A Beauty Contest for Misshapen Half-Wits

The Daily Reckoning PRESENTS: Even Wall Street agrees the pound sterling must tumble. Adrian Ash can’t help but wonder: so why have central bankers been buying all they can get?


Everyone wants a piece of the United Kingdom today. Bill Bryson just got himself an honorary gong. Monty Python’s ‘Spamalot’ musical will soon hit Las Vegas (it’s a hoot, by the way). And half-a-million Polish citizens are now living in Britain to earn Sterling, not Zloty.

Should U.S. investors hail a black cab to Britain? Hold the pound up to the light before you hedge your dollars this Christmas.

Check the watermark. Make sure the metallic strip is intact. Then read the “promise to pay” signed by Mervyn King, Governor of the Bank of England. It’s just as empty as the promise on U.S. Treasury notes. Nothing but more fiat promises back it up – which will work fine so long as everyone accepts sterling in payment of debt.

But the pound is set to fall hard, according to two big U.S. investment banks. Goldman Sachs says the pound is 13% overvalued on a trade-weighted basis. Lehman Brothers are gloomier still. “I’m not saying that things will be terrible, but they will feel much worse,” warns their chief UK economist, Alan Castle. He sees sterling falling to $1.82 next year, before sinking to $1.68 by Christmas 2008.

Wall Street’s reasons are simple. They might give you déja vu, too…for Great Britain and the United States have much more in common than merely the mess in Iraq.

Just like America, Britain is currently running a huge trade deficit with the rest of the world. The largest shortfall in Western Europe, it reached a near 18-year record this fall. And just like America, Britain also has a mountain of government debt.

Officially, public sector net debt stands at £486.7bn. That’s equal to US$953.9bn and represents a little under 38% of annual GDP. Add the state’s “off balance sheet” debt, however – including its pension promises to state-paid employees – and the total shoots nearly three times higher. Research by the Centre for Policy Studies in London says it would put UK government deficits at a staggering 103% of GDP. The debt burden per household would be over $103,880.

Then there’s consumer debt – only here, Britain is way ahead of the States. Total consumer liabilities now run to an entire year’s worth of GDP, thanks to house prices tripling since 1996. That’s when the last wipeout troughed. It started in late ’89 and knocked average home prices, adjusted for inflation, down by 35% and beyond. Fast forward to Dec.’06, and the British now owe $2 trillion in housing debt, much of it held as a naked call – otherwise known as interest-only home loans with no money down.

Now add unsecured debt per household of $16,840 on average…plus personal bankruptcies doubling to an all-time record since 2004…and “the surprise is that the Pound has been so strong,” gasp Lehman Brothers. “Current account deficits matter over time,” the suits in the City remind us, “and we’re worried that Britain’s [trade] deficit could widen to 4% of GDP in 2008.”

But c’mon! What took Lehmans so long? None of this trouble is new. And other U.S. investment banks have called the pound lower before. Trouble is, they were wrong.

“As a top trade for 2005, we recommend going short AUD, GBP and NZD,” said Morgan Stanley in January last year. By their expert math, these three Anglo-Saxon currencies were all “overvalued [and] no longer trading on fundamentals.” That bit was right, but the trading idea was not. If you had sold the Aussie, Kiwi and Sterling against Euros and Dollars in 2005 it would have cost you dear long before now. As 2006 draws to a close, the trade’s barely back in the money.

And all this while, the pound has grown weaker on all fundamentals. Britain’s broad money supply has exploded 25% since the start of ’05. That’s the fastest growth by far amongst the G7 economies, and nearly twice the rate of world money growth judging by the Bank of England’s own data. Worse still, in early April this year, dollar interest rates overtook pound rates for the first time since 2001. This didn’t bode well for sterling, as a research note from HSBC said.

During the previous three decades, the GBP/USD pairing – known as “cable” by traders – had lost 12% per year on average whenever dollar rates were higher. Yet this time the pound shot higher against the greenback as the yield-premium went Stateside. In fact, it leapt 15 cents higher to $1.90 within only five weeks!

It’s a good job that sterling broad money has risen so fast – because the pound has become the “anti-dollar” of choice for the world’s central bankers.

“There are not many places to go once you decide to get out of the dollar,” shrugged an official from the Banca d’Italia in August. Italy’s monetary wonks had just said that Sterling accounted for 24% of their foreign currency reserves. They didn’t hold any in 2004.

“Japan is always a question mark,” he shrugged again. “At least the British economy is humming along okay and UK bonds offer a decent yield…”

In other words, sterling is better than a poke in the eye. And it’s thanks to that logic, says a report from the Bank for International Settlement (BIS), that the pound now accounts for 12% of all foreign reserves held by governments worldwide. In fact, the UK currency – underpinned by record inflation of the money supply…record house-price inflation…and near-record trade deficits – is now the world’s third reserve currency, second only to the dollar and euro.

What’s to love about sterling in this beauty contest of misshapen half-wits? Put simply, it isn’t the dollar or euro. Nor are buttons or whale’s teeth, of course. But a government vault full of cowrie shells would be tough to explain next time the wonks met for dinner in Paris. And the same sorry logic is at work on Wall Street, remember.

Lehman Brothers say Sterling will drop to $1.68. Goldman Sachs forecast a 13% drop or more versus the dollar. Morgan Stanley this summer set “fair value” at $1.63. But what if the dollar keeps falling…and sterling falls too? Where will central banks turn next as they try to spread their currency risk from one fiat money to another?

“In the 1980s,” the BIS says, “the yen had begun to erode the U.S. dollar’s share [of central bank currency reserves]. At its peak the yen accounted for over 10% of reserves. By 2006, it accounted for less than 5%. The decline in Japanese asset prices and the subsequent long period of low relative returns on yen assets appear to have contributed to the shift out of yen reserves…The pound sterling has replaced the yen as the third largest currency in reserve portfolios. According to the BIS data, the share of sterling doubled between 1995 and 2006.”

Funny, but the UK economy looks uncannily like late ’80s Japan Inc today…only in miniature and minus the trade surplus. Yet central bankers have piled in regardless. Even the Swiss have bought sterling, pushing it to 10% of their foreign exchange reserves! The BIS can’t be sure what China, Japan and Russia have done. The three largest owners of foreign exchange reserves now deal secretly – through private bank transfers – to avoid telling the market what they’re selling or buying. But Russia collects some $12bn per month thanks to its oil and gas sales. Sterling’s strength in the currency market says it can’t all have been destined for dollars or euros.

All central bankers now share this headache. The BIS puts total worldwide currency reserves at $4.8 trillion…a full 11% of world GDP. When the pound hits the skids – which even Wall Street knows it must, soon – the stampede out of sterling will send the next-best-thing soaring. In fact, the glut of central bank pound buying may in fact have already ended.

In October, the official data report, the largest buyers of British government bonds were private foreign investors rather than central banks. Okay, furtive officials in Beijing, Tokyo or the Kremlin may have placed those orders “off book”. But if they have chosen to stop buying sterling, they’ll find the four other major currencies in a race to the bottom.

Japanese inter-bank lending pays less than 0.4% today. Eurozone bankers have got all the Euros they want; the “Esperanto Experiment” now yields two percentage points less than the dollar. The Swiss France pays even less, and the Dollar itself…well, you already know how ugly the dollar now looks.

What about the commodity currencies, Korean won, or the newly convertible Russian rouble? “The BIS data suggest,” says the Bank’s September Review, “that at the margin [central bank] reserve managers have increased their holdings of Australian and Hong Kong dollars, Danish kroner and other currencies in recent years. The share of currencies other than the major five rose to 4% of deposits in 2005-06.”

But there’s a snag. For while cash deposits of non-major currencies are easy enough to snap up, there aren’t enough non-major bonds to go round. The dollar, euro, yen, sterling and Swiss franc account for 83% of the world’s debt issuance in total. Most likely that leaves non-major securities too tight. The big central banks can’t seriously increase their holdings without freaking the market, most of all at the long-dated end where supply is tightest.

Finally, of course, there’s gold. Since it pays no interest in a world always seeking out yield, it now accounts for just 0.5% of all government reserves by value. But now the five major currencies all look as bad as each other, then who knows? Gold might just find favor…most especially in Asia.

“It is unfortunate how much [India] has lost by…holding on to the antiquated belief that gold transactions in the market by the Reserve Bank of India are bad, while frequent transactions in USD, euro, yen and sterling are good,” said former RBI Deputy Governor S.S.Tarapore late in November. “Gold is unique, in the sense it is both a commodity and a store of value…

“More importantly,” he went on, “gold invariably moves inversely with the US dollar and also rises in value when international inflation gathers momentum. Thus, there are strong reasons for holding a reasonable proportion of Indian foreign reserve exchange reserves in gold.”

Central bankers in gold-buying shock? You read it here first…


Adrian Ash
for The Daily Reckoning
December 19, 2006

Editor’s Note: City correspondent for The Daily Reckoning in London, Adrian Ash is head of research at www.BullionVault.com – giving you direct access to investment gold, vaulted in Zurich, on US$3 spreads and 0.8% dealing fees. Learn more here:


“Everything seems to be going up here,” reports our old friend, Doug Casey, in Buenos Aires. “We bought a place down here for $1.2 million only about a year ago. Last week we got an offer for $1.7 million. And it’s not even for sale.”

We were sitting in a restaurant not far from the Four Seasons hotel. The place was packed. We had to wait for a table.

“I liked this place better a couple of years ago,” Doug continued. “You could go into any hotel and any restaurant in the city. You didn’t need reservations; they were all empty. And very cheap.”

Buenos Aires is still relatively cheap, but only because everything else is so expensive. A nice four-bedroom apartment can be had for $400,000 – maybe $500,000. That is peanuts compared to similar digs in London, Paris or New York. But it’s twice what they sold for here three years ago.

“This place is extremely cyclical,” continued our friend. “It goes up and down in cycles of about ten years. This up-swing began about four years ago…so I figure it’s got at least another five years or so to go. That would be a good time to sell.”

Humans are ‘thinking, expectant beings,’ we recall from last week’s quote of Edmund Phelps – which is why you can’t count on cycles. As soon as they begin to expect a cyclical change, it changes in some way so as to catch them off-guard. Expecting a slump in 2010, for example, investors are likely to sell in 2009…bringing on the correction a year early.

That is the trouble with thinking, expectant beings. An alarm clock neither thinks nor expects. Set it for 6AM and it will go off everyday at 6AM. But when men begin thinking and expecting, well, anything can happen.

We read in today’s paper that consumer prices – as well as real estate prices – are rising in Argentina. They’re up 12.5%, says La Nacion. Elsewhere, we read the investors are taking up more fixed-income assets. And what rate of return are they getting on their money? This is the funny part – just 8%.

Obviously, something is going on that we don’t understand. What sense does it make to lend money at 8% when consumer prices are rising at 12.5%? What is it that they put in the water down here? We admit – we are still only learning Spanish. Maybe we got it wrong.

Then again, north of the equator…and north of the Rio Grande…there might be something in the water there too. What does a lender get – 5%? What is the rate of consumer price inflation? It’s hard to say…but there is also the dollar to consider. If it goes down another 10% next year, a U.S. Treasury bond yielding less than 5% may not seem like such a good investment – especially to the thinking, expectant beings who keep score in other currencies. They’re likely to start thinking that maybe lending in dollars at 5% is not such a good deal after all. They might even begin to expect another year of losses. “Maybe the price of gold will go up another $100,” they may think to themselves.

And then…whammo…the Crash that no one thought possible is suddenly the Crash that everyone is trying to avoid – by selling U.S. dollar assets all at once.

We caution readers that, most likely, a crash will not happen. Crashes are rare. Nor do we have any special information on the subject. Most often, what happens tomorrow is what happened yesterday. But there are times when betting on a change brings you such a nice long-odds payoff…it’s worth taking the bet, even if it doesn’t happen.

More news:


Greg Guenthner, reporting from Charm City…

“…At the moment, the world of penny stocks is dotted with several interesting semiconductor firms. I know that some people cringe when they see the word ‘semiconductor’…”

For the rest of this story, see the latest from The Sleuth


And more thoughts…

*** “In Europe, drugs are less expensive than beer or café,” says a headline article in La Nacion. “An ecstasy pill costs the same as a glass of beer,” the article explains. “A line of cocaine is less than a cup of coffee.”

Everything else may be going up. But there’s a major deflation in drug prices. Marijuana is down 12% in the last five years. Heroin prices are off 45%. Amphetamines have gone down 20%.

How come?

Globalization. Better supply chain management. More competition and across-border movement.

Interestingly, this report comes from Reuter’s today: “Marijuana top U.S. cash crop.”

“U.S. growers produce nearly $35 billion worth of marijuana annually, making the illegal drug the country’s largest cash crop, bigger than corn and wheat combined, an advocate of medical marijuana use said in a study released on Monday.”

Probably not something that will be added to the commodities market anytime soon…

*** We came into Buenos Aires after a storm had come through town. Six people died as the streets floods and tree limbs came down. Water was everywhere.

Coming in from the airport, our silly cab driver splashed into a pool of water. Then, traffic was diverted onto a side street, as there had been an accident on the highway. Naturally, the cab stalled out a few minutes later, right on some train tracks. ‘Wouldn’t this be the perfect way to get rid of us,’ we thought to ourselves. ‘The cab driver will hop out…just before the 7:39 bound for Cordoba smashes into the cab.’

It was then that we noticed that both door handles were broken off. Perfect! We couldn’t get out…at least not quickly. But it was not a hit…just a nuisance. After grinding away for a few minutes, the cab restarted…and we were on our way.

*** Goldman Sachs is perhaps the most successful lending company in the world. It is making record profits. And it has its men at the top of the world’s biggest and most important borrower – the U.S. government. Former Goldman CEO Hank Paulson is the top man at the Treasury. Other Gold-men hold other important posts.

It helps to have friends in high places…especially in the places where key money decisions are made. Recently, Goldman used its connections to get a sweet deal for its new headquarters in Manhattan. State and city officials will provide the company with $1.65 billion in tax-free bonds…and more than $115 million in various other subsidies.

Goldman also operates the largest hedge fund in the world – the Goldman Alpha Fund. But what’s this? The Alpha fund is down 11% so far this year. Gosh, even the best-connected, smartest hedge fund managers in the world can’t make money. We wonder what the dumb, un-connected ones are doing.

*** Feedback from our visit to India. Think you’re going to make a fortune by investing in Indian stocks? We remind readers that ignorance and absurdity increase by the square of the distance you are from the facts…and by the cube of the complexity.

Browsing through some Indian blogs, we came across these posts by economist Atanu Dey:

“My brother came to visit me at our offices in Lower Parel in Mumbai this afternoon.

“‘What brings you to Mumbai?’ I asked. He was here to attend the wedding of the son of a high-ranking official of XYZ (a loss-making state-owned enterprise which I will not identify to protect my brother’s life). It was a grand affair attended by high-profile political figures. ‘How can an official of XYZ, however high-ranking, afford such a grand affair?’ I asked. After all, these people have a salary of about $250 a month (plus some modest perks). ‘It is all part of a system,’ my brother replied.

“The chief engineer of XYZ makes about $2 million a year in kick-backs from suppliers because the going rate is about 10% of the budget that the chief engineer controls. Just to put that figure in perspective, that is about 500 times the per capita GDP of India. When promoted to ‘technical director’ from the rank of a chief engineer, the annual take of the person goes up to $5 million. Which is why the going rate for the promotion is about $3 million. Merely having one’s tenure as the technical director extended by six months costs about $1 million.

“The private sector suppliers of these public-sector monopoly enterprises compete amongst themselves and the competition is primarily based on how much they are willing and able to give back in kick-backs to just be awarded the contracts that often range from a low $5 million to upwards of a $100 million. Merely being awarded contracts is not the end of the game. Getting paid for work done and material supplied is also a huge challenge. Without regular kick-backs, payments can take years and could easily doom the private sector supplier.

“The question that I persistently seek the answer to is this: Why is India so abjectly poor? There is no single factor, of course. But pervasive corruption has to be one of the most important factor among the mix of factors such as a poor culture, questionable ethical standards, a cargo-cult democracy, widespread illiteracy, stupid economic policies, and so on.

“India is rated as one of the most corrupt countries with a “corruption perception index” (CPI) of 2.8 and is tied in the 90th place (out of 145 surveyed) with countries such as Gambia, Malawi, Mozambique, Russia, Nepal, and Tanzania according to Transparency International Corruption Perceptions Index 2004 which notes that “corruption is rampant in 60 countries, and the public sector is plagued by bribery”. Finland, New Zealand, Denmark, Iceland, Singapore, Sweden, Switzerland, Norway, Australia, and the

Netherlands hold the first ten positions as the least corrupt countries. Haiti and Bangladesh are tied at rank 145 as the most corrupt countries.

“One cannot fail to appreciate the correlation between how corrupt a country is and how poor it is. Are corrupt countries corrupt because they are poor, or is it that they are poor because they are corrupt? Perhaps there is some circularity in the causal chain and poverty and corruption are mutually cause and consequence.

“Public sector monopolies represent a resource sink precisely because they are ridden with corruption from top (the bureaucrats and politicians who appoint the high-ranking public sector officials) to the bottom (the clerk who will not push your file to the next desk without being paid his Rs 100).

“Here is my proposition. Let it be known that any corruption above a certain figure (say, $1 million) is an offense that will attract the death penalty. Between half a million to a quarter million, it will be a mandatory 20-year rigorous imprisonment. Then every month, take the harsh step of convicting about ten and hang them. In a year, the number of people who find corruption in the millions of dollars attractive will fall. This is simple economics: when the price goes up (death), the demand for the thing (getting one more million dollar in one’s Swiss bank account) goes down.”

The Daily Reckoning