Global economy headed for danger

By John Berthelsen

HONG KONG - The precipitous falls in equities markets across the world this week are raising concerns whether, after years of central-banker complacency, the global economy could be headed for a real crisis. They could be simply hiccups, but if they are, they are vicious ones. The entire year's gains in almost every world equities market have been erased in less than a week.

On Wednesday, the London market registered its biggest one-day percentage loss in three years; Germany's DAX index fell 3.4%; France's CA lost 3.2%; the Dow Jones Industrial Average fell 1.8%; the Nasdaq Composite fell 1.5%; and the broader Standard & Poor's 500 sank 1.7%. Compounding the gloom, prices for US Treasuries fell along with stocks, with yield on the benchmark 10-year note rising to 5.15%. Bond prices and yields move in opposite directions. Though most bourses seemed to regain ground in early trading on Friday, the ominous signs remain.

At issue are fears that while the world's biggest central banks - the US Federal Reserve Bank, the Bank of Japan and the European Central Bank - have been watching out for interest rates and money growth, they have been ignoring, or at least been complacent about, the rapid proliferation of derivatives and the soaring price of gold and other commodities such as oil and copper. The Indian and Chinese governments, both of which have tame central banks and concerns about restive populations, have kept monetary policy relatively loose as well. Now, some economists believe, the sharp global market falls in both commodities and equities over the past few days could be the start of an economic nightmare. The central banks may have waited far too long to try to control inflation.

For instance, Dr Jim Walker, the Hong Kong-based economist for CLSA Asia-Pacific Markets, told investors in a private newsletter this week, "We are possibly in the most dangerous period for global financial markets in my working life."

Walker is not alone. "The Fed is grappling with two risks: (i) that it has already tightened too much and that a sharp economic slowdown is in the works and (ii) that it has tightened too little and an acceleration of inflation is on the way," write Ethan Harris, Drew Matus and John Shin, economists with Lehman Brothers, in their May 12 Global Economics Monitor.

Geoffrey Barker, economist and macro-fund manager at Ballingal Investment Advisors in Hong Kong, says central banks have forgotten the lessons of the early 1980s, when Fed chairman Paul Volcker applied historic and painful brakes to inflation, driving up interest rates to the point where US five-year T-bills were commanding rates as high as 20% annually.

Until just this week, when the markets have started to come apart, a tidal wave of liquidity generated by rising commodity prices and derivatives has swamped financial markets, not only in Europe but emerging markets as well. Even a country as disastrously managed as the Philippines has experienced a stock-market surge to record peaks. Markets in Australia, South Korea and Hong Kong have hit equally giddy heights as hot money has washed in from a global economy in which far too much money is chasing far too few financial instruments.

This liquidity has charged into commodities, emerging-market debt and equities, Asian currencies and particularly Chinese assets. Cross Border Capital, a financial advisory service, estimates total global financial assets now at US$74 trillion - $36 trillion in equities, $18 trillion in bonds and $20 trillion in liquid assets, looking for places to park on low interest rates.

Sean Darby, Asia strategist for Nomura, depicted one aspect of the phenomenon in April - a Sotheby's art and ceramic auction in which a painting of a pink lotus by Chang Yu sold for HK$28.12 million (US$3.62 million), more than five times the HK$5 million offer price. "Ironically, Chang Yu spent most of his life inventing games rather than painting, believing the former would make him rich and famous," Darby wrote. "We think the auction represents further anecdotal evidence that the financial economy is still flush with money."

Darby described what he called a "cocktail of global demand and excess liquidity ...
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