Contagion Spreading (and seeds of a US dollar base?)

We have written many times (such as here, here and other posts) that the financial crisis will be landing hard in various Developing Markets, and that inflation (food, fuel, etc) and could be the catalyst in the further "great unwind" of global pressures that have been building this decade.

Our main point in the posts was to say why we remain underweight equities, and that the coming global market selloffs would ultimately take us closer to "the beginning of the end" of the global financial crisis, and subsequently a better time to buy equities -- both globally and in the U.S.

Now, signs are clearer than ever that circumstances are creating the conditions for financial crisis in some developing markets. Acute food inflation, subsequent export barriers that are making matters, worse, food rioting in a half-dozen countries, and increased political risk (for example, note India's nervousness at the Maoist election victories in Nepal) are raising matters to a head. This comes on the heels of years of currency manipulation and hypercredit in certain countries, the slowing pace of trade & financial reform, and of course the continuing U.S. credit bubble implosion.

A Bloomberg update today contains implications that we're closer to cusp of true contagion into Developing Markets. The news may signify only the early stages of a continuing destabilization to the post-2000 trends:

• Rupia Weakens With Peso as Rice Jump Spurs Inflation (Bloomberg, April 14) At the end of last year, rice was selling at $13.865 per 100 pounds, the Philippine central bank had met its inflation target for the first time since 2003 and the peso was the world's second best-performing currency.

  By April 1, rice was surging toward a record $21.60, the inflation rate had almost doubled, and the peso suffered its biggest monthly decline in seven years.

  Record prices for rice, wheat, milk and cooking oil are wreaking havoc with currencies in Southeast Asia, causing a slump in the peso and Indonesia's rupiah. Investors from Deutsche Asset Management to Fortis Investments are dumping their bondholdings on concern inflation will erode returns, putting further pressure on exchange rates. The region has come to depend on strong currencies to contain the rising cost of food and fuel imports.

  ``You can't just rely on currencies to fight inflation, as there comes a time when they have no potential to appreciate further,'' said Nicolas Schlotthauer, a money manager who helps oversee $5 billion at Deutsche Asset Management, part of Germany's largest bank, in Frankfurt. ``Everyone is so complacent about the fact that if there's inflationary pressure, they will let their currencies appreciate. No one thought of potential currency weakness.''

  Currency Reversal

  The Philippine peso tumbled 3.2 percent in March, the most since June 2001. It fell 0.4 percent to 41.750 by the close of trading in Manila, according to data from the Bankers Association of the Philippines. That's a reversal for a currency that gained 9 percent in the fourth quarter, second only to the Armenian dram. In Indonesia, the central bank probably bought more than $2 billion of rupiah, limiting its decline since March 1 to 1.1 percent, according to Oversea-Chinese Banking Corp., Singapore's third-biggest bank. The rupiah slid 0.3 percent to 9,200 per dollar in Jakarta by 5:30 p.m. local time.

  International investors cut their holdings of Indonesian government bonds 3.2 percent in March to 80.7 trillion rupiah ($8.8 billion), according to finance ministry data. Foreign funds sold a net $154 million of stocks in the Philippines this year, helping drive the Philippine Stock Exchange Index down 19.5 percent.

  Deutsche Asset sold all its rupiah debt earlier this year and didn't buy peso bonds because of inflation, Schlotthauer said. Fortis Investments, a unit of Belgium's biggest financial group, expects the rupiah will weaken 3.2 percent to 9,500 per dollar within three months. The firm is ``short'' the rupiah, meaning it is betting the currency will depreciate.

  `Bearish on Indonesia'

  ``I'm really bearish on Indonesia,'' said Didier Lambert, a London-based money manager who helps oversee $4 billion in emerging-market debt at Fortis. ``You will see investor outflows that should weaken the currency.''

  The last time Indonesia's rupiah depreciated due to rising commodity costs was in August 2005, when a jump in global oil prices increased the cost of a state fuel-subsidy program. The rupiah slumped to a four-year low of 10,875.

  ``Subsidies can be very disruptive and expensive for a government to maintain,'' billionaire investor George Soros said in a teleconference from Washington on April 9. Rising food prices may cause ``social and political disruptions,'' he said.

  Emergency Meeting

  The Philippines is urging China, Japan, India and other Asian nations to convene an emergency meeting this month or next on the region's food crisis, Agriculture Secretary Arthur Yap said today. International Monetary Fund Managing Director Dominique Strauss-Kahn said April 12 that ``hundreds of thousands'' worldwide may starve as food costs jump.

  Philippine President Gloria Arroyo said on April 1 she may abandon plans to balance the budget. Two days later, Indonesia widened its 2008 deficit target to 2.1 percent of gross domestic product from an earlier 1.7 percent.

  Food accounts for 49 percent of the consumer price index in the Philippines, the world's biggest importer of rice, and 38 percent in Indonesia, according to Mirza Baig, an economist at Deutsche Bank AG in Singapore. In the U.S., it's 14 percent.

  Indonesian inflation surged to an 18-month high of 8.2 percent in March, breaching Bank Indonesia's target of 6.5 percent. It reached a 20-month high of 6.4 percent in the Philippines, above Bangko Sentral ng Pilipinas's 5 percent target.

  Asian central banks may be able to curb inflation by raising interest rates and seeking stronger currencies because of ``robust'' growth, the Washington-based IMF said on April 9. Excluding Japan, Asia will grow 7.5 percent in 2008, compared with 9.1 percent in 2007.