Russell Napier a consultant with CLSA and one of the finest financial minds in the world, sees another deflationary shock coming. “Yes I am looking at a global deflation shock. So I see all the markets global equity markets coming down,” he says. When asked to predict a level he adds “I will just go back to my book the Anatomy of the Bear which was published in 2005 and in the book I forecast that the equity market, the S&P 500(an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points (On Friday the S&P 500 closed at 1,428.5 points)….So I am happy to stick with the number of 400 and then just tell everybody else who sort of reads this interview to work out what that means for the rest of the world,” he told Vivek Kaul in an exhaustive free wheeling interview.
How do you see thing in Europe right now?
My focus of the way I try to look at these economies is really to look at the financial conditions, the banking systems, credit availability etc. Those numbers are about bad for Europe. If you look at bank lending in Europe it is contracting to the private sector. The money they are lending is going to the governments. The key issue really is that is lack of credit going to the European private sector due to lack of supply or demand? There is more and more evidence that it is actually demand, and that just makes it just a more difficult problem to solve.
Why is that?
When your banking system is incapable of providing credit there are lots of things you can do to help it. But when people fundamentally don’t want to borrow and corporates don’t want to borrow then it’s a different situation. What would normally happen is quantitative easing and trying to keep money growing at a time when bank credit is contracting. But for political reasons that is difficult in Europe. So Europe is facing a very difficult and nasty economic downturn, and things are going to get significantly worse. It’s worth adding on Europe as well that there is a chance that somebody is going to have to leave the Euro as early as next year. All seventeen members have to ratify the fiscal compact which is a major constitutional change. Still quite a few of them haven’t ratified it and maybe that early as first quarter next year some country may be unable to ratify that fiscal compact. And at that stage we would have a crisis for the euro because the country that fails to ratify wouldn’t be able to stay in the euro. So we are all rolling into a European crisis next year.
So what can keep the euro going?
Ultimately the only thing that can keep Europe going is can they become a Federal States of Europe?
No. that is highly unlikely. There are seventeen members of the euro zone and all of them have to make the same constitutional changes and the same surrenders of sovereignty. And this is not an economic call. This is a political and social call. And it is highly unlikely that all sovereign states will end up surrendering their sovereignty to a Federal government of Europe.
How do you see the things in the United States?
There is a much more mixed picture coming out of the United States of America. Bank credit is expanding and the private sector is borrowing. What is interesting is that small and medium enterprises have been borrowing and we have been seeing a growth there for over a year now. That is normally a very good sign of thing because those are normally the people who create jobs.
What about other borrowing?
Banks balance sheets have premium components to them in terms of credit. And one is credit to small and medium enterprises. The other is mortgage credit. There is no sign of growth of mortgage credit. The other is consumer credit. There is no sign of growth in consumer credit either. At this stage one can be more optimistic about the United States simply because small and medium enterprises are borrowing.
But what about the long term view?
I have a longer term problem with the United States which isn’t going to show up quarter to quarter in the growth numbers but it is structurally the most important thing that is going on there. The rate at which foreign central bankers particularly the Chinese are accumulating treasuries has dropped very dramatically. The Chinese are not buying and actually seem to be selling United States treasuries. Along with the Federal Reserve of United States they are the biggest owners of treasuries. They are neck and neck. When the biggest owner of treasuries is effectively a forced seller, it has to make you cautious on America despite the shorter term positive data coming out.
What will be the impact of this?
If the Chinese are not going to be funding the American government it’s more of an onus on the American savers to fund the American government. With savings being a reasonably finite number then there is less to lend to the private sector. I see us already in a larger picture trend of America where the savings of America will be increasingly be funding the American government and not the private sector. At the minute that is not having any negative impact or particularly negative impact on private sector credit availability. But ultimately it will.
That being the case are Americans saving enough to bankroll the American treasury?
The answer to that is no. They are not saving enough to bankroll the American treasury and the private sector. You have to put them both together. If you look at a country like Italy in Europe the government always gets funded. The governments always get funded someway. Likewise, the American government will always be funded. And if has to force the American people to buy treasuries it will force the American people to buy the treasuries. The question is are they saving enough to fund the government and also fund the demand of the private sector for capital as well. My answer to that is definitely no. But if it comes to push whether the government is funded or the private is sector funded, even in America which is ideologically more to the right, more free market than elsewhere, even there you will find the savings are forced towards the government and away from the private sector.
That being the case how do you expect the US government to finance its unfunded liabilities over like social security, mediclaim etc, over the years? One estimate even puts the unfunded liabilities at $222trillion.
In the short term as long as they can keep borrowing at this level they will probably keep borrowing at this level. There is a basic rule. A government that can borrow at 2% will borrow at 2%. That’s an entirely and completely unsustainable path for the American government. But it is just so easy to borrow at 2% that they will continue to do that. So that reality for America will not dawn for unfunded liabilities until it has to borrow at a more realistic interest rate, which is inevitable. The numbers you point out are absolutely huge but it’s becoming incredibly difficult to say when that will happen, when they will have to live with proper real interest rates. It could be several years. It could be several days. But eventually of course they will have to do that. And there is a whole host of solutions for the United States government.
There is a thing called financial repression which is effectively forcing people to lend money to the US government or forcing financial institutions to lend money to the US government. That is the path to travel for all the developed world countries. But there will have to be a renegotiation of benefits to the baby boom generation. Every society has to choose where the burden has to fall. Does it fall on tax payers? Does it fall on savers? Or does it fall on people who are recipients of this dole of money from the government. It will be a mix of all of these. So at some stage we will have to see a major renegotiation of the obligations that were signed for the baby boom generation in the 1960s. But it could be many years away. I have to stress that this will be political dynamite. No society wants to withdraw benefits from its retired or elderly population. But the entire western world faces the reality that is exactly what it will have to do.
Do you see what they call the American dream changing?
It has massively changed over the last two decades already. American people sustained by going from one person working to two persons working and then adding significant leverage to it. So the dream has been extended through those two mechanisms and clearly it is not going to go much further from here. It’s a much harder slog from here given excessive levels of debt on the starting position. It’s not only an American phenomenon but it’s a developed world phenomenon. It’s easy to be negative but the only possible positive way out of this is some technological innovation which gives us some very high levels of no inflationary growth and very high levels of productivity.
Could you elaborate on that?
If you read financial history sometimes these things just come along. They surprise everybody. One thing that is that could do it is cheap energy. Shale oil and shale gas are the main places we would be looking at for cheap energy. But it is worth stressing that we are going to need a very high level of real economic growth. So in America it will have to be in excess of 4% or maybe as high a 4.5%. That’s the sort of real economic growth that would help countries grow their way out of the debt problem and meet most of the potential liabilities going forward. One shouldn’t rule out that we have that wonderful outcome but it still does seem like very unlikely.
Talking about technological innovation can you give me some examples from the past?
Yeah absolutely. They have really been energy related. In United Kingdom the canals were such a revolution that the transportation cost collapsed. The price of coal in some major cities came down by 60-70% due to the introduction of canals. Obviously when energy prices fall by that much you get a productivity revolution. The railways had several impacts. Electricity which we didn’t really get going into the industrial process until the start of the last century, had a major impact. The automobile had a major impact. These are the types of major technological innovations which can change the world. When you can give the world cheap energy then that’s when you can begin to talk about much higher levels of growth. It is almost impossible to tell where these things come from but one that is sort on the horizon is shale oil and shale gas and potentially what that can do. But I want to stress it is going to have to produce levels of real economic activity in America, which haven’t seen for a very very long period of time, perhaps ever.
Do you the American government defaulting on all the debt it has accumulated?
They will not default in the technical term of the word default which obviously means refusing to pay back in dollars the debt in principle. That would be definition of default. That seems unlikely. But we are already in a situation where the Federal Reserve of the United States has intervened in the treasury market to hold the treasury yield below the level of inflation. Now that is not a default. But if you own treasuries and the yield is below the rate of inflation then the real value of your investment is declining in dollar terms. In terms of you and I investing in that treasury market it means that we are losing capital and therefore I would call this a democratic default. The second democratic default which I will come to America and the whole developed world will eventually be restrictions of free movement of capital. We are heading towards a world of controls and capital restrictions, which was a norm from 1945 to 1980-81.
Do you see them printing money to repay all the accumulated debt?
The answer is that partially they are already doing it. Quantitative easing is a form of printing money. Therefore you can say that is a process that is underway. So I have no doubts whatsoever that the Americans will be printing money to satisfy their foreign creditors.
Do you see that leading to a hyperinflation kind of scenario?
No. It is always assumed that if there is a dramatic sale of the treasuries by the Chinese, the Federal Reserve will simply buy all those treasuries and simply create lots of money in the process. If that mechanism happened you would end up with hyperinflation. But it’s worth remembering that there is a technical definition of hyperinflation and that is a rate of inflation of 50% per month or more. So it’s a very high number. Sometime people think that 20% per annum is hyperinflation but its 50% per month technically. The Federal Reserve is not stupid enough to do that. It would not simply print all the money it could to do to repay its creditors.
So what will happen?
What will happen is that there will be some money printing and as I stressed inflation will be higher than yield of treasuries. But Plan B is financial repression which is to effectively force the financial institutions and the people of America to buy the treasuries. Now this does not involve printing of money. I am sure that if the Federal Reserve sees inflation climbing to anywhere near 10% it would go to the government and say that we cannot continue to print money to buy these treasuries and we need to force financial institutions and people to buy these treasuries. In India you must be aware that banks have to compulsorily buy government debt. We can force banks and government companies to have a minimum amount of their assets in government debt. The road to hyperinflation is well known by central bankers. It has never ended well even though it can wipe out your debt very very rapidly indeed. Nevertheless, the political and social implications of that are truly dire. It tends to throw up despots and destroy democracies. Financial repression if you are a saver is a terrible but is much less painful than hyperinflation.
But what about the Western world practicing austerity to repay its debt?
True austerity is when you if you simply closed down on the government spending and accepted the economic consequences of that and still kept taking in the tax revenues. But that’s apolitically painful way of doing it. True austerity is highly unlikely. What Europe has nothing like sufficient austerity to take them to a situation where they can repay the government debt. So the only way out is repression, which is simply funding the government by forcing the people and financial institutions to buy government securities. That’s a very painful thing if you are a saver, but so much better than austerity, default and hyperinflation. It is ultimately the most acceptable form of getting out of this problem. Even with repression we are talking about a couple of decades before we could gain levels of gearing in the developed world drawn towards normal levels.
Do you see the paper money system surviving?
Yes I do see the paper money system surviving. To say that it doesn’t survive means we replace it with something that is based or anchored on metal. But the history of the paper currency system or the fiat currency system is really the history of democracy. Within the metal currency there was very limited ability for the elected governments to manipulate that currency. And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money. But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn towards paper currency and unless you see the destruction of democracy in the developed world and I do not see that we will stay with paper currencies and not return to metallic currencies or metallic based currencies.
What about gold?
Gold is never easy to predict and it is particularly difficult at the moment. In the long run view which I have just run through that repression is ultimately the best choice for democracies, gold is the best asset class. It is the standout asset class. In a world of negative real interest rates prolonged for some decades gold does really well. And secondly in a world where tax rates are going up where the government needs to get more private wealth under its own control then gold is small, portable and hidable and therefore becomes an asset of choice. So my long term prognosis for gold remains very good. In the short run I am concerned that if we get another economic setback from here and we see growth coming down from here, the price of gold may come down. But I would say any declines in the price of gold are wonderful opportunities to buy some more and for the long term holder gold remains essential.
What are the other asset classes you would bullish is on?
I tend to believe that we are in for another deflation shock. The Asian crisis of 1998 was a deflation shock and we had one in 2002 when the American economy slowed and Mr Bernanke had to make his helicopter speech. We had another one post Lehman Brothers. So what you would want to look at is what asset classes did well during those periods? And really very little does well when we have deflation shocks. Whether deflation turns up or not the shock is very bad for pro-growth assets. So actually it’s time to own cash. Cash has historically been a good preserver of health during periods of deflation. It is worth buying debt of some of the governments that don’t have very much debt. There are some countries out there with small amount of government debts and they are small such as Singapore and Norway. So I would recommend cash and very small holding in government debt in markets where the governments don’t have very much debt. Also when markets have come down a bit we are looking to buy equities and we are looking to buy gold.
By when do you see this deflationary shock coming?
Well its coming. It is very rare for these things to erupt in the morning. Lehman Brothers was the exception a bank with $600billion of liabilities going bust suddenly threatens the stability of the entire financial system. Sometimes it happens like that but rarely. It happened like that in the 1930s with the bankruptcy of Creditanstalt (An Austrian bank which went bankrupt in 1931 and started a chain of bankruptcies). Occasionally it can be a major event. But it can be just like it was in 2003 just slower and slower growth. The only sort of one red flag which could suddenly jump and signal deflation is if someone leaves the euro because clearly if it’s a major currency leaving the euro they will be re-denominating their debts in their domestic currency which is tantamount to a large default on the global banking system. That is a small chance of that early next year.
What if the country is Greece?
Frankly Greece defaulting on its debts isn’t going to make much difference to a banking system but makes a big difference to the IMF and the government. But more likely it’s just going to be slower and slower growth coming forward particularly in China. The world has bet a lot on Chinese growth. The more the growth slows in China and capital flows out of China, the more the world begins to realise that its China which has been the source of global growth and global inflation, and if that’s not there we are more likely to get deflation. So that’s the more likely scenario rather than a Lehman Brothers style event.
So you are basically saying that the high Chinese growth rates will now be a thing of the past?
Yes unless they do some major reforms. And in my opinion that they need to do is reforms which will encourage private Chinese capital to remain in China and invest in China. And at the minute where is very limited reason for the Chinese private capital to remain in China because the returns are so poor. So anything they could do to open up the financial system for private sector investment and private sector competition would be good. And more importantly allow the private sector to take over some state owned enterprises and restructure them. If they are prepared to make that giant leap in terms of reforms then there is every prospect that keep they will keep capital in China. The good thing is we are getting a new administration. The bad thing is it is very difficult to predict what a new Chinese administration stands for. But soon enough we will know and if they come up with some policies like this, then there are many reasons to be more optimistic about the outlook for global growth.
By what levels do you see the stock markets falling in the coming deflationary shock?
I will just go back to my book the Anatomy of the Bear which was published in 2005 and in the book I forecasted that the equity market, the S&P 500(an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points (On Friday the S&P 500 closed at 1,428.5 points). As you know in March 2009 it got to 666points. It got somewhere there but it did not get to 400. So I am happy to stick with the number of 400 and then just tell everybody else who sort of reads this interview to work out what that means for the rest of the world.
The interview originally appeared in the Daily News and Analysis on October 15, 2012. http://www.dnaindia.com/money/interview_we-are-in-for-another-deflation-shock-so-actually-its-time-to-own-cash_1752471
(Interviewer Kaul is a writer. He can be reached at [email protected])
Sonia Gandhi must be having the last laugh, at least when it comes to economic reforms and their salability among Indian politicians. “Maine kaha tha, Mamata nahi manegi(I had told you Mamata will not agree),” she must be telling the Prime Minister Manmohan Singh these days. “Par aap zidd par add gaye(But you became rather obstinate about the entire thing),” she must have added.
Whether this government survives or not remains to be seen but economic reforms will now be put on the backburner, that’s for sure. Also, the Congress party led United Progressive Alliance(UPA) will start preparing for elections (early or not that doesn’t really matter). And given that Sonia Gandhi’s form of “giveaway everything for free” economics will come to the forefront again now.
The various Congress led governments, since India attained independence from the British in 1947, have always followed this form of economics. As Sunil Khilnani writes in The Idea of India “The state was enlarged, its ambitions inflated, and it was transformed from a distant, alien object into one that aspired to infiltrate the everyday lives of Indians, proclaiming itself responsible for everything they could desire: jobs, ration cards, educational places, security, cultural recognition.”
When someone is responsible for everything, the way it usually turns out is that he is not responsible for anything. A major reason for the economic and social mess that India is in today is because of the various Congress led government trying to be responsible for everything.
This is going to increase in the days to come with Sonia Gandhi’s pet projects of the right to food and universal health insurance being initiated. It need not be said that the projects will help spruce up the chances of the Congress party in the next Lok Sabha election.
These are populist giveaways which have existed all through history. As Gurucharan Das writes in his new book India Grows at Night “Populist giveaways have always been a great temptation. Roman politicians devised a plan in 140BCE to win votes of the poor by offering cheap food and entertainment – they called it ‘bread and circuses.’”
But even with that, the idea of right to food and health for all, are very noble measures and difficult to oppose for anybody who has his heart in the right place. Nevertheless, the larger question is where will the government get the money to finance these schemes from? As P J O’Rourke, an American political satirist, writes in Don’t Vote! It Just Encourages the Bastards “We’re giving until it hurts. That is, we’re giving until it hurts other people, since we’re giving more than we’ve got.”
The fiscal deficit target of Rs 5,13,590 crore or 5.1% of the gross domestic product(GDP), for 2012-2013 will be breached by a huge amount. Fiscal deficit is the difference between what the government earns and what it spends. This will happen primarily because of the subsidy bill going through the roof (as the following table shows).
|Subsides||Apr-July 2012||Apr-July 2011||Increase over last year||budget estimate||% of budget estimate|
|Source: Controller General of Accounts, Deutsche Bank. In rupees crore|
As is clear from the table the subsidies on oil, fertilizer and food for the first four months of this have been much higher than the previous year. Also four months into the year the subsidies are already more than 50% of the amount targeted for the year. Like the food subsidy for the year has been targeted at Rs 75,000 crore. During the first four months subsidies worth Rs 46,400 crore have already been offered. Unless the government controls this, the spending over the remaining eight months of the year will definitely cross the targeted Rs 75,000 crore. This will increase the overall spending of the government and thus the overall fiscal deficit, which is in the process of reaching dangerous proportions.
As I have stated in the past at the current rate the fiscal deficit of the Indian government could easily surpass Rs 700,000 crore or 7% of the GDP. (you can read the complete argument here). Now add the right to food and universal health insurance to it and just imagine where the fiscal deficit will go. And that means the scenario of high interest rates and high inflation will continue in the days to come.
But that’s just one part of the argument. Those in favour of subsidies and a welfare state have often given the example of the greatest western democracies (particularly in Europe) which have run huge welfare states with the government taking care of its citizens from cradle to grave. An extreme example of such a welfare state is Greece.
Greece categorises certain jobs as arduous. For such jobs the retirement age is 55 for men and 50 for women. “As this is also the moment when the state begins to shovel out generous pensions, more than 600 Greek professions somehow managed to get themselves classified as arduous: hairdressers, radio announcers, musicians…” write John Mauldin and Jonathan Tepper write in Endgame – The End of the Debt Supercycle and How it Changes Everything.
But the Western democracies became welfare states only after almost 100 years of economic growth. “Western democracies had taken more than a hundred years of economic growth and capacity building to achieve the welfare state,” writes Das. And given this India is indulging in “premature welfarism”. “A nation with a per capita income of $1500 cannot protect its people from life’s risks as a nation with a per capita income of $15,000 could. It came at a cost of investment in infrastructure, governance and longer-term prosperity,” adds Das.
That’s one part of the argument. In order to finance these programmes the government will have to run huge fiscal deficits. This means that the government will have to borrow. Once it does that it will crowd out borrowing by the private sector and thus bring down the investment in infrastructure and hence longer term prosperity.
There is no example of a premature welfare state in the history of mankind rising its way to economic prosperity. An excellent example of a country that tried and failed is Brazil. India is making the same mistakes now that Brazil did in the late 1970s.
As Ruchir Sharma writes in Breakout Nations “Inspired by the popularity of employment guarantees, the government now plans to spend the same amount extending food subsidies to the poor. If the government continues down this path, India might meet the same fate as Brazil in the late 1970s, when excessive government spending set off hyperinflation and crossed out private investment, ending the country’s economic boom…the hyperinflation that started in the early 1980s and peaked in 1994, at the vertiginous annual rate of 2,100 percent. Prices rose so fast that cheques would lose 30 percent of their value by the time businesses could deposit them, and so inconsistently that at one point a small bottle of sunscreen lotion cost as much as a luxury hotel.”
Inflation in such a scenario happens on two accounts. First it happens because people have more money in their hands. And with this they chase the same number of goods, thus driving up prices. The second level of inflation sets in once the government starts printing money to finance all their fancy welfare schemes.
As far inflation is concerned things have already started heating up in India. As Das writes “The Reserve Bank warned that wages, which were indexed against inflation in the employment scheme (the national rural employment guarantee scheme), had already pushed rural wage inflation by 15 per cent in 2011. As a result, India might not gain manufacturing jobs when China moves up the income ladder.”
Other than inflation, giving away things for free has other kinds of problems as well. With states giving away power for free or rock bottom rates, the state electricity boards are virtually bankrupt. As Abheek Barman wrote in a recent column in the Economic Times “Most of the power is bought by state governments, through state electricity boards (SEBs). These boards are bankrupt. In 2007, all SEBs put together made losses of Rs 26,000 crore; by March last year, this jumped to a staggering Rs 93,000 crore. Just two SEBs, Uttar Pradesh and Jammu & Kashmir, account for nearly half this amount. To cover power purchase costs, the SEBs borrow money. Today, the total short-term debt of all the SEBs has soared to a mind-boggling 2,00,000 crore. Many states would buy as little electricity as possible, to avoid going deeper into the red.” (You can read the compete piece here). So the farmer has free electricity but then there is no electricity available most of the time.
Das writes something similar in India Grows at Night. “Punjab’s politicians gave away free electricity and water to farmers, and destroyed state’s finances as well as the soil (as farmers overpumped water); hence, Haryana supplanted Punjab as the national’s leader in per capita income.”
Other than this a lot of things given away for free by the government are siphoned off and do not reach those they are intended to. It would be foolish on my part to assume the politicians in this country (including Sonia Gandhi and of course Manmohan Singh) do not understand these things. But as Das writes “But neither the ‘do-gooders’ nor the Congress party was deterred by the massive corruption in the supply of diesel, kerosene, electricity and cooking gas as well as in ‘make work’ schemes and food distribution. Politicians felt there were still plenty of votes there.”
But these votes will come at the cost of economic progress. No country in history has got its citizens out of poverty by giving away things for free. Countries have progressed when they have created enough jobs for its citizens. And that has only happened when the right investments have been made over the years to build infrastructure, industry and human skill.
So the votes for the Congress will come at the cost of economic prosperity for the country. In the end let me quote a couplet written by Allama Iqbal: “Na samjhoge to mit jaoge ae hindustan waalo, tumhari daastan bhi na hogi daastano main” ( “If you don’t wake up, O Indians, you will be ruined and razed, Your very name shall vanish from the chroniclers’ page” – Translation by K C Kanda in Masterpieces of Patriotic Urdu Poetry: Text, Translation, and Transliteration).
The Prime Minister Manmohan Singh’s love for urdu poetry is well known. It is time he went back to this couplet of Allama Iqbal and tried to understand it in the terms of all the problems that will come along with the premature welfare state that his party has created and is now trying to spread it further.
The article originally appeared on September 20, 2012 on www.firstpost.com. http://www.firstpost.com/politics/sonianomics-will-put-india-on-the-path-to-disaster-462163.html
(Vivek Kaul is a writer. He can be reached at [email protected])
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.
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])
Half way through the interview, I ask him where does he see the price of gold reaching in the days to come. “Well, I don’t see gold’s trajectory being typical of what you’d expect to see in a bull market….And I expect that physical gold will be repriced somewhere around $55,000 per ounce in today’s purchasing power. I have to add that purchasing power part because it will likely be concurrent with currency devaluation,” he replies. Meet FOFOA, an anonymous blogger whose writings on fofoa.blogspot.com have taken the world by storm over the last few years. In a rare interview he talks to Vivek Kaul on paper money, the fall of the dollar, the coming hyperinflation and the rise of “physical” gold.
The world is printing a lot paper money to solve the economic problems. But that doesn’t seem to be happening. What are your views on that?
Paper money being printed to solve the problems… this was *always* on the cards. It doesn’t surprise me, nor does it anger me, because I understand that it was always to be expected. The monetary and financial system we’ve been living with—immersed in like fish in water—for the past 90 years uses the obligations of counterparties as its foundation. These obligations are noted on paper. In describing the specific obligations these papers represent, we use well-known words like dollars, euro, yen, rupees and yuan. But what do these purely symbolic words really mean? What are these paper obligations really worth in the physical world? Ultimately, after 90 years, we have arrived at our inevitable destination: the intractable problem of an unimaginably intertwined, interconnected Gordian knot of purely symbolic obligations. A Gordian knot is like an unsolvable puzzle. It cannot be untangled. The only solution comes from “thinking outside the box.” You’ve got to cut the knot to untangle it. So the endgame was always going to be debasing these purely symbolic units. Anyone who expected anything else simply fooled themselves into believing the rules wouldn’t be changed.
Do you see the paper money continuing in the days to come?
Yes, of course! Paper money, or today’s equivalent which is electronic currency, is the most efficient primary medium of exchange ever used in all of human history. To see this you only need to abandon the idea of accumulating these symbolic units for your future financial security. They aren’t meant for that! They are great for trading in the here-and-now, not for storing for the unknown future. To paraphrase Silvio Gesell, an economist in favor of symbolic currency almost a century ago, “All the physical assets of the world are at the disposal of those who wish to save, so why should they make their savings in the form of money? Money was not made to be saved!” In hindsight, this statement is true whether money is a hard commodity like gold or silver, or a symbolic word like dollar, euro or rupee. In both cases, saving in “money” leads to monetary tension between the debtors and the savers. When money was a hard commodity, this tension was sometimes even released through bloodshed, like the French Revolution. So no, I don’t think we’re swinging back to a hard currency this time.
Do you see the world going back to the gold standard?
No, of course not! “The gold standard” means different things depending on which period you are talking about. But in all cases it used gold to denominate credit, the economy’s primary medium of exchange. Today we have a really efficient and ultimately flexible currency. Bank runs like the 1930s are a thing of the past. But that’s not to say that gold will not play a central role in the future. It will! The signs of it already happening are everywhere! Gold is not going to replace our primary medium of exchange which is paper or electronic units with those names I mentioned above. Instead, physical gold will replace paper obligations as the reserves—or store of value—within the system. Physical gold in unambiguous ownership has no counterparty. This is a much more resilient foundation than the tangled web of obligations we have today.
Can you give an example?
If you’d like to see this change in action, go to the ECB (European Central Bank) website and look at the Eurosystem’s balance sheet. On the asset side gold is on line 1 and obligations from counterparties are below it. Additionally, they adjust all their assets to the market price every three months. I have a chart of these MTM (marked to market) adjustments on my blog. Over the last decade you can see gold rising from around 30% of total reserves to over 60% while paper obligations have fallen from 70% to less than 40%. I expect this to continue until gold is more than 90% of the reserves behind the euro.
Where do you see all this money printing heading to? Will the world see hyperinflation?
Yes, this will end. I am pretty well known for predicting dollar hyperinflation. As controversial as that prediction is, I think it is a fairly certain and obvious end. I don’t like to guess at the timing because there are so many factors to consider and I’m no supercomputer, but ever since I started following this stuff I’ve always said it is overdue in the same way an earthquake can be overdue. As for other currencies, I don’t know. Perhaps yes for the UK pound and the yen, but I don’t know about the rupee. The important things to watch are the balance of trade and the government’s control over the printing press. If you’re running a trade deficit and your government can (and will) print, then you are a candidate for hyperinflation.
In that context what price do you see gold going to?
Well, I don’t see gold’s trajectory being typical of what you’d expect to see in a bull market. Instead it will be a reset of sorts, kind of like an overnight revaluation of a currency. I’m sure some of your readers have experienced a bank holiday followed by a devaluation. This will be similar. And I expect that gold will be repriced somewhere around $55,000 per ounce in today’s purchasing power. I have to add that purchasing power part because it will likely be concurrent with currency devaluation. So, in rupee terms, I guess that’s about Rs3.2 million per ounce at today’s exchange rate.
The price of gold has been rather flat lately. What are the reasons for the same? Where do you see the price of gold going over the next couple of years?
“The price of gold” is an interesting turn of phrase because I use it often to express “all things goldish” in the gold market. In today’s market, “gold” is very loosely defined. What passes for “gold” in the financial market is mostly the paper obligations of counterparties. These include forward sales, futures contracts, swaps, options and unallocated accounts. I often use the abbreviation “$PoG” to refer to the going dollar price for this loose financial “gold”.
The LBMA (London Bullion Market Association) recently released a survey of the total daily trading volume of unallocated (paper) gold. That survey revealed a trading flow of such magnitude that it compares to every ounce of gold that has ever been mined in all of history changing hands in just three months, or about 250 times faster than gold miners are actually pulling metal out of the ground. Equally stunning were the net sales during the survey period. The rate at which the banking system created “paper gold” was 11 times faster than real gold was being mined.
What is the point you are trying to make?
The point is that gold is being used by the global money market as a hard currency. But it is being treated by the marketplace as both a commodity that gets consumed and also as a fiat currency that can be credited at will. It is neither, and gold’s global traders are in for a rude awakening when they find out that ounce-denominated credits will not be exchangeable for a price anywhere near a physical ounce of gold in extremis—ironically failing at the very stage where they were expected to perform.
So what are you predicting?
But don’t get me wrong. It is not a short squeeze that I am predicting. In a short squeeze, the paper price runs up until it draws out enough real supply to cover all of the paper. But this paper will not be covered by physical gold in the end. It will be cash settled, and it will be cash settled at a price much lower than the price of a real ounce of gold, like a check written by an overstretched counterparty. It is a tough job to make my case for the future of the $PoG in just a few paragraphs. The $PoG will fall and then some short time later we will find that the market has changed out of necessity into a physical-only market at a much higher price. If you were holding paper you will be sad. If you were holding the real thing you’ll be very happy
Why is the gold price so flat these days?
Today’s surprisingly stabilized $PoG tells me that someone is throwing money into the fire to delay the inevitable. Where do I see the $PoG going over the next couple of years? Maybe to $500 or less, but you won’t be able to get any physical at that price. I think that today’s price of $1,575 is still a fantastic bargain for physical gold.
Franklin Roosevelt had confiscated all the gold that Americans had in 1933. Do you see something similar happening in the days to come?
Not at all! The purpose of the confiscation was to stop the bank run epidemic at that time. There’s no need to do it again. The dollar is no longer defined as a fixed weight of gold, so the reason for the last confiscation—and subsequent devaluation—no longer exists. Gold that’s still in the ground is a different story, however. Gold mines will likely be considered strategically important national assets after the revaluation, and will therefore fall under tight government control.
The irony of the entire situation is that a currency like “dollar” which is being printed big time has become the safe haven. How safe do you think is the safe haven?
Indeed, everyone seems to be piling into the dollar. Especially on the short end of the curve, helping drive interest rates ridiculously low. The dollar is as safe as a bomb shelter that’s rigged to blow up once everyone is “safely” inside. You can go check it out if you want to (sure, from the outside it might look like shelter), but you don’t want to be in there when it blows up. You’ve got to realize that it is both economically and politically undesirable for any currency to appreciate against its peer currencies due to its use as a safe haven. Remember the Swiss franc? As soon as it started rising due to safe haven use they started printing it back down. The dollar is no different except that it’s got a whole world full of paper obligations denominated in it. So when it blows, the fireworks will be something to behold.
What will change the confidence that people have in the dollar? Will there be some catastrophic event?
That’s the $55,000 question. It is impossible to predict the exact pin that will pop the bubble in a world full of pins, but I have an idea that it will be one of two things. I think the two most likely proximate triggers to a catastrophic loss of confidence are a major failure in the London gold market, or the U.S. government’s response to an unexpected budget crisis due to consumer price inflation. Most people who expect a catastrophic loss of confidence in the dollar seem to think it will begin in the financial markets, like a stock market crash or a Treasury auction failure or something like that. But I think it is more likely to come from where, as I like to say, the rubber meets the road. And here I’m talking about what connects the monetary world to the physical world: prices. I think these “worlds” are connected in two ways. The first is the general price level of goods and services and the second is the price of gold. If one of these two connections is broken by a failure to deliver the real-world items at the financial-system prices, then we suddenly have a real problem with the monetary side. So I think it will be a relatively quick and catastrophic event, but maybe not as dramatic as a major stock market crash. It will be confusing to most of the pundits as to what it really means, so it will take a little while for reality to sink in.
The Romans debased the denarius by almost 100% over a period of 500 years. The dollar on the other hand has lost more than 95% of its purchasing power since the Federal Reserve of United States was established in 1913, nearly 100 years back. Do you think the Federal Reserve has been responsible for the dollar losing almost all of its purchasing power in hundred years?
Yes, inflation was a lot slower in Roman times because it entailed the physical melting and reissuing of coins of a certain face value with less metal content than previous issues. This was a physical process so it occurred on a much longer time scale. The dollar, on the other hand, has lost nearly 97% of its purchasing power in roughly a hundred years. Do I think the Federal Reserve is responsible for this? Well, given that the lending/borrowing dynamic causes expansion of the money supply, I think the government and the people of the world share in the responsibility. But just because the dollar has lost 97% of its purchasing power doesn’t mean that any individual lost that much. How many people do you think are still holding onto dollars today that they earned a hundred years ago? How long would you hold dollars today? As long as the prices of things you want to buy don’t change during the time you are holding the currency, what have you lost? So imagine that you simply use currency for earning, borrowing and spending, but not for saving. Will it matter how much it falls over a hundred years? Your earning and spending will happen within a month or so, and prices won’t change much in a month. Also, your borrowing will be made easier on you as your currency depreciates. And your gold savings will rise. So with the proper use of money, there is no need for alarm if the currency is slowly falling at, say, 2% or 3% per year.
Do you see America repaying all the debt that they have taken from the rest of the world? Or will they just inflate it away by printing more and more dollars?
The debts that exist today can never be repaid in real terms. And as I mentioned before, they are all denominated in symbolic words like dollars, euro, yen, yuan and rupees. The debt of the U.S. Treasury, most of all, will of course be inflated away.
What are your views about the crisis in Europe? Will the euro hold?
Contrary to most of what we read in the Anglo-American press, I don’t think the euro currency is at risk from the sovereign debt crisis in Europe. They are two different things, the debt crisis and the euro. The euro currency faces none of the usual devaluation risks. Trade between the Eurozone and the rest of the world is balanced and the ECB has plenty of reserves. So aside from devaluation risk, which the euro doesn’t face, the only other risk is if the people decide to abandon the euro. Procedurally this would be so difficult for any country to do on a whim that I can confidently say it is virtually impossible aside from the most extreme situations like a revolutionary war or something like that. And I don’t see that happening. I think the euro survives come what may.
What does FOFOA stand for?
I remain anonymous because my blog is not about me. It is a tribute to “Another” and “Friend of Another” or “FOA” who wrote about this subject from 1997 through 2001. So FOFOA could stand for Friend of FOA or Follower of FOA or Fan of FOA. I never really stated what it stands for, so you can decide for yourself. 😉 Sincerely, FOFOA.
(The interview was originally published in the Daily News and Analysis(DNA) on July 2,2012)
(Interviewer Kaul is a writer and can be reached at [email protected])
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] )