World Markets and News

» Normxxx - The Idea of Europe

By John Mauldin | 27 June 2005

This week we return to Europe, as what is happening there is one of the most important questions of the day. It is every bit as critical to our long-term world economic future as the valuation of the Chinese currency or US trade deficits or Fed policy.

Let me set the stage with this note. I am not happy about and take no pleasure in what is happening in Europe. For a variety of reasons, I view it with some concern. A united Europe is simply better for the world at large, even recognizing the problems associated with unity. I recognize the polarities and difficulties. But I had always hoped (and still do), that somewhat like Massachusetts and Texas, or California and Alabama, a political union could emerge.

Even so, we cannot make investments based upon what we might wish the world to look like but upon what the facts are. And the facts suggest some problems. We will look at several of the more significant ones today.

The Idea of Europe

The United States, it is often said, is more of an idea than a place. It is an idea that has compelled millions of people from every nation to come and join in a grand experiment of human liberty and opportunity.

Europe, or at least the concept of a united Europe, is no less an idea. It is certainly not a country. Not yet, and maybe not ever. Composed of multiple countries with multiple languages and multiple currencies and a very diverse population who have many individual thoughts on what being European means, Europe is trying to find out what kind of an idea it is. Is it a continent with many countries or is it a country which spans a continent? And if it is a country, what will be the basic philosophies which drive it? What is the idea that will be Europe?

There has been an idea among European intelligentsia for over 50 years that has been driving the unification movement. It was "... the illusions of social democracy that once thrilled and motivated the most gifted minds. They presuppose that societies evolve in whatever way governments wished them to." That idea is now on life support. Can that "illusion" take shape? Or, will the realities of the markets, the realities of demographics and new technology and globalization force a new model? Or, will Europe once again become a continent inhabited by a number of competing countries?

James Dale Davidson and Lord William Rees-Mogg in The Sovereign Individual. state: "Market forces, not political majorities, will compel societies to reconfigure themselves in ways that public opinion will neither comprehend nor welcome."

The French Social Model?

Tony Blair and Jacques Chirac met a few weeks ago, and the conversations were, in diplomatic terms, frank. My friends at Bridport Investor Services (Lord Alex Bridport and Dr. Roy Damary), a monster bond house in Geneva and astute observer of all things European write:

"The stubbornness of European politicians in their deafness to the popular swell of anti-EU feeling is remarkable. The more they attempt to push ahead with referenda, the more the voters will revolt. Even Luxembourg might vote 'no'! The entire European project is now ready for a re-orientation: less centralization, more democracy, retained responsibility at national level, freedom of choice on the mix of social vs. free-market economy. It is obvious which opposing sides Blair and Chirac are on, but the wind is clearly in favor of the Blair vision.

"The 'All is well in la Belle France' of Villepin and Chirac can only survive so long. The role of Sarkozy is crucial. He is playing the game of pretending to agree with Villepin and saying that the 'acquis sociaux' [social entitlements - John] are to be protected, but the details of his comments point in a different direction (see http://sarkozyblog.free.fr). Our guess is that Sarkozy is more of a Gorbechev than a Thatcher. Rather than making a frontal attack, he will seek reform in France (taming of the public sector unions, proper pension financing, a return of the work ethic, etc.) by using the language of the old guard. For France's sake and Europe's, we hope so."

I hope Alex and Roy are right. But if and when Sarkozy and/or his successors decide to confront French unions and the entitlements, it is not going to be pretty.

To get an idea of what they will be facing, let's look at just the unions representing the French National Electric Company. There, the workers have negotiated a fantastic deal for themselves over the years. As if guaranteed lifetime employment and a 90% discount on their electric bills weren't enough, EDF contributes 1% of their revenue into a "social benefits council" which uses its half-billion dollar budget, vacations and other perks to control the 110,000 employees of EDF and apparently to support the Communist Party.

Here's what the union members get:

-- posted by Normxxx

» Normxxx - CB Alpha Dog?

By Jim Willie CB, "the Golden Jackass" | 20 July 2005

The US Federal Reserve is engaged in a significant battle behind the scenes in the banking world. This is a true battle of the titans. The USFed is a household word, with its Chairman Greenspan a celebrated icon, a hero among inflation supporters, nay monetary drug addicts intent on speculation in lieu of actual work, and a savior in engineering a climate for commercial purchases without money. However, the Bank for International Settlements is the "old world" central bank from Switzerland. A better description of BIS is one of insurer/ underwriter/ counselor to all major world central banks. The war is over supremacy, leadership, lately steeped in defiance. The battle is over sound monetary policy. The true alpha dog is the BIS. The pretender to the throne is the USFed, whose role has been the more public for scrutiny since the 2000 stock bust, which was clearly the responsibility of the USFed in a grand colossal error. That concluding event might have merely stood as the climax of the Asian Meltdown of 1997, which took three years to reach the USA shores. The bust drew countless billions of European money, the resentment for which has not dissipated.

[Normxxx Here:  This is not strictly accurate. BIS has always been the 'alpha dog,' but the USFed, which is a most vocal non-member, has played the role of the 800 pound gorilla… I quote from the referenced description of the BIS:

"Even though an isolationist Congress officially refused to allow the U.S. Federal Reserve to participate in the BIS, or to accept shares in it (which were instead held in trust by the First National City Bank), the chairman of the Fed quietly slip[s] over to Basel for important meetings. World monetary policy [is] evidently too important to leave to national politicians." ]

DIFFERENCES IN POLICY DIRECTIVES
The USFed has long been chartered with a dual objective and chartered mission, 1) to limit price inflation, 2) to maintain maximum employment. Notice how definition of price inflation is lacking, and how obfuscation of what price inflation means has become the curious cloud of confusion generated by bankers, policy makers in the USGovt, Wall Street brokerage houses, and academia itself. As a nation, the United States has no idea what inflation is, how to measure it, where to detect it, and has gone so far as to bless its effects in higher asset prices as virtuous and favorable, and its effect on consumer staples as undesirable and damaging. All inflation is harmful, some clearly in your face now, some looming overhead for future wreckage.

The BIS has long argued that central bankers must keep to a dual mission also, 1) to limit price inflation, 2) to limit credit growth. It seems the BIS has a deeper comprehension of the dreaded debt impact. Huge debt growth leads to bubbles, which almost never avoid collapse. So the battle of titans is waged behind the scenes. It begs the questions "Do the US Federal Reserve and Greenspan answer to anyone?" and "If the USFed is on the wrong path toward crisis, how will the Bank for Intl Settlements play a role?" The clear policy in dispute is whether the USFed is willing not only to lead the way toward huge credit growth, but to justify it, encourage it, perpetuate it, and rationalize away its harmful risks. The BIS has an ongoing dispute with the USFed. We focus entirely on consumer price inflation, while we permit unchecked credit growth, which has wrought the attention and ire of the BIS in return.

The USFed might be coerced to hike rates more than it wishes, by the powerful Bank for International Settlements. This powerful central bank among central banks might be telling the USFed to justify continued rate hikes by whatever means. The basis could be false claims of strong US Economic growth, as measured by the Gross Domestic Product (GDP). Games were played in upward Q1 GDP growth revision two weeks ago. Apparently declining housing prices bring about a rise in inflation adjusted housing construction business activity. My analysis points to the absurdity that is the GDP Deflator. See "Three Great Big Lies" for details on the surprisingly simple argument that most of the claimed economic growth in the USA is nothing but improperly treated price inflation. The US Economy grows at about 1.5%, no more.

The BIS is extremely concerned about the frightening rise in credit. They fear how the world economy is (in their words) "vulnerable to housing corrections" and the financial strains it would cause. One can safely include asset bubbles in their general concern. Chairman Greenspan is on record as labeling housing inflation as legitimate wealth generation, which must sound like PURE HERESY to the established tradition at the BIS. The Swiss banker reputations have stood the test of time. Recall the USFed is less than a century old. Rumor is strong, that the BIS might harbor deep concerns that the United States has mismanaged to the extreme the world economy, put the world economy at great risk, and has abused on a grand scale its authority granted by owning the world reserve currency, the USDollar.

The BIS argues that America needs to raise interest rates further in order to restrain risk taking in financial markets and borrowing by households. With debts and house prices already so high, consumer spending will be hurt, but a more painful adjustment later could be ensured. Allow me to paraphrase their positions. Looking ahead, the BIS argues that policymakers need to modify their current policy frameworks in order to prevent the build-up of imbalances in the future. Targeting inflation is not enough, so they urge. Central banks also need to take more account of the increase in debt and exceptional rise in asset prices, whose correction reversal can cause instability.

The BIS argues some specific policy directives. Interest rates should be raised to curb excessive credit growth even if inflation remains tame. Regulatory policy could also be adjusted in a discretionary way over the cycle. Banks should be encouraged to build up more capital during booms, which would help to avoid excessive lending, and then be allowed to reduce their capital in bad times to cushion the economy from a credit crunch. During a rampant housing price boom, lenders should be told to reduce the amount they can lend as a percentage of the purchase price of a home or to shorten repayment periods. What the BIS urge is the exact opposite of what has happened in the USA. Quotes are extremely difficult to come by. The BIS, based in Basil Switzerland, prefers to operate quietly. They enjoy their mysterious elevated status, shun the public spotlight, but exert tremendous power. Some credit them for destroying the Soviet Union with a pull of the debt due lever. The US Defense cold war race surely set up the USSR for collapse financially, but the BIS pulled the plug!!!

THE INTERNATIONAL MONETARY FUND CHIMES IN
Criticism and concern by the BIS is echoed by the International Monetary Fund, on US twin monster deficits and their threat to global economic stability. The IMF might be a tool of big US banker interests, might be a weapon used to wreck entire foreign economies (see Argentina, Brazil, Mexico) in our hemisphere. Nonetheless, the IMF carries some weight. Managing director Rodrigo Rato stated there was no sign of capital flows to the USA even beginning to decline, but conditions could change rapidly if markets took a "more negative" position. He has commented on the deficits. He noted the capital movements needed to sustain the widening US current account deficit could not be perpetuated. He warned that foreign investors could easily lose their appetite for US assets. He has offered a stern warning. "When we speak of global imbalances, we often are referring to the large current account deficit in the United States, and the matching surpluses in other countries. Unless action is taken… to facilitate an orderly resolution of these imbalances, we run the risk of investors drastically reducing the flow of capital into the United States. In that event, the dollar could depreciate rapidly, currency and capital markets could become disorderly, and interest rates could rise sharply, posing serious threat to global economic instability." One must wonder if the BIS had asked the IMF to speak publicly on its behalf as a convenient mouthpiece.

Rato noted the USGovt has promised action to cut in half its budget deficit over five years, but proposals required in his words "firm implementation." He said "Even bolder deficit reduction would be desirable and warranted, especially in view of the cyclical strength of the US Economy, and the importance of lowering government debt ahead of the retirement of the baby boom generation." In other words, words from Washington DC are meaningless, especially given the common practice of placing costs from the war in Iraq and Afghanistan off budget. Oh yes, let us not overlook the common constant confiscation of the Social Security Trust Fund on a quarterly basis, which adds further to the future obligation risk. The Medicare spending obligations fly in the face of federal budget deficit projections. Basic math drawn from the arithmetic we learn under the age of 12 suggest the recent USGovt federal deficit is more on the order of $900 billion. See the article by Doug McIntosh, which stands in contrast to the USGovt claims.

Rato of the IMF spoke about foreign financial matters. Report of his words might shed light on the BIS position on China as well. He advised Chinese bankers not necessarily to make its yuan currency convertible in a single step. He has suggested they keep some controls on capital flows in place. "China does not have to [have] immediate total flexibility, and China could perfectly live with some capital controls as a guarantee that the country would be able to handle some speculative money or short-term money." The IMF words chime in harmony with industrialized nations, in the common criticism that the fixed yuan exacerbates world economic imbalances as their exports are made too cheap. Nobody can stand up to Chinese competition. No timetable has been put forth by China, which is probably awaiting resolution of the Unocal deal, textile quota decisions, and other items on the bargaining table.

COMPARISON TO THE 1970 DECADE
Back to the true alpha dog. Even the overarching BIS is capable of disputed economic analysis. They point to similarities between the current climate and the early 1970 decade. My work has identified the enormous differences later in that decade in "Lack of Parallel to the 1970 Decade" from almost a year ago. The BIS points to low interest rates on a real basis (after removing price inflation from the rate). They complain that loose monetary policy maintained by the USA has been spread around the world, exported if you will. They cite higher energy and commodity prices endured within the cost structures. Our federal budget deficits are huge and unchecked, aided and abetted by several major governments. They curiously find comfort, however, in a learning experience by central bankers to avoid rampant inflation, the basis of which escapes me. They point to functional independence by central banks to anchor and subdue inflationary expectations, which seem more than silly and baseless when housing is put on the radar. They overlook the frightening collusion among Wall Street and the USFed and the Dept of Treasury (see the Working Group for Financial Markets, aka Plunge Protection Team) which has become the norm. The BIS does cite differences from the past, which are indeed whoppers, but whose effects are in discord with my analysis. Cheaper Chinese import product prices are seen by them as positive, as they halt price inflation, even as how mature economies are recognized to require less oil than in the past. Herein lies the painful rub, a scratchy chafe indeed, not mentioned by the BIS, but regularly argued in my analysis. Cheaper Chinese imports kill US jobs, and thus reduce income. Also, if costs are rising but prices cannot due to a Chinese imposed ceiling, then corporate profit margins in the real economy (where things are made) can only diminish if not vanish. This is seen in the movement to offshore manufacturing in China and Asia generally, and in outsourced services to India. 'Imported productivity' has not helped US job growth nor wage growth, but has certainly done so in China and India instead.

Wisely, the BIS highlights the need for the United States to curb credit and to discourage the unprecedented rampup in credit. The USFed is perfectly willing to create bubbles as long as their narrow-minded consumer price index shows no strain. For years, since 1996, the USFed has lost its way and proceeds to inflate with abandon with only a half-cocked queer eye on the CPI for green light guidance. This is heretical and has wrought horrendous damage. The BIS sees a housing correction as inevitable, with painful consequences. Without directly mentioning the bond conundrum, they urge the USFed to force long-term rates higher, but do not propose a way for that to happen. Perhaps they urge the USFed to stop their secretive monetized support of Treasuries generally. They propose that home mortgages be secured with HIGHER down payments and SHORTER repayment periods, the exact opposite of the current borrowing climate. A grand conflict is brewing behind the scenes. The USFed has created bubbles in every conceivable economic closet. They cannot expect the sympathetic help of the most powerful financial institution on earth if things go awry. Most investors are unaware of either the existence or powerful reach of the BIS.

A recent quote is brief but important. The BIS issued a statement that "Growing domestic and international debt has created the conditions for global economic and financial crises." The statement was made at a global meeting of 55 central bankers. The BIS has long been at odds with the USFed, in competition for the "alpha dog" role among bankers. The USFed mismanages the world reserve currency. The BIS acts as the underwriter insurance institution for all central bankers, more like all Western banks. Between the lines, fully understood at the meeting, was the directive for central banks to distance themselves from the USA monetarily, financially, and economically before the inevitable debt crisis arrives. The nucleus of the debt threat is the twin deficits of the USA, which have peculiarly been accepted as normal inside the USA but declared as a major cancer outside the USA.

DERIVATIVES & HEDGE FUNDS DRAGGED IN
Of more immediately concern, the bankers have pushed hard to win a crisis management arrangement, as they are desperately seek to preserve their control under the threat of meltdown. Among the largest risk factors, according to the BIS report, is "the widening current account deficit of the United States, which could eventually lead to a disorderly decline of the dollar, associated turmoil in other financial markets, and even recession. Equally of concern, and perhaps closer at hand, it could lead to a resurgence of protectionist pressure." As identified by the group is the explosive growth in the credit derivatives securities (CDS) market, called one of "the most significant developments in finance in recent years… The notional amount outstanding on CDS contracts globally reached $4.5 trillion at end-June 2004, up sixfold from end-June 2001." They regard the GM/Ford events as only a glimpse, with the real stress test to come. They believe "Two-way markets could conceivably disappear as protection sellers exit at precisely those times when default insurance is needed most… The events of spring 2005 might not be a true reflection of how these markets would function under stress."

At the forefront of the credit derivative distress are the hedge funds. Several prominent groups have either been killed or suffered major losses. The GLG Partners firm of London made the news this spring, the details of which are $3.5 billion in losses. A description was made by Executive Intelligence Review, "What Argentina was for the loans of sovereign debtors, and General Motors was for investment loans, so was GLG Partners for the European hedge fund sector." The much awaited rogue event could be hedge fund deaths, following big changes such as the GM/Ford events, European Union disintegration, or Chinese currency revaluation.

SUMMARY POINTS
The annual BIS report summarized the ongoing discussions among world banking circles about whether a "new international macro-financial stabilization framework" is needed. Three approaches have dominated the high-level private debate, each either frightening or highly encouraging:

-- posted by Normxxx

» Normxxx - On The Edge Of Chaos.

By Dr. Joe Duarte, Editor and President | 29 July 2005

The Eurozone and the Euro are two of the world’s most endangered entities. Signs of dissention and unilateralism are starting to emerge, with the markets still not acknowledging the emerging dynamic.

According to the Eurobserver.com: “Italian prime minister Silvio Berlusconi called the euro a ["disaster" and a "rip-off" that "screwed everybody"] in a vitriolic attack on opposition leader and former European Commission president, Romano Prodi.”

According to Stratfor.com: “Spanish Prime Minister Jose Luis Rodriguez Zapatero made a state visit to China the week of July 22, shelving calls for a new phase of European relations with China in favor of a Sino-Spanish alliance. Zapatero spoke of ending the EU arms embargo to China as though it were a specifically Spanish goal rather than one for Europe. Spain understands that a fragmented Europe is one in which countries that are often marginalized in larger negotiations can increase their influence by keeping Washington's ability to project its interests in doubt.”

And according to Russia’s Ria Novosti: “After German Chancellor Gerhardt Schroeder's possible ousting this fall, the Russian-German-French troika that tried to integrate Russia with Europe may cease to exist. President Vladimir Putin will be left without any strategic partners in the EU, Alexander Rahr, director of Russian and CIS programs with the Berlin-based German Council on Foreign Relations, wrote in the Nezavisimaya Gazeta daily Thursday.”

Indeed, just as we predicted, the failure of ratification of the EU constitution in France and the Netherlands has emboldened the Euro’s opposition. Eurobserver.com noted the following: “A recent HSBC bank report entitled "European meltdown?" - suggested that countries such as Italy, the Netherlands and Germany might benefit from switching back into weaker currencies.”

And in Italy, there are calls to bring back the lira as a “parallel currency.”

Meanwhile, Germany’s unemployment rate remained above 11%, and the U.K. remains at a high state of alert after the July 7 bombings, which have been linked to Iraq by an MI-5 report posted on the intelligence agency’s website.

Conclusion: From Chaos To Disorder

The world has changed dramatically in the last six months. What was once unthinkable is now the daily rule.

Chaos, according is the normal state of the Universe, may be a non-linear journey between two parallel trendlines that define the current state of affairs. When a trend line is breached, the Universe falls into disorder. At that time complexity takes over, and self adjusts events into a new state of non linear order, restoring chaos.

In our opinion, the world, at this moment, is traveling along a trend line, that some scientists describe as the "edge of chaos."

China and Al-Qaeda are becoming the leading variables, emerging as the catalyst to most geopolitical and economic situations. The jockeying for position between those emerging, those falling, and those who are trying to stay at the top tier of the world’s power structure continues to create a situation which is increasingly difficult to assess and organize into any kind of reasonable order.

At the current time, events are taking on a much different tone than they had been, as most countries are starting to think openly in terms of self-interest. Gone is even the presence of some kind of attempt to reach agreements based on mutual understanding and the potential benefit to all parties involved.

[Normxxx Here:  Can 'Begger Thy Neighbor' be far behind? ]

<img src="http://comstockfunds.com/files/NLPP00000...">

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx

» Normxxx - Recession On Tap

Frank Veneroso called last week with a straightforward idea: It was time to tell a decidedly different story on the China boom and its knock-on effects in global markets, particularly commodities markets, and in the world economy.

Well, if that was the case, I knew of no one better to tell it, so I made an immediate date for an interview with Frank, whose day job is as market strategist for the global policy committee of RCM, the equity money management platform of Allianz Dresdner Group. I first became acquainted with Frank’s far-ranging and exhaustive market analyses back in the early 1990s, when he was a partner in the hedge fund Omega Advisors responsible for global investment policy. That was a while ago. But Frank has lost none of his edge. Read on.
Kate M. Welling

I take it from your message that your global strategy research has led you to some conclusions about China and the commodities markets that are distinctly outside the current consensus?
Right, though I should point out that my views on China are not the view of the RCM Global Policy Committee. While they listen to my views, they are basically soft-landing people. As a hard-landing person, mine is a dissident position. But I can tell you that my position is listened to attentively by some of Dresdner’s board, who can tend to take longer-term views than the money management people, who have to be where the action is quarter-to-quarter.

That’s what they’re paid for.
Exactly. Of course, the fact that the marketplace doesn’t agree with me makes my position very uncomfortable. But I’ve been here so many times before. I was early to get negative on the techs in the late 1990s. Everyone hated the position. But while I was early, they all stayed overly long and it almost ruined Dresdner’s asset management business.

So you’re no neophyte contrarian?
I’ve been in this position too many times before, unfortunately. I’ve been around a long time, decades. And I can tell you that taking contrarian positions, decades ago, sort of worked. But it’s much more difficult to do now, because the markets run to greater extremes than they used to, relative to fundamentals. Clearly that was true with the tech bubble, but, it’s also true of a lot of markets now.

Which are your favorite bubbles?
Let me give you an example: I was doing work on steel late last yearend. I could see China going from a steel importer to a net exporter. I am no steel expert, but I know something about the market. So when the scrap steel price started down hard at the end of the year, and when hot bands dropped $800 a ton or so between August and October, it didn’t surprise me that the price of steel was down by yearend— or that it kept falling. Yet steel stocks kept running up until the middle of March— until plant closings were announced because demand was down by 14%. It was just absolutely mind boggling to me that the stocks stayed up so long. If anyone was looking at the price of steel—

They would have been selling?
Yes, but everyone had it in their head that they should be in basic commodities and China proxies, and the steel is one of them. Now, once steel was tarnished, the steel stocks did start to collapse, even though other metals didn't. Now, all the metals have slid into downturns, one after another. Except copper. This persistence in playing trends, after the fundamentals have turned, just didn’t exist in the past.

There’s a lot more liquidity sloshing around in the system than there used to be.
A friend of mine says that the marketplace now generates synthetic realities, and I feel that that’s very true. That was certainly true about the tech bubble. Anyhow, my view is that this story of unending growth in China is one of those synthetic realities that the market has embraced.

Why not? Isn’t the potential almost as infinite as the internuts, back in that bubble? There isn’t much solid data on China to dampen the bullish imagination, either.
The data on China is rubbish. It is an economy that has a very high share of fixed investment in GDP, a very high share of industry; it should be very cyclical. It has growth rates and credit oscillating hugely—depending upon what data series you use and whether you look year-over-year or sequentially and over what time period—between zero and 30%. So you should expect variability in GDP. I mean, even developed countries, which are quite a bit more stable, have fairly variable real GDP growth, quarter to quarter. You’ll get up 6, up 3, even if the country’s growing at a fairly steady rate. But in China now, you’ve seen 9.4% real growth reported, give or take a couple of tenths of a percentage point, virtually every quarter over the last three years.

Isn’t that the beauty of a command economy?
Well, someone’s commanding the production of data! No economy has that kind of stability to its real GDP growth rate, particularly China. Any trained economist looking at those numbers has to say, “My God. These are rubbish.” What’s very interesting about it is that the nominal GDP growth rate is far more valuable. It’s an old saw in economics that output growth tends to change first and then price inflation changes with the lag. But not, evidently, in China, if you believe the data. Because China’s nominal GDP growth rate fell from 19% in the third quarter of last year to 11% same quarter this year. That’s a big decline, yet its reported “real” GDP growth during this entire period didn’t change. So, it’s going to be very hard to know when this thing really turns. Another problem is that if you look at Chinese industrial production data, which they release on a monthly basis, but in a weird format— they update the cumulative yearly number, instead of releasing each month’s total— and try to compare it to their GDP accounts, you find out that there’s no relationship. The monthly data that they produce simply cannot be squared with the annual GDP data and that was particularly conspicuous in the first quarter of 2005, when the change in net exports contributed the majority of the 9.5% GDP growth that they showed for a quarter in which they also claimed to have fixed asset investment and consumption growing at very, very high rates.

Do you have to adjust the numbers for large dollops of Chinese politics?
Yes, but I also believe they have a number of procedural problems. Merely gathering the data in China, after all, is an enormous undertaking. Especially when you consider the backdrop to all this: This is a country that not long ago routinely released its GDP growth rate for each quarter— before that quarter ended.

Alan Greenspan wishes he could do the same. But why are you so insistent that China won’t have the soft landing of so many investors’ dreams?
My real gut reasons are first, what I call “first principles, which are straight out of macroeconomics 101, monetary theory 101, and second, my years of experience in emerging economies. My professional career started in 1971 as an advisor on emerging economies. In many different ways in conjunction with many institutions, I worked on many, many countries— long before anyone thought of private investments in emerging economies. Then I became a crisis advisor, so I saw lots of severe economic downturns in these countries— first-hand, working out of the finance minister’s office or the central bank. And when I take that perspective and apply it to China, I basically see a disaster.

How about some specifics?
Let’s start with my first principles. In 2002-2003, when China took off, two things about its take-off were most extraordinary. The first was that the ratio of fixed asset investments to GDP, or the investment ratio, exploded. The second was that the credit aggregates also exploded. At one point on a year-over-year basis, monthly delta credit (or the change in debt to GDP over a one-month period) went to 38%. In other words, the increase in credit was 38% of GDP. During this same period, the investment ratio went from its historical mean of about 36% into the 40’s. In 2004, it was 44% officially. First of all, let me say this: To my knowledge, no major economy in the history of the world ever had an investment ratio that went to 44%, and certainly none ever stayed there.

Not even, say, the U.S. in the 19th Century?
There’s a real problem in getting good data, but as far back as I can recall ever seeing it constructed, I think the peak investment ratio in the U.S. economy was 19% sometime around 1880. But that ratio isn’t directly comparable to modern investment ratios, basically because today’s GDP accounting tends to understate the non-investment component of GDP and raise the investment ratio, compared with past era’s. So now, it’s typical for investment ratios in today’s emerging economies in Asia to be much higher. The Thai investment ratio went slightly above 40% prior to the Asian crisis in 1997. And we’ve seen investment ratios in the high 30’s in some Asian economies. But they’ve turned out not to be sustainable.

China’s 40+% doesn’t sound all that far off the chart, though.
Well, with investment ratios, five or six percentage points matter. For most of the other emerging economies in Asia, investment ratio peaks would tend to be 35 to 40%, and never sustained. And in China, the mean investment ratio over, let’s say the last 20 years of data, is about 36%. This cycle, it topped over 40%. The other key variable, delta debt to GDP, over the last 15 years prior to this spike, ranged between 12% and 19%, and the mean was probably 15%. Yet in this cycle went to over 30%. So the amplitude in this cycle is higher than China’s past cycles and higher than in any top cycles in comparable economies.

But are they really comparable? Those other developing countries were at least making a stab at developing free market economies. China is still working on an economic oxymoron: a socialist market economy.
That’s a very valid point. Where I think it’s most relevant is that the Chinese investment ratio probably will not crash to the degree it could crash in other economies, because the state will step in and build fixed investment if there’s a need for it. Nonetheless, if we take a look at the evolution of the Chinese economy, it is clear that is more of a private sector economy than it was in the past. Anytime that the investment ratio got above 40 in previous cycles, in ’86 and ’94, it subsequently declined back into the mid-30’s. Since it went higher in this cycle and since there’s been more private investment that will respond adversely to negative returns generated by over-investment, you would expect the potential decline to be at least of the same amplitude.

Now, for monetary theory 101: the Chinese authorities realized that the credit boom and the investment boom got out of hand. So they started to apply stabilization measures to reign in investment, particularly in a bunch of industries where there was clearly over-investment. The first was an attempt to reduce credit growth around the third quarter of 2003. It didn’t hold and the banks started to lend again, very aggressively. So starting in April of 2004, they applied quantitative credit restrictions, which did cause a pull-back in certain classes of expenditures. We saw, for instance, imports drop sharply for a time. But then it appeared there was something of a credit easing as we went into late summer and early fall of ’04. There were clearly a lot of banks controlled by provincial governments that had trophy projects they wanted to get done, so there was a circumvention of the restrictions. So late in 2004, the Chinese authorities made another pass at credit restriction, and the credit aggregates started to slow again. So now, in essence, you have had another decline in credit growth to the point where on a sequential seasonally adjusted basis it now is quite feeble. As the chart below shows, that’s a huge swing. Nothing could look more restrictive.

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Nothing?
Let us consider the other variables we can quantify. Short-term deposit interest rates have gone up a bit. Ceilings on loan rates were removed last year, so they are up by more. Inflation is down hard, so real interest rates are up by even more. Again, yet more restrictive. As to the other variables, there isn’t much of an equity market. It’s down, but that probably doesn’t matter. But, after soaring in 2004 and early 2005, property prices are down. The exchange rate is basically unchanged over this period. But FDI [foreign direct investment] is now falling. Lastly, to this we can add qualitative considerations. There has been a tightening of lending standards from outright quantitative credit restrictions to draconian changes in some credit related variables. That’s more restrictive yet. All of which monetary theory 101 tells you should mean a big slowdown ahead; a slowdown in aggregate demand, with maybe a lagged response into aggregate production.

But that’s still just a slowdown of growth, from China’s very high base—
Right, yes. The thing is credit is swinging much more violently than the monetary series, but both have decelerated. Diana Choyleva of London’s Lombard Street Research does the best work on this of anyone I know. I was just talking to her today; she’s got four different series. But they all show that in previous Chinese cycles in the ’80s and in the ’90s, the growth rate of credit turned down first and then the investment ratio turned down with a lag, and these tended to be about four to five year cycles. Likewise, Morris Goldstein and Nicholas Lardy, two very serious China specialists at the Institute for International Finance, wrote a piece some time ago basically saying, “This looks very similar to the prior two cycles, which means that we will get a multi-year slowdown.” Granted, the growth rate they predict at the end of the slowdown isn’t that much different from the growth rate at the beginning of the cycle. Maybe the GDP growth rate will slow down, year-over-year, to 7%. That’s still growth, but quite a comedown from the recent past. If you take a look the growth rate of electricity consumption, which might be a better gauge to what’s happening in the Chinese economy, it might go from 15% year-over-year to 2%. What I am saying is that China has significant cycles of investment booms, driven by credit growth, followed by busts that might not involve outright declines in fixed investment, but do involve drops in the investment ratio. And this time around, with very little inflation and 30% credit growth, the downside of the cycle will likewise most likely be significant.

And you’ve written that you see a sign it’s already begun in the drop in the Baltic freight rate index?
Well, let me talk first about what this could mean for the rest of the Chinese financial system, because you mentioned gray market finance. Now, China’s debt-to-GDP ratio at the peak of the last cycle was 100%. It’s now about 150%, if we look at bank credit of all kinds. But last cycle we had a lot of bad bank loans in those numbers. They’ve hived a lot of the bad loans off, taking them out of the banking system and putting them in asset management companies. So the real debt in the economy is actually understated by that 150% number. In addition, when quantitative credit restrictions emerged in this cycle, a proliferation of informal credit finance operations emerged to circumvent them, called the gray market. So that debt aggregate has become much larger in this cycle than in past cycles. The upshot is that there is a lot more debt in the system this time than we had at the beginning of the last cycle. Which creates more risk to this cycle.

Not to mention that if problems emerge in the gray market, by definition, the government can’t help.
Exactly. No one is paying any attention, but I think this is a hidden risk. OK, so economics 101 says it’s an investment boom that by all historical precedents is unsustainable. Monetary theory 101 tells us that the cycle is driven by credit, which went to great excess to create this upswing. Since China now has had a significant deceleration in credit growth, the investment ratio should drop. And economics 101 also tells us that when you bring the investment ratio down, there are accelerators and multipliers— you get a process that feeds on itself. For some bizarre reason, the marketplace is sanguine about all this. People say, “Well, maybe the investment ratio is too high, but the consumer will pick up the baton.” Yet history tells us that has seldom happened. Usually, an investment bust leads to a weaker consumer by way of the multiplier. Still, it need not happen that way. So, in the United States from 2000 to 2002, it didn’t happen. We had an investment bust, but the consumer kept on spending. That was highly unusual in our business cycle, and happened here only because we had the tools to apply aggressive fiscal policies to stimulate consumer demand, a very highly developed consumer finance system, including mortgage credit, plus policies that were designed to stimulate consumer demand by way of extending credit to households.

You’re implying China is lacking on those scores?
Of course. Now, China has mortgage credit to a bloated, speculative real estate sector, but they just apply draconian controls.

And smashed the market.
Because speculation had driven the price of dwellings out of the reach of the common people and the party got a lot of bad feedback about that. They had also toyed with consumer credit. They created a book of auto-loans that grew very rapidly. But it says something about China’s lack of a credit culture, both in the banks and among the borrowers, that after a mere three years— amid an economic boom— that book went 60% into arrears.

Yikes.
The termination of that lending because of bad loan performance had something to do with last year’s very sharp decline in Chinese auto sales. So what little experience they have in the way of consumer credit does not bode well for a consumer credit expansion that would somehow allow Chinese consumers to pick up the baton. So the reasons I’m negative are pretty simple.

Yet the world mostly sees endless growth in China—
The world is looking at the official Chinese statistics, which show no slowdown at all in GDP growth. My point is very simple. The data, as I said, coming out of China is rubbish. The most reliable statistics we have are on trade, because we can cross-check them with China’s trading partners. And what we see when we do that is that China’s first quarter domestic demand must have slowed remarkably— but that this has been obscured by a surge in net exports. Exports made a large contribution to China’s first quarter growth. We can see that. Yet if China’s real growth rate was only 9.4% in the first quarter, as it claims, it follows that there was a very large deceleration in the growth rate of real domestic demand. But what then happened to Chinese growth in the second quarter? Based on the trade statistics, the contribution of net trade to GDP growth was much less. This means that if real GDP growth stayed constant, as China claims, domestic demand growth experienced a very large recovery in the second quarter. Yet if one looks at the nominal GDP growth data, which decelerated from 13.6% to 10.7%, the contribution from rising domestic demand may have been somewhat less. In fact, if you if you look at the data on industries, sectoral data, it appears there was an inventory build in the second quarter, perhaps voluntary, probably involuntary, which kept the real growth rate up in the absence of the first quarter’s export surge. Anyhow, it appears to me that China’s GDP at the very least didn’t accelerate in real terms in the second quarter—

Actually, it appears even the Chinese don’t know—
But what we do know is that when we slow credit growth as dramatically as China has done, domestic demand growth drops. In theory. But that’s also what I think we can decipher in the numbers. Net exports picked up the baton in the first quarter, and that sort of made sense, because they have had this gigantic investment, much of it with multi-national participation, much of it in tradables. They started to bring the stuff on stream. Gluts appeared. So they started to export like mad. Look at the steel data. They went from being a net importer of steel to being a net exporter of steel, and we can see that in many industries. More importantly, we are getting more and more anecdotal reports of growing gluts and, as the huge investment ratio results in more and more capacity, declining profitability. Lastly, FDI is now starting to fall. So the process is underway that will make the investment ratio revert to its mean.

That could be nasty.
Well, these adjustments don’t occur overnight. The response of investment to eroding financial returns is slow because investment has a long lag. Once you get the plants authorized and you’re building them, you don’t stop until you complete them. The gestation periods are measured in years. The financial returns have only been deteriorating for a year, so I think the real decline in investment demand should still lie ahead. I think business fixed investment is just now turning down. So activity should start to fall. Then, as final demand falls, China should go from inventory building to inventory liquidation. And the combination of a big cyclical downswing in business fixed investment— or at least in its growth rate— coupled with an end to speculative overbuilding in the property market, coupled with an inventory adjustment, is a recipe for a 19th Century-style recession. Now, I’m not predicting that— but that’s what logic says.

But you are predicting “a hard landing.” That’s pretty 20th Century, even if not 19th Century.
But what is a hard landing for most people in the case of China? A hard landing in an emerging economy is a deviation from trend. So we have to decide what the trend rate of growth is. In the 1990s, the trend rate of growth for China might have been 9%. I don’t know what the real growth rate was at the nadir in 1998, but it might have been 3%. That wasn’t a recession, but six percentage points below trend is a big deviation. Enough to feel like a hard landing.

Especially when you’re geared for something a lot more exhilarating.
That’s right. Now, my own view is that as emerging economies become larger, as they complete the easy projects like the steel mills, as they become more sophisticated and move closer to the technological frontier, their trend rates of growth fall. Look at history. When I was an advisor in Mexico in the ’70s, we thought, based on the past 20 or 30 years, we had a 6% grower. In fact, it turned out the growth rate was half that. Brazil in the ’60s, I thought was an 8 or 9% grower. It turned out to have a growth rate that was a third of that. Korea used to be a 10% grower. Then the Asian crisis occurred and when we all woke up again to the recovery, maybe now we think it’s a 4% grower. Now, I think the same thing is happening with China, but no one knows about it yet because the recent growth rate was so excessive, relative to trend. We’re more overheated in this cycle than in the prior cycles, but it is always very dangerous to extrapolate the recent growth rate as the trend, as the marketplace is doing.

Gee, what a surprise.
There’s another consideration that we’ll have to bring up here: more than in any other part of the world, Asian growth has been export-driven. That has been the model. None of these economies has ever had leadership from consumption. China bulls try to say it will be different this cycle, but the historical record is that these have not been consumer-driven economies. And when they have adjusted, those adjustments have always been made possible through a huge surge in exports. This time round, that is not so easy for China, for two reasons. First, we’re just beginning the down cycle, but we already have in China a very large trade surplus. Back in 1994, China started its down cycle with a trade deficit. How far, how high, can China’s trade surplus go? And that takes us to the next problem, which is China’s sheer size. Historically, the typical emerging Asian economy was small relative to the markets. It could sell all of its excess without really getting anyone riled up because it was so small relative to its trading partners’ economies.

While China enjoys no such luxury.
Exactly. China’s exports now are so large, because she is so large and because trade is such a large share of the Chinese GDP, that there is a kind of market and political limit to how much improvement in China’s net trade can lie ahead.

Okay, so how much of a downtrend will we see when China lands hard?
Look, I basically will say the Chinese hard landing will be similar to the ’90s experience. A multi-year affair in which the reported growth rate falls to 7% and the real growth rate falls to 3%— but that’s a political statement on my part.

And if I took you out for a few drinks?
Okay, that is not what I really think. I really think that in this cycle there is a lot more room on the downside and I could give you a long list of reasons.

I thought you just had, but I’m still listening.
Well, I have. Gray market finance could be a complication. The amplitude of the cycle is higher, therefore the amplitude of the downside could be higher. There’s less potential for help from net trade than in the past. To that, I should add that if the U.S. consumer ever has to pull back to live within his means—

Heaven forbid!
It could happen. And that would also create a risk to the Chinese cycle. Another is that the last time China’s economy came off of a peak, there was high inflation, so real interest rates were very negative. Well, even though inflation went down, interest rates stayed negative. This time around, we’re on the verge of deflation. China is going to go into the deflation as the economy softens— outright price deflation, and with the debt-to-income ratio not at 100%, like at the peak of the last cycle, but at maybe 170%. We all know that the debt and deflation are a nasty combination— that is what we are staring in the face, in China. There are just a lot of reasons why it could be worse in this cycle. But we know what will happen. When this becomes apparent, the command economy will step in and probably prevent that from happening for the time being, particularly with the Olympics coming up in 2008.

“Probably” because there are limits to what bureaucrats can pull off, even in a command economy?
Particularly when you partly believe your own bad data.

So let’s talk investment implications.
Let me bring up one repercussion that Morgan Stanley’s Andy Xie has written about that I think is of immense importance. There is a huge amount of over-positioning by investors and speculators in Asia because, with the demise of tech and pharma, China has been the only great growth story. If China seriously disappoints there could be a reversal of that hot money. Andy says there is $700 billion of hot money in Asia which could reverse. I don’t know if his number’s right, but I think the point is correct. If that huge flow of hot money should reverse, that would affect markets in many complex ways. That is very important. And Andy is the only person I know who is making this point. But I think its spreads could widen, and you could actually get dollar strength out of it. The hot money flows have just got to be huge.

And accompanied by plentiful leverage.
Yes. I have said to my organization that there’s a potential for another Asian crisis here. Not that the erstwhile Asian Tigers have current account deficits and debt burdens like the last time around. But they do have this exposure to hot money that could reverse. What’s more, if China, the locomotive of Asia seriously slows, they don’t have the escape hatch through net exports to the U.S. that they used to have, not with the U.S. current account deficit at 6% of GDP.

Another Asian crisis? It sounds like you’re in a time warp—
Andy Xie is the only other analyst, besides me, that I’ve heard talk about the potential for another Asian crisis. When I bring it up, people tend to laugh at me. So I’ll just say I wouldn’t discount the possibility entirely, and point out that the commodities markets are much more likely to be directly affected by a hard landing in China. I also believe that the hedge fund community is extremely heavily positioned in all things Asian and there might be exposures there. I don’t think, though, that the major banks in the West are at risk. I don’t see any threat to the banking system.

Certainly not in terms of direct loan exposure, like when Argentina was on the hook to Citibank— and it turned out the situation was really the reverse. But the world is awash in credit, all neatly sliced and diced via the miracles of syndications and derivatives. Thing is, that doesn’t mean risk has been eliminated, just moved around.
Look, it’s all black box. I don’t understand what the dealers’ exposures can be, I just have no idea.

Nor does anyone, really. That’s the risk.
That may be the case. What I know is that there isn’t old-fashioned lender exposure because these are now current account surplus countries that don’t have a lot of debt. It seems to me that the risk is with those who are responsible for the hot money over-positioning, whoever that is.

In any event, you think the commodities markets are in much more near and present danger?
Yes. In part because they’re very tiny relative to today’s financial market portfolios and financial market flows. And just looking at it from a broad brush view, we’ve had now a very considerable bull market in commodities, both in terms of amplitude and duration. Bigger than anything since the ’70s. But real global GDP over this four-year period has grown at a sub-par rate, because big pieces of the global economy remained quite sluggish: Europe, Japan, and even the U.S. expansion has been slower than prior expansions. So the case has to be made, somehow, that Chinese and Indian GDP growth have offset this to justify the very large increases we’ve seen in commodities.

Isn’t part of the explanation just a pent-up rebound after a multi-decade bear market?
And therefore there was under-investment in old economy industries. In part, yes, but it depends upon the commodity. And I would suggest that another reason why this commodities cycle has been so outsized is that there is a lot of speculative money in commodities that has never been in the commodities markets before, and that has exaggerated the bull move. But that, too, probably depends a lot on which commodity you’re talking about.

I remember lots of speculation in commodities in the late ’70s.
Yes, but I think that the amount of funds chasing commodities in those days, relative to the size of the commodity markets, was not nearly as large. And the commodity markets have changed. Back then, there were no futures on oil, which is the biggest market today. Very few financial futures of any sort. Commodities speculation was really limited to individual speculators and commodities funds in the 1970s, maybe private bankers. It wasn’t something that large institutions did.

No, but there were the Hunt brothers.
That’s right. By contrast, today you have pensions funds and endowments buying commodity baskets. More importantly, you have all kinds of investors, including pensions and endowments, putting huge amounts into hedge funds, many of which are very active in commodities markets and sometimes with a great degree of leverage. I think it’s appropriate to ask whether there is a very large premium in commodity prices today because of this excess of speculative money? Mike Rothman of ISI Group put out a piece not too long ago estimating that there was perhaps an $18 to $20 premium in the oil price due to this kind of speculative money, and if anything like that is true, it’s probably true for many other commodities. Surely the long side orientation of this is speculative money that is tied to the China story.

So if the China story disappoints significantly, not only will Andy Xie’s hot money flows reverse, but a great deal of the money that is in commodity markets may come out, or even reverse. In the Asian crisis of the late 1990s, commodities were judged to be a proxy for Asian growth, just like they are now. So when hedge funds went heavily short Asian equities markets and Asian currencies, they also went short a lot of commodities. The subsequent $250 gold and $10 oil were probably due in part to speculative funds going short.

You think? The CFTC stats don’t really show huge positions—
The CFTC’s position of traders reports only show the tip of the iceberg of the net longs. In today's markets, these large investors participate in commodities through OTC derivative instruments. Swaps, OTC market instruments, upstairs transactions, We don’t know much about this activity, but most people who have looked at these markets carefully believe that in most of the major markets you only see a small portion of what’s going on when you look at the CFTC data, which is very heavily biased towards computerized funds, or CTAs [commodities trading advisors].

Sure, that’s what they regulate. But you’re implying that the downside in commodities could take us back to $250 gold and $10 oil?
No, no I don’t want to say that. $10 oil was a totally unsustainable price and the fundamentals of oil have probably improved. I think oil is a unique situation, I am totally on the fence on it. I believe that oil demand was well above trend last year for transitory reasons that we don’t understand very well, and I believe that at today’s higher prices, there should be rationing of demand. So I believe that demand growth should be less than the sub-2% rates of the low price oil era of the 1990s, which means that if oil supply growth is 2%, the market will swing into a surplus and the price will go down until OPEC pulls back production. The catch is that none of us know what the growth rate of the oil supply really is. That’s the problem. We have become dependent on the mega reservoirs that were discovered many decades ago. They are now very mature and are entering, or are in, decline. And, because of the hydro dynamics of the extraction of oil, once a field goes into decline, even huge amounts of money cannot reverse it. That’s unlike other commodities.

The Hubbert Curve.
That’s the key. There is plausibility to the peak oil thesis, globally. But we don’t really know. After all, in 1973 the Club of Rome wrote “The Limits Of Growth,” on the grounds that there was a kind of Hubbert’s peak for all commodities. Which was totally wrong. Still, if you read

<img align="left" src="http://images.amazon.com/images/P/047173876X.01._PIdp-schmooS,TopRight,7,-26_SCMZZZZZZZ_.jpg" border="0"> Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy
by Matthew R. Simmons you walk away saying, “My God!”

And looking for a comfy cave.
That’s right. We may be at peak oil production, but CERA [Cambridge Energy Research Associates], which is a very reputable organization, has just put out a piece predicting 4% per annum oil supply growth for the next five years. CERA’s chairman, Daniel Yergin, is a very respectable name in this business. I don’t know who is correct. But if the truth lies somewhere in between, so that oil supply grows at 2%, at these prices, oil demand will grow at less— so the oil price will tend to decline, until the Saudis cut their production. But that will be very easy for them to do because they’re now pushing it. Of course, this all assumes no geo-political risk to supply. Yet we know, from the Arab-Israeli War in ’73 and the Iranian Revolution in ’79 and the invasion of Kuwait in 1990, that geo-political risks tend to surface under these circumstances. So I just find oil a tough call.

Well, you’re not alone there. But other commodities are distinctly vulnerable?
Yes, even though the commodities complex is very diverse, I would say, overall, that when a serious China slowdown emerges, demand for most commodities will abate. Because prices have been high, supplies are accelerating for most commodities. So there will be a tendency for commodity prices to fall— and when that happens the excessive speculative fund flows will abate or reverse, producing a correction in commodities prices. How deep it is will depend upon on how serious the China hard landing is and whether the other locomotive of global growth, the profligate U.S. consumer pulls his expenditures down towards the level of his income.

Including gold?
Gold is a very complex equation, having to do with an unusually stingy mine supply, an unfathomable and overwhelming official supply, and an unstable and hard to fathom investment demand, and I have conflicts in discussing it. But my view essentially is that the gold price will not have a major move from here until we get serious global investment demand such as surfaced in the 1970s. I believe there is no serious demand of this sort outside the Middle East in the world today. But if deflation results from a hard landing in China and a retrenchment by U.S. consumers, the world will have to ask itself whether it wants to have recourse to Ben Bernanke’s helicopters. That specter, or the actual use of those helicopters, are what it would take to fire real gold investment demand.

But the industrial commodities?
The familiar thesis is that China and India, have insatiable demands for these commodities. And the other side of the story is that there has been such a long period of under-investment that the markets won’t be well-supplied for a long time. But the evidence that the consensus is wrong grows daily. Take steel, China is now a net exporter and the price of flat rolled steel has dropped from $800 a ton to $475, with a still-more bearish trend going forward. I think that’s a model for what’s going to happen in other industrial commodities. Except that the steel price has gone down hard even though there are no speculative financial investors in steel, because there is no futures or forward market in it. Meanwhile, The Journal Of Commerce index, which has some exchange-traded commodities and some others that are not, has rolled over and not bounced, Some of the base metals have rolled over. Aluminum is significantly off its highs, lead has come off its highs, zinc has come off its highs, nickel has come considerably off its highs. The only industrial commodity that is making new highs is copper.

But you’re not a copper bull?
Right. Copper has a long history of manipulation. It may well be that the same games are being played today. I just don’t see this as a super commodities cycle. First, the copper price traded between the mid-50s and $1.60 for literally decades, probably averaging around $0.85, which in nominal terms was marginal cost, Now, this has occurred during a period of global inflation. The price level has probably risen by three fold since this trading range was entered in the early ’70s, which means that like most commodities, its real price has fallen a couple of percent a year— and therefore its marginal cost in real terms has been falling. This is because the demand for copper rises less rapidly than global income, even as its price declines. In economic jargon, copper has a declining intensity of use and income elasticity of less than one, or less than unity. And why is that? Basically because the supply schedule for copper shifts out at a decent rate. In other words, you can bring out more and more copper at the same real price and even at a declining real price. That’s the key question. Will the copper supply continue to grow and what will happen to demand at a constant or falling real price? I’ll simply say that the latest estimates I have seen on second quarter growth in copper supplies had concentrate supply up 10% year over year and refined supply up 8.6%. Hefty increases.

What about consumption?
In the post WWII-period it has probably grown about 3% per annum, at least until 2004. So that was a big increase in supplies. This is nothing like gold or oil, where you can’t generate significant increases in supply.

Enough for China?
Well, many people feel that because of the emergence of China, the trend growth rate in demand has increased. But if you look at the long history of industrial commodities, what you find out is that the platform of manufacturing has been moving from the First World to the Third World. So we consume the copper largely in the First World, but now fabricate it into product to an increasing degree in the Third World. This is a story that’s decades old. It’s just that now China is so big that it has become the global platform. But a great deal of China’s copper consumption growth is at the expense of the growth in copper consumption in the First World. What’s happening is that the consumption of copper cathodes for fabrication in the United States or in Europe or Japan is being displaced— but not the consumption of the end products that contain copper. So the while the location of the cathode consumption has changed, the intensity of use trend has not changed.

You’re implying, with production up, we’re going to be swimming in excess copper supplies?
That’s right. We’re going to go into a significant surplus. Not to mention that every commodity, copper included, experiences demand destruction at high prices, some of which occurs through the substitution of other commodities for the high priced one. And since copper has been rising while aluminum and stainless steel were going down, substitution is in full swing. I was talking earlier today to a copper merchant, or trader, who provides the metal to plants. He told me, “Demand is a disaster. I’m just amazed at what I’m hearing from customers. But the the modern cable plant has been designed to switch immediately from copper to aluminum, based on price.”

Immediately?
Yes, all the plants built since the ’90s were designed with that flexibility. So that copper merchant’s customers are shifting more and more the mix of their wire output to aluminum from copper, in a much faster substitution than used to be possible. With that sort of demand destruction, you’re talking about the market going into huge surplus. Perhaps the largest the copper market has ever seen, as a percentage of demand, within the next 12 months.

Then why is copper hitting new highs?
A good question, when steel, nickel, lead, zinc, aluminum are nowhere near their highs. All I can say to you is that there are rumors everywhere about manipulation in copper, and it’s happened in the past, so it is not inconceivable that where there is smoke there is fire. Or maybe the strength in copper is just the extreme edge of the speculative flows inflating many commodities. But I think the big decline in the Baltic Freight Index is yet another indication that demand for things like copper has slowed dramatically in China. So too, is an email China watcher Simon Hunt passed on to me the other day. It’s a stunning commentary [albeit in fractured English], from the Chairman of the second-largest copper fabricator in all of China, about the bottom falling out of his markets:

“As two of the largest manufactures in copper tubes, Golden Dragon has nearly stop to run all their production line in Xingxiang, Shanghai, and Hailiang got a little orders from domestic market and oversea market in this month. Our department has about 1/5 ACR tubes orders compared with last month. For copper bars to produce copper wire, Hailiang nearly stops it. The high LME hurts us a lot compared with the strong RMB. Now LME+Premium takes nearly 90 in the total price. All the customers complain the high LME and importing can not take the workable saving as before, so all exporting copper tubes from China are coming to not be the competitive in the whole price.”

Wow.
I’ve been in this business a long time. I’ve seen many economic downturns and found out they all have three hallmarks: 1) You get the ingredients for a classic downturn; 2) You get one or two data series that just start to get very extreme, and 3) You get a couple of bottom-up inputs from corporations that are so extreme, you know they only happen when there’s a recession. When all three come together, you know there’s a recession. Now, looking at China, all the pieces are there; declining investment, declining property values and construction, and an inventory adjustment. The Baltic Freight Rate Index just comes crashing out of the sky and now you start to get bottom-up inputs, like this chairman’s email. This is the mix that heralds the beginning of a recession.

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