Are there really no risks left in the financial system?

published 17 November 2006

No major financial problem starts at the centre, but always with fringe events which then run out of control: the butterfly effect of chaos theory. Hence at Bedlam we are always interested in minor' news events, as well as in a global consensus that there are no significant financial risks left in the system at all. Although consensus is more often right than wrong, we are convinced it is currently incorrect and an outstanding example of financial folly.

Are the markets priced for perfection?

In the last four months there have been two events in unimportant little countries which briefly made the headlines: Thailand enjoying yet another coup d'etat, and then North Korea going nuclear. Equity markets - and more importantly the much larger debt markets - considered not only that both events were trivial but that as a consequence, global risks had become even less. Consider the numbers. On 1st January this year, South Korea had a risk premium on its government debt of 1.38% over the clearly safer American government 10-year Treasury bills. After the quite insane Kim Jong-il exploded his nuclear bomb on October 16th, this risk premium has actually fallen to a mere 0.17% p.a. So buyers concluded that the risk of investing in South Korea declined by over 85% this year, because North Korea now has nuclear armaments and, as evident from the rockets seen at frequent military parades, the ability to deliver.

In terms of that once-beloved phrase, a clear and present danger', the overthrow of the democratically elected Thai government in July probably matters less. The markets certainly think so; at the start of the year the risk premium of Thai government debt was 0.93% more than the equivalent US government paper. By end October, the markets decided the coup was an excellent event so reduced this risk premium even lower to 0.34%. Thus every time the unexpected occurs, proving the previous analysis was wrong, the financial markets perceive the latest disaster to be excellent news, and that there is even less risk than before.

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Whilst clearly nonsense (yet a common fallacy), the real problem is the secondary' consequences; because the initial incorrect analysis often leads to more severe financial loss than had the markets listened more and been less optimistic. The outstanding example was ignoring the first bomb attack on the World Trade Centre in 1993; then the price of risk briefly rose, but was soon even lower than before the bombing. When the allies left Iraq that same year after the first war, this too resulted in a sharp reduction in both interest rates and the risk premium on Iraq's debt. A far older example occurred after the UK won the Battle of Britain' in 1941; risk premium in America started to decline, just before Japan decided that Hawaii and Pearl Harbour would make a useful base.

We are convinced that events in North Korea are being misinterpreted and matter far more than its puny share of the world economy or trade. The markets consider it an irrelevance for several reasons. One is that hard information is scant, witness that TV footage repeatedly uses the same few photographs and film clips. Another is that the handful of foreigners allowed in under strictly controlled conditions all report the same: there is not a single fat person in the country (apart from the Dear Leader' himself one of his many titles) and the electricity often fails. Perhaps the most obvious reason is that no-one tries to emigrate to North Korea, the flow is dramatically the other way.

Kim Jong-il, like his father before him, has consistently out-negotiated every major power as the country has developed an impressive military and nuclear programme, plus the ability to deliver; so to assume risks are falling is nave. Fun though it is to deride him (and the puppet movie "Team America" probably contains more true data on him than all the files in the Pentagon), such an attitude has resulted in the market perception of the inherent risks to be declining, even as they rise.

The consensus is that most of North Korea's military equipment is old, the technology backwards, and the quality of the troops and their morale low. Maybe, but last time the West underestimated Korea's abilities in 1950, the outcome was that for the first two years of the Korean War, their Russian/Chinese airplanes proved markedly superior to anything the UN forces, including America, could put in the air. It was a close run thing. Since the nuke went off, all immediate neighbours China, Japan, South Korea and Russia - have done almost nothing save to continue to send necessities as required, a bad message to any dictator.

North Korea also knows that America currently lacks the appetite for strong action. The Dear Leader must be grinning given the response to his clear message "I can and would nuke Seoul whenever I feel like it" - is that his supply of lobsters was briefly curtailed. Most important, the real pay-master, China, has prevented almost all sanctions. Perhaps this is because North Korea suits China's purposes rather well; it is the ultimate ace up the sleeve when negotiating difficult treaties with Japan, South Korea and America. "Fail to agree with us and we'll let our fruit-loop out".

We accept there must be a good chance that North Korea implodes under its excessive military expenditure, starvation, or the army turning on its masters. However, we also know that there has been one constant since the division of the peninsular: each passing year North Korea has become more xenophobic, militaristic and aggressive, coupled with a far higher propensity to deliver on its promises than other nations. Thus we are foxed to see why the risk premium, especially in South Korea on its government debt and hence the value of the equity market, should have diminished and caused the stock market to rise.

Investment Banks and fund managers often talk tough, but then play possum. They are bravely outspoken' when commenting on national leaders where there is a liberal press (hence notes on PMs or Presidents such as Messrs. Blair, Berlusconi, Bush or Chirac are often defamatory and inaccurate), yet meek as kittens if the nation has tougher laws. Accurate analysis of politically more repressive countries is avoided; much research has a deliberately favourable tilt. The reason is these firms wish to do business there, so take the commercial view that it is better to mislead investors to make a fast buck, than to tell the truth and earn none. This is admirable; capitalism at its very best.

Thailand is a case in point. The authorities are very touchy about published views suggesting that in The Land of Smiles', all is not well. One example is that criticising the monarchy - lse-Majest - carries a punishment of up to fifteen years in Thailand's gloomier gaols. This strong sanction is perhaps because two-thirds of the 62 million population believe the Monarchy is semi-divine; so the reaction to criticism is similar to religious extremists elsewhere. Every nation has its idiosyncrasies (burning the national flag, or using it as an item of clothing is often a minor offence). Thailand is in the Premier League in its hostility to criticism.

King Bhumipol Adulyadej the Great (an official title) is the world's longest serving monarch. Even the cynical liberal western press regularly uses phrases such as the Father of the Nation', a source of wisdom', or a vital fount of stability', without a trace of irony. There is no doubt he has many virtues. Acceding to the throne because his elder brother King Ananda died in his palace bedroom in mysterious and still unexplained circumstances, his early life was one of uncertainty, both personally and the institution of the monarchy. There is no doubt he has the welfare of his subjects genuinely close to his heart, has worked hard, and is perceived as successful.

The problem is that acting in other people's interests can be a swamp for democrats and dictators alike. Political stability must be one measure of success - yet on his watch there have been at least 19 coup d'etats - with the King positively endorsing many new governments. If the removal of an oligarchic or dictatorial government by the army is a sign of a good ruler, then he has been a triumph, yet he is no rubber stamp monarch and enjoys real power. Several coups have clearly had his prior approval, such as the failed one in April this year and the subsequent success in July.

One conclusion to draw from Thailand's inability to create a stable government must be that the King is a part of the problem. Thais are understandably proud that the country was never formally colonised (although in practice Japan was the colonial master during WWII). As Western powers left or were booted out of Asia, most countries have gradually evolved more stable political systems. A few remain retro - Pakistan and Burma stand out - but most show greater stability, semidemocratic politics, a free-ish press and some respect for dissenting minorities. We have zero sympathy for the policies of the recently deposed Prime Minister, Thaksin Shinawatra, (reinforced by meeting him in his corporate days). For his history as a senior policeman, as a one-time coup leader, his cronyism and corruption are all well-known.

With the exception of French controlled New Caledonia, in Asia only Thailand retains some aspects of a colony. The ethnic make-up is approximately 85% Thai, 14% Chinese and 1% don't know', or aboriginals. Economic wealth breaks down very differently; approximately 85% Chinese, 1% aboriginals and about 14% for the Thai majority. This is not immediately apparent to visitors, for from the 17th century onwards, the assimilation of the early Chinese traders and of later mass immigrants from China has been a consistent theme. This included an insistence that all inhabitants take Thai names, conversion to Buddhism has always been encouraged' (94.6% of the population) and not acting' Thai has forever been a poor career choice. As a policy for racial harmony, the West could learn much. A brief look however at the composition of most cabinets, the family controllers of many leading companies, or the Royal Family itself shows a very different picture.

This explains recent voting patterns. Greater Bangkok dominates the nation's wealth even more than Greater London the British Isles. Like all middle class and wealthy areas, Greater Bangkok (where the Chinese are concentrated) tends to vote squishy-liberal, for free enterprise, perfect infrastructure and low taxes. The far poorer rural areas where the population is Thai-Thai, consistently reveres royalty, votes for pork-barrel politics - and to be governed by Thais. Hence Thaksin Shinawatra's political party (Thai Rak Thai' or 'Thais love Thais' there's a clue) stormed to victory in 2001, then again in 2005. This was with 61% of the votes cast, and 375 of the 500 seats in Parliament; this was a party only founded in 1998. One conclusion must be that however many votes a Thai government wins, only those approved of by the Palace, underwritten by the generals and delivering the goodies to the urban Chinese metropolitan elite will survive. Otherwise, a coup is engineered.

This could last for a long time. It is quite normal for an immigrant racial minority to run a foreign country for a prolonged period; the French ruling England from 1066 to 1422 springs to mind. It is very unusual however to do so within the pretence of a democratic government, especially a constitutional monarchy which nudges and winks in favour of a military takeover every time the Palace doesn't like electoral results, even if that government commands near-record support. As with North Korea, the market clearly disagrees with our view, given the reduction in the price of risk explicit in Thai government debt. We believe this is because Thailand is highly successful at cowing investment banks; buyers are thus mis-informed so pay too low a risk premium.

Examples include Venezuela (where Chavez seems completely potty), Sudan (genocide), or Pakistan (where General Musharraf will be lucky to die in bed). In all three, the risk premium over US bonds has narrowed markedly this year. To use a legal expression, debt markets and their pricing structure "have embarked on a frolic of their own". We do not know how or when this will reverse; our suspicion is it will occur as soon as America suffers a normal, cyclical slowdown so that money is less freely available, i.e. before the end of 2007. What we do know for certain is that now is a dangerous time to buy emerging market debt, index tracker funds, Bulgarian property, hedge fund of funds or other investments perceived as all but risk-free. Unfortunately this encompasses considerable parts of many equity markets priced as they are off bond yields - for they too are extrapolating the strong growth of the last three years into the next three and assuming the world is now one without danger.

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