Allocation and Africa -- II

We continue to think "Frontier Markets" -- and African markets particularly -- will rise toward the status of an asset class for many investors. This stems from (1) low portfolio-correlation of many African stock markets owing to highly country-specific developments, and (2) the world's race for resources that is increasingly investing in African nations. We highlighted these trends here and primarily here.

A Bloomberg article today highlights the additional drive toward #2, investment in Africa. (It's also suggested in the article that China's model of investment, which does not concern itself with human rights, may still do more good than harm. It this standard continues to be adopted, it could clear-away a major hurdle to African economic that was not possible when America's liberal values predominated in previous decades.)

From Bloomberg: (China Fund May Pledge $1 Billion in African Investment in '08)

• A Chinese fund set up to encourage investment in Africa may commit to spend $1 billion by the end of the year, Liliang Teng, president of the China-Africa Development Fund said today.

  The fund is in discussions with Chinese companies on projects to improve energy infrastructure in South Africa, Mozambique, Zimbabwe and eastern Africa, Teng said in interview at a business forum in Tanzania's northern city of Arusha.

  ``Besides energy and power plants we will also focus on infrastructure, like rail, roads and airports as well as other areas, including agriculture and manufacturing,'' he said.

  The China-Africa Development Fund, announced by Chinese President Hu Jintao in November 2006, will grow to $5 billion and may become bigger depending on its initial results, said Teng. Financed by the China Development Bank, it approved the first investments with four Chinese companies totaling $90 million on Jan. 15, according to a press release on its Web site.

  Sino-Steel Group, the China Building Material Co., Shenzhen Energy Group Co., and the CGC Overseas Construction Ltd. will use the money to develop electricity, construction, and mining projects in Africa, the statement said, without elaborating.

  China's trade with African nations will rise to $100 billion by 2010 from $73 billion last year and $2 billion in 1999, Khalid Malik, the United Nations resident coordinator in China, said at the opening of the China Africa Business Forum in Arusha today. The two-day summit is bringing together 300 trade officials and businesspeople.

  Critics say China's push into Africa for oil and raw materials to feed its growing economy in some cases disregards environmental laws, labor standards and human rights.

  Economist Jeffrey Sachs, the UN's special envoy on the Millennium Development Goals, said the positive impact of Chinese investment and skills transfer to Africa far outweigh the negatives.

  ``What is being promoted is a great increase in business development,'' Sachs said in a taped address.

  To contact the reporter on this story: Sarah McGregor in Dar es Salaam via Johannesburg at 1933 or abolleurs@bloomberg.net

Underlying Risks to China (and its Trading Partners) Still Growing

We've been arguing that (1) the Developing Markets' "inflation beast keeps growling" (click and scroll down) due to structural problems such as oil prices and governments' trade and regulatory policies, (2) Chinese equities' still have an adverse risk/reward ratio, and that (3) we probably won't go overweight equities until we see contagion from the U.S. & European financial crisis result in real crisis in some of the Developing Markets (noted throughout this section).

A post from Michael Pettis in "China Financial Markets" supports our overall caution quite strongly. He continues to see the Chinese yuan on a freight train higher (which will increasingly destabilize global inflation, trade, and demand trends) -- and he sees decreasing chances of anyone stopping it. The consequence of a painful revaluation of the yuan would be another major "leg" to the global financial/economic contagion:

• Speaking about exports, I am increasingly concerned that the trade surplus in China is actually beginning to decline, and much faster than people think. My reasoning is simple and completely intuitive – i.e. there is not a shred of hard evidence to back it up – but I nonetheless think it highly plausible. I contributed the following (somewhat edited) comment to today’s discussion on Chinese reserves on Brad Setser’s blog (http://www.rgemonitor.com/blog/setser):
  

• “Given the rapid increase in various proxies for hot money inflow, it is probably pretty safe to assume that hot money disguised as FDI [foreign direct investment] and/or trade is also growing quickly. Certainly the nearly 70% growth in FDI during the first quarter suggests that there has been an increase in speculative inflows disguised as FDI. After all there was no very good fundamental reason for this growth – in fact it is not hard to argue that FDI in China is less, not more attractive today than in the past few years. If this is true and a big chunk of FDI is simply hot money, it is probably also plausible to argue that hot money disguised as trade has also increased significantly.”
  

• “From that it follows that export growth and the trade surplus have probably declined much faster than the small decline in headline numbers suggest. If true, this complicates matters. Thanks to deteriorating global conditions China may actually already be running a narrow trade surplus or even a small trade deficit, which could make the authorities all the more afraid of a maxi-revaluation [a deliberate, sharp strengthening of the Chinese currency, to ward of speculation/"hot money" that it will continue to rise], and yet for the reasons we have been discussing over the past fifteen months the maxi-revaluation is probably inevitable because of the crazy monetary consequences of hot money inflow. The cost of a maxi-revaluation may be rising even as the cost of steady appreciation is. The longer they wait the worse the options become.”
  

• In other words, if we are starting to see Chinese monetary growth powered exclusively by hot money inflows, instead of by the trade surplus as it was in the past, we are entering into a far more volatile stage of the game, where the consequence of a policy misjudgment may be higher than it has been in the past because the outcome is likely to be much more heavily determined by very volatile and hard-to-control and hard-to-judge hot money flows. The risk associated with an adjustment is rising, in other words, even as the cost of not adjusting is too. I worry that another quarter or two of $200 billion plus increases in reserves is going to make the adjustment process for China much more difficult. It is increasingly important that the recession in Europe and the US be as brief as possible if China is going to have room to adjust. If we see additional weakness in the global environment, I think China’s room for maneuvering declines substantially.
  
  

Long Run U.S. Outlook Not Much Improved

It's been a long time (in blog terms) since we've argued for a strategic underweight of U.S. versus non-U.S. assets, but our view remains. America's serial indebtedness, its multi-trillion dollar war in Iraq, its narrowing borders to foreigners relative to its size, its stagnant state of public education, and its increasingly polarizing political tones are the main drivers. In our view, these major negatives slightly counter-balance America's tremendous entrepreneurial power (innovation and access to capital), its information intensity, and its economic diversity.

One of our favorite conduits, NakedCapitalism.com, has just produced a bevy of citations that make us increasingly concerned about the financial risks facing America. A few of the citations:

• An academic paper reviewing several hundred years of world history repeatedly found waves of sovereign debt criss hitting nations that (1) had received very large capital inflows to support very large indebtedness, and (2) existed in a global context of financial liberalization.
• A list of luminaries predicting worse-to-come as result of household and government debt.
• The risks and downsides of a currency losing its reserve status -- "Debasing the Dollar Will Accelerate America's Decline."

It seems that the blog's author, having correctly predicted (repeatedly) a severe financial crisis such as we experienced since late-'07, has now turned his guns on the longer-term fallout from the underlying problems that contributed to the near-term crisis.

There is a best course: America can reign in spending, and can save its way out of its debt. But the cost will be slower economic growth and higher taxes for years. We'd need to see strong evidence that it's happening before giving the nation credit for it, so to speak.

In the next five years, we think more funds (which have led the way already), financial planners, and self-proclaimed investment gurus will cite "world equity" as the core long-term asset allocation, rather than U.S. equities. Of course this shift has already begun to occur, but it has a lot further to go. We think we're still on the early side of the multi-decade "trade."

Another aspect of this "trade" will be the continued outperformance of well-run U.S. companies with superior international growth trajectories.

Chinese Inflation Will Scare Investors More, Then Temper Demand

China's artificially low currency and domestic price control program is one of the world's largest "imbalances." (Of course, it goes hand-in-glove with excessive American credit and borrowing.) Now the world is waking up to those imbalances more than ever, which means securities market volatility remain high while the resolution is pending but uncertain.

Specifically, we see increasing risk of more acute Chinese inflation fear in newspaper headlines, and subsequently some demand moderation in China as the normal function of higher prices finally kicks in. This outlook contributes to our (1) unwillingness to fully re-balance our underweight equities allocation until we see more evidence of "crisis" on some Developing Markets, and (2) unwillingness to go overweight energy now, believing that they're becoming more vulnerable to the global slowdown that's unfolding.

To elaborate, we'll offer a few snippets from Professor Michael Pettis' blog in the past two days. Shortages as a result of price controls are becoming more acute, such that prices will have to rise, which should ultimately lead to a "demand response." This process has been taking far too long, but it may accelerate. From Pettis' post today:

• I had lunch with a senior banker from a major Chinese bank today. He is based in Shenzhen, across the border from Hong Kong in the southern province of Guangdong. Among other things he told me that lines at gasoline stations are getting terrible, in part because a lot of Hong Kong residents drive to the mainland to fill their gas tanks. Gasoline on the mainland is at less than the half global price, so this isn’t much of a surprise. He also told me that he thinks actual inflation is higher than the headline CPI number. That isn’t a big surprise either, I guess.

  Finally we discussed concerns about a coal shortage, and I read in today’s Xinhua a confirming article that claims that coal reserves have fallen to a 12-day supply, which I think I understand from the Xinhua article is a record low level, even less than March’s already-worrisome 15-day supply. The combination of low coal reserves and gasoline shortages means, I think, that it is going to be hard to keep a lid on energy prices. I wouldn’t be surprised to see energy prices, which are controlled in China, rise in the next few weeks, even amid all the worry about spreading inflation.

And from yesterday's post:

• I noted two other interesting pieces today. Xinhua reports that the authorities are announcing new measures to crack down on “profiteers.” They say:

  China’s oil regulators are ready to launch a nationwide crackdown on wholesalers who sell to illegal filling stations and dealers in the wake of supply shortages…

  …Illegal dealers and filling stations are believed to have aggravated the situation by hoarding oil and jacking up prices to drivers wanting to avoid the long queues at licensed stations.

  Aside from the obvious point that shortages are a common consequence of price controls, it is clear that an inflation purist would insist that the long queues, from which people are willing to pay money to escape, are a form of reduction in the quality of good or service that is as much a component of inflation as higher prices, and so headline inflation is being disguised as waiting time. Real inflation is higher than the official numbers, and Chinese motorists are paying this higher cost, but it is not showing up correctly in CPI.

China Equities -49% From Peak, But Still Adverse Risk/Reward

We continue to wait for the financial crisis to hit some of the Developing Markets before we'll be more comfortable fully rebalancing our somewhat underweight equity allocations. We see a crisis-of-confidence in some Developing Markets as just one of the signposts that it's safer to raise weightings significantly, but an important signpost.

We see China as the bellweather for our call, and we still see the risks somewhat outweighing reward for a 1-2 year time horizon. One the one hand, its economic dynamism continues in many regards, and its equity market has gotten a lot cheaper, nearly cut in half since its peak, and with P/Es in the low-20s for example. On the other hand, we worry about the effects of China's artificially weak currency, its inflation problem, its opaque financial statements, its immature banking system, its real estate bubble, and so on.

An insightful post by professor Michael Pettis at Peking University adds to our view that the economic slowdown that is spreading around the world could treat the Developing Markets more harshly than is generally believed. First, he details the spike in "hot money" flows to China, which will make it more difficult for China to keep its currency weak and its export machine well lubricated.

Second, Pettis describes why he thinks Chinese companies' financial conditions have deteriorated, perhaps more than the much-reduced equity markets discount. It gets to the heart of our reason for slowly raising our Developing Market weightings specifically, and equity weightings generally, following the selloff since the peak in '07:

• In [the 4/19 edition of the South China Morning Post, reporter Shirley Yam] wonders about the much-repeated claim among many of the mainland’s larger firms that “profits and profit margins have dropped because of raw material and fuel cost increases.”

  Displaying a journalist’s cynicism she decides to look at a number of companies to check to see if their margin declines have really been caused by commodity price increases or other factors over which managers have no control. “Is this the sole reason, or just a convenient excuse for inefficient management to pass the buck?” she asks. As she explains in her article,

  This is an increasingly relevant question given the global business environment has turned from deflationary to inflationary where raising costs is the norm. I read through the 2007 annual reports of 10 major state-owned enterprises. The results were disappointing.

  It turns out that the companies she examines have all seen distribution expenses, administrative costs and staff expenses shoot up much faster than revenues – two to eight times as fast. Rather than enjoy economies of scale they seem to be suffering massive diseconomies of scale.

  This kind of thing worries me not because I care about the how managers choose to spend and/or waste money. It worries me because boom times like the one we have enjoyed in China since 2003 often lead to rigidities and excesses in corporate activity and balance sheets that make it very difficult for them to survive sharp turndowns, and this is precisely one very common such type of rigidity.

  Corporate costs can grow much more rapidly than revenues while still allowing the company to show significant increases in net profits as long as revenues are surging, as they have been for Chinese companies in recent years. In case however of a slowdown and a decline in revenues, or at least a sharp reduction in revenue growth, it can take a long time for management to get rising costs under control. The result can be a collapse in cashflow, profitability, and perhaps creditworthiness.

  This is likely both to increase the risk of a sharp, adverse financial adjustment (as companies ability to withstand a downturn is seriously weakened) and to increase the adjustment cost if such a downturn takes place (deteriorating creditworthiness immediately increases financial distress costs and causes corporates to engage in systemically adverse behavior).

  Readers of my blog might easily accuse me of always focusing on the worst case scenario and always looking for problems. Perhaps that is because as a former bond trader I tend naturally to pessimism – after all bond prices tend to have limited upside and nearly unlimited downside, so it pays to worry about the downside more than the upside. But as someone who has experienced too many financial crises and who has written extensively about the history of capital flows and financial crises, I am also pretty sure that when things go wrong nearly everything goes wrong at the same time. This is not a coincidence. It is simply the way unstable balance sheets work, and during boom times companies tend systematically to build risky balance sheets – by, among other things, letting costs get out of control.

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.

China Equity Market Not Expensive If Real Growth Slows Some

We recently increased our Developing Markets exposure slightly -- via Chinese ADRs -- given signs of the world financial system "muddling through" the crisis period. A "muddle through" is the bull case, and the more we muddle, the lower the chance of the "tail risk" of a major melt-down.

We're still underweight equities overall, and Developing Markets equities specifically, because we don't think we're at "the beginning of the end" of the financial crisis yet. (One thing we're waiting for is a Developing Market financial crisis as a sign that the global crisis has come full circle.)

Nevertheless, a bump-up in our Developing Market allocation via China has a somewhat higher reward/risk ratio than it has for a while, we think. A few helpful tidbits today in an FT Opinion article from Jake Lynch of Macquarie:

• A recent survey of Chinese A-share investors found that 70 per cent believed they were investing in a bubble, matching the perception of most foreign observers.

  The A-share market has been cited, according to a standard calculation, as trading at a price/earning ratios of 70 times. Even worse, 30 per cent of earnings are alleged to come from investment income (that is, stock trading) - in effect, a giant Ponzi [pyramid] scheme.

  Combine the above with a reputation for questionable accounting practices, as well as the threat of $1,300bn of previously non-tradable shares becoming unlocked in the next two years, and it is no wonder that the A-share market is now off about 36 per cent from its highs.

  So is this correction just the first leg of the great unwinding? Not likely.

  In fact, it is hard to find evidence of a bubble at all. Take valuations: the benchmark CSI 300 index is now trading at 23 times 2008 consensus earnings forecasts. This is not cheap, but it is far from what we think of as bubble valuations and below its 10 year average of 30 times. How did we get from a multiple of 70 to 23 with a 25 per cent share price correction? First, bearish commentators were focusing on the smaller but more expensive Shenzhen market and looking backwards 12 months. Second, earnings grew 48 per cent in 2007 and the consensus forecast is for 32 per cent earnings growth this year.

  While 32 per cent seems like an aggressive number given the global slowdown, 7 percentage points come from a one-off tax break and a 25 per cent pre-tax growth rate may be achievable with a mid-teens nominal GDP growth rate - particularly when banks, oil and commodities are the main drivers.

  And what of all that investment income (which would presumably be turning into losses about now)? In fact, the 30 per cent figure was and is misleading as "investment income" contains all operating income from joint ventures and associates. Stripping those out, we found that only 9 per cent of non-financials income was generated by some form of asset revaluation.

  How much can we trust these numbers? More than 70 per cent of the CSI 300 market cap is now audited by the Big Four accounting firms using IFRS: the risk of accounting misadventures is now no higher than other emerging markets.

  The final issue supposedly dooming the A-share market is the unlocking of the non-tradable shares and the threat that the current holders of such shares will flood the market.

  Yet a quick glance at the A shares that have been unlocked since 2006 shows that only 10 per cent were actually sold into the market In fact, more than 75 per cent of the shares being unlocked belong to the government. That they would be sold down en masse is highly unlikely. A much more likely scenario is the one that the government itself gives - that it will control the issuance of supply to continue to foster a healthily developing market.

  Indeed, the increase of share supply is critical for a sustainable market. A shares have historically traded at high valuations because China's ratio of free-float market capitalisation to both GDP and savings remains far below other emerging and developed countries.

  In other words, there is not enough "supply" of shares relative to high "demand" from savers (especially given today's negative real interest rates). Both supply of and demand for shares are likely to rise rapidly in coming years, inevitably resulting in high volatility.

  Does any of this matter for international investors? With 72 per cent of the market cap of the MSCI China already dual-listed in Hong Kong and Shanghai (and the percentages rising monthly) the answer is yes. Hong Kong investors closely watch the price movements of the listed A shares and the recent correction in the A-share market has been an important cause of the MSCI China's underperformance relative to other emerging markets.

  While the A-share market may not yet be at a bottom, it can't be characterised as a bubble that is bursting.

When Are "Food Export Barriers" Simply "Protectionism"?

Despite the cracks in Alan Greenspan's reputation because of the credit bust and regulatory negligence he fostered, it's worth focusing instead on his repeated warnings against erecting barriers to trade. He frequently stated that a resurgence in trade barriers was the one poison he feared most. Today he reiterated those sentiments to the Senate Finance Committee, and how destructive it would be reverse the wealth-generating tide of the past two decades of trade liberalization.

If the rapid spike in food export barriers (part of what's been happening in the past couple of weeks) creates an even larger contagion of protectionism, ill-feelings, and tit-for-tat among nations than it already has, global economic prospects will quickly darken and become more volatile. This article on Asia Business Newswire today points how quickly the risk of protectionism is rising.

(It is also a reminder of how owning the food commodities and commodity-linked securities may become an even more important element in an optimal diversified portfolio.)

• Sydney, Apr 4, 2008 (ABN Newswire) - Across the developing and emerging economies of the world, and in some developed economies for that matter, governments are opting to shoulder some of the burden of higher food prices or try and control their immediate direction.
  
  The efforts are likely to be fruitless and very expensive for the countries involved, consumers and taxpayers.
  
  From India to Egypt governments are slashing import tariffs on foodstuffs and curbing exports, as well as boosting subsidies: all to try and ease the impact of what will be the big story of 2008 and 2009 - the soaring cost of food.
  
  As we reported this week, an exploding price for rice is the latest cause of much government action.
  
  Egypt, India, the Philippines, Vietnam, Indonesia, Cambodia, parts of Africa, Mexico, Italy, China, Russia, Argentina: the list is growing by the day of governments who now see the rising cost of food and all the social and political problems that brings, as far more important that good governance, low debt, the US recession, subprime debt or American foreign and economic policy.
  
  Even in the developed world the impact is startling. Biofuels in Asia, Europe and the US are withering because of rising costs for corn, canola and palm oil. Food riots have happened in Mexico over the cost of tortilla flour. Italians have protested about the sharp rise in the cost of flour for pasta and bread.
  
  Farmers are being blamed in some countries, such as Argentina and parts of Europe; in the US it's causing an explosion in land values and incomes in parts of the country that have been slowly withering away.
  
  The irony won't be lost on Americans that in the midst of a recession farmers and some of the biggest companies in the US (think Cargill and Archer Midland) will be booming, some with record incomes, and much of it (like Europe) subsidised.
  
  Longer term, however, the side-effects of this largesse will be ugly. Forgoing revenues and paying subsidies hurts national budgets.
  
  India, for example, spent $US600 million on rice and wheat subsidies in 2004-05. Given the surge in rice, maize and wheat prices since then, the cost could be up by a third to a half: something approaching $US1 billion, which a country like India can ill afford, even in the midst of its boom (which is slowing anyway).
  
  In the Philippines, the rice subsidy could top the half a billion dollar mark this year, according to the Asian Development Bank, and the country is scouring Asia and the US for around 1.5 million tonnes of rice at subsidised prices because its stocks have run down.
  
  Indonesia which is thinking of banning some rice exports, like China, India, Vietnam and Egypt, may have to pay $US2.2 billion in food subsidies this year, or around 3% of spending by the national government.
  
  That's three times earlier estimates.
  
  Nearby Malaysia is looking to boost rice imports and hitting a wall because the Philippines has been mopping up as much grain as it can get.
  
  Indonesia and many other countries in Asia also subsidise energy costs and they have skyrocketed with the rise in oil prices over the past three years.
  
  Indonesia is thinking of cutting rice exports, even though it will have a surplus this year of around two million tonnes (it imported just over 1 million tonnes in 2007).
  
  Soaring food and fuel prices are driving global inflation. Consumer prices in China hit an annual rate of 8.7% in February, an 11-year high, and reached a 13-month peak in India of 6.8%.
  
  World prices for rice, wheat, soybeans and corn have all increased sharply: rice and wheat prices have doubled in the year - rice is up 30% or more in a week....
  
  The World Bank said this week it considered soaring food and fuel prices as greater challenges to East Asian governments than the financial turmoil in the United States and slowing global growth.
  
  As we said yesterday, it's a similar outlook from the Asian Development Bank.
  
  "The major risk lies not so much in softer growth but in rising commodity prices and accelerating inflation,'' the Bank said yesterday. "Appropriate macroeconomic responses to accelerating inflation are likely to include tighter monetary policy and some exchange-rate appreciation.''
  
  "Indeed, published inflation rates disguise the true extent of underlying inflation pressures due to the presence of subsidies, administrative price controls and cuts in excise taxes," it said.
  
  The subsidies used by many governments in the region to cushion the impact of soaring fuel and food prices are posing a threat to budgets and the bank said that cash handouts to the poor may be a better and cheaper option.
  
  "If governments do not rethink these expensive and inefficient subsidy programs, fiscal costs could escalate sharply and require painful adjustments (or accelerating inflation, or both) later," the ADB said.
  
  "Carefully targetted direct income support for the poor, within strict budgetary limits, might better alleviate stresses, and at much lower cost."
  
  Saudi Arabia has cut import taxes across a range of food products this week, slashing its wheat tariff from 25% to zero and reducing tariffs on poultry, dairy produce and vegetable oils.
  
  On Monday, India scrapped tariffs on edible oil and maize and banned exports of all rice except the high-value basmati variety, while Vietnam, the world's third biggest rice exporter, said it would cut rice exports by 11%.
  
  In Argentina, farmers called off a protest against attempts by the government of President Cristina Fernández to redistribute the benefits of rising commodity prices by increasing export taxes on soybeans and other crops.....
  
  

Allocation and Africa

At this rate, it won't be long before many more investors are breaking out "Africa" (even excluding South Africa) as a region unto itself in their asset allocations, rather than lumping it with Middle East, Developing Europe and other regions.

Tens of billions of dollars of investment (in many forms) have poured into Africa at an accelerating rate.

• Yesterday, for example, China offered Nigeria insurance cover of $40-50b to help fund investment in Africa's biggest oil producer.
  
• Private investments have also been pouring to develop not only oil and mineral resources but also telecom, infrastructure and financial assets.
  
• And Africa's trade with some nations is rising exponentially; the IMF reported last month: "Two-way trade flows between Africa and China have been growing rapidly. Between 2001 and 2006, Africa’s exports to and imports from China rose on average by more than 40 percent and 35 percent, respectively, significantly higher than the growth rate of world trade (14 percent) or commodities prices (18 percent)," which is a combined increase from $10b to $55b."
  
• Many African stock markets have soared in the past two or three years, attracting (and further driven by...
  
• Western hedge funds and African funds being launched and working hard to gain exposure. Brokerage businesses in Africa have also been improving,
  
• and we find several instances of Western-educated ex-pats from Africa returning to start companies, both non-financial and financial. Databank Group (an investment bank) in Ghana, founded by Ken Ofori Atta, is an example. Another is a fund being raised by Tutu Agyare, highlighted in an FT article this week.
  
• At the ground-level, we see many reports of Africans applying both new and basic science to agriculture in Africa, and seeing dramatic increases in productivity, versus incremental increases on already-developed Western farms.
• Solar power investments are also arising in Africa, thanks to the weather patterns and the rapid development of lower-cost solar technologies and production methods outside Africa. (Even on the most micro level: we've read of some Nigerian villagers.

Political instability, erratic policy, inflation, corruption, disease and history's gamut of challenges meet many African nations, although less-so after decades of gradual reform. And now the increasingly sophisticated, wealthy and resource-hungry Developing Markets (particularly China, Russia and India), as well as Western investors, are putting assets to work there, and indigenous enterprises are becoming much more prominent as well. Some of the developments would stun casual observers of Africa: Rwanda launched a stock market this year, in part to float the companies intended for privatization. Articles citations by RGE Monitor, and its own articles such as "Africa Growing at Unstoppable Momentum?" offer helpful overviews (located here).

Some Western investors, even those without employees in Africa, are getting a foothold. We read of several hedge funds making big country-bets, new hedge funds forming, and the occasional Western mutual funds finding pockets of liquidity as well. Retail investors will be able to gain only scant access for now, and not without a lot of work to gain reliable access and research to identify the opportunities. But things are slowly changing. The FT reported on the launch of the Duet Victoire Africa Index to track the largest stocks across sub-Saharan Africa outside of South Africa. Asset allocators will raise an eyebrow that correlation among the African stock exchanges is much lower than in Developed continents, according to the Index's originator. That's in addition to the low correlation that many African markets will have with non-African markets in the same asset class, as we mentioned in our post "Asset Allocation: New Paradigms."

Developing Markets' Inflation Beast Keeps Growling

Today the Asian Development Bank (ADB) contributed to our explanation (expressed here and in previous posts) of why rising inflation in Developing Markets keeps us underweight there, and mired in the middle, not at the end, of global financial crisis. The DevelopING Markets don't yet have a track record of engineering soft landings, and a combination of their inflation, the U.S./Europe economic slowdown, and credit crisis make the maturing markets quite vulnerable to financial crises of their own. Such crises, would signal a better time to raise allocations to the Developing Markets.

According to the FT today:

• Ifzal Ali, ADB's chief economist, warned that the inflationary threat was much greater than official figures suggested in countries such as India that damp the price impact via subsidies.
  

Our previous posts (such as this link) also explain why Developing Nations' subsidies and other forms of micro-management of inflation only make matters worse -- because they inhibit the natural function of higher prices from dampening demand, and because the underlying inflationary causes of easy credit and artificially weak currencies go un-addressed.

The FT continues:

• [Ali said], "South Asia is going to be very vulnerable to high commodity prices," Mr Ali said. "What is happening because of [price] controls is that the inflationary pressures are grossly under the table. But the pressures are there and building."

And switching to Asia:

• In China, where inflation has accelerated to its fastest pace in 11 years, "the challenge is now to bring down inflation and at the same time avoid a hard landing", according to Mr. Ali
• In the case of countries such as Vietnam, where the inflation rate is expected to double this year to about 18%, the ADB said the government needed urgently to introduce a blend of monetary and fiscal tightening. It also needed to allow some currency appreciation, in order to prevent its stellar recent economic progress from grinding to a halt.
• Several Asian governments are likely to be forced into monetary tightening soon, says the ADB, including India where inflation could turn into a serious political issue in the run-up to elections next year.

And in a nod to the biggest fear -- a wage & price spiral that becomes very painful to break, once it gets started, the FT article continues:

• While inflation has been fueled by soaring world food and energy prices, the ADB also stressed on Wednesday that the problem was in equal part generated by domestic factors, such as skills shortages amid an economic boom.
  

If Developing Markets do show signs of "muddling through" the crisis period by getting a handle on inflation (via a healthy combination of gradual currency appreciation, financial reforms, and slower demand from U.S. and European trading partners, etc), we'll raise our Developing Market underweights. In the meantime, we're too nervous about potential crises in these new markets to raise allocations now.

Developing Markets' Inflation Beast Continues Growling

For two days we've cited anecdotes about how the Developing Economies' micro-mercantilist policies to address inflation aren't working, and won't engineer a soft landing (slower, less-inflationary economic growth rates). There will be financial crises along the path to slowdown, and that's why we're not raising our Developing Markets allocation from our current underweight.

Our post yesterday highlighted India and East Asia's widespread policies of limiting exports of inflationary goods (to retain more supply at home), and reduction of import taxes on those goods to encourage cheaper imports. We view these as potentially offsetting policies that don't address the root causes of inflation, namely the rapid growth in credit, currency manipulation in many Developing nations that artificially juices export growth and high import prices, and other policies. A previous post implicates Brazil, too.

Today, a WSJ article makes the same point about Argentina:

• The recent trouble [social unrest[ began not in Buenos Aires but in the provinces, where agriculture is the main economic activity. Farmers rebelled earlier this month when the government announced an increase in export taxes on agricultural products....
• Take, for example, soy beans. The new export tax will be raised to 44% from 35%. But since farmers also have to pay a 35% income tax on profits, the effective tax rate is significantly higher. "The farmer ends up paying essentially a 63% tax on gross income," says Pablo Guidotti, dean of the school of government at Argentina's DiTella University. If the price of soy goes up, Mr. Guidotti adds, the "retention rate" increases until the government can end up taking as much as 95% of any marginal increase in a farmer's gross income.
• In response to the tax increases, farmers have blocked roads in some 300 locations around the country, pledging not to allow their goods to reach markets. The effects of the action have been felt in the capital, where demonstrators have taken to the streets in sympathy for the farmers and against what they say is government arrogance. The strike is now in its third week.
• [President Cristina] Kirchner says the tax increase is a redistribution mechanism, suggesting that growers and ranchers have to be forced to share more of their good fortune with others. But the greater motivation behind the export-tax increase is inflation.
• This government, it seems, will do just about anything to reduce inflation except the one thing that would solve the problem: Let the peso strengthen. It has imposed price controls on businesses; frozen, and then subsidized, energy prices; and prohibited the export of beef. Last year it fired the director of the government's agency for inflation data because she refused to fudge the numbers. Even so, prices rose by an estimated 20% in 2007 and expectations for this year remain high. This would explain the new round of confiscatory export taxes. By discouraging farmers from sending food abroad, the government thinks it can increase food supplies inside the country and damp prices.

To repeat from our post last night:

This is a big reason why we're not adding to our Developing Markets weighting now, and it's also a reason why we're waiting-out the dollar weakness rather than piling-on the shorts. As instabilities and unsustainable policies within Developing Market economies become more apparent (very very soon), the dollar will give more reassuring signals. Financial seizures within Developing Markets will, we continue to believe, signify "the beginning of the end" of the global financial crisis, and a buying opportunity for equities worldwide.

Developing Markets' Inflation Beast Growling Louder, Even As Their Economies Decelerate

We're not ready to raise our underweight Developing Markets allocation, as we'll only believe the "soft landing" scenario when we see it.

Our post yesterday on Brazil expressed our concern that underlying inflation pressures are only exacerbated by government policies to micro-manage prices rather than slow down the credit and demand boom.

India presents the same concerns. Earlier today, India's inflation reached a 13-month high of 6.7%, exceeding estimates. The following form of micro-management of the economy -- discussed in today's FT report -- would seem to have be neutral to global inflation, which circles back to keep India in the inflationary net:

• The finance ministry is expected to cut import duties on commodities such as steel, while clamping down on exports. Last week it reduced import duty on edible oil and has limited export of non-basmati rice. "Large price increase portends significant government action," said economists at Goldman Sachs. "With inflation driven by high commodity prices, the government has reduced import duties, banned exports and increased minimum export prices of certain food commodities."

Reduce some prices, raise others ... How does that combat inflation?

This form of inflation micro-management seems to be becoming a lot more common across the Developing Markets, as shown by tonight's WSJ article titled "Rice Hoarding Pressures Supplies." While the world would benefit from increased free markets in goods that are in local short-supply, the "rational" reaction pursued by self-interested parties is to hoard. So:

• As prices hit new highs, farmers across Asia are hoarding their crops, raising the prospect of a shortage in Asia and Africa that could lead to widespread unrest.... Governments around the region are curbing exports to safeguard their domestic supply, putting further upward pressure on prices.

The greater the Developing Market inflationary pressures become -- ultimately caused by the rapid growth in credit, currency manipulation and other policies that favor very rapid growth over stable growth -- the harder they'll be to reign in without causing a few major dislocations along the way.

This is a big reason why we're not adding to our Developing Markets weighting now, and it's also a reason why we're waiting-out the dollar weakness rather than piling-on the shorts. As instabilities and unsustainable policies within Developing Market economies become more apparent (very very soon), the dollar will give more reassuring signals. Financial seizures within Developing Markets will, we continue to believe, signify "the beginning of the end" of the global financial crisis, and a buying opportunity for equities worldwide.


Keying-off the rice example used above, we'll reiterate that we think most major ag-related investments will remain less susceptable to the macro gyrations that we see continuing. See our post "Allocation and Agriculture," for instance.

Brazil: Internal Financial "Reform" Deformed?

After its '00s boom, Brazil is not as safe a haven for assets that its market indices show many investors believe.

In our March 25 post we cited a VoxEU article (Foreign Direct Investment, and Domestic Financial Reform: A Marriage Made in Heaven?) that concluded:

• Not only does financial reform matter, it is the most important reform a country can pursue in order to influence the decisions of foreign investors.

The linked article here on RGE Monitor describes how Brazil is making big mistakes in its internal financial management, as the country is facing increasing inflation pressures. Rather than take its medicine by making credit more expensive, it is making piecemeal efforts to band-aid problems, leaving higher risks that inflation pressure will build.

While Brazil's macro picture -- its wealth of water & land (agricultural production capacity), and infrastructure investment growth -- is enormously positive, at some point these positives will be fully factored into the skyrocketing equity prices there, and imbalances perpetuated by internal financial system mismanagement will end the bull market. We think the "at some point" may be nearer at hand than many investor suspect, due to contagion from the current financial crisis.

From RGE Monitor (originally published by Valor Economico), titled Brazil: Back to the Past:

• Different from the policy followed since 1999, which set the exchange rate floating according to the market and executed monetary policy horizontally, using classical tools, like interest rates, the current administration apparently prefer micro managing the system, with constant interventions. An increase in the price of iron ore? The government calls the iron-ore producers, with an implicit threat to impose price controls, instead. The exchange rate is appreciating? There is an increase of import tariffs and export subsidies in the sectors that are 'worthy', and the government issues internal debt to increase international reserves in a useless and expensive arbitrage for the country. Instead of increasing interest rates, they impose a selective control on credit. It is a mirror image of the economic policy from the '70s and '80s, with all the distortions and inefficiencies that led to disaster.

Brazil's year-over-year broad money growth is 16.2% means that a range of micro-management tactics may mask inflationary pressure for a while but probably can't contribute much to restoring balance. Our blog posts have raised similar questions about China; its M2 is growing at a 17.5% rate. The global slowdown that's starting to unfold will ultimately help restore something like a balance, but history tells us not to bet the farm on "soft landings" in emerging markets.

We continue to wait for lower levels in U.S. and non-U.S. equities before rebalancing to our long-term strategic targets.

"China, If You Think the U.S. Real Estate Bust Is Bad..."

There's a big reason why, before rebalancing our underweight equity allocations, we're waiting for financial crisis to hit the Developing Economies. In particular, China's real estate boom could end very badly.

Today a WSJ article provides more fodder for this line of argument, especially because it's attracting so little attention from Developed investment markets, as this link sensibly points out.

Read the WSJ article today titled, "Tables Turn Quickly on Chinese Developers."

From our past readings, we understood that the inflationary roots in China's real estate development story run deep and wide: (1) an enormous amount of Chinese property development was premised on the certainty that values would increase in the future (sound familiar to the U.S. mortgage lending bubble?). We also understood that (2) a major source of financing for China's development boom has been city governments evicting poor residents and giving the land to property developers as partial compensation for developing the land (same as printing money) -- and that China's many large cities have been aggressively competing to add real estate capacity in this way for most of the last decade. We also understand that (3) low-to-negative real interest rates in China have financed a significant portion of China's stock market boom -- consumers have been borrowing to speculate in stocks despite the government's efforts to enforce rules (remember, China is a DevelpING economy), and the too-easy money has surely found its way into the pockets of individual home buyers. We've read that (4) there is almost nothing like a developed market "credit score" for individual Chinese borrowers. Isn't that even worse than the widespread "no-documentation" loans that epitomized the U.S. mortgage boom-bust?

The Chinese government is starting to pull out the stops to rectify these problems (at least they're being more proactive than U.S. financial regulators were during the boom), working desperately to prevent new real estate capacity from coming to market. But it may be too little too late.

From Jonathan Cheng's WSJ article:

• Three months into 2008, China's property developers are under siege. Property prices are showing signs of weakness in many of the country's key markets, and capital markets have all but seized up for these -- and other -- offerings. The Chinese government is on a high-profile campaign to clamp down on new bank loans, hoping to curb inflation, rising at its fastest clip in a decade.
• Companies that leveraged big last year are now strapped for cash, unable to build on the land they have accumulated. Beijing is breathing down their necks, having pledged earlier this year to tax and seize hoarded land.....
• The latest casualty of changed conditions: Guangzhou-based developer Evergrande Real Estate Group, which last week shelved an IPO it hoped would raise as much as $2.2 billion....
• Evergrande's woes illustrate many of the headwinds facing Chinese developers. Despite stock-market turmoil, the developer was so weighted down by debt it had no choice but to take a crack at an IPO. More than half the funds Evergrande was hoping to raise were set aside to pay for plots it accumulated during a furious land grab last year.
• "We are highly leveraged, and a deterioration of our cash-flow position could materially affect our ability to service our indebtedness and to continue our operations," Evergrande wrote in its listing prospectus. With the IPO shelved, the company hasn't said how it will seek funds.
• Even titans have had to trim their ambitions.... Soho China Ltd [co-founder] Pan Shiyi ... told Shanghai Securities News that Chinese developers this year will "find themsevels in extraordinarily difficult financial straits."....
• "The 'model' that worked in 2007 was predicated on prices for apartments growing faster than land costs," says Todd Schumbert, an analyst with Deutsche Bank in Singapore.... Now, with home prices faltering and funding sources scarce, "This game is over."....
• In the past few months, Wang Shi, the head of megadeveloper China Vanke, a Shenzhen-listed company based in that boomtown, surprised the market by slashing prices heavily on new flats and suggested in a recent television interview that people wait three to four years before purchasing a new home.
  

This topic is much bigger than any single article can tell. Back on September 18 '07, I clipped an article by Jamil Anderlini at the Financial Times. A few quotes:

• China Construction Bank, the country's second largest lender, is taking a cautious line on China's economy and is reducing its exposure to an overheating property market, the bank's chairman told the Financial Times.
• [CCB chairman Guo Shuqing said], "The real estate market is more overheated in the coastal areas and the annual price increase is too high." [Oh, only the "coastal areas" of China?]
• Investor interest [in real estate company equity, at the time the article was written] is partly driven by soaring profitability at China's newly reformed banks, but those profits are diverting attention from rising credit risks, according to Standard & Poor's, the rating agency. "The rapid industry-wide expansion of credit exposure suggests many banks prioritise expanding their asset base and market share over strengthening their capital," Ping Chew, S&P credit analyst, said.

A clip from another FT article by Anderlini, this one on 9/14/07:

• Wu Xiaoling, deputy central bank governor, said on Friday that Chinese banks were not heeding the central bank's directives to slow lending growth. Banks are lending out money much faster than the central bank's target, with new loans reaching Rmb3,080bn ($409bn) in the first eight months of [2007], 97% of the total for the whole of [2006].
  

The Chinese real estate situation seems to have the makings of another slow-motion train-wreck. CCB chairman Guo said his bank is 90.67% provisioned, but one wonders how thoroughly he's counting CCB's total exposure. And it's the second-largest lender in China. Smaller banks are probably far less provisioned than CCB.

A real estate banking crisis in China would perpetuate the global contagion, and also soak up a lot of the nation's reserves, creating a follow-on shock wave for the global financial system that China is a central player in.

The most hopeful case is that a serious cooling in China's real estate sector will offset its overheating in other sectors, to produce a "soft landing" for the economy. This isn't where our bets lie right now.

Muddling Through "The Beginning of the Middle"

We've read numerous economists' road maps of an typical recession and are making our own observations -- and we believe we're only at "the beginning of the middle" of the current down-cycle. (That's why we're adding to underweight allocations gradually, despite the extra risk of market timing.)

Yet we're quick to acknowledge small signs of progress, the happy "muddling through" which gradually erodes the cases of doomsday-sayers. (For a brief summary of a highly credible super-bear, see this interview of Nouriel Roubini, NYU professor and founder of the RGE Monitor economic research boutique.) One such small sign of progress came from today's TIC data (U.S. Treasury International Capital data from January) that shows foreign governments were still buying U.S. assets in January at a fairly vigorous pace. A summary of the data is at this link.

It's fairly important to watch this data because one of the biggest concerns of the most dour forecasters is that foreign governments won't continue to recycle their reserves into U.S. assets, having reached a conclusion that the dollar will continue to erode the value of their investments. A corollary of the same fear is that countries will fairly rapidly de-peg their currencies from the dollar, which will viciously reinforce the foreign abandonment of U.S. assets. These are very legitimate and troubling fears, driven by years of under-saving by U.S. consumers, wildly speculative corporate and institutional lending and borrowing, the trillion-dollar Iraq war fiasco, and China's (and some other countries') enormous efforts to keep their currencies undervalued versus the dollar in order drive export growth and protect home markets.

But the dollar may well unravel slowly enough to avoid a financial calamity, and the January TIC data is one small datapoint affirming that. It's in the financial interests of foreign governments to continue investing heavily in the U.S., even if at a slower pace; meanwhile, foreign private entities will continue to have a significant allocation toward U.S. assets to meet their portfolio's diversification demands.

Although we're not calling for a calamitous dollar-unwind, we see risks that are large enough to justify only a gradual buying of asset classes where we're underweight. And ultimately, we expect to keep a somewhat larger-than-benchmark allocation in Developing Economies, but only after some of them experience financial shocks of their own, something we're waiting for in 2008 as a sign of "the beginning of the END" of the crisis.

For Country Allocation, Focus on Financial Reform (and Deform)

A new study referenced by Voxeu.org concludes:

• Not only does financial reform matter, it is the most important reform a country can pursue in order to influence the decisions of foreign investors.

After a powerful bull run in emerging markets, it will become more crucial to take into consideration which countries continue to adopt financial reform, rather than suffer the "reform fatigue" which often plays a role in ending bull markets.

More from the research abstract:

• What are the main determinants of the geographical distribution of foreign direct investment (FDI) across emerging economies in the two regions [Latin America and transition economies in Eastern Europe]? First there are classical sources of comparative advantages such as market size, the level of economic development, infrastructure, natural resource abundance, and macroeconomic stability. Second, there are institutional quality of the host countries such as rule of law, quality of bureaucracy, and executive constraints. Third, we argue in our research, the host government's structural reforms may play a crucial role in attracting foreign investment - we focus on financial sector reforms, trade reforms, and privatization efforts.
• Using the newly constructed data panel [see link above], we estimate the effects of structural reforms on FDI inflows along with other standard determinants. We find that, in addition to the classical sources of comparative advantages, structural reforms in the financial sector and privatisation are particularly important for FDI in emerging markets. The former is significant after controlling for institutional differences across countries (i.e. rule of law, quality of bureaucracy, executive constraints). We also examine various policies in financial sector reforms to see which policy is more important to foreign investment decisions. In particular, we find that reform policies to strengthen banking sector supervision, to reduce credit ceilings for banks, and to liberalize securities markets have a positive impact on FDI inflows. By the same token, privatisation efforts measured as governments' proceeds from privatisation also give an impetus to FDI inflows. Finally, we find that trde liberalization raised the ability to attract FDI in Latin American countries, not in [Eastern Europe]
• The fact that financial reforms have a stronger effect on FDI than privatisation and trade liberalisation suggests that foreign investors highly value a host country's financial system that is able to allocate capital efficiently, monitor firms, ameliorate, diversify and share risk, and ultimately mobilize savings. Financial reform is arguably a pre-condition for the maximisation of the benefits of spillovers to foreign investors via backward linkages as an efficient domestic financial system greatly facilitates the establishment and gorwth of domestic suppliers of the foreign firms.....

There's also a perverse implication for Developed Markets. If more financial reform is crucial to foreign investors in Developing Markets, then increasing financial DEFORM, as is being exposed now in the U.S. in particular, will continue to lead to selling by foreign investors. (We continue to believe we're only in "the beginning of the middle" of the financial crisis, because (1) the transition of bad assets to better balance sheets has only just begun -- accumulated leverage mountains and liability holes are enormous, as is the systemic risk, (2) the Fed and U.S. government are somewhat restricted in their rescue efforts by the failing dollar, (3) the crisis hasn't even yet caused areas of financial crisis in developing markets.)

More Signs We're Still Deep in the Woods

Our posts for the past week argue that until some of the Developing Markets experience financial crisis, global equity markets can't begin another bull run. It will be the last shoe to drop; we're waiting for it.

China is the most important to watch. It's a very immature market economy, where the global financial crisis will expose major cracks. It's battle with inflation needs to end in tears before we'll be ready to significantly boost our equity allocation.

An indication of weakness is the Chinese government's continuing blatant efforts to manipulate the stock market. It's a sign of serious weakness and the government's worry. On Thursday, China suspended tax collection on mutual fund shares to bolster share prices. Retail "investors" in China borrow amid near-zero real interest rates and speculate in the stock market. Down 40% from its peak (down merely to October '07 levels), the market could drain savings and cause serious financial and social dislocation. Yves Smith summarizes it well, as usual.