• Financial Times article on Chinese Sovereign Wealth Funds: SAFE and CIC. A quote”

“The State Administration of Foreign Exchange (SAFE) is both competing with CIC for investments and complicating the sovereign fund’s attempts to defuse criticism of the way it operates and makes investment decisions.

SAFE, which is under the central bank, has long conservatively managed China’s rapidly swelling foreign reserves, which stood at about $1,650bn (€1,050bn, £828bn) at the end of February.

For a long time, that meant investing largely in US Treasuries. Even now, about 70 per cent of its assets are in dollar bonds, say bankers.

But in recent months, SAFE has emerged as a powerful and more aggressive investor, chasing the kind of returns offshore that CIC was mandated to go after.

SAFE has built up a 1.6 per cent stake in the French oil firm, Total, worth about €1.8bn ($2.8bn, £1.4bn), the Financial Times revealed this week. It has bought stakes in Australian banks and considered investing in private equity funds.

Bankers familiar with its operations believe that it is also considering investing in international real estate.”

• FT article on soaring rise prices, by 50% in the last two weeks. A quote:

“The increase also risks stoking further inflation in emerging countries, which have been suffering the impact of record oil prices and the rise in price of other agricultural commodities – including wheat, maize and vegetable oil – in the last year.

Kamal Nath, India’s trade minister, said the government would crack down on hoarding of essential commodities to keep a lid on food prices. “We will not hesitate to take the strongest possible measures, including using some of the legal provisions that we have against hoarding,’’ he said on Friday.”

The chart with rice futures is below:

There is a nice article in The Economist about history lessons regarding crises. A quote:

“In today’s unholy tangle of short-term funding and long-term derivatives contracts, more banks may well fall into the liquidity traps that snared Bear and Britain’s Northern Rock. If so, central banks may find they have to go further than ever and provide a floor for asset prices in illiquid markets. Since banks are unwilling to trade in mortgage assets, because they do not have the capital or cannot risk marking losses to market, there may be an opportunity for governments to buy assets at big discounts. Judicious intervention could in principle improve liquidity, bolster confidence and may in the end even make money for taxpayers if asset prices recover. But supporting badly run investment banks should also come with strings attached: regulatory control to reduce the chance that public support will be needed again.”

Newspapers are filled with the crisis scenarios, Soros presented his view while in Austria, that recent turmoil may have more serious consequences for the global economy than any other turbulence after the Second World War.

Maybe those Mr Dooms are right, and global economy will experience a period of major slowdown after twenty years of “Great Moderation”. But do notice that:

• while markets are crashing in the West, companies in the East (China) are raising USD22bn and 4bn respectively to embark on global acquisitions trip
• monetary policy is better than it has ever been in the after-war period, it is run by incredibly bright minds who do understand the importance of expectations for future inflation and growth
• globalization made world economy very resilient to shocks. When hard times come companies have much more possibilities to change their business processes than before. Again in the face of rising costs I expect the next big wave of offshoring (Asia, CEE and possibly Latin America may become big winners in this process in the long run)
• Greenspan put was replaced by SWF bid

This list could be much longer. I think that this “crisis” should be seen in relative terms. It was caused by inter-temporal strategic blindness of John Smith times 300 million, who wanted a bigger house and did not understand the importance of saving for retirement. In the long run it will cause a major drop in valuation of US assets RELATIVE to Asian and EM assets (just wait and see China market cap chasing US market cap in the coming years). It will be extremely interesting to see what is the “quality” in the possibly upcoming “flight to quality”.

In short, the next few quarters may be extremely volatile. But I do expect a fairly robust recovery in the late 2008. I also expect that Asia will play a much more important role in this recovery that it did in the past.

Large western financial institutions which suffered huge losses in the subprime markets have been able to raise additional capital by attracting investors from Singapore and Middle East. FT article describes transaction between UBS, Government of Singapore Investment Corporation (which is a state owned Sovereign Wealth Fund)  and unnamed Arab investor. Few weeks earlier a similar transaction was executed to recapitalize Citigroup (Abu Dabi 7.5bn dollars), who also suffered large losses in the subprime market.

I have been arguing for some time on this blog that in the era of lack of confidence and depressed asset prices it should not be the job of developed countries central banks to restore confidence, as it may lead to large moral hazard and excessive risk taking. Emerging markets central banks and sovereign wealth funds are in a much better position to play that role, as they may step in, buy distressed assets, support the market and make lots of money at the same time. It does appear that the Greenspan put era is gradually replaced with SWFs bid times.

This is also likely to be much more effective. Economists are worried that banks’ balance sheet trimming may ignite recession. It is better to raise new capital than to prevent financial markets -induced recession by providing put option. Every time Greenspan put option is exercised, the next “transaction” notional value will likely be an order of magnitude bigger.

In the 20th century crisis taxpayers paid the cost of the crisis in a form of inflation tax or  direct fiscal burden. In the 21st century the “cost” of a crisis seems to be the transfer of wealth from short-term oriented, liquidity constrained institutions in the North and West to long-term focused and liquidity abundant financiers from the South and East. In old times British Empire merchants traded tea for opium with China and silver was the currency. In 21st century we trade “greed” for liquidity, and the currency is power and control. It is the intangible century indeed.

FT article summary is below:

UBS on Monday became the second big investment bank in a fortnight to be bailed out by a sovereign wealth fund when it announced a SFr19.4bn ($17.2bn) recapitalisation plan after revealing another $10bn of losses on subprime mortgage securities.

UBS was forced to turn to the Government of Singapore Investment Corporation (GIC) and an unnamed investor from the Middle East for funds to shore up its balance sheet after the fresh losses emerged.

Where is the next skeleton in the cupboard? This question is often asked by investors these days. There is no doubt that very low interest rates on US T-bills price in a lot of skeletons. I read many research notes in the last few days. In general people do not agree whether we see liquidity problem or solvency problem, or both. Or maybe it is about trust, trust about ratings, about balance sheets properly reflecting off-balance sheet items, such as implicit exposure of banks to their SIVs. There is also no agreement about who will pay the bill, will regulators face losses on accepted collateral and taxpayers will foot the bill, or will those who took the excessive risk assume the responsibility for their actions and pay the bill. Because typically they made a lot of money before, they have deep enough pockets to face the excessive risk taking consequences.

Among many research notes I found a very informative piece by the Institutional Risk Analyst about leverage in reverse, worth reading.

While the focus is on very transparent actions by central banks in developed world, I think that responsibility for securing orderly functioning financial markets is also in the hands of emerging markets’ central banks and SWFs, seating on 7 trillion plus assets, often invested in a very conservative way. At times when private sector appetite for risk fades, they could step in, stabilize the markets and make a lot of money at the same time buying cheap assets that will appreciate in value when liquidity comes back. This would not be perceived as a moral hazard as they will act in their own interest, to make more money for their countries (see my paper on why it matters a lot).

As usual Brad Setser blog offers an excellent overview on the topic, see his post on reverse financial engineering. He is quite right that in many markets price discovery process ceased to exist, and as long as this is the case valuation of many portfolios will be an academic exercise, far away from reality. My suggestion above becomes even more valid.

In the last few days every major newspaper had a cover page story on global credit crunch, on funds suspending withdrawals, on funds reporting major losses (20-30 percent or more). There are many stories suggesting that a global crisis may lie ahead and that global economy will experience a recession.

It is important to understand what is going on, and the story seems very simple. Some funds, banks and other institutions suffered heavy losses, so unhappy investors want their remaining back. But we all know that liquidity is a coward it runs away on the first sign of a trouble. Because investors expect prices to decline further they do not want to buy, so those who face redemptions and cannot sell amid no bids have to borrow to remain liquid or have to suspend redemptions. In the absence of new credit more and more institutions will be unable to meet client withdrawal demands, eventually they will be forced to sell at any price and major asset price collapse and recession will follow.

This scenario may lie ahead, but there are two ways to prevent it from happening. Firstly, and this is already happening, major central banks inject liquidity into the world financial system, so funds do not have to continue selling their assets. Secondly, and here we have no knowledge amid lack of transparency, the Sovereign Wealth Funds and the world central banks which are largest reserve holders may start buying now much cheaper assets to stabilize market situation. Under the assumption of markets returning to normal functioning, current spread levels may seem attractive enough for those institutions to step in, buy cheaply, stabilize situation and make large profits at the same time.

This is an unprecedented situation, unseen in the 20th century. The global stability lies in the hands of central banks in the developed world which are supplying liquidity (old story), AND in the hands of central banks and SWFs from the emerging world, which may be providing bids at times when private sector is unwilling to do it.

If both channels are operating now, the markets will calm, sooner or later. But in such case the result could be the biggest ever moral hazard in financial markets, the global one. According to some commentators the Greenspan put (Fed willingness to bail out troubled US financial institutions) is one of the factors behind the current turmoil. It is easy to imagine the future investors behavior if the global bail out takes place. So any action should carefully balance short-term stability goal with a long-term one.

We live in a truly global world. I am siting in a cosy motel in lovely Polish mountains (as always, great food, great atmosphere, nice weather, beautiful views), dressed in pants bought on a Russian market in Phnom Pehn, Cambodia and jumper bought few years earlier in San Francisco, from Indian shop and I am checking eamails and RSSes from all over the world. One just came from Emerging Markets newswire, on China. Some truly interesting notes. See below: