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Dec 6, 2007 | 22:00 GMT

18 mins read

Global Market Brief: Sources of Liquidity in the Global System

Contrary to expectations, Japan's core inflation in October — measured by the consumer price index — clawed its way back into positive terrain for the first time in 2007, at 0.1 percent over the core inflation in October 2006, according to data released Nov. 30 by Japan's Ministry of Internal Affairs and Communications. Japan has been stuck in a deflationary crisis for much of the past decade — largely because of the country's artificially cheap credit environment, in which money was more often allocated according to connections (i.e. "keiretsu") than business fundamentals. So even though this positive margin is slim — and at least 10 times less than every other developed economy's — the fact that Japan's economy picked itself back up is notable. However, viewed against the global backdrop of record high oil prices and rising food prices, this result is not all that surprising. If anything, it is rather subdued. Inflation has risen steadily across four of the world's top economies — the United States, the eurozone, China and Japan — for the whole of 2007. Among these, the rate at which China's inflation has accelerated relative to 2006 stands out. With inflation at 6.5 percent in October, China's overall prices are now rising almost three times as fast as they did 10 months ago. There is nothing to stop inflation from running far higher and for much longer — and with rising inflation, the real value of an existing pool of credit shrinks, making credit more expensive. In a seemingly unrelated event, on Oct. 15 Kathleen Casey-Kirschling — born in January 1946 — became the United States' first baby boomer to retire. Both events indicate a critical and unavoidable trend just around the corner — one that STRATFOR highlighted just more than a year ago: The days of cheap, unlimited credit are numbered, and key sources of liquidity in the global market are bound to dry up sooner or later. The unparalleled economic growth rates which the United States (and the world) has enjoyed for most of the last decade and a half can be traced to multiple sources. While specifics in the U.S. system — mass education, reward for risk, functional bankruptcy laws, a mobile population, enthusiasm for technology, relatively uncorrupt culture and other factors that help spark growth — have been critical factors, the growth would not have been possible without the macroenvironment (i.e. excessively cheap credit) that existed at the same time. The two main sources of this credit were cheap and plentiful Asian credit, and the United States' generation of baby boomers (born 1946-1965).

Cheap Asian Credit

With memories of 1997's Asian financial crisis still lingering, most Asian governments — most notably those of China and Japan — have spent a good portion of the last decade hoarding whatever trade revenues they earn toward ever-fattening arsenals of foreign exchange reserves (much of which were used to buy U.S. Treasury assets, thus indirectly feeding the U.S. credit pool). Money leaving Japan's economy in 1990 amounted to $4 trillion; money leaving the rest of Asia combined totaled $2 trillion. By 2006, these outward flows had grown to $4.5 trillion and $5 trillion respectively. To keep these arsenals vested in low-risk assets with positive (but conservative) rates of return, Asian governments have flooded the international system with billions of dollars in exchange for U.S. Treasury securities. Tokyo and Beijing are the top two holders of such assets today. As of September, Japan held $582 billion in U.S. Treasury assets and China $396 billion. These Asian credit pools are built on banking systems that hand out artificially cheap loans priced not on economic risk assessments but political priorities. In most Asian states — with China and Japan atop the list — the state actively intervenes in the financial system to ensure that anyone who needs cash and has the right connections can get access to loans at well-below-market rates, regardless of the soundness of the borrower's business plan. In China, this artificially cheap credit (and an abundant cheap labor force) helped to boost export volumes and revenues, resulting in enormous trade surpluses which Beijing subsequently invested in U.S. Treasury bonds in order to keep its currency from leaping too high. The money earned by the Federal Reserve from such sales found its way into the American, and consequently the world, economy. Apart from purchases of U.S. Treasury assets, Japan's artificially cheap credit was also used by local firms to fund rapidly expanding international operations. Only in recent years have Chinese state-backed companies started to follow the same path. Conservatively, these companies alone have pumped another $2 trillion into the global economy — above and beyond their respective governments' holdings in U.S. Treasury assets. But this flood of money is going away. Japan is finally raising its interest rates as positive inflation peeks back above the horizon, reducing the ability of the Japanese to funnel money abroad. And China has begun to invest large portions of its excess capital in domestic industries (via foreign banking deals in some cases) even as it gets a handle on its runaway banking sector, similarly shrinking the outflow of capital. With less money available in the global system to be loaned, rising inflation is the natural result. Japan's positive October core inflation reading was significant because the country's economy has been stagnating in a deflationary environment since the late 1990s. This, taken together with the significantly steeper inflation trends for China, the United States, the European Union and others (and the greater possibility of higher future interest rates), indicate that credit is about to get more expensive throughout the world.

Baby Boomers

A second and more fundamental source of credit lies inside the American economy itself: the number of baby boomers in the workforce. And that number is beginning to shrink. The baby boomers — the largest population cohort that the United States has ever produced (as measured by their percentage of the total population) — started entering the workforce in the early 1960s as young workers (who live off more borrowed credit than they can earn). By the late 1990s, most of them had graduated to mature worker status, generating more credit than they were spending and plugging much of what they earned back into the economy through savings and investment. As a result, much of the credit that fueled the U.S. in the 1990s can be traced back to the baby boomers who had entered the mature workforce. Casey-Kirschling's retirement signaled the first trickle of older baby boomers opting to leave the mature workforce for early retirement. Once retired, such baby boomers (in most cases) stop earning a regular salary. To replenish the disposable income in their current accounts, they will have to extract either from their savings or from money previously set aside for investment. Aside from this extraction effect, the boomers will also stop putting new money into new investment, so what would have been new streams of credit from boomers to the economy's central credit pool will start drying up as well. Retired baby boomers are also more likely to start moving the majority of their funds from high-risk-and-return stock and private bond markets into the sedate world of government Treasury bills. The shrinkage in the total national pool of credit (which includes money in both equity and debt) means that credit will become more expensive, pushing interest rates up. And assuming that companies that used to raise money by issuing new equity start to borrow more from banks in order to make ends meet, interest rates will be pushed up even higher. As this demographic shift starts to take effect, these baby boomers' investments — well beyond what any previous generation has been able to provide — will start to decline, gradually taking away the low interest rate environment of the 1990s and 2000s. In theory, provided the population of dependents (retirees and young workers) in a country is smaller than the mature worker population, existing credit conditions can continue. But given that every retiree today is being supported by 3.3. workers (compared to 16 workers in 1950) and will only be supported by two by the time the bulk of U.S. baby boomers start retiring en masse (after 2012), the cheap credit of today cannot last indefinitely. The same phenomenon is being seen, or has already occurred, in other countries. In Europe, a similar demographic decline or "population chimney" — when a population bell hollows out over time because of reductions in the birth rate — is occurring, albeit with an older average age than that in the United States. Italy's and Denmark's pension outlays, as a percentage of gross domestic product (GDP), are three times the United States' (which stand at 4.5 percent of GDP). Japan's baby boomer bulge peaked in 2000. But rather than using this boomer population bulge as an opportunity for a revolutionary economic spike akin to the U.S. computer revolution, Tokyo fell into chronic deficit spending instead, saddling itself with a national debt that is the largest in human history (and growing). Meanwhile, Russia's post-Cold War trauma gave it a demographic picture worse than even Japan's; and after 60 years of the one-child policy in China, every four Chinese grandparents on average now have only one grandchild. The only major economy in the world that has a "traditional" population bell curve is India, which has yet to experience the joys and pains of being a capital exporter. So ultimately what does this mean for the global economy? Compared to Japan, Germany or China, the United States' baby boomers (including some often referred to as Generation X-ers) have a generation waiting in the wings: Generation Y. But this younger cohort — today's teenagers and young adults — will not graduate into the mature worker category for another generation or so. Nonetheless, given that only the very first batch of the baby boomer cohort has started to think about early retirement, it should still be at least another five to 10 years before the bulk of American baby boomers retire en masse. In the meantime, the Asian credit shrinkage has already started to occur. China has reportedly wound down all new purchases of U.S. Treasury securities, while Japan's holdings fell by $36 billion (to $582 billion) for the 12 months ending in September. With less spare cash swirling through the global economy, credit will inevitably become increasingly expensive — meaning that economic growth targets will become much harder to hit. With a smaller pool of credit, investors will have less room for error. For the world economy, this means higher volatility and more hair-raising rollercoaster rides between booms and busts. ECUADOR: Ecuadorian President Rafael Correa said Dec. 1 that a protest in the Amazonian Orellana province prevented the extraction of 36,000 barrels of crude, at a loss of at least $10 million. Correa declared a state of emergency Nov. 29 in the province after demonstrators began a violent protest Nov. 26. The protesters — demanding that more oil revenues be spent on infrastructure and job creation in the province — targeted state oil firm Petroecuador's Auca Sur facility, detonating dynamite and disabling a hydraulic pump, which halted output. In response to the crisis, Correa also sacked close adviser Interior Minister Gustavo Larrea for not stopping the protest sooner, replaced the head of Petroecuador with a high-ranking military official and petitioned that a government commission work to negotiate with the protesters. Petroecuador is plagued by inefficiency and urgently needs restructuring, especially given Ecuador's recent re-entry into the Organization of the Petroleum Exporting Countries. IRAQ: Iraqi Oil Minister Hussein Shahristani said Dec. 5 that "irreconcilable" differences between parliamentary factions will prevent the country's hydrocarbon law from being passed any time soon. Shahristani was quoted as saying, "Until there is a breakthrough, I don't envisage that the law will be passed in the very near future." He did not say anything revealing in terms of the law's content. Iraq's Oil Ministry is locked in an escalating conflict with the Kurdistan Regional Government (KRG) over the ownership of contracts with international energy firms. Short of entering into open conflict with the Kurds, Baghdad cannot block the KRG from signing energy development agreements. By actually highlighting the problem, the Shiite-dominated central government wants to discourage international oil firms from doing business with the Kurds until a law emerges. U.S. Deputy Treasury Secretary Robert Kimmitt said Dec. 4 in Baghdad that Washington is discouraging oil firms from investing until the central laws are passed. IRAQ: Sunnis ended a year-long political boycott Dec. 4 in the oil-rich northern Iraqi region of Kirkuk as part of a cooperation pact mediated by U.S. diplomats. Sunni lawmakers walked out of the provincial council in November 2006, claiming discrimination by the Kurds. The boycott ended after Kurdish lawmakers agreed to allot one-third of government jobs, such as police and other official positions, to Arabs and appoint an Arab as deputy governor even though they only hold six of the provincial council's 41 seats. The Kurdish bloc dominates with 26 seats, largely because Sunnis boycotted the last provincial elections in 2005. This development is a success of sorts for Washington at a time when both Sunnis and Shia are up in arms over the Kurds consolidating their autonomy in the north. But the Kirkuk referendum and the dispute between the Shiite-dominated central government and the Kurdistan Regional Government are issues that will linger for some time. The pact between the Sunnis and the Kurds is significant, but will not be sufficient to make progress on the other two contentious issues. GULF COOPERATION COUNCIL: Leaders of Kuwait, Saudi Arabia, the United Arab Emirates, Oman, Bahrain and Qatar said Dec. 4 that the Gulf Cooperation Council (GCC) will launch its common market in January 2008, KUNA reported. Member countries said the market, stipulated in the Doha Declaration released at the end of the GCC summit, is in line with the council's and the Gulf population's goals for equality. The market is also intended to open up regional and foreign investment, the declaration says. The GCC leaders explained the move as an effort to allow each member state to seek an equitable share of the foreign investment the region as a whole is attracting. Essentially, a common market is a free trade zone, which will streamline the process by which international businesses can invest money in the six Arab states. While the five smaller GCC states are more or less on par with one another in terms of attracting foreign investors, Saudi Arabia will have to play catch-up in order to benefit from the common market. From a geopolitical point of view, this common market could allow the Persian Gulf Arab states to align closely in the wake of the U.S. National Intelligence Estimate on the Iranian nuclear program. Thus far, the GCC states have not been able to reach a consensus on how to deal with a rising Iran, which now appears to have a much freer hand because the threat of war has receded. EU, ITALY: Air France-KLM, the biggest airline company in the world in terms of total operating revenue and the biggest European airline in terms of passenger miles, has sent a nonbinding offer letter to the board of the financially beleaguered Alitalia, the Italian national carrier. Alitalia is losing $1.5 million per day and has incurred the wrath of its unions, most recently evinced by an unofficial pilot strike in September. Air France-KLM has already warned Alitalia's unions that it expects the support of the "entire workforce" in its plan to make the Italian carrier profitable again. Key to that plan is the idea that created the September strike: reducing the international hub flights to Milan's Malpensa airport and directing more low-cost and cargo flights there. While the acquisition of Alitalia gives Air France-KLM a firm foothold in the lucrative Mediterranean market, it remains to be seen whether Air France-KLM will be able to push through the difficult financial reforms that Alitalia needs to become profitable again. Another angle to consider here is the nationality of the buyer: Air France-KLM is a French-Dutch conglomerate, and the only other airline to make Alitalia a non-binding offer is Rome's low-cost operator Air One. While the Italian Prime Minister Romano Prodi has maintained that the nationality of the buyer of the Italian government's 49.9 percent stake in Alitalia is of "secondary importance," his opposition might not agree with him — especially if Air France- KLM's plan for Alitalia's return to profitability includes a reduction of the Italian carrier's international visibility and operations. RUSSIA, UKRAINE: The Dec. 3 negotiations between Gazprom and Ukrainian Energy Minister Yuri Boyko concluded with an agreed-upon price increase for Russia's natural gas shipments to Ukraine from $130 per thousand cubic meters (tcm) to $179.50 per tcm. While the deal might seem like a breakthrough, there are three serious flaws with it that will probably ultimately lead to another energy crisis. First, the deal did not set an actual amount of natural gas to be shipped; therefore the price could be for some miniscule amount. Second, key Central Asian countries involved in the natural gas trade have increased prices (both of actual natural gas and of its transportation tariffs), suggesting that the price Ukraine might have to pay is closer to $200 per tcm. Third, the deal was concluded by the pro-Russian — and outgoing — Boiko, who will be replaced when the next prime minister appoints a Cabinet. Yulia Timoshenko, who is likely to be the next prime minister, has made it clear that she will "renegotiate" any energy deals made with Gazprom once she becomes the premier. The trouble is that the ardently anti-Russian Timoshenko might not be able to renegotiate a better deal than the $179.50 price. A new energy crisis for Ukraine, and by extension Europe, could therefore become a reality. NIGERIA: A peace deal will be reached Dec. 7 between the governor of Nigeria's Bayelsa state and the Ijaw Youth Council (IYC). The IYC is an umbrella organization that includes Ijaw militants from the Movement for the Emancipation of the Niger Delta (MEND). MEND has been instrumental in shuttering a third of Nigeria's oil production since it began its militancy campaign in late 2005. The Dec. 7 peace deal will only be preliminary, however, as it so far only involves Bayelsa state actors, and could be essentially blocked by rival militants and politicians in the neighboring Niger Delta states. The IYC will later present the deal to the Ijaw in the three other leading oil producing states of the Niger Delta (Delta, Rivers, and Akwa Ibom). The Ijaw have tribal representation in those three other states, but do not dominate the ethnic make-up in those states like they do in Bayelsa state. CHINA: Beijing is set to ramp up its outward foreign investment deals by 20 percent per year, with South Korea as one identified target, a Chinese Ministry of Commerce affiliated research entity said Dec. 5 at a bilateral investment conference in Seoul. Also indicated was that China's foreign reserve holdings are on the verge of hitting $1.5 trillion. To mitigate the bad international press over China's surging trade surplus and undervalued yuan, Beijing has successfully used the lure of its bulging foreign exchange reserves to win over foreign companies and governments eager for investment capital flows. Having already secured the support of governments in energy-rich developing nations, Beijing increasingly is using its sovereign fund — China Investment Corp. (CIC) — as a diplomatic tool to deal with treasuries from more developed economies. British Treasury Minister Kitty Ussher announced Dec. 4 that the CIC will soon be invited to invest in her country.

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