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?