Best to sit tight as central banks play the credit game

LEGENDARY investment guru Warren Buffett once noted that it is only when the tide goes out that one discovers who has been swimming naked.

His observation would have applied to the pandemonium that has hit the world's stock markets, after the United States central bank flagged its intention to scale back on the huge pool of liquidity it had been pouring into the global financial system since September.

As the hot money gushes out of the bond and equities markets, it exposes some very ugly fissures that had laid hidden by the sea of cheap money provided by the world's central banks.

Take the Tokyo stock market, which had fallen an eye-popping 21 per cent in the past four weeks after gaining 50 per cent since the start of the year. Its gains had been predicated by optimism over Japanese Prime Minister Shinzo Abe's so-called three arrows - monetary easing, fiscal spending and economic reforms.

However, Japan's ability to spend is constrained by its sky-high public debt, while the lack of bite in Mr Abe's reform programme underlined Japan's resistance to change.

As such, the only arrow that mattered was the Bank of Japan's ambitious programme to print up to 7.5 trillion yen (S$98.1 billion) in fresh money every month - a move that would rival in size the US Federal Reserve's own US$85 billion (S$108.8 billion) monthly money-printing efforts.

Now, that threatens to turn awry as the US monetary policy heads in the opposite direction.

But the biggest threat of all is the People's Bank of China's purported move to flush out the excesses in the mainland's shadow banking system by keeping its hands folded, as cash-strapped commercial lenders struggled with an unprecedented cash crunch last week.

Its hardline stance led to troubling questions as to whether it was merely a ploy by the Chinese central bank to punish troublesome small lenders for using short-term interbank funding for longer-term investments - or a sign of even more serious failings which have yet to be unveiled in the Chinese financial system.

Whatever the reason, coming as it did in the wake of the Fed's preparation to "taper" off its money-printing programme, the impact on the rest of the world was devastating.

Stock markets in commodities exporters such as Brazil, South Africa and Australia, which sell to China, were pummelled, as the Shanghai stock market plunged almost 10 per cent in a week.

Even markets such as Singapore were hit, with the benchmark Straits Times Index falling 109.39 points, or 3.4 per cent, at the same time.

It raises the spectre of the 1997 to 1998 Asian financial crisis once again, as gigantic sums were pulled out of the region's equities markets.

Citi Investment Research strategist Markus Rosgen, for example, estimated that as of last week, foreign investors had taken out about 90 per cent of the US$9.4 billion which they had put in regional equities funds in March.

But it may be the differences - rather than the similarities - between the Asian financial crisis and current developments that are of significance.

True, regional economies have been experiencing a stock market roller-coaster and a big cash outflow in their debt markets. But painful though these pull-backs may be, they do not pose the same kind of threat experienced during the Asian financial crisis.

For one thing, the sky-high fortresses of cash reserves built up by Asian economies will act as a big buffer against any instability caused by the "hot money" fleeing the region.

Take South Korea, which was one of the worst-hit countries during the crisis. As of April, it had US$329 billion in foreign reserves, as compared to just US$8.9 billion in December 1997.

True, Mr Frederic Neumann, HSBC's co-head of Asian economic research, noted that the foreign reserves will have to be offset against the foreign investment made in the country as well as any jittery local cash which may head for the exit too.

"But for the most part, they should still prove plenty enough to stave off bigger trouble," he said.

One concern raised by some quarters is what happens if the yuan comes under attack, as China's trading surplus dries up and its banking woes worsen.

Think about it. If China has to liquidate part of its massive US$3.3 trillion foreign reserves holdings to defend the yuan, the resulting sell-off may cause US bond yields to rise to a level that could potentially choke off the nascent US economic recovery.

The Fed - as the biggest buyer of US government debts - may have to think twice before pulling the trigger on its credit tightening gun. Otherwise, the deflationary pressure it unleashes may push the global economy into a fresh slump.

For investors, it is best to sit tight while the game is being played out.

The central banks call the shots, but until the smoke clears, it is not exactly clear where the shots are landing.

engyeow@sph.com.sg

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