Wednesday, October 1, 2008

How Will The Financial Crisis Affect Cambodia?

The expat community in Cambodia has been heatedly debating this topic over beers and elsewhere for the past few months. After all, it might affect them as well. Apart from NGO and diplomatic personnel many expats come here for the lower cost of living. Inflationary pressure and the strengthening dollar, ironically a consequence because of falling oil prices due to expectations of lower demand, will wipe out part of their purchasing power if they are from Euro-countries. But they usually find a consensus that the boom years for Cambodia are over. A sure first sign of that will be when the real estate bubble pops.

Now, if we take a closer look at that crisis and the underlying factors we may find that the dangers and risks are not nearly as big as they appear at first glance.

The informed reader knows by now what caused that crisis in the U. S. Worthless or nearly worthless mortgages were packaged into negotiable securities, which mortgage banks sold to other financial institutions, which in turn used them as collateral to raise money to infuse into the (mostly real estate) market or to resell them themselves. When it became apparent that a great number of those mortgages would no longer be serviced by defaulting home-owners and the real estate market crashed (mainly in the U. S. and Britain) those securities had to be revalued to a fraction of their nominal value. As a consequence the collateral they were put up as wasn’t worth what it was supposed to secure. When loans that were backed by those securities were called in those big banks didn’t have the cash to pay them back, resulting in the bankruptcy of Lehman Bros, for one, and bailouts or sale of others. Banks throughout the world participated in this speculation and consequently had to write down billions of dollars on their balance sheets. Stock markets reacted accordingly and sent share prices into a nose-dive first, followed by an ongoing roller-coaster depending on what the latest news is.

Another factor not mentioned as often is the amount of speculation in the financial and futures markets. Oil is a prime example of what speculators can do to prices. Even though oil demand has gone up sharply over the past 4 years that demand would not have produced a spike that eventually saw prices at $150 a barrel, five times higher than in 2004 and double the increase in oil consumption caused by such countries as China and India. For the average observer it is very hard to follow the reasoning of speculators when they claim that a brief border skirmish between Kurds and Turkish forces on the Iraqi border might have an impact on oil production in Iraq thus sending the price up by $10/barrel.

Short selling, a very nefarious practice of the stock market, is another speculative factor that contributed to the current crises. For those of you who still haven’t understood this scheme, as I have for the longest time, it works like this. You borrow stocks at the today’s price and sell it at today’s price. You are betting on the declining value of that stock. When you think the stock will bottom out you buy it back and return it to the owner who is usually represented by a broker. You can determine the time or the value when you want to buy that stock back at the time of the original sale. Fortunately for the stock owner, you have to deposit the money of the sale with the broker. When you return the stock you get your money back, less a commission for the broker. The difference between the sale price and the buy-back price is your profit. These transactions have been suspended in both the U. S. and the EU until the end of the year. They should be outlawed along with a lot of other highly speculative instruments altogether, if you ask me.

And we are not even talking about things like swaps, junk bonds, and all other kinds of deals in intangibles going on Wall Street, not to mention the futures market.

The bad thing about all this is that financial institutions will be severely hampered in the ability to loan money to businesses that need it to finance their day-to-day operations, inventory, etc. The banks, as mentioned above, aren’t able to raise that money themselves. That is the real danger affecting the U. S. and other economies around the world that are closely linked to it.

Businesses will cut jobs, consumers will cut spending, demand will decrease, prices will drop – it is a vicious cycle. There is no escaping it. One good example is automakers in the U. S. Those pricey, gas-guzzling SUVs - sales are down by 75% at Ford, and more than 50% at GM.

Now, what does all that have to do with Cambodia? On the surface, nothing, but because of its dependence on garment exports and tourism, foreign money inflows, whether as FDI or loans, will slow down.

Garment exports to the U. S. have declined already. Tourism is still up over last year but it will most likely be only a matter of time when those numbers start leveling off. This could put a serious dent in Cambodia’s economy.

But what about the real estate bubble or the construction sector that has largely fueled those incredible growth rates over the last few years? Land was sold left and right with everybody betting on further increases and hoping to make a profit when re-selling it, in other words, pure speculation. There was no real purpose behind most of those deals, like building a house, factory, condos, etc. on it. Builders from South Korea who obviously see Cambodia as a playground for their ventures came in by the droves starting new projects, whether it was Cambodian flats or mega-projects like Camko City, the 42-story tower, etc. Both speculators and builders contributed to the growth. Quite a few people all of a sudden had a lot of money buying all those luxury items, and workers in the construction industry had money to spend on motorcycles, small cars, clothing, etc. What both overlooked, it seems, is that they should have done some market research first. Cambodia is a small country with only 14 million people and a very thin capital base. 35% are below poverty level, the vast majority is employed in the family business generating only the bare minimum income, and the garment and tourism sectors pay only minimum wage, like $75 a month. This, of course, means there is a natural limit for the demand in new houses and condos. No doubt, those luxury apartments will find their buyers. But compared to the huge oversupply of Cambodian flats this number is minuscule. Once the Koreans find out they are building for a non-existent buyer they will abruptly stop, putting a lot of those construction workers on the street. If the projects are financed by banks, as they must, simply based on the magnitude of the investment, we will all of a sudden see a lot of quiet and desolate construction sites. There are no numbers available on the number of Korean banks that speculated in those toxic securities, but it would be a safe assumption that most of them did. They will most certainly also feel the crunch, maybe not as much as U. S. banks, and maybe they can cover it with a broader equity base, but they will surely be a little more cautious with their lending.

The land speculators have already begun to realize that the party may be over. They adopted their traditional wait-and-see attitude before and after the election but there are no signs on hand that the market is awakening from its pre- and post-election nap. For all intents and purposes, it is dead right now. This has already led to a price drop of between 5% and 10% in Phnom Penh, and up to 40% in rural areas. Now the people who loaned money for their speculation are in for a rude awakening when the banks start calling in their loans. The ones that used their own savings will have to sell their nice Landcruisers or Lexuses as nothing is coming in to support them as there is no job market for them to speak of.

The Cambodian banks who worked along traditional, conservative lines usually loaned money only for real housing or other projects, not for land speculation. They may find themselves with a lot of real estate assets on their balance sheet when they have to repossess all those empty flats. But, of course, they will be short of cash unless they can generate more money inflows, which is traditionally done by issuing bonds. But initially at least, there will be a tightening credit market. But the upside for Cambodian banks is that none of them speculated in foreign stocks or participated in those imaginative U. S. securities. They made money the original banking way - deposits paid up to 6% and loans cost around 18%. In all likelihood, they will weather the storms that might come their way.

So what does that all boil down to? It would be sort of presumptuous to know an accurate answer to that question. But here is what I think.

The garment sector will not suffer too much as the garments produced are for the most part low-end items that will have a market even in bad times. Wal-Mart is the best example. They posted an increase in sales in the first quarter of 2008 despite the bad economic news and with many people losing their homes and jobs.

Tourism will stagnate in 2009, perhaps starting in the last quarter of 2008 already. Many Europeans are already staying home or opting for less expensive destinations in the Mediterranean (due to shorter flights). On the other hand, Cambodia is still an attractive destination as both accommodations and meal prices are despite a 23% rate of inflation still very reasonable compared to Thailand or Indonesia, for instance.

The real estate bubble will deflate but not burst. The reason for that is that only an estimated 20% is leveraged, mostly by larger companies. In the U.S. that rate is nearly 100%. People who bought and now own unusable land will not be able to sell it, no matter how low they will go with their prices. So they will just have to keep it. Will speculators resort to fire-sales? If they desperately need money, yes. If they have something to fall back on, most definitely no. One shouldn’t forget the Cambodian mentality either. They can be pretty stubborn. They will just wait it out, or go back to farming temporarily, or turn to agriculture altogether. Rubber and cassava plantations are viable alternatives to earn an income. I would be very surprised to see a real estate melt-down like in Vietnam. And most importantly, Cambodia is a cash-based economy. People usually don't spend money they don't have, like in the U. S. where credit card spending is rampant and virtually everything is purchased on credit.

In that sense, I personally believe that the adjustment of the growth rate to around 6%-7% is probably still a little too optimistic, but the economy most certainly won’t crash – at least I hope not.