Month: May 2012

Facebook is a bubble and it will burst


Vivek Kaul

So let me be a killjoy this Monday morning and say that Facebook is a bubble. And like all bubbles it will burst.
The price of the Facebook share closed at $38.23 at the close of trading on Friday. At this price the company was worth around $104.6billion.The basic question that crops up here is that whether Facebook deserves such a high price? “It’s exceedingly dangerous to pay a $100 billion valuation for a company that hasn’t figured out a way to make money,” Aswath Damodaran, a professor at Stern Business School at New York University told Barrons Online. Damodaran is one of the world’s premier experts on valuation.
Facebook versus Google
Facebook earned 43 cents per share in 2011. At its Friday closing price of $38.23, the company has a price to earnings ratio of around 88.4 ($38.23/43cents). Now compare this to Google, which is the closest comparison we can make with a stock like Facebook. Google had an earnings per share of $33 in 2011. The market price of the company closed at $600.4 on Friday, implying a price to earnings ratio of 18.2 ($600.14/$33). This makes Facebook around five times as expensively priced as Google (88.4/18.2). Price to earnings ratio is equal to the latest market price of the share of the company divided by its earnings per share.
Even if we were to look at the expected earnings for the current year, Facebook is expensively priced. Analysts expected Facebook to earn around 50 cents per share in 2012. This means that the forward price to earnings ratio of the company is at 76.5($38.23/50cents). Google’s forward price to earnings ratio for 2012 works out to 14, making Facebook more than five times as expensive as Google.
Let us get into little more detail here. Both Google and Facebook have around 900million users. “There isn’t much scope for growth here, really – we’re beginning to run out of connected adults on the planet,” points out venture capitalist Mahesh Murthy on his Facebook page.
Google had sales of $39.98billion with a profit of $10.83billion. From almost a similar number of users Facebook had sales of $3.71billion and profits of $1billion. Hence Google makes average revenue of around $44per user. At the same time Facebook makes average revenue of around $4 per user. It is rather ironic that even though Google has average revenue per user 11 times that of Facebook and also earned a profit which was nearly 11times, the price to earnings ratio of Facebook is 5 times that of Google.
So what are investors paying for?
Investors are essentially paying for the future growth of Facebook. As Kevin Landis chief investment officer at Firsthand Capital, a Facebook holder told Barrons Online “The investment thesis is pretty simple. Facebook knows more things about more people than does Google, and those people have stronger emotional connections and loyalty because that’s where their friends are…So given a few years to figure it out, Facebook could end up being worth more than Google, which has a market value of $200 billion.”
One advantage with more user data is that Facebook can help advertisers reach their targeted audience better. When companies advertise in mass market mediums like newspapers or television channels they have no clue of whether they are reaching their target audience. But with Facebook they can be sure.
At least the story being bandied around by analysts who are bullish on the stock. But companies aren’t buying this yet. In fact General Motors, a company with one of the largest advertising budgets in the United States, recently pulled its ads from Facebook, cancelling its $10million Facebook advertising budget.
As Matthew Yeomans wrote in a recent column on www.guardian.co.uk “GM clearly believes Facebook users aren’t engaging in banner and targeted advertising and, in that analysis, the company is probably right. Frankly I’ve never met a single person (apart from those who work in the digital advertising industry) who believe online banner ads are effective”.
This is something I totally agree with. What makes it even worse on Facebook is its cluttered look. In fact I only realised that my homepage on Facebook page has ads when I went looking for them. In comparison the Google.com page has a very clean look and with a white background the targeted ads are easily available.
Given this Facebook might find it a little difficult to grow its revenues. As Murthy puts it “This (the valuation of Facebook) might make sense if there was room for Facebook to grow. Where is that? More ads per user? Would we really like that? More charges per ad? Advertisers are already smarting at FB’s rates. Will you pay for apps on their store? Will you pay for premium listings? Not many will, I believe. The point is that FB will find it hard to grow its revenues per user – which is around $4 per year now.”
In fact the revenue growth of Facebook is slowing. Its revenues for the first quarter of 2012 stood at $1.06billion in comparison to $1.13billion in the fourth quarter of 2011. The primary reason for the same is the fact that more and more users are accessing Facebook from their smartphones. And smartsphone screens do not lend themselves well to advertising. Facebook admitted to this in a recent filing with the Securities and Exchange Commission, the stock market regulator in the United States, where it said “we do not currently directly generate any meaningful revenue from the use of Facebook mobile products, and our ability to do so successfully is unproven.”
The bubble signs
Other than the basic doubt on the business model (i.e. how does the company plan to make money) of Facebook, there are other signs also of why the company is in bubbly territory. Too many analysts are bullish on it.
Towards the end of the dotcom bubble in 1999, even though the stock market had gone up too soon too fast, most the stock recommendations from the analysts remained a buy i.e. the analysts of Wall Street were commending investors to buy stocks even at very high levels.
According to data from Zack Investment Research only about 1% of the recommendations on some 6000 companies were sell recommendations. The remaining 99% was divided between 69.5% buy recommendations and 29.9%hold recommendations(i.e. don’t buy more shares but don’t sell what you already have).
Analysts typically do not like issuing sell recommendations (or in the case of Facebook asking investors not to buy the stock) because that did not put them in the good books of the company involved. This would mean that the company would stop sharing information and deny the analyst access to its top people. And what good is an analyst who has no access to information on the company he is covering.
Henry Blodget one of the premier analysts during the days of the dotcom boom is quoted as saying in Andy Kessler’s Wall Street Meat “You’ve got to understand. If I stop recommending stock and the shares keep going up, there is hell to pay. Brokers call you up and yell to you for missing more of the upside. Bankers yell at you for messing up their relationships. There is just too much risk in not recommending these stocks.”
Facebook is in a similar situation. Analysts are predicting that Facebook will grow its profits by 38% and its revenues by 35% on an average over the course of the next three years. This is groupthink at its worst.
Another thing that happened during dotcom bubble was the fact that the valuations of the dotcom companies with no business models were worth much more than companies which had genuine businesses in place which had been generating revenue for years. Priceline.com sold its shares at $16 and ended its first day of trading at $69. The website basically resold airline tickets and did not own any airplanes, but was worth more than the entire tangible airline industry put together.
Valuations had reached crazy levels. eToys a tiny seller of toys on the web with revenues of $25million was listed on the stock exchanges at a market capitalization of three times the value of Toys “R” Us, a company with tangible business and stores throughout the United States generating a revenue of $11billion.
While the situation is nowhere as crazy now as it was back then but it is a tad similar. At its current market capitalization of around $104.6billion, Facebook is worth as much as PepsiCo, a company which has been in the business for years. PepsiCo has a sales of $67billion with profits of around $6billion. While people may call PepsiCo an old economy stock but it can be pointed out that the company still has huge scope to expand across large parts of Asia and Africa where the annual per capita consumption of cold drinks continues to remain low.
In comparison there is not much scope for Facebook to grow from its current levels as far as number of users is concerned.
To conclude:
Warren Buffett one of the greatest investors of our times did not invest in any of the dotcom stocks in the late 1990s. His returns fell for a few years and he was also the laughing stock of the market. But when the bubble burst and billions of dollars of investor money were lost, Buffett was the last man standing. What he wrote in his annual letter to the shareholders of Berkshire Hathaway for the year 2000 after the dotcom bubble burst is worth repeating here:
By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street – a community in which quality control is not prized – will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
And for all we know Facebook might just be a passing fad. I would like to conclude with something a gentleman by the name of Marc Effron, the President of The Talent Strategy Group, and author of One Page Talent Management, told me a few months back, when I asked him if Facebook was just a passing fad. “The first thing that comes to my mind when you say Facebook is MySpace,” he replied.
(The article originally appeared at www.firstpost.com on May 19,2012. http://www.firstpost.com/investing/facebook-is-a-bubble-and-it-will-burst-316100.html)
(Vivek Kaul is a writer and can be reached at [email protected])

‘In the global beauty contest, the US Dollar is the least ugly candidate’


Central banks around the world seem to have only one solution for every problem that the various economies have been facing: print more money. And a large portion of this money has been used to prop up banks and financial institutions that would have otherwise fallen and shut shop by now. “It is unfortunate that nobody is allowed to default these days, because all these bailouts are only adding to the inflation menace and the ongoing money creation is confiscating the purchasing power of the public,” says Puru Saxena, the founder and CEO of Puru Saxena Wealth Management. Based out of Hong Kong, Saxena is also the editor and publisher of Money Matters, a monthly economic newsletter. In this interview he speaks to Vivek Kaul.
In a recent column of yours you said “the world’s stock and commodity markets are defying all logic and advancing in the face of adverse economic conditions”. Why has that been the case?
All asset prices are determined by the risk free rate of return and by suppressing interest rates near historical lows, central banks in the developed world have engineered this rally in risky assets. When it comes to investing, monetary policy trumps economic fundamentals and cheap credit triggers a rally in stocks and commodities. This is why, despite sluggish economic growth in the US, Wall Street has been rallying for over 3 years. Conversely, despite good economic growth in India, due to monetary tightening, Indian equities have underperformed over the past year!
Do you expect this trend to continue?
As long as the Federal Reserve keeps interest rates at historical lows, the uptrend on Wall Street is likely to continue. Of course, the bull market will be subject to periodic corrections, but the primary trend should remain up. In our view, the next bear market on Wall Street will arrive after several months of monetary tightening by the Federal Reserve and we are at least 3 years away from this scenario. After all, Mr. Bernanke has pledged to keep short term rates unchanged until at least December 2014, so there is clear visibility for another 2 and a half years.
In Europe, the attention seems to have shifted to Spain. I was reading somewhere that the assets of the three biggest banks of Spain are at $2.7trillion or around twice the size of the Spanish economy. And the banking sector in Spain seems to be in a pretty bad shape. How do you see that playing out?
Spain is in real trouble, but the politicians will probably not let it default. So, either the European Central Bank will bail out Spain or it will continue to provide cheap loans under its LTRO(long term financing operations) scheme. It is unfortunate that nobody is allowed to default these days, because all these bailouts are only adding to the inflation menace and the ongoing money creation is confiscating the purchasing power of the public. Already, the Federal Reserve and the ECB have provided trillions of dollars of loans to hundreds of banks and this trend should continue for the foreseeable future.
What are the other dangers that you see the European markets throwing up in the days to come?
Many European nations are essentially insolvent and they cannot repay their loans in today’s money. So, unless they are allowed to default, the central banks will probably continue to bail out all the distressed bondholders and banks. The truth is that the central banks do not want anybody to default because the losses will be catastrophic for the financial institutions; so they are shoving even more debt down the throats of these heavily indebted nations! It is easy for us to see that more debt cannot solve a debt crisis but this is the strategy the central banks have come up with and we all have to live with the consequences.
The European Central Bank seems to be going the Federal Reserve way. The Federal Reserve in 2008-2009 seemed to have been rescuing banks and companies, the ECB is rescuing countries? Aren’t some of these countries like Italy and Spain are too big to bail-out?

So far, nothing has been ‘too big to bail out’! Already, the ECB has extended over $1.4 trillion of loans under its LTRO scheme to several hundred banks and if need be, it will probably create more currency units to bail out its banking cronies. If the situation becomes desperate, then, we may even get fiscal integration within the Euro zone but we don’t think that the establishment will let the Euro fail.
In all this talk about Europe, attention seems to have shifted away from the problems in the United States, which is where it all started. How good or bad is the scene there?
Although the economy is struggling in the US; things are much worse in Europe. Fortunately, the US is in the enviable position of being able to print its own currency at will and this is a luxury which the distressed European nations do not have. Under a crisis scenario, the US can always create even more dollars out of thin air and repay its creditors, but this is something Greece, Italy and Spain cannot do! Moreover, despite having a federal debt to GDP ratio of over 100%, the US still controls the world’s reserve currency and this is a big advantage.
One talk in the market seems to be that the Federal Reserve Chairman Ben Bernanke will initiate QE III given that Presidential elections are scheduled this year. Several Federal Reserve Chairmen have in the past have run easy money policies to help the incumbent US President who is running for the election again..
In our view, Mr. Bernanke will only initiate QE3 after a big dip in the CPI. Currently, the CPI is hovering around 2.7% and it is conceivable that QE3 will be announced when the CPI dips to around 1-1.5%. With the CPI close to 2.7%, we believe that Mr. Bernanke will find it difficult to unleash more stimulus.
You have maintained for a while that world’s developed nations are all bankrupt. In fact in a column last year you wrote “Let’s face it; many of the world’s ‘developed’ nations are insolvent and the writing is on the wall. Either these indebted states will default or they will try and inflate their currencies into oblivion.” How do you see this scenario playing out?
Given the developments of the past 3-4 years, it is clear that the policymakers do not want to see defaults. So, they have chosen the monetary inflation route and this is destroying the purchasing power of currencies all over the world. As a result of massive money creation, currencies are being debased and prices are rising all over the world. In fact, inflation is surging in most nations and people are struggling to make ends meet. In the US alone, the Federal Reserve has created trillions of dollars to bail out the banks and the ECB has also created and loaned out over US$1 trillion to hundreds of banks over the past six months! Never before in history have we witnessed such monetary inflation in so many nations and nobody really knows the consequences of this strategy.
“When the interest payments on US debt become painfully high, Mr. Bernanke will be called upon to unleash the hyperinflation genie.” This is something you wrote last year. When do you see this happening?
As long as foreigners are willing to invest in US Treasuries and demand for US government debt is high, hyperinflation will not occur. However, if one day, bondholders stop financing the US deficit and they stop buying US Treasuries, then Mr. Bernanke will have no other option but to use the printing press to purchase US Treasuries. Already, the Federal Reserve is a very large player in this market but if other investors flee this market, then out of desperation, we may experience hyperinflation in the US. Fortunately, there are no signs of that happening anytime soon as demand for US Treasuries is still strong.
Many pundits in the last few years have forecast the crash of the dollar. The biggest among them being Pimco’s Bill Gross. But that hasn’t happened. Every time there is a slight hint of some new trouble, money rushes into the dollar. How do you explain this?
In the global beauty contest, the US Dollar is being perceived as the least ugly candidate! This is why the US Dollar has not collapsed against major world currencies, although it has depreciated gradually over the past decade. If you review the world today, Europe is a mess and Japan is still struggling. So, apart from the US Dollar, we don’t really have very many choices! In the developing world, no nation wants a strong currency and countries such as China, India and Brazil are all engaged in competitive currency devaluations. Under this scenario, the US Dollar cannot really crash against other currencies because either they are equally bad or they are being held down on purpose.
What is your prognosis on gold?
Gold is in a multi-month consolidation phase and currently, it is trading under the 200-day moving average. So, in our clients’ portfolios, we do not have any exposure to gold at present. In our view, QE3 will be required to trigger the next big rally in gold and until then, prices are likely to drift lower. Furthermore, after 11 years of gains, investors should be mindful of the fact that gold is no longer cheap and the bull market is now in its mature phase. Thus, owners of gold should be very cautious and consider booking their profits on the first sign of trouble.
What about India? Which are the sectors and stocks you are positive about?
It appears as though India’s monetary cycle has peaked for now and further rate cuts should assist the Indian stock market. Usually, there is time lag between monetary easing and its effects on the economy, so in our view, the Indian stock market may not take off for another few months. Nonetheless, we remain optimistic about Indian stocks and continue to like those companies which earn high rates of return on shareholders’ equity.
(The article originally appeared in the Daily News and Analysis on May 21,2012. http://www.dnaindia.com/mumbai/interview_in-the-global-beauty-contest-the-dollar-is-the-least-ugly-candidate_1691544)
(Vivek Kaul is a writer and can be reached at [email protected] )

If PIIGS have to fly, they will need to exit the euro


Vivek Kaul

I’ve long said that capitalism without bankruptcy is like Christianity without hell. – Frank Borman
If you have been following the business newspapers lately, you would have probably come to the conclusion by now that a break-up of the euro will lead to a huge catastrophe in Europe as well as the rest of the world.
Yes, there will be problems. But the world will be a much better place if the countries like Portugal, Ireland, Italy, Greece and Spain opt out of the euro. To know why read on.
How it all started
The European Coal and Steel Community was an economic organisation formed by six European nations in 1958. This gradually evolved into the European Union (EU) which was established by the Maastricht Treaty in 1993. The EU introduced the euro on 1 January 1999. On this day, 11 member countries of the EU started using euro as their currency. Before the euro came into being the German currency deutschemark used to be the premier currency of Europe. The euro inherited the strength of the deutschemark. The world looked at the euro as the new deutschemark.
The move to euro benefitted countries such as Portugal, Italy , Ireland , Greece and Spain (together now known as the PIIGS). Before these countries started to use euro as a currency, they had to borrow money at interest rates much higher than the rates at which a country like Germany borrowed. When these countries started to use the Euro they could borrow money at interest rates close to that of Germany, which was economically the best managed country in the EU.
Easy money and the borrowing binge
With interest rates being low, the PIIGS countries as well as their citizens went on a borrowing binge. Greece took the lead among these countries. The Greek politicians launched a large social spending programme which subsidised most of the key public services. In fact a few years back, the finance minister of Greece claimed that he could save more money shutting down the Railways and driving people around in taxies. In 2009, Greece railways revenues were at around $250 million and the losses of around $1.36billion. All this extravagance has was financed through borrowing.
Greece was not the only country indulging in this extravagance, other PIIGS nations had also joined in. Also other than the low interest rates, the inflation in the PIIGS countries was higher than the rate of interest being charged on loans.
As John Mauldin and Jonathan Tepper write in Endgame – The End of the Debt Supercycle and How it Changes Everything “In plain English, that means that if the borrowing rate is 3 percent while inflation is 4 percent you’re effectively borrowing for 1 percent less than inflation. You’re being paid to borrow. And borrow they did. And the European peripheral countries (PIIGS) racked up enormous amount of debt in euros.”
This was because loans were being made by German, French and British banks who were able to raise deposits at much lower interest rates in their respective countries and offer it at a slightly higher rate in the PIIGS countries.
The citizens of Spain borrowed big time to speculate in real estate. All this building was financed through the bank lending. Loans to developers and construction companies amounted to nearly $700billion or nearly 50% of the Spain’s current GDP of nearly $1.4trillion. Currently Spain has as many homes unsold as the United States (US), though the US is six times bigger than Spain. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion or that is double Spain’s GDP, are in trouble.
The accumulated debt in Spain is largely in the private sector. On the other hand the Italian government debt stands at $2.6trillion, the fourth largest in the world. The debt works out to around 125% of the Italian gross domestic product (GDP). As a recent report titled A Primer on Euro Breakup brought out by Variant Perception points out “Greece and Italy have a high government debt level. Spain and Ireland have very large private sector debt levels. Portugal has a very high public and private debt level.” Debt as we all know needs to be repaid, and that’s where all the problems are. But before we come to that we need to understand the German role in the entire crisis.
The German connection
Germany became the largest exporter in the world on the strength of the euro. Before euro became a common currency across Europe, German exports stood at around €487billion in 1995. In 1999, the first year of euro being used as a currency the exports were at €469billion euros. Next year they increased to €548billion euros. And now they stand at more than a trillion euros. Germany is the biggest exporter in the world even bigger than China.
With euro as a common currency took away the cost of dealing with multiple currencies and thus helped Germany expand its exports to its European neighbours big time. Also with a common currency at play exchange rate fluctuations which play an important part in the export game no longer mattered and what really mattered was the cost of production.
Germany was more productive than the other members of the European Union given it an edge when it came to exports. As Mauldin and Tepper point out “since the beginning of the Euro in 1999, Germany has become some 30 per cent more productive than Greece. Very roughly, that means it costs 30 per cent more to produce the same amount of goods in Greece than in Germany. That is why Greece imports $64 billion and exports only $21 billion.”
German banks also had a role to play in helping increasing German exports. They were more than happy to lend to citizens, governments and firms in PIIGS countries. So the way it worked was that German banks lent to other countries in Europe at low interest rates, and they in turn bought German goods and services which are extremely competitively priced as well as of good quality. Hence German exports went up.
The PIIGS countries owe a lot of money to German banks. Greece needs to repay $45billion. Spain owes around $238billion to Germany. Italy, Ireland and Portugal owe $190billion, $184 billion and $47billion respectively.
Inability to repay
When the going is good and everything is looking good there is a tendency to borrow more than one has the ability to repay, in the hope that things will continue to remain good in the days to come. But good times do not last forever and when that happens the borrower is in no position to repay the loan taken on.
Greece tops this list. It has been rescued several times and the private foreign creditors have already taken a haircut on their debt i.e. they have agreed to the Greek government not returning the full amount of the loan. Between Spain and Italy around €1.5trillion of money needs to be repaid over the next three years. The countries are in no position to repay the debt. It has to be financed by taking on more debt. It remains to be seen whether investors remain ready to continue lending to these countries.
In the past countries which have come under such heavy debt have done one of the following things: a) default on the debt b) inflate the debt c) devalue the currency.
Scores of countries in the past have defaulted on their debt when they have been unable to repay it. A very famous example is that of Russia in 1998. It defaulted both on its national as well as international debt. Oil prices had crashed to $11 per barrel. Oil revenue was the premier source of income for the Russian government and once that fell, there was no way it could continue to repay its debts.
If the country’s debt is in its own currency, all the government needs to do is to print more of it in order to repay it. This has happened time and again over the years all over the world. Every leading developing and developed country has resorted to this at some point of time. The third option is to devalue the currency and export one’s way out of trouble.
Exit the euro
The PIIGS countries cannot print euros and repay their debt. Since they are in a common currency area there is no way that they can devalue the euro. A straight default is ruled out because German and French banks will face huge losses, and Germany being driving force behind the euro, wouldn’t allow that to happen.
So what option do the PIIGS then have? One option that they have is to exit the euro, redominate the foreign debt in their own currency, devalue their currency and hope to export their way out of trouble.
A lot has been written about how you can only enter the euro and not exit it. The situation as is oft repeated is like a line from an old Eagles number Hotel California “You can checkout any time you like / But you can never leave.” A case has also been made as to how it would be disaster for any country leaving the euro.
Let’s try and understand why the situation will not be as bad as it is made out to be. A report titled A Primer on Euro Breakup, about which I briefly talked about a little earlier explains this situation very well.
The first thing to do as per the report is to exit the euro by surprise over a weekend when the markets are closed. Many countries have stopped using one currency and started using another currency in the past. A good example was the division of India and Pakistan. As the report points out “ One example of a currency breakup that went smoothly despite major civil unrest is the separation of India and Pakistan in August 1947. Before the partition of India, the two countries agreed that the Reserve Bank of India (the RBI) would act as the central bank of Pakistan until September 1948….Indian notes overprinted with the inscription “Government of Pakistan” were legal tender. At the end of the transition period, the Government of Pakistan exchanged the non-overprinted Indian notes circulating in Pakistan at par and returned them to India in order to de-monetize them. The overprinted notes would become the liabilities of Pakistan.”
Any country looking to exit Euro could work in a similar way. It will need to have provisions in place to overprint euros and deem them to be their own currency. Then it will have quickly issue new currency and exchange the overprinted notes for the new currency. Capital controls will also have to be put in place for sometime so that the currency does not leave the country.
Despite the fact that there are no exit provisions from the euro, after the creation of the European Central Bank, the individual central banks of countries were not disbanded. And they are still around. “All the euro countries still have fully functioning national central banks, which should greatly facilitate the distribution of bank notes, monetary policy, management of currency reserves, exchange-rate policy, foreign currency exchange, and payment. The mechanics for each central bank remain firmly in place,” the report points out.
Technical default
By applying the legal principle of lex monetae – that a country determines its own currency, the PIIGS countries can re-dominate their debt which they had issued under their local laws into the new currency. As the report points out “Countries may use the principle of lex monetae without problems if the debt contracts were contracted in its territory or under its law. But private and public bonds issued in foreign countries would be ruled on by foreign courts, who would most likely decide that repayment must be in euros.”
The good thing is that in case of Greece, Spain and Portugal, nearly 90% of the bonds issued are governed by local law. While redomination of currencies in their own currencies will legally not be a default, it will be categorized as a default by ratings agencies and international bodies.
Another problem that has brought out is the possibility of bank runs if countries leave the euro. Well bank runs are already happening even when countries are on the euro. (The entire report can be accessed here: http://www.johnmauldin.com/images/uploads/pdf/mwo022712.pdf).
The PIIGS coutnries can devalue their new currencies make themselves export competitive and hope to export their way out of trouble. This is precisely what the countries of South East Asia after the financial crisis of the late 1990s. As the report points out “history shows that following defaults and devaluations, countries experienced two to four quarters of economic contraction, but then real GDP grew at a high, sustained pace for years. The best way to promote growth in the periphery, then, is to exit the euro, default and devalue.”
The German export machinery
A breakup of the euro will create problems for the highly competitive export sector that Germany has built up. The PIIGS countries would start competiting with it when it came to exports. Given this they will not let the euro break so easily. As the bestselling author Michael Lewis said in an interview sometime back “German leadership does not want to be labeled as the people who destroyed the euro.”
But as Lewis also said “If you put Germany together with Greece in a single currency, it’s a little like watching an Olympic sprinter and a fat old man running a three-legged race. The Greeks will never be as productive as the Germans, and the Germans will never be as unproductive as the Greeks.” So it’s best for PIIGS countries to exit the euro.
In the end let me quote my favourite economist John Kenneth Galbraith as a disclaimer: “The only function of economic forecasting is to make astrology look respectable.”
(The article originally appeared at www.firstpost.com on May 19,2012. http://www.firstpost.com/world/if-piigs-have-to-fly-they-will-need-to-exit-the-euro-314589.html)
(Vivek Kaul is a writer and can be reached at [email protected])

What Mamata can learn from Surf, BBC, Sony and Nokia


Vivek Kaul

Vidhu Vinod Chopra the producer of the superhit 3 Idiots made a movie called 1942:A Love Story which was released in 1994. The movie had soulful songs and could have been a big comeback for the great R D Burman. But alas that never happened. Pancham da died of a heart attack before the movie was released.
The movie set during the days of the British Raj starts as a love story between the hero Anil Kapoor and the heroine Manisha Koirala, who keep singing all the beautiful songs composed by Burman in the first half of the movie. But throughout the first half all the characters other than the hero and the heroine keep saying this one line “shubhankar da aa rahe hain”, building the expectations of the audience for his arrival.
Shubhankar da (played by Jackie Shoff) finally arrives around 30 seconds before the interval. Until that moment the movie was a love story. Then on it becomes a movie on the freedom struggle, which in this day and age would have been called a political thriller.
As was the case in the movie, there comes a time in life of individuals as well businesses when the story has to change. The past has to be dumped and made insignificant and a new story needs to emerge.
This is something that Mamata Banerjee, rabble rouser par excellence and the only angry young man in the country with the days of Bachchan long gone, needs to realize. She built her career and life around trying to throw out the Left Parties out of West Bengal and finally after more than two decades of hard work and sheer persistence she succeeded.
If ever there was an example of an individual not giving up and finally succeeding she was it. But after becoming the Chief Minister of West Bengal what is her story? She still seems to be working on the same story of rabble rousing against the Left everywhere all the time, and holding them responsible for everything that is happening in the state of West Bengal. From rapes of women to lack of governance!
The irony of course is that she is the government now. Her level of paranoia against the Left is reaching extreme proportions now. Most recently she called the students of Jadhavpur University CPI-M cadres. As she said “They are the CPI-M cadres. I am not going to reply. I will give reply to questions from common people. I am sorry to say you belong to CPI-M. You are SFI (Student Federation of India, the student wing of CPI-M) cadres. We know all of you.”
While Bengal may be full of CPI-M cadres this is like stretching it a little too much. It is time that Mamata Banerjee changed her anti-left story.
There are a few things that Banerjee can learn from businesses from around the world which experience this phenomenon time and again. Some learn and adapt, others don’t and for some others by the time they realise that things have changed, it’s already too late.
Take the case of Nokia, the largest mobile phone manufacturer in the world. The company started in 1865 as a groundwood pulp mill. It gradually became an industrial conglomerate and among other things produced paper products, tyres, footwear, communication cables and consumer electronics.
In the early 1990s the company realised that its story had to change. It decided to concentrate on the telecommunication business. It gradually sold out a host of its other businesses. The change of story helped the company become the largest mobile phone manufacturer in the world.
But the company missed out on the smart phone revolution completely. By the time it changed its story and started concentrating on smart phones, other companies had already moved in and captured the market. A host of smaller companies from Micromax to Karbon Mobiles and many more are giving Nokia a run for its money in the Indian market.
Why did this happen? For the simple reason, like Mamata, the company remained attached to its earlier story.
There are other such examples as well. When it came to reliable trustworthy news there wasn’t a bigger brand than the British Broadcasting Corporation(BBC). The company did not see the story changing and the rise of 24hour news channels. CNN grabbed the opportunity and broadcast the Gulf War live into homes. Sony is another great example. The company changed the entire music business with the launch of the Walkman. But failed to see the story changing and handed over the mp 3 player market to the likes of Apple, on a platter.
Bharti Beetel which revolutionised land line phones in India by launching push button phones failed to see the story changing and remained stuck to selling push button phones, when more and more consumers were moving to mobile phones. Ironically, its sister company Airtel became the biggest mobile phone company in India.
The company has recently started selling mobile phones. Now imagine, during the days when Airtel was a growing company, Bharti could have sold its own mobile phones (under the Beetel brand) to consumers who bought an Airtel connection and thus could have been one of the biggest mobile phone companies in India.
Those who do see the story changing and change their stories accordingly benefit from it. An oft quoted example is that of Nirma and Wheel. The Nirma detergent started selling at Rs 3.50 per kg at a time when Hindustan Lever’s (now Hindustan Unilever) Surf used to sell for around Rs 15 per kg. The low price of Nirma made it accessible to consumers, who till then really couldn’t afford the luxury of washing clothes using a detergent and had to use soap instead.
To Hindustan Lever’s credit they did not remain stuck in their past, realised that the story had to change, and thus went ahead and launched their Nirma killer “Wheel” detergent, which eventually beat the sales of Nirma.
The moral of the story from all these examples from Surf to Nokia to Sony to Bharti is simple. At times in lives of individuals as well as companies the story that had worked previously needs to be dumped. It is time for Mamata to come up with a new story. She is no longer in the opposition when blaming the Left for every problem in the state of West Bengal was her story. Now she is where the Left was earlier.
If she doesn’t change her story and come up with a new one, her innings as a Chief Minister is going to be a short lived on. The people of West Bengal need to know what does the new Mamata stand for?
(The article originally appeared on www.firstpost.com on May 19,2012. http://www.firstpost.com/politics/what-mamata-can-learn-from-surf-bbc-sony-and-nokia-314738.html)
(Vivek Kaul is a writer and can be reached at [email protected])

Of deficits, falling rupee, good economics and mindless austerity

Vivek Kaul
The UPA government is now talking about austerity. Has the cookie finally crumbled? But let’s try and understand why the words of the finance minister in the Rajya Sabha on May 16,2012, should not be taken very seriously. The argument is slightly long so kindly stay with me.
The fiscal deficit
The fiscal deficit of the government of India has been going up over the last five years. Fiscal deficit is the difference between what the government earns and what the government spends. 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. This shot up to Rs 5,21,980 crore for the financial year 2011-2012. In a time frame of five years the fiscal deficit has shot up by nearly 312%. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore.
The fiscal deficit targeted for the current financial year 2012-2013(i.e. between April 1, 2012 and March 31,2013) is a little lower at Rs 5,13,590 crore. Let us try and understand why lowering the fiscal deficit from the amount proposed by the government would be very difficult.
Interest and debt repayment
The increasing fiscal deficits over the years have been financed through raising debt. Now debt does not come free of cost. Interest needs to be paid on it. Also the debt raised needs to be repaid. In the year 2012-2013, the government will spend Rs 3,19,759 crore to pay interest on the debt that it has taken to finance the fiscal deficits. 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. This is something that the government cannot really do away with. It has to pay interest and repay the debt previously taken on.
Subsidies
The other big entry on the expenditure side of the budget is the subsidy on food, fertilizer and petroleum. This is an expenditure which the finance minister typically ends up underestimating at the time he presents the budget.
In his budget speech last year Pranab Mukherjee had set the fiscal deficit target for the financial year 2011-2012, at 4.6% of GDP. 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.
Generally all the three subsidies of food, fertilizer and petroleum are underestimated, but the estimates on the oil subsidies are way off the mark. For the year 2011-2012, oil subsidies were assumed to be at Rs 23,640crore. They came in at Rs 68,481 crore. 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).
The twin deficit hypothesis
The hypothesis basically states that as the fiscal deficit of the country goes up its trade deficit (i.e. the difference between its exports and imports) also goes up. Hence when a government of a country spends more than what it earns, the country also ends up importing more than exporting.
So what are the reasons behind this theory? One particular reason is the fact that governments typically end up with greater fiscal deficits when they cut taxes but at the same time do not match the cut in taxes with an increase in expenditure. This leaves people with a greater amount of money in their hands. Some portion of this money is used towards buying goods and services, which might be imported from abroad. This leads to greater imports and thus a higher trade deficit.
The government of India has been cutting taxes since 2007, but the cut in taxes hasn’t been matched up a cut in expenditure. This has meant increasing incomes of the Indian taxpayer maybe to some extent responsible for an increase in Indian imports. But that could have hardly been responsible for the trade deficit of $185billion that India ran in 2011-2012. In simple English this meant that the Indian imports were $185billion more than Indian exports.
It’s basically about oil and gold
The major reason for India’s huge trade deficit is the fact that we import a major part of our oil needs. And we continue to be obsessed with gold. Very little of both the commodities is found within the country and hence has to be imported. So we end up importing more than exporting. The trend continues in the current financial year as well. The imports for the month of April 2012 were at $37.9billion, nearly 54.7% more than the exports which stood at $24.5billion.
With imports being greater than exports there is a greater demand for dollars, which are used to pay for imports. This means importers sell rupees and buy dollars. When this happens the amount of rupees floating in the foreign exchange market goes up, leading to its losing value against the dollar. This to some extent explains the current rupee dollar rate of $1 = Rs 54.5. The Reserve Bank of India does intervene at times to stem the fall of the rupee. This it does by selling dollars and buying rupee. But the thing is that the RBI does not have an unlimited supply of dollars and hence cannot keep intervening indefinitely.
The double whammy
As mentioned earlier the major part of the trade deficit is because of the fact that we need to import oil. Oil prices have been high for the last few years, though recently they have fallen. Oil is sold in dollars. Hence when India needs to buy oil it needs to pay in dollars. But with the rupee constantly losing value against the dollar, it means that Indian companies have to more per barrel of oil in rupees.
The government of India does not pass on a major part of the increase in the price of oil to the end consumer and hence subsidizes the prices of diesel, LPG, kerosene etc. This means that the oil companies have to sell these products at a loss to the consumer. The government in turn compensates these companies for the loss. This leads to the expenditure of the government going up and hence it incurs a higher fiscal deficit.
Hence in India’s case a greater trade deficit also leads to a greater fiscal deficit. So the causality in India’s case is both ways. A high fiscal deficit leads to a higher trade deficit. And a high trader deficit leads to a higher fiscal deficit. And this in turn also leads to what economists call a weaker rupee, which pushes up the cost of oil in rupee terms, leading to a higher fiscal deficit.
Oil prices have come down a little recently. But this is unlikely to benefit India because the rupee is constantly losing value against the dollar. Hence most likely Indian companies will continue to pay the same price for oil in rupee terms as they had.
High interest rates
As mentioned earlier the government finances its fiscal deficit by borrowing money. It borrows money from the same pool of savings that the private sector does. This in effect leads to what economists call “crowding out”. When the government borrows more and more, the pool of savings left for the private sector to borrow constantly narrows. This leads to higher interest rates. A higher interest rate also means that a lot of opportunities that the private sector might want to invest in do not remain viable because the cost of borrowing has gone up.
In fact the high interest rate scenario that has prevailed in India since 2008 is to some extent responsible to the private capital spending coming down from 17% of the gross domestic product to the current 12%. This in turn has been to some extent responsible for lower economic growth. But it works both ways. Higher interest rates have led to corporates cutting down on their capital spending, leading to low economic growth. And low economic growth has in turn has led to lower capital spending by corporate.
How do we take care of this?
The starting point of getting out of this rut is cutting the fiscal deficit. As mentioned earlier, the payment of interest on debt and repayment of debt together account for nearly 86.5% of the fiscal deficit. This is something that cannot be done away with. The other major expenditure of the government are subsidies. This is where something can be done.
If the government decides to stop subsidizing the various oil products and ask consumers to pay the “right” price, the fiscal deficit can be brought down to some extent. If these products are priced correctly, their consumption is likely to come down as well in the near future, given that their prices will go up. Lower consumption is likely to lead to lower imports and thus a lower trade deficit. This to some extent also takes care of the other problem that we have.
When imports are more than exports what it means is that the country is paying more dollars for the imports than it is earning from the exports. This difference obviously comes from the foreign exchange reserves that India has accumulated over the years. But that clearly isn’t healthy given our imports are more than 50% of our exports and there is a limited supply of foreign exchange reserves.
A lower trade deficit takes care of that problem to some extent. A lower trade deficit would also mean that the fall of the rupee against the dollar may stop. This in turn would mean a lower price for the oil we import in rupee terms and that in turn help overall economic growth. A lower fiscal deficit will lead to lower government borrowing and hence lesser “crowding out” and so lower interest rates, which might get corporates and individuals interested in borrowing again.
To conclude:
On the flip side an increase in the price of oil products will immediately lead to higher inflation. One of the few things in economics that most economists agree on and do not offer a counterpoint to is the fact that a higher price of oil leads to higher inflation, in the short term. The question is whether the UPA government is willing to take that risk?
The other major point is that the only way out of this economic “rut” is to start by cutting subsidies. A cut in subsidies will bring down the fiscal deficit, which in turn will bring down both the interest rates as well as the trade deficit. The trade deficit coming down will lead to the rupee stabilizing against the dollar.
But the government will have start with cutting down subsidies. Will that happen? We all saw the hungama that happened when Dinesh Trivedi, the erstwhile Railway Minister, tried to increase rail fares after almost ten years. Will the allies in the Congress led UPA allow it to increase prices of various oil products? Will the Congress cut down on food subsidies budgeted at Rs 75,000 crore for the current financial year, which have been a favourite with Sonia Gandihi? And the biggest point remains that 2014 elections are largely being seen as the launch of Rahul Gandhi as the Prime Ministerial candidate for the UPA. Under these conditions what are the chances that the government will slash subsidies?
I remain pessimistic.

(A version of this article appeared in Daily News and Analysis on May 19,2012. http://www.dnaindia.com/money/column_of-deficits-falling-rupee-good-economics-and-mindless-austerity_1690732)
(Vivek Kaul is a writer and can be reached at [email protected])