Foreign Affairs
In the 1990’s, Americans and Europeans had “discovered” the developing countries of South and Far East Asia. In earlier decades during a different period of financial exploration, they made similar discoveries in Latin America. Massive foreign investment and loans generally followed the discoveries. Asia was the “newest best new thing.” It generally was, at least, since the last newest best new thing.
It ends invariably in massive losses. There are defaults on loans. The discovery turns out to be not quite what it had promised. There are a few recriminations, usually from investors and shareholders. Senior executives huff and puff – “we acted in the best interest of our stakeholders in pursuing this attractive growth option.” The more literary frequently quote Brutus at Phillipi - “there is a tide in the affairs of men which taken at the flood, leads on to fortune, omitted, all the voyages of their life is bound in shallows and miseries”. Unfortunately, in most of these cases the tide has not led to fortune. Brutus had been defeated at Phillipi.
During my 28 years in the business, I have witnessed more than half a dozen Latin American crises. In the 1990’s, Asia was “hot”. Observers were smitten with the Asian “miracle”. Exactly why was puzzling.
The Asian economies grew rapidly in the 1990’s. Much of this growth was unsustainable. Analysts were taken by the high savings rates. Political instability and the lack of a social welfare system forced people to squirrel away money (especially in Swiss Bank accounts). Analysts focused sagaciously on the growth prospects and high returns for investors. Asian labor costs were low. There were no labour laws. Abundant natural resources were free to be exploited without environmental safeguards. Unexploited domestic markets excited foreign businesses.
There were, of course, “problems”. The sudden increase in the rate of growth and demand set off rapid price rises. The office space in Mumbai’s Narriman Point business district was among the most expensive in the world. This was a matter of Indian national pride. Productivity was pitiful. The phones and plumbing did not work. The traffic was horrendous.
Some experts claimed to know the rules of the game. The shaven headed, black leather jacketed professional skeptic of matters financial leaned against an ill lit bar in Hong Kong’s Wan Chai district. There were “hostesses” in fashionable dishabille all round. This was the Grand Master's “office”. I listened as he sallied forth.
“There are distinct phases in investment madness in emerging markets. Phase 1 is growth. You get a lot of foreign investment. It is mainly relocation of production facilities. Cheap brown people to do dirty jobs for nothing. You dig up, cut down everything you can. The locals deregulate everything because the World Bank tells them it will attract foreign investment. Government owned businesses are sold cheaply to the favoured sons and their foreign cronies. Government controls are relaxed as the foreigners tell the locals that it will create jobs and wealth.” The Grand Master paused to take a drink.
“In Phase 2, living standards improve for the fortunate. For the bulk of people nothing changes, of course. A middle class develops chasing McDonalds and Wal-Mart consumer heaven. Property prices and shares go crazy. More and more money comes in. Local banks lend recklessly. Foreign banks lend recklessly to local banks. The foreign banks think the local banks won’t fail because of government support. Investors dive in. They talk about “growth” and “portfolio diversification”. People are excited. Prices spiral up as the tidal wave of money pours in.”
“Phase 3. Costs rise to levels that make the economies uncompetitive. They are not cheap any more. Alas, the capitalist caravan must move on. Everything is over priced. Politicians talk bravely about the “need to move up the value chain”. They launch ambitious initiatives – the world’s tallest building, the world’s longest building, a new port in a country which has no sea access, bridges over rivers between two cities that do not exist, entire new cities! Locals bristle at any criticism. Everybody tries to shake off the opprobrium of being an emerging market nation. Talk of new paradigms becomes popular – “the Asian century”, “Asian values”.”
“Prices don’t make any rational sense. You only buy because you think you can sell it tomorrow to someone else at a higher price. You are caught in an endless spiral of higher and higher prices. Fear and greed rule financial markets. You are afraid that you might miss out. Your greed is endless. Foreigners develop a peculiar hubris. They are bullet proof. Fundamentals of value are irrelevant in this world.” The Grand Master paused and looked around to see if everybody was paying attention. He leaned back and smiled wryly in a well practised dramatic gesture. “Then, of course, kaput. It all collapses.”
Other seers dispensed more worldly investment wisdom. “If you arrive at a country and discover limousines waiting to transfer foreign investors and their investment bankers to 5 star hotels, then generally speaking it is time to sell. There is a second unfailing test. If you can’t buy a good meal and a young, attractive woman for the night for less than $100, then it is time to get out.”
In July 1997, as the Grand Master had predicted, the Asian boom began to unravel. The Thai Bhat fell sharply. The Thai Central Bank, it turned out, had spent Thailand’s entire foreign currency reserves trying to keep the Bhat within its agreed trading range. It finally conceded defeat and freed the Bhat to float. The HMS Bhat was not seaworthy. It did not “float”. In fact, it seemed to have no visible means of support. It promptly plunged. In a matter of days, it had halved in value. Traders joked about “submerging” rather than “emerging” markets.
Investors belatedly reviewed the value of investments. Glamorous companies, touted as “best-of-breed” world beaters, turned out to have no earnings, no cash flows and no value. Most seemed to be vehicles for property speculation. Investors began to sell. There was only one problem. There were no buyers. The music had stopped. All the seats in this game of musical chairs were firmly occupied.
In 2006, Asia is “hot” again. They have even found someone to blame for the 1997 crisis. The villain, it seems, is a man with a splendid moniker – Rerngchai Marakanond. Marakanond had been the Thai Central Bank Governor. He oversaw the country’s failed attempt to protect the value of the Thai Bhat in 1997. Marakanond was ordered by a Thai court to pay back Bhats 186 billion (about $5 billion). The Central Bank had spent this amount in an ill conceived and ultimately futile defense of the fixed rate exchange rate regime. The court chastised Marakanond for “grave negligence”. Marakanond, a career Central Banker, was ordered to pay the vast sum back within one month or face seizure of his assets. Marakanond was a scapegoat. Asia is back to it old tricks.
Things have changed. The focus is different this time. The “tigers” of South East Asia have given way to the Chinese “tiger”. The Amur tiger that once roamed China is actually long extinct. Most companies now are into “BRIC” – Brazil, Russia, India and China. Investors are all throwing money at these countries. Businessmen speak in awe of the potential of the Chinese “dragon”. I had always thought that the dragon was a mythological creature.
China reports growth of around 8.00-10.00 % pa exactly each quarter. The accuracy, precision and speed with which the figure is published is commendable. Nobody actually knows whether the number is accurate. The productivity of capital in China is abysmal. Foreign investors are learning that there is no functioning legal system when they try to enforce legal rights. Many Chinese banks seemed to be defying the laws of solvency once you notice that many of their loans are unrecoverable. In fairness, in a communist system, with communal property, it probably doesn’t much matter who pays or doesn’t pay whom.
Corruption is said to be a major problem. The Chairman of China Construction Bank (CCB), one of the biggest banks in China, resigned for “personal reasons”. Lawsuits alleged that he had collected bribes from suppliers to the bank in return for awarding contracts. He allegedly also asked for all-expenses paid golf trips to Pebble Beach in California, payment for his son’s education in London and his wife’s expenses to visit the son. The allegations were very personal. The Chairman denied everything. Business couldn’t be discussed during the golf outing because of “language barriers”. A predecessor was serving a jail sentence for accepting bribes. [For an account of the China Construction Bank scandal, see “Personal Banking” (26 March 2005) The Economist at 67]
Investors are dazzled by China’s low production costs and its huge potential market. The Southern provinces of China bordering Hong Kong, since 1997 a Special Administrative Region of China, have emerged as the world’s factory. Environmental conditions are appalling. There are no safeguards. Western buyers don’t care. The price is low.
Southern China is also exporting other things. It has proved a hothouse of biological development. Diseases like Avian Flu and SARS appear to have originated in the region. Epidemiologists worry that the next pandemic will start there.
The potential of the huge domestic market has given rise to the “armpit theory”. There are more than 1,000 million Chinese. This translates roughly into over 2,000 million armpits. That’s a lot of deodorant. The fact that the vast majority are malnourished, have no disposable income or aren’t interested in Western hygiene products is just negative thinking.
In 2005, Bank of America paid $3 billion for 9% of CCB. This valued the bank at more than $33 billion. The implied value is larger than the market capitalisation of many major global banks. Bank of America’s Chairman chanted familiar incantations. “We’ve been looking…for a way to invest in this growing economy.” In the recent past, CCB had received billions from the government to write off unrecoverable loans. An astonishing 40,000 employees of CCB had to be disciplined. Millions of dollars had disappeared from branches. Some of the money has ended up in casinos in Macau. Analysts said that CCB was the best of the Chinese government owned banks. Unsuccessful bidders were crestfallen at having missed out. [International Herald Tribune, Saturday-Sunday 18-19 June 2005]
These days there are many, many initial public offerings of shares in Chinese banks. They are duly over-subscribed. The values of the shares sky-rocket. The value of BA’s investment along with those of other “anchor” investors have soared to gravity defying levels. No one can quite explain why. Investors are untroubled by the lack of explanation of the price inflation.
I have some experience of China. A company I knew had a small trucking business there. Business volumes fluctuated wildly from week to week. It all had to with the PLA (People’s Liberation Army). Sometimes, the local garrison wasn’t paid on time. They relied on their latent entrepreneurial instincts. They had trucks and plentiful supplies of fuel. They just entered the trucking business in direct competition with us. The sales pitch from AK-47 toting PLA soldiers was irresistible to our clients.
The local Central Bank (China has multiple central banks) also frequently ran out of money. One of the local managers couldn’t make the payroll. He flew to Hong Kong and carried back a suitcase filled with dollar bills to pay staff. He later discovered that this was an “economic crime” under Chinese law. The punishment was death by firing squad. He wasn’t happy. You can’t have everything, especially in China.
There is massive over investment. It is not clear who is going to buy all the goods. Much of the investment in China seems to be in property. Investors from Hong Kong and Taiwan pour money in. Hong Kong businessmen frequently buy property in Shenzen that seems to come equipped with a new “wife”.
A group of entrepreneurial traders tried to capitalise on the new interest in China. In the early 20th century, the late Qing dynasty issued bonds to foreign investors. In 1949, the Communists took power and refused to honour the debt. In the 1980s, China wanted to issue bonds in international markets. There was a hitch. The UK government insisted that the Chinese first settle the pre-war claims with British investors. In 1987, China reluctantly paid about £20 million to settle the claims. The payment covered a range of claims - defaulted bonds, debt relating to the Shanghai cricket club etc.
American holders of defaulted Chinese bonds now pressed China for a settlement. The claim was for $120 billion, the present day value of the bonds. A group of US politicians wrote to the US Securities and Exchange Commission (SEC). They wanted the SEC to take action against rating agencies for failing to consider the default in rating Chinese bonds. They threatened to excommunicate China from the US capital market. The price of the defaulted Chinese bonds jumped. They went from 1 cent per $1 million to 2 cents. You had doubled your money.
The rapid growth in China is fueling a global commodity boom. Commodity prices have reached new heights. Analysts talk of a new commodity price cycle – a “super” cycle. Inflated prices for commodity stocks have followed. Tiny companies with dubious mineral properties are appearing on the bourses around the world at ridiculous valuations. If you ask anyone to explain any market move, then the answer is always “the Chinese”. Sorry, there was also another explanation – “hedge funds”.
Dubious schemes from yesteryear have reappeared. There is a proposal to build a shipping canal in the Isthmus of Thailand linking the Gulf of Thailand and the Bay of Bengal. It would speed tanker traffic between Middle Eastern ports and China, now the second largest consumer of oil after the US.
I last saw the scheme in 1985. The approach had been from a retired Thai General in dark glasses and a money broker. The money broker’s background was in arranging car finance for individuals. She wanted an introduction fee of 4% of the project cost of around $ 20 billion. We just laughed.
The “new” economy was passe. The “old” economy was back in favour. It was the China story. We were in yet another “new paradigm”.
In mid 2006, I was waiting for someone at a restaurant in London. My host was late. I waited at the bar. I read the inappropriately pink pages of the emblem of British capitalism – the FT (Financial Times).
A group of traders were talking about Brazilians. It wasn’t about Brazilian emerging market debt. They were talking about the total depilation of the nether regions of a woman. Only a brief “landing strip” is left, apparently. There was now a male version - known colloquially as the “sac to crack”. One of the men was considering the procedure. Traders like to discuss everything with other traders. In trading rooms, this is the normal code of behaviour. I winced with pain at the thought.
Fashions had definitely changed even if emerging markets had not. Emerging markets bonds had taken a hit. Many countries were having economic and political problems. Emerging market governments were having trouble convincing the poor in the favelas that they would have to make more sacrifices. BRIC, it seems, was about to hit a brick wall.
© Satyajit Das 2006; All rights reserved.
The above is adapted from Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das (2006, FT - Prentice Hall, London, ISBN 0273 70474 5) available at all good book stores or online at www.pearson-ed.com.
Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.
