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Sharp Reversal in the Economic Outlook.

The sharp reversal in the economic outlook is a serious one. True, there has been no one-day collapse in the share market as in 1987, but London has lost a quarter of its FTSE 100 index value since June, Germany has seen the DAX fall by one-third and in Japan the Nikkei is at its lowest for 12 years at less than half its all-time peak. Many of the smaller exchanges in Madrid, Seoul, Sao Paolo have followed, and in Latin America the sense of pending devaluation of currencies has been hanging over the Brazil election and over Columbia and Venezuela and the Argentines - a move which would again threaten the ability to service debts owed in non-devalued currency. The Russians have actually devalued and it appears to have been followed by a further deterioration in the markets with 90% of the value of shares in Moscow having been wiped off company assets. So, despite the consolation that there has been no repeat of Black Monday, there is a greater feeling of unease that this may not just be the savage correction of overheat so dear to the Chicago mentality, but, as George Soros has suggested, there may be some systemic fault in the whole system. If so, it certainly does not have to be terminal, but it is likely to be damaging us for an unnecessarily long time unless we cease to listen to the blather about free markets and actually admit there may be something in what Soros says in order to fix it. The Chicago school are so paranoid about any interference in the freedom of markets being motivated by bureaucracy or creeping socialism that they appear more willing to go down with the ship than to pull into port for repairs, in order to sail further, freer and better another day. Of one thing you may be sure - you are not likely to catch creeping socialism by listening to George Soros. And what he says is that the uncontrolled tidal wave of short term money travelling in and out of national economies is a dragon, a Godzilla, needing to be tamed.

If there is a common denominator to all these events - and in many ways they are coincidental in timing rather than from a common root cause initially - it is the instability and inadequacy of credit control and the lack of attention to ensuring at all times that minimum liquidity requirements are maintained. Two words are frequently mentioned - "Hedging" and "Derivatives". They have been heard before in recent years in connection with names like Barings and Sumitomo so we cannot say we were not warned. There is also too much secrecy about transactions of this $30 trillion dollar "hot money" and of the way this short term money is employed by banks in their dealings with other financial institutions to support long term commitments that have yet to bear fruit, without the funds being adequately secured for the necessary timeframe.

So what are the hedge funds doing, such as Long Term Capital Management, which had everybody including Alan Greenspan doing rapid overtime recently, apparently to avoid a collapse that would have imploded a large part of the western world's financial structure and left the rest stripped of confidence?

The London Sunday Telegraph of 27 September (says): "LTCM had used its capital to take massive leveraged positions (my note- the capital had been loaned by prime banks and even by one leading European Government). Its gross exposure to financial markets is thought to have hit $100 billion through derivative holdings. Liquidating the fund (LTCM) could spark a banking crisis - a comet was heading for the financial system. Though suffering heavy losses in Russia much of the fund was invested in bonds in Europe, Japan and America. Many of the investments were credit spreads - i.e. betting on an improvement, or a fall, in the credit rating of, for example, an Italian government bond. Derivatives would be used to take a short position - i.e. selling a security the fund did not own in the hope of buying later at a lower price. If the value of the securities it chose were to rise and those it did not were to fall, it could make huge profits. With Euro-convergence, it gambled on government bonds from weaker countries such as Italy or Greece converging to those of stronger nations such as Germany. But instead the crisis in Russia sent investors fleeing to quality and the gap did not converge it widened leaving LTCM sitting on massive losses".

The Chicago mentality is apparently quite happy with this manifestation of freedom leading to the fall of some while others prosper. But who prospers when bankers and even governments lend solid capital to almost unknown agencies - obscure from the view of the original investors with the banks -who then gamble on selling securities that the report says the agencies do not even own when they sell them - in the hope they have got it right...

It follows that Michel Camdessus, head of the IMF has said recently that greater transparency is needed and the G7 ministers who met on October 4 are believed to be drawing up new rules to cover this as well as new codes of conduct for the phenomenon of thousands of billions of dollars of short term money travelling with electronic speed between capitals looking for short term returns. That is what George Soros warns cannot continue without some standards and part of this new look must be to ensure minimum liquidity safeguards in the inevitable event of future collapses having to be provided with damage limitation emergency measures. Greater transparency should also be designed to minimise the collusion risk of old colleagues in new situations still operating together as they did when working for the same enterprise but now straddling the areas of big risk, leverage and hedging.

These techniques are here to stay. Thus the question posed by Soros and Camdessus for the G7 Ministers is - what are you going to do to improve free markets? If people in Chicago cannot distinguish between essential regulation and creeping socialism then will somebody please adjust their credibility rating urgently and make it lucently transparent to the rest of us for damage limitation purposes.

In the same way that liquidity traps can be expunged from financial city centres and the free international flight of capital - flight in as well as out - so too can economies in Asia/Pacific help themselves by building in safety factors for future recessions. A strong public sector in an enlarged domestic market can be a powerful cushion against the extreme economic downturns experienced by regimes in which everything is committed to the private sector and to the employed; because when the climate changes these employed are no longer employed and cannot make any purchases to help restimulate the economy unless provision is made during the good times. And that requires governments to assist the market to become more robust.

It is not long ago that in the UK, under the last government, one could hear ministers extolling the virtues of the Asian economic miracle - and in many ways they were right to draw the attention of the British to those achievements. But they would go further, being a monetarist government, and point to the very low public sector size in the economy of, say, Hong Kong or Singapore as though this were the key to the Asian success. But those of us with more experience recall the depression between the two world wars and how in both Britain and America survival depended on making the system robust by giving a little spending power to the unemployed, the disabled and the sick and old. It is not the humanitarian aspect of this provision that is important to the economy, it is the fact that to have a strong domestic market when export industries and their financiers are in deep trouble enables the system as a whole to maintain some positive movement or at the least to keep breathing.

Once again it is the liquidity principle in another guise. And it is better to have a surviving level of microeconomic activity in the shops and farms and entertainment and travel systems than to go for government megaprojects that require massive public sector financing and may not result in any self-sustaining improvement in economic activity. But here there is a risk of "creeping socialism"iwe do not need governments running every aspect of the system, every shop and bank in the city: but a wise government can ensure that in bad times the people still have something to spend, some cash to provide liquidity and to keep the system operating. It is especially important in the giant population economies of China, India, Pakistan and Indonesia.

The sheer scale of potential demand represented by the population growth in these countries and in the region as a whole underpins the inevitability of a return to growth in the Asia/Pacific region. Latest UN world population projections predict that India and China will both exceed 1.5 bn people before the middle of the next century, with Pakistan at 360m in third place in the world and with Indonesia, alongside Nigeria and Brazil, featuring in the nations having over 300m inhabitants. Together with Japan and Korea, the rest of the ASEAN group and Bangladesh the Asia/Pacific total population is expected to reach 5 bn out of a total of 9 bn for the whole world, and probably around 2040. This is within the life-cycle of two generations of young females still with their childbearing years mostly ahead of them and who are much more than a forecast statistic because they are already born...

There can be little doubt that the energy flows to support their needs will emerge and even if the present recession proves structurally difficult to eliminate - and it will not be the last one - the question about the forecast figures occurring is one of "if" rather than "when".

We may not see the 2010 global targets in the EIA forecast attained until 2015. In some regions the recoveries may be quicker but others may take even longer. Asia/Pacific will tend to be the pacemaker whenever possible to meet the potential demand of its massive population and strong population growth and turn this into actual consumption.

By the horizon year of this conference, 2011, we will know which of these rates of progress will have been achieved; but either way we shall be travelling along the same route of development. The scale of energy demand and the need to import most of the oil and gas will ensure that indigenous coal, especially in the giant economies of China and India, both already listed in the top six economies in the world, will be a crucial factor for the regional economy. It will also be a crucial factor in the national and global environment, including great potential for inward investment if world atmospheric quality targets are to be met...

Oil and gas imports, especially from the balancing sources in the Middle East Gulf region, will increase and maintain the dominant role that Asia/Pacific currently holds over this trade route. The pricing of world oil will come to reflect this factor, especially within the region. This route, the world's largest sea trade, will have particular significance for bulk ocean shipping, dry and wet cargo. Expert attention will need to be given to the specifics of routing, handling and processing the increasing volumes required, including environmental factors, those affecting the oceans rather than the atmosphere.
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Publication:APS Review Downstream Trends
Geographic Code:00WOR
Date:Nov 2, 1998
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