When the pie shrinks, people are less likely to share. It was clear back in early 2011 that with successive rounds or quantitative easing and debt monetization rotating through the world’s central banks, that eventually a trade war would develop. With the consumer demoralized, businesses cautious and governments broke, exports would be the last desperate hope for many countries seeking to grow their way out of voluntary and involuntary austerity. And so country after country, both net creditor and net debtor began to print money in an effort to either monetize a debt pile grown too big or to improve their terms of trade or both. Equal success in the former and equal failure in the latter has brought the phoney war to the surface. Japan’s once and new prime minister was firs to break the deadlock, sending the JPY into a downward spiral that today worries her trading partners but which tomorrow may worry the Japanese themselves as unforeseen consequences and diminishing returns to policy set in.

The phoney currency war has seen the build up of war chests in the form of bloated monetary bases and banking system balance sheets this far finely balanced country against country.  What happens when someone blinks? FX risk is no longer captured in option implied volatilities;’those measures are for normal and free markets. The risk of sudden and sharp, discontinuous moves in FX rates is heightened. This poses economic, political and hyperinflation risk.

While QE is by itself inflationary, it isn’t directly hyper inflationary, nor are the sources and ultimate manifestations of inflation or hyperinflation immediately clear. In a globalized world with open capital accounts, QE in weaker developed countries creates inflation in economically more robust emerging markets. Hyperinflation, however, is always a consequence of a crisis of confidence. Continuous FX markets are unlikely to cause hyperinflation. A discontinuity in FX markets could be a sufficient trigger for such a crisis of confidence.

In a trade war, the terms of trade are but one front. The cheapness of one’s goods and services are but one dimension. The other one is the quality and desirability of one’s goods and services. The ability to provide such desirable goods and service depends on the ability to innovate. Innovation and intellectual property will be the next front. Here, countries like the US, Japan and Europe have the advantage. China has seen some of the fastest growth rates in international patents sought, yet it’s share of the global total is only 9%. The US has seen growth slow over the crisis years is seeing a rebound and still accounts for over 26% of the total. Japan is second with a share of 21% and rapid growth. While Chinese companies are among the most prolific, their ability to commercialize their inventions has been less effective. Similarly, while Japan is number 2 by number and growth of number of patents filed, their ability to commercialize their intellectual property has been less impressive. What makes the US stand out is its ability not only to invent but to market and build a brand. Apple Inc was outside the top 50 companies ranked by number of patents filed yet their innovations are front and centre in consumer electronics.

As emerging market manufacturing costs and transport costs rise, developed world companies are repatriating manufacturing. This has been especially so for US companies. This theme favors the owners and generators of intellectual property over their erstwhile outsourced producers, the so-called OEM manufacturers.

Brands are another important element in trade wars. They serve as a signal of quality and desirability. Brands are valuable and take time and investment to establish. The value of brands can be seen in the premium pricing that their goods command and in the efforts to emulate or counterfeit their products. Whereas counterfeiting can often hurt sales, the power of some brands is sufficient that counterfeiting has low substitution effects. In other words the buyer of the counterfeit good could not afford the original article and would purchase the original when they can afford it. The counterfeit is therefore not a substitute for the original.

Western countries’ companies are overwhelmingly the owners of intellectual property and brands which places them well in the current brewing trade wars. While consensus economic forecasts are favorable for emerging markets like China, Asia, Latin America and the frontier markets, the nature of the growth and the trade expressions for capturing this growth through investing are not obvious or simple. China’s growth expectations are based on the growing importance of consumption and the middle class. This creates a value chain that includes both domestic as well as international companies. The relative distribution of commercial benefit, of revenues and margins will vary along this chain. A simplistic macroeconomic trade expression may miss the point. A careful analysis of who is buying what, where lies the bargaining power and thus margins, and tracking of cash flows from the ultimate buyer to the ultimate manufacturer and their suppliers and counterparties is necessary to identify who within this chain or web of supply, manufacturing and distribution profits most, and should be invested in.

In November 2011 I counseled caution on the Chinese economy, expecting a serious slowdown in growth. At the same time, I was concerned about the poorly policed financial system, a concern which has not gone away, despite the recovery in other parts of the Chinese economy. While the Chinese economy has recovered, it remains at risk from a fragile financial system and excessive credit creation.

A cursory survey of the physical infrastructure growth in China, simply by visiting cities and traversing rail and road, leads one to suspect that the scale of pace of such growth and investment cannot possibly be sustained from current income but must be financed out of credit. This is almost trivially true. A cursory survey does not, however, give us an idea of the extent of credit creation. One data point is total social financing which topped 15 trillion RMB in 2012.

The volume and pace of credit creation is not the only area of concern. Of equal importance is the structure of credit in the economy. Bank’s share of total lending has been steadily falling, as credit creation has been transferred to the bond market and the shadow banking system. This is not a bad thing, in fact, properly done, it is a good thing. However, we already see the weakness of the LGFV’s which are often poorly structured, are supported by local governments with weak cash flows, and backstopped by banks using dodgy accounting. Trust companies are another conduit whereby dodgy assets are financed by the issue of liabilities to retail investors in search of yield and who try to escape the financial repression of artificially low deposit rates. The last mile in the credit distribution system are wealth management products offered by banks and asset management companies. Retail investors are unwilling to lock up capital and wealth management products are thus structured with appropriately short maturities quite inappropriate to the duration of the assets they finance. The documentation of wealth management products and the disclosures are often sufficiently light that misselling and misrepresentation risks are high. Basically, a large proportion of assets in China are financed through structures that resemble SIVs complete with asset liability mismatches and poor asset quality, weak credit underwriting and dodgy selling practices.  

Adding to the complexity of the picture is the proliferation of credit guarantees, basically, credit default swaps with very loose margin and collateral management practices. The Chinese credit guarantee is ubiquitous for SME’s as banks tend to prefer to lend to larger firms or SOEs. Independent businesses seeking credit are forced to rely on credit guarantees.

China’s credit system is weak not for any reason other than that it has grown too quickly, and hasn’t learnt the lessons that the developed world learnt in 2008 when SIVs and CDOs blew up, CDS markets dried up and counterparty risk rose on the back of paranoia. This is a pity. The developed world behaved irresponsibly leading up to 2008 when financial innovation led prudence, but there were few examples to warn them. China, however, has copied the excesses and bad practices despite having Western history as a guide.

A Chinese Debt Obligation:

Source BoAML.

Until a week ago it was possible to buy a car in Singapore with a 10% down payment and a 10 year loan. Cars are acutely expensive a shortage of land (Singapore is a tiny island at the foot of Malaysia) has necessitated the rationing of cars through a quota system. The rationing requires car buyers to first buy a 10 year right to operate a car called a certificate of entitlement or COE. COEs are auctioned monthly with supply based on the number of cars being de-registered that month plus an acceptable growth rate. This idiosyncratic system has led to wild swings in COE prices, mostly to the upside, resulting in Singapore having the most expensive cars in the world. As an example, an Audi A6 in Singapore would cost the same as a Ferrari 458 Italia in London.

Not many people would be able to afford cars in Singapore were it not for the easy credit provided by banks. Which brings us to a rather simple question: why would anyone extend a loan, secured against a depreciating asset which almost guarantees that loan-to-values would rise from 90% at purchase to 105% overnight and to 120% in a year? Banks have to assume that car and COE prices would rise continually to defend their lending practices.

A week ago, the government stepped in to legislate that car buyers would have to put up 50% of the cost in cash and that loans should not exceed 5 years. At last someone was thinking rationally. One can only wonder who invented the 10 year car loan with 10% downpayment, for surely it is simply irresponsible lending behavior. It is an example of why regulators are necessary and why perhaps it is time to reconsider the limited liability concept, for who in his right mind would lend his own money this carelessly?

Singapore’s property market has surged since 2008 when it had previously halved from the highs of 2007. Low interest rates, easy credit and an influx of foreigners and foreign capital have propelled housing prices in the past 4 years. Money printing in desperate developed markets have also overflowed into capital attractors like Singapore fueling general inflation as well as asset prices. The state defined contribution scheme, the Central Provident Fund, is the largest creditor to the Singapore government and is the largest buyer of its bonds. This systematic deployment of the compulsory contributions of Singaporean workers is also a de facto form of quantitative easing which has probably fueled inflation to some extent. Singaporeans concerned about the credit worthiness of the CPF are also encouraged to buy property, depleting their CPF funds to reduce their credit exposure to the CPF. This adds to real estate demand on the tiny island state.

How stable is the property market and the economy? Most mortgages are floating rate mortgages or adjustable rate features, otherwise known in the US as ARMs. This makes the market especially vulnerable to rising interest rates.

Moreover, an over-dependence on foreigners in the economy creates a leveraged effect since a slowdown in the economy may well trigger an exit of work permit holders and to a lesser extent, permanent residents. By managing Singapore on purely commercial terms, the government has not fostered loyalty and stickiness among citizens. A case in point was the exodus of internationally mobile talent in the early 2000s when Singapore struggled with a weak economy. At that time senior members or government lamented the quitters and lauded the stayers. It can happen again.

It makes sense to have contingency plans in case of a property bust whether triggered by higher rates or weaker growth and resultant emigration.

A property bust is likely to also see debt service problems. A systematic program for the refinancing of positive equity properties is necessary. A nation wide scheme for standardized loan modification will avoid delays and uncertainty which would only create collateral damage and drawing out the price discovery and recovery process.

Where property owners face negative equity, there should be a scheme of forbearance under which home owners may sell their properties to a state sponsored special purpose vehicle, at market rates, while lenders will take a partial hit. The homeowner would crystallize a loss but face no further recourse. The state would put up the financing to purchase inventory and lease the same back to occupiers at controlled rates of rent. Homeowners would be given a free option to buy back their properties at the same price they sold into the scheme. Such options may be tradable subject to constraints, and certainly may be bequeathed to offspring.

These are merely initial ideas for a scheme which would address uncertainty and hopefully help avoid a disorderly market should the unthinkable happen.

The ideal pension would be a defined benefit scheme whereby workers would be required to contribute a minimum portion of their earnings into a pension scheme. The assets of this pension scheme would be held in custody on behalf of the worker.

Pension income would be subject to tax at preferential rates reflecting the credit and investment risk the individual assumed. Under no circumstances would the pension custodian or manager have discretion into the investment of the workers’ funds. All assets will by default be placed on fiduciary deposit with the relevant central banks in their respective currencies. The pension scheme would require banking licenses with the major central banks. Thus USD will be held in a fiduciary deposit with the US Fed, GBP with the Bank of England, Euro with the ECB etc etc. Workers may self manage their investments within limits, choosing from a set of approved investments, which have been pre screened and on which due diligence has been performed. A small fee, being the cost of professional due diligence may apply, such cost to be minimize through scale. Under no circumstances will the pension scheme be obliged to fund the country’s national debt. The assets of the worker must be segregated from the balance sheet or the pension administrator and custodian. In the event of bankruptcy of the pension administrator, trustee or custodian, or indeed the state, the assets of workers shall be protected by way of a legal segregation of assets in the individual names of the relevant workers.

The above structure is but one way in which workers’ pensions can be protected from the direct, indirect or de facto expropriation by their governments.

Any so-called defined contribution pension scheme without adequate protections from financial oppression and expropriation by government should be classified a tax. Individuals should account for such pensions schemes in their own balance sheets accordingly for planning purposes.

The advantage of the above structure also is that it avoids underfunded pension liabilities since the assets and liabilities are always in balance to contributions, withdrawals and equity and gains or losses. The major loser in such a structure are governments who rely on cheap financing from captive pension funds who have not the ability to choose freely what to invest in.

Any mature economy also requires some sort of social security and medical insurance. This should be funded separately from the pension which is purely for funding retirement liabilities. A social security and medical insurance fund should be funded out of tax and based on collective benefit model to provide basic unemployment benefits, retirement income and medical care. The level of benefit should be kept to a bare minimum. Additional expenses beyond the most basic level of care can be funded out of the defined contribution pension scheme.

The administration, custody and stewardship of this social security and medical insurance fund should be independently managed, outsourced to arms length professional fund managers, and where there are potential conflicts of interest such as where the fund may seek to invest in government securities, a higher standard of corporate governance and due diligence is necessary to ensure that there is no indirect or de facto expropriation of funds by government. The assets of such a fund should also be held in safe custody apart from any government or private commercial construct’s balance sheet.