China & the Arabian Peninsula as Market Stabilizer
China and the Arabian Peninsula as Market Stabilizers
By George Friedman
The single most interesting thing about today's global economy is what
has not occurred. In 1979, oil prices soared to slightly more than $100
a barrel in current dollars, and they are approaching that historic high
again. Meanwhile, the subprime meltdown continues to play out. Many
financial institutions have been hurt, many individual lives have been
shattered and many Wall Street operators once considered brilliant have
been declared dunderheads. Despite all the predictions that the current
situation is just the tip of the iceberg, however, the crisis is
progressing in a fairly orderly fashion. Distinguish here between
financial institutions, financial markets and the economy. People in the
financial world tend to confuse the three. Some financial institutions
are being hurt badly. Those experiencing the pain mistakenly think their
suffering reflects the condition of the financial markets and economy.
But the financial markets are managing, as is the economy.
What we are seeing is the convergence of two massive forces. Oil prices,
along with primary commodity prices in general, have soared. Also, one
of the periodic financial bubbles -- the subprime mortgage market -- has
burst. Either of these alone should have created global havoc. Neither
has. The stock market has not plummeted. The Standard & Poor's 500 fell
from a high of about 1,565 in mid-October to a low of 1,400 on Oct. 19.
Since then, it has rebounded as high as 1,550. Given the media rhetoric
and the heads rolling in the financial sector, we would expect to see
devastating numbers. And yet, we are not.
Nor are the numbers devastating in the bond markets. By definition, a
liquidity crisis occurs when the money supply is too tight and demand is
too great. In other words, a liquidity crisis would be reflected in high
interest rates. That hasn't happened. In fact, both short-term and,
particularly, long-term interest rates have trended downward over the
past weeks. It might be said that interest rates are low, but that
lenders won't lend. If so, that is sectoral and short-term at most. Low
interest rates and no liquidity is an oxymoron.
This is not the result of actions at the Federal Reserve. The Fed can
influence short-term rates, but the longer the yield curve, the longer
the payoff date on a loan or bond and the less impact the Fed has.
Long-term rates reflect the current availability of money and
expectations on interest rates in the future.
In the U.S. stock market -- and world markets, for that matter -- we
have seen nothing like the devastation prophesied. As we have said in
the past, the subprime crisis compared with the savings and loan crisis,
for example, is by itself small potatoes. Sure, those financial houses
that stocked up on the securitized mortgage debt are going to be hurt,
but that does not translate into a geopolitical event, or even into a
recession. Many people are arguing that we are only seeing the tip of
the iceberg, and that defaults in other categories of the mortgage
market coupled with declining housing markets will set off a devastating
chain reaction.
That may well be the case, though something weird is going on here.
Given the broad belief that the subprime crisis is only the beginning of
a general financial crisis, and that the economy will go into recession,
we would have expected major market declines by now. Markets discount in
anticipation of events, not after events have happened. Historically,
market declines occur about six months before recessions begin. So far,
however, the perceived liquidity crisis has not been reflected in higher
long-term interest rates, and the perceived recession has not been
reflected in a significant decline in the global equity markets.
When we add in surging oil and commodity prices, we would have expected
all hell to break loose in these markets. Certainly, the consequences of
high commodity prices during the 1970s helped drive up interest rates as
money was transferred to Third World countries that were selling
commodities. As a result, the cost of money for modernizing aging
industrial plants in the United States surged into double digits, while
equity markets were unable to serve capital needs and remained flat.
So what is going on?
Part of the answer might well be this: For the past five years or so,
China has been throwing around huge amounts of cash. The Chinese made
big, big money selling overseas -- more than even the growing Chinese
economy could metabolize. That led to massive dollar reserves in China
and the need for the Chinese to invest outside their own financial
markets. Given that the United States is China's primary consumer and
the only economy large and stable enough to absorb its reserves, the
Chinese -- state and nonstate entities alike -- regard the U.S. markets
as safe-havens for their investments. That is one of the things that
have kept interest rates relatively low and the equity markets moving.
This process of Asian money flowing into U.S. markets goes back to the
early 1980s.
Another part of the answer might lie in the self-stabilizing feature of
oil prices, the rise of which should be devastating to U.S. markets at
first glance. The size of the price surge and the stability of demand
have created dollar reserves in oil-exporting countries far in excess of
anything that can be absorbed locally. The United Arab Emirates, for
example, has made so much money, particularly in 2007, that it has to
invest in overseas markets.
In some sense, it doesn't matter where the money goes. Money, like oil,
is fungible, which means that if all the petrodollars went into Europe
then other money would flow into the United States as European interest
rates fell and European stocks rose. But there are always short-term
factors to consider. The Persian Gulf oil producers and the Chinese have
one thing in common -- they are linked to the dollar. As the dollar
declines, assets in other countries become more expensive, particularly
if you regard the dollar's fall as ultimately reversible. Dollars
invested in dollar-denominated vehicles make sense. Therefore, we are
seeing two massive inflows of dollars to the United States -- one from
China and one from the energy industry. China's dollar reserves are
derived from sales to the United States, so it is stuck in the dollar
zone. Plus, the Chinese have pegged the yuan to the dollar. The energy
industry, also part of the dollar zone, needs to find a home for its
money --
and the largest, most liquid dollar-denominated market in the world is
the United States.
The United States has created an odd dollar zone drawing in China and
the Persian Gulf. (Other energy producers such as Russia, Nigeria and
Venezuela have no problem using their dollars internally.) Unhinging
China from the dollar is impossible; it sells in dollars to the United
States, a linkage that gives it a stable platform, even if it pays
relatively more for oil. Additionally, the Arabian Peninsula sells oil
in dollars, and trying to convert those contracts to euros would be
mind-bogglingly difficult. Existing contracts and new contracts managed
in multiple currencies -- both spot and forward managed -- would have to
be renegotiated. Any business working in multiple currencies faces a
challenge, and the bigger the business, the bigger the challenge. The
Arabian Peninsula accordingly will not be able to hedge currencies and
manage the contracts just by flipping a switch.
This provides an explanation for the resiliency of U.S. markets. Every
time the news on the subprime situation sounds so horrendous that it
seems the U.S. markets will crash, the opposite occurs. In fact, markets
in the United States rose through the early days, then sold off and now
have rallied again. Where is the money coming from?
We would argue that the money is coming from the dollar bloc and its
huge free cash flow from China, and at the moment, the Arabian Peninsula
in particular. This influx usually happens anonymously through ordinary
market actions, though occasionally it becomes apparent through large,
single transactions that are quite open. Last week, for example, Dubai
invested $7 billion in Citigroup, helping to clean up the company's
balance sheet and, not incidentally, letting it be known that dollars
being accumulated in the Persian Gulf will be used to stabilize U.S.
markets.
This is not an act of charity. Dubai and the rest of the Arabian
Peninsula, as well as China, are holding huge dollar reserves, and the
last thing they want to do is sell those dollars in sufficient quantity
to drive the dollar's price even lower. Nor do they want to see a
financial crisis in the U.S. markets. Both the Chinese and the Arabs
have far too much to lose to want such an outcome. So, in an infinite
number of open market transactions, as well as occasionally public
investments, they are moving to support the U.S. markets, albeit for
their own reasons.
It is the only explanation for what we are seeing. The markets should be
selling off like crazy, given the financial problems. They are not. They
keep bouncing back, no matter how hard they are driven down. That money
is not coming from the financial institutions and hedge funds that got
ripped on mortgages. But it is coming from somewhere. We think that
somewhere is the land of $90-per-barrel crude and really cheap toys.
Many people will see this as a tilt in global power. When others must
invest in the United States, however, they are not the ones with the
power; the United States is. To us, it looks far more like the Chinese
and Arabs are trapped in a financial system that leaves them few options
but to recycle their dollars into the United States. They wind up
holding dollars -- or currencies linked to dollars -- and then can
speculate by leaving, or they can play it safe by staying. In our view,
these two sources of cash are the reason global markets are stable.
Energy prices might fall (indeed, all commodities are inherently cyclic,
and oil is no exception), and the amount of free cash flow in the
Arabian Peninsula might drop, but there still will be surplus dollars in
China as long as it is an export-based economy. Put another way, the
international system is producing aggregate return on capital
distributed in peculiar ways. Given the size of the U.S. economy and the
dynamics of the dollar, much of that money will flow back into the
United States. The United States can have its financial crisis. Global
forces appear to be stabilizing it.
The Chinese and the Arabs are not in the U.S. markets because they like
the United States. They don't. They are locked in. Regardless of the
rumors of major shifts, it is hard to see how shifts could occur. It is
the irony of the moment that China and the Arabian Peninsula, neither of
them particularly fond of the United States, are trapped into
stabilizing the United States. And, so far, they are doing a fine job.
-
Distribution and Reprints
This report may be distributed or republished with attribution to
Strategic Forecasting, Inc. at www.stratfor. com.
By George Friedman
The single most interesting thing about today's global economy is what
has not occurred. In 1979, oil prices soared to slightly more than $100
a barrel in current dollars, and they are approaching that historic high
again. Meanwhile, the subprime meltdown continues to play out. Many
financial institutions have been hurt, many individual lives have been
shattered and many Wall Street operators once considered brilliant have
been declared dunderheads. Despite all the predictions that the current
situation is just the tip of the iceberg, however, the crisis is
progressing in a fairly orderly fashion. Distinguish here between
financial institutions, financial markets and the economy. People in the
financial world tend to confuse the three. Some financial institutions
are being hurt badly. Those experiencing the pain mistakenly think their
suffering reflects the condition of the financial markets and economy.
But the financial markets are managing, as is the economy.
What we are seeing is the convergence of two massive forces. Oil prices,
along with primary commodity prices in general, have soared. Also, one
of the periodic financial bubbles -- the subprime mortgage market -- has
burst. Either of these alone should have created global havoc. Neither
has. The stock market has not plummeted. The Standard & Poor's 500 fell
from a high of about 1,565 in mid-October to a low of 1,400 on Oct. 19.
Since then, it has rebounded as high as 1,550. Given the media rhetoric
and the heads rolling in the financial sector, we would expect to see
devastating numbers. And yet, we are not.
Nor are the numbers devastating in the bond markets. By definition, a
liquidity crisis occurs when the money supply is too tight and demand is
too great. In other words, a liquidity crisis would be reflected in high
interest rates. That hasn't happened. In fact, both short-term and,
particularly, long-term interest rates have trended downward over the
past weeks. It might be said that interest rates are low, but that
lenders won't lend. If so, that is sectoral and short-term at most. Low
interest rates and no liquidity is an oxymoron.
This is not the result of actions at the Federal Reserve. The Fed can
influence short-term rates, but the longer the yield curve, the longer
the payoff date on a loan or bond and the less impact the Fed has.
Long-term rates reflect the current availability of money and
expectations on interest rates in the future.
In the U.S. stock market -- and world markets, for that matter -- we
have seen nothing like the devastation prophesied. As we have said in
the past, the subprime crisis compared with the savings and loan crisis,
for example, is by itself small potatoes. Sure, those financial houses
that stocked up on the securitized mortgage debt are going to be hurt,
but that does not translate into a geopolitical event, or even into a
recession. Many people are arguing that we are only seeing the tip of
the iceberg, and that defaults in other categories of the mortgage
market coupled with declining housing markets will set off a devastating
chain reaction.
That may well be the case, though something weird is going on here.
Given the broad belief that the subprime crisis is only the beginning of
a general financial crisis, and that the economy will go into recession,
we would have expected major market declines by now. Markets discount in
anticipation of events, not after events have happened. Historically,
market declines occur about six months before recessions begin. So far,
however, the perceived liquidity crisis has not been reflected in higher
long-term interest rates, and the perceived recession has not been
reflected in a significant decline in the global equity markets.
When we add in surging oil and commodity prices, we would have expected
all hell to break loose in these markets. Certainly, the consequences of
high commodity prices during the 1970s helped drive up interest rates as
money was transferred to Third World countries that were selling
commodities. As a result, the cost of money for modernizing aging
industrial plants in the United States surged into double digits, while
equity markets were unable to serve capital needs and remained flat.
So what is going on?
Part of the answer might well be this: For the past five years or so,
China has been throwing around huge amounts of cash. The Chinese made
big, big money selling overseas -- more than even the growing Chinese
economy could metabolize. That led to massive dollar reserves in China
and the need for the Chinese to invest outside their own financial
markets. Given that the United States is China's primary consumer and
the only economy large and stable enough to absorb its reserves, the
Chinese -- state and nonstate entities alike -- regard the U.S. markets
as safe-havens for their investments. That is one of the things that
have kept interest rates relatively low and the equity markets moving.
This process of Asian money flowing into U.S. markets goes back to the
early 1980s.
Another part of the answer might lie in the self-stabilizing feature of
oil prices, the rise of which should be devastating to U.S. markets at
first glance. The size of the price surge and the stability of demand
have created dollar reserves in oil-exporting countries far in excess of
anything that can be absorbed locally. The United Arab Emirates, for
example, has made so much money, particularly in 2007, that it has to
invest in overseas markets.
In some sense, it doesn't matter where the money goes. Money, like oil,
is fungible, which means that if all the petrodollars went into Europe
then other money would flow into the United States as European interest
rates fell and European stocks rose. But there are always short-term
factors to consider. The Persian Gulf oil producers and the Chinese have
one thing in common -- they are linked to the dollar. As the dollar
declines, assets in other countries become more expensive, particularly
if you regard the dollar's fall as ultimately reversible. Dollars
invested in dollar-denominated vehicles make sense. Therefore, we are
seeing two massive inflows of dollars to the United States -- one from
China and one from the energy industry. China's dollar reserves are
derived from sales to the United States, so it is stuck in the dollar
zone. Plus, the Chinese have pegged the yuan to the dollar. The energy
industry, also part of the dollar zone, needs to find a home for its
money --
and the largest, most liquid dollar-denominated market in the world is
the United States.
The United States has created an odd dollar zone drawing in China and
the Persian Gulf. (Other energy producers such as Russia, Nigeria and
Venezuela have no problem using their dollars internally.) Unhinging
China from the dollar is impossible; it sells in dollars to the United
States, a linkage that gives it a stable platform, even if it pays
relatively more for oil. Additionally, the Arabian Peninsula sells oil
in dollars, and trying to convert those contracts to euros would be
mind-bogglingly difficult. Existing contracts and new contracts managed
in multiple currencies -- both spot and forward managed -- would have to
be renegotiated. Any business working in multiple currencies faces a
challenge, and the bigger the business, the bigger the challenge. The
Arabian Peninsula accordingly will not be able to hedge currencies and
manage the contracts just by flipping a switch.
This provides an explanation for the resiliency of U.S. markets. Every
time the news on the subprime situation sounds so horrendous that it
seems the U.S. markets will crash, the opposite occurs. In fact, markets
in the United States rose through the early days, then sold off and now
have rallied again. Where is the money coming from?
We would argue that the money is coming from the dollar bloc and its
huge free cash flow from China, and at the moment, the Arabian Peninsula
in particular. This influx usually happens anonymously through ordinary
market actions, though occasionally it becomes apparent through large,
single transactions that are quite open. Last week, for example, Dubai
invested $7 billion in Citigroup, helping to clean up the company's
balance sheet and, not incidentally, letting it be known that dollars
being accumulated in the Persian Gulf will be used to stabilize U.S.
markets.
This is not an act of charity. Dubai and the rest of the Arabian
Peninsula, as well as China, are holding huge dollar reserves, and the
last thing they want to do is sell those dollars in sufficient quantity
to drive the dollar's price even lower. Nor do they want to see a
financial crisis in the U.S. markets. Both the Chinese and the Arabs
have far too much to lose to want such an outcome. So, in an infinite
number of open market transactions, as well as occasionally public
investments, they are moving to support the U.S. markets, albeit for
their own reasons.
It is the only explanation for what we are seeing. The markets should be
selling off like crazy, given the financial problems. They are not. They
keep bouncing back, no matter how hard they are driven down. That money
is not coming from the financial institutions and hedge funds that got
ripped on mortgages. But it is coming from somewhere. We think that
somewhere is the land of $90-per-barrel crude and really cheap toys.
Many people will see this as a tilt in global power. When others must
invest in the United States, however, they are not the ones with the
power; the United States is. To us, it looks far more like the Chinese
and Arabs are trapped in a financial system that leaves them few options
but to recycle their dollars into the United States. They wind up
holding dollars -- or currencies linked to dollars -- and then can
speculate by leaving, or they can play it safe by staying. In our view,
these two sources of cash are the reason global markets are stable.
Energy prices might fall (indeed, all commodities are inherently cyclic,
and oil is no exception), and the amount of free cash flow in the
Arabian Peninsula might drop, but there still will be surplus dollars in
China as long as it is an export-based economy. Put another way, the
international system is producing aggregate return on capital
distributed in peculiar ways. Given the size of the U.S. economy and the
dynamics of the dollar, much of that money will flow back into the
United States. The United States can have its financial crisis. Global
forces appear to be stabilizing it.
The Chinese and the Arabs are not in the U.S. markets because they like
the United States. They don't. They are locked in. Regardless of the
rumors of major shifts, it is hard to see how shifts could occur. It is
the irony of the moment that China and the Arabian Peninsula, neither of
them particularly fond of the United States, are trapped into
stabilizing the United States. And, so far, they are doing a fine job.
-
Distribution and Reprints
This report may be distributed or republished with attribution to
Strategic Forecasting, Inc. at www.stratfor. com.
0
Please sign in to leave a comment.
Comments
0 comments