Vivek Kaul
Buried somewhere in the Reserve Bank of India‘s first quarter review of monetary policy released yesterday is the following paragraph:
The stickiness in inflation, despite the significant growth slowdown, was largely on account of high primary food inflation, which was in double-digits during Q1 of 2012-13 due to an unusual spike in vegetable prices and sustained high inflation in protein items.
In simple English what this means is that despite economic growth slowing down inflation continued to remain high because of high food inflation. The Reserve Bank of India (RBI) has not seen the last of food inflation and there are several reasons why food inflation will continue to remain high in the days to come.
Below average rainfall: The immediate reason for the food prices continuing to remain is the below average rainfall this monsoon season. As the RBI said in the first quarter review of monetary policy:
During the ongoing monsoon season, rainfall up to July 25, 2012 was 22 per cent below its long period average (LPA). The Reserve Bank’s production weighted rainfall index (PWRI) showed an even higher deficit of 24 per cent. Further, the distribution of rainfall was very uneven, with the North-West region registering the highest deficit of about 39 per cent of LPA. If the rainfall deficiency persists, agricultural production could be adversely impacted.
The availability of water can make a huge difference to the agricultural output in India. Areas fed by canals form only around 40% of the total arable land in India. The remaining 60% are dependent on rains. With deficient rains this year the current khareef crop is likely to be impacted with production not being enough to meet demand. This will lead to food prices going up in the days to come.
Rural India is eating better: The various social schemes being run by the current United Progressive Alliance (UPA) government have put more money into the hands of rural India. The income of rural India has more than doubled in the last five years. One thing that seems to have happened because of this is that people are eating better than before. Economists are of the opinion that as income of people rises above the subsistence level of $1000 per year, a substantial portion of the new money is spent on food. People eat more and better quality food. At the same time they also move from cereal based diets to more protein based diets. In major parts of the world this means that people start consuming more meat. But India has a lot of vegetarians and hence consumption of other high protein food items like dal, milk and other dairy based products has gone up, pushing their prices up. This is likely to continue in the months and years to come given the social commitment of the current UPA government. If the proposed Right to Food Act goes through you could see a further increase in food prices.
The Japan syndrome: As a densely populated country industrialises, the area under agriculture tends to go down. This phenomenon was first observed in Japan, and has since then been observed in South Korea, Taiwan, and very recently China. As Lester R Brown points out in Outgrowing the Earth: The Food Security Challenge in an Age of Falling Water Tables and Rising Temperatures “First, as a country industrialises and modernises cropland is used for industrial and residential development. As automobile ownership spreads, the construction of roads, highways, and parking lots…takes valuable land away from agriculture…. Secondly as rapid industrialisation pulls labour out of the countryside, it often leads to less double cropping, a practice that depends on quickly harvesting one grain crop once its ripe and immediately preparing the seedbed for the next crop…Third, as incomes rise, diets diversify, generating demand for more fruits and vegetables. This in turn leads farmers to shift land from grain to these more profitable high-value crops.”
This is a long term phenomenon which is clearly playing out in India right now. Just drive around towards the outer limits of the city you live in and you will realize that what was once agricultural land has been taken over to build malls, apartments, offices etc. This leaves less area to grow vegetables, cereals and other crops, pushing up their prices in turn. Depleting aquifers: A huge amount of increase in the irrigation of crops across the gangetic plane, India’s agricultural heartland have substantially depleted the aquifers or the underground water tables. As a report by DWS Investments points out “Dramatic increases in the irrigation of crops across northern India have substantially depleted the region’s groundwater. Between April 2002 and August 2008, aquifers lost a total of more than 54 cubic kilometers per year. That decrease in groundwater is even more than double the capacity of India’s largest reservoir.”
While this data is around four years old there is no reason to believe that the situation could have improved in the last four years. It could only have got worse. This is something that Brown agrees with in his book Outgrowing the Earth. He writes “the extensive overpumping of aquifers in India will deprive farmers of irrigation water and will also reduce grain production”.
Climate change also threatens food security: As the following table points out Indian agriculture has very low productivity when it comes to other parts of the world. Even Bangladesh does better than us when it comes to producing rice.
Comparing productivity of Indian agriculture with the world (kg/ha)
Country Paddy Country Wheat Country Maize
World 4,223 World 2,829 World 5,010
Bangladesh 4,012 China 4,608 Agentina 7,666
Brazil 3,826 Egypt 6,478 Canada 8,511
China 6,422 France 6,256 China 5,151
India 3,303 India 2,704 India 2,440
Indonesia 4,705 Italy 3,568 Italy 9,144
Japan 6,511 Spain 3,470 Turkey 6,838
USA 8,092 United Kingdom0 7,225 USA 9,458
Source: Agriculture Statistics at a Glance /Kotak GameChanger Report
Even this production is threatened now because of rising global temperature which beyond a certain point tends to reduce the amount of crop produced. As Lester Brown told me in an interview I did for the Daily News and Analysis (DNA) a few years back “For each degree celsius rise in temperature above the norm during the growing season, farmers can expect a 10% decline in wheat, rice, and corn yields. Since 1970, the earth’s average surface temperature has increased by 0.6 degrees Celsius, or roughly 1 degree Fahrenheit.”
As the earth’s temperature rises it has led to glaciers melting. “Nowhere is this of more concern than in Asia. It is the ice melt from glaciers in the Himalayas and on the Tibetan plateau that sustain the major rivers of India and China, and the irrigation systems that depend on them, during the dry season. In Asia, both wheat and rice fields depend on this water. China is the world’s leading wheat producer. India is No 2 (The US is third.) These two countries also dominate the world rice harvest. Whatever happens to the wheat and rice harvests in these two population giants will affect food prices everywhere. Indeed, the projected melting of the glaciers on which these two countries depend presents the most massive threat to food security humanity has ever faced,” said Brown.
Cars and people are competing for grains: As the price of oil keeps going up, the world has started to look for alternate sources of fuel to run cars and other forms of transport around the world. One such fuel is ethanol which is made from corn and sugarcane in different parts of the world. In Brazil, a lot of cars run on ethanol, which is produced using sugarcane. So if oil prices go up, ethanol becomes more viable as an alternate fuel. And this pushes up the price of ethanol input, i.e. sugarcane. With lesser sugarcane available to produce sugar, the price of sugar also goes up. The United States uses corn to make ethanol. So oil prices going up leads to corn prices going up as well. As Brown put it “If the fuel value of grain exceeds its food value, the market will simply move the commodity into the energy economy. If the price of oil jumps to $100 a barrel, the price of grain will follow it upward. If oil goes to $200, grain will follow. From an agricultural vantage point, the world’s appetite for crop-based fuels is insatiable. The grain required to fill an SUV’s 25-gallon tank with ethanol just once will feed one person for a whole year. If the entire US grain harvest were to be converted to ethanol, it would satisfy at most 18% of US auto fuel needs.”
Given these reasons the food prices are likely to remain high in the months and years to come. And the Reserve Bank of India can fiddle around with the interest rates as much as it wants to, but there is no way it can control food prices.
(The article originally appeared on www.firstpost.com on August 2,2012. http://www.firstpost.com/economy/why-food-prices-will-continue-to-rise-in-the-coming-years-400532.html)
(Vivek Kaul is a writer and can be reached at [email protected])
China
'You can shut the equity market, India would still be doing fine'
Have you ever heard someone call equity a short term investment class? Chances are no. “I have always had this notion for many years that people buy equities because they like to be excited. It’s not just about the returns they make out of it… You can build a case for equities on a three year basis. But long term investing is all rubbish, I have never believed in it,” says Shankar Sharma, vice-chairman & joint managing director, First Global. In this freewheeling
interview he speaks to Vivek Kaul.
Six months into the year, what’s your take on equities now?
Globally markets are looking terrible, particularly emerging markets. Just about every major country you can think of is stalling in terms of growth. And I don’t see how that can ever come back to the go-go years of 2003-2007. The excesses are going to take an incredible amount of time to work their way out. They are not even prepared to work off the excesses, so that’s the other problem.
Why do you say that?
If you look at the pattern in the European elections the incumbents lost because they were trying to push for austerity. And the more leftist parties have come to power. Now leftists are usually the more austere end of the political spectrum. But they have been voted to power, paradoxically, because they are promising less austerity. All the major nations in the world are democracies barring China. And that’s the whole problem. You can’t push through austerity that easily in a democracy, but that is what is really needed. Even China cannot push through austerity because of a powder-keg social situation. And I find it very strange when people criticise India for subsidies and all that. India is far less profligate than many nations including China.
Can you elaborate on that?
Every country has to subsidise, be it farm subsidies in the West or manufacturing subsidies in China, because ultimately whether you are a capitalist or a communist, people are people. They don’t necessarily change their views depending on which political ideology is at the centre. They ultimately want freebies and handouts. In a country like India, they don’t even want handouts they just want subsistence, given the level of poverty. The only thing that you can do with subsidies is to figure out how to control them. But a lot of it is really out of your control. If you have a global inflation in food prices or oil prices you are not increasing the quantum in volume terms of the subsidy. But because of price inflation, the number inflates. So why blame India? I find it absurd that the Financial Times or the Economist are perennially anti-India. They just isolate India and say that it has got wasteful expenditure programmes. A lot of countries hide things. India, unfortunately, is far more transparent in its reporting. It is easy to pick holes when you are transparent. China gives no transparency so people assume that whatever is inside the black box must be okay. That said, I firmly believe the UID program, when fully implemented, will make subsidies go lower by cutting out bogus recipients.
If increased austerity is not a solution, where does that leave us?
Increased austerity, while that is a solution, it is not achievable. If that is not possible what is the solution? You then have a continual stream of increasing debt in one form or the other, keep calling it a variety of names. But you just keep kicking the can down the road for somebody else to deal with it as long as the voter is happy. Given this, I don’t see how you can have any resurgence. Risk appetite is what drives equity markets. Otherwise you and I would be buying bonds all the time. In today’s environment and in the foreseeable future, we are overfed with risk. Where is the appetite to take more risk and go, buy equities?
So are you suggesting that people won’t be buying stocks?
Well you can get pretty good returns in fixed income. Instead of buying emerging-market stocks if you buy bonds of good companies, you can get 6-7% dollar yield, and if you leverage yourself two times or something, you are talking about annual returns of 14-15% dollar returns. You can’t beat that by buying equities, boss! Even if you did beat that by buying equities, let’s say you made 20%, it is not a predictable 20%, which has been my case for a long time against equities. Equities are a western fashion. I have always had this notion for many years that people buy equities because they like to be excited. It’s not just about the returns they make out of it: it is about the whole entertainment quotient attached to stock investing that drives investors. There is 24-hour television. Tickers. Cocktail discussions. Compared with that, bonds are so boring and uncool. Purely financially, shorn of all hype, equities have never been able to build a case for themselves on a ten-year return basis. You can build a case for equities on a three-year basis. But long-term investing is all rubbish, I have never believed in it.
So investing regularly in equities, doing SIPs, buying Ulips, doesn’t make sense?
I don’t buy the whole logic of long-term equity investing because equity investing comes with a huge volatility attached to it. People just say “equities have beaten bonds”. But even in India they have not. Also people never adjust for the volatility of equity returns. So if you make 15% in equity and let’s say, in a country like India, you make 10% in bonds – that’s about what you might have averaged over a 15-20 year period because in the 1990s we had far higher interest rates. Interest rates have now climbed back to that kind of level of 9-10%. Divide that by the standard deviation of the returns and you will never find a good case for equities over a long-term period. So equity is actually a short-term instrument. Anybody who tells you otherwise is really bluffing you. All the fancy graphs and charts are rubbish.
Are they?
Yes. They are all massaged with sort of selective use of data to present a certain picture because it’s a huge industry which feeds off it globally. So you have brokers like us. You have investment bankers. You have distributors. We all feed off this. Ultimately we are a burden on the investor, and a greater burden on society — which is also why I believe that the best days of financial services is behind us: the market simply won’t pay such high costs for such little value added. Whatever little return that the little guy gets is taken away by guys like us. How is the investor ever going to make money, adjusted for volatility, adjusted for the huge cost imposed on him to access the equity markets? It just doesn’t add up. The customer never owns a yacht. And separately, I firmly believe making money in the markets is largely a game of luck. Even the best investors, including Buffet, have a strike rate of no more than 50-60% right calls. Would you entrust your life to a surgeon with that sort of success rate?! You’d be nuts to do that. So why should we revere gurus who do just about as well as a coin-flipper. Which is why I am always mystified why so many fund managers are so arrogant. We mistake luck for competence all the time. Making money requires plain luck. But hanging onto that money is where you require skill. So the way I look at it is that I was lucky that I got 25 good years in this equity investing game thanks to Alan Greenspan who came in the eighties and pumped up the whole global appetite for risk. Those days are gone. I doubt if you are going to see a broad bull market emerging in equities for a while to come.
And this is true for both the developing and the developed world?
If anything it is truer for the developing world because as it is, emerging market investors are more risk-averse than the developed-world investors. We see too much of risk in our day to day lives and so we want security when it comes to our financial investing. Investing in equity is a mindset. That when I am secure, I have got good visibility of my future, be it employment or business or taxes, when all those things are set, then I say okay, now I can take some risk in life. But look across emerging markets, look at Brazil’s history, look at Russia’s history, look at India’s history, look at China’s history, do you think citizens of any of these countries can say I have had a great time for years now? That life has been nice and peaceful? I have a good house with a good job with two kids playing in the lawn with a picket fence? Sorry, boss, that has never happened.
And the developed world is different?
It’s exactly the opposite in the west. Rightly or wrongly, they have been given a lifestyle which was not sustainable, as we now know. But for the period it sustained, it kind of bred a certain amount of risk-taking because life was very secure. The economy was doing well. You had two cars in the garage. You had two cute little kids playing in the lawn. Good community life. Lots of eating places. You were bred to believe that life is going to be good so hence hey, take some risk with your capital.
The government also encouraged risk taking?
The government and Wall Street are in bed in the US. People were forced to invest in equities under the pretext that equities will beat bonds. They did for a while. Nevertheless, if you go back thirty years to 1982, when the last bull market in stocks started in the United States and look at returns since then, bonds have beaten equities. But who does all this math? And Americans are naturally more gullible to hype. But now western investors and individuals are now going to think like us. Last ten years have been bad for them and the next ten years look even worse. Their appetite for risk has further diminished because their picket fences, their houses all got mortgaged. Now they know that it was not an American dream, it was an American nightmare.
At the beginning of the year you said that the stock market in India will do really well…
At the beginning of the year our view was that this would be a breakaway year for India versus the emerging market pack. In terms of nominal returns India is up 13%. Brazil is down 3%. China is down, Russia is also down. The 13% return would not be that notable if everything was up 15% and we were up 25%. But right now, we are in a bear market and in that context, a 13-15% outperformance cannot be scoffed off at.
What about the rupee? Your thesis was that it will appreciate…
Let me explain why I made that argument. We were very bearish on China at the beginning of the year. Obviously when you are bearish on China, you have to be bearish on commodities. When you are bearish on commodities then Russia and Brazil also suffer. In fact, it is my view that Russia, China, Brazil are secular shorts, and so are industrial commodities: we can put multi-year shorts on them. So that’s the easy part of the analysis. The other part is that those weaknesses help India because we are consumers of commodities at the margin. The only fly in the ointment was the rupee. I still maintain that by the end of the year you are going to see a vastly stronger rupee. I believe it will be Rs 44-45 against the dollar. Or if you are going to say that is too optimistic may be Rs 47-48. But I don’t think it’s going to be Rs 60-65 or anything like that. At the beginning of the year our view that oil prices will be sharply lower. That time we were trading at around $105-110 per barrel. Our view was that this year we would see oil prices of around $65-75. So we almost got to $77 per barrel (Nymex). We have bounced back a bit. But that’s okay. Our view still remains that you will see oil prices being vastly lower this year and next year as well, which is again great news for India. Gold imports, which form a large part of the current account deficit, shorn of it, we have a current account deficit of around 1.5% of the GDP or maybe 1%. We imported around $60 billion or so of gold last year. Our call was that people would not be buying as much gold this year as they did last year. And so far the data suggests that gold imports are down sharply.
So there is less appetite for gold?
Yes. In rupee terms the price of gold has actually gone up. So there is far less appetite for gold. I was in Dubai recently which is a big gold trading centre. It has been an absolute massacre there with Indians not buying as much gold as they did last year. Oil and gold being major constituents of the current account deficit our argument was that both of those numbers are going to be better this year than last year. Based on these facts, a 55/$ exchange rate against the dollar is not sustainable in my view. The underlyings have changed. I don’t think the current situation can sustain and the rupee has to strengthen. And strengthen to Rs 44, 45 or 46, somewhere in that continuum, during the course of the year. Imagine what that does to the equity market. That has a big, big effect because then foreign investors sitting in the sidelines start to play catch-up.
Does the fiscal deficit worry you?
It is not the deficit that matters, but the resultant debt that is taken on to finance the deficit. India’s debt to GDP ratio has been superb over the last 8-9 years. Yes, we have got persistent deficits throughout but our debt to GDP ratio was 90-95% in 2003, that’s down to maybe 65% now. So explain that to me? The point is that as long as the deficit fuels growth, that growth fuels tax collections, those tax collections go and give you better revenues, the virtuous cycle of a deficit should result in a better debt to GDP situation. India’s deficit has actually contributed to the lowering of the debt burden on the national exchequer. The interest payments were 50% of the budgetary receipts 7-8 years back. Now they are about 32-33%. So you have basically freed up 17% of the inflows and this the government has diverted to social schemes. And these social schemes end up producing good revenues for a lot of Indian companies. The growth for fast-moving consumer goods, mobile telephony, two wheelers and even Maruti cars, largely comes from semi-urban, semi-rural or even rural India.
What are you trying to suggest?
This growth is coming from social schemes being run by the government. These schemes have pushed more money in the hands of people. They go out and consume more. Because remember that they are marginal people and there is a lot of pent-up desire to consume. So when they get money they don’t actually save it, they consume it. That has driven the bottomlines of all FMCG and rural serving companies. And, interestingly, rural serving companies are high-tax paying companies. Bajaj Auto, Hindustan Lever or ITC pay near-full taxes, if not full taxes. This is a great thing because you are pushing money into the hands of the rural consumer. The rural consumer consumes from companies which are full taxpayers. That boosts government revenues. So if you boost consumption it boosts your overall fiscal situation. It’s a wonderful virtuous cycle — I cannot criticise it at all. What has happened in past two years is not representative. It is only because of the higher oil prices and food prices that the fiscal deficit has gone up.
What is your take on interest rates?
I have been very critical of the Reserve Bank of India’s (RBI) policies in the last two years or so. We were running at 8-8.5% economic growth last year. Growth, particularly in the last two or three years, has been worth its weight in gold. In a global economic boom, an economic growth of 8%, 7% or 9% doesn’t really matter. But when the world is slowing down, in fact growth in large parts of the world has turned negative, to kill that growth by raising the interest rate is inhuman. It is almost like a sin. And they killed it under the very lofty ideal that we will tame inflation by killing growth. But if you have got a matriculation degree, you will understand that India’s inflation has got nothing to do with RBI’s policies. Your inflation is largely international commodity price driven. Your local interest rate policies have got nothing to do with that. We have seen that inflation has remained stubbornly high no matter what Mint Street has done. You should have understood this one commonsensical thing. In fact, growth is the only antidote to inflation in a country like India. When you have economic growth, average salaries and wages, kind of lead that. So if your nominal growth is 15%, you will 10-20% salary and wage hikes – we have seen that in the growth years in India. Then you have more purchasing power left in the hands of the consumer to deal with increased price of dal or milk or chicken or whatever it is. If the wage hikes don’t happen, you are leaving less purchasing power in the hands of people. And wage hikes won’t happen if you have killed economic growth. I would look at it in a completely different way. The RBI has to be pro-growth because they no control of inflation.
So they basically need to cut the repo rate?
They have to.
But will that have an impact? Because ultimately the government is the major borrower in the market right now…
Look, again, this is something that I said last year — that it is very easy to kill growth but to bring it back again is a superhuman task because life is only about momentum. The laws of physics say that you have to put in a lot of effort to get a stalled car going, yaar. But if it was going at a moderate pace, to accelerate is not a big issue. We have killed that whole momentum. And remember that 5-6%, economic growth, in my view, is a disastrous situation for a country like India. You can’t say we are still growing. 8% was good. 9% was great. But 4-5% is almost stalling speed for an economy of our kind. So in my view the car is at a standstill. Now you need to be very aggressive on a variety of fronts be it government policy or monetary policy.
What about the government borrowings?
The government’s job has been made easy by the RBI by slowing down credit growth. There are not many competing borrowers from the same pool of money that the government borrows from. So far, indications are that the government will be able to get what it wants without disturbing the overall borrowing environment substantially. Overall bond yields in India will go sharply lower given the slowdown in credit growth. So in a strange sort of way the government’s ability to borrow has been enhanced by the RBI’s policy of killing growth. I always say that India is a land of Gods. We have 33 crore Gods and Goddesses. They find a way to solve our problems.
So how long is it likely to take for the interest rates to come down?
The interest rate cycle has peaked out. I don’t think we are going to see any hikes for a long time to come. And we should see aggressive cuts in the repo rate this year. Another 150 basis points, I would not rule out. Manmohan Singh might have just put in the ears of Subbarao that it’s about time that you woke up and smelt the coffee. You have no control over inflation. But you have control over growth, at least peripherally. At least do what you can do, instead of chasing after what you can’t do.
Manmohan Singh in his role as a finance minister is being advised by C Rangarajan, Montek Singh Ahulwalia and Kaushik Basu. How do you see that going?
I find that economists don’t do basic maths or basic financial analysis of macro data. Again, to give you the example of the fiscal deficit and I am no economist. All I kept hearing was fiscal deficit, fiscal deficit, fiscal deficit. I asked my economist: screw this number and show me how the debt situation in India has panned out. And when I saw that number, I said: what are people talking about? If your debt to GDP is down by a third, why are people focused on the intermediate number? But none of these economists I ever heard them say that India’s debt to GDP ratio is down. I wrote to all of them, please, for God’s sake, start talking about it. Then I heard Kaushik Basu talk about it. If a fool like me can figure this out, you are doing this macro stuff 24×7. You should have had this as a headline all the time. But did you ever hear of this? Hence I am not really impressed who come from abroad and try to advise us. But be that as it may it is better to have them than an IAS officer doing it. I will take this.
You talked about equity being a short-term investment class. So which stocks should an Indian investor be betting his money right now?
I am optimistic about India within the context of a very troubled global situation. And I do believe that it’s not just about equity markets but as a nation we are destined for greatness. You can shut down the equity markets and India would still be doing what it is supposed to do. But coming from you I find it a little strange…
I have always believed that equity markets are good for intermediaries like us. And I am not cribbing. It’s been good to me. But I have to be honest. I have made a lot of money in this business doesn’t mean all investors have made a lot of money. At least we can be honest about it. But that said, I am optimistic about Indian equities this year. We will do well in a very, very tough year. At the beginning of the year, I thought we will go to an all-time high. I still see the market going up 10-15% from the current levels.
So basically you see the Sensex at around 19,000?
At the beginning of the year, you would have taken it when the Sensex was at 15,000 levels. Again, we have to adjust our sights downwards. A drought angle has come up which I think is a very troublesome situation. And that’s very recent. In light of that I do think we will still do okay, it will definitely not be at the new high situation.
What stocks are you bullish on?
We had been bearish on infrastructure for a very long time, from the top of the market in 2007 till the bottom in December last year. We changed our view in December and January on stocks like L&T, Jaiprakash Industries and IVRCL. Even though the businesses are not, by and large, of good quality — I am not a big believer in buying quality businesses. I don’t believe that any business can remain a quality business for a very long period of time. Everything has a shelf life. Every business looks quality at a given point of time and then people come and arbitrage away the returns. So there are no permanent themes. And we continue to like these stocks. We have liked PSU banks a lot this year, because we see bond yields falling sharply this year.
Aren’t bad loans a huge concern with these banks?
There is a company in Delhi — I won’t name it. This company has been through 3-4 four corporate debt restructurings. It is going to return the loans in the next year or two. If this company can pay back, there is no problem of NPAs, boss. The loans are not bogus loans without any asset backing. There are a lot of assets. At the end of every large project there is something called real estate. All those projects were set up with Rs 5 lakh per acre kind of pricing for land. Prices are now Rs 50 lakh per acre or Rs 1 crore or Rs 1.5 crore per acre. If nothing else, dismantle the damn plant, you will get enough money from the real estate to repay the loans of the public sector banks. So I am not at all concerned on the debt part. If the promoter finds that is going to happen, he will find some money to pay the bank and keep the real estate.
On the same note, do you see Vijay Mallya surviving?
100% he will survive. And Kingfisher must survive, because you can’t only have crap airlines like Jet and British Airways. If God ever wanted to fly on earth, he would have flown Kingfisher.
So he will find the money?
Of course! At worst, if United Spirits gets sold, that’s a stock that can double or triple from here. I am very optimistic about United Spirits. Be it the business or just on the technical factor that if Mallya is unable to repay and his stake is put up for sale, you will find bidders from all over the world converging.
So you are talking about the stock and not Mallya?
Haan to Mallya will find a way to survive. Indian promoters are great survivors. We as a nation are great survivors.
How do you see gold?
I don’t have a strong view on gold. I don’t understand it well enough to make big call on gold, even though I am an Indian. One thing I do know is that our fascination with gold has very strong economic moorings. We should credit Indians for having figured out what is a multi century asset class. Indians have figured out that equities are a fashionable thing meant for the Nariman Points of the world, but for us what has worked for the last 2000 years is what is going to work for the next 2000 years.
What about the paper money system, how do you see that?
I don’t think anything very drastic where the paper money system goes out of the window and we find some other ways to do business with each. Or at least I don’t think it will happen in my life time. But it’s a nice cute notion to keep dreaming about.
At least all the gold bugs keep talking about the collapse of the paper money system…
I know. I don’t think it’s going to happen. But I don’t think that needs to happen for gold to remain fashionable. I don’t think the two things are necessarily correlated. I think just the notion of that happening is good enough to keep gold prices high.
(A slightly smaller version of the interview appeared in the Daily News and Analysis on July 31,2012. http://www.dnaindia.com/money/interview_you-can-shut-the-equity-market-india-would-still-be-doing-fine_1721939)
(Interviewer Kaul is a writer and can be reached at [email protected])
By 2015, gold price will average significantly below $1,200 per ounce
Gold, the yellow metal, has been touching new highs in India. But the international price in dollars has been largely flat since the beginning of this year. Nikos Kavalis, Strategist in the Commodity Research Team of RBS feels “By 2015, we expect the gold price will average significantly below its current levels, at $1,200/oz. As the road-map to more normal macroeconomic conditions is laid, we believe that more attractive opportunities will emerge for investors and, eventually, higher interest rates will also reduce gold’s appeal.”
In this interview he speaks to Vivek Kaul.
The price of gold has been largely flat in dollar terms since the beginning of the year. Why is that?
For most of last year, gold behaved like a “safe haven” asset and was negatively correlated with risk. For example, it rallied by 28% from end-June to its all-time-high of $1,920/oz in early September, whereas the S&P500 fell by around 15% over the same period. Aft/er the sharp September correction, when gold dropped to a $1,600-1,650/oz range (per ounce, where one ounce equals 31.1grams), the story changed dramatically. Since then, gold has been trading in line with risk.
Can you explain that further?
2012 so far can be divided in two periods. The first period was the euphoria of the first two months of the year. A series of good economic data and hopes that the worst of the Eurozone crisis was behind us, pushed investors to risky assets. This helped gold, which was also boosted by a weakening US dollar at the time – gold has traditionally been negatively correlated with the US currency. By late February, gold had rallied to $1,790/oz, from around $1,560 at the start of the year. The period since the end of February has been the mirror image of the first two months. The first hit for gold came after Ben Bernanke’s speech at end-February, which hurt market expectations of QE3. Renewed concerns about the Eurozone crisis, poor economic data out of Europe and concerns that China’s growth is slowing boosted risk aversion over the following few weeks. Greece’s election added fuel to the fire and intensified fears of a break-up of the Eurozone. Gold trended downwards and by the end of May its price had virtually erased all the previous gains, returning more or less where it started the year. The price rebounded somewhat in early June, but remains far below the late-February high.
But it’s been going up in terms of rupees…”
Since its peak in September, the gold price has declined by 15%, in dollar terms. In rupee terms, and here I am looking at the nearest gold futures contract on the MCX, the price has recently made new highs! The story here is one of currency depreciation. As you know, the Indian rupee has been under pressure, partly because of fundamental reasons and partly due to the wider “risk off” environment hitting emerging markets currencies. It has depreciated by 5% against the US dollar since the beginning of the year and by more than 27% since the summer of 2011. This has boosted the Indian rupee denominated gold price. The rise in the rupee-denominated gold price has hurt Indian demand. High inflation eating into disposable incomes of local consumers has not helped either. This is evident in the World Gold Council data, showing weak jewellery and bar investment demand in the country, both in the fourth quarter of 2011 and the first three months of 2012. You no doubt will have also seen the numerous anecdotal reports that suggest demand has remained weak over the course of the second quarter.
How do you see the performance of gold in dollar terms during the course of the year?
I am moderately bullish towards gold for the rest of 2012. I think that the current uncertain macroeconomic environment still provides good reasons to own it, particularly against the backdrop of negative real interest rates. Moreover, we at RBS commodity research expect that the wider commodities sector will move upwards later in the year. We expect Chinese commodity demand to accelerate and I think that the latest interest rate cut and other steps taken by Chinese authorities towards a more accommodative stance will help in this. As risk appetite grows, flows into the space should also emerge. We believe that all this will benefit gold. Specific to the gold market, continued central bank buying should also help gold, both directly, by taking metal out of the market, and indirectly, by boosting investor sentiment. Lack of producer hedging and limited growth in scrap supply, are other positive factors.
Any target?
Finally, I want to note that at the moment speculator positioning in gold is very light. Look at the CFTC data on net positions in Comex futures for example – the net investor long is at the lowest since December 2008 and short positions are significant. When sentiment changes, I think this situation will be reversed and therefore believe there is some very good upside to be had. Our projections see gold average at $1,800/oz in the fourth quarter of this year.
What about the performance in terms of rupees?
We have a team of Emerging Markets economists at RBS and their outlook for the Indian rupee is cautious, owing to the imbalances (fiscal & current account) that weigh on the currency. The recent reduction in the petrol subsidy and the possibility for further fuel subsidy cuts are all steps in the right direction and some better news in Europe could also help, but our economists cannot see a material appreciation any time soon. Based on this and our forecast for a higher dollar-denominated price, we expect the rupee price to also rise in 2012.
What is the scene on the investment demand for gold?
There are a few different “segments” of gold investment and activity in them has varied. Investment in physical gold continues, although at a slower pace than last year. You still have the risk-averse retail players buying bars and coins in Europe and North America and of course the Indian and Chinese demand. We are seeing a lot less large scale metal account buying than in 2011 and before, but on the positive side, we have also not really much selling from these positions. We had some good inflows into gold ETFs earlier in the year, but these were in large part offset during the recent liquidations. Finally, as I mentioned earlier, positioning in Comex futures is very low and has declined year-to-date. Our outlook for investment demand in gold is positive and this assumption is an essential part of our bullish outlook for the price of the yellow metal. We think that, for reasons discussed earlier, investor appetite for gold will continue and actually grow later in the year. A very important driver for this growth will likely rising speculative investment in gold futures. These guys have actually been net dis-investors in 2012-to-date and many of them are now short gold (based on CFTC data).
Quantitative easing carried out by countries all over the world was one reason for the bull market in gold. Is that still a reason? I think that the expectation of QE3 in the US has been a very important driver of gold investment in the past. This was illustrated by the sharp correction following Ben Bernanke’s statement in late February that dampened expectations of further quantitative easing. Recent developments continue to suggest that QE3 is very much in gold investors’ minds. For example, look at the early-June rally (from ~$1,550/oz to ~$1,640/oz); it came after the poor US payrolls data on 1st June and dovish comments by Federal Reserve officials, which rekindled QE3 expectations. Similarly, the sharp correction that followed was triggered by Ben Bernanke’s latest testimony, which, again, lacked any clear indication that QE3 is on the way.
What are the chances of QE III happening, and that in turn pushing up the price of gold?
Our US economists ascribe better than even (60%) odds of Federal Reserve action, but think that an extension of “Operation Twist” is more likely than outright QE3. Having said this, if QE3 were to materialise, I think that gold would clearly benefit, for a number of reasons: the risk-on trade that would follow; the negative impact on the US dollar; and rising inflationary expectations (perhaps to a lesser extent now than in the past).
What can be the newer reasons for a bull market in gold?
As I mentioned earlier, we are only modestly bullish on gold, for the reasons I explained earlier. Moreover, our projections see the end of the gold bull market is in sight and we see a downtrend emerge from next year onwards. By 2015, we expect the gold price will average significantly below its current levels, at $1,200/oz. As the road-map to more normal macroeconomic conditions is laid, we believe that more attractive opportunities will emerge for investors and, eventually, higher interest rates will also reduce gold’s appeal.
If a country like Greece were to decide to leave the euro zone, do you see that having any impact on the price of gold?
Absolutely. I think the immediate reaction would be for gold to fall sharply, as investors sell all risky assets and there is a flight to cash. Further down the line, “after the dust settles”, I would expect that such an event would re-ignite safe haven buying of gold and as such drive the price higher.
What can pull down the price of gold?
I think the biggest headwind for gold at the moment is the strength of the US dollar. If the US currency continues to strengthen, gold will remain under pressure. Further into the future, there are a number of potential factors which we indeed expect will push gold down, such as flows into other asset classes and, eventually, higher interest rates.
Do you see more central banks buying gold in the time to come?
Yes, we expect central banks will continue to be net buyers of gold and that purchases will amount to 400 tonnes overall in 2012. As I mentioned earlier, we think that this is supportive for the gold price both directly, as these purchases take bullion out of the market, and indirectly, as central bank buying confirms gold’s status as a key reserve asset and boosts investor sentiment towards the metal.
What sort of retail consumption of gold does China have?
Chinese demand for high-carat gold jewellery and for investment products is huge and in 2011 was the second largest, after India. Chinese jewellery demand amounted to nearly 500 tonnes and bar investment to 250 tonnes last year. Importantly, it is a market with potential for further growth and I would not be surprised if in 2012 Chinese demand surpassed India, particularly given the recent weakness of demand in the latter.
There is a lot of speculation about how the Chinese central bank is quietly buying up gold. How true is that?
In 2009 China did publish revisions to its official gold reserves which suggested it had been buying and there indeed is much speculation that this continues. In April, net imports of 67 tonnes were one of the highest figures on record and twice the average of the previous three months. As I do not believe there was a similar increase in jewellery and investment demand, this does suggest more gold entered the country than was consumed privately and one possible explanation for this could be official sector buying, although it is also possible that local commercial banks were building inventory. Ultimately, I can only comment with certainty on published information and, as you know, there is no data or announcements confirming Chinese official sector purchases of gold have taken place recently.
(The interview originally appeared in the Daily News and Analysis (DNA) on June 18,2012)
(Interviewer Kaul is a writer and can be reached at [email protected])
Sonia’s UPA is taking us to new ‘Hindu’ rate of growth
Vivek Kaul
Raj Krishna, a professor at the Delhi School of Economics, came up with the term “Hindu rate of growth” to refer to Indian economy’s sluggish gross domestic product (GDP) growth of 3.5% per year between the 1950s and the 1980s. The phrase has been much used and abused since then.
A misinterpretation that is often made is that Krishna used the term to infer that India grew slowly because it was a nation dominated by Hindus. In fact he never meant anything like that. Krishna was a believer in free markets and wasn’t a big fan of the socialistic model of development put forward by Jawahar Lal Nehru and the Congress party.
In fact he realised over the years looking at the slow economic growth of India that the Nehruvian model of socialism wasn’t really working. This was visible in the India’s secular or long term economic growth rate which averaged around 3.5% during those days.
The word to mark here is “secular”. The word in its common every day usage refers to something that is not specifically related to a particular religion. Like our country India. One of the fundamental rights Indians have is the right to freedom of religion which allows us to practice and propagate any religion.
But the world “secular” has another meaning. It also means a long term trend. Hence when economists like Krishna talk about the secular rate of growth they are talking about the rate at which a country like India has grown year on year, over an extended period of time. And this secular rate of growth in India’s case was 3.5%. This could hardly be called a rate of growth for a country like India which was growing from a very low base and needed to grow at a much faster pace to pull its millions out of poverty.
So Krishna came up with the word “Hindu” which was the direct opposite of the word “secular” to take a dig at Jawahar Lal Nehru and his model of development. Nehru was a big believer in secularism. Hence by using the word “Hindu” Krishna was essentially taking a dig on Nehru and his brand of economic development, and not Hindus.
The policies of socialism and the license quota raj followed by Nehru, his daughter Indira Gandhi and grandson Rajiv ensured that India grew at a very slow rate of growth. While India was growing at a sub 4% rate of growth, South Korea grew at 9%, Taiwan at 8% and Indonesia at 6%. These were countries which were more or less at a similar point where India was in the late 1940s.
The Indian economic revolution stared in late July 1991, when a certain Manmohan Singh, with the blessings of PV Narsimha Rao, initiated the economic reform process. The country since then has largely grown at the rates of 7-8% per year, even crossing 9% over the last few years.
Over the years this economic growth has largely been taken for granted by the Congress led UPA politicians, bureaucrats and others in decision making positions. Come what may, we will grow by at least 9%. When the growth slipped below 9%, the attitude was that whatever happens we will grow by 8%. When it slipped further, we can’t go below 7% was what those in decision making positions constantly said. On a recent TV show Montek Singh Ahulwalia, the Deputy Chairman of the Planning Commission, kept insisting that a 7% economic growth rate was a given. Turns out it’s not.
The latest GDP growth rate, which is a measure of economic growth, for the period of January to March 2012 has fallen to 5.3%. I wonder, what is the new number, Mr Ahulwalia and his ilk will come up with now. “Come what may we will grow at least by 4%!” is something not worth saying on a public forum.
But chances are that’s where we are headed. As Ruchir Sharma writes in his recent book Breakout Nations – In Pursuit of the Next Economic Miracles “India is already showing some of the warning signs of failed growth stories, including early-onset of confidence.”
The history of economic growth
Sharma’s basic point is that economic growth should never be taken for granted. History has proven otherwise. Only six countries which are classified as emerging markets by the western world have grown at the rate of 5% or more over the last forty years. These countries are Malaysia, Singapore, South Korea, Taiwan, Thailand and Hong Kong. Of these two, Hong Kong and Taiwan are city states with a very small area and population. Hence only four emerging market countries have grown at a rate of 5% or more over the last forty years. Only two of these countries i.e. Taiwan and South Korea have managed to grow at 5% or more for the last fifty years.
“In many ways “mortality rate” of countries is as high as that of stocks. Only four companies – Procter & gamble, General Electric, AT&T, and DuPont- have survived on the Dow Jones index of the top-thirty U.S. industrial stocks since the 1960s. Few front-runners stay in the lead for a decade, much less many decades,” writes Sharma.
The history of economic growth is filled with examples of countries which have flattered to deceive. In the 1950s and 1960s, India and China, the two biggest emerging markets now, were struggling to grow. The bet then was on Iraq, Iran and Yemen. In the 1960s, the bet was Philippines, Burma and Sri Lanka to become the next East Asian tigers. But that as we all know that never really happened.
India is going the Brazil way
Brazil was to the world what China is to it now in the 1960s and the 1970s. It was one of the fastest growing economies in the world. But in the seventies it invested in what Sharma calls a “premature construction of a welfare state”, rather than build road and other infrastructure important to create a viable and modern industrial economy. What followed was excessive government spending and regular bouts of hyperinflation, destroying economic growth.
India is in a similar situation now. Over the last five years the Congress party led United Progressive Alliance is trying to gain ground which it has lost to a score of regional parties. And for that it has been very aggressively giving out “freebies” to the population. The development of infrastructure like roads, bridges, ports, airports, education etc, has all taken a backseat.
But the distribution of “freebies” has led to a burgeoning fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
For the financial year 2007-2008 the fiscal deficit stood at Rs 1,26,912 crore against Rs 5,21,980 crore for the current financial year. 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 huge increase in fiscal deficit has primarily happened because of the subsidy on food, fertilizer and petroleum.
This has meant that the government has had to borrow more and this in turn has pushed up interest rates leading to higher EMIs. It has also led to businesses postponing expansion because higher interest rates mean that projects may not be financially viable. It has also led to people borrowing lesser to buy homes, cars and other things, leading to a further slowdown in a lot of sectors. And with the government borrowing so much there is no way the interest rate can come down.
As Sharma points out: “It was easy enough for India to increase spending in the midst of a global boom, but the spending has continued to rise in the post-crisis period…If the government continues down this path India, may meet the same fate as Brazil in the late 1970s, when excessive government spending set off hyperinflation and crowded out private investment, ending the country’s economic boom.”
Where are the big ticket reforms?
India reaped a lot of benefits because of the reforms of 1991. But it’s been 21 years since then. A new set of reforms is needed. Countries which have constantly grown over the years have shown to be very reform oriented. “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?” says Sharma.
India has hardly seen any economic reform in the recent past. The Direct Taxes Code was initiated a few years back has still not seen the light of day, but even if it does see the light of day, it’s not going to be of much use. In its original form it was a treat to read with almost anyone with a basic understanding of English being able to read and understand it. The most recent version has gone back to being the “Greek” that the current Income Tax Act is.
It has been proven the world over that simpler tax systems lead to greater tax revenues. Then the question is why have such complicated income tax rules? The only people who benefit are CAs and the Indian Revenue Service officers.
Opening up the retail sector for foreign direct investment has not gone anywhere for a long time. This is a sector which is extremely labour intensive and can create a lot of employment.
What about opening up the aviation sector to foreigners instead of pumping more and more money into Air India? As Warren Buffett wrote in a letter to shareholders of Berkshire Hathaway, the company whose chairman he is, a few years back “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down…The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.”
If foreigners want to burn their money running airlines in India why should we have a problem with it?
The insurance sector is bleeding and needs more foreign money, but there is a cap of 26% on foreign investment in an insurance company. Again this limit needs to go up. The sector very labour intensive and has potential to create employment. The same is true about the print media in India.
The list of pending economic reforms is endless. But in short India needs much more economic reform in the days to come if we hope to grow at the rates of growth we were growing.
To conclude
Raj Krishna was a far sighted economist. He knew that the Nehruvian brand of socialism was not working. It never has. It never did. And it never will. But somehow the Congress party’s fascination for it continues. And in continuance of that, the party is now distributing money to the citizens of India through the various so called “social-sector” schemes. If economic growth could be created by just distributing money to everyone, then India would have been a developed nation by now. But that’s not how economic growth is created. The distribution of money creates is higher inflation which leads to higher interest rates and in turn lower economic growth. Also India is hardly in a position to become a welfare state. The government just doesn’t earn enough to support the kind of money it’s been spending and plans to spend.
Its time the mandarins who run the Congress party and effectively the country realize that. Or rate of growth of India’s economy (measured by the growth in GDP) will continue to fall. And soon it will be time to welcome the new “Hindu” rate of economic growth. And how much shall that be? Let’s say around 3.5%.
(The article originally appeared at www.firstpost.com on June 1,2012. http://www.firstpost.com/politics/sonias-upa-is-taking-us-to-new-hindu-rate-of-growth-328428.html)
(Vivek Kaul is a writer and can be reached at [email protected])
Yesterday, once more! Is the world economy going the Japan way?
Vivek Kaul
High risk means high returns.
Or does it?
Not always.
When more risk does not mean more return
The ten year bond issued by the United States (US) government currently gives a return of around 1.8% per year. Bonds are financial securities issued by governments to finance their fiscal deficits i.e. the difference between what they earn and what they spend.
Returns on similar bonds issued by the government of United Kingdom (UK) are at1.9% per year.
Nearly five years back in July 2007 before the start of the financial crisis the return on the US bonds was at 5.1% per year. The return on British bonds was at 5.5% per year.
The return on German bonds back then was around 4.6% per year. Now it stands at 1.44% per year.
Since the start of the financial crisis governments all over the world have been running huge fiscal deficits in order to try and create some economic growth. They have been financing these deficits through increasing borrowing.
In 2007, the deficit of the US government stood at $160billon. This difference was met through borrowing. The accumulated debt of the US government at that point of time was $5.035trillion.
In 2012, the deficit of the US government is expected to be at $1.327trillion or around 8.3times more than the deficit in 2007. The accumulated debt of the US government is also around three times more now and has crossed $14trillion.
The situation in the United Kingdom is similar. In 2007 the fiscal deficit was at £9.7billion. The projected deficit for 2012 is around 9.3times more at £90billion. The government debt as a percentage of gross domestic product (GDP) has gone up from around 37% of GDP to around 67% of GDP.
The same trend seems to be happening throughout the countries of Western Europe as well. Hence we can conclude that it is more risky to lend to the governments of United States, United Kingdom and countries like Germany and France in Western Europe. Though to give Germany the due credit it doesn’t run fiscal deficits as large as US or UK for that matter. Its fiscal deficit in 2010 had stood at €100billion but was cut to around €25.8billion in 2011.
Even though the riskiness of lending to these countries has gone up, the investors have been demanding lower returns from the governments of these countries. Why is that?
The answer might very well lie in what happened in Japan in the late 1980s.
The Japan story
The Japanese central bank started running a low interest policy to help exports from the mid 1980s. This other than helping exports fuelled massive bubbles in both the stock market as well as the real estate market. The Nikkei 225, Japan’s premier stock market index, returned 237% from the start of 1985 to December 29,1989, the day it peaked at a level of 38,916 points. The real estate prices also shot through the roof. As Paul Krugman points out in The Return of Depression Economics “Land, never cheap in crowded Japan, had become incredibly expensive…the land underneath the square mile of Tokyo’s Imperial Palace was worth more than the entire state of California.”
This was the mother of all bubbles.
Yasushi Mieno took over as the 26th governor of the Bank of Japan, the Japanese central bank, on December 17, 1989. Eight days later on December 25, 1989, he shocked the market by raising the interest rate. And more than that, he publicly declared that he wanted the land prices to fall by 20%, which he later upped to 30%. Mieno didn’t stop and kept raising interest rates.
The stock market crashed. And by October 1990 it was down nearly 40%. Since then the stock market has largely been on its way down. And it currently quotes at 8,900 points down 77% from the peak.
The real estate prices also fell but not at the same fast rate as the stock market. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracle “ “The greatest bubble in human history” burst in 1990 with no pain at all, like falling off Everest without breaking a bone. At its peak Japan accounted for 40 percent of the property value of the planet, but instead of collapsing, the price of real estate slowly declined at a 7% annual rate for two decades, ultimately falling by a total of about 80%. There was never a major round of foreclosures or bankruptcies, as the government kept bailing out debtors, ruining its own finances.”
The GDP growth rate collapsed from 3.32% in 1991 to -0.14% in 1999. In the next ten years i.e. between 2000 and 2009, the GDP growth rate never went beyond 2.74% and was at -5.37% in 2009.
The balance sheet depression
Japan has been in what economist Richard Koo calls a balance sheet recession. What this means in simple English is that after bubbles burst, specially real estate bubbles, the private sector companies as well as individuals and families who had speculated on the bubble end up with a lot of excessive debt and an asset (like land or stocks) which is losing value. The excessive debt has to repaid. Given this individuals and companies try to save, in order to repay the debt. But what is good for the individual is not always good for the overall economy.
The paradox of thrift
John Maynard Keynes unarguably the greatest economist of the twentieth century called this the paradox of thrift. What Keynes said was that when it comes to thrift or saving, the economics of an individual differs from the economics of the system as a whole.
If one person saves more then saving makes tremendous sense for him. But as more and more people start doing the same thing there is a problem. This is primarily because what is expenditure for one person is an income for someone else. Hence, when everybody spends less, businesses see a fall in revenue. This means lower aggregate demand and hence slower or even no growth for the overall economy.
The Japanese savings rate at the time when the bubble popped was around 0%. After this the Japanese started to save more and the savings rate of the Japanese private sector and households increased. It reached around 16% of the GDP in the year 2000.
All this money was being used to pay off the excess debt that had been accumulated. This meant slower growth for Japan. The government in turn tried to pump economic growth by spending more and more money. For this it took on more debt and now the Japanese government debt to GDP ratio is around 240%.
Ironically as the government debt went up the return on the government debt kept coming down. As Martin Wolf of Financial Times points out in a recent column “At the end of 1990, when its “bubble economy” went pop, the Japanese government’s 10-year bond was yielding 6.7 per cent…But yields on 10-year Japanese government bonds (JGBs) fell to close to 2 per cent in 1997 and then, with sizeable fluctuations, to troughs of 0.8 per cent in 1998, 0.4 per cent in 2003 and, recently, to 0.9 per cent. In short, the worse the Japanese government’s present and prospective debt position has become, the lower the interest rates on JGBs has also become.” (All returns per year)
The reason for this in retrospect is very straightforward. As the Japanese individuals and companies were saving more they did not want to risk their savings in either the stock market which had been continuously falling or the real estate market which was also falling, though at a slower rate. Hence a major part of the savings went into JGBs which they thought were safer. Given that there was great demand for JGBs the Japanese government could get away with offering lower returns on its bonds, even though over the years they became riskier.
The Japan Way
Richard Koo believes that what happened in Japan over the last twenty years is now happening in the US, UK and parts of Europe. Individuals in these countries are saving more to pay off their excess debts. An average American in the month of March 2012 saved 3.8% of his disposable income in March 2012. Before the crisis the American savings rate had become negative. . The same stands true for Great Britain where savings of household were -3% at the time the crisis struck. They have since gone up to 3% of GDP. The corporate sector was saving 3% of GDP is now saving 5% of GDP. Same stands true for Spain, Ireland and Portugal where savings were in negative territory (i.e. the people were borrowing and spending) before the crisis struck, and are now going up. In the case of Ireland the savings have gone up from -10% of GDP to around 5% of the GDP since the crisis struck.
Hence companies and individuals across countries are saving more to pay off the excess debt they had accumulated. This in turn has meant that they are spending lesser money than they used to. This has led to slower economic growth. A large part of these savings is going into government bonds keeping returns low. Retail investors have taken out nearly $260billion out of equity mutual funds in the United States since 2008, even though the stock market has doubled in the last three years. At the same time they have invested nearly $800billion in bond funds, which give very low returns.
ZIRP – Zero interest rate policy
The governments of these countries have cut interest rates to almost 0% levels and are also borrowing and spending more money. That as was the case in Japan has resulted in some economic growth, but nowhere as much as they had expected. Even though governments want their citizens and companies to borrow and spend money in order to revive economic growth, they are in no mood to do that.
The citizens would rather pay off their existing debt than take on new debt. And the companies need to feel that the economic opportunity is good enough to invest, which it clearly isn’t. That explains to a large level why US companies are sitting on more than $2trillion of cash.
The banks are also not willing to take on the risk of lending at such low interest rates, as was the case in Japan. What has also not helped is the case of continuously bailing out the financial sector like was the case in Japan. Hence real estate prices in countries like Spain still need to fall by 35% to come back at normal levels.
Slow growth
All in all most of the Western world is headed towards the Japan way, which means slow economic growth in the years to come. As Sharma writes “Over the next decade, growth in the United States, Europe and Japan is likely to slow…owing to the large debt overhang”. This will impact exports out of countries like China, South Korea, Japan, Taiwan, India etc. The Chinese exports for the month of April 2012 grew at 4.9% in comparison to 8.9% during the same period last year. This in turn has pushed down imports. Imports grew at a negligible 0.33% against the expected 11%.
A slowdown in Chinese imports immediately means lower prices for commodities. As Sharma puts it “It’s my conviction that the China-commodity connection will fall apart soon. China has been devouring raw materials at a rate way out of line with the size of its economy… Since 1990, China’s share of global demand for commodities ranging from aluminum to zinc has skyrockected from the low single digits to 40,50,60 % – even though China accounts for only 10% of total global output.” .
Over a longer term slower growth in the Western World will also means slower and lower stock markets. As the old Chinese curse goes “may you live in interesting times”. The interesting times are upon us.
(This post originally appeared on Firstpost.com on May 17,2012. http://www.firstpost.com/economy/japan-disease-is-spreading-high-risk-and-low-returns-311952.html)
(Vivek Kaul is a writer and can be reached at [email protected])