As the days of low interest rates and a liberal money supply slowly fade, there's no denying the fact that cheap money in the U.S. has had a tremendous global impact.
For example, cheap money here has led to the rising home prices and household wealth that have kept U.S. consumers spending. That has supported a global economic boom that has produced 8% or better annual growth in the economies of India and China -- at the cost of a U.S. trade deficit in goods and services that hit $620 billion in 2004.
Low U.S. interest rates touched off capital-spending booms across Asia. With the effective cost of capital close to zero after you've factored in government subsidies, hordes rushed to build new semiconductor plants and car factories. Those facilities quickly saturated the market with new, cheaper products, which in turn led to lackluster stock performance in both the automobile and semiconductor sectors. (And that has, not so incidentally, damped global and U.S. inflation.)
U.S. consumers snapped up these inexpensive goods at an incredible clip, and this resulted in dollars pouring over foreign borders. In an effort to keep those dollars from producing runaway growth, China sopped up the dollars by selling yuan-denominated bonds. Other countries did the same using their own currencies.
In China, this move led to an explosion of Chinese hard-currency assets: Reserves grew by $210 billion in 2004 to $610 billion, giving the country the world's second-largest foreign currency reserve after Japan. But that still hasn't kept China's money supply from growing by 14% in the 12 months ending February 2005. That's an improvement from the 18.4% in the 12 months ended in February 2004.
China is not an isolated case. In India, money supply grew at an annualized rate of 12.8% in the period that ended on March 4.
The cheap-money cycle has had powerful positive effects on global economies. For example, India's GDP grew by 7% in the fiscal year that ended in March 2005, after recording 8.5% growth in fiscal 2004. China's State Information Center projects that its economy will grow at an annualized 8.8% in the first quarter of 2005, after growing by 9.5% in the fourth quarter of 2004. By comparison, the U.S. economy grew at an annualized 3.8% in the fourth quarter of 2004.
Hard to Pay the Bills
Cheap money fueled an investment boom in everything from factories to telecommunications systems to make that growth possible. In China, the State Information Center projects that investment in fixed assets such as factories will grow by 24% in the first quarter of 2005 compared with the first quarter of 2004.
So what's the problem? Well, companies and individuals loaded up on goods because money was so cheap, and they will be hard-pressed to make payments when interest rates climb. The less developed a country's financial markets are, the larger the damage is likely to be in any shift from a cheap-money cycle to a less-cheap-money cycle.
In the U.S., where credit-card companies, banks and credit bureaus run sophisticated data collection and crunching operations, the turn is likely to produce a bump up in consumer defaults that will catch some badly run financial institutions by surprise. If the transition from one cycle to the other is abrupt enough, the result can even be the kind of massive default among financial institutions that characterized the savings-and-loan crisis of the late 1980s and early 1990s. That debacle cost U.S. taxpayers somewhere north of $300 billion.
Corporate giants are not immune. When interest rates began to climb in 1993, companies as sophisticated as
Procter & Gamble
wound up losing millions on derivatives designed to offer financial insurance. (And don't forget the $1.5 billion in losses suffered by Orange County, Calif., at about the same time on its portfolio, due to a derivatives package designed by
China's Debt Crunch
The damage has the potential to be much worse in a country such as China, where the financial markets are still very much works in progress. Consider this example: According to the official Xinhua News Agency, China's local governments owe $50 billion (at official exchange rates), or about 15% of the country's total fiscal revenue in 2004.
That figure is likely to be low, an official audit has concluded, but even that total exceeds the repayment capabilities of China's local governments. How did local governments get in such a fix when Chinese law prevents local governments from borrowing from banks? They evaded the law by borrowing from intermediaries set up specifically to secure bank loans for investments in local infrastructure.
Or this: China has put state-owned businesses on notice that
within the next four years
the central government will stop the practice of bailing out bankrupt companies, and companies that are technically bankrupt will actually have to file for bankruptcy. The government has closed some 3,400 state-owned businesses under existing transitional rules and estimates that an additional 1,800 state-owned businesses are now technically bankrupt and need to be closed. Most of these bankrupt businesses are owned by local and provincial governments that are already in hock, and they were financed by loans from state-owned banks run by local governments.
Nobody knows exactly how big the bad-loan problem is. Nonperforming loans (a very subjective category in China) at Chinese banks total at least $200 billion. I say "at least" because a company owned by the People's Bank of China, the Chinese central bank, has injected $45 billion in capital into just two of the country's biggest banks, China Construction Bank and Bank of China, to clean up bad loans in preparation for an initial public offering and overseas stock-market listing for the two banks.
Hey, sign me up for those two deals.
And finally this: Despite sometimes rudimentary risk-control systems, China's financial institutions are up to date in one area: They're willing to play in the derivatives market with the big boys of Wall Street. Last November, China Aviation Oil, a jet-fuel importer listed on the Singapore market but backed by the Chinese government, sought protection from creditors after it ran up $500 million in losses in derivatives after betting that oil prices would fall.
In China, just as in the U.S., nobody really knows the details of any financial institution's exposure to the derivatives market. In China, however, because of the immaturity of the financial system, it is much more difficult than in the U.S. to figure out where the risk in any derivative trade will actually come home to roost.
Fastest Growth, Biggest Risks
All this creates a conundrum, to use Alan Greenspan's word de jour, for investors. The fastest economic growth in the global economy over the next decade -- possibly the only growth in the world economy outside the U.S. -- will take place in China and India.
At the same time, the biggest risks of either a major institutional crash or a financial-system crisis are to be found in the relatively underdeveloped financial markets of those countries.
The more abrupt the transition from a cheap-money to a less-cheap-money cycle -- and the faster interest rates rise -- the slower global growth will be, and the higher the risk of financial crises in the markets of these key countries in the developing world.
Overseas Investing Strategy
I think there's a way around this problem that maximizes any investor's potential return from growth in these developing markets and minimizes that investor's potential exposure to a market-specific financial crisis. The key is to own the shares of companies that do business in China and India and that derive a substantial portion of their current revenue and future growth from those markets, but that are listed on financial markets that require reasonably transparent public financial reporting and that derive their capital from relatively mature capital markets. In other words, I think you get the most bang and the least bust by investing in China and India through stocks traded on the U.S. financial markets.
I think I've put together two basic rules for finding stocks that will do well in the post-cheap-money global economy:
Buy the stocks of companies that generate lots of cheap cash internally.
Buy the stocks of companies with substantial exposure to economic growth in the developing markets of China and India but without exposure to the risks to those immature financial markets.
Updates to Jubak's Picks
Sell ICICI Bank
: When the U.S. financial markets get anxious over climbing interest rates, emerging financial markets often have a nervous breakdown. So I'm going to take my own advice from my recent columns on the end of the cheap-money cycle and take my profits in India's ICICI Bank Limited. I just don't know how fast interest rates are going to climb in the U.S., and that creates just too much risk in emerging-market financial stocks for my liking. I'm selling these shares with a 29% gain since I added them to Jubak's Picks on Feb. 2, 2004, at $15.86. (Full disclosure: I will sell my shares in ICICI Bank Limited three days after this column is posted.)
I'm adding shares of Coach in an effort to add more retail sector exposure to Jubak's Picks. The retail sector has been one of the top-five performing sectors recently and aside from
Wolverine World Wide
, Jubak's Picks doesn't hold anything in that sector. Besides, Coach looks like it's setting up for a good run.
The stock split 2-for-1 on April 4, and while financial theory says that shouldn't have any effect on share prices, financial experience tells us that stocks often pick up momentum after a split. Coach already has some solid fundamental momentum going for it: On March 3, the company raised its earnings guidance for the second half of 2005 to 85 cents a share (pre-split) on 10% same-store growth. That would be a 33% jump from earnings in the second half of last year. I'm adding the shares to Jubak's Picks with a target price of $65 a share by December 2005.
At the time of publication, Jim Jubak owned or controlled shares in ICICI Bank.