for oil. Whatever price hikes there were came largely from the collective decision by the OPEC countries to restrict and control supply.

This time, nobody’s restricting supply. In fact, too little supply isn’t the world’s pressing problem as much as there is too much demand.

Too much demand. More countries now demand oil. Developed countries are demanding oil more than ever. Newly-developed and developing countries are demanding more of it. There’s even significant demand coming from pure speculators – hedge fund managers who are betting that supply will not be able to meet demand. In the process, their bets are adding more artificial demand for oil.

So Middle East countries supplying oil are now awash with cash. Dubai is the financial hub of the Middle East, much like New York is the financial hub of North America, London of Europe, and Hong Kong of Asia. So far, Dubai has been merely a regional center. But now, much money is currently flowing to the Middle East, and much of it is flowing through Dubai. Dubai therefore now needs to learn quickly how to funnel these new streams of cash flows into high-earning assets and investments.

During the 1970’s oil price hikes, much of the Middle East’s newfound wealth was reinvested in US Treasuries, thereby indirectly funding the US trade deficit much like how China is funding the current US trade deficit. Simple enough. Just funnel excess cash back into your biggest customers, and you get to prop up their economies and currencies, thereby keeping them coming back for more of your goods.

But there is big difference between what is happening now and how it was in the 1970’s.

Back then, the US dollar was considered the most stable currency in the world. Therefore, it was the world’s default currency for global trade. Now, the USD is still the world’s global default currency, but the USD is fast falling from its prominence as the most stable currency.

The US budget and trade deficit s are now higher than they ever were at any time in its history. It has arguably reached levels where they are no longer sustainable, even with trading partners willing to prop it up by re-investing surplus earnings into USD-denominated Bonds and Treasuries.

Right now, putting government surpluses into USD-denominated securities is turning out to be a sure-fire wealth-destroying strategy. With the US trade deficit getting higher, the US dollar has been declining in value vis-à-vis many other world currencies. And with the decline in value of the USD, Americans are now shelling out more currency to buy imported goods that the need, among them oil. So the more Americans continue to buy ever-appreciating oil, the more money will flow out of the US economy, the more likely there will be trade deficits for the US economy, and the more likely the USD will depreciate again.

Unless the US economy finds a way out of this bind, funnelling government budget surpluses into US securities is no longer going to be the same no-brainer sovereign portfolio management strategy that it used to be. OPEC countries now would have to look for other alternatives to just putting their money into the US market.

Where should they put their money then? A good start would be in places where the currency is stable, or better yet, increasing in value. Right now, that could mean the same oil-generating countries that have been incurring significant trade surpluses.

There could just be more growth opportunities in the Middle Eastern region now than there is in the USA. There's more work to be done for Middle Eastern infrastructure standards to catch up with that of the US. Hence, there are potentially more value-generating investments to be made in their own region than in the US.

It is also the more patriotic thing for them to do. The Middle East also needs to learn from its past omissions. Because they did not invest their 1970’s petrodollars into their own domestic development, they were soon left behind once the price of oil was no longer the super-charged revenue-generator that it was. So this time, the Middle East needs to be more aware of these things. Oil is not going to last forever.

What is a regional financial center to do? Well, it could start by learning to employ the same strategies successfully utilized by the global financial centers - New York, London, Hong Kong.

And you know what? This projected extended downturn in the US financial markets is putting a lot of American financial professionals out of work. Right now, it’s not looking like they are going to get their old jobs back anytime soon. In New York, at least.

So what is newly-laid off New York finance guy to do?

Well, just look around and it's clear that there's a perfect match of need to available skills. Dubai needs to learn to become a global financial center. So Dubai investment houses and banks can literally take their pick of much low-hanging fruit. Many of these professionals can transfer much technology and know-how to the Middle East. All these countries need do is to open up and welcome this golden opportunity.

The Middle East is poised to benefit from the golden combination of available capital, talent, and ample opportunities, to catch up with the standards of the West. Dubai is strategically positioned to be the new center or much of this activity, if and when it does happen.

Is Dubai set to be a new Global Financial Center?