Reserve currency war?

The 2008 Financial Crisis marked a major turning point for the global economy but also a challenge to the economic hegemony which the United States has enjoyed since the end of the Cold War. Today, the United States is experiencing both a financial weakness, but also a steady decline in its image as a global superpower given its foreign policy actions in the past decade. Though originally touted as a viable successor to the USD, the Euro has lost such considerations in the face of the ongoing European debt crisis.

A reserve currency is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. If we look back historically, no one currency is immune to be dethroned as the global reserve currency. The British Pound faced a gradual decline after World War I and a complete replacement by the USD after World War II. The Cold War’s polarization of nations around the world around ideological lines provided a great platform for the United States to extend its influence around the world under the guise of combating Communism. With this greater influence came the political and economic alignment from allied nations with the United States. Thus, it is clear that the rise of the USD was very much connected with the United States’ foreign policy during the Cold War era. With the Soviet Union disbanded, the spread of capitalism became truly global and we entered into a new era of globalization which has also shown the complexities of large financial flows to destabilize economies.

In much the same way that the Bretton Woods agreement sealed the fate of the British Pound as a reserve currency, the 2008 Financial Crisis represented a similar unforeseen but large disturbance in the global political and economic landscape. We are now beginning to see China gradually chipping away at the economic hegemony of the United States, with its own diverse set of soft power tactics. China’s large reserve of over three trillion USD has been a potent weapon in its bid to expand its global reach. Outbound Chinese M&A activity such as Lenovo’s acquisition of IBM in 2005 demonstrate the subtle but continued Chinese strategy of appropriating its pent up reserves globally to increase its power projection. More recently, China’s heavy investment globally in an attempt to secure its energy future has put significant Chinese presence in countries such as Angola or Venezuela. Though these countries represent more of ideological allies with the Chinese Communist government, China’s recent offer to purchase Greek bonds is again a sign of their gradual build-up of their foreign power base. If we were to compare this phenomenon in the absolute with the United States’ policies of aiding countries fighting against Communism, then we see some striking similarities which would suggest that China is well on its way to establishing the global influence needed for the widespread use of the RMB.

In the context of China, the political situation is very unlike that of the United States or the United Kingdom at the time of their respective currency ascendency. Though China possesses aspects of a modern market economy, it is today a unique mix of ideological communist governance with the economic benefits of its liberalized economic policies. However one key aspect of its growth model which in its current will limit the adoption of the RMB is its fixed exchange and stringent capital controls imposed by the Chinese government. Though, the People’s Bank of China has over the past decade has let the RMB appreciate on several instances against the USD, the topic of the fixed RMB exchange rate is still a contentious issue today. For the RMB to be a true reserve currency, its exchange rate would have to be allowed to float against other major currencies. Though this is unlikely within the next decade given that such a move would considerably undermine the competitiveness of Chinese exports, there are some fundamental changes in the Chinese economy which hint that the importance of keeping the RMB fixed is waning in the eyes of Chinese policy makers.

Over the past decade we have seen a gradual transition from the export-driven model to the production of higher value-add products, but also the development of a service economy domestically as rising incomes facilitate the demand for luxury goods and services. The Chinese economy has been able to facilitate the development of more high tech manufacturing such as solar cells and the active development of domestic Chinese companies in the technology space (Lenovo, Haier) demonstrates a desire on the part of the central government for China to gradually switch to a consumption economy like that of the United States. Another factor which could curtail the dominance of Chinese manufacturing is the large relative increases in wage rates for workers in manufacturing. It is conceivable that China could have less of a role in global manufacturing as other developing nations like Vietnam come in to take up Chinese output with its cheaper labor. Given these broad economic trends within the Chinese economy, the importance of the RMB fixed exchange rate could significantly diminish in the coming decades thus allowing for a liquid global market for RMB.

Exchange rate aside, the Chinese government has made significant efforts to increase the volume of RMB traded globally and facilitate the creation of markets for RMB denominated securities. Recent efforts to popularize the use of the RMB though ‘dim-sum’ bonds which are corporate bonds denominated in RMB have grown exponentially. China has also negotiated with Brazil to settle trades in RMB. In addition to these steps there have been recent measures to develop Chinese financial markets with the launch of Chinese options and futures markets. The recent innovations in Chinese financial markets demonstrate a gradual sophistication of the Chinese financial system and it is likely that over time, a large market for RMB denominated securities will emerge. This process however will be slow and may likely take decades.

Though trends in the central government’s stance towards establishing freer financial markets for the RMB have been promising, there is a big but less obvious setback for the RMB and this involves both China’s political relations going forward with its major trade partners, but also general concerns around governance and stability. Since its economic reforms, China has steadily built its relations with the developed West, however this relationship can be characterized as being more along trade than any political or cultural lines. Issues around human rights, corruption and fake products are some of the sensitive political issues which have caused tension between China and the United States. Furthermore, provincial rioting and the lack of free speech lead to concerns over further domestic tension which may undermine stability. Unlike the Bretton Woods agreement, which was more or less a transfer of reserve currency status among allies in WWII, the rise of China is a phenomena which has caused political unease in the established West. It remains to be seen if countries such as the United States or United Kingdom will readily adopt the RMB as a reserve currency given their undercurrent of political tension with China. An alleviation of such contentious issues would require a drastic reform of the central government and thus is the greatest challenge to the RMB achieving reserve currency status. Assuming continued growth and the promotion of the RMB, it is likely that the central government will gradually reform to stay in power and maintain stability.

There has been much talk of the rise of China as a challenger to the United States. In actuality this is to some extent an exaggeration given the many domestic political and economic problems which the Chinese leadership must address. History has shown that a change in the reserve currency is gradual and takes place over decades. The United States today is financially weak and arguably in a decline, thus it is conceivable a new currency may take the USD’s reserve currency status. The RMB has the potential to achieve this status given China’s extensive trade relations and its active efforts to project soft power globally. The obvious hurdles of fixed exchange rate and limited financial markets are issues which are already being addressed and will likely change in decades as the Chinese economy adjusts its growth model. The more serious hurdle is the political tension and perception which hold China back as a benevolent global power and hence also the global adoption of the RMB. It is however plausible that the Chinese government will undergo a gradual form of reform in the coming decades to allow the RMB to become the world’s next reserve currency.

I’ve always pondered the significance of unfolding global events and its relevance in the grand narrative of defining an era. For me the following events in history have really caused a cataclysmic shift in global geopolitics and power dynamics:

Berlin Wall (1989)

Berlin Wall 1989

Important here for its symbolism of bridging a divided Europe ever since the end of WW2. The fall of the Berlin Wall signaled a sea change in the Cold War.

USSR Dissolution

Kremlin Coup

The binary opposition of political and economic ideology was to be no more after the dissolution of the U.S.S.R. The world entered into an era of increased globalisation as capitalism spread across the world. There was a profound new sense of global cooperation as coalition forces fought to free Kuwait in the first Gulf War, which was to be followed by interventions Somalia and Bosnia.

Asian Financial Crisis (Global Contagion)

Hong Kong Skyline

The truly interconnected nature of global economies was to be felt with the onset of the 1997 Asian Financial Crisis. An economic crisis that originated in Thailand was to set off the default of Russia in August 1998 and the downfall of Long Term Capital Management. This crisis exposed the truly fragile nature of the new global economic paradigm.

September 11, 2001

911 Memorial

An unforgettable day which would lead to two conflicts and exorbitant spending on the part of the U.S. government.

Lehman Brothers, September 15, 2008

Lehman Brothers NY HQ

Though Bear Stearns went down in March 2008, the collapse of Lehman was truly momentous for it set off a wave of panic across global financial markets. Marc Andreessen mentioned in CS 183 class the scarring effects of the 2000 internet crash on industry people. One has to wonder how the 2008 Financial Crisis has affected those who were old enough to discern the implications of such a momentous time in history. Only time will tell.

I do not necessarily see the current European debt crisis nor the public backlash against Wall St. as a zeitgeist moment for this new decade. Rather these events in aggregate are the derivative of what unfolded in 2008, with the Lehman HQ image being the symbolic image of the Financial Crisis.

The new age we have entered into is one which is fundamentally indeterminate. I say indeterminate due to the seemingly indecisive nature of global governments to settle upon an economic philosophy and to proceed with it. After 2008, one had a real sense that the unfettered free market capitalism advocated by the likes of Milton Friedman, Ronald Reagan and Larry Summers was coming to an end and that Keynesian policies were making a comeback. It is true that the capital injection aspect of Keynesian economics has made a comeback, but there is also a real sense of inconsistency in some of the policies that have been implemented.

The unfolding European debt crisis is a prime example of inconsistent policies, where fiscal austerity as a way out has now been challenged by rival Keynesianesque policies of government spending. It is this back and forth indecision which has to some extent dragged on and escalated the debt crisis that originated out of Greece. Now almost four years since Lehman, there is a real sense that governments around the world are broken, indecision and infighting almost brought the U.S. to the brink of default in August 2011.

There is a very real sense that the global economic and political power has been fragmented since Lehman. China has steadily chipped away at the economic hegemony of the U.S. and is now in a position to provide capital to debt laden developed countries. We are living through a very interesting age of global power dynamics shifts. It will be interesting to see what the next zeitgeist moment is.

Smart defence: a call for further NATO integration

The establishment of the EU in 1993 marked a major step towards greater European integration. In the wake of the 2008 Financial Crisis and the ongoing European Debt Crisis, EU nations have more than ever been constrained by dwindling fiscal budgets for military spending. As a means of greater fiscal consolidation, NATO nations must seek greater integration of their defence capabilities to avoid unnecessary duplication and cost overruns.

In a world where there is increasingly fragmented power, NATO is no longer facing the imminent threats it faced during the Cold War. The fall of the Soviet Union marked a transition from mass-scale warfare through the Fulda Pass to more localized conflicts. The interconnected nature of the global economy means that it is very unlikely that NATO will face a similar threat like it did with the Soviet Union. It is time for NATO to adapt to evolving threats it is currently facing and its tighter fiscal situation.
Instead of the replication of capabilities by individual nations, it is far more cost efficient for countries to specialize on their own areas of immediate need and skillsets. For instance, Bulgaria which is largely landlocked and has only naval access through the Black Sea contributed a frigate to the Libyan naval blockade in early 2011. It can be argued that given its geographic location and the small scale of its existent navy, that it would be far more cost efficient for Bulgaria to allocate its defence budget to more tangible ground forces. Bulgaria’s navy is a clear example of unnecessary defence expenditure in outdated equipment which would not standup to threats faced by more advanced adversaries. A more pertinent example of deadweight loss in defence spending is in Greece, whose Elli Class frigates do not have the capabilities possessed by the more advanced frigates of the English and French navies. It is unlikely that the naval capabilities of Greece or Bulgaria would be able to confront the threats faced by more advanced adversaries. The examples outlined above demonstrate that such capabilities are no more useful than to maintain a false sense of strategic security for a nation.

Specialisation of capabilities is very necessary given the tighter budget constraints faced by NATO members in the ongoing European Financial Crisis. In order for NATO members to move away from a diverse set of capabilities there must be agreements set in place for members to specialize and deploy their capabilities in a regional role. For instance, in order for Greece to scale back its outdated navy, a larger NATO member such as France may have to step in to guarantee regional protection for the Mediterranean. NATO members must familiarize themselves to the concept of a regional defence network as opposed to a defence limited by a member nation’s boundary. In giving up some capabilities, member states will become more tightly integrated given the need to coordinate different military assets in a regional defence scheme.

In order for a regional defence system to be coordinated, a follow on action must be a more uniform adoption of military equipment. In the past, the introduction of the NATO 5.56mm round marked a great step forward in unifying ammunition on the battlefield. More of such integration is necessary with other military capabilities such as fighter jets and ground forces. The joint development of the Eurofighter was another great development in further integration, but member states still possess different fighters in their existing fleets which make munitions sharing difficult for a truly regional defence network to be set up. Though there are economic arguments for defence manufacturers to come up with their own designs such as the French Rafale, more collaboration and joint ventures would forego this need to develop off the shelf designs as a revenue source. A broad mandate for the common adoption of newly developed fighters through defence contractor joint ventures would one allow better integration of munitions sharing and refueling capabilities. Secondly, the purchase of NATO produced equipment would keep more spending circulating amongst EU defence contractors. A notable example of defence outflows was with the Danish and Dutch purchase of F-16 fighters. Further integration will require clear mandates for NATO members to adopt common equipment such as the Eurofighter when they replace their existing aircraft fleet. Similar strategies can be implemented with ground vehicles.

In conclusion, greater NATO integration requires the establishment of a regional defence mindset. Member states must be willing to retire capabilities that are no longer competitive and specialize in areas of their strength. Secondly, there must be more joint NATO developed weapon systems and mandated adoption for member states as they begin to rollover their older military hardware. These measures will ensure a more effective NATO force in these lean times, whilst also promoting further integration and peace across the region.

Butterfly effect

Election Year: Best Response Strategy for Obama

The escalation of the Iranian nuclear standoff this year with Western sanctions and the threat of an Israeli preemptive strike on Iranian nuclear facilities. Amid the politics and rhetoric it is interesting to see how the United States’ collective action with the EU to impose an embargo on Iranian has put it in a reactionary role to Israeli foreign policy.

Wanting to gain a deeper understanding of the perspectives of Turkey and Israel in this standoff, I recently reached out to Bloomberg Op-Ed Efrain Inbar, Soli Ozel and Dmitry Trenin to get a feel for the ways in which this crisis can be resolved. It is interesting to see here two contrasting views on how to deal with Iran. Whereas the United States has looked at preventing Iran obtaining nuclear weapons in the absolute, the Russian and Turkish approach has been based on the idea that Iran will eventually obtain a nuclear weapon no matter how many setbacks they face and hence it is better to integrate into the global community as opposed to shutting it out. Israel on the other hand has had a history of covert strikes against nuclear programs, with one on Iraq in 1981 and more recently in Syria back in 2007. Clearly Israel has shown its propensity to preemptively remove threats from its hemisphere of influence before. The Israeli mentality towards a strike on Iran is not so much a question of whether or not to strike, but at what cost to strike. It would appear that risk calculus has now tipped in favor of a preemptive strike. All this puts the United States and particularly president Obama in a tight spot given that its election year.

Though Obama has gained some political capital with the killing of Bin Laden in 2011, the more than decade long U.S. military involvement in Iraq and Afghanistan is not far from the voter’s mind. Having pulled troops out of Iraq last year, the prospect of another U.S. Middle East conflict causing more U.S. spending and costing U.S. lives is not something most voters would like to deal with. Yet on the other hand, the incumbent President is also at risk of appearing soft on U.S. foreign policy in front of Republican attack. Obama is thus truly between a rock and a hard place in terms of the Iranian nuclear standoff. He must appear strong in U.S. policy denouncing Iranian nuclear ambitions, yet also not go far enough to give some illusion to Israel that U.S. would launch a joint effort to preemptively strike Iran.

Israel Calling The Shots

Given Obama’s predicament, it would appear that the U.S. for the time being has switched to a reactionary posture towards Israeli foreign policy. Israel could be argued to be the lynch-pin in this entire situation.

Let us conduct a little thought experiment here on how this chess game will unfold should Israel attack. A preemptive strike whether successful or not would likely prompt Iranian retaliation as a means of saving face, but also the closure of the Strait of Hormuz (again to follow through on the bluff). An Iranian counterattack would most likely materialize in the form of long range missile bombardment, Israel’s response is really anyone’s guess. But more importantly though, an Iranian closure of the Strait of Hormuz would more than likely draw the United States into direct contact with Iranian forces on the premise of global energy security.

If we go back in history, the ‘Tanker Wars’ of the Iran-Iraq conflict drew the Soviet Union and the United States into an escort role in the Persian Gulf. Given the structural change (Chinese demand) in global energy demand these days, it would appear that the United States would be even more inclined to protect a vital waterway for the world’s crude oil supply. Nonetheless, a direct confrontation would be won by the United States, but at what cost?

Impact On Oil Markets

Though the collapse of the Soviet Union has enabled the development of large reserves in the Central Asian countries of Kazakhstan, Azerbaijan and Turkmenistan, oil from the Gulf Region still represents a sizable portion of global daily demand. In 2011, an average of 14 tankers carrying 17 million barrels per day passed through the Strait of Hormuz. That’s a huge amount of oil that would be removed from the global markets! The bigger issue today with oil trading is the rise of paper and electronic trading, which has made oil a truly fungible commodity. Thus, the rise of global oil markets has also brought about the risk of market overreaction to supply disruptions, as we saw in 2008. Thus any such disruptions in supply would be reflected in a dramatic increase in spot prices. With that being said it is most likely we see Dubai Crude exhibit pricing deviations with Brent and WTI prices.

Though the U.S. Strategic Petroleum Reserve has the ability to some extent ease prices, the dual impact of high oil prices in a weak U.S. economy and the uncertainties of the duration of a U.S. conflict with Iran do not bode well for the incumbent President in election year. It is extremely fascinating to see how minor action could have such wide reaching effects around the world.

Logistic function

Legal Risks in M&A, How Do You Quantify Them?

The AT&T, T-Mobile deal marked a great relief for consumers from a competition standpoint, but also a large quarterly loss for AT&T given the exorbitant break-up fee they agreed to pay in the event of that the deal falls through.

Last year in June, I wrote about the harmful effects to consumers from the proposed merger, however what I have also been interested in is quantifying the regulatory risk that companies may run into for either cross-border transactions or ones which may harm competition.

My original approach on working with large M&A data sets was to unsupervised learning techniques such as cluster analysis to cluster transactions into distinct groups, yet this technique gives no good method to make future predictions. Rather such a technique would only allow a primitive classification of the deal being analyzed with the historical transactions. Of course, building a classifier for a multi-categorical data set would be possible, but perhaps an easier method would be to utilize logistic regression.

The Need for Numbers

The issue historically has been the difficulty of placing a hard physical number of the likelihood of a deal facing legal scrutiny to go through. Surely, there must be associated patterns hidden in M&A data that may reveal whether one or another legal firm (Linklaters or Sullivan Cromwell) are better at such tricky issues.

The use of logistic regression is a viable method to estimate the probability of success. Given a data set of M&A transactions limited to within a specific time period, we can classify transactions as either having succeeded or failed and according to a range of variables (deal size, financial advisors, legal advisors).

The beauty of the logistic function is its range boundaries are between 0 and 1 for all x in R, which works well in the case of probability estimates. Thus we can define a Z to be a linear combination of selected variables which would have a domain in R. The linear coefficients in Z are regressed against the chosen variables and data. We would be able to make a prediction for the probability of success P(Success) based on the inputs of the variables we have chosen for our predictor equation.

This is a very early stage idea which arose out of the interest in quantifying risks in M&A and thus could provide a basis for event driven trading strategies or event driven M&A insurance underwriting.

Forbidden City in Beijing

In my past two years at Berkeley, I have seen a rapid growth in interest in on campus entrepreneurship. However when it comes to entrepreneurship, Berkeley’s impact on the Valley is not as well known in popular culture. Berkeley is a system which teaches one how to adhere to a system and how to succeed in one, which sets its students up as great employees, but not as great employers.

In summary, the fundamental debilitating issue at Berkeley is the risk aversion exhibited by its students. This was the main reason why I chose to build out the Kairos Society fellowship at Berkeley in order to catalyse the undergraduate entrepreneurship spirit through creating a tight knit group of student entrepreneurs working.

When I reflect on my time in Asia this summer, I see similar issues between Berkeley and Asian society which hold back entrepreneurial activity. To clarify things before going forward, I must state that the form of entrepreneurship I am referring to here is of the ‘grassroots’ kind where a great idea is funded and grown from scratch.

In Asia, the notion of entrepreneurship is fundamentally different. For one, a greater majority of entrepreneurs are involved in mass scale manufacturing as opposed to less capital intensive and scalable businesses. It is often very hard to come by ‘grassroots’ type startups which are doing something truly innovative. For those ‘grassroots’ startups that are innovative, there is still the dogma of adhering to a process in creating a company. Now it is never bad to have plan or a process, but the process I am referring to here is of where teams apply for successive business plan applications to incrementally scale.

This kind of practice has its roots in shame-based Asian culture. In the West, guilt-culture is a form of social control whereby individuals are kept in line through an internal sense of morality. In Asian shame-based societies, social control is obtained through the connection of shame to the family name and the subsequent threat of ostracism. Thus, shame-based cultures have an associative effect for both good and bad actions. Applied in the context of entrepreneurship we see that the associative effect of one’s actions with one’s family creates substantially more downside risk for a budding Asian entrepreneur. In an industry where the likelihood of success is low, this specific cultural feature creates an even greater downside risk which for most is too much.

I wrote in April this year on the features which make the Valley what it is (Business Today Article) and a summary of that article would be that the Valley is truly a place where startup failure is not frowned up on. The same cannot be said in Asia, where startup failure becomes a social stigma.

Now there is no doubt there are a great number of startups that have also developed in this tougher environment (Alibaba, Baidu and Weibo to name a few), but you may also notice that the founders are generally older and came into the venture with good financial resources. For all the talk of building an entrepreneurial culture both in the workplace and more broadly for venture creation, Asia today is at a real crossroads with its ancient cultural practices. The question is not whether there will be more hot Chinese internet companies to emerge (these will develop for the most part as good geographical transplants of U.S. ideas), but whether more innovative and game changing companies will be created by the younger generation, people my age with little experience, but a creative mind and a hunger to realize them.

Congested HK Skyline

This past summer I was fortunate enough to visit the Asia after a long hiatus. My first visit to Hong Kong was four years ago during that visit I had the impression that it was a city all too small for an extended stay. This summer however was my first extended stay in Hong Kong and apart from the plethora of new opportunities opened by four years in age difference, the city did have a lot more to offer and see.

Tsim Sha Tsui & The Chinese Tourist Mob

Chinese Tourists Raiding LV Store

Despite its small size, the city of Hong Kong can be quite diverse in its many small suburbs. Central and Wan Chai are predominantly expat areas with Lan Kwai Fang being at the heart of HK nightlife. Though I did have many memorable nights in Lan Kwai, in retrospect my favourite area would have to be Tsim Sha Tsui. Unlike Central, TST has just the right amount of commercialism blended in with a touch of spice that makes it seem more genuine when you’re not spending cash on luxury items. In TST, you’ll find your batch of expats, tourist, locals, mainland Chinese but also Africans and Indian tailors whom speak Chinese. Added into the mix you’ll also find a bevy of laid back beer bars (recommend Ned Kelly’s last stand) plus more higher end bars and clubs (Aqua).

Of course with that being said, Hong Kong is known for its luxury goods and you’ll find them at TST as well. What makes TST different is the horde of mainland Chinese tourists raiding luxury goods stores as the picture above shows. On many occasions whilst heading into the office on weekends, I had the opportunity to observe a viking style pillage of the Louis Vuitton store in TST Peninsula. It usually starts with a tourist bus dropping 30 or so mainland tourists followed by a guide.

The group will congregate with the guide announcing the group’s time limit plus the benefits of buying in Hong Kong due to the luxury goods tax added on the mainland. Then the fun begins. Standing on the second floor and looking down, one gets an omniscient view into this commotion. What is fascinating to this is the propensity for the mainland Chinese to carry large amounts of cash abroad. Though this practice has lessened in recent years, if one observes carefully, small suitcases and bags loaded with RMB are still prevalent. When it comes to check out, the amount of goods that are brought is truly astonishing. A massive (and obnoxious) LV patterned bag for a short stocky Chinese man, small LV bags packed to the brim in a larger LV suitcase and so on. Before you know it, the horde has left and store looks odd due to the absence of display items being brought in large quantities.

To the careful observer, it is absolutely fascinating to see this materialism and insatiable appetite for luxury goods. Seeing many instances of stores being raided viking style was one of the experiences which made TST more “out of the box” than any other areas in Hong Kong. For me, you need some spice in life, something very different and TST definitely has flavours for the discerning taster.

Mong Kok – Haggling and Its Lessons

Mong Kok Night Market

Mong Kok is a region of Hong Kong, which is known for its vibrant nightlife and shopping culture even up to 2am. This part of town has an interesting mix of markets for a plethora of fake goods and it was here that I came one Sunday evening with a colleague in trading.

Wandering through the many streets of fake electronics, one could not help but stop and see (and laugh) at the many replications of original equipment. For instance, Dr. Dre headsaets, Apple iPhone USB and so forth. Though there were many cheap and cheerful goods, my biggest takeaway was how to negotiate and drive a hard bargain which applicable in so many other areas of life.

At a younger age, it is very imperative to develop negotiation skills and ways of meeting halfway as opposed to yielding. Of course, haggling at a market will be different than in a sell-side M&A situation, but haggling does nonetheless sow the seeds which will bear fruit later down the track.

Like TST, Mong Kok can be a little run down for the discerning tourist, but one has to only dig a little to find an interesting experience and have fun while haggling.

Hiking & Stanley Market

Stanley Market Waterfront

My last stay four years ago was too short to do any “non-touristy” activities, which was why I was left with the impression that Hong Kong was a one dimensional city. This summer however, I discovered the hidden gems laying on the south side of the Hong Kong island, namely hiking trails and Stanley Market.

Though the city of Hong Kong is very congested and built on a the small amount of flat terrain facing Kowloon, the rest of the Hong Kong island consists of hilly terrain that opens up into nice sand beaches on the south side. Due to the small size of the island, one doesn’t have to go for to get a slice of nature. Trails like Dragons-Back wind through the hilly terrain behind the sprawling office towers. The terrain itself can be very steep and presents a decent challenge for any amateur hikers. The trails’ proximity makes them very convenient even for the busy professional to get away from the hustle and bustle of the Central district.

Certain trails will also cross the peaks straight to an area called Stanley Market. Stanley is essentially an upscale Mong Kok selling locally produced and antique goods for mainly Western tourists. The market is small enough and filled with an interesting array of oriental antiques for gifts or personal use. It is also very close to a bevy of bars which allow drinking out on the streets.

The ability to drink freely in the open in Hong Kong is one of its libertarian perks, but in the context of Stanley it is just wonderful. One can stroll through the markets or street with a icy cool Corona in hand and actually enjoy the humid weather with a touch of cool ocean breeze.

Stanley Market is definitely one of the more laid back places I visited during my stay and it is a great destination for a Saturday hike and some beach time during the afternoon.

Then & Now

The economic history of the last century has been marked by sinusoidal swing between government fine tuning of the economy and free markets. The failure of the Federal Reserve to intervene in the wake of the 1929 stock market crash was the turning point for the adoption of Keynesian economics. Today we see a strikingly similar repetition of the past.

Although the world economy did not plunge to the depths that the US economy did during the Great Depression, the cycle of government and control and free markets is very apparent. A system of economic modality is only as good as the bubble it can sustain. When the bubble bursts we see a new system introduced. This back and forth motion between government intervention and free markets was very evident during the Great Depression, the Great Stagflation and today in the aftermath of the 2008 Financial Crisis.

An IB economics teacher once told me that economics is akin to driving down a hilly stretch of road with the front windshield covered. Indeed, our modern economic tools have not yet able and will never be able to allow mankind to have a-priori knowledge of the future state. It would appear that the world economic modality is condemned to a cycle between government and free market economics. It is as if the world is a blind child navigating its way through an alleyway of infinite length. Only when we have hit the wall do we realize that it is too late, the economy has overheated and a new direction must be taken. In light of this we must accept the fact that the rules of the game in the competitive landscape has changed.

The massive government bailouts and stimuli following the Financial Crisis is already a sign that the economic modality has shifted towards intervention. The recently introduced Frank-Dodd Act in the United States places quite drastic regulatory reforms on the financial services industry and as introspective analysis of what went wrong nearly three years ago continues we can only expect to see more regulations.

Businesses operating in this more complex environment must be prepared domestically to vie for weaker demand, but also face tougher competition from emerging markets. In some ways, the Financial Crisis lessened the gap between developing and developed nations as much of the economic set backs were felt in those nations with the greatest exposure to the financial services industry. From this we can infer that the power asymmetry we saw during the Cold War with the world roughly aligned in a binary opposition is far weaker today. Developed economies are facing a spending limbo as they try to reduce massive budget deficits. The world is becoming more fragmented with localized powers such as China, Brazil and India emerging to challenge the hegemony of the United States. For these emerging powers, their growth model is very simple – copy the technologies and growth mechanisms that have propelled the developed nations to their place.

This growth model is most apparent in China, where labor costs are rising to such an extent that we are seeing the beginnings of a shift towards higher value added products in computer software or photovoltaic modules. China currently has significant market share in solar wafers and has put massive emphasis on the production of light emitting diodes. Now these technologies are by no means cutting edge in developed nations for they have been around for at least a decade. The key question is how will developed nations grow in the face of stiff higher value added technological production from emerging markets?

For the United States, the answer can be found in Silicon Valley which is still the innovation capital of the world. Research being conducted in nanotechnology and the University of California, Berkeley or genomic sequencing at Stanford University will be the key for US growth. We have witnessed this type of innovation driven growth in the US during the 1980s with the rise of Microsoft and IBM, both of which revolutionized the way professional work is conducted. The emergence of information technology has subsequently spurred a plethora of nuanced industries. However, since then we have seen too much speculation in very low entry barrier internet companies and the financial markets. Such irrational exuberance as John Maynard Keynes once said is not sustainable. The United States and other developed nations now need to focus on ground breaking innovation once again.

Such innovations need to be outside the internet startup paradigm, for they need to be completely new and radical technologies which can truly change human living standards. Technologies such as genomic sequencing for personalized medicine, nano-scale targeted drug delivery vehicles or even the long talked about fusion reactor need to have more funding to make them a reality. Though these technologies may be capital intensive and require significant research, the returns if successful will far outweigh the costs. This shift in funding may be from government and market solutions. Already we see that a significant number of internet startups are being acquired by large conglomerates like Google or Cisco. This trend of consolidation will continue and may shift more focus for entrepreneurs to lucrative new technologies in the fields I have mentioned above. In conjunction, governments and the private sector must also take measures to educate more young students in math and science based subjects to offer a ready talent pool that is needed for the major technological breakthroughs.

Indeed, the mean reverting nature of world economic paradigm has put us in a period of increased government regulations, while also allowing developing economies to play catch up. Speculation and the movement of capital which fuelled the Financial Crisis are not sustainable growth models. Developed nations must be willing to accept the reality that a more long term growth model in real innovation is required which has the potential immense long run returns. My vision for world growth and innovation is thus that we will see a world with greater power distribution where developing nations copy the growth model of the developed, while developed nations must pursue real technological innovation.

Photo Courtesy of Flickr

With the August 2nd deadline looming, the big question on a lot of people’s minds is the possibility of default for the United States. A temporary one would absolutely smash investor confidence in the risk free US treasuries which have been regarded as the safe haven in the modern financial era. But for better insight let’s look at a comparison of spot yields for different nations which have experienced debt servicing difficulties.

For those of you who’ve My Big Fat Greek Wedding, you’ll know that with exuberance comes a cost which cannot be sustained by the fruitful gains of others. The recent spate of news around Greece is a result of policies which have been too short sighted in their vision. As a result, the Greek 2 year bond spot yield to maturity (YTM) has skyrocketed in recent months as shown by the following chart:

Photo Courtesy of Bloomberg

This year to date chart shows the dramatic increase in spot yields from less than 10% in January to now more than 30%. This is truly an astonishing increase, but for a better comparison its worthwhile looking back 3 years to see the progression of yields as news of a possible Greek default surfaced and to see how this compares with a timeline of US announcements.

Photo Courtesy of Bloomberg

The chart above shows the percentage change of spot YTM based on a base level 3 years ago for Greek 2 year benchmark (green), Portuguese 10 year benchmark (Orange) and US 10 year benchmark(Dark Orange). As we can see from the following the chart, the current YTM has in fact decreased compared to 3 years ago, in part driven by strong buying after recent turmoil in European treasury markets. If we were to look back at 1H 2010, when news broke of Greece deficit troubles, we see significant spikes in YTM.

Compared this with US spot YTM and we see a significant difference. Although an incredibly low Federal Funds Rate in addition to safe haven buying are factors to be considered in analyzing current US 10 year YTM, it must be said that if investors ever had an inkling of the possibility of US default being a real and serious threat, the YTM should then be much higher than today’s levels.

Despite a string of recent news on the roadblocks in Republican and Democrat negotiations, the market has apparently not priced the risk of default with a high probability. The risk of default for the US is on the tables, albeit small according to information from the market. Expect markets to become more mercurial and VIX to swing up as news and announcements trigger hairpin decisions by speculators on both sides of the trade.