The World is looking a lot like Japan

The complacency about the global economic recovery is gradually giving way to concern that the world economy may be able to relapse into another recession and even a depression. Infact the US and Western economies are looking a lot like Japan after its bubble burst in the early 1990s. Unless the policy makers think of solutions that may have to include default, this crisis will only be prolonged. Short-term quick-fix postponement of the solutions will only prolong the eventual pain and prolong the crisis. The World economy is in urgent need of long-term structural solutions but there is a clear lack of will power amonst the policy makers to undertake drastic reforms as they fear being branded 'anti-business'. Ironically, a 'pro-business' tag would mean a complete systematic siphoning off of public money to bailout speculators. I have reproduced some empirical data (shorne of any analytical inputs) in order to try and provide readers with a hope that they will be able to come to their own conclusions.

Problems in USA

A number of very important indicators are indicating troubling times ahead. The most important indications of problems ahead have once again come from the Bond markets and subsequently the commodity markets. The US Benchmark S&P 500 has lost nearly 16% from its 2010 high. The losses in the markets have largely been due to the fears that the deficit cutting may cause to the weak global economy that could dash all hopes for a recovery. It has been pointed out that globally governments have promised to cut nearly the equivalent of 2.5% of the world GDP. If the bond market is right, this could be a historical blunder.

All the important economic statistics released over the last two weeks are leading to concern replacing complacency as the dominant macro-economic theme. Concerns related to double-dip recession in the west or even an economic depression is coming to the forefront. Employment generation is still a distant dream in the USA. Unemployment claims actually increased to 472,000 as against the consensus estimate of 454,000 for the last week, while manufacturing in the USA slowed from 59.7 to 56.2, while the consensus was 58.9. Pending home sales collapsed by 30% (immediately after the expiry of US Government tax benefits, while the consensus expected it to fall by just 7.4%. The hope the private sector demand is turning out to be a mirage. The latest statistics from USA indicate that against the expected private sector job creation of 110,000 only 83,000 were created.

The yield on two-year US Treasuries has fallen to a record low of 0.61pc in a flight to safety, a level not seen during the depths of the Great Depression. Ten-year yields dropped below the psychologically sensitive level of 3pc to 2.96pc. Japan 10 year bond yields have reached a 7 year low of 1.06%, the same that they were when the government started its battle against deflation. Bond market sales by corporate dropped by 39% in the first six months of this year from last year’s level because of increased emphasis on safety rather than returns.

The US Housing 26 months of supply overhang – inventory of all kinds and the next big down move in the US housing sector has just begun. The housing sector cannot be helped due to the large debt overhang among the US and European households. In the USA, debt-fuelled demand during that last exponential surge in the credit cycle that took the household debt-to-GDP ratio from 100% in 2001, to the peak of 136% in 2008. That ratio has since come down, to 126%, but that suggests that the process of mean reversion will take more time. This ratio was closer to 30% at the end of the last secular credit collapse as we emerged from World War II.

Leading economic indicators are showing that the US economy would be lucky if it could expand by 1% in the second half of 2010, against the stock market discounting of 3% or more GDP. This would indicate that once the stock markets in the US start discounting low growth (which the bond market has already started discounting) then we could witness more panic in the equities markets which will boomerang throughout the world. The manufacturing gauge fell by more than forecast to 56.2 in June from 59.7 in May. A reading greater than 50 points to expansion. Other data showed contracts to buy existing homes fell 30 percent in May, and claims for jobless benefits unexpectedly rose last week. Car sales too were down sharply in June. They usually fall by about 3% from May to June each year, but this year they fell by an average of about 11%.

This has been aggravated by the banks unwilling to lend to small and medium enterprises which provide most of the jobs. Money supply has declined at an annualised pace of 5.5% in USA. In the first three months, Money supply fell by 9.6%

The JOC Commodity Index (which has a high degree of reliability) has crashed by nearly 45% this month after a 80% fall over the last two months. The only other time that the index collapsed with such speed was after the collapse of Lehman Brothers. The Baltic Dry continues to fall and it fallen by nearly 43% over the last one month, indicating that there is trouble for the commodity market over the next few months.

The US economy has officially lost 8.4 million jobs during the recession that began in December 2007. If we add those who are employed part-time, who want to work full-time but are unable to find work then the figure is nearly 18 million.

There are other equally important problems of mammoth size, both of which will pressurise employment and as a corollary consumption over the next few years. One is the problem of huge pension liabilities of the most of the US states, which varies but is estimated at a minimum of US$1 trillion to a higher estimate of US$5 trillion. Nearly all the US States’ have a gaping pension shortfall. The private Industry is no better. Therefore this will not only force people to cut down on spending by the nearly 78 million people who will retire over the next few years, but would force them to work longer, making it harder for the already unemployed to find work.

The second problem is that over burdened US States’ have just embarked upon a programme that would cut their work force by upto 20% in the next one year because they are running big budget deficits and are unable to find financing due to loss of tax revenues and the problems with jittery bond markets.

Thus it is clear that the US economy is about to slow down, quite substantially and this is increased concern about the tentative signs of stabilisation that came with the government support US and other parts of the world. The bond market on the other hand seems to be indicating that there is a very serious risk of a double dip recession in the west if not an outright depression. It is clear that the consensus estimate about US GDP growing at 3% during the second half of the year are extremely optimistic and the US should consider itself lucky if it is able to grow at 1% over the next six months.

Problems in Europe:

Europe continues to be beset with problems of phenomenal scale. Gradual deterioration of the world economy, especially European economies became more manifest over the past four weeks. Spain sold 3.5 billion euros ($4.3 billion) of five-year notes, with demand falling to 1.7 times the amount of securities offered, from 2.35 times at the previous auction on May 6. The notes were sold at an average yield of 3.657 percent, compared with 3.532 percent a May 6 auction.

The Spanish cajas or savings banks are clearly in trouble, relying on the ECB for 21pc of their funding. A number of banks in Europe may go insolvent (or already are insolvent, without ECB Help). 171 banks borrowed about Euros 131 billion. The markets are relieved the short-term because they expected Euros 200 billion borrowing, and hence the relief rally in the Euro.

Greek and Spanish spreads continue to be at record high. More worryingly, Italian spreads are slowly climbing that the bond market is has Italy’s problems in this shooting range. Bond markets spreads at least nearly double the level they were three months back indicating that the bond market is sceptical about the economic recovery.

A Spanish newspaper recently cited confidential sources that claimed that both Spain and Italy were likely to need a bail out.

Italy was the most recent county (after UK) which has announced another Euro 25 billion of austerity measures. These measures are likely to create further problems for the European Economy at the time of the most susceptibility.

Consumer prices continue their slide in Europe in a clear indication of deflationary pressures that stem from the lack of pricing power for nearly all the segments.

New Industrial order fell by nearly 5% from the previous months and were barely positive.

European Retail sales and consumer spending continued their downward decline.

French consumer confidence fell to a 8 month low.

Bank of England policy maker Alan Posen has warned that there is a high probability that Britain will slip bank into recession, due to a combination of Government austerity measures and importantly due to the unwillingness of the banks to lend money. Manufacturing in UK has declined consecutively for the past three months. Only 7.1% of the UK banks in a Bank of England survey were found to have increased their lending while a majority stated their intention to lend less. Problematically for UK the number of export order fell sharply from 56.7 to 50.7 in June. Home prices continued their fall in June.

Money supply (M3) in Europe continues to decline on a monthly basis, with the most recent being a 0.2% decline over the previous month.

Problems In China

There was a fond hope that China would rescue the world economy. Unfortunately, not only does China comprise just 6% of the world economy, but even that has started to slow down.

Chinese stocks continue to drop and they have dropped nearly nine percent this week, in response to a drop in their manufacturing index. The HSBC/Markit index of Chinese manufacturing has fallen from a high of 57.4 in January to 50.4 in June (50 is the terminal reading that differentiate a contraction from expansion)

China has decided to increase the minimum wages to its workers in response to the increased number of industrial strikes. The wage hikes differ in each provinces and they vary from 20% to 40%. While this is good over the long-term as it would increase the consumption ability of its populace, in the short-term it would make China’s exports less competitive as the rise in the cost of production would have to bear the impact of falling Euro thereby making their exports to Europe (which comprise about 27% of its total exports) more expensive.

The only sort of good news for the China bulls is that the nation has 28.8 trillion yuan of unfinished projects in place, amounting to 85 percent of gross domestic product. While that may be good news, the fact that the Chinese have recently increased minimum wages means that it will continue to have inflationary pressures over the short-term forcing the government to take up further measures to cool the economy.

Goldman Sachs has just cut its GDP growth estimate of China from 11.4 percent this year to 10.1%. Phew! This is the second time that we have realised that the investment banks can cut their estimates so quickly. The first time was in the aftermath of Lehman. Probably they have just completed their long liquidation.

China's car sales have slowed to about 10.9% for June, compared to the breakneck speed of the March, April and May. Little do most of the Western analysts realise that the structural nature of an Emerging market is such that while the growth can be extraordinary, so can the down move.

India Scenario:

India does not face similar problems to the west, but our policymakers and people need to be less complacent. India is not on the verge of tipping point into an abyss as of now. However, Indian econmy doesnot have the depth in its economy that would normally be expected of a country of its size and diversity. The dominant theme is that India will be insulated from the crisis. It is imperative to remember that in a globalised world, there can be region that can be insulation from a crisis, especially one of this magnitude. It is just a matter of time before it is affected. India needs to quickly overcome some of its deficiencies. While the economy will be stable this financial year, a prolonged crisis in the West, combined with a slowdown in exports will create new problems for India.

India’s recovery is largely because of its recovery of exports to China, trade and other concessions given by the government, which reacted proactively. Unfortunately that is where the good news stops. The government should not be overly complacent because its balance got better due to the petro price hike and the procceds from the sale of spectrum. The 1 lakh crores from sale of spectrum is a one off jackpot. The government is unlikely to gain such large amounts even if were to sell stakes in public sector assets as their success is completely dependent on the market conditions. Moreover, the huge quantity of supply of equity in the primary market will only dilute the potential for market conditions.

A more pressing concern is the problem of growing overseas borrowings by Indian companies. This growing indebtedness among the Indian companies, especially at a time of declining demand and margins means that we are bound to witness an increase in the pressure on the corporate balance sheets. It has been pointed out that nearly 44% of the borrowings in India are short-term in nature. That would make the country more prone to volatility and troubles if this debt mix doesnot change soon. This pressure will be aggravated due the government’s withdrawal of subsidies and an increase in taxes at the Central, State and Local level, due to the cash constraints facing the government.

The government has to remember that a prolonged crisis in the world economy would mean that they would be staring at problems by the end of next year the interregnum would be the period of declining exports (especially if China were to slow down dramatically), declining tax revenues (especially from service tax and other indirect taxes), while its expenditure would not decrease because they would have to spend more on the social schemes while the demands for concession increase.

What would investors need to do?

Investors may be well advised to be extremely cautious and preferably increase their cash holding. Any sharp declines in Gold should be used to increase their holdings as the crisis still has a number of chapters to play out. In times of uncertainty, Gold is the best investment.

Why Global Finance Got Into Trouble in the First Place

Have you ever wondered why global finance got into trouble in the first place. For decades, we mortals in India, were lectured on why our business models were unsustainable. We did not have the 'process' or 'systems' as a manager in GE Money put it to me in 2004 during the course of my field-work. Owners of Indian companies (referred to as 'partnerships') in contrast would constantly tell me that while their (the local partnership) model survived on the fact that they knew the inside out of their clients and had withstood economic cycles of nearly everykind, the national and international companies would not last long. They depended too much on a mechanical way of doing business. How could a finance company that set targets for loans every hope to get back their loans.

The picture below provides the best answer to the GE's problems. They decided that the best way to expand in India would be to push credit everywhere. 

Who knows, you would probably be willing to contemplate a loan when filling your petrol tank! This finance company in a petrol bunk is probably the best barometer to an unsustainable mechanical model that is often peddled as 'systems based process'. I am sure at that juncture, GE thought it was the type of  aggressiveness' that they needed from their 20-something employees. Hopefully, at least now, our management consultants understand that business success depends on understanding the local needs and conditions that exist in a particular region. The faster they understand to the limits of a 'systems based process' the more successful they will be in the business world.

Little wonder that GE decided to sell out in India. 

One would only wish that at least henceforth, they would understand the basic business logic of the fianance business that when you push credit to those who cannot hope to repay it, you are not doing a service and instead you are inviting trouble. That basic understanding would have served the world trillions of dollars.These trillions could probably have been better used if only our policy makers had decided that would come up with long-term solutions to the problems of the availability of finance.

Culture of Business: The Art of Exploring New Opportunities?

We keep hearing about the growing strengths of organised retailing in India and the multiple opportunities for the retail sector as about 98% of the present retail trade is in the hands of the unorganised sector. There are innumerable stories about how the organised retail sector is grabbing market share from the hitherto unorganised players through innovative marketing strategies. Innovation has been the hallmark of the Indian business culture for centuries. Innovation exists in the formal as well as the informal sector, though we rarely hear of the innovation in the informal business sectors as they tend to be much more localised in nature. 

The pictures below show that while the organised sector may be expanding its market share, innovative ideas for marketing abound in the informal sector. In Vijayawada, one unorganised player  decided that it makes good business sense to meet competition head-on and market his products by giving Reliance a literal run for its money and decided that he would take the battle right to the doorstep of the behemoth. After all , the can sell their products at a lower price in that single segment and they would  get great visibility - all at little cost.

This is surely one business segment that Reliance cannot compete. Reliance should best ask such entrepreneurs about the best marketing strategy.

Gold: Is it in a Bubble?

The interesting aspect of analysing the financial markets or for that matter the economy is that for every ten analysts (or economists) we invariably will have twenty different opinions. Spotting a bubble is always a very difficult thing, timing it right is a unique art that very few possess. Bubbles reinforce a brilliant observation by Keynes who wearily pointed out that ‘the markets can stay irrational for longer than you can stay solvent’.

The past couple of weeks have increased the number of people who are calling a bubble in Gold. Such has been the ‘noise’ that we have the mainstream media now taking a plunge. A recent spate of articles in The Wall Street Journal are very interesting. The writer quotes Warren Buffett who is stated to have observed sometime back “Gold gets dug out of the ground in Africa, or someplace, then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head"

Unfortunately, Warren Buffett does not live in the developing world and since he is a billionaire, he does not have to bother about accessing credit. Ask billions in the developing world, for them gold is money. Even a beggar can get raise money, if he can pledge gold in most of the developing world. I am sure the day is not far, when the Western world is probably going to be like that for the simple reason, that their own citizens will not trust their currency. Moreover, I really doubt an extremely savvy investor like Warren Buffett will actually tell Wall Street Journal about his personal holdings. The day Buffett defended Moody’s and Goldman, I think we should stop giving much credence to his objectivity.

A number of people may do well to try to remember what has been the best performing asset class in the past decade? Gold has returned 400%, and stocks (probably Buffett’s favourite asset class) have returned less than cash.

There are nonetheless, a number of important arguments that we may have to deal with as a number of other arguments deserve greater attention. The Wall Street Journal article itself raised two important points: (a) high levels of gold production accompanied by reduced demand for jewellery, and (b) the fact that gold cannot be used for anything except as a store of value. Both are valid arguments, but to a certain point. It has been pointed out that since 2002, total demand for gold for jewellery as well as other uses has declined to 22,500 tonnes from about 29,000 tonnes due to increased supply .

Invariably the above statistics about gold are quite important and should in normal times be a major cause for concern. Reports indicate that there has been reduced demand in traditional consumers like India. However, these are hardly normal times.

It has been pointed out that all the gold mined in the world in human history can fit into four Olympic sized swimming pools. A number of observers claim that it is bad news, but on the contrary, I believe that is good news, probably it may be reason why for centuries people have fought and died to possess it. More importantly, in a recent article, the Financial Times pointed out that the current composition of gold in a person’s portfolio averages about 0.05%, with “investment herd” concurring with the views of the Buffett like claimants. Infact most of the people in the West hardly own any gold, and those who have investible surplus there are in such a state of paranoia that even if they were to move about 5% of the their total cash holdings into gold, it would lead to the price shooting up. Despite all the claims, the Commodity markets are quite shallow when it comes to their ability to absorb huge amounts of cash. It has been pointed out that in 2009 about US$190 billion of new cash went into commodities and the result: most of them shot up by about 100% from their lows.

The Wall Street Journal articles cited above had a very interesting chart (given below). If history were to repeat then Gold will have a long way to go when compared to traditional bubbles.

 

I am personally bullish on gold in the long-term as I have been for the past few years. By long-term the time horizon is over a period of 3-5 years. That reasoning is based on two critical factors. One, is the Sovereign Debt Crisis, which is likely to morph into a currency crisis, sooner rather than later and, two the consequences of millions of people buying a few grams in the third world and in Western world by a few ounces.

The sovereign debt crisis is far from over, on the contrary the worst phase seems to be just about getting underway. It has been pointed out by David Rosenberg, that the global liabilities (private sector as well as public sector) stand at nearly US$220 trillions, about four times the global GDP. These excess need to be washed out. The nature of capitalism and the process of financialisation will mean that this debt will not totally disappear. I assume that the world needs to get rid of at least one-third of the outstanding (if not half) if there has to be a meaningful return to a bull market. This is not to mean that people and companies have no money. Those who have are not willing to spend it, those who need it are not able to get it. That is the inherent nature of the banking system. The age old description of a banker is apt for the present situation. A banker is one who lends you an umbrella when it is not raining and demands it back when it starts to rain.

It is likely to end when there are debt write offs (or defaults on an biblical proportions). However, before we get there, Gold is likely to rise further. But asset prices do not move in straight lines. The sovereign debt crisis will be no different. We are bound to have phases when the policy makers will invariably take up measures that would be provide some hope to investors and speculators. There will be periodic bouts of buying and selling frenzies in the asset markets.

More importantly, the economy is likely to go into a grinding downward move over the next few years – remember Japan. Every year we will witness people who will be excited about a possible recovery and there a slight improvement in the risk appetite. If history is a guide, these hopes will be dashed to the ground, leading to ever larger convulsions in the financial markets. There are a number of events that could trigger a major buying frenzy in gold, including a BP bankruptcy, geo-political tensions, etc. There are sufficient number of innumerable risks that the world faces at this point of time and this is not likely to change in the near future. If the Republicans come to power in the USA in 2012 then we are likely to see another war, this time with Iran. The list is literally endless. But, there is no need to be carried away by such things at the present juncture.

If there are two asset classes that investors are under-exposed then it is Bonds and Gold. Since investors are sceptical, and rightly so, that would leave them with only two alternatives – Gold and its poor cousin, Silver. Both these are likely to witness consistent gradual investment buying, especially in the Western Countries. As far as the Eastern Countries are concerned, it would be a fallacy to think that gold buying will reduce dramatically, considering its solid grounding in the soico-cultural ethos, especially in India. Moreover the collapse of the other investment favourite of Indian (buying land) it is likely that gold will retain its attraction. Millions of Indian get married every year and millions of kids are born every year. In each of those social occasions (even for the poorest of the poor) gifting gold (in whatever form) is a centuries old tradition, which will not only disappear but would instead regain the centre stage because of the rising prices.

Risks:
However, it is imperative to note that spotting a bubble is not only very difficult but is invariably accompanied by multiple risks. Gold is no different. The biggest risk is the gradually running out of the gold de-hedging by Gold Mining companies. It has been pointed out that gold mining companies break-even when they are able to sell at prices from US$400-600 (varies from company to company). It is likely that after a substantial run up in prices, companies are likely to want to protect at least some of their margins and hence, they are likely to re-start hedging their production, though this is only an assumption. The assumption is based on my thinking that as the cost of capital increases because the growing problems of the banking sector, companies would probably find it more profitable to hedge a part of their protection.

When to Invest in Gold?
I really wish I could time the market perfectly and knew the correct answer, because if I could do it consistently well, then I would be a billionaire many times over. But a look at the long-term charts are quite instructive. The long term chart (see the Kagi chart below from 1997 to present) seems to indicate a substantial correction because we find negative divergences building up. However, it is pertinent to note that the 200 day EMA stands at about 1100 and the 500 day EMA stands at 996.
 

 Thus as long as gold stays above those levels, technically gold is deemed to be in an uptrend – one of the few commodities that still continue to remain in an uptrend. Speculators are best advised to avoid gold if it moves below 1000 as it has the potential to fall to 800 (worst case scenario).

Charts Tell Another Tale

I find it quite fascinating to watch a number of these business channels in India. Nearly all of them are claiming that this is a good time to buy equities. So I thought that the easy answer would come from a look at the charts. Almost all the important Indices that I looked at are indicating a long-term downtrend. The interesting chart was the Shanghai Composite Index chart which is showing signs of a short-term upmove. But, dont jump the gun as yet. There are a lot of important economic news releases due to be released on 9th and 10th (tomorrow and the day-after). 

So there could be some profitable moves there. But if the index were to break the lows of the last one month then expect a major fall.The interesting part of the charts is that they are precariously balancing on the 500 day Exponential Moving Averages and they have broken the major trend lines. So watch for violent moves. The only thing that is certain in these uncertain times, is an exponential rise in volatility, which is a classic bear market symptom.

The Chart below of the CRB Commodity Index (Kagi Chart) is quite scary. It looks like the uptrend in the commodities is over. The index has already fallen below the 200 day exponential moving average and is about to fall below the 500 day exponential moving average (which stands at 440)

Dow Jones Transportation Average
This is yet another interesting chart, because I have been reading of a bit about the rise in trucking charges, which in some case is estimated at about 20% rise in the past few months. One has to keep in mind that such a rise is not because we have a major revival in economic activity but because a number of companies in the sector are closing down, not a very optimistic scenario for the long-term health of the economy. The chart below is once again quite bearish.

Shanghai Composite (Short-term)
This is very interesting. there is some positive divergence that may provide some interesting short-term speculative opportunities.

At the same time be very careful, there are not only a lot of news releases slated that could change the game. I am quite sure that they would indicate an economy that is rapidly slipping out of control because of overheating. Moreover there is a major trendline. If it breaks the trend line, then expect a major crash in that market and with that the commodity market.

Tailpiece:

The Journal of Commerce Smoothed Index is already indicating a recession in the USA so conserve cash.

Are we Heading for a Major Downmove in the Economy?

That is a difficult question to answer but I would believe that the present conditions indicate that such a major down move is very likely. 

At last we have the markets correcting (as the conventional wisdom would say), but since I tend to take up a more unconventional (and always a hated stance), I would think that we are at the throes of the start of a bear market. Undoubtedly, this is very early days in the start of the bear run, though I am willing to stick my neck out and call the start of a bear market. I think the world has seen the best of the economic growth story and now starts the “Age of Pain”, which could last about 3-5 in the west. It is important to note that the pain will not be equally spread out over the whole world. There will be pockets of growth (as there will be pockets of pain). Economy and the markets are always a Zero sum game. One winner needs at least one loser, though in the markets the proportion of winners and losers is disproportionate.

I had confidently asserted about a year back that the bounce would be temporary, and about six months back had clearly stated that the second half of the 2010 will be horrible – to put it politely. Therefore, I was considered to be a part of the lunatic fringe and was actually called a number of names (only a few directly and mostly behind my back). Now I stand vindicated. Sadly, it required the loss of nearly US$1.9 trillion of market cap, though I hope it would have been less scary. Interestingly, I am not exactly in a panic mode, since I have had the time to reflect on strategies that would enable anybody who listens to survive and actually take advantage.

Every Dawn compounds our problems:
The problem with the world’s economy is that the margin of safety that exists is almost nil. We need one incident even if it quite small, to boomerang all over the world causing great pain and billions of dollars of losses. Each of these losses may not seem too large at a cursory glance, but cumulatively they are slowly destroying even the best companies. When the best are going to see cash dissolve from their balance sheets, it is a matter of time before the smouldering mass of combustible material explodes. The most recent example is BP, where a loss that was erroneously estimated at a loss of 5000 barrels of oil a day now has the potential to cost damages that may exceed US$20 billion over the next 5-10 years. Undoubtedly, BP can overcome this problem, but not another few of such magnitude. What are the probabilities of such Black Swan events in the future? I believe quite high as we have had nearly 2 years of relentless cost cutting where companies are most likely to have cut off the muscle and bone rather than fat. Most of the companies are led by entrepreneurs who are more prone to either selective amnesia or hype (or fear) created by the media. A number of them still continue to believe that they can borrow their way to prosperity despite the fact that we are in an era of structural change where I am almost certain that the age of low interest rates have come to a close. The only way the low interest rate regime can be continuously perpetuated is by printing ever exponentially large amounts of money year after year for the next 10 years – an unlikely event. The next two years will see an increase in printing money but not beyond that.

Why I continue to bearish on the real economy:
It is pertinent to note that the present note, deals mostly with the logic behind my bear-case analysis on the real economy and not the financial markets. For the time being, it is important to overlook the financial markets as they are dominated by speculative capital flows, which are in turn an offshoot of easy liquidity conditions perpetuated by the Central Banks. The main reasons are enunciated in the following pages.

The Red Flags:
The problem areas in the world economy are well known and have not changed since the start of 2010. The problems are however, being accentuated by the inertia of the policy makers to undertaken drastic changes that are required. The problems at the present juncture include,
(a)    A likely recession in the West.
(b)    Deterioration in the US economy
(c)    Accelerating problems in European Sovereign Debt Issues
(d)    Slowing China
(e)    Insolvency of the banking systems of Europe
(f)    Pressure to cut deficits.
(g)    Gradual (future) deterioration of the financial sector over the next one year (this would include the banking, non-bank finance companies as well as the insurance companies).

In all likelihood we are about to witness a relapse of the western world into a recession. While it may be too early to claim that the whole west may relapse into a recession, I would bet that the USA and large parts of Europe are likely to relapse into a recession in the next one year. The news that has emanated from different parts of the world is clearly indicative of either economies that are topping or those that already have seen their peak performance. Interestingly, in an era of government cost cutting everybody seems to think that the best way to overcome the recession would be export their way out of troubles. One only is forced to wonder, who will be the consumer, since most of the world is highly indebted and those who are not indebted have no intention of taking on more debt.

US Economy: Recession, Highly likely
A recession is quite likely in USA unless it is aided by fortituous circumstances (that we don’t know as it) or unless there is a large statistical jugglery. The deterioration of the balance sheet of the US consumer continues abated as does the deterioration of the balance sheets of the US states, most of which have to cut their budgets by at 20% this year (over the previous) ones. The recent Household survey indicated that the total employment fell by about 35,000. The unemployment rate did come down, but that was largely because of statistical anomalies rather than real improvement in the economy. This was because the US labour force actually declined by 322,000. It has been pointed out that nearly half a million people have simply disappeared from the way US labour force statistics, because of the peculiar way in which the US calculates its unemployed. The four-week moving average (which is more reliable) continues to consistently show that the job losses continue to remain at 100,000 a week. This time we remain short of the old peak of employment, by an astounding 8.4m jobs. One in six Americans is either unemployed or underemployed. This is not a normal cycle when compared with a typical recession, which sees no more than 2m to 3m jobs lost. The average duration of unemployment rose to 34.4 weeks from 33 weeks in April. This is taking place when the number of hours worked has increased from 0.3% and wages declined.

Consumers continue to be in a bad shape and are becoming more and more despondent, so it is unlikely that they would spend go back to their old spending habits. The mood of US households is despondent. In May only 11.3 per cent believed they would see their income rise in the following six months, while 16.6 per cent thought they would see it decline. The May retail sales are quite indicative of the larger trend, when the year-on-year Chain store sales rose 2.5% (which was about 1.5% less than the consensus estimates). Moreover, last in last May the US was just witnessing the positive impact of the huge US government rescue packages. Interestingly, only about 54% of the retailers in the USA managed to beat their lowered sales targets, while those like Wal Mart clearly indicated that the economy was too soft for their comfort. Half of the US employers froze pay for at least a part of their workforce in the past year and about 13% actually cut salaries for their workforce.

One of the critical reasons why we are betting on a high probability of recession in the west are based on the movement of the bond markets, and the commodity markets – both of them are indicating turbulent times ahead. Manufacturing in the US may have already peaked or will peak in the next one month. Manufacturing new orders increased by about 1.2% over April, while the consensus was for an increase of about 1.8%. This is worrisome as it is clear that the recent growth was largely because of the rise in manufacturing may only have been inventory restocking, which may now be coming to an end.

Another important source of concern about the state of the world economy is the acceleration in the concern about the problems and issues related to sovereign debt. The last in the list of concerns is Hungary. There are growing fears that Belgium is doing precious little to solve its problem of indebtedness. This led to jump in interest rates on the 10-year bond from 3.15 to 3.50 percent (Belgium’s debt is now 99% of the GDP). The only likely solution that seems to exist (which nobody is interested in at the present) is a default by Greece and at least another one or two countries). The major panic is likely to occur as there is a persistent increase in the probability of a default rises. I believe that such a forecast would become more mainstay by the end of 2011 (that should be sufficient time for the Morons - twenty something traders to fully understand the internal dynamics of the state). The recent statement by the UK PM that they should expect huge cost cutting that would be ‘generational in nature’ should give rational investors what they could expect over the next few years. One option that the UK government is seriously considering is to cut its budget spending by 20% per year for the next three years, akin to what Canada did in 1994. This the PM claims is because the debt level of about 156 billion pounds is unsustainable. He is correct, but so are the cuts as they will bring unimaginable suffering to the people with the consequence being a recession. While Canada got away, I am not so sure about UK for the simple reason, that in 1994 consumer leverage was barely starting and the world was a different place then. Moreover, Canada did not carry such a large debt as UK. According to the British Prime Minister, Britain’s national debt stands at 770 billion Pounds and is expected to touch 1.4 trillion Pounds within five years – or 22,000 pounds for every man, woman and child in the country.

The government cutting in fiscal deficit along with the problems in the banking system will only create a perfect storm of another crisis. European banks have insufficient capital. SocGen has estimated that European banks have to raise US$357 billion of additional capital. This figure will only increase as more assets grow bad. The banks probably have a reasonably good idea as to which assets will go bad in the foreseeable future, and it is for that they are not lending. Interestingly the era of counter party risk is back on the table and banks are not even lending to other banks, let alone other borrowers. Overnight deposits with the ECB has increased by Euros351 billion, the highest since the establishment of the Euro, this was a jump from about Euro 300 billion the previous day. However, the financial buffer for most of the corporate sector (especially in the USA) is much better as a large number of them have borrowed sufficient amount of cash that would probably last for about a year, along with the cash flows that they generate in their business). It is for this reason that I believe that the problems will reach crisis proportions more slowly. As assets grow bad we are likely to witness the need for banks to come with more capital. The largest rally since 1930s led to the problem of the banks taking a backstage as most of the asset prices rose. This provided a false sense of security. This problem will come back to haunt the banks in the very near future.

Lower interest rates are simply not working, at least not with the consumer. Mortgage rates were actually down in May by about 15 basis points and the result: mortgage applications for new homes crash to a 13 year low. See the chart in the Charts section (Charts Tell Another Story).

There is simply too much complacency amongst business that China can provide the valuable cushion to the rest of the world. More importantly, the estimates about the corporate sector profitability is too high and it would have to be revised downwards very soon. This downward revision will invariably mean that the markets will have to grapple with another down draft. The problem with falling markets is that it would open a can of worms, which will probably increase the stranglehold. Credit shortages will lead to a rise in the cost of carrying out business, just at a time when companies have no pricing power and when their margins are being squeezed due to volatility in the currency and commodity markets. Where exactly is the pain threshold, is a fact that very few know and even if they know, very few would be willing to admit until it is too late.

Investors losing more will lead to more panics:
American equities have lost nearly US$1.9 trillion dollars of market capitalisation since April 23, 2010. A number of hedge funds have been burned because they bet on the rise of inflation and betting on a continuation of narrow credit spreads. The age-old dictum, those who forget history are condemned to repeat it still holds true even to this day. During the 1990s, investors were burned because they bet on a Japanese recovery. Now, shorting US Treasuries has led to huge losses, which will only come out in time. Hedge funds fell by 2.6% last month, the largest drop since November 2008. These losses may lead to a situation where funds and investors will have to sell profitable holdings in order to pay for their mark-to-market requirements or simply to provide more collateral for their trades. This could in turn set off losses in asset classes such as Gold and Silver, though one is not sure as to how severe the cash requirement or loss are as it would vary from fund to fund.

Gold:
The bull market in gold has more legs, but in the short term expect a pull back. I would not be surprised if a meaningful pull back starts sometime in the fourth quarter of 2010 rather than immediately. This bullishness is the result of a rather simple logic. Investors, the world over, are over invested in equities and under invested in bonds and Gold. Bonds are troubling because investors are stuck with a never-ending list of shoes that may be the next in line, hence the more prudent probably prefer gold to others. The world’s liabilities are nearly US$220 trillions (public and private sector) and the US has had to pump in US$2 trillions for a GDP growth of about US$200 billion. Thus, the law of diminishing returns for large money printing is quite advanced as far as the real economy is concerned. More importantly, only about 0.05% of the share of household networth is in gold. So all we need is about another 0.01% of new buying and gold can shoot up by another 50% since the markets are actually quite shallow. There are sufficiently scared millionaires in the world, who don’t know where to put their money. Ten Kilos of gold will easily be hidden in a bank locker.

Sting is in the tail
The latest Investors Intelligence poll for the past week showed the first rise in bullish sentiment since early May - up to 39.8% from 39.3%, while there are only 28.4% bears, down from 29.2% last week.

The Mirage of the Recovery

The last few months have been quite taxing on any rational person, a fact that has been aggravated by naive (or maybe intentional hype) about the so-called recovery in the economy. Any sane person searching for signs of recovery would have very clearly come to the conclusion that the recovery (if at all it existed) was due to the government support and the near disappearance of the capitalist order that was propounded as the panacea just three years ago. 

It is perplexing that all those who at one point of time were strongly against subsidies are now demanding not just subsidies but doles that are many times more than what the government would spend on public health and education. I remember the years immediately after the process of liberalisation started we had industry bodies demanding that subsides to people (poor as well as middle classes) only made them more lazy and that these should be dismantled because free markets are the best way to reduce poverty and create a work ethic that supposedly doesnot exist in India. Two full years into a crisis, nobody talks about dismantling subsidies, instead these bodies are now clamouring more subsidies, albeit to their own members. 

As a student of Social Sciences, I find it absolutely interesting to watch how fickle the markets are. Till about January this year we had everybody (including the 20 something reporters in the press, who would be hard pressed to explain the difference between macro and micro economics to the policy makers who are willfully lying about the state of the economy) claimed that the world has recovered. Even important members of the bond houses were warning about the era of hyper-inflation that was about to be unleashed - I guess their assistants forget to give the charts of M3 and M2. In reality, the recovery turned out to be the case of 'so near yet so far' - as it has happened so often in the past three years. 

 Two charts given below would probably reinforce the need as to why people should be more circumspect about the supposed recovery.

The Chart above shows the Personal incomes in the USA including the government transfers, often used till now to indicate the 'recovery'. Seems good! Good as long as we dont see the chart along with the rise of government debt. 

The chart below shows the state of Personal Incomes in the USA excluding government transfers. 

The chart is one that I guess our learned friends in the media and among the policy makers would like to think that did not exist. Unfortunately, our elected politicians donot have that luxury as they will learn in the next few months and years - if you dont believe me, ask Germany's Chancellor Merkel. She has stopped making public statements after the provincial elections wiped out their alliance due to a 10% vote swing. Rest assured her political career is likely to come to a spectacular end in the probably the next three years.

For long I have been in the deflation camp. I continue to believe, as I did for the past two years, that we are heading into a deflationary (at least over the next two years, if not more). Nor do I believe the hype about China, India and the emerging markets replacing the west as the major consumers in the present context. It will happen, but the argument is probably a few decades early. By the middle of this century, it is likely to happen but we are likely to be too old (and I am sure i will be quite senile to even think about the issue). 

Interestingly, if my argument is about a likely deflationary environment wrong, then I think it will be unique because the very fundamental nature of capitalism as we have known since the end of the Second World War will have changed - forever

Where are we in the Sovereign Debt Issue?

I am sure the predominant question that everybody would like to ask is the title of the post. So I thought it would be a nice time to take stock of the situation (NOTE: take stock is more of a metaphor). As usual i would like to give you some important statistics and ask a few important questions and then would prefer to leave it to the best senses of the read to come up with rational answers. The last part of the post will consist of some important scenarios that investors have to consider in the present economic environment.

Is the Sovereign Debt crisis winding down or at least are we seeing light at the end of the tunnel? One would only wish and hope that we could give straight short postive answers to the question. Unfortunately the only short answer is that we still have a long way to go. The reason for this negative brutally frank answer is clear. Despite all the rhetoric about the Greek package, Greece is only a small fringe player in Europe. That may surprise the passive observers of the economy. But anybody who follows the bond market will understand that the problems for Greece are only partly over and the problems for ther other countries, especially Spain and Italy are just starting.

The bond markets are likely to panic far more than the present (unless we have dramatic action by the world's central banks) in late June and early July because a number of countries have to roll over or repayment of substantial amounts of outstanding debt.

In the next five months the amount of debt that various countries in EU have to roll over varies from about 4% in the case of Ireland to about 9.7% in the case of Italy. EU as a whole needs to rollover or repay about 6.2% of its total outstand public debt.

The following statistics will probably place the issue in a better perspective (the total quantum of debt is given in brackets).

Italy needs to roll over 9.7% of total debt (which stands at US$1.4 trillion)

Portgual needs to roll over 8% of total debt (which stands at US$286 billion)

Spain needs to roll over 4.7% of total debt (which stands at US$1.1 trillion)

Ireland needs to roll over 4% of total debt (which stands at US$867 billion)

Greece needs to roll over about 6.2% of total debt (which stands at US430 billion)

UK needs to roll over about 4.4% of total debt (which stands at more than 848 billion Pounds)

The total outstanding debt is likely to be more than that cited above as most of the statisitcs are for total debt at the end of February-March 2010 while in the case of UK the outstanding debt is as on 18 February 2010.

Therefore the options that the Central bankers, especially ECB, have are rather limited. They (ECB) can either rollover the debt by printing more money and using the procceds to buy bonds or simply allow a default. The second option is inconceivable, especially on such a scale. So they will have to buy bonds and concurrently allow the banks to pledge any collateral, even if it has 100% likelihood of default being pledged with the ECB. Among the other smaller measures that the ECB will invariably take up will include a cut in interest rates (all the way to Zero - and they can still cut 1%: not bad) and providing the banks with unending supply of loans on very easy terms. This money will (after about 6-12 months) come back into the markets. But in the process the ECB would have only postponed the issue by that much time and would help create the mother of all bubble which will probably burst in about 18 months time - IF EU is able to weather the present perfect storm.

There are a number of scenarios that an investor would have to seriously consider. These are enumerated below. Though some of them are unthinkable at the present juncture, the more prudent investors should probably have an open mind about various options.

1. What would be the market reaction if the ECB were to announce Quantitative Easing by buying their own bonds (most of which are anyway near junk)?

2. What would the government do with their largely insolvent banking system? Till date sovereign debt was considered a risk free asset and its holdings went into the calculation of the banks capital adequacy ratio. Imagine if this were to happen in India: most of our public sector including LIC would be insolvent as they hold GSec's.

3. How to deal with the hitherto unthinkable: How would the market react to a collapse in the Euro (as it exists in its present form)?

Probably the Governments will ask their banks (or even better Goldman Sachs) to rig up the markets by buying all the indices and would ask JP Morgan and HSBC to keep selling gold futures so that people dont panic.

Deja Vu all over again.

Don't Stop Looking for the Exits

How many times have we heard the Policy makers emphasise that there is no crisis and that they are top of a situation? Their bland speeches, ad nauseam content is actually taking a toll on my health (though not the financial part, because I dont believe them anyway). In late 2007 and early 2008, we were told that the banks were safe and then were told that the bailouts were essential to save the financial system. Any discerning investor should have avoided investing in the financial sector (unless one was a speculator). Everybody loves a rally, especially the financial sector and the policy makers for the simple reason that for one (financial sector) they can profit immensely from the proclivities of investors who think this time is different; while for the other (Policy makers) capital is easy to come by during market rallies. They dont have to do anything. Rising asset prices give a false sense of capital buffer (as they did during 2003-2007 rally).  

This time is different. But, for the wrong reasons.

It is imperative to note that the basis of calculating the price of an asset is at best inaccurate or at its worst speculative. It depends on two parties making a lot of inferences about the future, which is essentially unknown. This could have remained at the realm of abstraction but for the fact that with fiat money and financialisation the financial markets cannot be ignored. In 2008 and 2009, the policy makers transferred private risk from the banks onto themselves by massive bailouts and by assuming more debt by attempting to reinvigorate the global economy. The money would probably have been well spent had they immediately forced the much delayed structural change that was needed. Instead, their thinking was based on only one assumption: hoping that private demand would come back. Unfortunately, that has not and now we are in the throes of yet another crisis: only this time it is much larger than the previous only. The postponement of a surgery only leads to greater problems down the line. 

I am reproducing two important charts. One chart shows that Europe is so interconnected that we have now reached the end of the road because till date various countries were only running a ponzi scheme.  The chart below shows the amount of debt that each country owes the other cannot and no way can they repay such large amounts. Add to this other obligations of the countries including those related to pensions, health, etc and the only way that a country can meet its obligations to all other stake holders is by defaulting on their loans. I believe that it is a matter of time before there is one form or another of debt default (or call it restructuring if you may).

The bond market is not going to like that and it would instead prefer that the governments' cut down on spending, which would hurtle the global economy into a deflationary spiral. But creditors will be big winners in such a scenario. I am quite sure that it is going to be disappointed in the long-term because the polity of west is not like China. Take the case of Greece: It has promised austerity measures that are nearly 13% of its national income spread over the next four years. If the government actually attempts to deliver on its promise then rest assured that the ruling party will not be elected for at least another 20 years. 

A candid confession to this possible outcome created a flutter in UK recently when Mervin King is supposed to have claimed that if the parties deliver on their promised reduction in expenditure then they will not be elected for a generation. 

The Second Chart (above) shows why the problem has just got out of hand. The banks in most of the countries are on the verge of insolvency. Hence the urgent need for the Greek bailout (and many more down the line).It shows that the banks of Europe have exponentially large amounts of money (nearly 150 billion Euros) to Greece and Portugal. Add to that the monies lent to Spain, Italy and UK. Compound that to the lending spree in Eastern Europe, Latin America and USA.

There is another short-term solution to the problem: create an even bigger bubble by pumping in more money. The interesting aspect that has been missed is that the very fundamental nature of Capitalism has changed due to the most recent crisis in the following ways:

1. State Capitalism now rules most parts of the developed world (OECD, India, China, etc)

2. Public Sector is the only game in town

3. The time duration between two recessions have been cut short: in the 1970s the next recession was 10 years, by the 1990s it was 5 years away and now it is probably 18 months to 2 years (or who knows may be even more)

Charts Tell Another Story: The Case of Wheat

The chart of Wheat (given below) is probably one of the more interesting charts. In technical analysis terms, we have what is often referred to as positive divergence or what seems to be an accumulation pattern. The reason why the chart seems so interesting is that the chart seems to indicate accumulation despite the fact that there are a number of news items' that claim that we are heading for a record Wheat crop in USA as well as India. The significance of the chart (US markets Wheat Continuous KBT) increases since it has occurred in the weekly charts, which tend to have a greater bearing on the long-term trend. Add to this the recent reports about the complete crop failure in Niger.

Interestingly, the Base metals complex is exhibiting more signs of distribution (or negative divergence) han accumulation. The significance of this pattern would only be known once there are more details about the actual output of wheat, rather than estimates. The fact that the world food stocks are at their lowest point in three decades may have ominous portends, if these charts turn out to be true.

                                           (Click to Enlarge Chart)

Greek Tragedy:
Beginning of the End or End of the Beginning

A remarkable feature of the financial markets is their recurring problem of selective amnesia. The past decade has seen short-term volatility jump exponentially and reach record levels that were often considered the realm of theoretical possibility. A flabbergasting feature of the markets over the past decade seems to be at odds with the conventional logic that fundamentals always catch up over the long-term. The point is: what is our long-term should perspective and what metrics should we use? This question is not simply a point for academic debate, it is probably the most important riddle that we need to solve in the era of rapid financialisation that is vastly aided by technological changes just at a time when the world is at the cusp of a major structural change. This paper attempts to grapple with changes in the sphere of political economy of global finance

One is forced to wonder whether the structural changes that are taking place in a number of the more advanced economies are being missed by a number of market participants.

A few months ago (in February 2010) a former Chief Economist of IMF (Simon Johnson) described the G-7 economies as ‘fundamentally useless’. We could extend that analogy could probably be extended to describe the emerging markets as ‘technically useless’. We attempt to grapple with the major issues facing some of the economies of the world. This could be a particularly good time to take up such a study as we are bound to witness increased euphoria that the ‘Greek tragedy’ has come to an end and the world economy could roar back into growth – just like old times. I really hope so. But I would probably be a bit more circumspect and would probably keep the age old adage: buy the rumour and sell the fact. It is likely that this time is no different. Nothing has changed structurally over the weekend – not even with the US$61 billion bailout of Greece. At most it is just the end of one chapter. We are bound to witness a short interregnum period (at the most 2-3 months) before another country take the markets take pot shots at the next most vulnerable country. The list is quite exhaustive, to put it mildly.

BIS, one of the most authoritative voice, in global finance has pointed that public sector debt is now expected to exceed 100% of GDP of OECD countries in 2011 – something that has never happened before in peacetime.

Major Structural Issues:
    * The world may be ending the policy that drew largely on Keyanisian policy of  counter cyclical spending by governments because of their public debt has almost in every country reached its sustainable level. Any increased debt is likely to lead to a sharp deterioration of public finances.
    * Concurrently, we have consumers wilting under heavy debt caused by a culture based on debt induced consumption. The process of debt deleveraging has probably just begun – as implied by the demand for loans in different parts of the world.
    * A large number of European countries have no competitive advantage in their economies that will enable them to recover from the blows of the recent credit crunch. In most of the countries the boom was based on spending that accrued in the form of increased revenues originating from over priced assets, especially in the housing sector.
    * With the likely end of government largesse turning into an era of enforced fiscal tightening, would the world economy return to economic boom conditions? The short answer once again is negative because of the simple reason that if the governments were to tighten liquidity then we are likely to witness a deflationary spiral at which point the burden of debt only grows due to the declining incomes. If the governments’ donot withdraw the money that they have pumped into the world economy as stimulus then the best case scenario is likely to be stagflation: none of which are good for the return of a consumption oriented economic boom conditions that two generations have come to rely on for any growth.
    * The era of low long-term interest rates (over the next decade) is likely to have come to an end, implying that everybody from the governments to the consumers will have to pay a lot more for their debt.
    * OECD countries are rapidly ageing and this will open up the Pandora’s Box of problems in their pension systems.

Questioning the Unknown:
    * An interesting question that investors would need to grapple with is: why is gold rising, especially if what was supposed to be a Greek tragedy has come to a happy ending? A lazy answer would be that the US Dollar is falling after the announcement of the bailout package. But gold rose from about 1044 in February 2010 and is now near the technically critical resistance of 1170.
    * Bond markets seem to thinking that they will not be asked to forego their principle. This seems to quite an oxymoron. Never in the history of capitalism have lenders been not forced to take a haircut (especially large ones) when sovereigns or countries default.
    * The countries in trouble profess extreme confidence that they will be willing to reduce their deficit from levels that exceed 11-15% to about 3% (as required by EU) in 2-3 years.

The Never ending Greek Tragedy:
Unfortunately, the ‘Greek Tragedy’ is not about to end so easily, at least not because of the package that the EU has announced. Interestingly, they have not announced as to who will pay the US$61 billion. It has been estimated that the financing requirements of Greece over the next three years is about US$150 billion. The EU has committed to less than half the Greek requirement. Invariably we can be sure that the issue will come back to the centrestage, sooner rather than later. The next time it comes back to the centre stage we may rest assured that it will be accompanied by similar predicaments for other countries. Unless the problem is solved permanently (through drastic structural change) we are bound to witness the game of who is next? The list is quite large and in each country the political instability (or perceptions about such instability) are enough to send ‘hot money’ rushing for the exit. Thailand is the latest example. Geo-political tensions in the middle east could provide another source of problem. More troubling such stop gap bailouts will only provide an opportunity for speculators. The next issue that Greece and its banks have to face is how to overcome the flight of capital, which is already growing at an alarming pace. It has been estimated that nearly 4.5 percent of the GDP has already been transferred out of the Greek banks. Unlike some of the emerging markets, Greece is helpless against such capital flight.

The first important question that any person willing to go beyond the financial media headlines would like to ask is how is Greece going to move from at least 4% GDP primary budget deficit to a 9% GDP Primary surplus – needing a total of 13% GDP further fiscal adjustment. Not an easy task, especially in countries that have been so used to a welfare state model. By the end of 2011 Greece’s debt will be 150% of the GDP (as per IMF estimate) with nearly 80 percent of the debt being owned by foreigners. Therefore even if Greece were to withdraw from the Euro and devalue its currency, the huge increase in the nominal value of the debt is quite high for consumers and government. It has been pointed out that every 1 percentage point rise in interest rates means that Greece needs spend an additional 1.2 percent of its GDP to it bond holders.

The only viable solution for Greece: Default on its debt and write down the principle by about 60-65% and that would bring down the debt to about 50-60% of its debt. Unfortunately, the bond market is not discounting such a big haircut but unfortunately that is the write down that Argentina offered after its default in 2001. Interestingly, there are a number of similarities between Argentina and Greece, if anything Argentina seemed better (at least on paper). In 2001, Argentina’s public debt was 62% of GDP, while in the case of Greece it is 114%. Argentina’s fiscal deficit was 6.4% of GDP in 2001, while in the case of Greece it is 12.7% of GDP in 2009. The current account deficit of Greece is about 11.2% of GDP, while in the case of Argentina it was 1.7% of GDP (in 2002).

Grappling with the unknown:
The BIS has pointed out that there will be substantial pressure on the balance sheets of various OECD countries in 2010-2011 (See Chart Below). This would need deep fiscal tightening in order to reduce their debt from current levels, but their debt would remain far above the levels that existed before the start of the crisis. We could therefore extrapolate that the next few years will lead to less government spending and with it a collapse in domestic demand in most of the various OECD countries. Unfortunately, the Purchasing power of the populace of the emerging markets is far below that of the OECD and therefore they are unlikely to replace the lost demand. Importantly most of the governments’ in the emerging markets too have increased since the beginning of the crisis, thereby capping the upside growth potential for the world economy.

Can Governments’ Cut Debt so quickly:
The Quick answer is theoretically plausible, but practically speaking probability of a democratic government cutting debt so quickly successfully will probably be less than 10 percent. Take the case of Greece. Simon Johnson the former Chief Economist of IMF, has pointed out the country which had a deficit of about 12.7 percent of GDP in 2009 will have to cut it down to 3 percent by 2012 (two years from now). He estimates that every One Euro cut in government spending (or fiscal tightening) will lead to a decline of about 1.5-2 Euro in lost domestic demand. Greece is not like China, where the rulers need not face a direct election. The government will have to face an election, though not in the near future. The only way Greece can meet that target will be if their policy makers decide to risk political oblivion. Let us accept it: that is unfair or more like asking for too much from a party that has just been elected, after 8 years out of power. Unfortunately, Greece has no industry that can lead to its revival. Their important foreign exchange earner is tourism and that is stuck in the quick sand as Greece has no currency of its own which it can simply devalue to the extent of say 35-50 percent so that their goods become competitive in the global market place. They are stuck with the Euro. Therefore over the next year or two it will become increasingly clear that the only way Greece can come of out of this quagmire is to either to default or exit the Euro.

Ultimately, every $1 of fiscal tightening may generate $1.50-2.00 in lost domestic demand.  Fiscal tightening only works if the new unemployment leads to wages and prices falling, so making a nation more competitive.

Counter Point:
There is always a contrarian opinion to any view. It may be pointed out that most of the bull markets will probably start this manner. That may be true to a certain extent but there are two important differences, this time. Unlike in the past (the post World War II era) we have never had so many countries (especially the richer countries) facing such crisis. In most of the cases, they are staring at solvency issues and not liquidity issues. More importantly, unlike the last time this time the policy makers have run out of ammunition thereby limiting their ability to continuously indulge in trillion dollar bail out.

How much is a Trillion Dollars

Came across this interesting piece:

Picture a stack of $100 bills. It might surprise you to know that it only takes a stack four inches high to be worth $100,000. So $1,000,000 would be a stack of $100 bills 40 inches tall. How about a Billion? Well, you would have to stack $100 bills up to the top of the Empire State Building...twice...in order to reach a Billion. So to picture $1.25 Trillion represented by a stack of $100 bills - that stack would be 850 miles high. If you could turn that stack on its side and were able to drive alongside it, it would take you longer than 14 hours to reach the end. If you laid those $100 bills down side by side, they would travel around the world 50 times.

Sovereign Debt: A Snapshot

Country	Debt as % of GDP 2007	Debt as % of GDP 2009	Debt as % of GDP 2010 (Projected)
Japan	167.1	189.3	197.2
Iceland	53.6	117.6	142.5
Italy	112.5	123.6	127.0
Greece	103.9	114.9	123.3
Belgium	88.1	101.2	105.2
France	69.9	84.5	92.5
USA	61.8	83.9	92.4
Portugal	71.1	83.8	90.9
Hungary	72.2	85.2	89.9
UK	46.9	71	83.1
Germany	65.3	77.4	82.0
Canada	64.2	77.7	82.0
Ireland	28.3	65.8	81.3
Brazil	57.4	66.9	69.6
Spain	42.1	59.3	67.5
India	42.3	45.0	45.7
South Korea	25.7	33.2	36.8
Australia	15.3	15.9	20.3
China	21.9	20.0	20.0
Russia	6.8	7.2	7.4

Source: OCED, JP.Morgan

Europe is Looking  a lot like Japan

• Most of the European countries need 8 to 9 per cent of GDP-worth of permanent fiscal tightening which would lead to a huge deflationary spiral if carried out. But unfortunately the governments would have to take up this belt tightening if that were to happen.
•  All the governments in the G-20 will have to start cutting their fiscal deficit, which means that they will have to grapple with the prospect of a deflationary spiral as it will leave little room for further stimulus measures over the next three years. Europe will contract this year due to the greater emphasis on reducing fiscal deficit: Greece’s GDP has already contracted by 3.0% YoY, as of Q4, and is expected to contract 1.1% in 2010 and 0.3% in 2011 as a 13% deficit-to-GDP ratio is sliced from 13% to 3% (assuming this fiscal goal can be achieved politically). Portugal has a 9.2% deficit-to-GDP ratio that is in need of repair and Spain has a deficit ratio that is even worse, at 11.4% of GDP.
• Now governments are being forced to cut their spending, which will inevitably lead to great suffering a large scale rise in the already high unemployment. It is worth noting that about 25% of the Spanish youth are unemployed. At some point (though may not be immediately) we are bound to see a rise in social tensions across Europe).
• Greece has offered to cut between Euro 8 billion to 10 billion in budget. However, EU is demanding that they increase these cuts by a further 2-4 billion Euros. It has been pointed out that this year Greece will have to shrink its budget by upto 20% of its GDP – a disastrous recipe for accelerating pressure of deflation.
• Greece needs to raise about Euro 54 billion this year and has so far raised only about Euro 13 billion.
• More importantly international banks are still not safe. EU (as with most of the governments in different parts of the world) forced their banks to buy sovereign debt. Now that has become a problem issue. It is pertinent to note that about nearly 95% of the Greek debt issued by the government is owned by European banks. Apart from this U.K. banks have $193 billion of exposure to Ireland. German banks have the same amount of exposure and an additional $240 billion to Spain. Many international bond mutual funds also have sizeable exposure to sovereign debt of Portugal, Ireland, Greece and Spain as well. US banks have about US$190 billion exposure to the countries that are in trouble. So any problem of perception (need not be actual default) will lead to exactly the same type of consequences as those in the aftermath of the bankruptcy of Lehman Brothers in September 2008 – only this time it will be many times more severe because now various countries will be impacted. In the past two years various banks were buying the debt of the countries thinking that they are safe, if a country sinks then invariably the banking system of that country will also collapse.
• There is a very important structural problem for the troubled countries of Europe. Most of them have no product that they can sell and earn money in order to enable them to recover from their problems. Spain’s economic growth was because of Housing, where a nation of about 45 million was building more houses than the combined number of houses being built in Germany, France and Italy at that point of time(which had a combined population of 200 million). 
• Globalisation over the past few years has systematically deindustrialised countries such as Greece, Spain, Italy, Portugal as well as others who had a lower wages. Industrial production has now shifted to different countries of the emerging markets, especially China.
• Add to this the problem of the Aging Europe and we have a recipe for a disaster in the making. The only difference is that unlike Japan, EU is not one entity that can print money. EU doesnot have the reserves like Japan. 

So the only solution to the mess that Europe finds itself may be to go back to the state of individual nation states so that they can simply print money as they like and tax people as they like (and of course, if necessary run deficits as they like). EU better come up with a solution quickly as if the greater the delay, the greater the problem.

There seems to be only one certainity in this age of uncertainity: The people of those countries better prepare for greater suffereing, higher taxes and less government spending. After all this is not a new age as it was claimed, just a return to a forgotten chapter of our history.

A Greek Tragedy & Other Interesting Statistics

I complied some of these statistics from different sources on the Internet

• Fiscal Deficit of Greece: 12.7% of GDP 
• Workers in Greece have the second highest level of actual hours worked.  
• Greece needs to refinance about Euro 64 billion worth of debt - most of it before April. By end of January they raise about Euro 8 billion. 
• EU wants Greece to cuts it budget by 8.7 percent this year and down to three percent within three years.  
• The total debt of Greece is Euro 254 billion other estimates place the debt at Euro 300 billion.  
• Nearly 30 percent of Greece's economy is underground and hence beyond the scope of taxes. 
• If Greece swallows bitter pill and makes the budget cuts, that means that nominal GDP will decline by (at least) 4-5% over the next 3 years. Since tax revenues will also decline, even with tax increases, it means that the country will have to make even further cuts, over and above the ones contemplated to get to that magic 3% fiscal deficit to GDP - a great recipe for an economic depression. 
• Add into the equation that borrowing another €100 billion (at a minimum) over the next few years, while in the midst of that recession, will only add to the already huge debt and interest costs. 
• Unfortunately for Greece it cannot take the easiest way out by devaluing its currency or printing more in order to take up 'quantitative easing' like UK, USA or Japan, because it does not have a national currency. (A great reason why the Euro could fail). 
• Bank of International Settlements (the central bankers' central bank) says that the largest holders of Greek debt are the French, Swiss and Germans. In June 2009 it was France €86 billion, Switzerland €60bn, and Germany €44 billion. Other estimates place this at of France €73b, Switzerland €59b, and Germany €39b. In terms of GDP, for Germany it is minimal - just over 1%. Of more concern, for France it is nearly 3%, and for Belgium 2.5%.

That is not all. Others are not far behind:

• By the way, the politically right word to refer to the troubled countries of Portugal, Spain, Ireland, Italy and Greece (which were also refereed to as PIIGS) is now Club O'Med. 
• Barclays Capital says the net external liabilities of Greece are 87pc of GDP, or €208bn (£182bn). Spain is worse at 91pc (€950bn), and Portugal worse yet at 108pc (€177bn); Ireland is 68pc (€123bn), Italy is 23pc, (€347bn). Add East Europe's bubble and foreign debts top €2 trillion. 
• It has been pointed out that the total exposure of various countries to Club O'Med is $853bn for France (30pc of its GDP), and $707bn for Germany (19pc of GDP).

Hold your breath! the UK takes the cake: It has been pointed out that UK banks have a 250 billion pounds exposure to the Club O'Med countries.

See the following table