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Debt-based
monetary systems are inherently unstable. Money is created out of thin air by
the banks and lent to government, consumers and businesses. In order to
service and replay those debts, the borrowers take on more debts. Asset prices
are inflated, and the vicious cycle continues until the debtors are unable to
borrow or the banks are unwilling to lend. At that point the system snaps,
everything is sold off, and we have a financial crisis at hand. In this paper
we examine what happens to equity and currency markets in the aftermath of
financial crisis.
1998 Russia
Declining
productivity, an artificially high fixed
exchange rate between the ruble and foreign
currencies to avoid public turmoil, and a chronic fiscal
deficit were the background to Russia's financial meltdown in
1998. The economic cost of the first
war in Chechnya that is estimated
at $5.5 billion was also a cause.
Prior to
the culmination of the economic crisis, the government-issued GKO bonds
policy had been described as similar to a Ponzi
scheme, with the interest on matured
obligations being paid off using the proceeds of newly issued obligations.
Two
external shocks, the Asian financial crisis that had begun in
1997 and the following declines in demand for (and thus price of) crude oil and nonferrous
metals, impacted Russian foreign exchange reserves. A political
crisis came to a head in March when Russian
president Boris Yeltsin suddenly
dismissed Prime Minister Viktor
Chernomyrdin and his entire cabinet in March.
The Asian
crisis and political event rattled investor confidence caused foreign
investors to sell off Russian stocks, bonds, and took a flight out of rubles.
The
amount of GKO at some $150 billion was not a cause of concern for a $1
trillion economy. But with over 30% of GKO owned by foreigners, the foreign
selloff caused havoc in equity, bond and the ruble.
 
Russian
broad equity index down 90%+ from late 1997 to October 1998
Ruble
went from 5 to 1 USD to 30 to 1 USD in June 1999
After the
equity panic bottom in October 1998, Russian equity index, measured in rubles
rebounded strongly in part thanks to the depreciating ruble.
However,
measured in US dollars, Russian stocks didn't make full recovery till some 5
years later.
2001 Argentina
In 1998, Argentina officially entered a recession, which lasted for three years and ended in a
collapse as fears of the devaluation of the peso led to bank runs. This
brought about grave amounts of protest and violence affecting many people and
companies, causing several deaths.
In 2001 Argentina had US $100 billion of national debt, which is approximately 40% of its GDP. While
the amount is containable relative to its GDP, the Argentines made a mistake
of denominating its debt in US dollars. With shrinking current account
surplus, the country wasn't able to raise dollars to pay debt principal and
interests in 2001 and eventually repudiated on the foreign debts. The fixed exchange
rate was removed and the peso was quickly devalued. The
exchange rate was then left to float, causing further devaluation (about 4
pesos per dollar).
Argentine
equity index dived 60% in 2001
Peso went
from 1 to 1 USD to 4 to 1 USD in early 2002 after the government allowed the
Peso to float.
Although
Argentine Equity Index recovered fully in 2002 in nominal terms, it wasn't
till 2004 before the stocks come back to pre-crisis level in US dollar terms.
Today USA
The US just experienced the biggest debt blowup known to man. Trillion dollar plus mortgage
debts had to be bailed out. Lehman Brothers, Merrill Lynch, Bear Stearns,
Countrywide, Fannie/Freddie's have all become history. Even the American icon
Citibank was brought to its knees at $1 before the government bailout. S&P500 was
halved in 12 months.
America is
privileged to have its dollars serving as the world's reserve currency. America's debt is denominated in dollars, which can be printed at will by the Fed. And printing is what
the Fed did.
The Fed
has printed over 1.5 trillion dollars to bail out various groups.
S&P500
responded positively to monetary easing as it rose 40% since March in nominal
terms. It shouldn't be surprising to see the index recover to pre-crisis
level. Equities have to rise as in Russian and Argentine cases, when
currencies had been massively devalued.
In real
terms however, when S&P500 is measured in gold in the chart below, it
likely takes many years before the index recovers.
Where
does the dollar go from here?
When
foreign investors took flight from Russian rubles and Argentine pesos, the
dollar was the beneficiary. When global investors took flight from the
dollar, which currency benefits?
Gold is
the ultimate antithesis to the dollar. Gold is liquid, universally
recognized, limited in quantity. Just like Russians and Argentines trying to
anchor their currencies to the dollar, the US government devised various ways
to slow down the rise of gold prices to maintain dollar's soundness. However
the massive money printing by the Fed and fast-eroding confidence in the
dollar by international investors might just be the key to drive gold past
the all illusive $1,000/oz level and not look back.
As we saw
in the past crisis in Russia, Argentina, Thailand, and Brazil; equity markets eventually do return while the devalued currency never regained strength. The
US case is no different. Further rebound by the equity market in nominal
terms can be seen albeit with extreme volatility, and we will likely witness
a 4-digit gold price in 2009 that will never look back. As the Chinese
saying, crisis is spelled danger + opportunity. There is still time to
diversify out of dollars before the world recognizes the dollar's permanent
debasement and demotion of status. Visit goldmau.com and sign up for our free
market and stock updates.
John Lee, CFA
Goldmau.com
All
other articles by John Lee
John Lee is a portfolio manager
at Mau Capital Management. He is a CFA charter holder and has degrees in
Economics and Engineering from Rice University. He previously studied under
Mr. James Turk, a renowned authority on the gold market, and is specialized
in investing in junior gold and resource companies. Mr. Lee's articles are
frequently cited at major resource websites and a esteemed speaker at several
major resource conferences.
Please visit www.GoldMau for
instant market alerts and stock updates.
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