Tuesday, January 17, 2012

Crystal Ball 2012

It has been a volatile 2011. S&P stripping the US of its top rating, problems compounding in the Euro-zone and revolution in the Middle East have surely made 2011 an eventful year. It has been a roller coaster ride and as a passive onlooker I thoroughly enjoyed every bit of the action.
Now, what's in store for 2012?
Well no one has the answer to that but I surely know who is going to write the script for the events that will unfold during the course of the year and I shall reveal that towards the end of the article.
As expected the crisis that emerged in Greece has managed to engulf the major nations in the Euro-zone. The pressure has been growing over the ECB to start printing more Euros in its Frankfurt office to solve the crisis. The recent LTRO operation has more or less acted as a proxy to a fully fledged QE. Germany has stubbornly resisted calls for QE but it is just a matter of time before the Germans succumb to the pressure. The LTRO operations have had a positive impact on the Euro-zone borrowing cost and bond markets. Rising uncertainty over the ability of the EFSF to raise funds and growing doubts over the credit rating of the nations in the region would eventually prompt the ECB to undertake a fully fledged QE to avert the catastrophe.
Calls for QE in the US, UK and Japan too have been getting louder. Looking at the worsening health of the global economy it is evident that at regular intervals we will be seeing most of the central bank undertaking easing measures to boost growth. It is clear that the easing measures by the Fed and BoE have helped their respective economies from collapsing. But are these measures taken by the major central banks improving the situation in Main Street?
The unemployment in the UK has reached record levels. There has been a marginal improvement in the US job market but analysts expect the job market problems to resurface after the euphoria following Christmas and New Year dies down. Moreover, unemployment in the US has remained above the 8% mark since the subprime crisis broke out. Japanese economy has indicated that despite continued easing measure for over two decades, problems related to growth and deflation continues to persist.
The problems that global economy faces is that none of the measures taken by the political class and policy makers in the central banks addresses the key issues faced by main street. QE/stimulus and other fiscal measures has enabled the economies to mathematically avoid a recession but deteriorating conditions in the job markets across the world has fuelled the discontent amongst common citizens across the nations. Besides problems related to unemployment, there is a growing discontent over policymakers and dictators across the world. The revolts in Middle East, protests in Wall Street and riots in the UK are all signs that people across the globe are urging their leaders and policymakers to implement reforms to bridge the gap between the rich and the poor.
It is clear that the seeds of revolution were sown in 2011. However, these worrying realities fail to awaken the political class which has been focusing on measures to stem the crisis rather than tackling the crisis head on. Elections in France and the US in 2012 and German elections next year will provide direction to how things shape out for the global economy.
Recent crisis clearly reveals that capitalism in its current form is clearly failing. The harsh reality is that when animal instincts hijack the human mind, capitalism gives birth to crony capitalism. With protests across the world against the current form of capitalism being practiced, let’s hope that the global economy moves away from crony capitalism to a system which enhances sustainable and inclusive growth.
Therefore, the person who is going to decide the course of 2012 is the protester in the Middle East, Russia, Wall Street, Britain and India. The protesters across the globe shall grab the headlines in 2012. Let's hope that these protesters successfully shape the future for a brighter tomorrow.

Monday, August 22, 2011

The Governance Deficit

Governance Deficit-It is among the widely used terms to describe most of the problems faced by our country. However, the entire world seems to be facing enormous problems due to inefficiencies shown by the governing class.
Let us ponder the crisis that we have landed into due to the mistakes that governments have committed in the past.
The Euro-zone is facing a huge sovereign debt problem, but the harsh reality is that the leaders of the region laid the foundation of this crisis. Let's analyse the performance of the largest of the PIIGS economies.

Based on the IMF and World Bank data Italian debt has risen by close to $400 billion in the last five years, while the country's GDP has grown by slightly more than $300 billion. So, for every $1.0 dollars borrowed, the country has managed to grow by $0.75. Meanwhile, in Spain, in the last two years the country's sovereign debt has risen by more than 40% but the unemployment rate has risen from 12% in 2008 to a whopping 21% in 2011. The stats for the other three economies that are a part of the PIIGS, are not encouraging either . These figures clearly suggest that, despite increasing the national debt, these large nations in the Euro-zone have failed to stimulate their respective economies in the recent past.

Much of the borrowing is undertaken to propel the government's social sector schemes. It is the fiscal mismanagement that leads to such crisis. It is time for the political class across the globe to look at deficit management from a different angle. It is utterly unfair for the political class to undertake popular social sector schemes on the assumption that the future generation would pay for it at a later date. Social sector schemes are not an outcome of brave initiatives taken by the political class, but they are actually schemes sponsored by the future generation to boost the current standard of living. John Maynard Keynes believed that fiscal deficit helps to bring the economy out of recession. History has shown us that Keynes theory is right. Using fiscal deficit as a tool to propel growth in difficult times should be appreciated. Meanwhile, reckless spending just to win the mandate of the people for few years would make the situation worse for the nation in the long run. The PIIGS economies present a clear picture, which highlight reckless spending can potentially derail the economy in the long run.

The Italian and Greek debt to GDP ratio currently stands at 116% and 113% respectively. In the last two decades there has been a steep rise in the debts of these nations. The slowdown a couple of years back added to the woes of these countries. Now these countries have piled up so much debt that the servicing costs of the national debt hits record highs in every bond auction. Therefore, it is essential for nations to set fiscal deficit targets and debt limits and act accordingly.

India has managed to outpace most of the global economies in the last ten years. Despite such high growth rates there are several governance issues that we face on a regular basis. Socialism seems to have been deeply embedded inside in our political system. Most of the policies framed in India are based on the socialistic ideologies that are deeply rooted in the minds of the political class. Policies such as the NREGA and the Food Security Act highlight this fact. One may argue that such policies will help the nation to alleviaate poverty and raise the standard of living of the weaker sections of the society, but I have my reservations about such policies. It would be better if policies are framed in such a manner that investments flow into areas comprising the weaker sections of the society and let the benefits of the increased flow in liquidity uplift these weaker sections. It would be unfair to blame just the ruling party for passing this Act. The Act was framed by a Parliamentary Standing Committee and the bill was passed by Parliament. NREGA may have helped in job creation, but it remains one of the leading factors that has fueled inflation in the country. Increase in wages have caused a shortage of manpower, and of course leakages only makes things worse. Barring Rahul Bajaj I have not come across any other Parliamentarian to have opposed this bill. NREGA has caused an outflow of close to $9 billion for the current year. Once the Food security bill is passed, expenses would increase further. Undertaking such policies for a temporary period of time, till development work is undertaken in a particular area is justified, but having such social sector schemes for an indefinite period of time would be irrational.

Austerity measures across the world seem to receive no support from the people. Widespread protests across Euro-zone are providing signals that such measures may not go down well with the citizens of the country. Implementing austerity measures, would be a way for choosing a hard landing. However, such measures would help revive the economy in the long run. Japan opted for a soft landing couple of decades back, and till date there seems to be signs of recovery for the country. Despite lack of support, governments should bite the bullet and go ahead with such schemes. Standard & Poor's downgrade of the US credit rating definitely caused jitters across the global markets, but lets closely analyze the statement provided by the agency. The rating agency stated that the downgrade "reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics."
So the downgrade was mainly on account of debt reduction falling short of S&P's targets. It is encouraging to see the credit rating agency take such bold initiatives, especially after their mismanagement during the subprime crisis. However, it was unfortunate to see the US Treasury Secretary taking pot shots at S&P.

It is time for the US economy to introspect, especially when the writing is on the wall. To conclude, I would say that the current crisis across the globe is an outcome of series of errors committed by the political class, and focus would probably shift from the central bankers to the global leaders to tackle the problems that we currently face.

Monday, August 15, 2011

The Quest for Safe Havens

Equity markets around the world have plummeted in the last few weeks. The downgrade of the US sovereign debt has dented market sentiment, and the quest for safe haven assets has begun. The US Federal Reserve has pledged to maintain the benchmark interest rates at near zero levels for another two years, hoping that lower interest rates would help revive the economy. Problems for the Euro-zone seem to have worsened in the last twelve months. The PMI readings across the emerging markets have dropped. There is a sense of uncertainty across the global markets.
The drop in appetite for riskier assets due to poor macro-economic data across the global economies has boosted demand for risk free assets. The yield movement in the 30 year US bond highlights this fact very much. Despite a credit downgrade, the bond prices rallied to record highs. This probably highlights the fact that despite the downgrade, the greenback seems to have retained its safe haven status. The US Treasury continues to maintain lower risk weights on the US bonds, thereby providing respite to the US banks. A US default is technically impossible, but it is practically difficult to digest the fact that, a country is enjoying a fall in its borrowing costs, despite its credit rating getting lowered. Rising global uncertainties have given birth to events that seem to defy common logic. Macroeconomic indicators from the US too have not been great. The first quarter GDP was revised significantly lower to 0.4%, while the growth rate for the second quarter stood at a dismal 1.4%. The growth rates should fall further as the QE 2 ended in July. The recent agreement to lower the country’s debt too should hamper growth. Bank of New York Mellon Corp. is planning to charge a fee for holding cash in accounts. Such unseen events are due to maintaining near zero interest rates for a prolonged period of time. Economic stimulus probably has helped the US banks to improve asset quality, but now that there has been an improvement in asset quality, the question that needs to answering is: How are these huge financial institutions going to grow in a stagnating economy?
Meanwhile, in the Euro-zone economic indicators are pointing towards weakening of the region’s economy. French GDP stagnated in the second quarter. Greek GDP recorded a steep drop in the previous quarter. There has been a contraction in the manufacturing output in July, which indicates that manufacturing, which occupies a major portion of the European economy, has probably slipped into recession. Countries are being forced into austerity measures to get their debt refinanced. The Spanish and Italian bond yields rose to record highs, prior to the ECB’s intervention in the bond markets. However, such actions would be temporary. The European Union leaders have to raise the EFSF to tackle this crisis. Currently the total funds in the EFSF stand at €440 billion. Inclusion of Italy and Spain to the EFSF should probably lead to the fund crossing the trillion dollar mark. Such an action could probably lead to a downgrade in the German and French credit rating. Many of the European banks have posted weak earnings in the current quarter. The fall in profits, was mainly due to provisioning in Greek debt. The central bank and the EU have not provided any concrete solutions to tackle the rise in toxic assets in the balance sheets.
It is clearly evident that both the US and Euro-zone economies are facing plenty of problems, that could eventually lead to the derailment of global economic growth. 85%-90% of the global reserves are held in form of US or Euro-zone assets. Such never-seen-before events have led to the outflow of liquidity into safe haven assets such as the yen, Swiss franc and gold. Low bond yield on Japanese bonds, enables the government to raise funds at lower interest rates. The Japanese economy has been facing many problems in the last few decades. Rising capital inflows should further cripple growth, since it is more of an export led economy.
Crude oil and base metal prices tumbled, amid concerns over slowdown in the global economy. Inflation has reached record highs in China, and declining growth in the Western areas should only contribute to the fall in the commodity prices.
The only safe haven asset that seems to be performing well is gold. It is the only safe haven asset which has a zero default risk. Gold has always performed well in times, when the world faced threats due to rising prices. Gold has been seen as a great hedge against inflation, but with commodity prices tumbling, the yellow metal has not provided any signs of cooling down. Markets seem to believe that holding precious metals in times of such uncertain environment should provide protection of wealth. There has been a steady rise in gold reserves across the world. Sovereign debt concerns seems to have spurred demand for the precious metal. Central banks in Korea, Mexico, Thailand and Russia have reported a steep rise in gold reserves in the last twelve months. Would the weakening greenback and rising global uncertainties force the world to return to gold standards?

Wednesday, November 17, 2010

The Printing Press

Recently The US federal Reserve announced it's plans for the second round of quantitative easing. The US fed should complete this 600 billion bond-buying program in the next eight months. The US Fed printing all this money to prevent the economy for going into a double dip recession.
In the last decade the two countries to have used this route were japan and Zimbabwe, both have failed miserably to revive their economy through quantitative easing. The increase in money supply has caused hyper-inflation in Zimbabwe and has failed to stimulate the Japanese economy, through these actions the central banks in these countries have been acting like a printing press. However it has to be noted that quantitative easing is used when the central banks are left with no other options. The interest rates in the US is close to zero, so QE2 was the last option with the US fed to tackle recession.
The bigger question that the federal reserve has to answer is that- will QE2 bring any significant changes to the economy?
Inflation in the US has been very low. The high unemployment rate has been one of the main reason for these low inflation figures, hence the increased money supply should not cause much problems in the short run. It can be noted that despite the increase in money supply after QE1, the inflation US has been stable. The main reason for stable inflation is because of the falling velocity of the greenback. the money supply has been rising but the falling velocity (circulation of currency) has been the main reason behind the failure to improve the economy.
Banks in the US are sitting on surplus reserves and the increased liquidity should only inflate this surplus reserves. The problem is the lack of confidence to lend. Fear of defaults in the US is the main reason behind the falling velocity of the US dollar. There are not many lucrative investment options in the US and this is forcing the dollar to move out of the US system to much greener pastures in Asia. The increase in supply of dollar is one of the main reason for the rise in emerging market equities and precious metals. The only positive impact that is visible through this policy is that this increase in supply should depreciate the dollar making US exports more attractive. Despite the fall in dollar it is going to be very difficult to compete with the Chinese exports mainly because of the pegged Renminbi. The bond purchase should bring the prices of the US treasury higher, but a depreciating dollar may prevent the central banks from making any significant inflows into the US treasury. The spike in gold prices is a clear indication suggesting that the central banks are looking at better options to invest their surplus reserves.
The emerging markets are witnessing huge amounts of capital inflows, this should further give rise to protectionist policies to prevent the domestic currencies from appreciating. The bigger worry for the emerging economies should be the probability of a bubble in metals and crude. The rise in inflows should fuel inflation, and it may in the end force countries like India too to implement capital controls. Looking at the recent monetary policies of China and South korea it is clear that the countries in Asia are going to use liquidity tightening measures to fight the threats they could face due to QE2. The currency wars between nations seems to have fueled the speculation that the world is moving towards a new exchange rate system, the World Bank president Robert Zoellick too seems to have joined these speculators.

The news flows from the European union continues to disappoint. Analysts predict Ireland could face a potential default. The bond yields have risen by more than 500 basis points. It is just a matter of time before the ECB announces a bail out package for Ireland. The most troubling part about the situation in Europe is that the toxic assets gets transferred from banks to the government and then to mightier organizations like the IMF and the ECB. This may lead to greater problems considering the fact that there may be many more nations in line waiting for a bailout.
It is now going to be interesting to see how the emerging markets tackle inflation worries and how the US and the EU deal with their set of problems.

Friday, October 29, 2010

Currency Wars

The unemployment rate in the USA has been hovering around 9% for the past 6 months. Despite the turnaround of many of the firms, there has been little change in the unemployment rates. Such high unemployment rates is not going to improve the consumer spending.
The key to recovery is to bring down the unemployment rates. It can be noted that despite the increase in liquidity in the U.S economy there has not been any significant improvement in the unemployment rates. The answers to this lies in China's growing current account surplus and the appreciation in currencies of the emerging economis.
China's growing current account surplus clearly highlights the fact that they have been the biggest beneficiaries of the increased liquidity in the global markets. The boom in the manufacturing sector has enabled China to take advantage of this excess liquidity. However it has to be noted that the exporters too have benefited due to the pegging of the Chinese currency. Analysts and Economists are of the view that the Chinese currency is undervalued by 20%-40%. The fixed currency regime is enabling the Chinese exporters to fight competition from other manufacturers throughout the world. US has been amongst the largest consumers on the Chinese products. This rise in demand for Chinese products is leading to fall in demand for the US manufactured goods and this in turn is one main reasons for rising unemployment in the U.S
US senate is currently considering imposing restrictions on Chinese imports but this issue will be in the back burner till the completion of the mid term election. Imposing restrictions on Chinese imports is not going to be a easy task considering the amount of US debt held by the China. Any restrictions on Chinese imports will also be countered by restrictions on US exports to China. Exports to China has been one of the main reasons for the turnaround of companies like GM and Ford. US treasury secretary Timothy Geithner has been very cautions during the recent G 20 summit. Upper limits for current account surplus for countries like China should enable the US to reduce its trade deficits but this move may not force China to stop pegging it's currency. Growing criticism from US may force China to appreciate its currency, but this appreciation may not factor in the real macro economic picture. It should be interesting to see how the US tackles this issue after the mid term elections. Republicans are expected to do well in this elections, it is going to be interesting to see how the right wingers in the US intend to tackle this problem.
The chairman of the Federal Reserve Ben Bernanke has expressed his interest to infuse more money into the system. These funds will be used to purchase more of the US treasury leading to the surge in liquidity. Increasing supply of dollars should lead to depreciation of dollar against most of the currencies. This surge in liquidity should further lead to the rise in the Emerging market equities and asset prices.
Depreciating Dollar has been a cause of concern for most of the emerging markets. Brazil recently has doubled the tobin tax on capital inflows, Thailand has recently reintroduced the withholding tax. These moves should curtail the currency appreciation of these countries to some extent. RBI has intervened in the currency markets to arrest the Rupee appreciation. However recently the finance minister has openly said that a country like India having a high current account deficit should refrain from imposing taxes on capital inflows. Shankar Acharya (Former advisor to the PM) in his column in business standard wrote that capital inflows should be taxed considering the fact that the inflows may rise after Fed's QE2 announcement causing the Rupee to further appreciate.
In the past many analysts were of the view that P-Notes were (partially) banned in 2007 mainly to bring down the capital inflows. This move did not go down well with the FII's. Similarly any moves to tax capital inflows may hamper the confidence of the FII's. Since we are a capital importing country we must not bring in any reforms that will hurt the confidence of the FII's.
Considering the above case it can be said that the finance ministry is taking the right step by not taking any actions against capital inflows. However appreciating Rupee is surely a cause of concern for exporters. Therefore RBI intervention is a must considering the fact that taxing capital inflows may not be positive for the country. Slowing down Rupee appreciations should enable exporters to compete with countries like Brazil and other emerging economies.
Looking at the recent events it can be said that G 20 has become very important in today's context. It should be interesting to see how the global economies intend to bring an end to the recent currency wars. Fed's bond purchase plan should help RBI determine it's role in the currency markets. To sum it up I would say that wars are now being fought using paper.

Thursday, October 21, 2010

The left turn to default.

Analysts and economists have been rejecting the prospects of a double dip recession. The global equity markets led by the emerging markets have performed extra ordinarily well in the last few weeks mainly due to the change in sentiments. Stress test results of the European Banks din't turn out to be as bad as people expected. Greece has managed to raise funds and the bail out package from the European Union too should prevent the possibility of European nations defaulting. U.S Fed plans to reinvest the principal repayments into bonds, this will have a positive impact on the global liquidity.
Signs of recovery are very much visible, but the bigger question is - "How did we land in this mess?"
Let's first look at all the countries that have leading contributors to this mess.
P.I.G.S is an acronym that refers to the economies of Portugal, Italy, Greece and Spain mainly in matters relating to sovereign default. Mismanagement of funds has been the main reason behind this crisis. Let's take a look at the debt to GDP ratios of these nations.
Italy tops the list with 116%
Italy's debt to GDP ratio was 109% in the year 2001 and it has risen to 116% in the year 2009. Silvio Berlusconi has been the Prime Minister for a major period of time in the last decade. Despite the right of center reforms Silvio's government has failed to bring down the public debt, the fiscal deficit too has gone up due to the stimulus provided to the economy. Silvio's government has introduced many austerity measures to bring down the deficits but there has been growing protests against these measures.
The bailout package prevented Greece from defaulting. The public debt rose to such high levels due to reckless spending by the socialist governments that were in power in the last decade. Figures were fudged due to which the problem was unnoticed. Portugal and Spain have been governed by socialist governments in the last decade.
Barring Italy it can be observed that all the other three countries were governed by Socialist governments in the last decade. One of the major problems faced by the countries ruled by socialistic governments is that they fail to cap the growing public debt and fiscal deficits. Socialism mainly deals with government funding most of the social sector schemes which in turn helps in the growth in the economy, but unfortunately most of these governments end up misusing the socialistic policies to garner votes. Socialistic governments generally resort to unnecessary spending which ends up inflating the fiscal deficits and the public debt, but such schemes tend to have a positive impact on the electorate in the short term, and end up damaging the economy in the long run. Several austerity measures must be undertaken to bring down the deficits and the debts. While undertaking such austerity measures the government is forced to cut down most of its social expenditure. This causes widespread protests by the people since they have been pampered by these schemes for years together.
Looking at the past it can be observed that countries that followed socialistic policies have not been very successful and the recent crisis in Europe too suggests the same.
Indian preamble says that India is a Socialistic Republic. Gandhi family has not distanced itself from Nehruvian Socialism. It may be a cause of concern but with the economy growing at such high growth rates it should not cause any problems in the near future, but it is necessary for the literate voters in India to understand the problems the country may face due to socialism and reckless spending of the government. India's debt to GDP ratio stands at 54%. It is higher when compared to most of the emerging economies, however >8% economic growth should help us bring it down. To conclude I would say that a government following conservative policies would prevent problems caused due to excessive spendings in the long run.

Tuesday, August 3, 2010

The Deregulation Gimmick

Deregulation is surely going to help the global market forces in determining the petrol prices in India. Post deregulation the international oil prices is going to be the determining factor for the price of petrol we pay in pumps.
As per the Kirit Parikh committee report the benefits of deregulation of oil prices far exceeds the pain the society has to bear for the spike in oil prices. The oil marketing companies should reduce the losses which in turn should increase the revenue receipts for the government and decrease the expenditure. This increase in revenues/reduced expenditure can be utilized to fund the various social sector schemes undertaken by the government.
Many may agree with the above analysis but there are a few facts that we need to consider before we give the credit to the government. Let's calculate the cost price for 1 liter of petrol.

CRUDE OIL Rs. 22.5 p/l (@$80 per barrel )
Refining cost Rs. 3.5 p/l (@$0.07 refining cost)
Marketining expense Rs. 1.05 p/l
Shipping & Transport Rs. 6.00 p/l
Total Rs. 33.05 p/l

After going through these facts we may realize that never in the last decade we have paid less than Rs. 40 for 1 liter of petrol. What's even more interesting is that despite the subsidies we have been paying more than the cost price of petrol (Cost price as per $80 barrel.However avg. crude oil price in this decade should be lesser than $80 per barrel).
The reason why we have been paying such high prices for petrol is because of the heavy taxes levied on it. Here is how the cost price post tax looks like

CRUDE OIL Rs. 22.5 p/l (@$80 per barrel )
Refining cost Rs. 3.5 p/l (@$0.07 refining cost)
Marketining expense Rs. 1.05 p/l
Shipping & Transport Rs. 6.00 p/l
Excise Duty Rs.14.35 p/l
CESS Rs. 0.43 p/l
VAT Rs. 3.50-5.50 p/l
customs Rs. 2.64 p/l
Total price Rs. 53.97-55.97 p/l

It can be concluded that prior to deregulation the tax paid on petrol was greater than the subsidy provided by the government. Interestingly except for VAT all the other taxes are under the purview of the Central Government. It is going to be difficult for the state governments to reduce VAT on petrol, since there are not many heads under which they can make up for the loss they will face after reducing VAT on petrol. Hence blaming the state governments would be unfair. Deregulating without making any changes to the existing tax structure is surely going to be very unfair on the common man.
This high rates of taxation is in turn used to compensate for the under-recoveries arising from sale of kerosene and L.P.G. It is going to be difficult if not impossible to sell LPG and kerosene at market price, however it would have been better if the prices would have been hiked as per the recommendation of the committee. The government lacks political will and the guts required to touch the LPG and kerosene prices.
Looking at the government's functioning it can be said that the entire act of deregulation was mainly undertaken to increase the revenues to reduce the deficit. If this entire process of deregulation has been undertaken to reduce the deficit then I am quite sure that subsidies will be re-introduced by the U.P or L.S elections or by the next oil bubble (The government would have managed to bring down the deficits by then). The biggest beneficiaries are the oil marketing companies. However its very early to comment, its better to make conclusions only after the government meets its promise of deregulating the diesel prices and raising the LPG and kerosene prices. Finally the timing was very interesting. Bihar is the only state to go for elections this year, Congress surely is not expecting much from Bihar. So going by this logic will the government find an appropriate time to deregulate diesel and raise the prices for L.P.G and kerosene???