Deja Vu: Second Phase of the Global Credit Crunch has started

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 seems 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.

It is commonly believed that Governments' may have realised the magnitude of the issues and are very keen on solving the problem. Unfortunately, we have this picture over the past three years. They have kicked the can for a long time and we may not have the luxury of doing it again, except for the very short-term. An attempt has been made to summarise some of the major issues. The data is essentially compiled from different sources. It is imperative to note that none of the issues are a bolt from the blue - just that policy makers have ignored them for so long, and they do not have the luxury of doing that again. It would be erroneous to believe that any country is safe. Each country has its own set of problems.

• Europe is the epicentre of the problems of the world. The bond markets there seem to indicate that the problems are not about to be solved and it is likely that Italy and Spain will need some form of bailout during 2012-13. End of elections in Spain have forced the attention on the country with bond yield jumping sharply. 
• A major constraint factor on the economy is that European Governments need to  refinance nearly Euro800 billion of debt in 2012 (excluding Ireland, Greece and Portugal).
• European Banks themselves have a problem as they need to raise (or sell assets to the tune of nearly US$2.5 trillion in order to meet their Tier I Basel Capital Requirements.
• 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 197 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. 
• 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. A downgrading of French Credit Rating (a matter of time) will reduce the lending capacity of the EFSF by nearly 35%. Imagine what would happen if Germany is downgraded. 
• 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.
• 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.
• Credit market may be about to freeze or become dysfunctional: 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$1.69 trilllon in October. The US Government is able to borrow at less than 2% for upto 10 years – less than those levels reached during the Great Depression. 
• European banks are parking more than Euros 225 billion on a daily basis with the ECB instead of lending – an event seen only twice: (a) in the immediate aftermath of the collapse of Lehman and, (b) at the start of the Greek crisis – in both cases it was because banks were worried about a uncertain future.
• 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. 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.

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 is in a particularly problematic position: 

• It runs a current account deficit, and iscal deficit and declining tax collections may in the worst case lead to a revenue deficit.
• 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 global headwinds and other problems are likely to last at least till the end of March 2012, if not beyond.
• 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.
• 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.
• The liability of the Airline sector to all its suppliers including banks is about Rs.80,000 crores of which Rs.40,000 is owed by Indian and the rest by the private sector airline companies. 
• 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. 
• A combination of these factors is likely to pressurise Industrial Production in the next few months.

What needs to be done? 

• The exponential growth in volatility over the next few months will be the worst enemy for companies and governments.
• There is an urgent need for Government’s to take up coordinated intervention in the bond markets in order to stem the rot. Unlimited bond buying could be a very short term solution, but a good starting point.
• The longer they delay this, due to political opposition, the greater the cost to the real and financial sector at later date. The EU will need to provide immediate stimulus that ranges from Euros 1-2 trillion at least over the next year if they are to buy more time. 
• This could be accompanied by a slow move towards greater fiscal consolidation by building a framework for issuing Eurobonds by a central authority. 
• If these short-and medium term measures are not taken up, invaribly the crisis will drag on and that in turn will lead to a self-fulfilling downward spiral which could even culminate in the collapse in the Euro system.

A Year After the Crisis: Have the MFIs learnt their Lessons?

Once year since the AP Government intervention on behalf of the borrowers' after a number of suicides through its law, AP Microfinance Institutions (Regulation of Money Lending) Bill, 2010, may be a good time to review the MFI sector. In normal circumstances, a problem of such magnitude should have force a number of government agencies to rush in with various offers to remedy the situation. On the contrary, the solutions offered by various government departments, other than the AP government, leaves much to be desired. While, the RBI has incorporated certain issues raised by the AP government in its orders, it unfortunately, comes through as an agency that seems to be more sympathetic to the lenders than the borrowers. The companies on the other hand are unabashedly incorrigible. The Solutions offered by the Central Government deserve the cake for completely missing the woods for the trees, which seems shocking considering that the Ministry of Finance, Government of India, never seems to miss an opportunity to show case its emphasis on financial inclusion. This is not to claim that its financial inclusion initiatives are unwelcome. On the contrary, it should seriously consider other vehicles that can expand financial inclusion and dispel its notion that MFIs are integral part of any financial inclusion programme.

One would have hoped that any review of the business dynamics of the Microfinance sector in the aftermath of the AP government legislation, would have led to important changes in the underlying business model. Unfortunately, any such hopes quickly fade away. Any review of the MFI business model may be long overdue as the entrenched claim made by all MFIs against the AP government is that (a) Investments into the sector has dried up, (b) it has stopped lending to the poor,and (c) The companies may default on the loans to banks.

MFIs never seem to lose an opportunity to point out that they are suffering financial losses due to the State Government action. The peculiar logic runs against the nature of government policies: they are reactive rather than proactive. Hence, if the AP Government cracked the whip it is because there was a recurring problem, and not the other way round. It is imprudent to believe that a business will never lose money, rather most of the businesses do lose money most of the time. History of Capitalism is replete with such example. Unfortunately, in India, we do not seem to have accepted the fact that companies or even countries can go bankrupt for a variety of reasons. Little wonder that in India, everybody from Airlines to imprudent lenders pestering the government for bailouts.

A constantly harped claim is that MFI sector was able to attract substantial private investor capital, especially in the form of equity over the past three years. It has been pointed out that Until 2010, the amount of money invested by private equity groups  in the sector was close to Rs.2,500 crores (approximately US$500 million) while in the last one year this declined to Rs.280 crores, out which about Rs.135 crores was invested in one Kolkata based MFI ("Lords of Poverty Struggle to Survive", Business Standard, Hyderabad Edition, 16 November 2011, p.13).

The second claim, about the chocking of credit supply to the poor, is of doubtful veracity. It is imperative to understand that the supposed credit requirements (just before the AP Government intervention) was based on a imprudent business practices that thrived on expanding the supply of credit backed by the use of coercive recovery practices. These claims are made on the basis of estimates provided by interested parties. There are few studies by independent agencies sources (who do not have a direct or indirect interest in the issue).

MFIs and their cheer groups constantly, claim that the problem has been exaggerated by the media - a standard, but weak defence. One recent study funded by MFIs claimed that "only" about half of the "alleged" suicides are related to MFI harassment. One wonders, how many people should die before wrong doing is accepted and there is a genuine change of heart. Five years of pushing credit (albeit high cost) to sections of the people who in the past lived amidst credit scarcity or had access to easy credit does not improve the end-use of the borrowed money. On the contrary, it bred culture of unsustainable subprime consumption - though on a localised scale. Problematically, MFIs are unable to cite any credible independent studies that have assessed the credit gap. One figure that is often cited is a supposed NABARD study that estimates the credit gap in Andhra Pradesh after the 2010 Act at Rs.4000 crores. While it may be inappropriate to comment on these figures without understanding the assumptions on which these estimates have been arrived at, it would be very interesting to see the basis on which these figures were computed. Hopefully it something different from a one-third estimation of the MFI lending in AP before the crisis. Undoubtedly, this figure will vary as one would have to deduct the cost of saving on the high interest because people are not repaying the loan. Unlike the case of SHGs, the profits from lending by MFI do not accrue to the members and is instead channelised to stakeholders outside the community. The fact that only a small component (maximum of about 20%) was used for income generation activities may mean that the figures may not be as high as NABARD seems to estimate.

It is a mistake to believe that MFIs had replaced the rural private moneylender. On the contrary, they became another source of credit, albeit a high cost, corporate version which unlike the local moneylender is completely inflexible. Moneylending has existed for thousands of years and is likely to exist long after the MFIs are gone.

The third issue that the MFIs raise is that they are likely to default on bank loans if they are not allowed to go back to their old ways. That is a completely unacceptable logic that should be discouraged as it would force the government into a bailout spiral. One reason why this should not be acceptable to the banks and other regulatory agencies, is that it would necessitate accepting MFI logic that they should be allowed to carry on their business even when it is socially detrimental. More importantly, to allow a business that has not changed its business model despite glaring deficiencies is to court a larger disaster in the near future. MFI business model is based on pushing credit and marketing standardised products without due diligence in places where the exact opposite are required. An example best illustrates their faulty business model: They fund the purchase of a Cow but insure the life of the borrower and not the animal. So if a cow dies, the household loses its livelihood and sinks deeps into the quagmire of debt. The MFIs offer two options: (a) recycle their loan, or (b) kill yourself so that they get the insurance. This business model has not changed. They have exited AP, but continue to follow this model. If they continue with the same business model it is likely that the crisis will come back to haunt the banks in a different version over the next few years. In the long-term, such a faulty model will become a powerful impediment to financial inclusion. The banks themselves need to understand that since they essentially bankrolled the MFI growth in AP, it may be more prudent for the banks to lend directly to the poor, through their business correspondents rather than promote and solidify a powerful rent-seeking intermediary. In a twisted manner, the AP crisis may actually be a great opportunity for the banks to build alternative credit delivery mechanism using the SHGs and their own Business Correspondents. If banks learn their lesson from the history of the microfinance business in AP, this is probably one crisis that would not have been wasted - despite the high cost for the banks and for the victims.

A field visit to many parts of AP indicates that the MFI continue to flout even RBI norms when it comes to collecting their dues. One such example is to demanding collateral for loans. Flouting many sections of the AP law are a common occurrence on a everyday basis.

Are Indians Ready to Navigate a Credit Crunch

The past few months raise important questions about not only the Indian economy but also the ability of Indians to grapple with the problems that are likely to take the centre stage in the next few years. It is another matter that the Indian, especially the more vocal elite and the middle classes would raise a hue-and-cry about the lack of responsiveness on the part of the government and the media will be full of hardships that the 'masses' are facing. Since the Indian media's perspective of the "suffering masses" often does not go beyond the middle class neighbourhoods, the whole issue may itself be important for a number of other reasons. IMF chief has already warned of a growing of "Japanisation": she was more polite and called it 'lost decade'. A large number of Indians seem to think that the government will continue to support them. Unfortunately the do not seem to understand that the present nature of financialisation simply a perfectly solvent government could in a short span of time become the equivalent of a sub-prime borrower.

First, the contesting claims for a discreet bail out from our corporates will gain greater centrality. Obviously, our businesses' are adept at incessantly harping on their 'developmental' role which will be stated to be in danger.  The need for a bailout in the form of soft loans from public sector is considered to be important as they understand that the middle class sensibility is bound to be hurt if the term bail out is directly used. This needs to be seen in the context that a large section of Indian businesses and the middle classes claim that they are against subsidies. One of the compulsive logic when liberalisation started was that subsidies should not be given by a fiscally stressed government. This is now conveniently forgotten as businesses realise that surviving without government largess. As the Eurozone crisis that run concurrently to attempts to fight inflation begin to bite, capital will get more scare even in countries like India. Attempts by RBI to reduce the CRR may take longer than commonly expected. There is a possibility that food inflation will reduce for a few months, before its starts rising in the summer months. It is likely to reduce structurally only from about 2013 as more storage capacities become more operational.

There are a number of other issues including the problem related to repaying nearly Rs.70,000 crores of FCCB loans taken by the corporate sector in the next two years. That should emerge as a perennial reason for greater demand for fund. To this one may add the rush by Indian companies to expand their capacities - which to me is reminiscent of the mid 1990s when Indian companies borrowed money through the GDR market to expand capacities. Then, as now, the only reason to expand was a unreasonable expectation that Indian's will keep increasing their consumption.  Government borrowings should continue to be a source pressure on the banking system. This apart, as with any slowdown, there will be rise in NPAs for the banks, forcing them to conserve capital. Since at least 2004, banks NPAs have declined for the simple reason that NPAs are always calculated as a percentage of credit disbursal - which till now has been growing. We may not be so lucky in the near future, thereby exposing the problems in the banking system. This is not to claim that the Indian banks are insolvent. They are unlikely to be insolvent as long as the Indian government is solvent because nearly 25% of their Statutory Liquidity requirements are invested in Indian bonds. At its worst, it will lead to liquidity issues for the banks, corporates and maybe the government. Foreign loans are out of the question as the European banks which had in the past few years lent nearly Euros 3 trillion are on the verge of inaugurating a multi-year process of contracting their balance sheet by an estimated Euros 7 trillion. The above as well as other macro factors will invariably make their impact fully felt. But, there are other important issues that have often gone unnoticed. Indians have never been so badly prepared for possible years of turmoil. There is a remarkable degree of complacency that "this time is different" for India. An example that is cited is that the downturn after the collapse of Lehman Brothers and the sharp recovery. Fond hopes of such a recovery pervade through all levels. Either ignorance is indeed bliss or they do not seem to realise that instantaneous death is always better than death from asphyxiation. The curse of Lehman Bros Inc., is that it will be the latter rather than the former.

A specific problem is that a large section of Indians who can afford to assume debt are nearly fully leveraged. Businesses have cleverly masked their leveraged through various means, but individuals have not been so smart. A large portion of their surplus has been invested in real estate or houses: good from a multi-decade perspective, but housing is always a highly leveraged investment. The benefits accrue only to those who live in it and capital gains realised from that asset may take years, if not generations. The lack of liquidity in such assets only makes things worse.

A more pertinent issue that one faces, especially in the smaller towns and villages is that the search for higher yield has forced a large majority to save with people of doubtful integrity, if not outright crooks. At times, such savings is also because of the institutional deficiency that exists with the banks ignoring the villages. There are innumerable instances where the poor (and middle classes) have saved money in the form of either chits (ROSCAs) or "deposits" with shady plantation companies or "saved" money in pyramid schemes. Luckily in some parts of the country (like Andhra Pradesh) the police have frowned on pyramid schemes but seem to have missed deposit taking by plantation companies. As credit supply tightens, these will be dissolve with the hard-earned savings of the people, thereby aggravating the problems of an over-leveraged section with few social security nets. These are issues that policy makers seem to have ignored - at least till now.

Brinkmanship Takes the World to the Brink

 3-4 November 2011

The last time one week made a critical difference to the future of the global economy was in September 2008 – in the immediate aftermath of Lehman Brothers’ filing for bankruptcy. The euphoria that greeted a half-baked agreement last week is on the verge of dissolving. One week after the literal early morning announcement that Greek will be bailed out, fast paced events put the world back in square one. EU political circus is clearly indicative of the constraints of effective decision making, unequal to the present challenges. A seemingly brilliant political move by the Greece’s President, to call for a referendum may have saved his political career but was likely to threaten the fast fading facade of normalcy in the world economy. EU nations seem to have successfully arm-twisted Greece to accept the conditions laid down by them to receive bailout funds. This seems to have succeeded – at least for now, with the Greek President withdrawing his offer for a referendum. Greece seems to have been browbeaten in the last two days to either fulfil the conditions laid down by last week’s Brussels EU summit or leave the Euro zone. While Greece is blamed for the present mess, it is imperative to note that the brief respite provided by unprecedented government intervention in the aftermath of Lehman’s collapse was largely wasted by policy makers.

A peek into recent history suggests, that fear started subsiding from early March 2009 with a public relations campaign inaugurated by the Chairman of the US Federal Reserve. The huge stimulus, estimated at more than US$10 trillion by different government’s created a semblance of normality as the easy money conditions transmitted through different sections of the economy. Easy money cannot solve the problem of indebtedness and lack of demand, which in the past was based on unsustainable assumption of ever larger quantities of debt. Interestingly, none of the problems that afflict the world economy are new. They have been the same set of issues that the world has grappled with, albeit piecemeal, since 2008. Hence, the need for a long essay on the issues may not be in order. Suffice to say that these will be the same set of issues that the world will have to grapple with for at least the next 7 years, if not a decade.

The statement(s) by the US Fed and Bernanke should be a cause for grave concern, though the headline grabbing equity markets seem to be ignoring the ominous indications for now. The bond markets, usually more accurate, are less optimistic: US 10 year yields are back below 2% (they closed at 1.93% on 2nd November). The Fed has revised downwards its June projections for the US economy – its old estimates for 2011 estimates are the new forecasts for 2012. If the Fed could have so badly (wrongly) estimated the growth, then it does little to help their credibility. It now claims that US GDP will rise by 1.6% to 1.7% in 2011 against its June forecast of 2.5 -2.7%. The 2012 GDP growth has been placed at 2.5 to 2.9% and 2013 GDP growth is estimated at 3% to 3.5% while 2014 estimates it to be 3.5% to 4.2%. The unemployment rate is forecast between 9% and 9.1% this year, between 8.5% and 8.7% in 2012, between 7.8% and 8.2% in 2013 and between 6.8% and 7.7% in 2014. Rest assured these estimates are unlikely to materialise as Fed is likely to have underestimated the problem again.

The Fed Chairman has clearly stated that additional stimulus is ‘on the table’. Market expectations now believe it is due in first quarter of 2012. Another view argues that unless there is a dramatic, further deceleration in the economy, a new programme may not materialise till the present round ‘Operation Twist’ is completed. It is likely that the market conditions will force the US Fed into another round of easing sooner than latter. A net consequence of this is that interest rates are likely to remain close to Zero till at least 2014 – well beyond the mid-2013 that the US Fed has assured. Even as the Fed seems to have gambled on waiting for a further round of QE, a mistake it is likely to regret over the next few quarters, the US economy continues to slowdown.

The US service industry is now set for a slowdown. However, it is pertinent to note that the last quarter of the US economy may be buoyed marginally due to the most important, Christmas shopping season. The first quarter of next year seems to be the most important phase of the US economic growth that one needs to watch closely and it is not likely to be something to be happy about. Manufacturing sector is likely to fare marginally better than the last two quarters because companies, which have become habituated to maintaining low inventories, have to increase their stocks for the main shopping season. Hence, Euro Zone and Asia are likely to be the source of major economic news that moves the markets. As an extension, since finance has become the tail that wags the dog, the movement of asset markets are likely to galvanise policy makers or send them back to their slumber (if the markets move up).

Low interest rates do not seem to be solving the problem of the world economy and further rounds of QE may have little incremental impact. Low interest rates may not be of great help in the era of debt deleveraging. A cursory glance at the mortgage statistics seems to indicate the diminishing returns from lower mortgage rates in the USA are underway. In 2003, refinancing peaked at US$2.5 trillion while last year it was US$1.1 trillion[1]. Till date, they number about US$783 billion – despite US 30 year fixed mortgage rate currently at 4.7%. The obvious reason is that with economic contraction leading to greater unemployment, credit worthiness has collapsed. It would be a mistake to believe that consumer deleveraging is at an end. The chart below clearly indicates that indebtedness amongst US consumers is still at peak levels.

In late 2009, I pointed out that the ‘the world is looking a lot like Japan’ and had circulated a chart with the conclusion that we will witness sharp rallies but the overall trend will be down. At that time, the skepticsm that greeted my view was surprisingly high. Almost everybody believed that the crisis would be overcome in one or maximum two years. The titbits gleamed from the mass circulation newspapers and the drum beat from regional television channels reinforce this shockingly simplistic view event to this day. This simplistic view of the economy essentially thrives on a remarkable lack of historical understanding of economic dynamics. I have updated the same chart is updated but the conclusion remains the same: the overall trend will be either sideways or down for the financial markets but periodic bouts of stimulus would lead to sharp rallies, with volatility being the order of the day. The only difference is that volatility in the next few months will be as high, if not higher than the past three months.

In short, while stimulus programmes may help in the short-term, deflationary pressures will take the centre-stage. At a more cynical level, since the world is not becoming more accustomed and psychologically prepared for a prolonged phase of crisis, the process of readjustment will be less painful.

Major Problem Areas: Euro zone and Emerging Markets

The US has not been able to solve its problems related housing, unemployment and toxic assets in the banking system,  but this is in contrast to the Eurozone, where they have allowed the problems to get worse. The German actions are clearly unfathomable. Their 1920s and 1930s experience has made them to demand the wrong solutions for a similar set of problems. While Greece is the favourite whipping boy for everybody, obstinate German’s are a bigger hurdle to finding a lasting solution for the simple reason that they are one of the few countries that have surplus cash that can fund future bail outs. Among the innumerable complexities, that exist in the Euro zone the most important are centred on Italy, Portugal and Spain. Economic data, especially M1 data, clearly indicates that the problems in Portugal and Italy are only beginning. Combine this with the fact that Greece is unable to pay creditors to the tune of even Euros 8 billion (the now withheld tranche of aid to Greece) and it provides insights into the magnitude of the problem.

The Greek-EU political circus in the aftermath of a brilliant politically strategic move by the Greek President has one lasting impact: finicky investors will forever remain nervous about the political stability of southern European political set up. Instead of supporting a referendum that would in the long-term have removed political uncertainty, they have panicked. Like in the 1930s the government’s in Europe have provided fodder to the extremists. Over the next five years, the most important beneficiaries are likely to be the extremist parties who now have tangible proof of a ‘sell out’ to add to the economic woes. Merkel and Sarkozy, two important leaders who should have remembered their history seem to be completely void of any intellect in this particular instance.  

The present crisis is already having an impact on Trade: the Chart below (from 3rd November 2011) provides an overview of the ships that pass through the Suez Canal and it has started declining indicating that despite the need for US companies to restock ahead of their busy shopping season, the real economy has started to decelerate. The speed of this deceleration in the next few months remains to be seen. It is clear that irrespective of the form of assistance provided, the odds are increasing for a disorderly Greek default in the next few months, especially if no new aid is provided.     

 

Euro Zone Recession a Certainty

After Japan and USA, it is the turn of Euro Zone to grapple with ‘Japanisation’, a process that is already underway. A Number of statistics clearly indicate that Euro zone is heading for a recession and the only way that a recession could technically have been averted is by huge money printing, which clearly the ECB has indicated it will not take up. Investors will not be pacified, and speculators cannot be kept at bay unless they are convinced that ECB will take up unconventional policies, like printing trillions, if necessary. It is difficult to concur with the ECB thinking that businesses and people who were not willing to borrow money for long-term investments at 1.50% will borrow more at 1.25% or even at 0.25%. Unless there a paradigm shift, that is based on acceptance that the present crisis is a solvency crisis at the apex of the financial pyramid (the central banks) rather than a liquidity crisis, Euro zone will tumble through crises at regular intervals. I believe, at this point, the only way the ECB can buy 2-3 years (like the US Fed did in 2009) is to print vast quantities of money that would deter speculators, especially since deflationary pressures will assume significant proportion in EU from next year. Austerity programmes that are likely to continue into 2014 in all the countries will accentuate these deflationary pressures during the course of next year. Ideally, if the EU is to buy time, they would have to increase the money supply to the tune of about 10-15% of Euro zone GDP. That large a figure would outlast the speculators and burn their trades forcing them to stay off Euro Zone for a few years. Discredited promises to come up money by financial engineering may convince the equity markets, but not the bond markets. Euro Zone’s problems include high unemployment amongst the youth: 46% in Spain, 43% in Greece, 32% in Ireland and 27% in Italy.

A look at the yields of Portugal (Chart Below) clearly shows that it is next in line, but the small size of the economy relative to Greece, Italy and Spain have led to less attention on the problem. This is unlikely to last for long. 

 Source: Bloomberg (chart 3^rd November 2011)

Portugal’s public and private debt will reach 360pc of GDP by next year, far higher than in Greece. Borrowing costs have soared to nearly 12%, an unsustainable level, indicating that a bail out will have to take place sooner rather than later. This has been aggravated by collapsing M1 deposits in Portugal: they have fallen at an annualised rate of about 21 percent over the past six months – October data will only be worse. An additional Problem: Recently concluded EU summit does not seem to have set aside money for bailing out Portugal. At least the figures do not add up in the European Financial Stability Fund (EFSF)

Italy on the Brink

The bond markets have forcefully drawn attention to the problems of Italy, by far the most important of the ‘too-big-to-bail’ countries. With a outstanding debts of Euros 1.9 trillion and expected decadal growth rates of about 1% there is little scope for Italy to repay its debtors, unless it convinces them of the need for a ‘voluntary’ rescheduling of debts. The problem with Europe is that, all the countries have proposed a series of austerity measures that will take affect in late 2012 and mostly from 2013, thereby indicating that the problems will continue well into the near future. The increased risk aversion will invariably lead to capital scarcity. This should be a cause for concern as the more indebted countries and banks need to rollover nearly Euros 3 trillion in the next three years. The problem was aggravated as a number of countries have in the recent past taken recourse to short-term borrowings. To place Italy’s problems in perspective, in the next three months they need to rollover or repay Euros 52 billion while in 2012 they need to rollover an additional 307 billion – in the midst of credit contraction. They will, ultimately, rollover those debts due to a helping hand by other countries but at yields that will be far higher. The consequences of rising interest burden only make matters worse. They are in exactly the same place as Greece was about 18 months ago. The only way yields may decline is with a bout of massive bond buying by ECB. That could have its own share of unintended consequences: if money is exhausted buying Italian bonds, then what would be left for Spain, Portugal, Ireland, Greece and a long list of others, possibly even French bonds. Rumours that the ECB has bought Euros 80 billion of Italian debt should be viewed with concern as the total bailout fund till date stands at Euro 440 billion.

These problems are aggravated by two important concerns for Italy: (a) low economic growth and (b) unfavourable demographics. Italy was the home to a dynamic manufacturing sector, before the onset of the Euro era. It has been estimated, that Italy like other Southern European countries has lost nearly 30-40% of competitiveness in its labour force. Unfortunately, the nature of the present globalised economy is that Italy and other countries have to be more competitive than the Asian countries, if even a small fraction of the industries are to return. Tragically for Italy, businesses continue to exit from Italy. Recent data indicates that manufacturing activity has started to contract at fast rates – Manufacturing Index in Italy dropped to 43.3 indicating contraction. Manufacturing is slowing down thereby likely to create ominous portends for Europe, including Germany.

Two limiting factors are politics and resistance to further austerity by citizens. Portugal is run by a minority government and thanks to the opposition which wants the ruling party to complete the unpopular measures before pulling the rug and Italy is famous for its fractious short-lived post-war coalition governments.

In the era of technology driven global finance, perceptions of strength or weakness are critical and no country is safe for a long-time. To think that France is safe is a folly. It is imperative for the emerging markets that France does not face a run on its bonds. French banks are the largest lenders to emerging markets. This lending binge also makes France very susceptible: its banking liabilities are 409% of GDP, while in the case of Spain it is 338%, 331% for Germany, 250% for Italy and 213% for Greece. France, which is likely to lose its AAA rating in the next few months is especially susceptible as it has never balanced a budget since 1976 and its public debt will reach 87% of GDP.

The Problems in Asia

A remarkable degree of complacency exists in Asia about the insulation of the vibrant economies of China and India from the present crisis. This is undoubtedly true to a small extent but it is largely a misplaced assumption. That view would be valid if the present problems were cyclical rather than structural, as in the present crisis.

Asian prosperity is built on cheap money magnanimously provided by EU banks (estimated at $3.4 trillion) of the outstanding loans. They account for 46% in Asia, 63% in Latin America and 90% in Eastern Europe. This magnanimity is about to end. It has been estimated that in the next few years, European banks are set to contract their balance sheets by about US$7 trillion in order to meet their capital requirements and write off losses that are likely from the present crisis. European banks are stated to require nearly Euros 400 billion in capital, and the EU summit offered to provide a backstop of only Euros 106 billion.

This comes at a particularly inopportune time for Asia and Emerging Markets: All parts of Asia are overheating. One of the reasons for the overheating has been the inability of these economies to absorb large amounts of capital due to structural deficiencies – at a time when easy money led to greater inflows. One can imagine the impact when capital flows reverse. Demand destruction due to high interest costs and the redundancy of an economic model built on exports is probably around the corner.

China and India deserve special mention. China, as I have pointed out in the past, is in throes of a major slowdown. It is a typical of a country whose buoyancy since 2008 has been built on debt and government largesse – both of which have their limits.  Without repeating, what has been reiterated in the past three months about China, it is safe to point out that unlike the last time, China does not have the leeway to take up a vast stimulus programme. Chinese officials now admit that growth is likely to slow down to 8.5% in 2012[2]. While rising inflation has grabbed the headlines, the 22% rise in wages in the country over the last year has largely gone unnoticed. China is placed on a hard rock between the devil and deep sea. It needs to transform its economy into a domestic, consumption oriented economy at a time when its export oriented economic model built assiduously over the past 25 years faces its biggest challenges. The peculiarity of the Chinese economic model is such that increasing local consumption comes at the cost of export competitiveness. Increasing wages have their own dynamic of fuelling inflation, thereby indicating that any loosening of monetary policy in the third largest economy may be minor, if at all possible. The impact of China’s slowdown will be felt on all commodity producers of the world. Stories about Credit Crunch in China do not improve the confidence about China.

House prices (and property speculation) continues in China and prices have only started to cool in different parts of the country (not even the whole of the country). Property prices are especially important as they provide 40% of the revenues for the local authorities.

India

The complexities in the nature and dynamics of the Indian economy often lead to wrong conclusions and this note may not be an exception. But, it pays to be a contrarian especially when consensus is one sided and often wrong. India’s growth story is at a terminal point, though as Indians we would love to gloat that this is not the case and we are an emerging power. Despite its controversial nature, I believe that the India growth story is at a turning point. The problems India faces are not cyclical but structural. It is imperative to note that historically the first two years after a general election are the years when governments have consistently tried to balance their finances. In contrast, due to the problems in 2008-09 as well the nature of electoral verdict, this was not possible. Therefore, it is safe to conclude that government balancing (or reducing its fiscal deficit through austerity programmes) is unlikely till the next general election. Till date, government expenditure has saved the day for the economy. A cursory glance at the results of Hindustan Unilever clearly attests that the bottom of the pyramid is yet to feel the impact of the global events – it is unlikely to feel the impact as long as the government social spending continues. Any slowdown in that spending will reverberate through the economy with exceptional force. Recent field visit in Kurnool district indicates that the bottom of the pyramid has slowly started feeling the pinch of rising costs and stagnating wages. While government expenditure is likely to buoy the economy, the fact that India is dependent on borrowings (due to its fiscal and current account deficits) makes it harder to continue the same levels of spending. That would force the government to spend money by expanding on its borrowing programme or directing the RBI to fund it through buying bonds.

A more immediate problem is that there will be a slow down due to a combination of factors including high food inflation, high oil prices, high interest rates and difficulty in finding capital. This will invariably lead to a postponement of capital expenditure plans considering that a large part of the corporate plans announced over the past three years are funded by debt. The banking sector is particularly susceptible to higher NPA – probably as high as three times the present levels unless the banks indulge on a large scale ‘ever-greening’ – over the next two years or the RBI changes the goal posts (like it did in 2008). This would reduce the ability of the banks to lend vast sums of money. CRISIL points out Indian banks will require Rs8 lakh crores by 2019 in order to meet their capital requirements in tune with BASEL III Norms.[3]

This is not to claim that Indian banks are on the verge of collapse. This is unlikely to happen as long as the sovereign debt crisis affects India, for the simple reason that they have invested nearly 25% of their capital in government paper. If issues were to be raised about India’s sovereign debt, should not be a problem for the country as at its worst, India is likely to face short-term liquidity issues due to higher proportion of short-term external debt while a large component of outstanding debt is rupee denominated and held by Indian banks or public sector financial firms. Therefore at worst, India will have to add a few shifts in the RBI printing presses to gain sufficient time. However, it is imperative to note that a ratings downgrade of India is likely in the 12-18 months and this would further increase the costs of capital. It is imperative to note that Indian dollar denominated debt is not sovereign debt but rather debt owed by the private sector. It therefore provides sufficient room for manoeuvrability for the country.

India’s problem is more long-term in nature: low economic growth rates aggravates the problems due to the demographics and disguised unemployment. High inflation and high fuel costs are reducing the budgets available for other consumption. Food Inflation will continue to remain a source of trouble for individual balance sheets. Any decline is likely to be temporary and to the tune of about 3-4 percentage points and likely to last till March-April, by which time it should perk upwards. Unlike last year, a source of trouble will be rise in price of rice due to a combination of drought in USA and floods in Thailand.

Hence, it is imperative that India lives with high inflation and low growth: a great recipe for disaster. Remember the 1970s! In the mean time exponential volatility has the potential to cause the maximum damage.

Investment Scenario

It would be an error to construe that the deteriorating economic conditions will reduce profitable opportunities. On the contrary, the opportunities are likely to be more than the finite capital resources of investors. A large portion of an investor’s portfolio should be in liquid high quality fixed income assets, with an asset allocation that is titled towards giving primacy to dividend yield. Shuffling between asset classes will be the new game in town. The next two years may be a good time for investors and businesses with a long-term horizon to start dipping their toes on every decline. The best opportunities are likely to be available for distressed asset investors, while those who have rushed headlong into capital intensive long gestation businesses are likely to be distress. Credit will continue to be scarce. Among the opportunities that investors and businesses may remain alert to seek opportunities for business that have a large asset base but are likely to fall into hard times due to liquidity issues. These include businesses/investments in Agriculture (including foodstuffs and milk), water and others with ownership rights to natural resources (only for those with a five year perspective). As always the public sector should rank as a high priority for the simple reason that recessions always uncover what auditors don’t. Credit crunch will only wipe many but those with a large asset base would always survive in one form or the other.

---

[1] http://www.mortgagebankers.org/NewsandMedia/PressCenter/78189.htm

[2] http://www.bloomberg.com/news/2011-11-04/pboc-adviser-sees-chinese-growth-slowing.html

[3] “Indian banks need Rs.8 lakh crore by 2019: Crisil”, Business Standard, 4 November 2011, p.6