The narrative of risk is a narrative of Irony
- Ulrich Beck
January 2011 was truly momentous as far as the financial markets are concerned. The inauguration of the New Year saw optimism reign supreme with the last of the bears sulking in hibernation – or so it seemed. Centuries of capitalism and markets have taught us (though public memory is always short) that it is exactly at times that when last bear seems to have been gored it is not the bear that is slain but it is big bloated obese, clumsy bull that meets an ignominious hospitalisation – at least for a time. The vice versa is very much applicable in case of bear markets. Thenceforth the cycle starts all over again. Only time will tell us whether this is validated for 2011, though for the market participants ipso facto validation may be no solace. Importantly, January 2011 vindicate what a famous social scientist had to say about risk: Ironically, in the case of the present-day financial markets, the risks were apparent to any objective observer since at least the beginning of November 2010, if not earlier. A pertinent question that we have to ask is if the nature of risks were so easily discernible with the information in the public domain for so long, why have the markets started discounting these factors only now? Hopefully, by the end of this note, I would have thrown light on at least some of the questions that are on our minds.
Apart from the plateful of risks that existed at the end of 2010, there are two new additions to the problems list. First, the rise of new geo-political risks due to political rumblings in North Africa. The problem with political protest is that nobody knows which dictator could be the next. Two, the surprise downgrade of Japan by S&P; third, the gradual realisation of the magnitude of the problems of overheating and inflation in the emerging markets and, last the clear evidence that the fiscal austerity is not working in Euro zone.
Starting with the first (political turmoil) it is clear that the problems that started in Tunisia have spread to Egypt and are likely to spread to Algeria and Morocco. The rise in food prices, which usually form 25-50 per cent of family budgets in the developing world make large parts of the Middle East and the developing world a tinderbox of combustible material. In the era of a globalised supply chain each country has its own position. The case of Ivory Coast is instructive: political turmoil (unrelated to that in North Africa) have led to a Cocoa prices shooting up to a 20 year high. While the political uprising in Tunisia may be ignored due to the size of the country, Egypt promises to be more interesting due to its strategic importance, economically as well as politically. Politically, Egypt is one of the most important countries of the Arab League and the home to the Suez Canal. The Suez Canal is important because nearly eight per cent of world’s trade passes through that region as do another one million barrels of oil per day. It has been pointed out that if the oil pipeline that runs adjacent to the Canal is included then nearly 4 million barrels of oil pass through it. More importantly, at the present juncture the new global supply chain cannot ignore the shortening of the travel time between the east and the west by ships transporting good. The usage of the canal shortens the voyage of ships by about 12 days, any re-routing of ships (which has not happened till now) will force an increase in costs – something that most debt stricken consumers in the west can ill afford. Companies are in an even greater precarious position and they cannot absorb the increase in costs. Hence, the events in Egypt are yet another unknown to the current already fluid global economy and hopefully they will not be aggravated. The longer the political uncertainty the greater the problem for the world economy and a quick end will be beneficial to everybody.
A more pressing problem for the global economy that was signalled in the last one week was the surprise warnings from the rating agencies which brought back the issue of sovereign debt back to the forefront. S&P cut Japan’s US$10.6 trillion debt by one level to AA-, the same as China due to lack of policy traction, shrinking workforce and rising interest rate burden. While this may not have an immediate impact on the Japanese economy, it will be a major problem if the world economy does not recover in 3-4 years time. Japan is an excellent case-study of what a large, modern economy has to endure once a debt driven real estate fuelled bubble bursts. Japan’s tax revenues comprised only of about 50 percent of the country’s expenditure in 2010. Interest rate payments comprise of nearly 28 percent of the tax revenues. The combined government debt is expected to reach 230 per cent of GDP this year.
Japan, however, has been spared of the sovereign debt issues largely because nearly 95 per cent of its debt is held by local investors. There are however, a number of problems that Japan will have to grapple with in the nearly future (next 2-3 years). First its population has been declining since 2005. Second, its savings rate has declined substantially from about 15 per cent of GDP in 1990 to the present less than 3 per cent. It is expected to reach negative territory in the next 2-3 years. In the mean time Japan will keep drawing down its substantial foreign exchange reserves (of about US$3 trillion) to meet interest as well as debt repayment needs. Third, IMF has recently warned that Japan’s public debt to revenue ratio will rise from 263 per cent in 2007 to about 482 per cent by 2015. Last, Japan’s economy has largely stayed afloat due to its burgeoning trade with China. Imagine the consequences of the bursting of the Chinese bubble.
The US was warned by the rating agency Moody’s that their debt will be downgraded in future, if measures are not implemented to start reducing the fiscal deficit. That came just a day after US President called for a spending freeze for the next five years. The advantage of fiscal consolidation in the present juncture is still hotly debated and at this point it seems to be a highly polarising and never-ending topic. Suffice to point out that a cursory glance at Euro zone (in the present) would make it clear that it is not the panacea for the problems in the world economy.
Japan & US Economy: So Near, Yet So Far!
At this point, may be helpful to compare the case of Japan and USA. The charts below (
Sourced from Gluskin Sheff) will help us place the economies in proper perspective. To this one needs to note the recent US Federal Reserve inflation (excluding fuel and food) gauge for 2010 indicated a rise of 0.8 per cent, while their comfort zone is 1.6 to 2 per cent. This pronounced deflationary pressure that lurks under the headlines blitz about quantitative easing may be responsible for what seems to be US Fed’s insistence on completing its QE2 even if there were to be marginal improvement in the US economy – which till date has been illusionary.
Private Spending on Housing
The chart below provides a comparison of Japan and the US private spending on housing. The marginal improvement that was seen in the US housing spending was due to spending that took advantage of tax concessions. It has been pointed out that the Case-Shiller index is now about
3.3 per cent from the all-time low reached in early 2009, indicating that all the measures to boost the economy have had only limited impact. Historically housing and housing related services contributed nearly 18 per cent of US GDP .
Three Month Treasury bill Yields (in per cent)
The eerie similarities do not end only with housing. The US Treasury yields look like a mirror image of the two post-bubble economies. The bond market is considered to be one of the best barometers of the economy. If the past is an indicator of the future then the US bond yields will remain low for a long time, as in the case of Japan.
Central Bank Reserve Credit Expansion
The rise in the markets may have more to do with the three sets of charts that we have provided below. It is apparent that there is a direct correlation between the rising deficits, rising credit expansion and the rising markets due to the growing financialisation and the use of derivatives.
The Market behaviour (see chart below) has substantial correlation to the rising balance sheet of the central banks
Government Deficit as a Share of GDP
There seems to be a lot of thinking that interest rates will have to rise in 2011 due to inflationary pressures. That seems to unlikely. Since late 2009, I have held the view that interest rates will continue to remain close to Zero till the end of 2011 or even mid 2012. I continued to hold this view despite lot of talk in 2010 about the rise in interest rates in the USA and EU being round the corner. I continue to believe that interest rates will remain at or close to Zero till the middle of 2012, if not beyond. The position of the consumer or the corporate sector in USA, EU or Japan is such that they are not in a position (financially) to sustain their anaemic financial health if there is an interest rate hike. The bond market clearly seems to have come to the realisation after the scare that interest rate hike is not due anytime soon. Goldman’s sale of its first 30 year bonds in more than year priced at 6.25 per cent was a resounding success, while the US Treasury Inflation Protected Securities attracted less than average demand. The bid-to-cover ration was down from 2.91 in November to 2.37 in mid-January.
This is not to claim that there is no improvement in the global economies. I believe that the improvement is marginal and it has been the product of massive amounts of government spending, globally. Governments are fearful or unwilling to remove the stimulus despite clamour.
The chart below places the constant claims about the improvement in retail sales in the USA. It is the chart of retail sales, six quarters after a recession.
Source: Gluskin Sheff
Euro Zone: No improvement on the Horizon
Euro Zone and UK are no better. UK’s economy contracted by and unexpected 0.5 per cent last quarter – a phenomenon that was wrongly blamed on the weather. Consumer confidence in the UK collapsed to its lowest level since March 2009. It has been pointed out that in 35 years since the index was established, confidence collapsed by eight points only on six occasions, the last time being during the middle of the 1992 recession. European Sovereign debt issues have no signs of easing. Bond prices continue to remain at alleviated levels indicating stressed fundamentals despite all the intervention by the European Central Bank. These high levels indicate that the problem countries have no possibility of riding out the storm. Interestingly monthly statistics do not any major improvement in the major economy. Personal loans in the Euro region declined as did money supply. It is clear that austerity measures may be having started to bite. The thinking that private consumption will replace government spending seems to be a clear case of misplaced optimism. A factor that most observers seem to have missed is that as economies contract, tax targets are unlikely to be met, thereby making the fiscal situation worse in the long-term term despite short-term improvements.
A comparison bond yields since our update on European Situation on 10th January 2011 places the state of the bond markets in proper perspective.
Bond Yields of Select countries (in percentage)
Name of Country | 10 Yr Bond Yields
2st November 2010 | 10 Yr Bond Yield
(10th January 2011) | 10 Year Bond Yield (28th January 2011) |
Spain | 4.28 | 5.5 | 5.45 |
Portugal | 6.23 | 7.10 | 7.07 |
Greece | 10.79 | 12.60 | 11.46 |
Ireland | 7.29 | 8.91 | 9.15 |
Belgium | 3.31 | 4.13 | 4.29 |
Italy | 3.96 | 4.81 | 4.78 |
France | 2.88 | 3.34 | 3.52 |
Germany | 2.47 | 2.87 | 3.14 |
UK | 3.03 | 3.51 | 3.65 |
Source: Compiled from Bloomberg
The above table clearly illustrates that the pressure on most of the countries remains largely intact. This in turn cascades into a system of gradual deterioration of the macro economic fundamentals of those countries that are forced to borrow high cost of money from the bond markets. The EU emergency fund is not aiding to any improvement, instead it is forcing the countries to borrow money at a higher cost. An interesting aspect of the bond markets that has largely missed the attention of the popular press is the gradual increase in the yields of France and Germany, which will be forced to pay for the bailouts. This indicates that there is an urgent need to think of other solutions as any future bailouts would risk an increase in the cost of borrowing for Germany, something which the electorate is already unhappy about.
In fact the most likely fall out of the present crisis is the likely political impact. We can safely say that in the event of an election, none of the incumbents may be re-elected, a fact that has dawned on most of the political class of Europe. This in turn is leading to the postponement of the day of reckoning in almost all the countries, including India. Even a unitary State like China cannot ignore the discontent of the people. In fact they need to be more cautious as a revolt in most of the democracies will only mean a loss of power while in the case of authoritarian states’ it will mean loss of the rulers head – remember the French Revolution of 1789! This is not to claim that Europe or other countries are on the brink of a revolution. That may not happen in the present conditions. One of the reasons why there may be that the decline in the standard of living has happened so gradually that a number of people have actually forgotten the crisis. After all, ignorance does seem to be bliss in this case.
The importance of this gradually process of deterioration in the real economy would have gone unnoticed but for some danger signs, which are flashing – some after a long time. These include the rise in food prices and the precipitous fall in the Baltic Dry Index. FAO Food Price Index has shot up by almost 25 per cent since December 2009, with a number of agricultural commodities almost doubling. Cotton has doubled from June 2008 levels. Wheat and Corn are up more than 50 percent over the past one year. The Thomson-Reuters Jefferies CRY commodities index has increased by almost 50% since May 2010. See Chart Below shows the movement of the Index since 2008.
Source: Bloomberg
Any discussion about the world economy, however brief, would be incomplete without a mention of the emerging markets, especially China and India.
Speculating on Speculation about China
Any discussion of China invariably leads us to important questions about the nature of Chinese bubble and when it would burst. The short, candid answer is: nobody knows. Essentially we are either speculating or speculating on somebody else’s speculation. In fact, that could be frank confession with all my views. If I really knew the precise answer (apart from rational guesses based on analysis) then I would be a billionaire many times over. But that after all is the nature of an increasingly globalised finance. Since I am a bit knowledgeable about nature of finance, I probably make a spate of observations that may turn out to be correct –especially over the medium to long-term, though I must confess that my short-term guesses have been horrendously inaccurate.
China is very important to the global economy for the simple reason that it China accounts for 35 per cent of global use of base metals, 21 per cent of the grains, and 10 per cent of the of crude oil. The fact that it has lent nearly US$896 billion to the USA is yet another reason why it is grudgingly accepted as an important power by Western Nations. The problem with most of the commodity markets is that relatively small amounts of money can move the markets substantially, unlike the currency markets. Barclays has pointed out that the total investments into commodities in 2010 accounted for only about US$385 billion.
There is no need to repeat a lot about the over-heating of the Chinese economy. When we first pointed out the possibility it was considered to be paranoia. Suffice to point out the latest indications that clearly show that the Chinese economy continues to overheat by the day and the government risks losing control. Property prices continue to rise and the government has no answers, and it is thinking in terms of price controls. It has introduced property taxes in different cites on an experimental basis and has increased the down payment for second homes from 50 per cent to 60 per cent. It has sought a differential system of capital reserve ratio of banks which exceed lending targets. However all these measures will do little to control the price spiral in the next few months. Unfortunately, since China’s growth is dependent on easy liquidity conditions and state subsidies, it can do little to upset the apple cart, lest it lead to social unrest. There are rumours that the annual bank lending target has not been set, due to the lack of unanimity amongst the senior policy makers. Commercial banks lent a total of 7.5 trillion Yuan (US$1=8 Yuan) while in 2009 it was 9.5 trillion Yuan. There are rumours that the lending targets have been fixed at 7.5 trillion Yuan, the same as last year. The interesting aspect that needs to be watched closely is how the banks deal with nearly US$250 billion off balance sheets this year and the consequences it has on the lending. It is still unclear as to how the present inflationary spiral impacts the savings, which have been the source of China’s economic strength over the past few decades.
The chart below provides an overview of the gross savings charges sector wise in China.
Source: National Bureau of Statistics
The inflationary spiral has led to a decline of savings over the past year (see chart below). Anecdotal evidence seems to indicate that the savings are being withdrawn with the intention of speculation in the property market. That along with the rising inflation may be detrimental to the long-term health of the Chinese economy. The inflationary spiral and the rise in commodity prices have led to a scramble for commodities in China – the latest commodity that they are hoarding is
cotton.
Source: National Bureau of Statistics,
Flow of Funds data and Urban and Rural Household Survey.
The problem for China the policy options seem to be few. One is that they need to increase interest rates, and two they need let the Yuan rise in value. But both these will invariably hurt its competitiveness in the global market place, thereby undermining the fundamental reason why it has succeeded – due to its importance as a low cost producer. The total value of China’s imports and exports was US$3 trillion, of which about 13 per cent was trade between China and USA. China’s dilemma is that if they drastically reduce the lending target then they risk choking funds to half complete projects, while if they continue to lend huge amounts of money then it would risk continued inflation. The money supply increases over the past few years should be seen in the context of the increase in the minimum wages by 21 percent in China that have come into effect since 1st January 2011. While this measure will improve the purchasing power of the workers, it would not help reduce the inflationary spiral. It is pertinent to note that in terms of value addition, China ranks very low. A high profile case that has recently been cited by Pascal Lamy, the Director General of WTO (in Financial Times, London) is that of Apple’s iPhone is instructive of the nature of China’s economy. Though the value of iPhone exports is estimated at US$1.9 billion, in terms of value addition, it is only US$73.5 million.
India
Indian markets have taken a beating during the first one month of the New Year. The hyperbole and exalted sense of India’s growth potential that was a staple of India’s inerudite media and large segments of the middle class has had to face a rude awakening in the past two quarters. The structural shallowness of the Indian economy is seen as gaping. Credit becomes scarce with an additional demand of about US$25 billion. Tight liquidity conditions will get far worse before they get any worse. I believe that they are unlikely to improve dramatically before October 2011 due to a variety of factors. Once again none of these factors are new. They have been building over the last few months – at least three months to my knowledge. Food inflation is just one of them. Rising oil prices and rising food prices mean that they have substantially impacted the poor and middle class – though in varied measures. Food has an impact on the poorer segements as 30-40 percent of their monthly budgets are utilised for that, while rising food and fuel is akin to a tax on the middle classes – the only difference is that it burns a hole in the pocket every week. The markets are down because they seem to have belated realised that these are not about to change in the near term and hot money flowed in has decided that India is too pricey given its risks. Only belatedly are they realising that in an era of rising prices, especially oil prices, India’s record current account deficit of 4.1 per cent of GDP which is funded wholly by short-term portfolio flows probably does not deserve such high valuations.
A close scrutiny of the results of the Indian corporate sector hides reveals the stress that a large number of companies, especially those dependent on consumption face. The steady deterioration in their balance sheets seems to have started – and it seems like late 2007-early 2008 period: Déjà Vu all over again. Suffice to say that this margin erosion due to tepid sales, increase in raw material costs and rising interest rates have only started to bite. India bulls have to look at the results of banks, Hindustan Unilever, ITC, Tata Global Beverages, Nestle and Maruti. The list goes on. This is not to claim that these companies will run into losses. Not in the next two years (at least). Instead, I think it is indicative of a medium term trend – which is likely to last at least to the end of September 2011, if not beyond. The companies that will be severely affected by this trend will be the small and medium enterprises, which would be hard pressed to stay afloat. Can this process be avoided? The short answer is yes, but only if commodities collapse by about 20 per cent.
A more ominous problem is building up in the banking sector. RBI has been warning of Asset-Liability mismatch in the banking sector. It has warned banks that while the tenure of their deposits has declined, with most of them being less than two years their lending has been mostly to the infrastructure sector (i “RBI Again Warns Banks on Asset-Liability Mismatch” Business Standard, 28 January 2011, Section II, p.4.). Nearly 50 percent of the liabilities of banks fall due in less than one year. It points out that nearly 58 percent of their investments are those above 3 years. At the same time their Non-performing assets have risen rather sharply. The saving grace in the Indian economy has been that the governments’ balance sheet has not deteriorated due to non-recurring sale of telecom spectrum and some IPOs.
Before concluding it may be useful to look at the charts that compare the Shanghai Composite Index and the India's NSE Nifty Index (Below). Both the charts indicate that the time for optimism may have ended (as the Chinese Index (in black) or is about to end (NSE index in Blue).
It is clear that the optimists may be badly jolted in 2011.
