To look at the past 14 years and draw the lesson that rich valuations can be ignored (even when market internals and credit spreads are deteriorating), that hedging is a fool’s game, and that Fed easing can be relied on to drive stock prices higher, is to forget the principal lessons from the most severe market losses that the equity market has endured throughout history. What repeatedly distinguishes bubbles from the crashes is the pairing of severely overvalued, overbought, overbullish conditions with a subtle but measurable deterioration in market internals or credit spreads that conveys a shift from risk-seeking to risk-aversion.

As for monetary policy, remember that the Fed did not tighten in 1929, but instead began cutting interest rates on February 11, 1930 – nearly two and a half years before the market bottomed. The Fed cut rates on January 3, 2001 just as a two-year bear market collapse was starting, and kept cutting all the way down. The Fed cut the federal funds rate on September 18, 2007 – several weeks before the top of the market, and kept cutting all the way down.  Many of the distinctions that investors believe are important are actually useless  in avoiding steep market losses, and many of the distinctions that investors are ignoring at present are absolutely critical.

So for those who value and rely on our work, know that I do see the challenging transition of recent years as fully addressed, as the adaptations we’ve made are robust to data from every market cycle we’ve observed across a century of history. We’ve got much to show for our efforts in recent years. I expect that it will be great fun, once again, to demonstrate it all in practice, as we did in the years prior to 2009 (and with any luck, even more clearly).

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“I cannot imagine any condition which would cause a ship to founder. I cannot conceive of any vital disaster happening to this vessel. Modern shipbuilding has gone beyond that.”
- Edward Smith, Captain, RMS Titanic

“One reason that risk premiums may be low is precisely because the environment is less risky… The Fed has long focused on ensuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil.”
- Janet Yellen, July-September 2007

by Stephen Roach
Project Syndicate
December 23, 2014

NEW HAVEN – America’s Federal Reserve is headed down a familiar – and highly dangerous – path. Steeped in denial of its past mistakes, the Fed is pursuing the same incremental approach that helped set the stage for the financial crisis of 2008-2009. The consequences could be similarly catastrophic.

Consider the December meeting of the Federal Open Market Committee (FOMC), where discussions of raising the benchmark federal funds rate were couched in adjectives, rather than explicit actions.

In line with prior forward guidance that the policy rate would be kept near zero for a “considerable” amount of time after the Fed stopped purchasing long-term assets in October, the FOMC declared that it can now afford to be “patient” in waiting for the right conditions to raise the rate. Add to that Fed Chair Janet Yellen’s declaration that at least a couple more FOMC meetings would need to take place before any such “lift-off” occurs, and the Fed seems to be telegraphing a protracted journey on the road to policy normalization.

This bears an eerie resemblance to the script of 2004-2006, when the Fed’s incremental approach led to the near-fatal mistake of condoning mounting excesses in financial markets and the real economy. After pushing the federal funds rate to a 45-year low of 1% following the collapse of the equity bubble of the early 2000s, the Fed delayed policy normalization for an inordinately long period. And when it finally began to raise the benchmark rate, it did so excruciatingly slowly.

In the 24 months from June 2004, the FOMC raised the federal funds rate from 1% to 5.25% in 17 increments of 25 basis points each. Meanwhile, housing and credit bubbles were rapidly expanding, fueling excessive household consumption, a sharp drop in personal savings, and a record current-account deficit – imbalances that set the stage for the meltdown that was soon to follow.

The Fed, of course, has absolved itself of any blame in setting up the US and the global economy for the Great Crisis. It was not monetary policy’s fault, argued both former Fed Chairmen Alan Greenspan and Ben Bernanke; if anything, they insisted, a lack of regulatory oversight was the culprit.

This argument has proved convincing in policy and political circles, leading officials to focus on a new approach centered on so-called macro-prudential tools, including capital requirements and leverage ratios, to curb excessive risk-taking by banks. While this approach has some merit, it is incomplete, as it fails to address the egregious mispricing of risk brought about by an overly accommodative monetary policy and the historically low interest rates that it generated. In this sense, the Fed’s incrementalism of 2004-2006 was a policy blunder of epic proportions.

The Fed seems poised to make a similar – and possibly even more serious – misstep in the current environment. For starters, given ongoing concerns about post-crisis vulnerabilities and deflation risk, today’s Fed seems likely to find any excuse to prolong its incremental normalization, taking a slower pace than it adopted a decade ago.

More important, the Fed’s $4.5 trillion balance sheet has since grown more than fivefold. Though the Fed has stopped purchasing new assets, it has shown no inclination to scale back its outsize holdings. Meanwhile it has passed the quantitative-easing baton to the Bank of Japan and the European Central Bank, both of which will create even more liquidity at a time of record-low interest rates.

In these days of froth, the persistence of extraordinary policy accommodation in a financial system flooded with liquidity poses a great danger. Indeed, that could well be the lesson of recent equity- and currency-market volatility and, of course, plummeting oil prices. With so much dry kindling, it will not take much to spark the next conflagration.

Central banking has lost its way. Trapped in a post-crisis quagmire of zero interest rates and swollen balance sheets, the world’s major central banks do not have an effective strategy for regaining control over financial markets or the real economies that they are supposed to manage. Policy levers – both benchmark interest rates and central banks’ balance sheets – remain at their emergency settings, even though the emergency ended long ago.

While this approach has succeeded in boosting financial markets, it has failed to cure bruised and battered developed economies, which remain mired in subpar recoveries and plagued with deflationary risks. Moreover, the longer central banks promote financial-market froth, the more dependent their economies become on these precarious markets and the weaker the incentives for politicians and fiscal authorities to address the need for balance-sheet repair and structural reform.

A new approach is needed. Central banks should normalize crisis-induced policies as soon as possible. Financial markets will, of course, object loudly. But what do independent central banks stand for if they are not prepared to face up to the markets and make the tough and disciplined choices that responsible economic stewardship demands?

The unprecedented financial engineering by central banks over the last six years has been decisive in setting asset prices in major markets worldwide. But now it is time for the Fed and its counterparts elsewhere to abandon financial engineering and begin marshaling the tools they will need to cope with the inevitable next crisis. With zero interest rates and outsize balance sheets, that is exactly what they are lacking.

Why Volatility Signals Stability, and Vice Versa
By Nassim Nicholas Taleb and Gregory F. Treverton
Foreign Affairs - January/February Issue

Even as protests spread across the Middle East in early 2011, the regime of Bashar al-Assad in Syria appeared immune from the upheaval. Assad had ruled comfortably for over a decade, having replaced his father, Hafez, who himself had held power for the previous three decades. Many pundits argued that Syria’s sturdy police state, which exercised tight control over the country’s people and economy, would survive the Arab Spring undisturbed. Compared with its neighbor Lebanon, Syria looked positively stable. Civil war had torn through Lebanon throughout much of the 1970s and 1980s, and the assassination of former Prime Minister Rafiq Hariri in 2005 had plunged the country into yet more chaos.

But appearances were deceiving: today, Syria is in a shambles, with the regime fighting for its very survival, whereas Lebanon has withstood the influx of Syrian refugees and the other considerable pressures of the civil war next door. Surprising as it may seem, the per capita death rate from violence in Lebanon in 2013 was lower than that in Washington, D.C. That same year, the body count of the Syrian conflict surpassed 100,000.

Why has seemingly stable Syria turned out to be the fragile regime, whereas always-in-turmoil Lebanon has so far proved robust? The answer is that prior to its civil war, Syria was exhibiting only pseudo-stability, its calm façade concealing deep structural vulnerabilities. Lebanon’s chaos, paradoxically, signaled strength. Fifteen years of civil war had served to decentralize the state and bring about a more balanced sectarian power-sharing structure. Along with Lebanon’s small size as an administrative unit, these factors added to its durability. So did the country’s free-market economy. In Syria, the ruling Baath Party sought to control economic variability, replacing the lively chaos of the ancestral souk with the top-down, Soviet-style structure of the office building. This rigidity made Syria (and the other Baathist state, Iraq) much more vulnerable to disruption than Lebanon.

But Syria’s biggest vulnerability was that it had no recent record of recovering from turmoil. Countries that have survived past bouts of chaos tend to be vaccinated against future ones. Thus, the best indicator of a country’s future stability is not past stability but moderate volatility in the relatively recent past. As one of us, Nassim Nicholas Taleb, wrote in the 2007 book The Black Swan, “Dictatorships that do not appear volatile, like, say, Syria or Saudi Arabia, face a larger risk of chaos than, say, Italy, as the latter has been in a state of continual political turmoil since the second [world] war.”

On its face, centralization seems to make governments more stable. But that stability is an illusion.

The divergent tales of Syria and Lebanon demonstrate that the best early warning signs of instability are found not in historical data but in underlying structural properties. Past experience can be extremely effective when it comes to detecting risks of cancer, crime, and earthquakes. But it is a bad bellwether of complex political and economic events, particularly so-called tail risks—events, such as coups and financial crises, that are highly unlikely but enormously consequential. For those, the evidence of risk comes too late to do anything about it, and a more sophisticated approach is required.

Thus, instead of trying in vain to predict such “Black Swan” events, it’s much more fruitful to focus on how systems can handle disorder—in other words, to study how fragile they are. Although one cannot predict what events will befall a country, one can predict how events will affect a country. Some political systems can sustain an extraordinary amount of stress, while others fall apart at the onset of the slightest trouble. The good news is that it’s possible to tell which are which by relying on the theory of fragility.

Simply put, fragility is aversion to disorder. Things that are fragile do not like variability, volatility, stress, chaos, and random events, which cause them to either gain little or suffer. A teacup, for example, will not benefit from any form of shock. It wants peace and predictability, something that is not possible in the long run, which is why time is an enemy to the fragile. What’s more, things that are fragile respond to shock in a nonlinear fashion. With humans, for example, the harm from a ten-foot fall in no way equals ten times as much harm as from a one-foot fall. In political and economic terms, a $30 drop in the price of a barrel of oil is much more than twice as harmful to Saudi Arabia as a $15 drop.

For countries, fragility has five principal sources: a centralized governing system, an undiversified economy, excessive debt and leverage, a lack of political variability, and no history of surviving past shocks. Applying these criteria, the world map looks a lot different. Disorderly regimes come out as safer bets than commonly thought—and seemingly placid states turn out to be ticking time bombs.

THE CENTER CANNOT HOLD
The first marker of a fragile state is a concentrated decision-making system. On its face, centralization seems to make governments more efficient and thus more stable. But that stability is an illusion. Apart from in the military—the only sector that needs to be unified into a single structure—centralization contributes to fragility. Although centralization reduces deviations from the norm, making things appear to run more smoothly, it magnifies the consequences of those deviations that do occur. It concentrates turmoil in fewer but more severe episodes, which are disproportionately more harmful than cumulative small variations. In other words, centralization decreases local risks, such as provincial barons pocketing public funds, at the price of increasing systemic risks, such as disastrous national-level reforms. Accordingly, highly centralized states, such as the Soviet Union, are more fragile than decentralized ones, such as Switzerland, which is effectively composed of village-states.

States that centralize power often do so to suppress sectarian tension. That inability to handle diversity, whether political or ethnoreligious, further adds to their fragility. Although countries that allow their sectarian splits to remain out in the open may seem to experience political turmoil, they are considerably more stable than those that artificially repress those splits, which creates a discontented minority group that brews silently. Iraq, for example, had a Sunni-minority-led regime under Saddam Hussein that repressed the Shiites and the Kurds; the country overshot in the opposite direction after Prime Minister Nouri al-Maliki, a Shiite, took office in 2006 and began excluding the Sunnis. Indeed, research by the scholar Yaneer Bar-Yam has shown that states that have well-defined boundaries separating various ethnic groups experience less violence than those that attempt to integrate them. In other words, people are better next-door neighbors than roommates. Thus, in countries riven by sectarian divides, it makes more sense to give various groups their own fiefdoms than to force them to live under one roof, since the latter arrangement only serves to radicalize the repressed minority.

Moreover, centralization increases the odds of a military coup by making the levers of power easier to seize. Greece, for example, was highly centralized when a group of colonels overthrew the government in 1967. Italy might have appeared just as vulnerable around the same time, given that it also suffered from widespread social unrest and ideological conflict, but it was saved by its political decentralization and narrow geography. The various economic and political centers were both figuratively and literally far from one another, distance that prevented any single military faction from seizing power.

Just as states composed of semiautonomous units have fared well in the modern era, further back in history, the most resilient polities were city-states that operated under empires that provided a measure of protection, from Pax Romana to Pax Ottomana. But at the tail end of their existence, many empires began to centralize, including Pharaonic Egypt and the Ming dynasty in China. In both cases, the empires tightened the reins after, not before, they thrived, ruling out centralization as a cause of their success and fingering it as an explanation for their subsequent failure.

City-states both old and new—from Venice to Dubai to Geneva to Singapore—owe their success to their smallness. Those who compare political systems by looking at their character without taking into account their size are thus making an analytic error: city-states are remarkably diverse in terms of their political systems, from the most democratic (Venice) to the most enlightened but autocratic (Singapore). Just as an elephant is not a large mouse, China is not a bigger version of Singapore, even if the two share similar styles of government.

Italy is resilient precisely because it has been able to accommodate virtually constant political turmoil.

Again, consider Lebanon. For much of history, the Mediterranean was ringed by multilingual, religiously tolerant, and obsessively mercantile city-states, which accommodated a variety of empires. But most were eventually swallowed up by the modern nation-states. Alexandria was consumed by Egypt, Smyrna by Turkey, Thessaloniki by Greece, and Aleppo by Syria. Luckily for Lebanon, however, it was swallowed up by Beirut, not vice versa. After the collapse of the Ottoman Empire, the state of Lebanon was small and weak enough to get colonized by the city-state of Beirut. The result: over the past half century, living standards in Lebanon have risen in comparison to its peers. The country avoided the wave of statism that swept over the region with Gamal Abdel Nasser in Egypt and the Baath Party in Iraq and Syria, a trend that concentrated decision-making power and created dysfunctional bureaucracies, leading to many of the region’s problems today.

UNSTEADY-STATE ECONOMY
The second soft spot is the absence of economic diversity. Economic concentration can be even more harmful than political centralization. Economists since David Ricardo have touted the gains in efficiency to be had if countries specialize in the sectors in which they hold a comparative advantage. But specialization makes a state more vulnerable in the face of random events.

For a state to be safe, the loss of a single source of income should not dramatically damage its overall economic condition. Places that depend on tourism, for example, are particularly susceptible to perceived instability (as Greece discovered after its economic crisis and Egypt discovered after its revolution), as well as unrelated events (as Hawaii found out immediately after 9/11) and even just the vagaries of fashion, as new hot spots replace older ones (as Tangier, Morocco, has come to recognize). Another common source of fragility is an economy built around a single commodity, such as Botswana, with its reliance on diamonds, or a single industry that accounts for the lion’s share of exports, such as Japan’s automobile sector. Even worse is when large state-sponsored or state-friendly enterprises dominate the economy; these tend to not only reduce competitiveness but also compound the downside risks of drops in demand for a particular commodity or product by responding only slowly and awkwardly to market signals.

The third source of fragility is also economic in nature: being highly indebted and highly leveraged. Debt is perhaps the single most critical source of fragility. It makes an entity more sensitive to shortfalls in revenue, and all the more so as those shortfalls accelerate. As Lehman Brothers experienced when it collapsed in 2008, as the confidence of investors wanes and requests for repayment grow, losses mount at an increasing rate. Debt issued by a state itself is perhaps the most vicious type of debt, because it doesn’t turn into equity; instead, it becomes a permanent burden. Countries cannot easily go bankrupt—which, ironically, is the main reason people lend to them, believing that their investments are safe.

Leverage raises risks in much the same way. Dubai, for example, has plowed money into aggressive real estate projects, increasing its operating leverage and thus making any drops in revenue extremely threatening. Profit margins there are so thin that shortfalls could easily accelerate, which would rapidly push the emirate’s companies into the red and drain state coffers. This means that Dubai, in spite of its admirable structure and governance, can rapidly go insolvent—as the world witnessed after the 2008 financial crisis, when Abu Dhabi had to bail it out.

THE VIRTUE OF VOLATILITY
The fourth source of fragility is a lack of political variability. Contrary to conventional wisdom, genuinely stable countries experience moderate political changes, continually switching governments and reversing their political orientations. By responding to pressures in the body politic, these changes promote stability, provided their magnitude is not too large—more like the gap between the Labour Party and the Conservative Party in the contemporary United Kingdom than that between the Jacobins and the royalists in revolutionary France. Moderate political variability also removes particular leaders from power, thus reducing cronyism in politics. When a state is decentralized, the variations are smoother still, since municipalities distribute decision-making power and allow for a plurality of political views.

It is political variability that makes democracies less fragile than autocracies. Italy is resilient precisely because it has been able to accommodate virtually constant political turmoil, training citizens for change and incubating institutions able to correct for mild instability. So far, perhaps predictably, none of the former dictatorships touched by the Arab Spring has demonstrated any such capacity. Egypt has reverted to military rule, and the others have fallen into varying degrees of chaos. Some states that emerged from autocratic rule without devolving into turmoil were able to develop means of accommodating change. Spain under Francisco Franco, for instance, over time became more and more an autocratic façade behind which the institutions of civil society could develop.

The fifth marker of fragility takes the proposition that there is no stability without volatility a step further: it is the lack of a record of surviving big shocks. States that have experienced a worst-case scenario in the recent past (say, around the previous two decades) and recovered from it are likely to be more stable than those that haven’t. In part, this marker is simply providing information: countries that sustain chaos without falling apart reveal something about their strength that could not be discovered otherwise. But this marker also involves the idea of “antifragility,” the property of gaining from disorder. Shocks to a state are educational, causing them to experience posttraumatic growth.

Look at Indonesia, Malaysia, the Philippines, South Korea, and Thailand. The fact that these countries weathered the 1997–98 Asian financial crisis suggests that they were robust enough to survive—and their impressive subsequent performance suggests that they might even have been antifragile, adjusting their institutions and practices based on the lessons of the crisis. Likewise, the fact that the former Soviet states have recovered from the collapse of the Soviet Union suggests that they are also relatively stable. The idea is analogous to child rearing: parents want to protect their children from truly serious shocks that they might not survive but should not want to shelter them from the challenges in life that make them tougher.

THE BEAUTIFUL AND DAMNED
These five markers function best as warning signals. They cannot indicate with high confidence whether a given country is stable—no methodology can—but they certainly can reveal if a given country should cause worry. Those countries that score poorly on multiple criteria are particularly concerning, since these markers are compounding: qualifying as fragile on two counts is more than twice as dangerous as doing so on one. When it comes to overall fragility, countries can vary from exhibiting no signs of fragility to being very fragile.

Saudi Arabia is an easy call: it is extremely dependent on oil, has no political variability, and is highly centralized. Its oil wealth and powerful government have papered over the splits between its ethnoreligious units, with the Shiite minority living where the oil is. For the same reason, Bahrain should be considered extremely fragile, mainly on account of its repressed Shiite majority.

Egypt should also be considered fragile, given its only slight and cosmetic recovery from the chaos of the revolution and its highly centralized (and bureaucratic) government. So should Venezuela, which has a highly centralized political system, little political variability, an oil-based economy, and no record of surviving a massive shock. Some of the same problems apply to Russia. It remains highly dependent on oil and gas production and has a highly centralized political system. Its one redeeming factor is that it surmounted the difficult transition from the Soviet era. For that reason, it probably lies somewhere between moderately fragile and fragile.

Some countries are best categorized as fragile but possibly doing something about it. Greece holds enormous quantities of debt and has an inflexible political system, but it has begun to undertake an economic restructuring. (Time will tell whether this is the beginning of a new era of responsibility or a false start.) Iran has an effectively centralized government that exhibits little variability and an economy tied to oil and gas production, yet the regime has been tolerating (although only implicitly) a measure of political dissent. And although Iran is nominally a theocracy, unlike Saudi Arabia, it appears to have an extremely adaptive form of Islam that may accommodate modernization. Greece and Iran could transform into more robust states or lapse into fragility.

Moderately fragile states include Japan, given its highest-in-the-world debt-to-gdp ratio, long-term dominance by a single party, dependence on exports, and failure to fully recover from its “lost decade”; Brazil, which is growing increasingly centralized and bureaucratized; Nigeria, which is highly centralized and dependent on oil yet has rebounded from the economic and political turmoil of the 1980s and proved somewhat adaptable in the face of new threats, such as the Islamist insurgent group Boko Haram; and Turkey, which is highly centralized and has no track record of recovery. (In addition, Turkey’s dependence on foreign investment is incompatible with its aggressive pro-Islamist foreign policy, which turns off Western investors.) India is perhaps best considered slightly fragile. Its political system is relatively decentralized and has adapted to rapid population growth and uneven economic progress, and its economy is somewhat reliant on exports.

Italy, paradoxically, shows no signs of fragility. It is effectively decentralized and has bounced back from perennial political crises. It also experiences a great deal of harmless political variability, cycling through 14 prime ministerial terms in the past 25 years. France, by contrast, is more fragile—centralized (in spite of the lip service it pays to decentralization), indebted, and without a demonstrated comeback. The country is at risk of economic trauma, which would raise the danger of erratic political reactions. Those, in turn, would likely enhance the appeal of right-wing factions and radicalize the country’s significant Muslim minority.

Then there is the China puzzle. China’s stunning economic growth makes its future hard to assess. The country has recuperated remarkably well from the major shocks of the Maoist period. That era, however, ended nearly four decades ago, and so the recovery is hardly a recent comeback and thus less certain to protect against future shocks. What’s more, China’s political system is highly centralized, its economy is dependent on exports to the West, and its government has been on a borrowing binge as of late, making the country more vulnerable to slowdowns in both domestic and foreign growth. Are the gains from past turmoil big enough to offset the weakness from debt and centralization? The most likely answer is no—that what gains China has accrued by learning from trauma are dwarfed by its burdens. With each passing year, those lessons recede further into the past, and the prospects of a Black Swan of Beijing loom larger. But the sooner that event happens, the better China will emerge in the long run.

By Ambrose Evans-Pritchard
14 December, 2014

 HSBC has warned that Japan’s barely-disguised attempt to drive down the yen is becoming dangerous and may spin out of control, leading to an exchange rate crisis next year and a worldwide currency storm.

“It is entirely possible that the Yen decline becomes disorderly and swift,” said the bank, in one of the starkest criticisms so far of Japan’s radical stimulus policies.

David Bloom and Paul Mackel, HSBC’s currency strategists, voiced growing concern that premier Shinzo Abe is backing away from fiscal retrenchment and may pressure the Bank of Japan (BoJ) to fund policies aimed at boosting household spending.

“The temptation to drift towards increasingly generous fiscal programmes could grow. We do not expect a ‘helicopter drop’ of income into every household, but the yen would react very badly to any sign that the government is heading down a route of overt monetisation,” they wrote in a report entitled “The Year of Living Dangerously”.

The warning came as Mr Abe won a sweeping victory in Japan’s snap elections over the weekend, consolidating his power in the Diet and giving him a further mandate for deep reforms.

 "I promise to make Japan a country that can shine again at the centre of the world," said Mr Abe.

Japan's recovery has faltered. Mr Abe's Thatcherite shake-up, or Third Arrow, has yet to get off the ground, though he is now in a much stronger position to break monopolies and confront vested interests.

The economy slumped back into recession in the middle of this year after a rise in the sales tax from 5pc to 8pc, a move that was clearly premature.

 The Abenomics experiment still depends largely on the BoJ's asset purchases, running at 1.4pc of GDP each month, the most extreme monetary blitz ever attempted in a modern economy. Economists are deeply divided over whether this alone can overwhelm the fiscal shock, and lift the economy out a 20-year stagnation trap.

HSBC said Mr Abe may succeed in driving up wages, setting off a "wage-inflation spiral". This may not necessarily lead to a bond rout since the Bank of Japan is effectively holding down bond yields. However, the exchange rate might take the strain instead.

The worry is that this could set off a beggar-thy-neighbour devaluation process across Asia, eventually sucking in China. "The tentacle of the currency war would spread," said the report.

HSBC said China is determined to avoid joining this debasement game as it tries to wean its own economy off export-led growth, but there may be limits. The Chinese economy is slowing and is already in deep producer price deflation. Japanese exporters have been switching to a new strategy over the last six months, cutting export prices to gain market share as the yen falls, rather than pocketing the windfall as extra profit.

"There are grounds to argue that China would join the currency war and devalue the yuan if currency moves elsewhere became disorderly," it said. The warnings have raised eyebrows since HSBC has close policy ties with the Chinese authorities.

The report sketched an unsettling scenario in which capital flight from Japan flows to the US, setting off an "explosive" rise in the dollar. This may combine with "reignited European break-up fears" as political risk spreads, most immediately in Greece.

Such a combination would put immense strain on those emerging markets that have borrowed heavily in dollars.The Bank for International Settlements says cross-border loans to developing economies have soared from $3 trillion to $9 trillion in a decade, creating systemic risk.

HSBC warns that the potential trifecta of a yen crash, a euro slide, and an emerging market crisis could lead to a dollar spike that the US authorities "would be powerless to prevent". This would "destroy the world" as we know it. The report stressed that this is not a forecast but a tail-risk that cannot be ignored.

Takeshi Fujimaki, a Japanese banker and former adviser to George Soros, has also issued a string of warnings. “Once investors see through the BOJ’s camouflage, the yen will spiral out of control to Y200 (to the dollar) and beyond,” he said.

The BoJ has already driven down the yen by 50pc against the dollar to $119 over the last two years, and by the same amount against the yuan. While this was welcomed by Japanese firms at first, it risks going too far. Protests are rising from those who rely on imports.

The central bank's governor, Haruhiko Kuroda, stepped up the pace of QE in October in a bid to push up inflation and reignite the damp wood of the Japanese economy. The move was fiercely resisted by four of the BoJ’s nine voting members.

The unstated purpose is to raise nominal GDP growth from past rates of zero to nearer 4pc or 5pc. This is deemed the safe required to stabilize the ratio of public debt to GDP – now 245pc – and avert a debt-compound trap.

The BoJ is currently soaking up the entire bond issuance of the government, forcing down the real interest rate to deeply negative levels. It has accumulated $2.14 trillion of state debt so far, equal to 47pc of GDP. This is rising fast, fuelling suspicions that Mr Kuroda’s true objective is to whittle away the debt burden by printing money.

 The HSBC view is unusually gloomy. Mr Kuroda said the bank will "approach" its 2pc inflation target in 2015 and there are signs that business investment is picking up.

The Daiwa Instititute says real wages are poised to rise as the tax shock fades. "Signs of a virtuous cycle are definitely emerging," it said. The yen may stabilize once the economy has adapted to a new nominal GDP trajectory.

Ryutaro Kono from BNP Paribas said Abenomics ran aground in late 2013 but may now have been rescued by the slump in oil prices. Japan imports almost all its fuel. The effect is worth a tax cut of 1pc of GDP. "Its a godsend for Abe," he said.

Yet Japan is clearly at a critical moment. Moody's downgraded the country's debt one notch to A1 earlier this month with an explicit warning: Japan cannot stabilize its debt ratio unless all elements come together at once.

These are fiscal and pension reforms, higher taxes, higher productivity growth, an end to deflation, and nominal GDP growth above 3.5pc. If any one of these falls short, Mr Abe's great gamble may fail.

by Doug Short
7 December, 2014

Excerpts:

The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It’s a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Fortunately, the government does the work of accumulating the data for the calculation. The numbers are supplied in the Federal Reserve Z.1 Financial Accounts of the United States of the United States, which is released quarterly.

The first chart shows Q Ratio from 1900 to the present. I’ve calculated the ratio since the latest Fed data (through 2014 Q1) based on a subjective process of extrapolating the Z.1 data itself and factoring in the monthly averages of daily closes for the Vanguard Total Market ETF (VTI).

Interpreting the Ratio

The data since 1945 is a simple calculation using data from the Federal Reserve Z.1 Statistical Release, section B.102, Balance Sheet and Reconciliation Tables for Nonfinancial Corporate Business. Specifically it is the ratio of Line 39 (Market Value) divided by Line 36 (Replacement Cost). It might seem logical that fair value would be a 1:1 ratio. But that has not historically been the case. The explanation, according to Smithers & Co. (more about them later) is that “the replacement cost of company assets is overstated. This is because the long-term real return on corporate equity, according to the published data, is only 4.8%, while the long-term real return to investors is around 6.0%. Over the long-term and in equilibrium, the two must be the same.”

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The chart below shows the Q-Ratio using a calculation method shared with me a few years ago by John Mihaljevic, formerly Dr. James Tobin’s research associate at Yale. It is based on several values from the Z.1 data and does not factor in intellectual property. The Q Ratio using this method of calculation is 92% above its arithmetic mean and 111% above its geometric mean.

By Ambrose Evans-Pritchard
7 December,  2014

 Off-shore lending in US dollars has soared to $9 trillion and poses a growing risk to both emerging markets and the world's financial stability, the Bank for International Settlements has warned.

The Swiss-based global watchdog said dollar loans to Chinese banks and companies are rising at annual rate of 47pc. They have jumped to $1.1 trillion from almost nothing five years ago. Cross-border dollar credit has ballooned to $456bn in Brazil, and $381bn in Mexico. External debt has reached $715bn in Russia, mostly in dollars.

A chunk of China's borrowing is disguised as intra-firm financing. This replicates practices by German industrial companies in the 1920s, which hid their real level of exposure as the 1929 debt trauma was building up. "To the extent that these flows are driven by financial operations rather than real activities, they could give rise to financial stability concerns," said the BIS in its quarterly report.

"More than a quantum of fragility underlies the current elevated mood in financial markets," it warned. Officials are disturbed by the "risk-on, risk-off, flip-flopping" by investors. Some of the violent moves lately go beyond stress seen in earlier crises, a sign that markets may be dangerously stretched and that many fund managers do not really believe their own Goldilocks narrative.

"Mid-October’s extreme intraday price movements underscore how sensitive markets have become to even small surprises. On 15 October, the yield on 10-year US Treasury bonds fell almost 37 basis points, more than the drop on 15 September 2008 when Lehman Brothers filed for bankruptcy."

 "These fluctuations were large relative to actual economic and policy surprises, as the only notable negative piece of news that day was the release of somewhat weaker than expected retail sales data for the US one hour before the event," it said.

The BIS said 55pc of collateralised debt obligations (CDOs) now being issued are based on leveraged loans, an "unprecedented level". This raises eyebrows because CDOs were pivotal in the 2008 crash.

"Activity in the leveraged loan markets even surpassed the levels recorded before the crisis: average quarterly announcements during the year to end-September 2014 were $250bn," it said.

BIS officials are worried that tightening by the US Federal Reserve will transmit a credit shock through East Asia and the emerging world, both by raising the cost of borrowing and by pushing up the dollar.

"The appreciation of the dollar against the backdrop of divergent monetary policies may, if persistent, have a profound impact on the global economy. A continued depreciation of the domestic currency against the dollar could reduce the creditworthiness of many firms, potentially inducing a tightening of financial conditions," it said.

The dollar index (DXY) has surged 12pc since late June to 89.36, smashing through its 30-year downtrend line. The currency has risen 55pc against the Russian rouble and 18pc against Brazil's real over the same period.

Hyun Song Shin, the BIS's head of research, said the world's central banks still hold over 60pc of their reserves in dollars. This ratio has changed remarkably little in forty years, but the overall level has soared -- from $1 trillion to $12 trillion just since 2000.

 Cross-border lending in dollars has tripled to $9 trillion in a decade. Some $7 trillion of this is entirely outside the American regulatory sphere. "Neither a borrower nor a lender is a US resident. The role that the US dollar plays in debt contracts is very important. It is a global currency, and no other currency has this role," he said.

The implication is that there is no lender-of-last resort standing behind trillions of off-shore dollar bank transactions. This increases the risks of a chain-reaction if it ever goes wrong. China's central bank has ample dollar reserves to bail out its companies - should it wish to do so - but the jury is out on Brazil, Russia, and other countries.

This flaw in the global system may be tested as the Fed prepares to raise interest rates for the first time in seven years. The US economy is growing at a blistering pace of 3.9pc. Non-farm payrolls surged by 321,000 in November and wage growth is at last picking up.

Two years ago the Fed expected unemployment to be 7.4pc at this stage. In fact it is 5.8pc. The Fed's new “optimal control” model suggest that raise rates may rise sooner and faster than markets expect. This has the makings of a global shock.

The great unknown is whether the current cycle of Fed tightening will lead to the same sort of stress seen in the Latin American debt crisis in the early 1980s or the East Asia/Russia crisis in the late 1990s. This time governments have far less dollar debt, but corporate dollar debt has replaced it, with mounting excesses in the non-bank bond markets. Emerging market bond issuance in dollars has jumped by $550bn since 2009. "This trend could have important financial stability implications," it said.

BIS officials are concerned that the risks may be just as great in this episode, though the weak links may not be where we think they are. Just as generals fight the last war, regulators have be fretting chiefly about bank leverage since the Lehman crisis.

Yet the new threat may lie in non-leveraged investments by asset managers and pension funds funnelling vast sums of excess capital around the world, especially into emerging markets. Many of these are so-called "macro-tourists" chasing yield, in some cases with little grasp of global geopolitics.

Studies suggest that they have a low tolerance for losses. They engage in clustering and crowd behaviours, and are apt to pull-out en masse, risking a bad feedback-loop. This could prove to be today's systemic danger. "If we rely too much on the familiar mechanisms, we may be missing the new vulnerabilities building up," said Mr Shin in a speech to the Brookings Institution last week.

 The BIS has particular authority since its job is to track global lending. It was the only major body to warn of serious trouble before the Great Recession - and did so clearly, without the usual ifs and buts.

It now warns that the world is in many ways even more stretched today than it was in 2008, since emerging markets have been drawn into the global debt morass as well, and some have hit the limits of easy catch-up growth.

Debt levels in rich countries have jumped by 30 percentage points since the Lehman crisis to 275pc of GDP, and by the same amount to 175pc in emerging markets. The world has exhausted almost all of its buffer.