Back in February 2007, I wrote an article in BNN. It was titled: Help: How to read global financial markets? 

And after lots of reading, writing and analysis; let me confess that I still don’t understand global financial markets. 

I mentioned about skeletons in the Feb. 2007 article. And since then, lots of skeletons have come out in the open from the cupboards of global financial markets.  

I suggested about going to the root of the global financial markets, and thereby understanding in details the balance sheet of the world. I still don’t have a clue of that, and I believe it to be same for most of us who write in any financial media. I won’t be wrong even if that’s true for major academicians to Central Bankers to government officials. 

The problem essentially is looking at parts and then looking at the whole. The whole is something more than the sum of the parts. And understanding the whole, by examining the global balance sheet, which in my opinion is more than the sum of different classes of balance sheets, is a must to get to the root of the problem. And that should be quite simple rather than understanding complex CDS or derivatives of derivatives. 

All of us individually can have a balance sheet (we all do have; we as individuals may not publish it – that’s different. Our credit worthiness is somehow dependent on our balance sheet). Similarly each private sector firm, including banks, has a balance sheet. Our governments, local and national, also have a balance sheet of their own. True, they may follow different accounting system to create more confusion, but we can apply a common-sense to decipher that. 

One can also understand that any of these three classes of balance sheets have interdependence with another, like a firm can have equity or debt from someone else. You as an individual can have an equity stake or a bond of a private sector firm. You can have loans from a bank against a mortgage. You can hold government treasury as an asset against credit card loan as another class of liability. 

At the end of the day, irrespective of classes of balance sheets (we essentially thought about three – individual, organizations and government), asset and liability of each balance sheet must match and so should the cumulative assets and liabilities of all the balance sheets. 

I admitted in the beginning that I still don’t understand global financial markets because I can’t explain two events that we have been witnessing lately. And they are the (1) phenomenal rise of dollar with (2) that of yen. I rather see them as the problems which are driving the global financial crisis. Now the explanations that other economies will cut rates or be weak in comparison to the US do not make much sense in explaining the rise of dollar or yen. They may be partly true, but the driver lies somewhere else. The weak links in global financial systems are getting stronger and stronger in a crisis…well, makes sense…but exactly how? 

We have heard a term called yen carry trade since long, where we used to see yen strengthening whenever markets (equities) went down and vice-versa. We have also lately heard another term called deleveraging as many banks in Europe and US were leveraged by 30-40: 1, which now has come down to 20-30:1. 

I believe it’s also time to introduce another term called ‘leveraged dollar carry trade’. And whatever the number one economy globally does; the number two economy follows. However, without any basis, I suspect that leveraged dollar carry trade to be of much higher magnitude than leveraged yen carry trade. Most speculative or non-speculative positions across asset classes and geographies were taken in dollar and yen; and as they unwind; the currencies temporarily strengthen. True, there may still be enough steam left for the dollar run as many forecast 1.0-1.1 dollar to euro in near future. However I doubt sustainability of that.

Let’s think about how it all probably works. You are a small businessman in Asia (India or China). Enters the bankers/investors/speculators of the world and offer you to increase your business with their money. You agree after much thought, anyway it was much difficult for you to get loans from the local state banks. Productive capacities are created. Your balance sheet size increases, but when problems come like now; your partner dumps your assets for any value and runs. Because it was not his own money, and the onwer of the money has now asked for it.

Point is, wherefrom did the investment banks get that money? It can be for creating productive assets, or taking position in forex markets or buying equities or even taking positions in commodities. For all that one needs money; and question is – wherefrom did the large institutional investors/speculators have that money? Did that money originate in US Dollar or yen or Euro from people like you and me in terms of our savings, or rich people giving that money for better return to the investment bankers? One can assume that major part of it originated where money itself is plenty and cost of it is the least (adequate supply and cost of borrowing). US and Japan perfectly fits in. 

Assets and liabilities of balance sheets cancel out, therefore no point if the value is one unit or hundred units, point is how the increase in size is getting funded. There’s another important term called (debt : equity ratio) in balance sheet. It’s the same as leveraging for banks.   

There’s no doubt that the size of balance sheets of us as individuals, business organizations, and also of local and national governments have been continuously on the rise, in most cases. Rarely do we see a decrease in balance sheet size. Important point here is, did global savings or equity rise proportionately to give stability to the phenomenal rise in size of global balance sheet? If it’s not, the system is bound to collapse. I suspect present balance sheet size of the world and many of its key constituents are not adequately balanced with desired equity.

Essentially, we have collectively created more assets and more liabilities over the years and therefore the balance sheet of the world now is significantly larger than what it was, say 10-years back. No problem with that, however important thing to ask is – wherefrom has the equity for the increased sizes of balance sheets have come. Otherwise, a significant part of it was created with speculative borrowed leveraged dollar or yen funds. One unit of saving (and my saving is not equity of the bank!) did result in 20-units of investment capital and with that positions/assets were created.

Equity can essentially be termed as the own money. So you can have a balance sheet with no debt, small size and 100% equity financed. Another person can have a much larger balance sheet with lower equity but significant debt. That’s true for an organization or a government body. Local governments can’t print money, but national ones can. Still that money should be shown as debt, ideally. 

Now just like assets and liabilities of each balance sheet and cumulatively of all in the world should be same; should all (debts + investments with others money) be less than our (cumulative savings + the additional liquidity that the financial institute issuing the debt must maintain)? In simple terms, our cumulative savings must be more than the assets created/positions taken cumulatively. The balance may come from increased money supply.

What I don’t understand clearly but believe should ideally be true for a sustainable financial system is that the total equity, in the form of equity (for an asset) or in the form of savings in banks of all these three classes must be greater than the total (debt + investments with others money) that the world has. 

However I wonder whether that indeed is the case. Have we been creating debt and investment bubbles in the air through fractional reserve banking systems? Do all the debts have a solid backing of equity of some one else? 

Let me honestly state that I am amazed by the strength of dollar as it’s shown over last one month, though I hinted at it in Strength of Dollar article, where I hinted at why the world may soon run out of dollar, barring OPEC, China and the US. But when all asset classes are being dumped for any value of dollar, the explanation isn’t as simple as the safe-haven amongst currencies, more so when it’s well known that it’s no longer the safe-haven, nor it has a future as bright as it had in the past.  

The explanation rather lies in leveraged dollar and yen carry trades and also in debts originating in two leading nations, which probably are not again backed by equities, that is in the US and Japan. 

The balance sheet of the world itself has a higher leverage ratio that what’s desired, and that leveraging did come from dollar and yen carry trades. On top of it, the borrowed money (which could be invested in equity or in any asset classes as a source of fund) may have been created artificially by banks and not by true equity of some one else, at least partly. And that’s most rampant in the US followed by Japan. 

An asset value can be looked by (1) cost of creating an asset, (2) from the return the asset can generate, and also (3) by technical factors (from sudden demand or supply) which may not be sustainable over the longer time frame. Let’s take two examples: one for a home in the US and another for a steel mill in China. 

A home buyer in the US bought a home for $400,000. The financing was done by a bank couple of years back based on (3) valuation above, which assumed that the price will keep on increasing due to the increased demand. Buyer gave in $20,000; the bank gave $380,000. The cost of the home was $240,000 (cost of land can also vary depending on technical sentiments). Now it’s priced at $300,000. Buyer has paid another $20,000 further equity in the form of EMI. If the mortgage owner wants to repossess and liquidate when the owner doesn’t pay the EMIs any more, it incurs a loss of $60,000. Due to same technical reasons that drove prices higher, now the prices can even be lower than $300,000.  

Important question here is: wherefrom the bank got that $380,000 that it lent? Definitely, it wasn’t bank’s own money. Someone, in some part of the world, should have saved that money, ideally. When one adds up all such lending by banks to individuals or organizations to nations, it runs to trillions of dollars, which in my hypothesis is higher than (the cumulative savings of US citizens + savings by corporate + money supplied by the Fed./treasury sale). And now who bears the loss of $60K, more so when banks have been failing under this weight? True, future tax-payers have come into the picture, but presently it’s again borrowed from some-one else.  

Extend the same logic to a steel mill in China, not funded from domestic savings; but through some FDIs. Has all the investments, be in asset classes or in financial markets, been made by real money or by leveraged borrowed money? Where leveraged money is allowed (in derivatives), that’s fine – however where leveraged money isn’t allowed; extensive leveraging was still used. 

The world suddenly finds itself in a place where it has a lot of assets, but not that much equity (meaning no leveraging and without any liability) money to back up the value of these assets nor much demand without credit funding for those demands. Since long, the emerging economies produced goods and the developed economies produced credit money. Though the developed nations, primarily US and Japan, produced hell lot of credit money; it still was not enough for leveraged dollar (or yen) carry trade.  Japan, after decades of running huge trade surpluses, recentlt reported trade deficit.

It’s a total mess in terms of who saved and how much, who borrowed and how much, and who lost and again by how much. A lot of speculative leveraged and artificially created (money supply multiplier?) dollars and yens did flood the global financial system. As the bubble busted, and as the equity owners pressed for their money; assets were dumped to recover parts of the equity. 

I admit one can find incoherence and loose ends here – the article looks like a rant. However at the same time I still search for the global balance sheet that sums up the whole picture. In the absence of that, the blame, true – without any proof, goes to the Federal Reserves and the US and to Bank of Japan and Japan. For their lax monetary policy and lack of regulations, for their belief that monetary policy alone can save an economy from recession and for their oversupply and under-costing of easy money when emerging economies followed a much more prudent system in a much illiquid society.  

It’s high time that a new global financial order emerges, with checks and balances. The patience of emerging world is indeed running out. Remember, it’s not the size of the balance-sheet that matters, but the quality of it. Ants may not have sizeable balance sheets compared to the dinosaurs or elephants, but they always proved to be quite efficient.

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