By Dr. Hans Black
Interinvest Review & Outlook

       Historians will debate when the credit crisis officially began, but in our view, it just celebrated its second anniversary. On June 22, 2007, Bear Sterns announced the insolvency of two of its collateralized debt obligation funds. When Morgan Stanley and other creditors seized the CDOs and tried to auction them, only 12 cents were retrieved on the dollar. The rest, as they say, is history...
      Two years in, while it may be premature to say that the worst is behind United States bank (ominously, commercial real estate and private credit debt are performing at the levels that we saw in housing last summer) markets have begun to fathom the extent of possible losses. The same cannot be said with prospect to the impact of the credit crisis and recession upon the rest of the world.
      In countries and regions whose economies and institutions are more opaque than America' relatively transparent financial system, a subtle but steady stream of news items is indicating that significant troubles were hidden - and no longer remain under wraps. Bank losses on 'non-performing' assets in Central and Eastern Europe are of particular concern, and have received a great deal of ink in the European press (if perhaps less in the U.S.); banking failures in the Middle East are less catalogued by equally concerning development; slow than expected economic growth in China is signaling that a global recovery will be weak. These factors have the potential to further disturb relative currency values, depress earnings, and lead to serious counter-party problems in the financial sector. They indicate that even as the steady stream of awful news coming out of the United States seems to have at least decelerated, the global economy is not out of the woods just yet.

Persian Gulf Deleveraging

       As was noted previously in these pages, a terrific real estate bubble developed in the Persian Gulf during the 2000s ("Dubai," September 2006). Dubai was a microcosm of the mania: The world's tallest tower and biggest shopping mall were built there, along with archipelagos in the shape of palm trees and planet Earth. While property prices swelled as oil hit $150/barrel during the summer of 2008 (even as global real estate prices were rapidly falling everywhere else in the world), valuations had plummeted more than 40% by early November and are in free-fall at present.
       Losses on similar real estate holdings are the main cause of the insolvencies of a series of Gulf-based investment groups and holding companies. The first shoe to drop was the Ahmad Hamad Algosaibi & Brothers Co., a conglomerate tied to the Saudi royal family whose holdings include Saudi Chevron Phillips, BP Solar Arabia, the Saudi Arabian American Express licensee, the Local Pepsi bottler, and a trading company that represents, among others, Sumimoto, Jeumont, and ShawCor. In late May, rumblings began to the effect that the Algosaibi group would not be able to make a $1 billion dollar payment to various creditors, including BNP Paribas and WestBank LB. Since then, the sum in default has been raised to $9.2 billion.
       Another Saudi conglomerate closely linked to the Algosaibi group called the Sa'ad Group announced on June 1 that it could not meet obligations on two revolving credit facilities worth $5.6 billion. While the Sa'ad group develops real estate, infrastructure, hospitals, and owns a 1,000,000 m2 manufacturing facility, it also owns a 3.5% stake in HSBC bank. Sa'ad's creditors include BNP Paribas and Citigroup, which are on the hook for at least $1 billion of Sanea's losses. The two top a list of 37 creditors who loaned the Sa'ad group $5.6 billion.
       The $14.7 billion in losses on loans to the Algosaibi and Sa'ad Groups might only be the tip of the iceberg. Huge amounts of credit were extended to Middle Eastern entities on the presumption that regional energy revenues secured the loans. Bloomberg reports that at least $64 billion was provided by non-Middle East banks to Saudi borrowers since 2004; a roughly equivalent amount was loaned across the remainder of the region. The largest foreign creditors are among the shakiest banks in the U.S. and Europe: HSBC, Citibank, the Royal Bank of Scotland, and BNP Paribas. The reader should see where this is going.
       The Middle Eastern banks do not look like they can withstand the onslaught, with each country's central banker speaking publicly about the need for "solidarity" and "a common front." Only May 20, the U.A.E. withdrew from a proposed currency union with Saudi Arabia, probably due to Saudi Arabia's unwillingness to cover losses on the assets of Saudi cvorporations.
      The global banks, for their part, claim to be prepared for the deluge. BNP Paribas has a 'war chest' of $5 billion dollars set aside against their total world-wide loan book of 508 billion Euros, while Citigroup has access to various U.S. government loan facilities to cover write-downs; the British banks have been promised similar facilities by the government of the U.K., though one wonders how much more credit the Bank of England can summon at this stage.
       This situation bears watching, as it is unclear how the banks - still licking their wounds - will be able to make up the losses. In general, writing down real estate portfolios throughout the G-10 was painful enough. With central banks and government budgets stretched to their limits at present, losses on developing world assets may prove to be quite painful indeed.

Chinese Decoupling?

       Due to the recession in the G-10 countries and the rapid deterioration of developing world economies, many are counting on China to drive global growth. Undeniably, China's economic miracle is among the great stories of the post-Soviet era. Between 1990 and 2000, China's real GDP increased by 257% according to official Chinese government statistics; between 2000 and 2008, average headline GDP growth was an astonishing 9.7%. The IMF now counts China as the world's third largest economy, surpassed only by the United States and Japan. The signs of this transformation are easily visible to casual travelers to the middle kingdom. A visitor to China in the early 1990s would have observed seas of people riding bicycles on unpaved streets. Today, those dusty roads and bikes have been replaced by super highways and cars.
      In light of China's spectacular growth over the past 25 years, many observers are predicting a rosy second half of 2009 for the Chinese economy. One hears that Chinese GDP growth will continue unabated by setbacks elsewhere in the world, that China has "decoupled" from the G-8 economies as a result of shifting trade flows, its developing domestic market, etc. It has become fashionable to claim that China has become the one "safe' investment in the global economy, indeed, that China might even pull the U.S. and Europe out of their economic downturns, and therefore, global asset allocations ought to be rebalanced with China "over weight' in the near term.
      With all due respect to the tremendous achievements of modern China, it seems that those who expect it to continue leaping forward at breakneck speed, immune to the global downturn around it, do so on the basis of a number of deeply flawed assumptions.
      The first assumption that we question is that China's export economy can thrive amidst a global downturn. In 2008, China exported $1.48 trillion in goods, accounting for 31.8% of China's GDP. As much as media pundits might enjoy trumpeting the growing economies of Asia and their gradual "decoupling" from the economies of the Atlantic, the fact remains that more than $400 billion of these exports were sent to the U.S. and Germany alone in 2008. With global consumption declining, and with consumers in the U.S., Japan and Germany abruptly retrenching (e.g., savings rates in the U.S. have moved from negative territory to 6.9% in under 12 month!), it is hard to see how Chinese exporters can avoid feeling at least moderate pain. Adding to their difficulties, protectionism is quietly reappearing in the G-8, and Chinese manufacturers are bound to suffer from the double whammy of having to crack shielded markets in the midst of a recession and global consumption cut-back. Reports that large Chinese plastics and metal manufacturers are operating at 70% of capacity reinforce this view.
      The second questionable assumption is that domestic consumption in China can pick up the slack created by weak exports. The Chinese consumer is notoriously conservative, saving approximately 35% of his income annually. While the Chinese government is attempting to 'stimulate' domestic spending by offering tax incentives on the household appliances, cars, and capital goods that foreign consumers will not be importing this year, as well as added infrastructure spending on roads and public transportation, early reports indicate that the expected income bump has not been huge.
      What's more, the easy money is producing unintended consequences. One visitor to Interinvest reported that large Chinese government-controlled banks have been issued orders to extend consumer credit and to offer corporations "take it or leave it" low-interest loans - even if they do not have any projects that they intend to undertake. The results are predictable: renewed real-estate speculation and, in the words of the official Shanghai Securities News, a stock market "asset bubble." Former Chinese lawmaker Cheng Siwai was quoted to the effect that 2.4 trillion of the 4.58 trillion yuan included in China's stimulus spending is flowing to investment assets, and the report concluded that "Nearly half of China's newly created liquidity has been circulating in the financial system instead of flowing into the real economy to support growth."
      Which brings us to the third flawed assumption about the Chinese economy, namely, that China's immense foreign exchange reserves - Bloomberg puts them at $1.9 trillion excluding gold - will be put to work buying commodities, thus bidding up prices. On the one hand, it is clear than China is hoarding commodities: Wah Kwong Maritime Transport Holdings CEO Tim Huxley is quoted to the effect that more than 90 freighters carrying iron ore were idling outside of Chinese ports mid-month; in the words of an FT editorial, "the further away from China you go, the cheaper the metal."
      The Chinese government is hoarding commodities precisely because prices are cheap, at least relative to 2007 highs. With metal inventories in China bulging, however, and with prices once again rising, surprise - Chinese commodity purchases are decelerating. In late June, Chinese officials announced that "strategic" purchasing would end. Those who expect Chinese commodity purchases in 2009 to shoot the values of natural resources back to their 2007 stratospheric levels are expecting Chinese buyers to bi up prices - against themselves.
      But what if Chinese policy makers come to fear that U.S. dollar depreciation will eat away at the value of China's foreign exchange holdings, or, in the words of Li Lianzhong, chief economist at the Communist Party's in-house think-tank, "Should we buy gold or U.S. Treasuries? The U.S. is printing dollars on a massive scale, and in view of that trend, according to the laws of economics, there is no doubt that the dollar will fall. So gold should be a better choice."
      Alas, the largest holder of U.S. treasuries worldwide is...China. Evaluated in dollar terms, 64% of Chinese foreign reserves are held in U.S. dollars. Perhaps one might imagine China gradually balancing down its dollar holdings on the margin, but a rapid purchase of foreign currencies or commodities would simply depress China's core holding: U.S. dollars. Chinese talk of a new "global reserve currency" should be considered in light of China's stake in the world's current reserve currency.
      The economist historian Niall Fergusson has dubbed the China-U.S. relationship "Chimerica," a term that nearly describes the symbiotic connection between the world's fastest growing emerging market and the world's largest economy. China has developed itself by looking abroad, and availing itself of global capital, global markets, and global trade. While one should expect China to continue its growth and modernization for years to come, it is hard to see how it can replicate the rapid progress of the past decade under the prevailing difficult economic conditions of 2009.
      Editor's Note: Dr. Hans black is editor of Interinvest Review & Outlook, P.O. Box 51462, Boston, MA 02205, 1 year, 12 issues, $125. wwwinterinvest.com.