World Economy: Bleeding through a Thousand Cuts

Some Statistical Information

Every passing day seems to bring back a sense of gloom that is similar to what we witnessed during the fateful years of 2008, just preceding the collapse of Lehman brothers. The only difference this time is that it is countries that are in the firing line. The bond markets seem to discounting a very severe recession in Europe, while the Equity market seems to be discounting a low growth scenario or at worst, a very mild recession. Unfortunately, historically, the bond markets have been most accurate in predicting a crisis, while the equity markets have been mostly wrong. There is a steady list of countries that have slowly started reducing their estimates for growth. This is because the problems on the horizon surpass the problems the world faced during 2008-09. A more worrying storm cloud is the possible opening up of the dispute in the US about reducing its fiscal deficit – which in the past led to a downgrade of its rating by S&P. Low interest rates now seem to be having no positive impact. In UK and USA the bond markets expect the interest rates to stay at the current levels till at least 2014, if not beyond.

The interesting aspect of December 2011 is that there have been attempts to reactivate the bail out machinery. First it was the US Fed, which  till date provided nearly US$625 billion of dollar liquidity to foreign central banks in December 2011 alone. Then it was the ECB's turn to open the liquidity spigots by inaugurating the Second Chapter of Easy money, no questions asked era: it provided nearly US$645 billion to 524 banks. This is money down the drain as there is no way that most banks are likely to ever repay the money. We have thus entered the Era of  not only Rotating Sovereign Crisis but also an era of Recycling bail out for the banks. 

For all those interested in Statistics, I have compiled various interesting Statistics and reproduced them in this post. Readers need to be cautioned that this post may have some utility due to some of the empirical data rather than analysis of the issues.

• Europe is the epicentre of the problems of the world and the situation is likely to get worse because The full blast of the austerity measures will be felt only from Q3 of 2012, thereby indicating that 2012 and 2013 will be worse than the present.
• Eurzone is likely to face a severe recession, which is not yet discounted, instead of the currently discounted mild recession.
• UK 10 year bonds yields have fallen to the lowest level since 1890s as the bond markets fear a double dip recession there. The writing on the wall seems to become clear when retail sales on the day before Christmas (their most important shopping day) are down by about 5%.
• European banks are parking more than Euros 346 billion on a daily basis with the ECB instead of lending. This figure is higher than the immediate aftermath of the collapse of Lehman Brothers. The only time this was higher was in early 2010, when they parked nearly Euros365 billion with the ECB. 
• The problems in the Banking sector are compounded by falling industrial production, rising unemployment and inability of policy makers to even outline a future course of action. Economic news coming out of the Europe and UK has been mostly negative. UK’s service sector has contracted for the second month in a row, making a recession inevitable. 
• As the European Banks were being blown out of the bond markets, the ECB was forced to step in with a burst of cheap financing in order to cushion the problems banks are likely to face over the next few months: ECB has offered ultra-cheap credit to the tune of US$645 billion on a three year loan at 1% to the banks. This is a gift to the banks as it would enable them to refinance a large part of their immediate requirements. 
• The above measure will postpone the problem rather than lead to a lasting solution. The measure essentially means that the problems in the banking sector are unlikely to be solved unless there is drastic action including large scale bailouts.
• These measures have however not been able to halt the rise in yield. After a brief respite Italian yields are again at nearly high of 7% - a level that is considered to be a danger level for the country. 
• Any decline in yields is possible only due to large scale buying from European Central Bank that has emerged as the sole buyer for bonds of stricken countries. It has already bought Euros 211 billion of bonds from the Euros 440 billion European Financial Stability Fund. These statistics are only increasing the panic as it means that unless urgent remedial action is taken, there is a fear that EFSF itself will run out of money. 
• Borrowing costs of most of the highly indebted countries has nearly doubled in the last one year, while revenues have been less than estimated, thereby making it clear that the problem is likely to get worse. This trend is likely to accentuate rather than the other way round. 
• France is about to witness a major deterioration of its fiscal health, though it is unlikely to require a bailout. But the manner in which borrowing costs for France are rising, make is unsustainable. 
• The problems in Europe are going to become worse as M1 money supply data indicates money is flowing out from the troubled Eurozone countries to those considered safe or to the USA. M1 has been collapsing in the trouble countries at annualised rates from 5% to about 8%. 
• The panic in the bond and currency markets seem to indicate that unless policy makers intervene, especially central banks, the situation could lead to a complete chaotic collapse by at least one or more countries.  
• Banks are stopping business with each other and are instead parking money with the central bank – mostly the US Federal Reserve. Foreign Deposits with the US Federal Reserve have nearly doubled to US$715 billion from about US$350 billion at the beginning of the year. 
• Instead of lending, banks are prefer to invest in US Treasury bonds – such investments have gone up from about US$1.1 trillion in 2008 to about US$1.70 trilllon in November. 
• The net result of risk aversion and capital flight is that he US Government is able to borrow at about 2% for up to 10 years – less than those levels reached during the Great Depression.

The impact of the problems in EU will be aggravated due to the magnitude of an attempt to cool down overheating economies in the Emerging markets.

China is especially susceptible to a slowdown.

• Nearly 60% China’s exports are geared towards USA and Eurozone. Since 2008, China has increased its credit growth along with a US$600 billion stimulus, effectively absorbed the impact of any slowdown in 2008.
• China has limited room to repeat this feat: Its bank credit to GDP is up from 100% to 130%. Its bank credit expanded at a compounded annual growth of 21.2% from 2005 to 2010. This has led to an inflationary spiral and rampant speculation in property markets. China is now trying to control inflation. This has forced it to curb credit growth. In Q3 total financing in China was down by 30% forcing businesses to borrow at rates that even exceeded 50% annually – clearly unsustainable. 
• Their M2 grew only by 12.9%, less than the targeted 16% - indicative of its own set of problems. 
• The rise in oil prices and rising wages (which jumped by about 22% last year) only make matters worse for the country which is mostly dependent on exports. 
• Falling property prices will only make matter worse for people, governments (which derive more than 40% of their income from property transactions) and the banks. Property prices are down in nearly 33 of the 70 largest cities.

India: Macroeconomic Shock Due?

The possibility of a macroeconomic shock seems to be causing sleepless nights to the government and after the 1991 collapse and the experience of 2008, the policy makers seem to be wiser. Little wonder that they have quickly opened a Currency swap with Japan (interestingly, US$ Swap rather than Yen) and the RBI and MoF have appointed a Special Monitoring Group to 'increase coordination between the RBI and MoF' to monitor the crisis. Wonder what they know that the public does not know?

• Historically, India’s problems are compounded during a slowdown. India too is facing problems related fiscal deficit and declining tax collections. The combined fiscal deficit of the Central Government and States’ is expected to cross 12%, a level that is considered to be unsustainable.
• It is clear that in the next financial year (2012-13), if India is able to attain 6% growth, it should be considered a good achievement in the present global context. 
• Policy measures are unlikely due to the election code of conduct in force. 
• Officials have pointed out that they expect tax collections to miss the target by at least Rs.40,000 from the budget estimates.
• Capital investments are down by about 45% in the last year, inflation and interest rates continue to be chokingly high. High oil prices have only made matters worse. 
• The liquidity crunch continues unabated with banks continuously borrowing Rs.1.4 to Rs.1.7 lakh crores from the RBI on a daily basis. 
• Advertising industry is the latest segment to be hit - its growth is currently expected to be in single figures. 
• Banking sector will continue to be deep trouble as it is hit by double whammy of increasing NPA and deterioration of margins. The problems for the banking sector are likely to remain unknown to the public eye as the banks lending to the Small and Medium enterprises and unlisted entities are not frequently disclosed. Hence while their asset quality deteriorates, investors will not know the problem until it is too late. It has been pointed out that banks’ lending to unlisted real estate ventures stands at Rs.1.1 lakh crores. 
• Add to this the problems that banks face in their nearly Rs.70,000 crore lending to the government utilities, which are not able to repay the loans. 
• The reason why this is likely to get worse rather than better is that there has been a steady deterioration in the corporate balance sheets. The interest coverage ratio of nearly 300 companies in the BSE 500 that have announced their results has declined from 8.42 in March 2011 to 4.48 in September 2011. In the case of Real Estate firms it has declined from 4.76 in December 2010 to 2.88 in September 2011. 
• Even the rise in sales has come at the cost of margins and by expanding credit. The debtor days has risen from 38.3 days a year ago to 41.1 by end of September 2011. 
• The problem of rising NPAs in the banks is likely to force the banks to slow their loan growth, thereby hurting corporate profits, with greater pressure on smaller companies. Corporate profits are likely to continue to fall for at least another 2-3 quarters. 
• The growing demand for funds from government and companies will lead to crowding out of the smaller player. The funds crunch will only increase over the next 2-3 quarters. Take for example the airline and power sector: together their liabilities (public and private sector crosses nearly Rs.2.5 lakh crores). Even if 5% of those become NPAs, banks will be in big trouble. 
• While the post-tax earnings of Nifty 50 are down by 2.7%, in the case of the Sensex it is down 2.1%. In the case of Nifty Midcap 50 the profits are down by nearly 20%. The EPS projection for the Sensex is down from 1492 in March 2011 to about Rs.1331 presently. Such downgrades are likely to pickup steam in the next few months. 
• Falling commodity prices would be beneficial to users but problematic to supplers. 
• A combination of these factors is likely to pressurise Industrial Production in the next few months.

Speculations for 2012: Remember Markets Never Move in Straight Lines

Economic forecasting is akin to speculation, little wonder that Economics is often referred to as dismal science. Attempting any analysis about nature of human economic behaviour is difficult not only because of the complexities involved but also due to the inability to understand human psychology. The fact that most of the time economic forecasts go horribly wrong does not reduce the increasing number of forecasters attempting their luck. Success is always ascribed to an individual’s brilliance while failure is ascribed to ‘black swan’ events. Since I have always claimed that my short-term forecasts are very often wrong, no claim is made being a successful forecaster. Instead, I have constantly made an attempt to capture important medium to long-term trends, which have often been right. This is in turn is largely because I have always attempted the present in the context of the larger socio-historical context. An attempt is made to highlight important trends for the New Year (2012).

The year 2011 is study in contrasts. In early 2011, most analysts were optimistic and a small minority (including Yours Truly) continued to be bearish. There is and will not be any change in my long-term bearish prognosis. At last, pessimism seems to have overtaken the herd, with some even suggesting that a break up of Eurozone as being imminent.  Before delving into possible trends for 2012, the past years mood is captured by the following photo. The next year should see yet another boom for this sort of business.

If the past four years are any indication, 2012 is unlikely to span out as most of the analysts expect. The prognosis for the demise or the reordering of the Eurozone is unlikely to occur – at least in 2012. It is pertinent to note that unless something dramatic is triggered, more as an unintended consequence rather than otherwise, Europe is likely to tumble in and out of a crisis in 2012, rather than collapse. This is because policy makers still have some amount of ammunition left, albeit a bit. While a meltdown in Europe is an extremely low probability event, an easily discernible trend is likely to be accentuated deleveraging of households, banks and even governments. The problem for the economy is that this is likely to occur at the same time, thereby aggravating the problems for the world economy.
A remarkable feature of 2012 is that this is probably going to one of those rare events in History where the impact of full blown, severe recession is unlikely to be buffered by counter-cyclical policy interventions.

If recent data emanating from the UK economy, Shipping industry and the results of Oracle Corporation may be construed as part of a broader trend, then it is clear that we are in the midst of a long-term secular contraction of the global economy. The only difference is that the globalised nature of the economy means that unlike in the past recessions, it may be contracting slower than normally expected. Importantly, each down move is accompanied by government interventions, which, in turn are reinforcing the supposed semblance of recovery that we see periodically. Illustrating the above contention by extrapolating data from UK, business services and finance (usually important advance indicators) have started to decline. Transport, storage and communications have plunged substantially. Shipping industry has pointed out with substantial exasperation that they do not foresee any recovery till at least 2013.

In an era of secular deleveraging, fixed income (non-EU region) will be the least risky investment space – a continuation of 2011 trend. The fact that in a number of countries, including EU, rates are likely to decline should help the fixed income space. Eurozone yields are likely to get worse, despite ECB reducing rates. I believe ECB will reduce the rates by another 50 basis points in the first quarter of 2012. Not that this will help, but they, like Alan Greenspan in the early 1990s and Ben Bernanke immediately after Lehman meltdown believe that one way they can help banks dig out of the hole is to help them earn larger spreads. One can only hope, they have understood the Japanese case of ‘balance sheet recession’, which is playing out on a larger scale with Governments, Banks and individuals facing the same feature – all at the same time. Avoiding EU debt may end up as a prudent move, unless yields shoot up to very attractive levels where they discount a vicious economic depression. Yields will rise in 2012, though it is unlikely they will rise to levels that may be attractive for a risky bet on the long side. The case of Italy is illustrative: despite aggressive bond buying by ECB, the yields continue to hover in the range of 6.75-7.50. it is likely that the EU zone countries as a whole, and not just the highly indebted ones, will face severe problems that will lead to a loss of investor confidence. The reason why the yields of Italy and other indebted EU countries are likely to get worse is that they are all likely to miss their austerity targets. Recession will lead to lower revenues and this in turn will lead to a ever-growing need for large scale future austerity and ever larger borrowing in order to bridge the budget gap. Large-scale sovereign defaults may not be likely in 2012, but a severe recession is likely to make defaults or rescheduling of debt a high probably event at the end of 2013 or 2014 (non Greek debt).

Europe: Light at the end of the Tunnel or Light at a dead end?
The major risks in 2012 are likely to emanate, in my opinion, from Euro zone and the Emerging markets. The problems in EU require some elucidation, even if it risks sounding like a broken record. The primary issue in 2012 will be that EU sovereigns need to raise about US$1.8 trillion while the banks need to raise another nearly US$800 billion. This excludes corporate debt that needs to be rolled over or repaid. A major portion of this falls due in the first six months. If this issue is resolved without hurting the economic prospects of the EU economy, the major issue that needs to resolved an orderly deleveraging and untying the Gordian knot in the EUs banking system which is estimated at Euro 23 trillion. This needs to be resolved at a precise time when the governments believe that fiscal austerity, exactly at a time when most countries are at the cusp of a recession or at best stagnation is the best way forward. In other words, the sheer magnitude of the problem of everybody deleveraging at the same time is terrifying – to put in mildly. This will have devastating consequences round the globe, especially in the Emerging markets. EU banks were the major funding agencies for the Eastern European Economies and Emerging Asia. UBS points out that the European banks have provided most of the credit in recent years – US$4.4 trillion out of the total US$5.5 trillion credit to emerging markets. EU bank deleveraging will invariably have a major impact on these countries. Others like Morgan Stanley estimates that the deleveraging could be about US$3.3 trillion spread over the next few years rather than by 2012. Apart from this, EU economy is a large consumer of various commodities: it consumes nearly 19% of the global copper produces and nearly one in six barrels of oil sold. Unfortunately, the growth in the emerging markets is highly correlated to commodity prices.

Growing problems in EU will invariably lead to an additional stimulus in various forms (quantitative easing). German resistance to full fledged QE may be overcome only after their elections in 2013; hence QE on the sly seems to be the way out in 2012. But, unless EU countries drastically reschedule their debt or preferably default on large components of their debt, the light at the end of the tunnel is likely to end up like this:

The markets will be euphoric at various points because of the mirage of recovery but as they realise that the reality is far from good, optimism that is likely to emerge in the middle may peter out by either the end of the year or in 2014. However, if there is full fledged quantitative easing by the World’s Central Banks, it may create a semblance of recovery for about 18-20 months, thereby providing a respite for countries – yet another wasted crisis.

An interesting aspect of 2011, is that the end of the year has seen renewed optimism about US economic recovery. However, the fact that most of the forecasters have been continuously wrong about the direction of the US economy for the past four years means that they have tempered their optimism and instead believe that US is the best amongst the worst when it comes to economic recovery. However, it is imperative that optimism about the US recovery needs to be tempered for the simple reason that the strength of the past two months is largely temporary. Consumers in a deleveraging cycle often slash their expenditure quite drastically. The occasional indulgence is likely, especially when there are large discounts or during their major festival times. More importantly, a large part of recent US economic recovery has been due to pick up in exports and capital flows on the back of weakness of the US dollar (till about October) and the need for inventory re-stocking just ahead of the important Christmas Shopping period. Capital flows may continue due to risk aversion but such capital is likely to flow into the bond market rather than the real economy. In 2012, export driven recovery is unlikely to beyond the first quarter. The weakness in the Euro and the rising strength of the US Dollar may be detrimental to US exports, unless there is another round of stimulus from the US Fed. Weakness in the Euro may help a marginal improvement in the economies of Eurozone, especially in the second half of the year.

Black Swans in 2012: Emerging Markets?
Conventional Wisdom believes that Emerging Markets are likely to emerge relatively less bruised from the EU crisis. It may be prudent to believe otherwise. On the contrary, I believe emerging markets will be surprise everyone to the downside in 2012. They are the Black Swans for 2012 The case of two major emerging markets (China and India) illustrates the problem at hand in the emerging markets. The manner in which 2012 spans out may have a lot to do with happens in Eurozone and the emerging markets, especially China.

China: A Plausible Japan in the Making?
China’s position is especially unenviable and, if their policy makers engineer a soft landing it should go down as an economic policy wonder. The present Chinese bubble ranks as one of the largest bubbles in the history of the human race. Over the past three decades Chinese have built an economic model that is completely dependent on exports and property construction, along with fixed investment by the State backed by liberal supply of subsidised cheap credit. The result has been that China has never seen an economic cycle in any industry segment at a time when they have excess supply and spare capacities. Investment accounts for 46% of the GDP and it has a savings rate of 54%.

The two fundamental pillars, on which Chinese economy rests, Exports and Property markets, are in deep trouble. Financial Times, London estimates that there are an estimated 80,000 property developers in the Country and they own enough land to build nearly 100 million apartments with capacity to satisfy housing demand for the next 20 years. Property construction accounts for nearly 13% of the GDP and more than one-fourth of all investment. At the height of the 2005 property bubble in USA the price of an average apartment peaked at 5.1 times average annual income and never crossed 6 times annual incomes. In China, it is now 8-10 times and in the pricey cities like Beijing and Shanghai it is close to 30 times. This boom in turn was financed by credit pumped in order to buffer the fall in the aftermath of Lehman meltdown. Credit supply increased by nearly 200% since 2008. Fitch points out that China needs ever larger doses of financing for its output: in 2007 one dollar of loans raised GDP by $0.77, by 2011 it had fallen to US$0.44. This occurred concurrent to a decline of consumption as a share of GDP from 48% in the late 1990s to the present 36%. China has now indicated that it would like to change its economic model to one that is based on internal consumption. Historically, that process takes decades. High indebtedness makes this attempted transformation more complicated and difficult, even for a country with huge foreign exchange reserves. It has been pointed out that local governments derive nearly 40% of their incomes from property and land related speculative activities.

2012 should be a particularly worrisome year for China. This worry arises because a large proportion of the financing by EU banks has gone into trade financing. The Chart below (from Financial Times, London) provides an overview of the nature of such funding against the total outstanding foreign bank claims in Asia and Latin America, the largest borrowers along with Central and Eastern Europe (CEE).

Deleveraging by banks has the potential to create tumult for China because it is likely to reduce trade credit, which in turn has an impact on goods exported by it.

This is not to claim that China is on the verge of a collapse. It is essentially argued that China has only marginal ability to provide stimulus, especially when compared to 2008. A severe recession is likely to erode China’s capital account surplus – a fact acknowledged by Chinese policy makers who are calling for a weaker Yuan in 2012. A slowdown in exports has the ability to create social unrest for China for the simple reason that slower exports are likely to wipe out innumerable smaller companies which in turn are likely to cause unrest amongst the nearly 200 million migrant workers.

India: Back to 1990s?
Amongst the BRICs countries, India is likely to be an economy that may end up being relatively more beaten than the rest in 2012. There are eerie similarities to the kind of economic issues that India faced in the period from 1995-1998. In the immediate aftermath of liberalization, there was a rush to raise money through Global Depository Receipts (GDRs). Most of this went into expanding capacities, speculating in the stock markets or speculating in Real Estate. The expansion drive of Indian companies was built of supposed consumption prowess of the India’s huge population. The initial burst of activity was fuelled in some measure with foreign investors rushing into India with their investment plans, in the hope that the Indian market was waiting to be exploited. The end result was that there were huge capacities built by assuming large quantities of debt. Overly enthusiastic foreign investors learnt the hard way that their Indian market was more complex than the spreadsheet driven plans envisaged. By the mid-1990s, highly leveraged Indian companies were more or less broken by the high cost of debt and it took them a long time to work through the period of excess. Déjà vu at the end of 2012? Though, a number of observers would be scandalized with such comparisons, a researcher would find many similarities. The claims of ever expanding demand to 2030 and the claim that “this time is different” with supposed dynamism of the country are the most commonly heard themes.

India has problems that are relatively well known: current account deficit that exceeds 3%, revenue deficit and a bloating fiscal deficit, which when combined with the State governments’ may exceed 12%. Last year, auction of spectrum saved the day, a luxury that is unlikely to recur for the next few years. The government has announced plans to dispose real estate assets, but if the plan succeeds it is likely to raise far less than expected for the simple reason that it will be selling assets in a falling market. The short fall in indirect tax collections is expected to exceed 10% of estimates (about Rs.40,000 crores, going by present trends). If the situation in Europe gets worse, it may revenue collections may exceed even that figure. Interestingly, the past two years has shown that any country with a current account deficit of more than 3% has run into trouble sooner than latter – France is the latest that is facing bond jitters. India has not balanced its budget most of the time. With revenues declining, it is unlikely to make matters better.

Corporate indebtedness and their inability to service their borrowing binge have now undermined the health of the banking sector. Till date, the banking sector was could overcome the crisis because of growing credit demand. Since NPAs are a calculated as a percentage of assets of the bank, as long as credit demand (and supply) continued to grow, the problem was never serious: it was easy to refinance and recycle existing debt, albeit at a higher cost. There are various estimates about the magnitude of indebtedness of the Indian corporate sector.

There are two important sources of stress for the Indian private sector that are likely to cast a shadow for at least 2-3 years. The sectors that are stressed are stated to have outstanding debts exceeding Rs.3 lakh crores (at least US$569 billion with INR-USD exchange rate taken as Rs.52). It has been pointed out that European banks have lent nearly US$159 billion out of the total foreign lender claims of US$289 billion. Even if 20% of these loans are not renewed, Indian companies will be in deep trouble. FCCB conversion is but one stress point. This pressure comes at a time when nearly US$137 billion of India’s total external debt is due to mature by end of June 2012 – most of the dues are in the private sector. In other words, if India, especially the Indian corporate sector can navigate the first two quarters, it should be considered a great achievement.

A decelerating world economy will be unmitigated disaster for India for a number of reasons, the primary of which are (a) India is a country that is deficit in capital, (b) Indian growth is highly correlated to commodity prices, (c) India’s largest trading partners are China, USA and Eurozone (all of which are in trouble). The confluence of the above factors with an over-leveraged economy, lack of ability on the part of the government to spend money on counter cyclical measures creates a potent mix of combustible material which could bring the Currency crashing down. All the conditions exist for a possible macro-economic shock in India: the missing piece of the jigsaw puzzle will fall into place if FIIs decides to sell another US$20 billion or if Oil prices shoot up. If that were to happen, it would the proverbial last straw on the camel’s back. If neither of these two negative events occur then India may close 2012 badly bruised but living to see another day. A crash in oil prices say to about US$60 level would provide the much needed succor.

Thus, 2012 may go down as the year of multiple low intensity crisis, rather than a Lehman type event. In other words, it will be a continuation of the Japan type downmove that we pointed out about two years back.

Ignorance is really bliss: Nature of Speculation in India’s Commodity Markets

Historically, India's speculative facets have often been missed despite the fact that they are extremely fascinating. The spread of computing and internet has facilitated and made speculation a preferred mode for small town speculators. Small towns, often without a bank branch, have trading terminal in which small time speculators try to gamble their way to riches, often with the opposite effect.

A recent advertisement issued by the Government, ostensibly to increase 'investor awareness' is very interesting. The advertisement in The Times of India (Hyderabad Edition, 18 December 2011, p.7), suggests that the government is intent on grappling with some of these important issues that plague stock and commodity trading in India – at least publicly. Luckily, policy makers do not seem to be intent on making the same mistake as Manmohan Singh, who disastrously statement in Parliament after the Harshad Mehta Scam, that he cannot lose sleep over such problems.

It is interesting to note that trading on the exchanges is reflective of the tendency on the part of participants to operate in the gray areas of the law or to indulge in outright illegal activities. The social acceptability of this illegality is itself an interesting phenomenon that is reflective of a broader malaise in the business environment. India is replete with business models that seem to be blissfully unaware of various provisions of the law. The complexities of the socio-economic environment make it relatively easy for such business models to flourish, especially in the backwaters beyond the major urban centres.

The advertisement itself raises very interesting issues as a form of tutorial for investors. A brief analysis of the issues raised by the advertisement is imperative as they reveal the nature of speculation in the different parts of India. A number of insights from interactions with market participants in Andhra Pradesh are fascinating and point to actual working that is opposite of what the government hopes and intends. That, the Union Government has decided to issue this advertisement is indicative that the issues raised are essentially prevalent in different parts of the country, albeit in different degrees.

1. Illegality of Trading outside the official exchange platform:
The ironic, though an unintended consequence of India’s liberalisation has been that it has led to the proliferation of illegal trading and business practices, including the existence of illegal stock exchanges. Illegal stock exchanges are not some shady underground centres of speculation that took place in the dark alleys of small town. On the contrary these illegal exchanges numbered nearly 22 in different towns of India and were often centres of speculation and the trading members were considered to be part of the social elite (). While technological growth has obviated the need for illegal stock exchanges, stringent regulatory norms, especially the KYC norms, are a sufficient justification for a number of people to work outside the regulatory ambit. The fact that unaccounted wealth needs to be hidden from the taxman increases this need.

A sane practice is that individuals or companies open accounts after submitting the necessary documentation to the broker or their sub-brokers, etc. A simpler way that speculators in the commodity markets prefer is to pool in their margin money with a broker in the form of cash and the broker opens an account in the name of a third party. The account holder may not even know that an account exists in his/her name and instead simply ‘lends’ his/her name: a classic old fashioned benami account! The broker serves as a literal intermediary and provides a business ‘opportunity’ to people who in normal circumstances may not even know each other. The broker trades in that account and speculators replenish the account with the required margin money. That solves the problems, at least for a short-span of time. The broker generates scarce trading volumes and hence revenues. A problem usually arises when the speculators start losing money, especially by trading on the advice of the broker.

2. Verifying broker credentials:
A well intended advice but, one that is rarely followed in India. Traders are keen on negotiating trading commissions rather than service and related issues – a classic case of penny-wise, pound foolish. The commissions charged are often a fraction of the profits/losses that occur. Since commodity trading is restricted to futures contracts, it means outsized, often leveraged bets. Small time speculators, who often trade blind and base their actions on the duration of the red/blue colours on the screen, will invariably tend to lose most of their capital. The more money they lose, the more they are convinced that larger bets and lower commissions would help forcing them to leverage ever greater sums until they finally go bankrupt.

3. Promises of Assured Returns:
The advertisement seems naive when it underscores the need for own research before investment decisions. In AP there are few long-term investors: there are mostly very short-term speculators and short-term speculators. Long-term is often a week. Making a quick buck is the primary objective of the entrepreneurial populace. What else who explain the ability pyramid schemes peddled as high return savings products? The long period of buoyancy has meant that those with excess capital believe that the era of perpetual buoyancy and high returns has just dawned.

A rather simplistic notion is that money is invested not only because people have an unnatural expectation of the returns possible, but also because they think that anybody can deliver 24% annualised returns. Interestingly, 24% returns per annum are often considered the justified rate of return – for a lender, the concept of dharmavaddi. Even a casual enquiry about expectations of returns among those people with investible cash quickly, draws attention to these high expectations. A frequently asked question for portfolio advisors is how much assured returns are they willing to ‘guarantee’. A visit to small town brokers suggests that they often ‘guarantee’ 24% or more. Interestingly, some of these assurances are based on written agreements. How the person with investible surplus hopes to enforce these agreements seems to be unknown even to those who invest the money. Brokers happily speculate on behalf of these clients and end up losing money – often through benami accounts. Once the investor loses money, there is little they can do as most this is undeclared money. This largely explains small towns in the coastal regions of Andhra Pradesh generating hundreds of crores of commodity volumes on a daily basis. The spread of broadband internet connectivity has only helped.

4. Keeping Verified records of all market transactions
That is clearly well intended but clearly a dangerous advice for speculators, especially those who deploy unaccounted money and trade on lending provided by a trading terminal operator. This leads to a peculiar feature of present day speculation: traders do not speculate with even a pie of their own money. Little wonder that we have the stampeding hordes.

5. I always pay by cheque from the designated account
This is probably one of the few rules that the regulators have been able to enforce, though there may be issues related to the exact entity or person who operates the account on a practical basis.

6. I trade within my investment and risk taking capacity
This is a rarity in India. There is a tendency among participants to leverage their futures trading bets. It is imperative to note that futures trading are inherently leveraged in nature. An example best illustrates the nature of trading. A speculator with about Rupees One Hundred Thousand in trading capital has the potential to purchase Rupees One Million worth of contracts in various commodity contracts. But, since mark-to-market requirement necessitates additional cash to be posted in case of price declines, trader is safe (provided they take the right directional call) only if their margin of safety is at about 30%. It is common for participants in India to purchase contracts to the maximum possible extent permissible: in the case of the above cited hypothetical participant, they would be eligible buy Rs.8 lakhs if not the full Rs.10 lakhs value of the contract. Hence, a 3-4% change in price is likely to trigger either sales or the need to post fresh collateral, forcing them to cough up money or liquidate their positions. The probability of a 3-4% move in the lifetime of a futures contract in the commodity market: Nearly 100%. A dominant trading strategy is to trade on ‘tips’ (rumours).

Thus, the probabilities are always stacked against India’s small town speculators. One must confess that Ignorance is, after all, bliss.

Microfinance: No Lessons Learnt from "Near Death Experience"

The remarkable aspect of the MFI crisis in AP is that, MFIs have clearly shown that they are not interested in changing their flawed business model. Instead, they have concentrated their energies on accusing the AP Government of high handedness. Ironically, we have a unique situation where the wrong doer has claimed that a belated attempted at regulation is actually wrong. MFIs seem to be more interested in blaming everybody, other than themselves, for their current predicament. To this day, MFIs do not like to admit that they have an unsustainable business model. An objective view of the issues in the crisis leads to the conclusion that either the MFIs suffer from either intellectual poverty or they were never interested in even nominally practising what they preached. Their business model seems to have been underscored by their belief that they business practices are essentially “harmless frauds” – something like pyramid schemes. Little wonder that SKS in the early days after Government action claimed that their battle was between those who were against free market.

A number of ridiculous arguments have been marshalled by MFIs in order to mobilise public opinion against the government attempts to regulate the sector. What is often missed by proponents of the MFI business is that this is probably the only segment of business in India that went unregulated for more than a decade. In a recent article, Industry claimed to have the following issues with the government action:

(a)    The Troubles in AP were politically motivated
(b)    Regulation were excessive and implying that the problems from the industry side were only minor indiscretions.
(c)    People were attacking the group based lending model.
(d)    Customers, especially the poorer borrowers are suffering.
(e)    The business was now more ‘responsible’ and it was promising good behaviour, thereby implying that the government should allow them to lapse back into their old behaviour.

The first three of the above claims require detailed analysis as the claims do not withstand objective scrutiny.

The MFI business has gone out of the way to point out that the crisis was politically motivated. Proof of that was the supposed statement by the opposition leader that people should stop repaying loans. What is important is that these pronouncements by the political parties started only after the government action, which was a consequence of suicides. It is imperative to note that the Microfinance business in AP was actively encouraged by the then CM (the present opposition leader).

The second claim is spurious at best. As this blog has pointed out in various instances, the regulations are long overdue – in fact, it is difficult to understand why the microfinance business was allowed to get away with activities. In 2005-06 nearly 30 people committed suicide and the MFIs promised good behaviour and a code of conduct, which was never implemented. Even to this day, MFIs do not follow the letter of the law - forget the spirit of the law. The MFIs continue to refute the claims that their business practices were illegal and unethical. They only talk of “alleged suicides” due to their practices. Ironically, a recent study commissioned by MFIN claims that nearly 45% of the reported suicides were due to MFI harassment. There is no doubt that the government should allow businesses to flourish, but a business cannot be allowed to flourish at the cost of the consumers and vice-versa.

A third claim is that the people have been attacking the concept of Group lending. Microfinance business was encouraged with the fond hope that it would create and expand existing social capital amongst members. Unfortunately, instead of that happening, the groups became instruments of coercion and a source of friction in rural society. There is no need for a government to subside a business that is detrimental to everyday social relations. The MFIs themselves live in denial, when they claim that they have received no subsidies. They seem to forget that Priority sector benefit is itself a great benefit, especially in a country where capital is a scarce commodity and formal sources for the supply of capital are scarce. The problem with the group lending practiced by the MFIs was that their business thrived on the an inducement of an ever larger loans backed by peer pressure as a vital tool for loan recovery. But unfortunately the clientele of MFIs is such that they end up guaranteeing peer loans that exceed their incomes many times over – apart from their own loans. That is a potent combination as default by one borrower in a group automatically destroys the financial health of the other borrowers.

Promises of good behaviour need not be trusted for the simple reason that they are bound to remain just that: promises. None of the MFIs, barring SKS, have bothered to change their business model. Instead their response has been shocking: they claim that they will spread to other parts of India and not in Andhra Pradesh. Such claims mean that there is no chance that the MFIs will ever learn their lessons. SKS was forced to change its business model because investors lost nearly 75% of their investment. The other MFIs are not listed, hence they can continue with their business model which is essentially a corporatized version of moneylending. 

Economic Slowdown and the Challenge of Protecting Savings

The RBI has deregulated the savings rates for those depositing money in the banks. This should be considered a welcome move by depositors. The issue of deregulating savings rates needs to be welcomed. The RBI’s attempt to regulate the banking sector should be commended, though much is desired in its ability to police the financial sector, especially its ability to implement its own orders. This is clearly visible in its ability to crack the whip when it comes to not-so-legal deposit collection by companies of doubtful veracity. Based on its own disastrous experience of regulating fly-by-night deposit seeking companies in the 1990s, the RBI should know that turning a blind eye could have devastating long-term consequences. The problem of vanishing savings is always felt during times of economic slowdown. During the early part of the 1990s, there was a rush to collect deposits taking advantage of the buoyant economy, as a consequence of capital inflows in the early phase of globalisation.

A cursory reading of RBI the Second Quarter Review (2011-12)  clearly points to the travails of the corporate sector. At the end of the First Quarter, corporate sectors sales were up 22.5%, but raw material costs were up 23% and Staff Costs up 27.7%, Interest payments were up 21.7% and profits up a paltry 6%. The Mid Quarter Review is due on 16th December 2011 and should indicate growing problems. Added to this is the deceleration in credit growth. In short, there is a liquidity crunch, which is likely to aggravate with problems in Europe. It has been pointed out that by 2014 EU banks (the largest lenders to emerging markets) are likely to deleverage to the tune of about US$2.5 trillion. While the Macroeconomic complexities have been pointed out a number of times, a major issue that has largely gone unnoticed is the likely problems we will have over the next few quarters. Tighter liquidity conditions usually mean that a number of small and medium businesses, especially those in the informal sector will face major difficulties in order to meet their daily working capital requirements. A number of fly-by-night companies with dubious business model collect deposits in a completely illegal but complex manner. Such companies vary from plantation companies to pyramid schemes. Invariably, these companies are the first to disappear taking with them millions of deposits, as in the period 1996-2005 in AP.

The present day scenario in rural and small town Andhra Pradesh is instructive of the problem at hand for the RBI. A number of companies, usually with a “Gold” suffix or a prefix collect deposits from middle and lower classes. These “deposits” are in reality complexly structured frauds in complete contravention of the law. They are often marketed as innocuous savings products for the poor and the lower classes. They tend to collect small amounts ranging from Rs.10 to Rs.50 per day with the promise of returning the amount collected after 2-3 years. They contract to sell the plot at Rs.7200 and agree to buy it back at Rs.8000 after two years. At times, they are essentially pyramid schemes marketed as savings products along with income generation opportunities for the poor (usually those classified as Below the Poverty Line by the Government). In one particular scheme (marketed to a 60 year old Below the poverty line pensioner in Kurnool district) they supposedly sold a piece of land (150 sq yards) which was immediately followed by a reverse sale agreement. Interestingly, the site is stated to be in a distant village in Khamman district - hundreds of miles from the present place of residence of the old lady. The "plot" sold to them has no details about the registered survey number, schedule of land, location, etc., indicating that this is probably a fictitious agreement. This complex agreement is necessary as the company is neither allowed to accept deposits by the RBI nor is it registered as a SEBI approved Collective Investment Scheme. In other words, the company is operating outside the law using the sale contract as the basis for its illegal activities.

The problem with such schemes is that, usually pyramid schemes is that they are first to flee once the easy liquidity conditions evaporate. This is because these schemes usually function like a Ponzi or money circulation scheme – new deposits are used to repay the old deposits, etc. Once they are unable to repay the deposits, they vanish. This is a segment that the RBI needs to regulate in order to avoid the unsavoury problems witnessed in the 1990s.

A Brief Respite Round the Corner in India?

Market contrarians tend to believe that it is always darkest before dawn. Historically, markets of various genre have bottomed at times where is maximum pessimism. While it is difficult to believe that the last word on the Eurozone crisis has been spoken, it may be profitable to look at what the chart patterns seem to indicate, at least in the short term. An overivew of some of the long-term chart patterns in the Indian equity market seems to indicate that there may be a phase of corrective upmove over the short-term. The nature of markets is such there is a plausibility that short-term trends may morph into significant uptrends over a period of time (remember the "Green Shoots" interview of Bernanke and its aftermath in 2009)!

An attempt is made to reproduce some of the long-term chart patterns that may have a significant bearing on the view that I have held for the last one month that the equity market is not as bearish as the bond market. This optimism may be a temporary phase, but it has a decent profits for people betting in a bounce. I would think that individual stocks may give a return of about 20% (from their October-November 2011) bottom before the next down move is triggered, as usual, by the lack of policy traction amongst the Eurozone policy makers.

Bank Index
A look at the CNX Bank Index (traded on the National Stock Exchange, India) seems to indicate that the banks are due for a short to medium term bounce. This could be due to plausible monetary loosening over the short-term. While the Kagi Chart on a price basis has made new lows, the Relative Strength Index (lower pane) has been making higher lows: a text book case of positive divergence, a bullish sign. The fac that it has crossed an important trend line from its 2009 lows is sufficient reason to be slightly more optimistic about the next 1-2 months.  

BEML 
The other very interesing chart pattern is one of Bharat Earth Movers Limited (BEML) a public sector infrastrucutre equipment manufacturer. It is clear that infrastrucutre sector is in deep trouble due to high leverage and the problems in raising cheap financing. As a natural corollary, it is natural to expect the manfucturers to suffer quite heavily. BEML has been mauled by the bears over the past year. But interestingly, it looks like the stock can survive the carnage as it has taken support on a very long-term trendline. Once again, the positive divergence seems to be extraordinarly exceptional.

That is interesting as signs that the infrastrucutre manufacturers are stabilising may be a harbinger of better news for the infrastrucutre stocks. Once again the good news may be in the form of a decline in interest rates or monetary policy easing. It could also be because the stock has been so badly beaten down that investors now consider them to be at attractive valuations.

Only time will tell which side is correct.

ABAN OFFSHORE
Personally, I find this to be one of the most interesting stocks at the present juncture for a number of reasons. If there is a credit crunch, this stock should be on the verge of bankruptcy. The simple reason being that it has debt of nearly Rs.13,000 crores (nearly US$2.5 billion dollars). That kind of debt is difficult to service even for a sovereign. The reason why the stock is interesting is due to the fact that the positive divergence is remarkable. One could only speculate on the causes for such buying, but nevertheless it is imperative for investors to keep a close track on the stock.

The reason why we have cited individual indices and stocks is because at times, they may exhibit some early signs of investor interest. The fact that Banking, Infrastructure equipment manufacturers and even highly leveraged companies in the resource sector drawing investor attention should be sufficient reason to be careful and reason to be agile when investing. 

It is pertinent to note that as I have constantly emphasised, I continue to be extremely pessimistic about the macroeconomic outlook for the global economy. I do not think that we will witness a roaring bull market on the back of a bouyant economy for a very long time. But, if we have another round of Quantitative Easing then there is no reason why we should not have another sharp rally. The larger the size of the easing, the larger the short-term rally. 

There is however, one catch: Positive divergences are rare patterns that take long time to build. Due to the time that they take to develop, they are considered to be important patterns in technical analysis. Any failure of the patterns would be disastrous and is often associated with new lows. Hence, there is need for prudent investment strategies based on an individual's risk profile. 

NOTE: As a matter of policy, we do not issue any buy/sell recommendations. The above charts have been provided in order to make a larger point.

Lack of Intellecutal Rigour Aggravates the Crisis

The present crisis has global policy makers running in circles over possible solutions. The nature of the Dismal Science (Economics) is that there are usually more opinions than the people debating the issues. The remarkable aspect of the present crisis is that the solutions offered seem to be insufficient for the present problems. There are two major problems that the global economy needs to grapple with are, (1) deleveraging from the high levels of debt, and (2) reinvigorating demand.

The first issue, especially the problems related to sovereign debt, seems to have assumed centrality and the other issue(s) have been brushed to the background. It is imperative to note that the first issue can be solved only if the second problem is overcome. But the present intellectual framework has completely failed in dealing with the issue of reinvigorating demand. The first two years (2008-09) was the only time when policy makers seem to have attempted to seriously grapple with the issue of declining demand and attempted to increase the faltering demand. Over the last two years, they seem to have given up on the task. Instead, the mistaken belief seem to have been that if the banks could be ‘induced’ to lend money to consumers, that would magically solve the problems of reigniting consumer demand. The banks were provided various incentives and low cost capital – all of which they gratuitously accepted but decided to invest in government debt, thereby creating a remarkable circularity. This is clearly reflected in the falling bond yields the world over.

The stimulus measures were well intended but wrongly conceived. The net result is that it has accentuated the present crisis for the sovereign nations. Bailing out banks without corresponding assurances and guidelines for good behaviour will go down as the single most important mistake during the course of the present crisis. Instead, policy makers seem to believe that if interest rates are retained at sufficiently low levels, especially when there is a credit shortage, it would facilitate the banks to ‘earn their way out of the hole’ by lending more thereby making larger profits from high spreads. This mistaken belief is reinforced the successful example of the early 1990s when Greenspan (interest rates dropped to about 3%) attempted this with success. Unfortunately, the difference between the two periods could not have been more different: the early 1990s was the start of a multiyear boom exiting out of years of stagnation and an era of high interest rates. A natural corollary of this is the belief that increasing the supply of money accompanied by low interest rates will serve as a trigger to solve the present problem. Though, increasing the supply of money may be a better alternative to inaction during debt deflations, especially when there is a ‘balance sheet’ recession. This is because monetary policy induced measures are premised on the assumption that there will always be an ever increasing number of willing borrowers in the private sector.

The deficiency of the present intellectual framework is largely responsible for this blunder. University Departments, Businesses and think tanks encourage borrowing money, especially when interest rates are low. The mistaken logic is reinforced by the assumption that demand will remain constant forever. Companies and individuals continuously make the same mistake as they assume that the current well being witnessed during periods of economic buoyancy will continue forever. The longer the period of economic buoyancy, the more the attraction of this view. That view would have worked but for two major problems: high levels of present debt and, the attendant onset of debt deflation. In such times, profit maximisation is not the main motive for the private sector, rather it is the survival as falling asset prices over a period of time gradually erode the networth. This happened during the Great Depression and then again in Japan. The case of Japan shows us that debt deflations are more dangerous than inflationary spirals. Japan is an excellent case of an economy afflicted by prolonged debt deflation. Over the past two decades Japan has lost the equivalent of nearly three years of GDP due to falling land and stock prices since 1990. During a deleveraging cycle, no amount of increase in money supply or a decline in interest rates convince a borrower to assume more debt. The problems created by high existing debts are invariably aggravated by increasing job losses, general decline in demand and an overall decline in networth.

Hence it is time policy makers seriously consider measures that put money (non-debt surplus) in the pockets of households and businesses. Though in the initial years, it will invariably be used to pay down debt, over the long-term it will lay the foundation for a strong recovery.

Possible Outcomes of Eurozone's Problems

Scenario I 

(Probability for this scenario from 2012-2013: 20-30%)
The first scenario is essentially a continuation of the present farces that we witness everyday in the Eurozone: Bond yields jump frequently, banks continue to face problems, EU leaders convene an ‘emergency summit’, the popular press is keenly awaiting the final word, after the photo opportunity there is a official statement drawing attention to the need for drastic action and promises of quick action. Bond yields fall slightly, then a German leader says cries halt to the circus and takes us back to square one. In the interregnum, ECB decides that they have to buy bonds of indebted countries – and the circus continues. The most recent evidence of this is the admission that the Eurozone’s bailout fund will be only half as big as originally announced: Euros 625 billion instead of the Euros 1.2 trillion.

Our Scenario I essentially extends the present trend where the world moves in circles, though each time running faster but ending up in the same place.  It contends that the Crisis bleeds Europe gradually, leads to a decline over a period of time. At least one country, if not more, are forced to exit the Euro by 2012-13. This triggers a major Crisis leading to claims and counter-claims and growing counter party risk. EU politicians are predictable breed: they only act when forced. But, it will be a classic case of too little, too late, with costs escalating exponentially. But over the long-term, this scenario will eventually end up inaugurating a generational change, namely, the decline of Germany. If one or more indebted country decides to exit the Euro it will be nothing short of a disaster. UBS has estimated that in the first year, the cost of break up will amount to least 50% of the Eurozone GDP in the first year, in addition to the endless litigation and the attendant dislocation. A natural corollary of this will be a long-term sharp rise in the Euro, leading to an export oriented Germany going into terminal decline.

Any sign of this scenario playing out in Europe beyond the next four months will mean that it would safe for investors to factor in a lost decade for Europe and the World Economy into their calculations. This is because of the nature of the present crisis (that started in 2008). It has (except for the six months immediately after Lehman collapse) gradually embraced various sections – at a crawl speed rather than in the past when the consequences were transmitted more quickly. This could be because of the nature of globalisation where the broader market has increased. But the gradual destruction of the ability of people to consume is clearly discernible – incomes are declining, disparities are increasing and the last nail in the coffin is increasing unemployment, falling wages and falling asset prices. Since the crisis started in USA, the comparison is easier: US Federal Reserve statistics point out that the income of American household is only about 1% more than what it was in 1989. The gradual decline in household netwroth is far worse than in the 1970s period: Household networht has fallen by more than 20% compared just 2.4% fall during the 1970s. Europe unfortunately is at the cusp of such a structural decline over the next few years. UK’s Chancellor of Exchequer’s candid observation indicates as much.

Scenario II
(Probability of this happening in 2012-13: 70%)
As the crisis bleeds European and the Global Economy, with politicians dithering on biting the bullet, one scenario that we can conjure up is that the Central Banks themselves step into the vacuum and once again start intervention. The legacy of Lehman Brothers bankruptcy is that policy makers now have reliable evidence of the magnitude of the problem and hence are more amenable to take immediate action. As the bond markets lunge to the downside with each failed summit, the central banks will be forced to intervene as continuous trouble is detrimental to the real economy due to the inter-linkages between credit and real economic needs. As bond yields go up, and due to the increasingly garrulous nature of the ECB board, it may be left to other central banks to simply start buying bonds of afflicted Eurozone countries. ECB is perpetually shooting itself in the foot due to the obstinate German resistance. The country which has the wherewithal to buy unlimited quantities of bonds is the US Federal Reserve and the Bank of Japan. A helping hand by the Chinese may help, but unfortunately the Chinese always drive a hard bargain so are unlikely to rush into any bail out.

There is an increasing likelihood that the US Fed may be about to undertake such a measure for the simple reason that the US and EU financial markets are too interconnected to remain insulated from any crisis for long. The extraordinary speed with which US Fed moved to enter into currency swaps, innocently stated to be ameliorate the growing shortage of dollars, may be the first of many such steps in this direction. The Foreign Currency swaps announced on 30th November are valid till 1st February 2013. Technically, the ECB and US Fed could enter into such contracts, which would be perfectly legal and something out of the purview of the acrimonious politicians. One could easily assume that the Euros supposedly owed by the ECB to the US Fed could be used to buy European bonds. That would serve multiple purposes: (a) it would be printing money without raising the objections of the German politicians, (b) it could be the ‘nuclear’ option that investors are demanding, (c) it would cause widespread short-term losses to speculators who have been betting against the indebted countries and importantly, (e) it could re-inject very short term liquidity into the European banking system.

However, the above assumptions are prone to various practical difficulties. The most important is that it would have to overcome German resistance in the Central Bank. ECB would have to ‘sterilise’ new dollar flows and what sort of impact such huge dollar inflows have on the local economies may be politically unpalatable.

The above scenario will not cure Europe of its ills. Rather, it will provide breathing space to the beleaguered governments of Southern Europe to introduce reforms. Therein, lies the long-term problem. It is pertinent to note that these reforms will not work as they are dependent on introducing austerity measures at a time when the whole world is about to undertake such an exercise. That would only increase the deflationary pressures. At best such a scenario will provide a respite for about 18-24 months after which the crisis will hit the world with greater intensity. However, in the interregnum, the complacency that the measures will create will be lead to greater problems.

Complacency that government policy interventions are easily discernible in India: each set of intervention leads to a temporary respite, which creates a semblance of normality as new debt if often used to recycle old loans, without actually solving the problems. This in turn convinces individuals and businesses that such a cycle will continue for ever. Businesses also have a wrong notion that markets (and asset prices) always move up in the long-term. Hence, they are witness, first hand to their increase the notional value of the assets they purchased during a down tick in the prices. This, peer pressure and short-term notional rise in asset values reinforces the wrong notion that it is best to buy during such temporary market panics. That notion is often right when there are ‘structural bull markets interlaced with cyclical bear markets’ (as in the past: 1991-2007 in the west and 2001 to 2011 in India). Unfortunately, the people who lose the most are those who continue with this strategy during structural bear markets interlaced cyclical bull markets. The net result is that each down move leads to greater indebtedness, exactly at a time when they should have repaid their debts. Indian corporate history is replete with such examples: prudent businesses that did not rush into any expansion till 2009-10 (if at all they were not carried away by the Bullish prognosis for emerging markets for the next 100 years) decided that they would lose out a golden opportunity to expand their business and decided that they would miss a lifetime opportunity, if they did not expand. The solution was to borrow money, if necessary from foreign lenders (indexed in dollars at a time when the Rupee was trading at 42-44 per USD). They forgot only one minor aspect: nobody told them that the list in the countries that comprised the ‘emerging markets’ saw only one deletion in the last 60 years – Japan. Otherwise the same set of countries have been ‘emerging’ for a long time and there are particularly good reasons why they will always be emerging markets). The net result is a replay of the breakneck expansion mania in the 1994-97 and the resultant overcapacity.

Déjà Vu all over again!!!

Scenario III:
(Probability of this happening from 2012-2020: less than 2%)
The scenario which I would personally like to advocate but am discreet as it is considered to be an insane option. Most of the indebte European Countries are likely to default on their debts in the next few years – though the exact form and nature of default is likely to vary. I have long-held (since at least late 2009) that the world is about to become a mirror image of Japan. Deflation has been rarely witnessed in the past few decades, but the problem with deflation is that once it takes hold, they often last longer than periods of high inflation. The history of 18th and 19th century attests to this fact. The nature of the present global economic structure is such that, once deflation encompasses all regions, it will take decades to overcome it.

Hence, instead of prolonging the pain for the next few years, simply write off the debts on a biblical scale in the next two years. Where necessary provide succour in the form of rescheduling loans and in the case of Individual borrowers simply write off the loans.

Presto! USA, EU and starts on a clean slate!!!

Americans, Greeks, Spanish and the dumber lot can go back to their consumption driven models while, the Germans, the Chinese and remaining of the stingy lot can go back to their savings habits. Easy solution?

The only catch is that the bond markets in their current form will be paralysed for the next 10 years – at least.