Months ago I wrote about the possibility of a Black Swan event for the financial industry. A Black Swan is an unlikely event but with severe repercussions and impact. The melt down of the financial industry constitutes such a Black Swan event. The severity of the credit crisis caught everyone by surprise. It seems no one knows how BIG the sub prime problem is . When the Federeal Reserve bailed out Fannie Mae and Freddie Mac, who are severely impacted by the mortgages they backed, everyone thought the crisis is more or less stabilised.
Then Bear Stern started wobbling and was bailed out by the Federal Reserve Board . Then Lehman Brothers was allowed to go bankrupt but AIG started to have serious financial issues and was given $80 billion loans. A more serious look revealed that the credit market was in a kind of seizure and $700 billion was approved by Congress to solve the mess. Central banks got together to lower interest rates and more liquidity was pumped into the market .But stock markets kept on falling, falling, falling.
When investment banks are leveraged thirty times and commercial banks leveraged ten times, there is an absolutely humongous amount of debt that needs to be cleared and eliminated. The Carry Trade has started to unwind as Japanese banks have obviously recalled loans in yen. This is why the yen have strengthened while the high yielding currencies like the Aussie and Kiwis have fallen. The Aussie Dollar fall resembles that of a bungee jump as it was steep beyond belief. There is no fundamental reason to such a steep fall in the Aussie, a country rich in resources , stable government and a highly educated population. It is obvious that many investors have borrowed yen and bought Aussie and now they have to sell the Aussie to redeem the Yen denominated loans. Hence Yen goes up and Aussie goes the other way.
Investors have also borrowed yen to buy shares and this has triggered selling all over the world. No one in his right mind would sell shares at such low prices. They did not want to but HAVE to because they have to return their loans whichever currencies the loans are in. Now assuming the total value of shares worldwide is worth $21Y trillions. Only $Y trillion is bought with cold hard cash .The remaining $20Y trillion is bought with loans, loans which now the banks are asking back. Investors borrowed to buy hedge funds which are extremely highly leveraged themselves. So we have this leveraging upon leveraging. Investors who are leveraged are buying investment products which are highly leverage. The deleveraging process has still some more weeks to go before their positions are unwind .
Central banks seem to see the problem as a credit problem and think that by providing more money at lower interest rates, confidence would be restored . What the Central Banks should do is to follow what Hong Kong did many years ago. The Hong Kong Government went in and buy the shares to prop up the market. Perhaps in time they will recognise this but buying shares seems to be political suicide especially with the Presidential elections around the corner. Shares will continue to fall until the loans have all been redeemed and then the rebound will begin. US and European shares will fall until overseas buyers see value and start buying them up. The first rebound will be Asian shares as they are fundamentally sound and do not have the debt and leveraging issues faced by USA and Europe.
But the Mother of all Black Swan has yet to come. This is the real biggie, the knock-out punch that will floor all but those who have hedge in gold. This is when confidence in the US dollar evaporates. When overseas customers stop buying US Treasuries, or US bonds or even US shares. The Federal deficit needs $2 billion a day. Without this infusion of funds from overseas, the only solution would be to print dollars. The result is extremely high inflation in USA and for a period of time, markets will be even more volatile than what we have seen.
There will be a scramble to find a currency to replace the US dollar. The IMF and World Bank will be expanded to include Asia and will be more reflective of the actual financial strength of each country. Perhaps even majority vote in these two world institutions may move to Asian and Middle East countries for after all they are the ones with the money. He who has the money calls the tune.It will be an irony that now IMF and the World Bank will be assisting developed countries who were previously the ones who provided them with the funds. Now an Asian pied piper calls the tune and it would be interesting to see a Chinese or a Japanese lecturing the Prime Minister of Germany or UK on how to manage his country. The only solution to such a massive crisis is to let the ones with the money decide on how they are to lend to the one who needs the money. The current situation is that the ones in debt are the one who decides how their debts are going to be repaid. China, Japan and Middle East countries are not going to provide loans to IMF or World Bank when they have no control over these institutions.
There will not be a collapse. The world is too sophisticated for that to happen. Central bankers and economist will gather together to find a solution. But it will not be just Western bankers and economists but Asians and Middle Eastern bankers and economists who has to come up with a solution that is palatable to their own citizens as well. A price must be paid for the folly of the past. Just as IMF insisted on strong medicine for the countries in which it provided loans, the same strong medicine has to be given out, this time to Western countries; higher tax, lower Government spending , no agricultural subsidies for farmers and so forth.
China , Japan and Asia will have to find new markets for their products. The emergence of countries like Brazil, Russia , Poland and others plus China's potentially huge domestic markets will take up the slack from the US. After all the US contributes only 20% to the global economy and this can be taken up by the emerging countries. Japanese consumers have not been spending but will be encouraged to do so when their Yen becomes so strong that going overseas and buying overseas products become very cheap. Will Japanese consumer take over from the American consumer? Not totally but together with Chinese, Brazilian, Russian and Korean consumers , they will take up the slack that the American consumers have left behind.
A reverse brain drain will occur when top talents and professionals now flow West to East , increasing the competitiveness of Asian companies. The West becomes a less important market .Already we see this in China where there are products catering solely to the Chinese market.Likewise we will see products tailored to Japanese taste which means smaller products to taken up less space and more functionality as well. The lack of funds by Western countries will lead to Asia becoming more dorminant in Africa and even Latin America.
In time to come , Latin America will become the next Asian tigers. America will be too pre-occupied and too poor to interfere with its southern neighbours. It would be interesting when educated Latinos and Mexicans start returning home from USA to their home countries and start new companies. Many Chinese and Indians have done the same in the past decade. It will be a different world but still a rich world where knowledge will continue to grow and new products , new services will sprout.
