Ruchir Sharma is the head of Emerging Market Equities and Global Macro at Morgan Stanley Investment Management. He generally spends one week per month in a developing country somewhere in the world. Also he has been a writer for as long as he has been an investor. Sharma has put his two areas of expertise that of having an extensive experience on emerging markets and being able to write about them, into a new book, Breakout Nations – In Pursuit of the Next Economic Miracle. In this interview he speaks to Vivek Kaul([email protected]).
How do you define a breakout nation?
Let me tell you where this idea came from. The last decade was a very exceptional decade for emerging markets in the sense that every developing economy did well. This is not consistent with the history of economic development. We have got two hundred countries in the world, and only 35 are developed, everything else is emerging. So the consistent history of economic growth is that you get bursts of growth and then it falters. Very few countries are able to sustain these bursts of growth and develop and become fully developed countries.
So why was the last decade different?
The 80s and 90s was a very bad period and this was a catch up happening because of that. Also there was a lot of easy money that started to flow out of the United States (US) from 2003 onwards. And there was a boom in the global consumer. It led to this myth at the end of the decade that if you were an emerging market it was all about a time as to when you would converge with the developed world. As I surveyed the world I figured out that’s not going to happen. That’s not the history of economic development and after a decade of economic success many countries were beginning to falter. Other thing that sort of stuck me was that people would ask me, listen even if India grows at 6%, no harm done, because the US is growing at 2-3%. There are two things that are wrong about that argument. One we saw last year, when the Indian equity market fell by 35% in dollar terms last year. So if you undershoot expectations it has a very negative fallout.
You are referring to the Indian GDP growth falling to less than 7%?
Exactly! One thing that people don’t take into account is expectations. Like in China today all expectations are of the country growing by 8-9% and if China grows below 8-9% it leads to instant panic in the markets, especially the commodity markets. So one of the definitions for a breakout nation is that the expectations have to be exceeded. If your expectations are already high and if you are just about meeting them, it’s not going to feel like bang for the buck for anyone.
You say one of the definitions….
The second is this per capita income argument, which is that if India grows at 4-5% that’s a real underachievement because we are only a $1500 per capita income country whereas if a country like Korea grows at 4% it’s a huge achievement because it’s a relatively rich country with a per capita income of more than $20,000. It is still classified as an emerging market but it is fairly rich. So there are three things behind which went into defining what a breakout nation is. One that not all emerging markets are going sort of emerge, so to speak, or become developed markets. Two that expectations are key in terms of how you define a breakout nation and three that you have to take into account per capita income levels. The lower the base the easier it is theoretically to grow and the more you should grow to get out of poverty.
You also say “very few nations achieve long term rapid growth”. Why is that?
This is because most countries or most emerging markets reform only when they have their back to the wall. They enjoy some success and then they stop reforming and begin to fritter away their gains. That’s what happened to Brazil. Brazil used to be the China of the 1960s. Its growth rate was nearly in double digits and then it completely lost its way. It started to fritter it away in terms of huge government spending, subsidies, and massive amount of wasteful expenditure which led to hyperinflation. If you look in the high growth list of the 1950s and 1960s, there were countries like Yemen, Iran and Iraq. The odds of long term success like it is with companies is very low. How many companies are there today which were there thirty years ago, or twenty years ago?
So which are the countries which have grown consistently over the long term?
There are only two countries which have grown over 5% for five decades in a row, South Korea and Taiwan. Only six countries were able at more than 5% for four decades in a row. The list included Hong Kong, Singapore, South Korea, Taiwan and I think there was Malta.
What is it that these countries did differently that other countries did not?
In countries like South Korea, China and Taiwan, they consistently had a plan which was about how do you keep reforming. How do you keep opening up the economy? How do you keep liberalizing the economy in terms of how you grow and how you make use of every crisis as an opportunity. Like Korea was really down in the dumps in 1997-98 crisis. They really had their back to the wall. But they capitalized on the crisis to clean up their balance sheet and to emerge again as an economic powerhouse. It is just about the fact you need to consistently keep reforming and understand that odds are against you. In India’s case what concerns me is the attitude. Listen we will grow by 7%, no matter what happens. That is a given. Now why it is a given, I don’t know. Earlier it was 8-9%. Many businessmen also like to parrot the line that 7% growth will happen, no matter what happens. To me I find that very disturbing. Maybe it is changing now, but till at least a year ago, the attitude was very clear.
You have set many doubts on China becoming a breakout nation. Why?
In fact I admire China’s success and of what they have done over the past thirty years but my point is that expectations on China have become too high. To me that is the big thing. Even though its per capita income has reached around $6000, IMF still thinks that for the next five years the growth will be 8% per annum. Every time the growth dips below 8%, it leads to panic.
Can you elaborate on this?
Surveys are carried out where fund managers are asked will China have a hard landing. I find two responses interesting. Only 10% say that China will have a hard landing. And how do they define a hard landing, a growth rate of 7% or less. The breakout nation concept is that you got to beat expectations. So what I am saying is that if China records a GDP growth rate of 6% next year, trust me it will lead to a lot of panic in many circles.
There are lots of negatives that you point out about China, which we do not tend to here in the normal scheme of things. Like you talk about salaries going up at a very fast pace i.e. wage driven inflation…
Chinese costs have been going up at the rate of 15% per year, and as I argue at the back of the book, the US in fact is now seeing some reshoring (i.e. factories are moving back to America), as we call it. After all the outsourcing and off-shoring the new trend in the US seems to be reshoring because the wage gap is narrowing. It is still there. But the wage gap is narrowing. An anecdote that I found very useful was when one of my portfolio managers went on the ground and the companies told him was that three years ago we could shout at the workers but today they can shout back at us. I think that’s natural. For the first time in China the urbanization ratio has gone to 50%. So a lot of the workers have moved from rural to urban areas, and the scope of workers left for companies to tap from is diminishing.
Why do you call the $2.5trillion foreign exchange reserves, an illusion?
If you look at the total debt of China as a share of their economy it comes to around 200% of their GDP. The Chinese know that. And therefore they are reluctant now to keep stimulating the economy with debt and they are trying their best to clean up the banking system by sort of being careful about off-balance sheet transactions. When you talk to the entire world, when it comes to debt statistics, they don’t look at the entire picture, they just look at the narrow picture that China’s central government’s debt to GDP is low. But a lot of the debt sits on the local government’s balance sheets or on company balance sheets which are owned by the government, which is all the same if you put it together.
You say that the Chinese consumer not doing well is a big myth…
This is because the Chinese consumer has been doing well. And this myth has got propagated because the Chinese consumption as a share of their GDP is low. But my entire point is that it is low not because consumption is doing badly but because investment and exports have done exceedingly well. My entire point is that the Chinese consumption growth cannot increase further. It can continue at this pace.
I was surprised when I read that the consumer spending in China has been growing in China by 9% every year over the last thirty years.
Yes. It is comparable to what Japan, China and Korea achieved.
So it’s been growing as fast as the Chinese economy…
No. Just a bit below. The Chinese economy has been growing at 10% and the consumption has been growing at 9%. Because the overall economy has grown at 10% and the consumption has grown at 9%, consumption as a share of Chinese GDP has come down, which leads many people to believe that the Chinese consumer is suppressed. Yeah, maybe suppressed relative to exports and investments but not in absolute terms.
Another thing I found quite fascinating in your book is the portion where you describe your experience of taking the maglev train in Shanghai. Can you take us through that?
It was like going to an amusement park. I had heard so much about this train which travels at 400 kilometres an hour. I never thought of taking it because typically someone is there to pick me up at the airport. In 2008, when I was driving from the airport back to my hotel, I heard this train zipping past me like zip. I was like what is this going on? It really feels like a bullet passing you by when you are going by the car. So I decided I have got to try this thing out. When we tried it out, it was a fascinating experience though you have to go out of the way to take the train. In the business class cabin there was nobody else there other than me and my colleague. And you have this fancy stewardess who comes and sort of buys the ticket for you. When you are on the train because it’s a levitation act you just feel zero friction. Outside the train zips past you, but inside you don’t feel as if anything is going on. It’s completely still.
But what is the broader point you were trying to make through this example?
The broader point is that no other country in the world will think of experimenting like this. But they have been investing at such a huge pace that they try out these experiments as well. When I asked why has this not been replicated in other parts of China, and I got all sorts of explanations. One was that now we get environmental protests because it goes through very close to some of the places. This is very new to China that you have got people who are protesting and saying we don’t what this to happen. The fact they are not extending this train to everywhere because it does not make logical sense from the economic point of view. This shows the Chinese thinking also that listen that how much can we keep spending on these things.
You call India and Brazil very high context societies. What is that?
This is a term that the anthropologist Edward Hall came up with. It would always strike me when I went to India and Brazil about the commonalities between the two countries. Someone says you come for dinner and the dinner won’t start till 9.30-10pm. And everyone sort of came late. I go to Brazil every year and in 2008 I heard about this serial called A Passage to India which was a huge hit in Brazil. People were talking about it in the party circles and I was like I want to see this serial. I figured out that it is a soap opera, and people are hooked to it at nine o clock at night. The whole thing is a love story set in Jodhpur and Agra, and the actors were all Brazilians in Indian garb, and they looked pretty much North Indian to me.
The latest item girl in Bollywood is a Brazilian…
Really? You can’t make out the difference very often. And that’s my entire point. There are many parallels. So all this was fun but what was the economic point coming out of it? I hope India does not go down the Brazil way with similar cultural habits of having a welfare state where you want to protect people. At that point of time the government spending in India was beginning to really take off and now it’s clearly sort of very high.
You even hint at India going the Brazilian way of hyperinflation…
This thing of having minimum wages and having them indexed to inflation, all these are traits through which a country like Brazil went down. The fact is that we have found inflation to be more sticky than it should be. This is happening because of all these welfare schemes being put into place. My whole thing is that you just can’t take this for granted. But just because it hasn’t mattered in the past does not mean that it won’t matter in the future.
What is your view on the S&P’s change in outlook on India?
It’s consistent with the fact that we need to obviously get these things under control before we begin to lose the plot.
You also say in the book that India has too many billionaires given its size. What is the point you are trying to make there?
Wealth needs to be celebrated. It is an integral part of a capitalistic society to have billionaires. But when I look at the number of billionaires we have in comparison to the rest of the world, it does seem a bit high. If we had new wealth being created and had new billionaires coming up, that would be a healthy sign. But if it is the same set of people holding onto their wealth, it is not a healthy sign. In the last five years the churn has gone down in comparison to what used to be. And you want high churn to take place because you know then new people are coming in. Also you want billionaires to come from industries which are celebrated because of the general entrepreneurial talent like technology, manufacturing etc, and not from places where the government is issuing licenses . If you look at other countries which have a high share of billionaires compared to the size of their economies they are all countries where cronyism is rampant. Like Russia and Malaysia. And if you look at the countries which have made economic success models in the past, the wealth of the billionaires as a share of their economy is relatively low. This is because to create up an environment conducive for the opening up of the economy, for reform and for wealth generation, you have to have this perception that it is being done in a fair manner.
Can India be a breakout nation?
I think so. I give India a 50:50 chance because expectations have now become lower to 6-7% GDP growth and that at least lowers the bar from growing at the rate of 8-9%, which is a very high bar. Most countries I have categorical stand which is I like I don’t think that Russia and Brazil are on my list of breakout nations. It is a clearly a negative take on them. There is relatively positive take on many of the South East Asian countries and Eastern European countries. But I think in India I am sort of caught in the middle. I see the positives taking place when I travel outside of Delhi, I go to the states. The whole India chapter in the book is about the fact that as the Southern States have dropped off in the growth statistics, but the Northern States which you never thought would do well, from Bihar to even Chattisgarh, are doing well.
I have lived in Bihar for almost 20 years. It is growing from a very very low base, and that’s why the high rate of growth.
Exactly. That is my point on India to you, which is that India’s biggest benefit for becoming a breakout nation is the fact that its base is so low. It is true of India. So what you say of Bihar in an Indian context is true of India in a global context, which is what gives India a 50:50 chance even though the policy makers keep messing it up at the top. As you know with Bihar the base has always been low. But obviously something has happened in the last seven years that the state has started to change.
In the last section of your book you talk about something called the commodity.com. What is that?
My whole point is that the world has developed for years and years and centuries and commodities have followed a very predictable pattern, which is that they go up for one decade and they go down for two decades because new technology, human ingenuity always come up triumph any demand burst that comes through. Yet at this stage all people think that commodities are in some sort of a super cycle that And one sort of stunning statistic that stood out for me is that in 2001 the world has twenty nine billionaires in the energy industry, seventy five in tech. By 2011, the situation had reversed, with thirty-six in tech and ninety one in energy, mostly in oil.
What is the point you are trying to make?
Why should you have so many billionaires out of commodities because all you are doing is digging dirt out of the ground? You are not doing something that is really smart and innovative. This is complete nonsense when you have so many billionaires coming out this sector. You can have a few. These are signs at the peak of any trend when it looks like that this trend is going to go on forever. But those lofty expectations have their own undoing. Along with all this comes my argument that China’s growth is about to graduate to a lower plane. And China is the 800 pound gorilla of the commodity market.
Why do you see the China-commodity connection falling apart soon?
Basically everyone says that China has to grow so it needs commodities. My point is again about expectations. If China’s growth falls to 6-7% as I think it may on a medium term basis, a lot of the investments, a lot of things will appear to be excessive. So China may grow but the demand for commodities could come of very significantly. So steel, copper etc could all face oversupply in the coming years.
One of the things you talk about in your book is that while central banks can print all the money they want, they can’t dictate where it goes…
Exactly. Even in India this whole sort of thing spread…and till date I get some of these questions that we have all this liquidity in the world, central banks are pumping it, you know it has to come here in search of opportunities where else is it going to go. And my point is that it can go into all sorts of wrong places like a lot of it has gone into oil, lot of it has gone into commodities, has gone into people buying fancy wine, luxury goods, gold etc Central banks have put all that money out there because they want growth to revive that the reason for doing it. But you can’t control it. You don’t know where it ends up.
(Vivek Kaul is a writer and can be reached at [email protected] A slightly different version of the interview appeared in the Daily News and Analysis, April 30, 2012)
किताबें इधर उधर पड़ी हुई,
और कुछ तकिये इधर उधर फेके हुए.
कपडे जो धोने के लिए रखे हैं,
और कुछ जो धुले पड़े हैं.
अख़बार के पन्ने जो तेज़ पंखे की वजह से उड़ से जा रहे हैं,
और मेरे कलम जो इधर उधर ठोकर खा रहे हैं.
उस कोने में पड़ा है तुम्हारा jeans पैंट,
और इस कोने में पड़ा है एक महंगा scent
यहीं कहीं है तुम्हारे pink earrings,
जो इस भीड़ में कहीं खो से गए हैं.
और यहीं कहीं है मेरे चश्मे का डब्बा,
जो उन्हें कई दिनों से खोज रहा है.
इन सब के बीच,
सिर्फ एक सफ़ेद टी-शर्ट में लिपटी तुम,
Virginia Woolf की किताब में न जाने कहाँ हो गुम.
चादर रहित गददे पर लेटी हुई,
अपने दायें पाँव के अंगूठे से मेरे कान को सेहला रही हो,
इतने नज़दीक हो कर भी,
मेरे और करीब आ रही हो.
“Did I say I’ll be back, when I left?” I asked.
“No,” she replied. “’You just said, this is the end my beautiful friend.”
“Ah! Jim Morrison had me doped.”
“Never mind,” she said. “Hope this time you are back for good.”
“That time will tell,” I replied cheekily.
“You are still as fickle minded as the stock market.”
“Well, there is clearly some logic in the way the stock markets operate. Just that it is not obvious to everyone.”
“Ah. There you go V, blowing your own trumpet!”
“Let me explain.”
“Please go ahead.”
“Let’s start with Spain where all the trouble seems to be concentrated these days. There benchmark index IBEX 35 is down around 10% since the beginning of this year and is down 30% over the last one year.”
“Their banks are in big trouble. The stock price of their biggest bank Banco Santander has fallen 18% over the last one month and 45% over the last one year.”
“But why?” she interrupted again.
“Spain had the mother of all housing bubbles! It currently has as many unsold homes as the United States (US), even though the US is six times bigger than Spain.”
“Oh! I didn’t know that.”
“Yes. And even though Spain contributes only 12% of the gross domestic product of the European Union it accounted for 30% of all homes built in the EU since the turn of the century.”
“And all this construction must have been financed by loans from banks?”she asked.
“Yes. Loans to developers and construction companies amount to nearly 50% of the $1.4trillion Spanish gross domestic product (GDP). Of course, with homes lying unsold developers cannot repay their loans and this means the banks are in trouble. And Spain’s banks are too big. In fact the asset size of the three biggest banks in Spain is around $2.7trillion, twice of their GDP,” I explained.
“So if banks go bust, Spain goes bust!”
“Exactly! And Spain is not the only country in trouble. Other European countries are not doing too well either. This has an impact on China because Europe is China’s biggest trading partner. Exports to Europe in March were down 3.1% in comparison to last year. Chinese exports had ranged between $475billion and $518billion in the last three quarters of 2011. In the first three months of this year the number has fallen to $430million. The Shanghai Composite, China’s leading stock market index fell by 6.8% in the month of March.”
“So a slowdown in Europe is having an impact on China?”
“Yes madam! Profits of Chinese companies were also down for the first two months of 2012.”
“So a slowdown in Europe, slows down China. What happens next?” she enquired.
“That in turn has an impact on Australia. Australian exports to China in 2011 stood at A$72billion (Australian dollar), up 24% from 2011. Now around 26% of Australian exports are to China. An ever expanding China bought coal, iron ore and natural gas from Australia, driving up Aussie exports. But exports for the month of February fell to A$24.4 billion, the lowest in an year. Coal exports were down by 21% to A$3.4billion.”
“All because of a slowdown in China,” she concluded.
“Yes. The other country which has suffered because of a slowdown in China is Brazil, which has been enjoying an economic boom to a huge demand for crude oil and agricultural products. A slowdown in China impacts any commodity exporting country because prices tend to fall as China consumes less. But that is not the only reason by Brazil’s exports have fallen.”
“So what is the major problem?”
“The major problem is an appreciating Brazilian currency. The central banks of United States, Japan and Great Britain have been running zero interest policies, in the hope of reviving their own economies. But what this has done is that international investors have been borrowing in these countries and taking the money into emerging markets like Brazil to invest there. When they come to Brazil with their dollars, they need to sell those dollars and buy the Brazilian real. This leads to an increase in demand for Brazilian real and hence the value of the real appreciates against the dollar, which in turn means that the Brazilian exports become expensive. Hence, the Brazilian Bovespa, the premier stock market index of Brazil has fallen 7.4% over the last one month,” came a long explanation from my end.
“Interesting, the way it’s all linking up!”
“So Europe slows down leading to China slowing down and then Australia slows down as well. Brazil slows down because of China and the United States. In the United States elections are due in November this year. If Obama is re-elected tax on long term capital gains could increase to 20% and income tax rates are also likely to rise as tax cuts initiated George Bush junior may be allowed to expire. The stock market of course won’t like this.”
“But what about India?”
“Do I need to say anything? We are in a big mess to say the least! And the state of the Indian stock market is largely decided by the foreign investors. If they are not feeling good about things, the Indian stock market will not go anywhere. In the last one month the BSE Sensex has been almost flat.”
“Hmmm. As my former boss used to ask, so what is the takeaway?” she asked.
“Things are not looking good all over the world.”
“So, is there any hope?”
“Yup, there always is. Ben Bernanke may come to the rescue with another round of money printing, technically now called quantitative easing. That is possible because it is an election year in America, and past Chairman of the Federal Reserve have helped incumbent Presidents fighting elections by running an easy money policy before elections. This money could find its way into stock markets around the world and juice up returns,” I replied.
“But that may or may not happen. So what does one do now?”
“An old stock market saying goes “sell in May, go away! It is time to change that to April!”
(Vivek Kaul is a writer and can be reached at [email protected])
(The article appeared in the Daily News and Analysis on April 23,2012. http://www.dnaindia.com/analysis/column_sell-in-may-oops-april-and-go-away_1679339)
Endgame – The End of Debt Supercycle and How it Changes Everything, John Mauldin and Jonathan Tepper, John Wiley &Sons. 2011
Minefields that can Blow-up Global Stock markets in 2012, Gary Dorsch, April 12, 2012, www.sirchartsalot.com
The Reserve Bank of India has cut the repo rate or the rate at which it lends to banks by 50 basis points, to 8% from the prevailing 8.5%. While theoretically this might mean lower interest rates charged by banks on loans, but practically that might not be the case.
So how will the interest rate cut announced by the Reserve Bank of India impact you and me? The answer is it won’t. Or to put it a little more positively, it will hardly make any difference. Even though the RBI has cut interest rates, the banks may not be able to do so. Even if they do, it will be by very small amounts. Also, it is highly unlikely that the RBI will be able to come up with any more rate cuts during the course of the year (the reasons are explained later).
So here is why the Reserve Bank of India cannot do much when it comes to lowering interest rates or in turn your equated monthly installments (EMIs) this year.
Banks are lending more than they are borrowing: If one looks at the data over the six month period of September 30, 2011 to March 31,2012, banks have lent a total of Rs 4,87,659 crore but at the same time they have borrowed only Rs 4,04,786 crore. Hence the ratio of what banks have lent to what they have borrowed over the last six months, which is referred to as the incremental credit deposit ratio, comes to a whopping 120%. This is clearly not a good sign. What this means is that banks have been unable to raise enough deposits to match their loans over the last six months.
Typically of every Rs 100 a bank raises as deposits, Rs 24 has to be invested in government securities, basically bonds issued by the government of India or its affiliates. This ratio of 24% is referred to as the statutory liquidity ratio. Other than this of every Rs 100 raised a bank has to maintain a reserve of Rs 4.75 with the Reserve Bank of India. This ratio is referred to as the cash reserve ratio. If one were to add the statutory liquidity ratio and cash reserve ratio, a total of Rs 28.75 or 28.75% of the deposits raised by banks cannot be given out as loans. Hence that leaves Rs 71.25 out of every Rs 100 that can be given out as a loan.
So when the incremental credit deposit ratio of bank is at 120%, it is giving out Rs 120 of loans for every Rs 100 raised as deposits. How is that possible? The bank may be lending out deposits it had collected in the past and not given out as a loan or it may be tapping other sources of funding like certificate of deposits. But this is a situation which cannot keep running forever. The loans made by banks cannot keep exceeding the deposits they have collected. What is interesting is that the incremental credit deposit ratio for the six month period ending December 30, 2011, had stood at only 68.5%. Hence things have tightened up over the last few months.
Given that banks are finding it difficult to raise deposits to match their loans means that they will have to continue offering high interest rates on their deposits. A high interest rate on deposits will lead to banks charging a high interest on loans as well, which of course means higher EMIs. There is not much RBI can do about it.
The finance minister has underestimated the level of subsidies : When the finance Pranab Mukherjee gave his budget speech in February last year, he had set the fiscal deficit target for the financial year 2011-2012, at 4.6% of GDP. Fiscal deficit is the difference between what a government earns and it spends and is expressed as a percentage of the gross domestic product.
He missed his target by a huge margin when the real number came in at 5.9% of GDP. The major reason for this was the fact that Mukherjee had underestimated the level of subsidies that the government would have to bear. He had estimated the subsidies at Rs 1,43,750 crore but they ended up costing the government 50.5% more at Rs 2,16,297 crore. The finance minister had underestimating the subsidy level of the three main categories of food, fertilizer as well as oil.
This has been the case in the past as well. In 2010-2011 (i.e. the period between April 1, 2010 and March 31, 2011) he had estimated the oil subsidies to be at Rs 3108 crore. They finally came in 20 times higher at Rs 62,301 crore. Same was the case in the year 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010). The estimate was Rs 3109 crore. The real bill came in nearly eight times higher at Rs 25,257 crore (direct subsidies + oil bonds issued to the oil companies).
Similar underestimates have been made for the financial year 2012-2013, to project a fiscal deficit of 5.1% of GDP. The total subsidies bill has been estimated to be at Rs 1,90,015 crore a good 12% lower than the subsidy bill for the year 2011-2012. The government has constantly underestimated the cost of subsidies and there is no reason to believe that it would not be the same for this year as well. Oil prices are unlikely to go down, and inflation is also not seen slowing down. Hence it is most likely that the government will miss its fiscal deficit target for this year as well.
This means that the government will have to borrow more than it had actually planned to finance the increased fiscal deficit. When the government is a big borrower in the market it has to compete for money with other players in the market and hence offer a high interest rate of interest on the bonds that it plans to issue to finance the fiscal deficit. Given this, the rate of interest charged by banks on all other forms of loans also remains high because all other forms of lending are more risky than lending to the government. Also, the government borrowing “crowds out” the private borrowers. And hence if the government is offering a rate of interest of 8% on its bonds, then the banks are likely to charge more on all other forms of loans that they make.
Why things won’t improve anytime soon: The government of India is in a huge debt trap. The fiscal deficit of the government of India i.e. the difference between the amount it earns and the amount it spends has gone up by 312% over the last five years, For the financial year 2007-2008 (i.e. the period between April 1,2007 and March 31, 2008) the fiscal deficit stood at Rs 1,26,912 crore, against Rs 5,21,980 crore for the financial year 2011-2012. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore. When expenditure is expanding nearly 9 times as fast as your income, it can’t be a good thing. What this means that the government has taken on more and more debt to finance the deficit. But more debt also means more interest that has to be paid on that debt.
The bigger question is where does the government get the money to pay interest as well as repay the earlier debt that it had taken on? If you and I take loans we have to pay interest and repay the principal from our income. A few smart ones think they can beat the system and take on new loans to pay off interest as well repay earlier loans. But this game also doesn’t last forever. Ultimately if you spend much more than you earn, the system does catch up with you.
But not for the government. Lets us try and understand how. The fiscal deficit target for the financial year 2012-2013 has been set at Rs 5,13,590 crore. Of this amount the government will spend Rs 3,19,759 crore to pay interest on the debt that it already has. Rs 1,24,302 crore will be spent to payback the debt that was raised in the previous years and matures during the course of the year 2012-2013. Hence a total of Rs 4,44,061 crore or a whopping 86.5% of the fiscal deficit will be spent in paying interest on and paying off previously issued debt. What this means is that new debt is being issued to pay off old debt and pay interest on it. The government can keep doing this longer than you and I can because ultimately it has the right to print
money to repay the debt.
But that is not a healthy option to choose and there are other long term repercussions of that. Hence the government has to keep offering a high rate of interest on its bonds to keep raising the money necessary to pay interest as well as repay its earlier debt. And the interest offered by the government on its bonds becomes the benchmark for the interest rate charged on all other loans. Hence if the government interest rate is high, the rate of interest charged by banks cannot be low. So, for the time being its bye bye low EMIs.
(The author is a writer and can be reached at [email protected])
The heat had finally reached Mumbai. She was fidgeting and he was snoring. Finally she woke him up.
“Did you happen to read what Warren Buffett has written in his latest letter to his shareholders?” she asked.
“What? Warren Buffett?” he replied. “It’s four in the morning!”
“Let me sleep.”
“Come on,” she said, trying to wake him up.
“I haven’t read it,” he replied, trying to go back to sleep.
“Don’t lie,” she said. “If you haven’t, what are these print outs doing next to your bed.”
“Yeah, printouts. I guess you won’t let me sleep.”
“No, I won’t” she said with a winner’s smile on her face.
“Well every year Warren Buffett writes a letter to the shareholders of Berkshire Hathaway, explaining the investment decisions he has made during the course of the last year and how he sees things panning out in the days to come.”
“Arre! Itna to I know!” she interrupted. “What are the main points he has made in this year’s letter?”
“This year he has talked about gold.”
“Yeah gold. And why investing in stocks is going to be a much better bet than gold in the days to come.”
“And what’s the logic there?” she asked.
“As Buffett puts it “Gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.””
“Seems like a fair point. So why do people buy gold then?”
“In the words of Buffett “what motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm.””
“Hmmm. And what do you have to say regarding this?”
“Well, gold has very few industrial uses, given the fact that it is very expensive. And yes, people beyond a point buy it because everyone else is. But then that is true about any other investment as well. Let us take the case of America. In the late nineties everyone wanted to buy dotcom stocks. Once they were done buying dotcom stocks, all of them wanted to buy houses. This pushed up the price of first dotcom stocks and then houses. Of course beyond a point the bubble burst, investors lost money, and landed the whole world into a big financial mess,” he explained.
“So? One shouldn’t buy when everyone else is buying?” she interrupted.
“ I never said that. Some of the investors who got their timing right did make pot-loads of money as well. As George Soros, the biggest speculator of them all once wrote “Nothing is quite as profitable as investing in an early stage bubble.””
“As usual, there are two sides to everything,” she said, rather philosophically.
“ But let’s stay on track. We were talking about gold.”
“I don’t agree with what Buffett has to say.”
“Because what he says goes against basic human nature over the years and I do feel that gold is going to give good returns in the days to come.”
“What makes you say that so confidently?”
“Let me get into some history before I get back to gold.”
“Yes history. Sir Thomas Gresham was a financial advisor to Queen Elizabeth I, in the sixteenth century. Gresham helped Elizabeth clean up the monetary mess created by her father Henry VIII and her brother Edward VI, who ruled before her. Those days the primary form of money was gold or silver coins. And the quality of a coin was known by the amount of gold or silver it contained. But Henry VIII and Edward VI had managed to completely debase the pound by ensuring that it had very little silver left in it.”
“But what was debasement?” she asked.
“Kings and governments throughout history have been debasing coins. Nero, who watched while Rome was burning, was one of the first kings to debase money. Debasement was a practice where the ruler lowered the precious metal content of the coin while keeping its value unchanged. So let us say one coin weighed five grams. The king decides that from now on the coin will weigh only four grams. Earlier 20 coins could be made out of 100 grams of metal. Now 25 coins can be made from the same amount of metal.”
“There is another other way to explain this. Let us say a particular coin has a face value of 100 cents (or paisa or pence for that matter). The face value of a coin is also referred to as its tale. Initially the metal content in the coin is also worth 100 cents. The value of metal content in the coin is referred to as specie. In this example, the tale value of the coin is equal to the specie value. Now the ruler decides to debase the coin and reduce its metal content by 10%. So the specie value of the coin will now be 90 cents even though the face value of the coin continues to be 100 cents. As explained above by doing this the ruler could mint more coins out of the same amount of metal,” he explained.
“Very interesting,” she commented.
“And that is how things were in Britain at that point of time. The economy was full of debased coins launched by the earlier rulers. Elizabeth wanted to launch new coins where the face value of the coin was equal to the amount of metal in it i.e. tale was equal to the specie.”
“Yes that made sense, given that the coins hardly had any silver left in them.”
“But there was a slight problem.”
“Problem? What problem?” she asked, getting into the discussion totally.
“In such a situation Gresham felt that bad money will drive out the good money. This meant that the citizens of the country will hoard onto the new coins whereas they would continue using the existing debased coins in the market for making payments. The new coins because they had a greater amount of silver in it would be melted and sold for their precious metal content. Hence the bad money would drive out the good. This in later years came to be known as the Gresham’s Law.”
“Yeah. That would be the logical way to react. Melt the coins and sell them for their silver value and get more money in the process,” she said. “So what did they do to get rid of this problem?”
“To get rid of this problem Gresham decided that all the old coins would be exchanged for new coins. So there were no old coins in the market, and the market moved onto using the new coins as the currency.”
“Hmmm. But what has all this got to do with gold?”
“I was just coming to that. This phenomenon of bad money driving out good has been observed time and again through the centuries, even before Gresham’s name became attached to it. As John Mauldin, a hedge fund manager explains it “‘Under the Greeks and Romans, when gold coins were debased, few people were dumb enough to want to exchange their old coins that had high gold content for newer ones that had low gold content, so older good coins disappeared as people hid them.””
“Hmmm. But how is it relevant today?”
“Bad money is driving out good money even today, though in a slightly different form. Governments across the world have been printing more and more paper money to tide over the various financial crises that they are facing. When a government resorts to printing more of its currency, it leads to a situation where there is much more currency in the market than before and hence like the coins which lost their precious metal content, paper money is also getting debased,” he explained.
“Hmmm. Sounds convincing.”
“To protect themselves from this debasement people buy another asset i.e. gold in this case, something which cannot be debased. During earlier days paper money was backed by gold or silver and it could be exchanged for gold or silver as and when needed. When governments printed more paper money than they had precious metal backing it, people simply turned up with their paper at the central bank or the government mint and demanded it be converted into gold or silver. This option hasn’t been available to people since the first world war started in 1914. Now whenever people see more and more of paper money, the smarter ones simply go out there and buy that gold.”
“So gold keeps disappearing from the market and hence its price keeps going up. And as was the case earlier bad money i.e. paper money, drives out the good money i.e. gold, away from the market.”
“Ah, what a comparison!”
“And that is why Warren Buffett will be wrong when it comes to gold. As long as governments around the world keep printing money to fight the financial crisis, gold as an investment class will keep doing well.”
“But why is Buffett anti gold then?”
“A major reason for it is the fact that Buffett is a follower of the school of value investing established by Benjamin Graham. For most of the period that Graham was an active investor, private ownership of gold in the United States remained banned. Franklin D Roosevelt outlawed it in 1933 and it remained so till 1974. Graham passed away in 1976. Hence during the price years of his life as an investor, gold was never an investment class. To him investments were limited to stocks or bonds. Hence the theory of value investing never got around to talking about gold.”
“Very interesting,” she said.
“So can I sleep now?” he asked.
“Na,” she replied.
“Its six thirty now. Time to get ready for office!”
(The author can be reached at [email protected] The piece was originally published at http://www.rediff.com/business/slide-show/slide-show-1-column-why-warren-buffett-is-wrong-about-gold/20120405.htm)