Journey to Asia: Dan Denning On the Ground, On the Case, and Always in Trouble

2004-07-20T01:58:00.000+05:30

A portfolio of currencies from my wallet. I did the bone headed thing and sold all my Chinese currency...the only one in the whole bunch which will appreciate against the USD on an inevitable revaluation. In the meantime...there's always the Reckoning Day Reserve...the Perth Mint coin in the middle, one of which I'll be giving away in Vancouver...

2004-07-20T01:55:00.000+05:30

Back where it all started...from the 12th floor of the Peabody Court. Looking down on the ugly, dirty Baltimore.

2004-07-19T23:29:00.000+05:30

Immorality from Coast to Coast

***From La Jolla to Baltimore
***Dollar Down, Bonds Up
***Revised Schedule

Dear Reader,

Woe is the U.S. market. Back in the States now, and again reminded of how the cult of Greenspan has grown to obscene proportions. The market hangs on the Chairman’s lips, like loose spittle at the mouth of a frothing maniac.

What will he say?

I’ll tell you what he’ll say and save you the trouble of waiting. “The Fed has flexibility to remain patient in removing its policy accommodation,” or some such non-committal nonsense. In other words, the Fed will not raise rates before the election. More on why below.

But one more personal broadside against the Fed. One of the first things I did when I made it back to America was buy a copy of Pete Peterson’s new book, “Running on Empty.” Peterson chronicles the inept failure of our elected officials to reign in the ruinous and immoral spending habits that bankrupt the country.

You’ve probably been hearing some version or other of the impending entitlement bust for years. The difference between ten years ago and today is that today we’re a few years away from the beginning of the boomer retirement wave.

Time has run out on preventing the crisis. The storm is upon us.

In dry, economic terms, much of government spending is non-discretionary (locked in). The mandated growth rates in Social Security and Medicare alone are going to consume most of Federal spending in the not too distant future. And that does NOT include the cost of paying interest on the debt.

If you STILL think it’s no big deal that foreigners own our bonds, let me know what you think when you find out that your taxes pay foreign bond holders first…and American taxpayers last…if at all.

Peterson’s book is grim reading. And he may again be a bit ahead of his time, although not by much. He gets to the heart of the issue: the immorality of government borrowing and the low-interest rate regime/demon child that Greenspan has midwifed.

You can borrow from the future to pay for your consumptive lifestyle today, as America is doing. But you’re impoverishing the future...gutting the American dream from future unborn children. It’s not just gluttonous. It’s prideful, slothful, and greedy too.

Greenspan, for his part in abetting the bankrupting of America and encouraging the moral decline that borrowed money brings, will go down as the John Law of his time—a man whose monetary alchemy destroyed the wealth of a nation and left its people poorer.

You look around in America and see that all the pieces of a radical decline are in place. What’s missing is any sense of urgency to prepare for it.

And I suppose from an investment point of view, that means you still have time to profit from it.

In any event, I’ve written more about both issues—the preparation and the profit—in the August issue of Strategic Investment—which is due out late this week or early next. Enough of the historical context for today. Let’s move to what’s happening to the dollar and the bond market.

Dollar Down, Bonds Up

“It doesn’t make any sense,” I explained to the audience. “But then again, financial markets aren’t sensible. They’re emotional. And if you’re a trader, that’s not a bad thing.”

I was trying to explain to the attendees at the currency and commodity conference in San Diego an apparent paradox in market action. On Friday last, you saw an economic cause that did not produce the expected effect. Instead, it produced precisely the opposite effect of what you would expect, economically speaking.

What am I talking about?

On Friday, the Treasury Department reported that foreign purchases U.S. securities were down 32% in May from April. Actually, the report revealed that foreign purchases fell from $81.2 billion in April to $54.8 billion in May, which works out to a one-month decline of 32%.

Private foreign investors continue to be net sellers of U.S. equities. In fact, private foreign investors increased their selling of U.S. equities by 680% from $2.4 billion in April to $7.8 billion in May. That begins to explain the lagging stock market, which has depended so much on foreign capital flows to keep it afloat.

It also explains weakness in the dollar…this is early confirmation that the adjustment in the current account deficit is going to come from a decline in the dollar caused by reduced foreign purchases of U.S. assets. Foreigner are going to stop trading the dollars they make selling goods to the U.S. for underperforming U.S. stocks and bonds.

Even more interesting, if you’re a data junky like me, is to break down the bond market numbers in terms of private and public purchases. That is, central bank buying and private sector buying. On both counts, and for both stocks and bonds, the news is ominous. But the bond market data is more urgent, as it has a direct impact on interest rates…and what the Fed might say and do in the coming months.

Net private purchases of Treasury bonds and notes fell 44%, from $13.2 billion in April to $7.3 billion in May. That was a big decline, in percentage terms. In nominal terms, net government purchases of Treasury bonds fell $7.5 billion, from $22.1 billion in April to $14.6 billion in May, a smaller percentage decline, but a decline nonetheless.

Foreigners, both central banks and private buyers, are reducing their dollar exposure by buying fewer U.S. bonds. That’s what the data shows.

In a sensible world, when the demand for a product declines, it indicates the price is too high. Normally, the price falls. In this case, that would mean falling bond prices. The cause (reduced foreign buying) would lead to a specific effect, lower bond prices.

Yet we didn’t see that at all last week. But the Newtonian world of causality does not operate in the bond market. In fact, take a look at the Lehman 20+ U.S. bond index (TLT). TLT is a proxy for the U.S. government bond market. It’s also one of my favorite trading vehicles for my options trading service.

If you look at a recent chart for TLT, you’ll see that on Friday, the same day the Treasury Department reported the big declines in foreign bond purchases, bond prices, as measured by TLT, actually went up. Specifically, TLT finally broke out of the glass ceiling it kept bumping into at 84 and moved up as high as 85.50 in intraday trading.

This mini bond bull in the midst of bearish data was made even more paradoxical by the fact that the dollar was making, at the same time, four and half month lows against the euro.

The dollar going down while the bond market goes up? What gives?

Like I said, it’s not sensible. It’s utterly irrational. You can see the vapors of a strategy in this madness. U.S. investors are still giving U.S. government bonds the “safe haven” bid. When U.S. investors get nervous on stocks, they stay in the market, but change asset classes and move into cash.

This is confirmation that in their heart of hearts, investors are still nursing dreams of a new bull market. The psychology of the bull is still in control.

The mini bond bull might also be an indication that investors realize the sell off in bonds was overdone, based as it was on Fed rate expectations. The bond market is expecting Fed rate hikes. It’s been selling off bonds.

But what if the Fed rate hikes don’t come? That would mean bonds are short-term oversold, and you might see a rally (long term, bonds are in what I believe will be the bear to end all bond bears…climaxing with the immolation of the dollar.) What if, in fact, the Fed is constrained in its policy making by an economic reality that makes short-term rate hikes a virtual death sentence for American consumers?

THAT would mean the Fed isn’t raising rates any time soon, and that there could be some legs to a rally in bond prices.

But one does not make predictions about changes in the global currency order lightly. As Lance Armstrong says, extraordinary accusations require extraordinary proof. My proof comes via Greg Weldon at Weldon Financial Publishing.

For months, Greg has been on a theme that I think is right on. Specifically, Greg has shown that average real hourly earnings in America are disinflating. In June, it happened for the fourth month in a row.

Greg reports that real earnings deflated by 1.4% in the last four months. That’s an annualized rate of 4.2%. Odd, isn’t it, to see real earnings deflating when everything else is rising (inflating) in price. And where does that leave us?

Let’s summarize, from the perspective of the average American consumer. Gas prices are rising. Long-term interest rates are rising, increasing the cost of debt service, or of financing consumption through borrowing. And average earnings are deflating.

Is this a scenario in which the Fed can tighten rates?

I don’t see it. Consumers already have little margin for error with such a low savings rate. Any rate hikes are likely to exacerbate the consumer’s chief problem: debt.

Thus the Fed’s choice: raise rates and put the squeeze on consumers or keep rates low and feed the speculative beast. Neither is a good choice.

In the meantime, expect more selling in the stock market, more buying in the bond market, and more acid reflux in millions of American esophagi.

Revised Schedule

I’ve been dealt another blow by the capricious gods of government immigration. I’m unable to pick up the proper documentation to enter the U.K. until next week…and I have to do it up in New York. So I’ve decided to make a trip of it and spend a few days up in the City visiting with the New York editor of the Daily Reckoning and his Wall Street friends.

From there, back to Baltimore (which you can see below in a shot from my 12th floor hotel room in Mount Vernon. And from THERE, to Colorado to visit hearth and what used to be home for a week, before I see some of you in Vancouver in for the Agora Wealth Symposium.

By the way, in Vancouver, I’ll be recapping my Asia trip as I did in San Diego. But by then I expect to have finalized the investment strategy, including specific picks that follow from the trip. Stay tuned.

From Vancouver, it’s back, finally, I hope, to London in mid August…. and from there…who knows? Perhaps I’ll be coming to a city near you soon…at the very least, I’ll be coming to an email box near you even sooner. Later this week, I’ll take another look at China-U.S. war scenarios…and a short-term strategy on trading the oil price (with credit due to the many talented traders and speakers whom I visited with in San Diego.)

Until then,

Dan

2004-07-13T18:51:00.000+05:30

Exit Strategy: The Adventure Continues

Wouldn’t you know it? I make it all the way through Asia with nary a stomach problem and felled, at last, by garlic shrimp in Darling Harbor. The Law of Perverse Outcomes (people get not what they expect, but what they deserve.)

My stay in Sydney was short anyway. Just a few days to pack up my bags one more time. I did, at least, get a chance to talk with a man we’ll call Kevin. Kevin is a trader. He used to work the swaps desk for a major international investment banker. We discussed a financial meltdown over tea.

Kevin came to Australia twenty years ago from England. He’s seen the halcyon days of the bull market. He started off his professional career as an actuary, in the business of scientifically assessing risk for insurance purposes. Trading derivatives (swaps are one subset of the derivatives universe) was probably a natural move.

After all, according to Greenspan and others, the derivatives market allows for more sophisticated risk intermediation. It turns liabilities (debts) into assets by packaging them up and parceling them out, often times with a snazzy credit rating, to investors looking for a higher yield than say, the money market or a U.S. Treasury bond.

“It’s not the GSEs you have to worry about, although there is certainly a problem there in its own right. It’s the CDO and CBO market,” Kevin said. He was talking about the securitization of debts and bonds. A CDO is a collateralized debt obligation…a CBO…collateralized bond obligation. The CDO/CBO market, according to the British Banker’s Association, has a notional value of just under $5 trillion. The business of trading debt is big.

In the great hunt for a few points on a trade…and investment instruments to sell investors…CBOs and CDOs represent a strange new devilry. Packaging up debts in and of itself is not so wicked.

But it IS an occasion for financial sin…and there are three cardinal ones.

First, you can be a hedge fund and make a wrong directional bet in the derivatives market. This is what happened to Long Term Capital Management. They expected global interest rates to converge. They had a position in Russian bonds. Russia defaulted. LTCM was leveraged to the hilt. Once their Russian position fell apart, they were forced to liquidate everything else, which brings me to the second sin, default.

Default is always a risk when you buy risk.

Greenspan has said that the derivatives market allows for the dispersion of risk in the market from a few players to many players, sort of like saying if you cut a big piece of evil up into many little pieces and give those pieces to individuals, you’ve made the world less evil by making evil less big.

It doesn’t work that way, of course. Especially when all the purchasers of the evil count on it for income.

I’m oversimplifying and moralizing. But I should stop, because the problem IS serious, not least because of the last and greatest sin: insuring risk.

There aren’t a lot of firms that guarantee CDOs and CBOs. And that’s exactly the problem. Some insurance firms found a good business in guaranteeing the quality of otherwise non-triple A rated CDOs and CBOs. That is, some institutions are barred from buying emerging market sovereign, corporate, or municipal debt on the open market because ratings agencies like Fitch, S&P, and Moody’s have rated the debt less than triple A. If it ain’t triple A, some institutions are forbidden from buying.

But if an insurance company comes in and slaps a guarantee on the packaged up debt, it’s effectively given the junk a triple A rating, making it safe for the big money to come in and play.

All of this is fine, although difficult to do. The real risk comes from having so few derivatives insurance firms. Insurance firms like MBIA carry enormous risk should any of the derivatives they’ve guaranteed default.

The obvious risk, and the reason Warren Buffett has called derivatives “financial weapons of mass destruction” is that a major derivatives insurer goes under…wiping out all the guarantees that firm has extended to CDO and CBO bond buyers. It’s the vaunted “daisy chain of risk default.”

Such is the modern financial era we live in. There is a gut busting irony to this predicament the West has gotten itself in. The West has a longer history and creating “sophisticated” financial instruments. And yet the East is gobbling them up at a ferocious pace.

Kevin tells me the Japanese are famous rain makers for the investment banking industry, buying up exotic new debt products almost as fast as they buy Luis Vuitton bags and Burberry Scarves. Instead of a handsome handbag, however, they’re getting something far more dangerous: a liability that looks like an asset right up until the moment it doesn’t.

Bondholders of the world beware. Those that have guaranteed your debt (the U.S. government, Fannie Mae, Freddie Mac, derivatives insurers) are running tremendous risks. I say “those” but what I really mean are individual traders now responsible for managing complicated positions AND making a profit. There’s a long history of traders in risk making faulty calculations, and I’m not talking just Orange County and LTCM. It’s a common occurrence in financial markets.

By this time Kevin and I were on our second cup of Earl Grey and moved on to the failure of the Western Welfare State and the urgent question of what will replace the dollar standard. We agree that we’re not witnessing the end of the world, just the end of the world as we know it.

We also agreed that the silver lining to this dark storm cloud is your ability as an individual investor to do something about it. You don’t have to sit idly by as the major institutions to which you’ve entrusted you financial future run enormous risks. You can have an exit strategy that keeps you out of harm’s way, and liquid in times of crisis…more on that later this week.

Gotta Go,

Dan

P.S. By the way, my return to the Continental United States doesn’t mean my trip is over. In the next six weeks I’m due to hit San Diego, Baltimore, London, Paris, New York City, and Vancouver, British Columbia. I’ll be reporting from several conferences, too. Stay tuned.

2004-07-10T02:18:00.000+05:30

Eureka Rebellion

“How you sparkle. How you shine. How you rise above the sky.”
-Rubyhorse

The Super Pit in Kalgoorlie, Western Australia used to be called “The Richest Mile on Earth.” Today it’s just Kalgoorlie, a real live twenty first century mining town. The work is hard, but prostitution’s legal, beer’s cheap, and when the gold price goes up, life’s good. I can attest to most of the above, because I was there on Tuesday.

Life is getting better everyday for the folks in Kalgoorlie. But if you’re not willing to work in a gold mine, how else can you profit from the rising gold price?

Long-suffering readers know that I’ve been tracking the debut of a gold related exchange traded fund in the United States. The idea is simple: securitize gold and make the security redeemable for the real thing. What’s the benefit?

Not everyone wants to own bullion…to find a safe place to store it, or to pay a bank to store it for you. Not everyone wants to collect gold coins, although there is a growing market for it. In fact the folks at the Perth Mint told me that a Russian bank recently bought the entire issue of a coin that commemorated the Eureka Stockade Rebellion here in Australia.

In 1854, hundreds of gold diggers rebelled in the town of Ballarat against official rule. They ran a flag up the pole at the stockade and swore the oath, “We swear by the Southern Cross to stand truly by each other and fight to defend our rights and liberties.”

Why would a Russian bank take down a whole coin issue celebrating gold and independence from the authority of the State? Hmm. Interesting question. Maybe the only real defense of freedom is sound money and a loaded gun. But we’ll leave that for another day.

Investors not interested in rebellion against the monetary system crave a way to buy and sell a paper form of gold. The market wants it. So why don’t we have one in the States yet?

One possible answer is that the SEC or CFTC is holding up a launch. That’s possible. But from what I’ve been able to gather from primary sources in Perth, it’s a lot more about infighting in the gold industry…and a series of blunders and court cases that have kept a usable product from hitting the market.

The answer is shrouded in tangle of court cases about who really developed the concept of securitizing gold. I won’t go into all the gory details. Suffice it to say there are two basic problems.

The first problem is that the actual structure of the investment vehicle that was eventually launched by the World Gold Council in London (following the launch of the Australian issue) was flawed.

The original structure constituted indirect ownership of gold through a security, something apparently not allowed by U.K. security law. The WGC had to reengineer the instrument and has since done so to clear up the problem.

In the meantime, there is a legal problem revolving around a WGC-backed gold ETF in the United States. All the court records are public so you can look it up if you’re interested. What we have here, though, is a simple case if intellectual property dispute.

The plaintiff in the case in front of the New York Supreme Court claims he broached the idea of securitized gold redeemable for bullion with affiliates of the WGC…and that those affiliates eventually advanced the idea in violation of a confidentiality agreement. The saga goes on, with the WGC in the middle of the mayhem and retail investors no better off.

Of course, nothing is holding back anyone else on Wall Street from launching a securitized gold product.

With the slump in the gold price, though, maybe Wall Street thinks main street isn’t interested in buying paper gold. That, of course, is a real problem.

The spot gold price isn’t volatile enough, right now, to make owning a security that tracks it attractive to speculators. If the underlying asset doesn’t move, why would there be a market for a security that tracks it? And if the underlying asset doesn’t move much, what’s the chance that the security would trade at a premium to the net asset value of the fund?

Funny enough, gold-based securities DO trade at a premium to net asset value. The Central Fund of Canada (CEF) which I’ve recommended in SI currently trades at a 15% premium to NAV.

Is that insane? Not if you believe the gold price is going up, and soon. By owning the fund, you own a non-expiring call on the spot gold price. If and when gold makes a $100 move up, the net asset value will also go up.

As the value of the fund’s gold goes up, the market for the shares heats up. It becomes more attractive to own a paper asset that derives its value from an asset in the middle of big bull market (as opposed, say, to a paper asset like a mortgage backed bond whose value is based on the mortgage payments of overleveraged home buyers.)

Why doesn’t Wall Street get with it and provide more securitized gold products?

One big reason may be lack of institutional demand. Pension funds, hedge funds, and other big market players don’t want to own bullion. If they want exposure to gold, they’ll get it in the futures market, or, in some cases, through gold equities.

In both cases, they get leverage. And in both cases, they get liquidity, the chance to pare several hundred million dollars in one place and get a quick return. Why give that up for a gold ETF that doesn’t move?

For those and more reasons, you don’t see big money managers lining up to trade cash and shares for actual gold bullion. But that doesn’t mean there isn’t real retail demand.

I’ve said for a year that the public is ahead of Wall Street on this way. There is a trillion dollars sitting in money market funds. The owners of this money obviously don’t care about yield since, in real terms, money market yields are practically negative.

If you’re going to get zero yield on your cash and run the risk of owning a depreciating currency, wouldn’t you seriously consider getting zero yield on gold bullion, but owning a commodity that acts like money and goes up in dollar terms the weaker the dollar gets?

I think it’s a no brainer. And we may see Barclay’s jump in with a gold iShare later this year.

But it’s a bit of a paradox anyway isn’t it? Real gold bugs aren’t interested in securitized gold or in a way to introduce mega liquidity to the gold sector. They buy and own gold because it’s real money and can’t be printed, not because they can buy today and sell it tomorrow at a higher price.

Still, it would be great for everyone if there were a liquid, U.S. listed security that’s redeemable for gold.

But I’m beginning to think it’s less and less likely to happen.

And I’m also beginning to think that the idea of owning “paper gold” has a short half-life. If the decline of the dollar is “disorderly” it will bode ill for all paper assets and you’ll better off owning some of the real stuff.

Of course if the deleveraging of the American economy takes another five or ten painful years…trading paper gold might become an easy way to cash in on the appreciation of the gold price. We’ll just have to wait and see.

Okay…it’s late here in Sydney, where I’ve just flown in and the beer is just as cold but the prostitution is less legal. Time for dinner.

Until Next Week,

Dan

P.S. When I was in Thailand I wrote about complimentary currencies, as described to me by a man on holiday there (who ironically lives in Boulder, Colorado…about 30 miles from where I grew up.) After getting a few reader e-mails about that article on currencies I went back and looked at my notes and wanted to add two new points.

First, the basic idea behind a complimentary currency is to meet unmet needs with unused resources. Easier said than done, of course. But I thought I’d clarify that point.
Second, Steven (the gentleman I spoke with) made a point that a reader who wrote also made. Namely, services are a better medium of exchange than commodities.

In that line of thinking, the service you provide IS the currency, the medium of exchange…. where you exchange your service for someone else’s service.

The idea makes sense to me, and probably works as a concept.

The baker trades his bread for shoes. The shoemaker trades shoes for beef. And on and on.

The problem with this model, as I see it, is that it’s not scalable. How is a microbiologist going to trade his services with a pastry chef? I’ll trade you my yeast culture for your pain chocolate?

Though I’m not a scholar on it, I suspect that money was commodified because it made it far easier for people in diverse lines of work to trade gold for what they needed instead of trading labor. The commodification of money probably enhanced the division of labor.

Instead of getting paid in a service, you can be paid in a commodity, which can be exchanged for other services or goods with anyone else you choose to do business with.

This isn’t to say that trading services as a form of payment is a bad idea. It works really well for certain types of exchange.

But the more complicated the exchange is, and the more value added that goes into the good or service, the harder it is to make a clean exchange of services of values where both sides agree on the value of services rendered.

In some services, like prostitution in Kalgoorlie, the whole process is a lot less complicated.

2004-07-09T16:12:00.000+05:30

Free wisdom from one of the merchants in Boulder, Western Australia. Western Australia is about three times the size of Texas. It's also rich in minerals, natural gas, and gold. The "Golden Mile" where the Super Pit is now has produced 50 million ounces since Paddy Hannan, Dan Shea, and Tom Flanagan stumbled on to some gold. Three miles south, Same Pearce and Will Brookman made the big find....and pegged the ground for the Great Boulder and Ivanhoe mines...two of the most profitable mines of all time.

2004-07-09T16:02:00.000+05:30

The little town of Boulder, outside the Super Pit and on the other side of Kalgoorlie. Boulder lives and dies with the mine...and the morning we were there...it looked pretty dead. But as a real estate play proxy on the price of gold, it's intriguing. The thinking, my friend Andre explained, is that as the spot price of gold goes up...real estate in and around big mining towns inflates. It's a sound theory. What we found in practice is that this town, at least, was too illiquid to come in and find good value and yield. If you can wait fifteen years...who knows. By then, the mine will be over 6km long, 500 meters deep and 1.2km wide.

2004-07-09T16:01:00.000+05:30

The little "doorways" in the side of the slope are evidence of the time when the mine was not an open pit mine, but an underground one. Underground mining in the area near Kalgoorlie, "The Golden Mile" as it came to be called, started in 1893.

2004-07-09T15:57:00.000+05:30

The mine is owned jointly by Newmont Australia and Barrick Gold Australia. It's also one of the big reasons why Australia now produces about 300 tonnes of gold a year.

2004-07-09T15:55:00.000+05:30

The Super Pit produces about 850,000 ounces of gold a year....the ore grade averages 2 grams per tonne....which means one truckload of ore contains about 16 ounces of gold, or enough to make a solid golf golf ball.

2004-07-09T15:42:00.000+05:30

A 793C Caterpillar dump truck toils in the distance. The bed of the truck is seven meters wide and six meters high. The engine is a 2400hp V-16 and uses about 4,000 liters of fuel per day. The mine's literature compares driving a truck to driving a two-storey house from an upstairs window. If you want to get a street legal one, it'll cost you about $3 million. Come to think of it, if Fed Governor Bob McTeer thinks buying an SUV on credit will get the economy going...what about putting a few thousand of these bad boys on the lot?

2004-07-09T15:38:00.000+05:30

Here's a picture of a truck on the far side of the pit, rolling up the slope. About 245,000 tonnes of 'dirt' gets moved each day.

2004-07-09T15:37:00.001+05:30

The mine runs continuously...trucks go up...trucks go down into the pit...

2004-07-09T15:37:00.000+05:30

And now with five times zoom...it gives you an idea of the scale. By the way, the tires on the trucks are solid, not inflated. It would be pretty trick to try and fix a flat with tons of ore in the bed. The big shovels that load up the trucks can load up 60 to 70 tonnes of ore in about two and half minutes.

2004-07-09T15:36:00.000+05:30

Little pink houses. Kalgoorlie can be a rough place. But it's also a free one. It was a bit early in the day to uh...see anything along Hay street...where the ladies of the night were fast alseep. We did stop by later...on the way out of town...

2004-07-07T18:50:00.000+05:30

Monetary Independence Day

Dear Reader,

Don’t let the beach pictures fool you. Your editor was not idle over the weekend, or on American Independence day. The pictures I sent along yesterday are bucolic. Lots of white sand, green trees, and blue skies. Lest you think your editor came to Perth to get a tan and work on his surfing, let me explain.

I came here to Asia looking for a path out of a dollar-based U.S. centric world and into a something-else based non-U.S. centric world. If possible, I wanted to find Asian stocks that provide direct exposure to the growth story taking place here, without taking on too much risk. Easier said than done.

Asia has all the tools to get out of the dollar…high savings rates, domestic demand, raw materials, and cheap labor. Yet it’s still wedded at the head to the greenback. And Asian stock markets are dominated by foreign money—which as we’ve seen in the past few weeks, is skittish. More on Asian stocks when my trip wraps up and I can put all the pieces together.

But I’ll now confess one of the other reasons I came to Asia, and specifically to Australia. I’m looking to become Sovereign. What do I mean by that? Let me put it in the form of a question….

What can you do today to make sure that your financial future is not dependent on things beyond your control?

I’m asking because most people’s eyes glaze over when you tell them the dollar could lose all of its purchasing power in the next ten years.

Most people, and maybe you’re one of them, find it unrealistic that the world’s entire financial system is so overleveraged that it threatens to topple and radically affect living standards.

These aren’t pleasant things to think about. But neither is Hell. And if you choose to ignore them, you do so are your own peril. Why not make Pascal’s gamble instead…hoping you’re wrong but hedging your bets in case you’re right? And if you haven’t done anything yet, the markets have given you a reprieve.

The dollar hasn’t crashed, yet. The bond market hasn’t imploded, yet. And the stock market hasn’t set a new standard for wealth destruction, yet. There is still time to reduce your risk.

Part of reducing your exposure to the biggest financial risk of your lifetime is to think about more than just your stock portfolio. You have to think about all your assets. If you take seriously the proposition that no currency regimes last longer than seventy five years, than you have to put some real thought into what changes you’re going to make to your personal balance sheet to adjust for a radical decline in the dollar.

It’s not simply a matter of reducing your equity allocation from 75% to 50% and adding cash and bullion. You can start with simple, principled goals. Stay debt free. You’re your assets liquid. Have enough cash to survive in a crunch. Live in a place that’s not going to go up in a ball of flame if there’s a great deal of social “disruption” in an American financial crisis.

That’s why I like Western Australia so much. It’s not densely populated. The climate, from what I hear, is a lot like San Diego. And it’s in close proximity to the major investment story of the next one hundred year.

It would be even sweeter, I thought, if it turned out you could get some real Indian Ocean real estate on top of all the other benefits, and get a cheap, with a currency upside. But there’s a slight problem.

Australia, like the U.S. and the U.K. is in the grip of a housing hysteria. A real estate broker I talked to yesterday says the average new homebuyer borrows around 95% of the cost of the purchase price. She all said the margin of error for a first time homebuyer is incredibly thin. If incomes don’t rise faster than inflation or interest rates…the marginal buyer falls off the margin, and is doing so at the rate of 50%.

That’s why the central bank here has already started hiking rates. And just a modest hike has been enough to put a crunch on new housing demand in the hot markets of Sydney and Melbourne.

But you’re hard pressed to find bargains anywhere, especially here in Perth. The market favors renters. It IS true that in some places of the world, this being one of them, people will always want to live. The Napa Valley, the Rockies, Paris, anything near a beach with a breeze…there are pockets of real estate that survive cyclical downturns quite well. At the worst, you may see real estate values and home prices grow less fast in these regions, but not fall in real terms.

However, in those places where home values have risen strictly as a function of low interest rates making a home affordable to new buyers, watch out. In those places, the housing stock itself is of lower quality. And the appreciation in prices is dedicated on a steady stream of low-rate powered demand coming on line.

The real systemic risk is not in the housing market anyway. It’s in the mortgage lending market, and the fact that personal liabilities (mortgages) have been securitized and turned into assets. The mortgage lending bubble has put trillions of dollars of mortgage-backed securities into the portfolios of pensioners, retirees, and otherwise hapless investors…whose retirements may now depend on the ability of their neighbors to make the monthly mortgage payment.

It’s too bad that the housing angle here hasn’t worked out here in Perth. You’ll have to look in more exotic, less well-lighted places, where the sanitation is dodgy and the value is still obscure to your average comfort loving business traveler. That’s where today’s real estate bargains are.

But the hard asset/real asset strategy is still very much alive. And Western Australia is going to play a big part in it. Which brings me to Independence Day.

On Monday my hosts Andre and his mother went with me to the Perth Mint. You may know the mint through my colleague and friend Michael Checkan. Michael works with the folks here in Perth to sell gold-backed certificates to American investors looking for gold bullion exposure and some currency diversification.

I went to the Mint in a pensive mood, pondering the fate of the dollar. You’ve probably heard about the death of the dollar in a dozen articles by now. Maybe you believe it. Maybe you don’t.

For my part, I believe the Federal Reserve and the Federal Government have betrayed the American people. They’ve robbed savers by destroying yields in the money market. They’ve issued debt that will either destroy America’s credit rating when the government defaults, or take Americans generations to pay back.

The government has sold America’s financial future to foreign investors. Some people think the foreigners are patsies for owning American debt and that there’s no risk to America if foreigners buy our bonds. I couldn’t disagree more.

Instead of directing their savings into new, wealth-creating investments, Americans are going to spend years paying higher taxes so the government can make interest payments to foreign borrowers. Not money well spent.

And with over $400 billion annually going to the defense establishment, we’ve managed to garner the enmity and distrust of nearly the entire civilized world (and all of the uncivilized world), while accepting and now passively enduring routine encroachments on our right to move freely in our own country.

The so-called guardians of our money have destroyed it. Interest rates are about incentives and rewarding risk. A market determined rate of interest would fund good entrepreneurial risks and punish bad risk takers by limiting their ability to borrow through high rates.

Failure would be punished. Risks that create new products and services for consumers that improve standards of living would be rewarded.

Instead, we have a Fed that’s changed the incentives to encourage financial speculation. Why borrow to spend on your business when you can borrow at one percent and buy a mortgage-backed bond yielding four percent? It’s risk free return right? Why worry about the future when you can consume today?

The Fed has engaged in what Richard Russell calls immoral behavior. Russell is right. Free markets break down when people start behaving immorally and taking bad risks simply because they can afford to. As my friend Andre says, it’s going to end up being return free risk by the time the whole affair ends. But when, you might ask, will the whole thing end? And why?

The when is anyone’s guess. The whole world is bound to the dollar’s fate. No one is eager to abandon the devil they know for the devil they don’t. So foreigners keep on selling their own currency and buying the American one. Asia lacks the self-confidence to get off the dollar standard.

Of course there’s got to be a real limit to how many yen Japan’s government can sell or how many dollars it can buy. And as Andre pointed out, the fact that China is now running a trade deficit may have a serious impact on its dollar consumption. When you have no surplus with which to buy dollars or U.S. bonds, you buy a lot less of them.

Heck, you might even sell a few of those bonds to raise the money you need for your raw material and energy needs, or the money you need to feed and provide medical care for the 600 million peasants who live in the countryside and have not enjoyed the prosperity of coastal capitalism.

But just what is the limit? Well…I suppose it’s possible you could see a current account deficit that’s 10% of GDP before the imbalances become so radical that an involuntary adjustment (crash) occurs.

Ten percent is just a number out of a hat though.

The truth is that the world’s financial system is now so intertwined and complex that it’s getting harder and harder for different financial players, from the biggest to the small, to make simultaneous adjustments for interest rates, currency fluctuations, and geopolitical risk.

That leads me to believe that when the adjustment comes, it will be because something has broken…a bullion bank goes bankrupt, a sovereign, corporate, or GSE bond default…an oil terminal terrorist attack that drives crude to $100.

Of course, these are all events, which are out of your control. You can’t do anything to prevent them. But you can acknowledge that any or all of them could happen today…in five weeks, or five years.

That means you still have time to make the big decisions about where you want your money invested and what mix of assets you want in your personal balance sheet. As I said, I’m leaning ever more to fewer equities, more bullion, and when you are in the equities market, being in with leverage in options bets that hedge your risk on your open long positions.

And then there’s gold. The other day at the mint Andre’s mom suggested I have a coin stamped in honor of American Independence Day. But I did her one better. Andre and I were unable to describe what the world will look like when the dollar-standard levee breaks and the great pool of liquidity pumped by the Fed over the last four years sloshes at last down the drainpipe of history.

But a little bullion in your pocket never hurts.

Accordingly, I had three coins stamped at the Mint. Mind you, I’ve not violated the U.S. constitution by minting my own currency. It’s not legal tender and it’s not transferable. Still, I have three collectable coins as a start to a new monetary regime.

On one side of the two silver coins and one gold-plated coin is the Black Swan, a symbol for Perth and the mint. It says, “The Perth Mint, est. 1899.”

On the other I had the following inscribed: One Bill Bonner, Reckoning Day Reserve, DDGU, July 4, 2004.

I know Bill is probably not keen to have a currency named after him. He’s pretty modest. But the Reckoning Day Reserve sounded right to me. DDGU is short for the trade of the decade, “dollar down, and gold up.” And I backdated the date by one day to commemorate this new declaration of monetary independence.

But the date doesn’t really matter. The question for you is, when are YOU going to declare your monetary independence from the fate of the currency your government has done so much to endanger? It’s not too late.

And who knows…maybe the Reckoning Day Reserve will catch on. I’m here in Perth for two more days. Maybe if I crank up the printing presses I can give the Fed Chairman a run for his money.

If not, I plan on giving the coins away as door prizes, one at the commodity and resource conference I’m speaking at in San Diego next week and the other at the annual Agora Wealth Symposium in Vancouver in August. I’ve posted pictures of my monetary experiment below (and the image that inspired them), although they’re kind of fuzzy.

It’s ironic that the hotel I’m typing from formerly housed the Australian Tax Office. Some things, like buildings and land, can be reclaimed and put to their proper, life-affirming, profit-making use. Other things, like fiat money, are irredeemable.

Human beings, for their part, are always redeemable.

It is our great virtue, or gift from God, as you choose to believe. And while our government may have betrayed us and behaved in a grossly immoral fashion by running up debts it can’t pay and selling out ownership of our future, there is always personal redemption to be found, and the financial kind can even be secured in this lifetime.

That redemption begins without debt, proceeds with cash in hand, and endures with real assets that you can make liquid if and when you need them. You may never need them. But it’s better to be sovereign than sorry.

Tomorrow, the much-anticipated truth about why there is no exchange traded gold fund, redeemable for bullion, in America. Plus, the Golden Mile, the Super Pit, and the brothels of Kalgoorlie.

Until Then,
Dan

Currency Decade: Most analysts believe we have not even reached the halfway point in the "Commodities Decade" that began in early 2001. One great way to take advantage of this opportunity in commodities is to own precious metals. And, one of the safest, most flexible, and easy ways to own precious metals is through the Perth Mint Certificate Program (PMCP), a cost-effective, government guaranteed precious metals program. I have just visited the Perth Mint, and I can attest to the fact that they are "for real." To find out more about this unique precious metals program, please fill out the short form to request detailed information.

2004-07-07T16:15:00.000+05:30

The "Reckoning Day Reserve," coming soon to a sovereign individual near you.

2004-07-07T16:14:00.000+05:30

Your editor strikes it rich at the Perth Mint.

2004-07-07T16:13:00.000+05:30

The Black Swan of Perth meets the Red Icon of America...and gives birth to a new sovereign currency? Details above...

2004-07-06T19:51:00.000+05:30

Surf crashing white sand.

2004-07-06T19:48:00.000+05:30

Looking West on the Indian ocean near susnet.

2004-07-06T19:46:00.001+05:30

I'll tell you about the pot of gold tomorrow.

2004-07-06T19:46:00.000+05:30

Another beach view...to cold to swim, plus, I dont' swim anyway.

2004-07-06T19:44:00.000+05:30

I took this to be a good omen as well...looking over to Freemantle.

2004-07-06T19:43:00.000+05:30

The Swan river and the city skyline from King's Park. I spent Saturday with my host Dr. Andre Homberg and his mother. They said the weather was awful by Perth standards. It felt an awful lot like a Colorado fall to me...and so was quite nice.

2004-07-02T19:35:00.000+05:30

Egg Butcher to the World

Perth is the first city I’ve arrived in in the last two months that didn’t greet me with a big traffic jam. Paris, London, Washington, Dallas, Hong Kong, Shanghai, Nanjing, Beijing, Tokyo, Bombay, Bangkok, all of them, massive traffic.

But Perth is small, only 1.4 million people (it’s also the second windiest city in the world, from what I gathered last night). In fact the entire population of Australia (20 million) is barely larger than the population of Shanghai. Geographically, though, Australia is as large as the continental United States. And it’s got a LOT of natural resources….

Wheat, wool, beef, lamb, lobster, prawns, pearls…wood, oil, wine, natural gas, iron ore, eggs…it’s a veritable company store for East Asia. Of course that’s why I’m here. Who’s selling what to whom and how much, per share, are they making?

What Australia doesn’t have is a lot of labor. As my unofficial host Andre (Strategic Investment reader, Daily Reckoning reader, and money manager) pointed out to me last night, you don’t see a lot of finished goods or even manufacturing. The cost is too high. What you get is mostly wholesale…an enormous open-air market for raw materials that get exported.

Andre is a German émigré who’s been in Australia long enough to sound South African. He dragged me out of a minor jet lag stupor early yesterday evening to pay a visit to a local club (not THAT kind of club). It was more like an English Gentleman’s club. Unlike an English club, there were women, and younger people, Cuban cigars, and Bon Jovi playing on the CD changer (Livin’ on a Prayer).

We had a chance to discuss the itinerary for the next few days…some vineyards, the Perth Mint, a day trip to the Kalgoorlie mine (one of the largest open pit mines in the world) and much, much more. You’ll be reading about it next week, and seeing some pictures too.

For today, my notes are short as I have a pile of deadlines to work through before my Baltimore-based publisher sends out a bounty hunter. Just two short, somewhat macroeconomic notes about the Money Migration and the end of the dollar standard and the U.S. centric global economy

Asia has a self-esteem problem. By the way, this is a bit ironic. You know the old saw about Americans being the most self-centered and arrogant people in the world? Turns out its true of just about everywhere I’ve been. France, England, China, Japan, India…everyone seems to think they’ve got the best culture in the world.

And they expect you—as a burger chomping, coke swilling, blue jeans wearing, non-football understanding American—to respect their exalted place in the world. Kind of refreshing actually. Everyone’s proud of where they come from. But enough of this chiding Americans for being arrogant. It’s a pretty common nationalistic fancy.

Still, Asia, with its long history lacks the economic confidence of young upstart America. Economically, Asia is the total package. It’s got the internal domestic demand to sustain GDP growth. It’s got the resources, labor, and technology, to trade amongst itself and with the rest of the world as an equal partner.

What it doesn’t have is that basic naïve American faith in a better economic future. In many of the places I’ve been, there’s a reluctance to shift away from U.S. centric growth. It’s almost like a belief that America still has some ineffable quality of success that outweighs the mountains of debt piled up from sea to shining sea.

And so the simple post World War two era economic model hasn’t changed yet, neither in practice nor in belief: keep your currency competitively low relative to the dollar and export. Generate a trade surplus and hold on to the dollars for a rainy day in the currency markets.

The variables in the formula that make it work are a U.S. consumer with a wallet full of credit cards and a U.S. dollar that remains relatively strong. But now both those variables ARE changing and the model is starting to break down. The U.S. consumer has reached a cyclical peak in his ability to consume. And the dollar is fixing for another decline as the current account deficit forces a dollar adjustment.

Still, Asia buys dollars and seems to lack confidence in its own future. It still believes, at least in currency terms, that there is strength in weakness. And of course there is a measure of truth to this. Currencies can only get to strong before their strength starts to hurt exporters. A stronger currency makes your goods more expensive to foreign buyers. When a good portion of your economy is based on selling to foreign buyers, a currency that’s too strong prices your goods out of the market.

The obvious answer is to weaken the currency by lowering interest rates. Print more money, inflate, and the problem becomes less acute. This is a double-edged sword, though. You can’t just make the cost of borrowing cheap and hope to solve the strong currency problem without unintended consequences.

As central banks all over the world are finding, a little monetary goosing goes a long psychological way. That is, central banks love to see the growth in GDP and consumer spending that comes from borrowed money. For a few quarters the stimulus looks benevolent.

But you can’t use monetary policy as if it were a chemistry set. When you change the cost of borrowing and encourage consumers to spend, you also change attitudes about risk. Generally, cheaper money for all leads to more bad risk taking.

What starts out as an attempt to keep the currency competitive and the economy growing morphs into a spending free for all based on credit, with its own set of stock bubbles, equity bubbles, and huge personal and corporate debt loads. Thus Asia’s ingrained fear of bad loans and bad debt in the banking sector.

That’s one “big picture” issue. The other, and I’ll be briefer this time, is experience. You can have the heart of a capitalist. But without the experience of one, you’re to going to make a lot of mistakes. All over Asia you see the signs of growing wealth.

But to go Platonic on you, the signs aren’t the wealth. The wealth, as Stephen in Samui pointed out, comes from people and their ideas and their hard work. It also comes from a certain kind of economic thinking…based on competition. Can you provide a better service at a lower price? Can you provide a product that consumers are willing to pay for?

These are different questions that whether or not something can be manufactured at a lower price in a different country. Asia has many advantages when it comes to labor costs. That’s pretty well known.

But where Asia may be at a genuine disadvantage to the West is experience in competing in a free market economy. The good news is that graft and corruption or simply old ways of doing things don’t stand a chance at surviving the more competitive the world begins.

Americans have been unpleasantly surprised that one of the unexpected side effects of globalization is that you may have to compete for your job with billions of people on the other side of the world.

On this side of the world, I suspect Asia is going to be unpleasantly surprised too. The institutions of free markets take years to develop. Banks, stock markets, property markets, and the insurance industry…the West has a big head start in how to provide financial services in a competitive marketplace. It’s one industry that we may do very well in, even in the Asian Century.

Until this weekend,

Dan

P.S. The great thing about a trip like this is the number of ideas you can generate when you come into contact with new people and new places. Most of them are investment or economic ideas. But not all of them.

For example, before I went to Thailand I didn’t know the Thais had a royal family, and that the current royal family is well educated and quite scientific. It got me to thinking of the differences between royal families…which lead to the idea of a new reality T.V. show. Put all the Royal families on a desert island and see which one survives. Think Royal Family Feud meets Survivor.

Since I’ve had so many cab drivers in the last three months, I’d also like to organize a pay per view contest called “World’s Best Cab Driver.” You hold competitions in big cities like London, Tokyo, New York, Bangkok, and Shanghai in order to find the best local driver. Then that driver brings his car and all the cab drivers compete on a busy downtown street to see who wins. Haven’t picked the location for the competition or the route yet. Suggestions are welcome.

I’m also considering writing a book about “Fine Airport Bars of the World, or “Secrets of Eating Deep Fried Food in South East Asia.” That’s if this whole Money Migration investment business doesn’t work out

It’s also occurred to me that many people may never make it to the parts of the world I’ve been fortunate enough to visit in the last year. That’s why I’d like to take several thousand acres in Las Vegas and create a “Museum of Museums.” The idea is to create scale replicas of the major tourist and museum sights of the world…. the Louvre, the British Museum, the Uffizi Gallery, Angkor Wat…and others. Vegas already has a Paris and a New York and a Venice.

With the world getting more dangerous and it getting harder for Americans to travel abroad safely, why bother with it? Instead, let’s simply recreate the best places in the world, but make them air conditioned and less dirty. If you’re a developer who has several hundred million dollars and some real estate in Las Vegas please contact me via email and we can talk further.

2004-07-02T13:31:00.000+05:30

Here's what cheap interest rates can do for a hot foreign market...drive stocks up until the cheap money cycle ends. You'll notice the downturn in EWA (a basket of Australian stocks that trades like a single stock) began at about the same time as talk of higher interest rates in the United States began. Also, the rally in the Aussie dollar began to run out of steam about about $0.80 Australian to $US. The Aussie dollar has since corrected (weakend) down to $0.70...so traders looking for another round of dollar weakness could see a move, albeit smaller than the last one, here.

2004-07-02T13:29:00.000+05:30

Ahh yes...a little different type of picture this morning to go along with the commentary above. This is the U.S. dollar versus the Aussie dollar over the last three years. The falling line means a weaker U.S. dollar and an appreciating currency. You can see the recent move up in the dollar. It was caused by two events. First, the threat of rising interest rates in America caused investors in emerging markets to take profits and exit. The "carry trade," where you borrow cheap in America and invest the borrowed money in higher yielding stock and bond markets abroad began to unwind in December. The second event is that a currency can only gain so much before its strength starts to hurt domestic firms. While Aussie consumers may have benefitted from more purchasing power at home, Aussie exporters saw the price of their goods abroad (at least in the States...and in China because it's linked) rise relative to the competition. There comes a point when a strong currency can be TOO strong for your exporters to be competitive.

2004-07-01T23:32:00.000+05:30

In the Sovereign I Trust

“Many of you are well enough off that... the tax cuts may have helped you. We're saying that for America to get back on track, we're probably going to cut that short and not give it to you. We're going to take things away from you on behalf of the common good.”
Hillary Rodham Clinton,
Former First Lady and Future Candidate for
Vice President or President of the United States

I’m writing today from Perth, Australia after traveling all day yesterday. My publisher (and you) may be glad to know I did not disappear in Thailand or Samui. It was tempting to give up Fed watching for water buffalo watching. I was even going to look for that beach in the Leo Dicaprio movie and start up my own experiment in deserted island economics.

Instead I got a plane to Perth, where the air is colder but cleaner. And from Perth I’m going to make two final observations about Thailand before launching into my Australia schedule.

First, the economy and the people are still vulnerable. The Thais who lived through the baht crash in ’87 are slow to believe in turn around stories. They saw first hand how your stand of living can disappear over night.

You still see signs of it all over Bangkok, giant concrete pillars supporting roads that were never built. Rebar cages sticking out of the ground waiting for cement that was never poured. And those are just the visible reminders.

The biggest scar that comes from a crash in financial markets isn’t physical. It’s psychological. It’s the giant gash in your brain where trust and confidence in the future used to be. That kind of damage isn’t easily repaired, which explains why the Thais I spoke with are deeply suspicious of another bad loan crisis in the banking system, or worse, another crisis in the currency.

And truth be told, there are plenty of reasons to be suspicious. There are the geopolitical risks of a growing and organized Muslim rebellion in the South. And yes, $60 oil would put a hurt on the country’s currency reserves, risking another baht crash. And absolutely, rising interest rates would cut off some of the easy credit that’s fueled GDP growth.

But the biggest risk in Thailand is that trust never fully recovers. It’s an interesting subject because it’s part of the reason why so many Westerners say they want to live in Thailand, to live in communities and around people that they trust. To replace that sense of distrust and isolation they have in their own lives, wherever they came from.

That’s trust in an uh…sociological context. And it’s not my usual beat. So I’ll say no more about it. But let’s talk trust in a monetary context.

Right now I have six different currencies in my wallet: dollars, yen, remnimbi, rupees, baths, and Aussie dollars. Except for the Aussie currency (which is some kind of rubber…meant to keep it from getting wet at the beach perhaps?) it’s all just paper… colorful, pretty paper.

The reason I can take it out of my wallet and exchange it for something real (food, shoes, a tax ride) is that the other party to the exchange trusts that he’ll be able to trade it for something he needs as well. Such is the basis of all fiat currency. Belief.

One of the men I was introduced to in Samui is Stephen Belgin. Belgin is working with a man named Bernard Lietaer on a book called "Of Human Wealth: Beyond Greed and Scarcity." Belgin says Litaer is one of the architects of the Euro currency and a thinker on the future of money.

The problem with the current monetary order, Stephen explained, is that it doesn’t help meet development needs in the many poor places of the world. Most of the world’s communities can’t raise money for infrastructure through a bond offering or a mill levy. There isn’t enough wealth extant to use as collateral for borrowing capital.

So how do you create wealth and opportunity in places that are not rich in capital or natural resources? Stephen is working on an idea called complimentary currencies. Notice that’s it’s complimentary not alternative. He has in mind mediums of exchange that work along side fiat money and are backed, not by the full faith and credit of a government or future tax revenues, or gold, or land, but human capital.

“Hmm,” I frowned. I asked Stephen what he thought of Hernando de Soto. I met De Soto in Paris last year and listened to his speech about the developing world. His main point is that land is the greatest form of unused capital in the world. By creating clear title to land and extending it to individuals—private ownership—you unlock the natural resources of both human beings and an economy.

It’s a pretty compelling argument, I thought. I like it because of the idea of stewardship…that an owner is likely to be the best caretaker of his most valuable asset, his property. Owners make the desert bloom. It’s only on publicly owned land, with no ownership and therefore no accountability, that you see huge mismanagement of natural resources.

Steven nodded but said I had put the question to him the way most of the world would. This didn’t offend my pride. But it did make me wonder. How can any economic transaction be based on anything other than a medium of exchange whose value is agreed upon by both parties? Granted, that medium could be arbitrary…a seashell, oxen, or an ounce of gold. But doesn’t it have to be a real thing that has the attributes of a good medium of exchange?

Steven nodded again, but less amused I think. He asked what the real source of all wealth is. “People,” I said. To use Thomas Sowell’s phrase, people are the ultimate resource.

Stephen agreed with that and asked me to imagine a world where the basis of the currency is the faith we have in each other as human beings, as wealth producers. What kind of great societies could we produce if we abandoned the mental trap of scarcity thinking and unleashed human capital on the world?

Hmm. It’s a provocative question. And what I like about it is that Stephen and his colleagues are trying to solve a real problem…how to create currencies that work at the local level. He said he believes in currencies that work alongside fiat money.

But I think that someday, and perhaps soon, it won’t be an academic question. It will be a practical one with some urgency.

How do communities create a medium of exchange when government paper becomes worthless? THAT’s why it’s a question worth asking.

The skeptic in me says you can’t have a currency based on belief in basic human potential.

Some human beings are bad loan risks, whether you look at it in banking terms or moral terms. It’s prudent not to trust all people because not all people are trustworthy. A man’s word may be his bond in some places, but in other places, I’d much rather have his land as collateral than his handshake.

It’s a matter of trust. And it’s also a matter of memory. You can get burned in a deal, at the micro level. And the macro level, crashes can happen. They happen all the time, in fact.

The other day a colleague sent me a note saying that a crash in the U.S. housing market was impossible because there was no such thing as the U.S. housing market. His point was a variation of a point I’ve made before. Don’t confuse the real estate market with the mortgage lending market.

Real estate prices are affected by interest rates. But they are also affected by local factors as well. Demand for housing, location, taxes…these are just some of the factors that account for the differences between real estate prices in different parts of the country. And in truth, regardless of what’s happened in the housing market, in some parts of the country real estate is still cheap.

But that doesn’t meant there won’t be a housing crash. Home prices in some parts of the country are up primarily because the Federal Reserve kept interest rates so low for so long before finally reversing course yesterday. In other words, the rising value of homes was as much a function of low interest rates as it was of sustainable demand for new housing.

And in any event, the Government sponsored enterprises aren’t exactly poster boys for full disclosure and transparency. We find out just this morning that Freddie Mac (FRE) posted a 52% decline in profit in 2003 from 2002. I don’t care what business you’re in, a 52% decline is pretty severe.

Freddie told investors it won’t report 2004 results until March of 2005. The company says it’s grappling with antiquated accounting systems. That’s a comforting for an entity that manages trillions in risk, and apparently isn’t managing it too well.

To what did the GSE attribute its losses, you ask? Rising interest rates and their affect on Freddie’s derivative positions. The company said, “To the extent changes in interest rates continue to be significant, our overall net income will remain volatile.”

Warning. Warning. Eject. Eject.

We’ve been assured that the GSEs are wizards at managing interest rate risk. And Alan Greenspan has told us that existence of the derivatives market has allowed for the dispersion of risk throughout the system…and that it’s been a GOOD thing.

But there’s another way of looking at it. That way is that you can’t package up dozens of other people’s liabilities and sell them as assets and pretend there is no risk. You can’t expect profits when you’re borrowing costs go up faster than the profits you make lending money at low rates.

These are all pretty well worn financial points by now. Patient readers are familiar with them and are either convinced or asleep. For now, the entire housing market rests on that oh so precarious of assets, trust.

Whether it’s a housing market, a currency, or an investment phenomena, once the trust is gone, it’s amazing how quickly the asset values follow. Americans who doubt this only need look all over the world to see that it’s true.

But if you can’t trust the dollar, a good old savings bond, or the government as we know it, who can you trust?

Sovereign in Samui

This is the other point I wanted to bring up with respect to Thailand. I met a lot people living their own lives here. Sure, they live with government hassles like anyone else. But anyone who decides to pick up and leave home and start over has a pretty strong sense that they’re being over-governed.

What I saw in Thailand was an attempt by people to reclaim some sense of their own individual liberty. Not political liberty. Simply the liberty to live your life unmolested by your neighbors or your government.

It’s a common mistake to attribute the quote “L’etat c’est moi” to Louis XIV. But the Sun King, that famous fan of absolutism, never said any such thing.

It was actually, at least according to my Google sources, Louis XI who said “I am the State.”

Today, let us reclaim the power of government and all say to ourselves, “I am the State.” Let’s secede from the common goodness of Hillary Clinton and become sovereign in our own right. One of the definitions of the word sovereign as an adjective is “self-governing, independent.”

Samui, like a lot of small islands, holds the alluring of a place where you might govern yourself, become a state unto yourself, a sovereign in your own right. Of course it turns out not to be that way. You are never really independent of your obligations to other people, whether you recognize them or not. That’s probably a good thing. People aren’t meant to be emotionally and spiritually sovereign, everyone running around in his or her own head ruling his own little realm.

I mean sovereign in the physical and financial sense, when you are not at the mercy of your government’s jails or its tax collectors.

Whether you can accomplish that kind of independence by moving out of America (whether, indeed, you have to move out of America to find it) or whether it can be achieved in other ways…by the accumulation and preservation of wealth…and by finding like-minded individuals…this is the question that I often try and answer through my work on Strategic Investment.

True, it’s a lot more grandiose that trying to forecast where interest rates are headed. But it’s also a lot more important.

2004-07-01T17:58:00.000+05:30

Breakfast for two at the twilight of the nation state.

2004-07-01T11:58:00.000+05:30

More empty beachfront...there isn't a lot of quality beachfront left in Samui that's been left undeveloped. A few of the five star hotel chains are rumored to be looking for places to set up shop...but the space is already crowded. This is in Lamai, where I stayed.

2004-07-01T11:56:00.000+05:30

This is probably what you think when you hear the words, "Tropical Island." Some readers even wrote and told me not to go to Samui to get a feel for what Thailand is really about. Maybe not. But that's not whey I went to Samui anyway. I went to see if it's really possible to build your own little nation state outside America...to escape the draconian tax laws and institutionalized corruption of the American goverment. It turns out there are draconian laws and corrupt governments pretty much anywhere you find laws and the legislatures that make them. Under the genus of corruption, there seem to be at least two distinct species. One is what I'd call democratic corruption. In democracies, the laws are for sale. Politicians bid out their services to the highest paying unions, special interests, and corporations. Money buys in regulatory and tax favors. No mystery here. And because this kind of corruption is systematic (within the democratic system), it's unfair to everyone equally. No one is unfairly disadvantaged. We all get screwed equally. Men have been living with this kind of corruption as long as there have been governments that govern through coercion and not the consent of the governed. The other kind of corruption is more personal and arbitrary. I will call it undemocratic corruption. Instead of being done in the name of the people by the institutions of the people, undemocratic courruption is when you get shaken down by free-lance extortionists and public officials who take bribes. This is the kind you see in Thailand and Samui. The question is: what's the difference between having to pay a cop 5,000 baht to keep your bar open for football matches on Friday night and having to put landscaping in front of your gas station to please the local zoning authorities? One is bureaucratic and arbitrary. The other is individual and less arbitrary. In fact, you might even argue that undemocratic corruption is better because you can at least negotiate with the corrupt. In any event, if you're hoping to move to a small island and set up a small juice bar and escape the evils of the modern world, forget about it. Corruption comes from the human heart, and you find it any where there are human beings looking to use the power of the State to provide themselves with personal gain. Still, Samui is probably a lot more comfortable place to put up with unfairness than say, Baltimore. (That little hut on the point of the rocks is where you can get a seaside massage at Rocky Resort.)

2004-07-01T11:36:00.000+05:30

Knowing When To Quit...this mud-caked, forlorn, tied up young water buffalo reminded me of my investment and mountain biking mistakes. How? A few hours after I snapped this picture I was on a steep hill, cranking away in a low gear on the mountain bike. I made it up the first switch back, breathing like a freight train (all that nicotine). Fione, the Scottish girl, motored right past me. Michael left me in the dust. I pushed my bike to the top of the next switch back and was lucky enough to find a tent to find some shade under. It was a little after noon, humid, and about 85 degrees fahrenheit. My body doesn't get rid of heat very well. So, before I lost control of my bodily functions, I did the honorable thing and quit. You don't always have to SEE the very top to realize it's there. Sure, it would have been nice to see the view after all the effort. But it would not have been just as nice to pass out. And all kidding aside, there is an obvious cautionary tale here for investors, especially if your mind is up in the air about the dollar or the U.S. housing market. The cost of trying to get out right at the top could be high. Why bother with that kind of risk when you have better alternatives?

2004-07-01T11:26:00.000+05:30

I did not take the Daily Reckoning's advice and book myself a ticket to Baghdad to check out the fledgling Iraqi stock market. Instead, I chased water buffalo off the beaten path in Samui. Not entirely for sport, of course. I was on the hunt for what the local real estate market is like, and not far from here under some rubber trees lies a piece of property that my new friends in Samui recently purchased. There is still lots of good land left in Samui. Whether you can get a good deal...that's another question. At the Rotary meeting I spoke out, I got different opinions. The real estate agents said Asian money is still pouring in. Others said the place was going to be ruined by the influx of foreigners who were driving property values too high too fast. Those were the ones that were selling. Property development is not my beat, although I did speak with several developers. Either way, real estate not denominated in dollars is certainly a worthwhile of diversifying your assets. And with these fellas as your neighbors...

2004-06-24T20:55:00.000+05:30

The Rule of Law and Sex Changes

There are two ways to start your research on a stock market you know little about. You can ask your cab driver what he’s buying (if he’s buying nothing, that’s a good sign.) Or you can take a look at the country you’re buying in first. That’s what I did the other day when I say down with Michael, an American expatriate who’s been in Thailand for three years and is invested in the market here.

I always start with big picture. It IS true that when you’re buying stocks you’re buying individual stocks, not the whole market. But it’s also true that you can buy a really good business in a really bad market and see your “value” stock stay undervalued for a long while.

What I wanted Michael’s opinion on is what kind of risk you’re taking when you buy Thai stocks, and whether the reward is worth it. What kind of market are you buying when you buy Thailand?

The good news, Michael said, is that the economy is growing about seven percent a year. The bad news is that in Thailand, just like everywhere else in the world, you see a contest between markets and government.

You can count on government to be generally corrupt and greedy. But you can hope for a transparent legal system and protection from the law. You can hope. But don’t count on it.

Based on what Michael said, the government has a pretty good lock on the press. It doesn’t appear to be a police state with little freedom of expression. But on paper, it might look a lot like that. The Thais seemed pretty laid back, however. I doubt the ACLU would get far here.

The bigger problem, from an investment perspective, is lack of investor confidence in the government. It matters a lot in a country like Thailand, where almost 70% of the daily trading volume in the SET represents foreign investors. In other words, Thailand, like India recently, is beholden to “elephant money,” the kind that can move in quickly and make you look big and powerful…and the kind that leaves just as quickly at the first hint of trouble…and leaves equity rubble in its wake.

In 2003, the SET doubled. And then the government stepped up to the plate and whiffed four separate times. As a result, Thai stocks are among the world’s worst performers this year.

Thailand is the world’s fourth largest poultry exporter. So when bird flu hit earlier this year, you’d think the government would have done more to a) acknowledge the problem and b) assure markets that it was doing something about it. The government did the opposite, lollygagging around and denying until investors punished the stock market.

Year to date the SET is down about 26%, worst of the 60 major country indexes Bloomberg tracks. There is some value. SET stocks are selling at just under 11 times projected 2004 earnings. But the question is whether the government will keep scaring away investors.

Mike made an excellent point about this. Thailand, he said, has its own version of margin trading. Under the old rules, an investor could borrow up to 100% of the value of his equity for further stock purchases.

Fair enough, and easy enough to understand. It’s simple margin trading. The problem with margin, as investors find out, is that as the value of your equity declines, the closer you are to having to close your position. Unless you’re right about the trade, the decline in your equity is multiplied by virtue of having leveraged up.

By the way, if you want to read more on this, the classic explanation of how leverage works against you is Roger Lowenstein’s “When Genius Failed.” It’s also the reason I remain convinced that Fannie Mae and Freddie Mac have a lot more interest rate risk than they’re letting on. Of course Fannie and Freddie aren’t letting anyone see their books (or who’s on the board of directors and how much they get paid) so we don’t really know. I’m sure we’ll find out one day, the hard way.

But back to Thailand. In order to curb speculation in the market the government went after margin trading. There are simple ways to do it. You can raise margin requirements, something Alan Greenspan suggested himself in Fed meeting notes before the blast off of the Great Equity Bubble. In effect, raising margin requirements means that investors have to pay at least, for example, 50% cash for any stock purchase. Raising margin requirements makes it harder to buy stocks with borrowed money.

Thailand wanted to do this. But instead of simply raising margin requirements in an orderly fashion, and telegraphing that intention to the market, they adopted a completely other tactic. They excluded some stocks from net settlement while allowing the practice for others. And there was no rhyme nor reason why you could margin up on one stock and not the other.

I suppose by doing this the government thought it would discourage ALL margin activity. In effect, any investor using margin would be playing roulette. If he happened to own a share on which net settlement was excluded for that day or week, he’d have to unwind his position quickly.

You can guess what happened. Not only did it discourage margin trading. It discouraged trading…and confidence in the market regulations in general. This is a key point Michael made and one that’s squarely in the tradition of the rule of Law.

In order for laws to work best, they have to be easily understandable, transparent, and relatively unchanging, especially in business. If you can’t count on conditions remaining relatively predictable in the future, it’s difficult to plan.

When the law changes frequently, at the capriciousness of the government and favors some interest or groups over others, it completely breaks down as an effective tool for ensuring the protection of everyone’s rights. For this reason, Hayek regarded legislation as the “chief instrument of oppression.” And you can take your pick of unpopular legislation designed to solve specific problems rather than provide general rules to see how right he is.

Hayek, and the rule of Law, are apparently not ideas well received, or even known, to Thailand’s stock market regulators. And to be fair, it’s not just Thailand. There are lots of pseudo intellectuals and arm chair economists in America still spitting out pithy quotes and bad economics from John Maynard Keynes.

In any case, by failing to understand the fundamental nature of predictable legislation on private behavior with money, the government, yet again, stuck a knife in the back of the market.

There are two more examples of the government failing the market that Michael discussed. The first was the government’s plan to privatize EGAT, the Electricity Generating Authority of Thailand (what the heck is it about privatizing the electricity business…France…India…Thailand?)

Granted, the government’s plan to privatize EGAT didn’t look all that transparent. And it looked like it would favor government cronies who “subscribed” to the privatization the same way plum IPOs get parceled out to the top customers of U.S. investment banking firms.

The folks who protested EGAT’s privatization on those grounds (and there were quite a few) had a legitimate complaint. But most of the complaints came from labor unions, who naturally hate privatization because it opens up state owned industries to competition. Competition forces firms to operate more efficiently, which often means eliminate redundant jobs. Bad for labor. But good, of course, for customers, who, in general, get better service at lower prices (provided the deregulation is thorough and honest.)

Faced with rising public opposition, or at least vocal opposition, the government could have done one of two things. One, it could have ignored the hullabaloo and gone ahead with the plan anyway. Or two, it could have restructured the plan, or abandoned it altogether.

The government took the famous “third way” and did nothing, hoping the problem could be talked through. Talking about a problem with people who don’t agree with you is not a solution. It is a failure of nerve or resolution. And markets can’t stand failure. Stocks get sold when government’s lose their privatizing nerve. So far, 0 for three for the government in 2004.

But the biggest problem I’ve saved for last. The biggest problem is the well concealed ethnic unrest in the South. And here I’m just being polite. In truth, the seeds of another Islamic secession may be brewing in Thailand. Google it and you’ll what I mean.

On April 28th there were ten separate attacks on security forces in Thailand’s far southern provinces. Buddhist monks and teachers murdered. Government troops powerless to do anything. Three provinces bordering Malaysia under martial law since January. It’s not exactly the kind of thing that promotes tourism or stock buying, which is probably why you won’t read about much in the Bangkok Post. But there it is…

I have sympathy for the Thais in this respect. Very few governments, from Moscow to Washington, are having much luck prosecuting a war on Islamo-fascists. But I write about that only in the sense that it poses a major strategic risk to the market, which again is dominated by foreigners.

Here’s a startler for you: in late March, gunmen stole one and half tons of ammonium nitrate fuel oil from the barely guarded Manu Rock Grinding quarry. Thai authorities claimed to have since recovered about half of the missing explosive.

This kind of ammonium nitrate is used for blasting, and came in a package deal with 58 sticks of dynamite and 108 detonators, according to Reuters. Keep in mind, this isn’t the same kind of ammonium nitrate that was used in the Oklahoma City bombing in 1995. That ammonium nitrate fertilizer had to be combined with diesel oil to become explosive.

The kind that was stolen here in Thailand is explosive off the shelf.

Think of Bali. Think of Baghdad. Think of Khobar towers. Think of anywhere in the world where a small number of terrorists, probably a tiny minority of the population, can precipitate a major political crisis with a sensitively-placed bomb.

With amount of ammonium nitrate stolen in southern Thailand, it doesn’t take Nostradamus to forsee a mass casualty attack on Thailand’s Western tourist industry, or perhaps on secular or Buddhist targets in the South.

It’s tempting, sitting here in the computer lobby of Rocky Resort on Koh Samui, to say that this kind of scenario is fanciful at best, if not impossible. It’s tempting because Thailand is beautiful, peaceful, economically prosperous, and well positioned to benefit from the economic growth of China and the whole region.

But the strategic investor in me always asks a simple question (and maybe I read this about Buffett somewhere) what’s the worst thing that could happen here and could I live with it (owning Thai stocks) if it did.

Obviously a Bali-style attack is a deal breaker for me on Thailand. It doesn’t mean there aren’t good businesses. It just means don’t expect to make money buying all of Thailand. Pick your businesses carefully. And don’t be surprised if the geopolitical situation gets a lot worse.

Regards,

Dan

P.S.

Michael’s talk wasn’t all doom and gloom (although I felt strangely at home with it.) He mentioned medical care in Thailand is some of the cheapest and the best in the world. You can get a rear end lift in Yanee on an outpatient basis. Nose jobs are cheap too. And Thailand is the world leader in sex-change operations. If you’re a man who wants to become a woman you can actually get functioning female genitalia that allow you have sexual gratification. Now tell me where you can get that in L.A.

P.P.S.

I’m down on the island of Koh Samui to check out the expat lifestyle and speak to the local Rotary Club this weekend. Despite my major reservations about geopolitical risk to Thai stock markets, one of the things I find intriguing about living abroad is the opportunity to take your dollar diversification more seriously. That is, there are other ways to get outside the dollar than buying puts on the dollar index.

Put buying is a financial strategy. But you can also alter the composition of your assets entirely, shifting to real estate, cash, and some other elements. I’ll be talking more about this as the trip goes along, and of course, in San Diego.

For now…I’m going to have a frozen fruit drink of some kind. Pictures of my mountain bike ride tomorrow to follow.

Publisher's note: Unfortunately, terrorism has become a permanent threat to America and every other freedom-loving country. Attacks may be an inevitable part of life in the long term world-future. But, you can take steps to defend yourself...and, you can even make the terrorists pay

2004-06-22T18:31:00.000+05:30

Rubber and Rice

Admit it. When I say Thailand the picture below is at least part of what you think, right?

Beautiful women and sex. That’s part of the country’s tourist image. Of course it’s completely superficial (if not entirely inaccurate.) Below, you’ll find more photoblogging from a couple of spots I visited today with my unofficial hosts here in Thailand, International Living and Strategic Investment readers Debra and Mike Yantis.

Superficially speaking, Thailand is a lot more developed than I expected after having been in Bombay. Not to slight Bombay. But in Bangkok, the airport is modern, the taxis are air conditioned, and there’s a good expressway that runs from the airport to the city in less than 40 minutes, traffic permitting.

The city also has a relatively new elevated subway that makes getting around cheap and easy. I point these things out because I think it’s worth remembering that they don’t happen overnight. And by the time they do happen, and make it possible for foreign business and tourists to operate in the country, a lot of the low-hanging investment fruit has already been picked.

To put this in the context of India, when you look around Bombay, you need to think of what it will look like in ten to fifteen years, not what it looks like now. In investing, image is not everything. A gleaming city with lots of neon and great infrastructure isn’t a sure sign that you’re going to be able to find good businesses at good values.

And in India’s case…thinking down the road also means thinking of a 24% national savings rate as somebody else’s future cash flow. If you can do that, your next question is to figure out who’s going to get that cash flow and how can you buy them right now, at a discount to that future cash flow. At least that’s how I’m looking at it.

Back to Thailand…the real business part of the trip begins tomorrow when I hope to visit the floor of the exchange and then later meet with some Westerners who’ve been doing business here for a while.

My first (superficial) impressions are favorable. And to be honest, that has to do, at least a little bit, with actually seeing the city, traveling around in it on public transportation (we took a long boat up the river to the temples we visited), and even getting some of its cultural heritage.

I’m beginning to think that it’s worth studying eastern religions more just to see how compatible they are with capitalism (if you’re an economics graduate student, get on it…read Max Weber’s The Protestant Ethic and the Spirit of Capitalism…then read Confucius, the Tao te Ching, and all the other books about Eastern religions I should know but don’t.) Why?

The main reason for my trip over here to Asia is that I believe the spirit of capitalism IS moving East…after having been slowly corrupted and eroded in the West. Money moves where there is opportunity. And opportunity comes when you put natural resources and abundant labor in close contact with risk capital. You’ve got all the ingredients here in Asia. But do you have the required “spirit.”

In China, I’d say yes. In Japan, I’d say it’s a tired spirit. In India…I’d say you have a lot of spirits…and a lot of destruction is needed before there can be more wealth creation (Siva first, Vishnu later.) In Thailand? Too early to say.

Debra and Mike pointed out that Thais are culturally anti-competitive. No one wants, at least visibly, to have more than other people. From what I could gather from them, there’s an innate sense egalitarianism, although they probably wouldn’t call it that.

For example, Mike and Debra tell me that back when the baht crashed in ’97, the government rolled out the “One tambon, one product” policy. In order to…what? Get the economy back on its feet….the government told each village (tambon) that it could produce only one item. Call it the reverse division of labor…or the concentration of production.

The result, Debra and Mike said, is bizarre. You have whole villages in which everyone produces exactly the same thing and sells it for exactly the same price. The idea, I suppose, is that no one is going to put anyone else out of business and every village will have a monopoly of sorts that supports the economic livelihood of its residents.

The problem, of course, is that you can’t command production efficiently, nor can you strip out the roll of price in allocating resources and labor effectively to satisfies people’s needs and wants.

Think about it. One village produces nothing but spam. Just spam in can. Maybe people buy it. Maybe they don’t. But the village cranks it out no matter what. What if the village can’t make enough? What if it makes too much? How does it adjust?

Or, take an expensive item like say, caviar. A whole village cranking out caviar. All at the same price, and regardless of demand.

You can see that it simply can’t work. Prices communicate valuable information. They tell producers what people want and what they’re willing to pay for it. High prices attract more producers because the margins look so good. This brings down prices…and as price goes down, demand increases, a pretty simple lesson in supply and demand curves.

The problem with a supply and demand curve is that it’s static. It takes a picture of the marketplace at any given moment. But the market moves. And the only way you can know which way it’s moving, how consumers tastes are changing, what they’re willing to pay, is if you allow prices to perform their communicating function.

Sorry for the educational digression. But the point is that most of the Western world (except for Europe and the United States and OPEC) understands that through competition and prices, you get the best products and services at the lowest prices (unless you’re providing subsidies to politically powerfully constituencies).

It’s not a complicated idea. But perhaps it’s an idea that has to take root organically and be proven to work over time. Ideas are their most dangerous when they’re simply imported as theories and divorced from real human experience.

I suppose my question about Thailand is whether the lack of a competitive culture (and an economy where prices move freely) is a serious investment disadvantage. We’ll see. I still think that as one of the world’s largest exporters of rice and rubber, Thailand’s got a lot going for it. It can feed the Chinese and put tires on their 100 million new cars. Now, let’s find us a rubber company and a rice company…

Okay, time to shower. I lost five pounds in water weight today, even with the fruit binging. A big dinner awaits.

Regards from Bangkok,

Dan

P.S. A reader writes that the Japanese must have laughed at me when I crunched on a roasted cricket (and nearly, uh, well you know.) He’s right. And he’s right that it was probably not typical Japanese fare, but a Chinese apothecary. Any apothecary’s know why we should eat more crickets (other than the pleasure of the texture)?

Also, the image below of the Thai girls playing instruments…I made a short movie out of it with my digital camera, to go along with my one-minute short “Tree falling in Bombay.” I’m no Michael Moore, but I will be shooting more of these clips to present, along with pictures, at a special session at the Agora Wealth Symposium in Vancouver in August. Cannes here I come.

And finally, I promised I would tell you more about my meeting at the Reserve Bank of India. I’m not breaking that promise. It’s just fulfilling it turned out to be less interesting than I thought. The whole conversation was “off the record.” It was a great conversation, if you’re fascinated with how central banks sterilize the money created in open market operations to prevent inflation. But as travel writing, economics is boring. And in any event, I didn’t really find out much about the rupee and Indian interest rates that I didn’t already know.

The notable difference between India and China right now is that the Rupee probably wont’ appreciate that much against the dollar, even in a major dollar collapse. On the other hand, as you well know, the Chinese currency has a built in springboard to strength that currency speculators love.

The direct implication of this is that China has had a much easier time attracting foreign direct investment and money to Chinese banks, with the revaluation of the Yuan lingering as an implied benefit. No such luck for India. Which means India must work harder to attract foreign capital to meet its large development needs. The July budget will be telling.

Finally (I really mean it this time), I wanted to pass along a thought that’s not totally developed. This is a blog, though, so I’m not ashamed. I’ve noted in the past, along with others, that 21st century Asia is a lot like 19th century America, namely a vast repository of raw commodities and future demand for both raw commodities and finished goods. It’s deflationary for finished goods in the rest of the world (flooding the world with goods) and inflationary for raw materials prices (consuming raw materials at break neck rates.)

There IS one big difference between 19th century America and 21st century Asia. America was an empty continent waiting to be tamed and harnessed by eager immigrants. Labor wasn’t in surplus.

In China and India, labor, both skilled and unskilled, is part of their respective competitive advantages. But it’s also part of the political and social risk you face as an investor. How will Asia feed its millions and care for them as they get older? How will it provide enough water and electricity to accommodate densely packed cities? And what will happen when millions of Chinese and Indians feel left out of the prosperity they see in their gleaming new cities?

This is all part of figuring out what the spirit of capitalism is really like here. Much to consternation of intellectuals and Leftists, Americans never took to class warfare, even in the face of opulence and waste by the richest Americans.

Even with the epic number of huge swindles coming out of corporate America in the last four years, you still don’t see an uproar that the wealthy are too wealthy. Why?

Americans (generally) don’t begrudge the wealthy their wealth. Instead, Americans see the rich as examples of what we all might become if we’re lucky, we work hard, or we invent the next operating system of the personal computer. What can that outlook be attributed to? Good question…let me know if you have any ideas. I have a few, but I really DO have to get showered before dinner..

2004-06-22T18:05:00.000+05:30

A postcard from Thailand.

2004-06-22T16:38:00.000+05:30

The day started when I met SI readers and Thai residents Deb and Mike Yantis in the hotel lobby. Deb and Mike are Silicon Valley Dropouts who are sold on the virtues of overseas living and have kindly offered to play tour guide for me while I'm here in Thailand. In fact, in a few hours we're taking a dinner cruise down the river. I'll post some pictures if I get some good ones. We took a quick trip to Phantip Plaza...which is a huge indoor mall full of electronic goodies. Also, when you're a tall single guy like me, you'll often be asked if you want to buy "sexy movie...sexy DVD." Your editor passed. I may, however, scoot back next week and get an iPod. Sexy digital toys.

2004-06-22T16:35:00.000+05:30

Lots of good food available, and really cheap, at Phantip Plaza. Some of it I recognized. Some of it...I did not recognize.

2004-06-22T16:34:00.000+05:30

...and here was what I had for lunch. Just kidding. I coudn't eat that much. I didn't get Dehli Belly in Bombay...but have immediately comedown with Bangkok something or other. I stuck with coffee for breakfast, although later in the idea I tried a bunch of different fruits, and drank the juice of a young coconut sacrificed in my honor and for the sake of my thirst.

2004-06-22T16:30:00.000+05:30

Your editor offered an orchid and some incense to this statue of Buddha at the Grand Palace. The Grand Palace was the old Royal Residence and, as you can see from the pictures below, houses many statues of Buddha...and sports some dazzling decoration. I confess to not knowing a great deal about Buddhism...and like any major religious site...it felt distinctly...not religious. That is, even though you're required to wear long pants and closed-toed shoes (or sox), it's a little hard to be meditative when you're surrounded by sweaty, bottled water guzzling, digital camera slinging tourists like yourself. Perhaps this is the problem with modern tourism...it's become too self-conscious...or too obsessed with sterile icons of the past, instead of real, authentic, living examples of the present. The problem with the present, of course, is that it never lives up to the image of the place you read in some book somewhere, or the idea of it you'd carried around in your head for all those years. Most of the time, we like the places we visit to be different...but not too different. That's just me thinking out loud on the subject now...in pennance for not thinking enough about it while I was there today.

2004-06-22T16:25:00.000+05:30

Here's a picture I could have rotated vertically...but would have lost some of the statue of the...man. It's a guard, I presume, standing guard over the reliquary. Interestingly, Thailand has never been invaded, so unlike the Forbidden City in Beijing, I don't believe any invaders have looted the temples...at least not Western invaders. (Why has Thailand never been invaded? Good question. A theory on that tomorrow.)

2004-06-22T16:23:00.000+05:30

Again, you'll have to forgive my gross ignorance in describing what I saw. But I did like the looks of this...and if time permits...maybe I can put together a short primer on Buddhism...or better yet, maybe YOU can. If you do, feel free to send it to me...and I'll post it for the erudition of the thousands of other folks who are now following along as I make my way through Asia.

2004-06-22T16:21:00.000+05:30

Some detail from one of the smaller buildings.

2004-06-22T16:20:00.000+05:30

This is a reliquary in the shape of a golden Chedi. I could have rotated the picture to show it vertically, but it altered the composition, so I left it as is.

2004-06-22T16:18:00.000+05:30

You can see the gems inset on this guard who sits outside one of the buidlings in the complex. I zoomed in on his face to catch the expression...yet I'm not sure how to describe it.

2004-06-22T16:17:00.000+05:30

A crowded picture...but you can see both the architectural style...and the pretty colors. It is, of course, a place of worship. And in the Royal Monastery of the Emerald Buddha (an enormous green jade Buddha inside) there was indeed a lot of praying. Your editor learned that you're not to point your feet toward Buddha...so you either sit on your knees or in some other awkward position (awkward when you're 6'1 anyway).

2004-06-22T16:14:00.000+05:30

The consequences of being asleep at the switch...from a series of wall paintings inside the complex. Close ups below.

2004-06-22T16:13:00.000+05:30

Here's the large view of a sleeping figure...presumably not guarding a temple, for which I believe he got in trouble.

2004-06-22T16:12:00.000+05:30

This from a large mural within the complex. Your editor sympathized with the sentiment.

2004-06-22T16:11:00.000+05:30

And here's a picture of a god that's really upset about something, I cropped it from the original.

2004-06-22T16:08:00.000+05:30

You can burn incense and offer prayers at many of the smaller statues throughout the complex. You can also buy small leaves of gold foil and attach them to the statue. Click on the picture to see finer detail and you'll see what I mean.

2004-06-22T16:07:00.000+05:30

Nice light hitting the gold-gilt edges of this part of the temple compelx.

2004-06-22T16:05:00.000+05:30

Not everything in the Grand Palace is so formal. Here you see a newer section of the temple complex with a dazzling silver roof. carefully arranged to look haphazzard.

2004-06-22T16:02:00.000+05:30

A full length of the largest Buddha image in the world, I'm told. It's the reclining Buddha. This Buddha is found at the Wat Po temple, the largest and oldest temple in Bangkok. I'm told by the literature that this Buddha is 46 meters long and 15 meters high, and represents Buddha passing into Nirvana. Wat Po is also famous as the center of Thai massage. Your editor can't speak to the quality of the massages...at least the ones at Wat Po.

2004-06-22T15:56:00.000+05:30

Here is another bad picture. I didn't have the camera steady. This is a family of stauettes in front of the reclining Buddha.

2004-06-22T15:54:00.000+05:30

The angle isn't great on this. But this is reclining Buddha...well...reclining.

2004-06-18T20:09:00.000+05:30

That Tree is Falling, That Tree is Falling

Pinank told us at dinner the other night that the monsoon hadn’t really begun to blow, and that we’d be glad to get out of town before it really DID start to blow. Well…we almost made it.

James and I were having a late lunch in the back of the hotel yesterday, looking out on the pool and a tall row of trees standing sentinel outside the wall. One of the trees—a big one, probably at least 100 feet high—was swaying madly at the top. “That tree is going to fall down,” I said.

We sat down and kept watching. James had his digital camera. I took it out and kept it nearby. Right after a Kingfisher beer but right before the carbonara came out, I walked out to the edge of patio and turned the camera on.

The great thing about digital cameras these days, by the way, is that you can shoot moving images with them. I’ll shoot it for a minute, just to capture the force of the wind, I thought.

I got the camera rolling…and about 50 seconds into it…the tree swayed violently towards me…then away…and kept falling…whooshing to the ground and leaving a big space in the sky. “There it went,” I said.

When a tree falls in Bombay, does anyone in America believe it? Well anyway, the tree fell, and our timing was remarkable. I have the image file loaded on to my computer. I’m going to keep it there as a reminder of good timing.

And of course it’s a reminder that being on the scene does have its advantages. I wrapped up my formal meetings here in Bombay this morning with some officials at the Reserve Bank of India. They were polite, helpful, but relatively non-committal, as you might expect from central bankers.

The general perception here is that India is not totally immune to dollar/interest rate risk, but that it IS relatively dollar immune, having fewer dollar reserves and U.S. Treasuries than other central banks.

It might be true that a rise in U.S. interest rates isn’t going to force India’s central bank to high rates, which are already significantly higher than in the U.S. And that means Indian growth—which is mostly powered by domestic activity—isn’t going to be slowed down by higher global rates.

Where India has already been hurt, though, is in the stock market. The “elephant money” (hedge funds who pay attention to interest rate differentials) has already stampeded out of the market, leaving the Bombay Exchange with absolutely pathetic volume.

In other words, investors are still treating India as an emerging market. At the first sign of trouble, it’s run home to dollar momma and the U.S. markets, even U.S. bonds, which finally got a bid yesterday.

This tells me that with the most mobile global capital, India is still perceived as a speculation, to be indulged in when interest rates make risk taking relatively cheap. That’s bad for the image of India. But it’ s probably good for you as an investor. And here’s why…

Despite the apathy in the equity market here, the real economy is indeed growing. The hullabaloo of the government rolling back privatization plans is a lot less important than you might think. It’s a case of the Indian tendency to say one thing and do another.

For example, the regional government is Western Bengal is nominally communist. But West Bengal is a hot bed for outsourcing. So strikes have been banned. The industry cranks out code and phone calls 24/7, 365. And in a stroke of political genius, the communists engineered the election of a union leader to the national government in Delhi (so we were told last night during our interview.)

If communists are leading the way in smashing labor laws in order to protect the growth of the outsourcing industry, you can be sure that this current government isn’t going to get in the way of it either…or of any reforms designed to gradually unleash India’s economy.

India’s economy, I believe, will grow at above average rates in the coming years. Like China five years ago, it needs huge fixed capital investment. What it doesn’t have is a way to pay for the many development needs it has. It will need foreign direct investment, of course. And it will need to make tax laws more transparent.

In the meantime, while the government clears the economic brush, there are many, many Indian companies doing just fine, thank you very much. These are companies who already have cash flow and trade at relatively low multiples to earnings. Some of them do business primarily in the domestic market. Some are exporters. Some are IT and outsourcing firms.

What they have all in common is that they’re being thoroughly ignored right now. But if I’m right that the growth here in India is just picking up, it’s the economy that’s going to lead the stock market. Now, when the big money is bailing, is the time to find value.

How long will you have to wait? India’s fate, like that of much of the region, is tied to the dollar standard. The world is still U.S. centric. Global capital still flows to America when geopolitical risks increase. Why will that be any different five years from now?

The big difference between today and five years ago is that the current account deficit is much less likely to be financed when U.S. asset markets are underperforming. The whole export-to-America-and-reinvest-the-profits-in-Treasuries breaks down when interest rates rise and the back of a 20-year bull market in bonds is broken.

In other words, the whole underlying structure of the global economy—achieve growth through exports to American consumers—is seriously, fatally challenged by falling bond prices.

As Asia begins to unwind its dollar risk, it finds that intra-Asian markets and domestic demand are a much healthier way to achieve non-inflationary economic growth. That means a rebalancing of currency reserves in order.

Who will that benefit the most? The euro? Gold? Hard assets? Probably a combination of all three.

But after the rebalancing, and what I believe will be another substantial decline in the dollar, the economic fundamentals of a growing India and a mature China will be firmly in place, waiting for investors to view this countries as the new crucial center of the global economic order, and not just peripheral plays for quick returns when interest rate are low.

Of course, if I didn’t believe any of that, I wouldn’t be here for two months looking for the best industries and sectors to own when the world finally sees the domestic growth stories taking place.

The first waves of the money migration—out of the West and into the East—have already hit these shores. Bigger waves are coming (they’re even knocking down trees).

Off for some sight seeing tomorrow. More spiffy pics to follow.

Balmy in Bombay,

Dan

P.S. My flight to Bangkok leaves at an un-Godly 4:30 am on Monday morning. I’ll be in Bangkok at least Monday through Friday. Right now, my schedule has some openings in it. If you’re an investment professional, businessman, or lover of fine wines and good local food, and you’re in Bangkok, let me know and maybe we can get together.

2004-06-17T19:29:00.000+05:30

Boric Meets the Buffett of Bombay

A setback today. Mortal telephone combat with Cathay Pacific over rebooking reservations to Bangkok for Sunday. I was vanquished. But Singapore Airlines rushed into the breech. All is well. Note to self: check into outsourcing airline reservation call centers from India to the United States.

Today is a much quieter day than the last two days. A few reporters from the Business Standard, one of India’s leading financial newspapers are stopping by to chat about how my trip is going and what I think of India. And James and I are meeting with some non-financial folks later this evening. A little man-on-the street view of India, if you will. As my new friend Pinank and his wife said at dinner last night, sometimes you can learn more from a cab driver than a stock broker.

Before we had dinner with Pinank and his wife Manisha at a Chinese restaurant, James and I made our way out to Worli, and the inconspicuous office of Bharat Shah, CEO and Managing Partner at ASK Raymond James here in Bombay.

Mr. Shah, like nearly everyone else I’ve met here in India, was unfailingly polite. He offered me a cup of tea, which tasted like sweet pumpkin. Then I launched into my inquisition.

My first question was if India, like the rest of South East Asia, has dollar risk. India has about $120 billion in foreign currency reserves, although not all those are dollars. You may recall that in 1991, after the Gulf War and the mini oil shock, India’s forex reserves dwindled to less than $1 billion. A planeload full of gold was flown to London for safekeeping. That’s when current Prime Minister and then finance minister Monmohan Singh pulled the fat out of the fire and launched many of the reforms that have put India in a much stronger position today.

I asked the question because I’d been told the day before that India, far from having dollar risk, is actually a safe haven for investors looking to get assets out of the U.S. market and into a market with real earnings growth and robust domestic demand.

Talk about role reversal…getting out of dollar risk by getting into India. You COULD make the argument that India is just as vulnerable to rising oil prices today as it was in 1991. And you COULD make the argument that rising rates in the U.S. will affect India by wiping out the carry trade, whereby hedge funds in the U.S. borrow at low U.S. rates to invest in so-called emerging markets.

But everyone I’ve asked here—except faithful Daily Reckoning reader Pinank—is convinced that India is largely immune to rising global interest rates. The biggest risk to interest rates here, the consensus seems to be, is an inability by the government to get the fiscal deficit under control (sound familiar?). The budget comes out on July 8th.

Between now and then, the stock market has other worries. Like selling. Today’s Economic Times reports that mutual funds have been net sellers in both the equity and the debt markets in the last 15 days. And it’s not just “dumb hedge fund money” getting out of India and closing out the carry trade. It’s corporate India.

That’s what uncertainty about tax law and government policy tend to do. They make it hard for business to plan. The new government, at least in words if not deeds, to let investors know just what its tax and regulatory policies are going to be.

James was chomping at the bit, at this point, to get away from the macro talk and talk about valuations in India’s robust mid cap and small cap market (which happens to be Mr. Shah’s expertise, valuing companies that is.)

I did ask a few more questions, though. My big one was if the domestic equity markets were up to the task of financing legitimate business risk. My initial observation is that India, like China, depends heavily on bank lending. This has led to bad loan problem in both countries, especially China.

But it seems like less of a problem in India. I say seems. I’ll have to do more digging. The bigger issue, as far as I’m concerned, is if start up businesses can get the capital they need. Is risk adequately funded in India. Mr. Shah’s answer is that good, well managed projects, don’t have any trouble raising money in the equity markets.

Of course, many of India’s major problems won’t be funded by the equity markets at all. Physical infrastructure (roads, electric, water, rail, airports) are usually finance in the bond market. Social infrastructure (education, health care, welfare) are usually financed through government spending. On the latter score, the government is already in a tight spot. On the former score, there doesn’t seem to be any great rush to structure bond issues to pay for the upgrade in physical infrastructure.

About all that’s left is foreign direct investment. India needs a lot more of it. And so the conditions to attract foreign capital (transparent laws and a more efficient tax system for starters) have to be in place before the real upgrades can take place. I’m sure the government knows this, of course (governments are on the ball right?) We’ll see what they do to attract more foreign capital.

The good news is that last time India faced a series of exogenous shocks, in ’91, the private sector actually got better at using capital more efficiently. When there’s less of it to go around, you husband it and mange it well, or you lose it. The government got out of the “license raj” business…telling business how much to produce. And the market got more competitive. Hayek would have loved it. Once you free prices up to communicate information on quality, prices tend to go down and services tend to improve.

In any event, Indian business appears to be better at using capital. Which leads to the obvious question…just which businesses are we talking about here? I won’t steal James’ thunder (see James' notes below.) But I will point out that Mr. Shah obviously knows his way around a balance sheet and income state. He’s reduced valuing companies to a pretty simple three-step plan. Evaluate the business. Evaluate the management. Find out if you can buy it cheap. Of course he has a little more quantitative approach than that. Look below, you’ll see what I mean.

Tomorrow, I’ll ask my interest rate question (and a few gold questions) to a real live central banker. My request for a meeting at the Reserve Bank of India has been graciously accepted. A full report will follow.

Until then, I remain,

Your man in Bombay,

Dan

P.S. I’d meant to include this little bit below about Tokyo while I was there, but it never quite fit. I think it does today, though.

The Silent Fight

When I was in Japan, my friend Jason told me the story of the silent fight. The Japanese keep to themselves on the subway. There’s no such thing as personal physical space. You often find your face in the middle of someone’s back, or your hand in places usually reserved for closed bedroom doors.

To make up for the lack of physical space, you get psychic space. That is, even when you’re packed into a car full of people, you pretend no one else is there, out of politeness I presume.

So you can imagine Jason’s surprise to see two well-dressed businessman grappling with one another, making nary a sound. Push, tug, grunt, grimace. Boom. Pow. Oof.

Ties were displaced. Shirts rumpled. Glasses knocked crooked. A small affront developed into a silent war of words, and finally, the ultimate escalation, a silent fight.

The rest of the passengers ignored the fight with determination, or maybe peeked out of the corner of an eye. The conductor stepped in wordlessly and separated the parties.

Inarticulate conflict. Inarticulate conflict resolution.

More tomorrow on how it’s different here in India. But believe me, it IS different.

P.P.S. I note with vindication, that after my making miserable, Cathay Pacific has earned its Karmic justice and is down in early trading.

JAMES’ Notes: Up-and-coming Indian Mid and Small Cap Powerhouses

I have to say, meeting Mr. Bharat Shah, CEO and Managing Partner at ASK Raymond James here in Bombay, was the highlight of my trip to India. Dubbed the “Buffett of Bombay” by Dan and I, Mr. Shah makes his living scouring the market for true value stocks – companies with both a margin of safety and a growing business. And he has a history of being very successful.

Before he became the CEO of ASK Raymond James, Mr. Shah helped run Birla Sun Life – where he managed $1.2 billion in assets. And at ASK R.J. he manages close to $50 million today – or as they say here in India, Rs. 250 crore.

There was no doubt this man knows what he is doing. And he knows how to spot a good value in the market. With that in mind, my first question was:

“Do you think the Indian market is overvalued, undervalued or properly priced?”

He told me as a whole he felt the Indian market was slightly undervalued – not much – mind you. But with stocks trading for right around 11 times earnings, Indian businesses certainly aren’t expensive.

(By the way, as a true value investor, Mr. Shah isn’t concerned with the PRICE of a company. He determines value by looking at how well a company manages its capital, how well the managers run the business and whether the company is undervalued based on EBITDA and cash flow).

Not quite content with his answer, I asked Mr. Shah to be a little more specific – and name the areas of the market he felt were most undervalued and worth investing in. He obliged.

You should be looking at the tech services, business services, pharma and specialty manufacturing industries. These are some of the areas that will continue to grow along with the Indian economy. (And no one I have talked to, with the exception of Dan’s Daily Reckoning friend, Mr. Pinank, thinks the Indian economy is going to be anything but strong.) And as more and more government money is spent improving the infrastructure of India (meaning everything from roads, ports, rails and even social infrastructure…education, health care and drinking water) some sectors to keep an eye on are…telecom, construction and the auto business.

This was great. But what Mr. Shah said next brought a smile to your faithful editor’s face.

If you really want to find value in India right now, you shouldn’t look to the large blue chip companies -- those trading on the Sensex and Nifty (the equivalent of the Dow and the S&P in the States). Rather, the real gems are hiding in the mid and small-cap markets.

There are many smaller Indian companies with cash, growing businesses and competent managers that are flying under the radar screen. These are the companies you should look to now.

At this point, I felt like hugging the man. Finally, someone who was seemingly as passionate about the small-cap market as I am! It was a great moment for me. It seems my hunches were right – both about India and its small-cap market. WHOOO HOOOO!

Ok...back to earth now.

Mr. Shah went on to explain that small-cap Indian stocks provide investors with the best chance to get both value and growth in this market. And he made a point that really resonated with me (as I have said the same thing in Penny Stock Fortunes) many times...

"Value without growth isn't value."

That seems so obvious. But it is SO important. If a company isn't growing its business, it isn't worth owning. It made me think...

Had investors followed this kind of logic in the 90s, no one would have lost a dime in the dot-com blowout.

And that’s where I will leave things for now. I am scheduled to catch a flight back to the States in a few hours. And I will use much of the 19 hours in the air to digest all I have learned here in Mumbia. You can expect a lot of post-India analysis from me in the next few weeks.

What a trip.

James

P.S. Dan took a picture of me and Mr. Shah. I will put that one on my desk. The Buffett of India and me! WHEEEE WHOOOO!

2004-06-17T14:53:00.000+05:30

Boric and the Buffett of Bombay. Film at eleven.

2004-06-17T00:21:00.000+05:30

India: Stunning Women & Emerging Profits

Dan's note: this post comes from James Boric, my friend, and the editor of Penny Stock Fortunes. He's joining me on the India leg of my trip...

What a day I had yesterday.

India is a place worth investing in for the long haul. I’ll explain by taking you through each of my three meetings yesterday.

The day started off at 9:30 a.m. – when Dan Denning and I went to McKinsey&Company where we met Mr. Ranjit Pandit – the managing director for all of India. He was a great guy – very intelligent and kind.

After offering Dan and I coffee, tea and munchies, Mr. Pandit started the hour-long meeting by telling us, “India is never as it seems.” And what he meant by that is simple.

In the news (especially in the United States) we hear about India’s new leftist government and how it plots to reclaim many of India’s private businesses – with the intent of reverting back to a State-run system. But that is about as far from the truth as you can get.

Mr. Pandit told us not to judge India based on the news. Watch and see what this government does for yourself – not what the media says it might do. And he thinks the government will do some great things for the economy – like opening the retail industry to foreign competition, lowering the consumption taxes and improve India’s infrastructure.

The net result will be an increase in productivity and consumption. And that will lead to a more prosperous Indian economy. We’ll see if what Mr. Pandit says is right. But I think it is:

The government recently added a one Rupee tax on every liter of gasoline – which they will use to build new roads. And trust me, every road built here in India will help immensely. Not only will it encourage more business (by supplying construction jobs and allowing people to travel further to get work), it will also help transport food to the poorer regions of the country where food can’t be found.
The retail sector is one of the last government run sectors in India. But that’s expected to change soon. Look for the new government to open it up to competition (foreign and domestic) in the next few years. When it does, goods will become cheaper. More jobs will be created (although mom and pop shops will likely be hurt.) And consumer spending will skyrocket. Right now, India’s savings rate is north of 20% and has $150 billion sitting in bank accounts. With the opening of the retail sector, that money will be tapped – sparking a chain reaction in the Indian economy. But before the retail sector is opened up, something has to be done about the enormous taxes the government charges for goods. And it will. The idea is to lower taxes – and make them uniform for retail items – so Indian consumers can do what Americans do best – buy, buy, buy. Just keep one thing in mind, there’s no credit bubble here in India – because the only lenders are the banks. Rather, Indians are net savers.

There’s a positive feeling in the air here in Mumbai. The Indians feel optimistic. They know they’re really close to making it. And they’ve thundered too far forward to backtrack now.

And the outsourcing industry is one of the industries that have helped India push forward.

I asked Mr. Pandit if he thought outsourcing was in a bubble – or if it still had legs. He responded very quickly by saying, “You’ve only seen the tip of the iceberg. The outsourcing industry still gains momentum. It will double in three or four years.” He went on to say that supply in the outsourcing industry is so great that prices will remain low – which will encourage more foreign activity here in India.

I recently read a quote that by the end of 2004, 40% of all Fortune 500 companies will outsource to India. And many people I talked to say all of them would arrive shortly.

I don’t doubt that.

Not only is it cheaper for U.S. and European companies to come to India in terms of wages…they also get a very skilled group of laborers working on their side.

The Indian outsourcing model stays strong. The people speak English (which is one reason the U.S. is so quick to send business their way). They are educated (so they can help spot inefficiencies in your business, a la British Airways). And the supply of workers here is incredible.

India has the largest and youngest working class in the world. And as more and more jobs become available, India’s population will likely serve as a major asset – not a liability like it has in the past. Of course, it won’t happen over night. But it will happen.

On the Ground Floor in the Growing Indian Telecom Sector

My next stop along the way was about a 30-minute drive outside of the city to Videsh Sanchar Nigam Limited headquarters -- where I met with the companie's CFO, Mr. Amitabh Khanna.

What an experience that was.

First of all, I was very grateful Mr. Khanna would even see me. (I managed to get his number after calling the company several times and being shot down. It pays to be a pain in the ass!) He is a busy man. After all, running Videsh is no small chore. It is an $876.38 million company, and the largest long distance provider in India.

(I wonder if I could have gotten an interview with the CFO of AT&T. Doubt it!)

Anyway, my meeting with Mr. Khanna was fantastic. We started with a brief history of Videsh…

After being the only long distance provider in India for 13 years (it was a state owned monopoly), the government decided to open the telecom industry up to competition in 1999. And by 2002, Videsh (and its newly created competitors) were open to investors.

As you might imagine, since 2002, Videsh has lost quite a bit in terms of sales and net income – simply because it is no longer the only game in town. But it is still the dominant long distance carrier. Right now, the company has about a 55% share of the long distance market. And Mr., Khanna seemed to be very optimistic that Videsh would continue on by becoming “the carrier’s carrier.”

Here’s what that means…

Right now, Videsh owns millions of miles of cable under the ground. It has more than a dozen switching stations in India. And it is getting ready to lay cable from India to Singapore. Videsh is like the AT&T of the United States. It owns most of the assets underground. And every time a local carrier needs to use that cable, it has to pay Videsh a fee. Well, Videsh seems content to rake in those fees. And if it gets its way, all new Indian carriers will never lay another mile of cable in India – it will simply pay Videsh to use its existing cable. Hence the name “the carrier’s carrier.”

We’ll see if Videsh gets its wish. But if it does, there could be some terrific upside in the years to come.

Right now, India only has 6 phone lines for every 100 people. That’s nothing. China, for instance, has about 17 or 18 lines per 100 people. So as India continues its upward trend, there is tremendous room for growth in the telecom industry. In fact, Mr., Khanna left me with this as I headed out for my third meeting of the day…

“Things can only go up from here.”

I tend to agree. Now it was onto my third meeting of the day -- at 151 Nariman Point – to visit a Daily Reckoning reader Mr. Ravi Dharamshi.

Mr. Dharamshi works for a company called Rare Enterprises – a private investment firm owned by Rakesh Jhunjhunwala. Let me tell you, these guys were great.

After introducing himself, Mr. Jhunjhunwala asked me a question…

“What do you think of the Indian women?”

I felt myself blush. My face undoubtedly turned from white to bright red. He definitely took me by surprise. But I responded by saying they were quite beautiful. He grinned and I immediately felt at ease. Now we could talk business.

Mr. Jhunjhunwala is very rich man. I don’t know how rich. But by the looks of his office and the size of his staff, he is doing quite well for himself. After all, his entire staff manages HIS money. He is a self-made businessman. And his life is the market.

Hung all over his office, are saying from the world’s great investors and economists – John Templeton, Warren Buffett, Phil Fisher, John Maynard Keyes and others. I got the sense Mr. Jhunjhunwala was a bit of a historian. He studied how others made their fortune – and he took the best parts from each of them to use in his own investing. One thing I liked about him was he had a long-term approach to the markets. He’s not the kind of guy who will panic and pull his money out of the market just because he’s down 20% on a stock. He will stay invested for 5, 10 or 15 years – like Templeton and Buffett did.

Obviously it is paying off for him.

Mr. Jhunjhunwala started off working alone. Now he has a staff of probably 15 or more. I didn’t count…but there were at least 6 or 7 other people in the room meeting with me.

While I sat and talked with the Rare Enterprise men, they gave me charts, tables and books – all showing me that the Indian markets were a great place to be right now. For instance…

The average PE ratio for Indian companies is a paltry 12.5 right now. Based on historical valuations, that is cheap. Not long ago, stocks were trading for more than 30 times earnings. And if you use forward-looking earnings, Indian stocks are even cheaper at just 10 times earnings.

But what about the low volume, I asked them? Since I’ve been here the average volume for the Sensex (the major Indian stock index) has been between 77 million shares a day and 140 million. Why aren’t more people buying?

His answer was straightforward.

For one, people are still scared of the markets. They have been burned before. And they don’t want to be burned again. It will take some time to gain back their confidence. But he thinks it will happen. And when it does, look out,

Right now only about 2% of India’s household savings are being invested in stocks. That means there is about $150 billion sitting in the banks. And when confidence is restored, more of that will make its way to the market. Nothing happens over night.

My next question for Mr. Jhunjhunwala was, “Why should investors look to India right now versus China?”

His answer was threefold…

India follows strict accounting rules – probably more so that anyone in the world, including the U.S. So India has safeguards that China simply doesn’t have. While it isn’t risk-free, you can at least feel good that India’s legal and accounting systems are transparent – the same can NOT be said of China.
China’s industries are so fragmented. There are 500 Chinese cement manufacturers. Even if you owned the top two companies, you’d only have a 1% or 2% share of the market. Where as in India, the top two companies may have a 60% market share. So you get more bang for your buck (or Rupee).
The Indian markets are earlier along in their growth stages than China. So if you are willing to take a longer-term approach (say 5 years or more), the upside is spectacular.

Plus, I should repeat, India has a young working class and they are well educated. They can perform skilled manufacturing jobs and service jobs that the Chinese might not be able to do – at least not competitively for the same low prices.

Finally, Mr., Jhunjhunwala told me the people in India are confident. (And this is certainly the sentiment I have gotten every where I’ve traveled.) They aren’t afraid to think big. They aren’t afraid to take risks.

In the end, I think that confidence and those risks will pay off – for anyone who invests in India (foreign or domestic).

That’s all for now.
James Boric

P.S. James Boric and Dan Denning invented the CXS system some years ago to pick soon-to-skyrocket Penny Stocks. James has focused their precision system firmly on India, the next rising Asian Goliath. In this report, you’ll see why Buffett dropped $1 billion in India’s stock market…and how to get in on the basement floor of the first “Indian Microsoft,” turning $10,000 into $152,697 or even $9,500,000 Also -- stay tuned as James and Dan continue to report on their Indian odyssey of emerging opportunity...

2004-06-16T11:46:00.000+05:30

I got the lighting wrong as usual. But I liked the look of this anyway. Click on it to see it in sharper contrast. That's the Gateway...from my third floor hotel room.

2004-06-16T11:45:00.000+05:30

If you click on the photo you'll see a much clearer resolution. In any event, it says, "Erected to commemorate the landing in India of their imperial majesties King George the V and Queen Mary on the Second of December MCMXI."

2004-06-16T11:44:00.000+05:30

That white pillar there in the center of the frame is where the kids were the other night...balancing on the top of it, and catapulting themselves backwards into the sea. I bet Boric that he wouldn't do it. He wouldn't take the bet. Neither would I, come to think of it. But it did look fun, and kind of refreshing given the muggy weather.

2004-06-16T11:42:00.000+05:30

I seem to have developed a knack for taking pictures in poor lighting. I'll try again at sunset. But this a ground's eye view of the Gateway to India. If it seems like I'm doing less sightseeing in Bombay, it's because I am (doing less that is.) Not that there's less to see...but duty calls. Hopefully the weekend will yield up some other pictures of the surrounding areas.

2004-06-16T11:38:00.000+05:30

Here's the Hotel from out on the sea wall.

2004-06-15T17:58:00.000+05:30

Gringopomorphism

Dear Reader,

I’m waiting on a club sandwich back at the hotel before heading out in the monsoon for a meeting with Standard Chartered Bank. But before I head out I wanted to pass along a few quick observations about a great morning meeting James (Boric) and I had this morning.

We met with Ranjit Pandit, a managing director for the Indian office of McKinsey and Company. McKinsey does management consulting all over the globe. Being a macro, top down guy myself, there’s no better way to start your evaluation of a country then by getting the lay of the investment and economic land from someone who knows. So that’s what we did.

It was an hour-long conversation, so I won’t pass on everything we talked about. But two issues jumped out at me as being critical to your attention if you're forming an “India Strategy.” The first is obvious, the second less so.

I’ll begin with the obvious issue on U.S. investor’s minds: outsourcing. I came to India as an outsourcing skeptic. That is, my initial impression is that it’s a far bigger issue in the press than it is in the economy, or for investors. I’ve revised that opinion.

Outsourcing IS a big industry here in India.

You have a well educated, English speaking population willing to work at a discount to Western Labor costs. But Mr. Pandit said multi-national firms like British Airways are finding that their Indian workers are also able to deliver substantial cost savings over and above the cost of labor.

An example would be in the airline industry and the efficiency of code-share tickets. BA pays a fee to other airlines when you buy a ticket through BA, but take part of your journey on a different carrier.

The problem for BA is that, prior to outsourcing, it wasn’t managing those claims efficiently, verifying that it wasn’t overpaying, not to mention the labor hours spent in actually processing the claims (or reimbursing the other carrier.) Mr. Pandit said BA was able to compound its outsourcing cost-savings through the additional efforts of its Indian employees to actually run the operation more efficiently.

This is an obvious benefit to shareholders in multi-national firms that are using outsourcing to handle a larger and larger portion of their business services.

It’s not just labor cost, in other words, but additional benefits. That’s the benefit of having an educated workforce on the other end of the service contract.

Mr. Pandit figures that twenty percent of all Western services could be headed to the Indian outsourcing market. That makes it a major industry in India, and probably an investable theme if you can find the right outsourcing firms.

As a skeptic, I objected that outsourcing might have diminished domestic benefit because the profits of the firms were going to multi nationals, not Indian firms. Perhaps, came the answer. But even if the benefit were just the wages and taxes being paid by multinationals, it would be well worth it for India to develop the industry along its current trajectory.

I won’t say I’m sold. I think as a political issue, outsourcing is over done. Americans tend to look at it purely as an issue of American jobs. And fair enough at that. But that’s a limited way to look at it as an investment idea. It’s what I call gringopomorphism.

I agree with Mr. Pandit that political concerns won’t stop the trend if it makes sense for business. And if he’s right, it DOES make sense for business, both Indian business and international business. James is heading out to a few outsourcing firms later this week while I talk to the banks. I’ll let you know what he finds.

My sandwich just got here and my car leaves soon so I’ll be brief on the second big point. Don’t be too preoccupied with the red herring that the new government is going to roll back privatization and re-regulate big industry.

This sounds counter intuitive if you look at the headlines. On Monday, the local papers reported that the government is getting back into the steel regulation business. On Tuesday, the papers reported that steel stocks and the whole SENSEX were down, on a paltry volume of 77 million shares.

It looks like a big problem. “Nothing in India is as it appears,” Mr. Pandit said. He said the big reform to watch for—the one that would mean more to India’s long-term economic growth—is introducing a value added tax (VAT) and opening up the retail business.

Retail is one of the few industries yet to be de-regulated, largely on the strength of the trade lobby, which makes a killing on the myriad taxes imposed on retail trade. A VAT streamlines the revenue collection for the government but eats into the margins of retailers, hence the strenuous objections. No one like their revenue model changed for the worse.

If a VAT is passed and foreign direct investment in India’s retail sector becomes a reality (it’s not right now) you’d have that Holy Grail of balanced economies…domestic demand and export growth working hand in hand to raise living standards.

There are dozens of examples of how the current retail trade regime suppresses domestic demand and leaves savings sitting in banks. And truthfully, the frugal miser in me wonders if you really want to “unleash” consumer culture in a country with a high savings rate.

But the law shouldn’t prevent people from spending money if they want to. After all, it IS money, not credit, which is much less of a problem here by all appearances. Unleashed domestic demand with a VAT increases the tax base, promotes the growth of domestic industry, and lets people buy what they want without being punished by high taxes or higher prices than they might otherwise pay.

Funny that this idea should come up so soon after the death of Ronald Reagan. It looks a lot like a Laffer curve…that by reducing nominal tax rates (or indirect retail taxes) you increase spending and productivity, which broadens the tax base…leading to increased government revenue and more consumer choice at lower prices. It’s Reagan’s nirvana.

Maybe it’s just gringopomorphic for me to think of India’s growth in Reaganesque terms. But chuck out Reagan and you still find that difference between China and Indian GDP per capita growth rates over the last five years (and probably since 1978 when the door in China flew open) is the importance of domestic demand to overall economic growth.

Speaking of demand, my stomach beckons. Back later this week with more insights from the rainy but optimistic sub continent.

Sincerely,
Dan Denning

Publisher's memo: As Dan said, outsourcing is not the devil the media makes it out to be. In fact, outsourcing made the “Indian Bill Gates” his $8 billion fortune. This industry will keep growing, especially because more and more major American corporations must look to outsourcing to stay in the game as their competition cuts costs. Look here for more on how to gain from the biggest trend in American business.

2004-06-14T23:23:00.000+05:30

And here's a view of the same the same Irohazaka road from the side, on the way to Kegon falls. There are fifty characters in the old Japanese alphabet...and nearly 50 corners on this road...hence the name.

2004-06-14T23:19:00.000+05:30

Not my picture, but taken from the public domain. This is the Irohozaka road from above in the fall.

2004-06-14T23:17:00.000+05:30

Dear Reader,

I'm checking in this week from Bombay. Last week was research week in Tokyo. I’d meant to go to the fish market, and back to Shibuya, and maybe to the Sony store. Instead, I spent the week looking at capital investment figures for Japanese small and mid cap firms. The government came out with a raft of revised first quarter GDP numbers. The bond market looks to have topped out. And the recovery story is gaining traction.

I don’t buy it, even though it was a story I was fully prepared to believe when I went to Japan. Japan is still a country built on an export mentality. Domestic demand (household spending WAS up in the first quarter. But a long-term, strategic view of the population tells me that robust domestic demand isn’t sustainable.

It’s a country that’s old and getting older. Throw in the little to no immigration, a high savings rate, and the emergence of China, and I think you get the picture of a Japan content to export capital goods and high-tech finished goods to the rest of the world at a surplus, while it continues to move down the road to a gray future.

This is exactly the case I made in my CNBC interview. And while I think the falling bond market in Japan may give stocks an added boost through the calendar year, I'm not fundamentally convinced there really is an investable recovery in Japan.

One or two quarters are hardly a long-term trend. And when the animal spirits of capitalism are dulled and dimmed by one of the most monotonous and relentless bear markets in history, they aren't likely to recover simply because business investment was up in one quarter. In any event, I’ve laid out the case more fully in the June issue of Strategic, which is a bit late but nearly done. More on this later in the week.

Bombay meanwhile is rainy, colorful, pungent, and humid. Spent today finalizing my appointments for the rest of the week. India is styling itself the China of the next five years, an emerging giant that’s just beginning to hit its investment stride.

As you may know, it's also just elected a new government. The government is led by a reformer who was the architect of many of India's financial reforms that led to the current prosperity. But the partners in his ruling coalition are also looking to roll back plans to privatize the economy. And India, like China, faces an enormous rural agrarian population that's failed to enjoy the benefits of the country's recent prosperity.

In other words, now is a pretty good time to be on the ground in India to find out just where things stand. Is it the next China? Is it even better? Or do the facts support the investment hype?

I’ll find out. I’m meeting bankers, brokers, central bankers, stock market directors, private equity investors, and economists. And just to keep it all real, I’ll be meeting up with some Daily Reckoning and Strategic readers, too.

My first impression, after driving in the hour from the airport to the Taj Mahal hotel here on the water, is that India, like China, will probably see a huge boom in fixed capital investment. Its comparative advantage in low-cost service jobs is well documented. But like any emerging market, it needs more physical infrastructure, not least to support such a large population. I’m talking about roads, water treatment plant, and rural electrification.

In the meantime, the driving conditions are a free for all. The roads are filled with black and yellow cabs that look like miniature versions of old Nascar hot rods. In fact, the roads even feel like a giant racetrack. It wasn’t surprising to learn that India accounts for one-tenth of global traffic fatalities. I’m buckling up.

So far so good on the food front. I had a nice chicken dish with some colorful sauces for lunch, although I couldn’t pronounce what it was. I admit to being a barbarian when it comes to food. But my rebellious stomach has been mostly cooperative on the trip, so I decided to push it a little and up the spice factor. In the short term, the lunch was good. In the longer term, the heartburn was worse.

It’s been raining fairly steadily out. And as James Boric and I found out, one of the disadvantages of being a big tall white guy is that you stand our like a sore thumb in some places (Tokyo for example, and here.) It’s hard to step outside the hotel without getting a dozen instant offers for food, balloons, or salvation.

Combine the humid drizzle and the human onslaught and we’ve been diligently preparing for our busy schedule this week. But don’t worry, I’ve scoped out the nightlife scene here. Bombay is the nightlife capital of the country, and I’m looking to get some Bollywood stars to autograph an old issue of the Daily Reckoning for Bill Bonner.

For now, I’m off to read up a little more on what the Indians think of outsourcing. I’m beginning to think a top is in for offshoring/outsourcing stocks. The public interest is reaching a tipping point…which might mean there’s a full year of headlines and stock stories on the way.

An item in one of the local papers reported that Catholic priests are even out-sourcing memorial masses and services to India. Do you have a loved one you want to have a mass said for in Des Moines? Could be your local priest is dialing up Delhi to have it said there.

God does indeed work in mysterious ways.

P.S. All the gloomy news on the Japanese stock market I've saved for the investment section in SI. But Japan wasn't all gloomy by any means. I mentioned that I got the chance to go up into the countryside and spend time in and around Nikko. It's a small little mountain town with a national park nearby, a beautiful lake, and monkeys.

The big highlights for me were a road, a snack, and a bath. The road was called Irohozaka. It's made up of 41 hairpin turns. It's a blast to drive on. It also reminded me of the l'Alpe D'Huez stage of the upcoming Tour de France. That's 19 hairpin turns, if I'm not mistaken. This year, it's a 19 km time trial. Go Lance!

The snack wasn't really a highlight partly because it tasted so...odd. After looking at some waterfalls in the national park, my friends and I stopped by a road side stand selling everything from snakes in jar to crickets covered in a thick brown, barbecuish looking sauce.

This was one of those rare occasions when having a buddy encourages you to do something you'd probably never do on your own. On the count of three, we both chomped on the cricket.

It was crunchy and didn't really have a taste. More a texture. Still, I almost puked. And I was picking cricket legs out of my teeth for the next hour. When in Rome....

I mentioned the bath last week but didn't elaborate. A few subscribers wrote in asking just exactly what kind of bathhouse I'd been going to. Now now, you know me better than that. Public baths are catching on Japan. Partly because it's social and partly because it's kind of nice to hang out in a warm bath outside, or in a hot spring.

And it WAS nice. Nothing too strange to report. I naturally got a few polite but odd looks for being so relatively tall. But I can't see much without my eyeglasses. And because they fog up so much in hot water, your editor simply opened his eyes, slid down into the water, and blissfully stared at the green ridge of the mountain ranges in the distance.

Sincerely,
Dan Denning

2004-06-14T23:15:00.000+05:30

Tatsuya, a friend of Jason's singing karaoke at a bar in Sano. Your editor belted out some Elvis tunes.

2004-06-14T23:14:00.000+05:30

My old high school friend Jason on my right, his girlfriend Yoshiko on my left, and her two nieces and nephew in front of us.

2004-06-14T23:12:00.000+05:30

Looking out at Lake Chuzenji.

2004-06-08T20:38:00.000+05:30

Up in the mountains it was cooler. I spent an hour and half in the baths, outside, with the rain falling in the water. The fog rolled in and curved things off even more.

2004-06-08T20:37:00.000+05:30

And more rice...

2004-06-08T20:36:00.000+05:30

Another rice paddie.

2004-06-08T20:35:00.000+05:30

On Sunday, we left Sano for a public hot spring bath up in the mountains. In the countryside, most families appear to grow their own rice.

2004-06-08T20:34:00.000+05:30

The mausoleum, right before the battery in my camera expired.

2004-06-08T20:33:00.001+05:30

A lifesize swordsman guarding the entrance to the mausoleum.

2004-06-08T20:33:00.000+05:30

Guess what the caption to this picture ought to be? To be honest, I'm not sure what the significance of this famous monkey carving is. Later though, Jason and I nearly ran over a monkey on our way out of Nikko. It scampered across the road, vaulted up on to the awning of a ramen shop, and disappeared into the night.

2004-06-08T20:30:00.000+05:30

Stone lantern and incense pillars in the courtyard.

2004-06-08T20:29:00.000+05:30

Me looking thorougly modern in pre-modern Japan.

2004-06-08T20:28:00.000+05:30

On Saturday we went to Nikko, the home of the Toshogu, the mausoleum of Tokugawa Ieyasu. The Tokugawa shogunate ruled Japan for more than 200 years, before the Mejii restoration in 1868 (see Cruise, Tom, Samaurai, Last.) The complex at Toshogu includes Shinto and Buddhist shrines, some of which you see above.

2004-06-08T20:16:00.000+05:30

This picture of Jason's girlfriend, Yoshiko, was a little bizarre when I first looked at it. But I thought I'd include it after I looked at for awhile.

2004-06-08T20:13:00.000+05:30

I finally got out of the city for a visit north, to the countryside, up in Sano and Nikko. I was visiting an old friend from high school, Jason Kelly, who coincidentally lives in Japan now. Jason invited me to dinner with Japanese students of his who are studying English. Sitting on the floor was a little tough on my legs. But the dinner was good. And later that night, we bought some industrial strength sparklers at the convenience store and set them off by the river. I captured a few pictures.

2004-06-08T20:09:00.000+05:30

An early sunset view of the Ginza district. If you get the feeling that Tokyo can be a little distant...you're not alone. It does light up at night...but not when I took this picture.

2004-06-07T14:21:00.000+05:30

Is it Paris...or Tokyo? The radio/television tower off in the distance. Looks Parisian...but Tokyo doesn't quite have the same vibe as Paris.

2004-06-02T13:12:00.000+05:30

The lighting is poor here...but let me put it this way...if you don't like crowds, you better not ride the Tokyo subway. I've noticed it's pretty difficult to find your way around when you can't read...or recognize the letters in the alphabet. Luckily the major stops of the Yamatone line which circles the central part of the city are also marked in English. And I suppose if you missed your stop you could just go all the way around again (or switch trains and double back.) Yes, I was the tallest guy on the train (6'1 here). I kept banging my eye glasses against the handles hanging from the ceiling. Tokyo is a major, Western style city, so I didn't feel to uncomfortable getting on the train and heading out, although it took me about ten mintues to figure out how to buy a ticket. Besides, I think it's a good sign whenever you get that little bit of anxiety in the pit of your stomach. It means you're about to do something new, maybe stupid, maybe exciting, maybe boring, but certainly something you didn't expect. Anyhow, I navigated the subway successfully. Round two this evening...by the way...I'm posting mostly light hearted stuff today because I've sequestered myself in my hotel room to finish up the June issue of Strategic Investment. I'm also fighting a little flu bug. Tomorrow, though, I'm meeting with a few Western financial analysts who work here in Japan. Also, amazing news! The Indian embassy called. They've granted my visa. I have to submit my passport tomorrow and I can pick it up...Friday. I'm holding off on the celebration until I actually have the passport in my hand and I'm in India. But I'm relieved. China and India...India and China...they are the words on everyones lips right now. This whole trip to Asia to find out first hand where the investment opportunities are would be incomplete without India on the agenda, although it's probably worth noting just how long it's taken me to secure the visa...assuming I get it, that is.

2004-06-02T13:03:00.000+05:30

This is the picture I meant to post of the West side of Shinjuku.

2004-06-02T13:00:00.000+05:30

The West side was a pretty jumpin'. It only tok me about five minutes to be lost. I avoided the temptation to eat in a Wendy's and instead found an English-themed pub. Of course there were no English inside. In fact, I was the only foreigner. Come to think of it, in the whole three hour excursion on the subway and in Shinjuku, I probably saw less than ten foreigners, 20 max. It wasn't until I strolled through the T.G.I. Friday's back at the hotel that I ran into beer swilling Germans and Americans. The French were swilling too, but from glasses. I haven't found the English yet, or the Australians. I'm told all the expats hang out in Roppongi, otherwise known as Tokyo's nexus of sin. A report will follow tomorrow, although I can't promise it will be a full one. As for Shinjuku, it felt like New Year's Eve. I tried to take a picture from inside a Pachinko parlor, but was restrained from doing so by an attendant. You'll have to settle for my description. Picture dozens of chain smoking people sitting in front of flashing lights gambling. Picture Vegas, only louder and more colorful, without Wayne Newton (although you might hear him in a karaoke bar.)

2004-06-02T12:53:00.000+05:30

The east side of Shinjuki is supposed to be more sedate. It certainly felt that way to me. T

2004-06-01T20:26:00.000+05:30

Bureaucrats 54, Dan Two

My first full day in Tokyo was spent much like my last full day in Baltimore: waiting, arguing, pleading, and explaining with passport officials to get a visa to visit India.

I have to admit, the gentleman I spoke with this time was a lot more helpful than some other folks I’ve worked with. He told me that he was “seventy percent sure I had a good chance of getting approval for the visa.”

Seventy percent sure…that I had a good chance…hmm. Somehow I get the feeling that’s not as good as it sounds. In any event, if I don’t get the Visa by Wednesday, I’ll initiate plan B (I’ll let you know what that is when I make it up.)

As you can tell by now, I’m in Tokyo. I’ll be here for awhile. I don’t know what to expect. The growth stories in Asia (China, India, Thailand, Malaysia) are obvious. Japan is less so.

But I’ll be talking with some people who know it well. And I’ll also get a chance to meet up with an old debating partner from high school on Friday. My friend Jason Kelly lives out in the countryside somewhere. He and his girlfriend promise to show me the non-concrete side of the nation.

So far, Tokyo looks like a more mature Shanghai. Lots of neon and concrete. The public transportation is better. And the air is cleaner. It’s also a little more subdued, at least from what I’ve scene.

Shanghai has the feel of a forty story tall two-year old just learning to walk. Tokyo feels more like one of the Ents in the Lord of the Rings, more serious and ponderous. I’ll tell you if it still feels that way after my night out tonight.

Before I immerse myself in Japan, though, I wanted to do a wrap on China. There’s so much to say. But I’ll try and keep it brief (I failed). I couldn’t publish as much as I wanted while I was in China, partly because my schedule was packed and partly because I signed an agreement not to do any reporting or journalism while I was there.

Yep. I was asked to write that out and sign it when I applied for my visa. I feel like I honored that agreement by not doing any hard core reporting while I was there.

But I’m in Japan now. And now, I have a few things to say.

First, all that worry about China cooling down and a soft landing is misplaced. The real story is that the government is turning over more and more control of the economy to market forces.

You can break it down into two broad categories: financial services and agriculture. And in these two areas, there is huge opportunity for investors without the risk of a bubble.

In the financial sector, you can start with the banks. Two of the big four state banks are cleaning up their balance sheets in preparation for IPOs in the U.S.

I said last week the banks were looking to sell off non-performing assets—especially commercial real estate loans—in order to raise cash and get the loans off the books.

Today, AP reports that the China Construction Bank sold off $169 million in commercial real estate assets. The sale came at 34% discount on the face value of the assets, which included, according to AP, a 31-story office tower and 400,000 square feet of office space.

This is great news as just a financial story. The bank is tackling its bad loan problem by selling of assets. That’s something that still seems to be a problem in Japan. The Chinese are dealing with it directly.

But the bigger fact is that since the Bank is the State, this amounts to the privatization of the credit business. The State is selling off its assets to raise cash. It’s gradually turning over finance and banking to the private sector. Why?

The State needs the money and the Chinese economy needs capital. Another good example is the emergence of commodity and futures exchanges. In China, you have the Dalian Commodity exchange, which is the second largest soy bean futures market in the world. The State Council that currently oversees futures trading just gave the green light for cotton futures to trade on the Zhengzhou Commodity exchange. In fact, trading starts today. And in Shanghai, the futures exchange is moving into currencies and got approval to trade oil futures back in April

These are popping up all over Asia. They’re not going to compete with the major futures exchangers in the West anytime soon. But that’s not the point. The point is to allow domestic producers of raw materials a more liquid way to hedge their risk, and establish a niche futures market at the same time.

The State is worried about the speculation that futures markets can incite. And it’s rattled sabers about foreign speculators keeping money locked up in banks, waiting for yuan revaluation, instead of investing in Chinese securities.

But the bluster aside, the opening up of the futures markets is a good sign, especially if the gold exchange in Shanghai moves into the futures market. For now, even trading spot gold is bullish for the “relic.” Like I said last week, volume is still small on the exchange.

It’s the concept that’s big. The traders I talked to in Shanghai say the big source of gold demand in China is industrial…mostly for China’s growing automobile industry. The Shanghai exchange is a way for industrial consumers of gold to hedge risk.

Personally, I think China needs food more than it needs cars. There is not enough oil in the world to fuel more cars in China. And the traffic Jams in Shanghai and Beijing (cities of 16 and 13 million people respectively) are already bad enough (not to mention the pollution.)

Even if I’m wrong, the traders at the exchange told me the government itself is a player in the local gold market. The problem here is simple.

The Chinese have too much dollar exposure, both in the form of U.S. bonds and dollar currency reserves (over $100 billion in bonds and $300 billion in currency reserves). One way of looking at the Shanghai gold exchange is as a way for the Chinese to switch out of dollars and into gold. Sell the dollar. Buy gold.

When you combine the industrial demand for gold, the demand for gold as a form of savings (as money), and gold jewelry demand, all three are bullish. And it’s not just gold.

I expect the Chinese might use some of those reserves to buy hard assets…like iron ore, or grains, or companies that own iron ore deposits…or farmland. This is a point brought up to me by a former money manager for George Soros. And it’s a point well taken.

When you think about it in these terms, it explains why Brazil and Malaysia have just concluded major bi-lateral trade talks with China.

It’s a truly strategic approach from the government…make deals with commodity rich countries…and use dollar assets to secure your hard asset needs. China has even signed a free trade agreement with New Zealand, another commodity rich exporter.

Do you see the pattern here?

For retail investors, it’s not likely you’ll be a private equity investor in a newly capitalized Chinese bank. But those opportunities are going to be there. And in fact, there are going to be plenty of opportunities to buy Chinese assets.

The only major problem is you’re going to have to deal with the Chinese. And that may be a risk too far for most investors right now.

Why take the risk? Chinese companies with transparent financial statements and real earnings MAY start coming public in the U.S. in the near future. All you have to do is wait.

In the meantime, there’s nothing to prevent you from looking into the leading grain, iron ore, and commodity companies doing business with China.

Forget what you’ve heard about soft landings. What’s happening here in China is not a simple financial asset bubble. It’s the emergence of hundreds of millions of people into the global marketplace as both consumers and producers. Look for China to unleash it’s dollar reserves on hard asset markets…well before the dollar itself starts declining even more.

And for truly long-term investors, anything that profits from the development of Chinese infrastructure, financial services, and health services is the best way to profit from development inside China.

That’s the bullish case for China. It’s undiminished by any worry over a soft landing, at least at is to me, after seeing what’s going there first hand. But that doesn’t mean there aren’t risks.

The government is selling off assets because it needs money. And it needs money because China is getting older.

China has no meaningful pension system. U.N. population figures project that 13.5% of China’s population will be over 65 by 2025. Doesn’t sound so bad as a percentage.

But with a projected population of 1.7 billion, that means China will have around 220 million senior citizens who have no real social safety net.

In other words, it will have a large nation of elderly people who need food and medical care. How will China deal with this problem? It’s a massive problem and a massive risk.

Then you have the public health cost of China’s rapid development. Because coal is cheap and domestic, most of China’s electric plants are coal fired. Not only does this make the air quality in major cities awful, but it fails to supply the country with the energy it needs. Economies need energy, literally, to grow. China will need more energy, and oil is just one component of this.

In the meantime, there is bound to be a built-in public health cost to such a fast pace of industrial growth. It uses the population hard. And it implies big medical bills in the future.

When you combine the aging of China with the continued implicit public health cost of unregulated environmental abuse, you can make the argument that China’s comparative advantage as a low cost manufacturer is not sustainable.

The labor is getting older and sicker. Energy is getting more scarce as demand rises. And the health cost of providing that energy from coal is bound to rise over time, at least canceling if not negating the low-price benefit.

Of course what China needs, like the rest of the world, is cheaper energy. More nuclear power would be a sensible option.

The other risks are mainly political. Many people, myself included, have speculated that outlying provinces in China might develop separatist leanings as the government relaxes its grip on the economy.

After talking with real Chinese, I think this unlikely. Ninety five percent of the population is Han, one of China’s 55 ethnic groups. There’s a strong notion of the China as a nation, at least with the Chinese I talked with. If there’s social unrest, it won’t be on ethnic grounds, but economic.

Over 50% of China’s population still works in agriculture. What their future is in the new modern China isn’t clear. They live above the poverty line, barely. And as China gets richer and its farmers get older, at the very least you have an economic problem. At the worst, you have a political one…the rural interior versus the urban coastal populations and mega cities.

The other obvious political risk is Taiwan. This is where being in China and talking to even moderate Chinese opened my eyes about how serious the Chinese are over Taiwan. China is willing to go to war over Taiwan. I don’t think this is just bluster.

At first, I was shocked that China’s communist leaders would risk so much economically over Taiwan. Economically, Taiwan is not essential to China’s development. It’s not the crown jewel of the economic nation. But as I was told by more than one Chinese person, no leader of China can afford to lose face and allow Taiwan independence. It simply won’t happen.

Strategically, Taiwan is important because of its location on vital shipping lanes and because the U.S. has committed to defending Taiwan if China attacks. In reality, I don’t think the U.S. wants to go to war over Taiwan. In fact, I don’t think the U.S. will go to war with China over Taiwan.

Is it in our long-term strategic interest to have some sort of military check on Chinese influence in Asia? I can’t see why. Chinese influence in Asia is a fait accompli, by virtue of China becoming the center of gravity for Asian markets. My expectation is that the economic ascendance of China is going to make the Taiwan question academic.

However, Hong Kong may be a different case. The Chinese have ruled out direct democratic elections in Hong Kong. Hong Kong’s population has already taken to the streets to protest this, not that you’d ever see that story in the mainstream American press.

Just yesterday, thousands in Hong Kong marched to remember the June 4, 1989 killings of hundreds of pro-democracy students in Tiananmen Square. In Hong Kong, you can talk about this subject and take to the streets to remember and protest. But even in Hong Kong, the mainland is putting pressure on democratic voices to be quiet. While I was there, several well-known radio talk show hosts resigned.

The Chinese I talked to (who didn’t want to be quoted directly) said these resignations came against the backdrop of threats against the families of the hosts. Next time you hear someone complain about censorship in America, keep this in mind.

And of course on the mainland, you can’t mention it at all in public. The guide for my tour of Tiananmen Square was asked by another American, in the square, if we were standing where the students were killed. That conversation lasted about three seconds, with the guide saying not to ever ask a question like that in public, not least for his own safety.

It’s a huge paradox. China has all the artifacts of a modern capitalist economy. And its people and entrepreneurs are a lot more opportunistic than many Americans I know.

Yet little is known of the millions Mao killed. And while not as visible, the military is a constant reminder of the coercive nature of the Chinese State. For all it’s remarkable progress toward free markets, there has been a lot less progress towards freely expressed political thought.

Can the government maintain its grip on information? Can it privatize nearly every other sector, but keep a tight reign on what people say and publish? I doubt it.

Then again, I modified my behavior in compliance with the government’s wishes. I’m an American and a writer who can leave the country and say what I want. Most Chinese don’t enjoy the same luxury.

That said, the genie is out of the bottle in China. Deng’s open door has ushered in a new generation of Chinese that aspire to wealth and are moving to get it. You have young China and old China. Old China will die first, unless it kills young China like it did in 1989.

I don’t expect that to happen. And I certainly hope not. The Chinese I met on my trip were bright, talented, ambitious people. They are also very proud of China. It will be their job to clean up the heinous mistakes of the State over the last fifty years.

China’s war on the family has left hundreds of millions without a traditional support network as they get older. There are no institutions to fill the void…not the State, which can’t afford it. Not the Church, which doesn’t exist in large enough numbers. And not the family, which was systematically eliminated by the one child policy.

Then again, Chinese culture is 5,000 years old. Communists can ruin a lot in a short time. Nothing is more destructive than the conceit that you can dispose of hundreds of years of tradition and evolution and replace it with a crackpot, egoistic, planned economy.

But Buddhist, Taoist, Confucian thought/belief is still at the heart of China. Not even an all powerful State could eradicate that. How else to explain that Sun Yat Sen, the father of the Chinese nation, is more popular than Mao?

As China moves into center stage on the world economy, its traditional culture and its emerging free market culture will replace the Statist culture. It will be better for China and the world. The State may be planning otherwise. But it can’t control what it’s unleashed. And for that, we should all be grateful. China is a beautiful place with kind, hardworking people. The real bull market there has just begun.

Dan

P.S. I hope I didn’t overload you with too many pictures or serious analysis. The case for China is pretty simple:

No short term financial correction is going to undo the fundamental economic dynamic. The best way to invest in it, until we have liquid and listed Chinese mid-caps in the U.S., is to look at the countries supply China with food, energy, and industrial infrastructure. On my short list are Brazil, Argentina, Malaysia, Australia, Thailand, and New Zealand. More on these opportunities in Strategic Investment.

The trip hasn’t been all work and no play, either. In Nanjing, the party I was traveling with threw an unexpected karaoke party in the lobby of the Hilton. Sinatra songs were sung. Judy Garland songs even. And your editor burned up the dance floor to some Latin music, although my dance partner Barb Perriello from Agora Travel put me to shame.

And in Beijing, the food was outstanding, including some Peking Duck that’s better than anything I’ve ever had. In fact, the cuisine in China was a lot less exotic than I expected, and a lot more healthy.

Maybe I’ll do some exotic eating tonight, here in Tokyo. Sushi anyone?

P.P.S. On a slightly different note, I got a letter from a reader last week that mentioned “reports” that several suitcase nuclear bombs were already loose in the United States and that his was what last week’s major warning referred to.

This is not the kind of intelligence I’m privy to and I have no way of knowing if it’s true. And to the extent that it’s an investment issue, the answer is short and simple: gold. I’d say oil too, but the difference between owning gold and oil is that you can own physical gold and acquire some security against illiquidity in the world’s financial markets. You can’t exactly store up your own crude oil and use it as a medium exchange or a store of value if there’s a major interruption in the economy.

And in fact, god forbid it ever happens, but a nuclear bomb going off in an American city, or any city for that matter, would bring world markets to their knees. There is no financial investment on earth that would retain its value in those circumstances.

Unfortunately, we live in a world where you have to take seriously the possibility of such an event. That doesn’t mean you sell everything and live the rest of your investment life in fear. But it does have a way of putting the argument for owning physical gold into sharp perspective. There are a lot of unknowns in the world. Owning gold won't prevent bad things from happening, but it will give you a little peace of mind.

U.S. markets were closed yesterday. But here in Tokyo, the terrorist attack on a civilian compound in Saudi Arabia drove October crude futures up by 2.7% on the Tokyo Commodity Exchange. Stocks were down. As one trader said in a Reuter’s story, “There's no need to buy (stocks) now when everything is so uncertain, like oil prices and U.S. interest rates."

Nope. But oil calls and index puts aren’t a bad idea…

2004-06-01T13:43:00.000+05:30

I took a rick shaw tour of Beijings Hu-tungs. The hu-tungs are old one story living quarters for the ancient city. The government is bulldozing many of them to make way for more modern housing before the olympics in 2008. It's worth going though, if you go to Beijing. It's where the real Chinese live. You'll see some authentic food markets...and one of the few sights you see in many other Chinese public places...young children, like this little fellow here who was giving me a curious eye. He wasn't the only Chinese child who looked at this big burly American like I was a total foreigner, which, of course, I am. Stil, I managed to get a few smiles.

2004-06-01T13:39:00.000+05:30

Near the Wall I heard singing. Off the right, about 100 below the wall...was this temple...with worshippers singing. Ironicially, the Temple was on the outside of the wall. But the sounds of the singing reached over the walls.

2004-06-01T13:37:00.000+05:30

Old Chinese currency...the shiny yellow metal kind...maybe the past is prologue after all.

2004-06-01T13:36:00.000+05:30

Treasure from the Ming Tombs...gold as a store of value...and above, gold as money.

2004-05-29T16:17:00.000+05:30

This portrait is not for sale...

2004-05-29T16:16:00.000+05:30

...but this one is... you can't see it nearly as well...and maybe that's fine...it's the Chairman, whose right hand waves back and forth.

2004-05-29T16:15:00.000+05:30

Red flags lit up by the orange sun.

2004-05-29T16:13:00.000+05:30

From the square back to the gate and the large portrait.