Asset boom-bust cycles and easy money in the GCC

THE history of world finance, from Dutch tulips in the age of Rembrandt to Japanese real estate, Internet IPO's, Thai banks and Kuwait's Souk al Manakh shares in our own time, proves that every asset bubble carries the seeds of its own destruction. Leverage is the oxygen of bubbles in shares and property as asset prices soar and leverage is poison gas when prices fall, because easy money triggers a pyramid of debt that must be repaid even if speculators have borrowed funds they cannot service, let alone repay to the go go bankers who financed them in the bubble. In 1989, Japan was the hottest investment destination in the world. The Nikkei had risen from 8000 to 40,000 in the 1980's. Tokyo real estate was the most expensive in the world and the Emperor of Japan's palace was worth more than all the land in California on paper. Japan's banking titans dwarfed their American, British, German and Swiss peers in size. Fifteen years later, the Nikkei is at a third of its 1989 peak. Japanese mutual funds lost 90% of their assets and value in the bear market of the 1990's. The Japanese banking system survived only because the government engineered the biggest experiment of fiscal largesse, monetary case and financial bailouts undertaken anywhere in the world since the Roosevelt Administration in the depths of the Great Depression. Yet the Japanese economy was mired in recession, bankruptcies and despair for 15 years after the collapse of the Nikkei-real-estate asset spiral. Asset bubbles are products of mass-market psychology as much as easy money or macroeconomic distortions. This is definitely the case with the asset bubbles in the Arabian Gulf share and property markets since 9/11. Repatriation of Arab funds from dollars to dirhams, riyals and dinars was accelerated by the fact that when the Federal Reserve Board slashed dollar interest rates to 40 year lows, it triggered off a buying binge on the regional stock markets. Since Alan Greenspan determines the monetary policy of the Gulf, thanks to the de facto GCC currency pegs to the greenback, the post-9/11 credit creation by the American central bank was high octane fuel to the Gulf stock exchanges and share markets on a scale not witnessed since the petrodollar bonanza of the 1990's. Cheap credit, imported from America, was the catalyst for secular inflation in the Gulf because the dollar's 30 per cent depreciation against the Euro and the Yen made the region's imports expensive. High GDP growth, a surge in bank loans for property speculation, excessive bank leverage for IPO's, price hikes in commodities, wage rises, opportunistic price rises by rental cartels — inflation has become a serious problem in the Gulf economies for the first time in a generation. Yet interest rates in the Gulf remain well below the inflation rate because central banks cannot revalue their currencies higher against the dollar. Ibrahim Dabdoub, the CEO of the National Bank of Kuwait, echoed my fears for Gulf real estate when he warned of an imminent property glut in the GCC last week. This is, after all, exactly what happened in Asian property markets in 1996-1997 and the property glut forced values down by 70-90 per cent and eviscerated the regional banking systems. Cheap money enabled banks and financial lenders to accumulate untold billions in speculative real estate loans to developers, real estate speculators and home buyers. Naturally, as long as construction costs were far below selling prices, new supply hit the market with a vengeance, a tsunami of new projects launched amid world class hype and razzmatazz. Yet the economics of supply and demand cannot camouflage the reality of a property glut that no amount of broker deceit can really disguise in the absence of end buyers. Yet while property values have sagged, even plunged in certain markets, new supply from marginal developers continues to erode the wealth of existing homeowners as construction costs remain still far below selling prices. Naïve banks continue to finance developers and real estate punters who are already in essence, bankrupt, if the NBK chief executive, one of the most powerful and best informed bankers in the Arab world, is right about the property glut. This is the point where leverage proves to be cyanide, not oxygen, for real estate speculators. This is the point at which speculators learn the hard way that paper values are meaningless when banks take a long, hard look at their dangerously overexposed and over concentrated real estate portfolios. This is the point at which speculative secondary market transaction vanish. Oversupply in the absence of sustainable end user demand means sharply lower prices, irrespective of artificial support, glitzy media "sold out" ads and desperate broker pitches. As Japan, Hong Kong, Florida and Texas real estate booms since the 1980's proved all too grimly, every property bubble contains the seeds of its own destruction. The May US jobs reports has accentuated the bond market short squeeze, the fabled pain trade on Wall Street. A year ago, when the Fed began to tighten, the yield on the ten-year Treasury note was 4.7% while the Fed Funds rate was one per cent. Now, eight FOMC conclaves later, the Fed Funds rate is three per cent while the T-note yield has plunged to 3.8%, a mere 30 basis point premium to borrow ten year money. Does the data suggest, as Dallas Fed President Richard Fisher observed that the American central bank is in the "eighth innings of a ninth inning tightening cycle". Has the Fed fought and won the war against inflation expectations now that crude oil is $53 but the T-note yields only 3.8%? Is the Greenspan conundrum, rock bottom long dollar rates, an indicator of global recession? After all, yield curves are either flat or inverted in Britain, Australia and New Zealand. The US Treasury yield curve can inverted with another Fed rate hike. Some critical indicators I track — LE1, bond yields, gold, Chinese imports-exports, Chinese GDP, steel, Baltic dry freight shipping index, M2 money supply growth. ISM — all suggest recession risk has risen. But the Fed will not ease as long as US inflation accelerates. There is a crisis brewing in the global financial markets. The European Union constitution debacle was just the tip of the iceberg. The US confrontation with China and Iran will re-inject a fear premium in global markets as 2005 reaches its endgrave. In chaotic markets, independent thinking, not cash is king.