I’ve long said that capitalism without bankruptcy is like Christianity without hell. – Frank Borman
If you have been following the business newspapers lately, you would have probably come to the conclusion by now that a break-up of the euro will lead to a huge catastrophe in Europe as well as the rest of the world.
Yes, there will be problems. But the world will be a much better place if the countries like Portugal, Ireland, Italy, Greece and Spain opt out of the euro. To know why read on.
How it all started
The European Coal and Steel Community was an economic organisation formed by six European nations in 1958. This gradually evolved into the European Union (EU) which was established by the Maastricht Treaty in 1993. The EU introduced the euro on 1 January 1999. On this day, 11 member countries of the EU started using euro as their currency. Before the euro came into being the German currency deutschemark used to be the premier currency of Europe. The euro inherited the strength of the deutschemark. The world looked at the euro as the new deutschemark.
The move to euro benefitted countries such as Portugal, Italy , Ireland , Greece and Spain (together now known as the PIIGS). Before these countries started to use euro as a currency, they had to borrow money at interest rates much higher than the rates at which a country like Germany borrowed. When these countries started to use the Euro they could borrow money at interest rates close to that of Germany, which was economically the best managed country in the EU.
Easy money and the borrowing binge
With interest rates being low, the PIIGS countries as well as their citizens went on a borrowing binge. Greece took the lead among these countries. The Greek politicians launched a large social spending programme which subsidised most of the key public services. In fact a few years back, the finance minister of Greece claimed that he could save more money shutting down the Railways and driving people around in taxies. In 2009, Greece railways revenues were at around $250 million and the losses of around $1.36billion. All this extravagance has was financed through borrowing.
Greece was not the only country indulging in this extravagance, other PIIGS nations had also joined in. Also other than the low interest rates, the inflation in the PIIGS countries was higher than the rate of interest being charged on loans.
As John Mauldin and Jonathan Tepper write in Endgame – The End of the Debt Supercycle and How it Changes Everything “In plain English, that means that if the borrowing rate is 3 percent while inflation is 4 percent you’re effectively borrowing for 1 percent less than inflation. You’re being paid to borrow. And borrow they did. And the European peripheral countries (PIIGS) racked up enormous amount of debt in euros.”
This was because loans were being made by German, French and British banks who were able to raise deposits at much lower interest rates in their respective countries and offer it at a slightly higher rate in the PIIGS countries.
The citizens of Spain borrowed big time to speculate in real estate. All this building was financed through the bank lending. Loans to developers and construction companies amounted to nearly $700billion or nearly 50% of the Spain’s current GDP of nearly $1.4trillion. Currently Spain has as many homes unsold as the United States (US), though the US is six times bigger than Spain. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion or that is double Spain’s GDP, are in trouble.
The accumulated debt in Spain is largely in the private sector. On the other hand the Italian government debt stands at $2.6trillion, the fourth largest in the world. The debt works out to around 125% of the Italian gross domestic product (GDP). As a recent report titled A Primer on Euro Breakup brought out by Variant Perception points out “Greece and Italy have a high government debt level. Spain and Ireland have very large private sector debt levels. Portugal has a very high public and private debt level.” Debt as we all know needs to be repaid, and that’s where all the problems are. But before we come to that we need to understand the German role in the entire crisis.
The German connection
Germany became the largest exporter in the world on the strength of the euro. Before euro became a common currency across Europe, German exports stood at around €487billion in 1995. In 1999, the first year of euro being used as a currency the exports were at €469billion euros. Next year they increased to €548billion euros. And now they stand at more than a trillion euros. Germany is the biggest exporter in the world even bigger than China.
With euro as a common currency took away the cost of dealing with multiple currencies and thus helped Germany expand its exports to its European neighbours big time. Also with a common currency at play exchange rate fluctuations which play an important part in the export game no longer mattered and what really mattered was the cost of production.
Germany was more productive than the other members of the European Union given it an edge when it came to exports. As Mauldin and Tepper point out “since the beginning of the Euro in 1999, Germany has become some 30 per cent more productive than Greece. Very roughly, that means it costs 30 per cent more to produce the same amount of goods in Greece than in Germany. That is why Greece imports $64 billion and exports only $21 billion.”
German banks also had a role to play in helping increasing German exports. They were more than happy to lend to citizens, governments and firms in PIIGS countries. So the way it worked was that German banks lent to other countries in Europe at low interest rates, and they in turn bought German goods and services which are extremely competitively priced as well as of good quality. Hence German exports went up.
The PIIGS countries owe a lot of money to German banks. Greece needs to repay $45billion. Spain owes around $238billion to Germany. Italy, Ireland and Portugal owe $190billion, $184 billion and $47billion respectively.
Inability to repay
When the going is good and everything is looking good there is a tendency to borrow more than one has the ability to repay, in the hope that things will continue to remain good in the days to come. But good times do not last forever and when that happens the borrower is in no position to repay the loan taken on.
Greece tops this list. It has been rescued several times and the private foreign creditors have already taken a haircut on their debt i.e. they have agreed to the Greek government not returning the full amount of the loan. Between Spain and Italy around €1.5trillion of money needs to be repaid over the next three years. The countries are in no position to repay the debt. It has to be financed by taking on more debt. It remains to be seen whether investors remain ready to continue lending to these countries.
In the past countries which have come under such heavy debt have done one of the following things: a) default on the debt b) inflate the debt c) devalue the currency.
Scores of countries in the past have defaulted on their debt when they have been unable to repay it. A very famous example is that of Russia in 1998. It defaulted both on its national as well as international debt. Oil prices had crashed to $11 per barrel. Oil revenue was the premier source of income for the Russian government and once that fell, there was no way it could continue to repay its debts.
If the country’s debt is in its own currency, all the government needs to do is to print more of it in order to repay it. This has happened time and again over the years all over the world. Every leading developing and developed country has resorted to this at some point of time. The third option is to devalue the currency and export one’s way out of trouble.
Exit the euro
The PIIGS countries cannot print euros and repay their debt. Since they are in a common currency area there is no way that they can devalue the euro. A straight default is ruled out because German and French banks will face huge losses, and Germany being driving force behind the euro, wouldn’t allow that to happen.
So what option do the PIIGS then have? One option that they have is to exit the euro, redominate the foreign debt in their own currency, devalue their currency and hope to export their way out of trouble.
A lot has been written about how you can only enter the euro and not exit it. The situation as is oft repeated is like a line from an old Eagles number Hotel California “You can checkout any time you like / But you can never leave.” A case has also been made as to how it would be disaster for any country leaving the euro.
Let’s try and understand why the situation will not be as bad as it is made out to be. A report titled A Primer on Euro Breakup, about which I briefly talked about a little earlier explains this situation very well.
The first thing to do as per the report is to exit the euro by surprise over a weekend when the markets are closed. Many countries have stopped using one currency and started using another currency in the past. A good example was the division of India and Pakistan. As the report points out “ One example of a currency breakup that went smoothly despite major civil unrest is the separation of India and Pakistan in August 1947. Before the partition of India, the two countries agreed that the Reserve Bank of India (the RBI) would act as the central bank of Pakistan until September 1948….Indian notes overprinted with the inscription “Government of Pakistan” were legal tender. At the end of the transition period, the Government of Pakistan exchanged the non-overprinted Indian notes circulating in Pakistan at par and returned them to India in order to de-monetize them. The overprinted notes would become the liabilities of Pakistan.”
Any country looking to exit Euro could work in a similar way. It will need to have provisions in place to overprint euros and deem them to be their own currency. Then it will have quickly issue new currency and exchange the overprinted notes for the new currency. Capital controls will also have to be put in place for sometime so that the currency does not leave the country.
Despite the fact that there are no exit provisions from the euro, after the creation of the European Central Bank, the individual central banks of countries were not disbanded. And they are still around. “All the euro countries still have fully functioning national central banks, which should greatly facilitate the distribution of bank notes, monetary policy, management of currency reserves, exchange-rate policy, foreign currency exchange, and payment. The mechanics for each central bank remain firmly in place,” the report points out.
By applying the legal principle of lex monetae – that a country determines its own currency, the PIIGS countries can re-dominate their debt which they had issued under their local laws into the new currency. As the report points out “Countries may use the principle of lex monetae without problems if the debt contracts were contracted in its territory or under its law. But private and public bonds issued in foreign countries would be ruled on by foreign courts, who would most likely decide that repayment must be in euros.”
The good thing is that in case of Greece, Spain and Portugal, nearly 90% of the bonds issued are governed by local law. While redomination of currencies in their own currencies will legally not be a default, it will be categorized as a default by ratings agencies and international bodies.
Another problem that has brought out is the possibility of bank runs if countries leave the euro. Well bank runs are already happening even when countries are on the euro. (The entire report can be accessed here: http://www.johnmauldin.com/images/uploads/pdf/mwo022712.pdf).
The PIIGS coutnries can devalue their new currencies make themselves export competitive and hope to export their way out of trouble. This is precisely what the countries of South East Asia after the financial crisis of the late 1990s. As the report points out “history shows that following defaults and devaluations, countries experienced two to four quarters of economic contraction, but then real GDP grew at a high, sustained pace for years. The best way to promote growth in the periphery, then, is to exit the euro, default and devalue.”
The German export machinery
A breakup of the euro will create problems for the highly competitive export sector that Germany has built up. The PIIGS countries would start competiting with it when it came to exports. Given this they will not let the euro break so easily. As the bestselling author Michael Lewis said in an interview sometime back “German leadership does not want to be labeled as the people who destroyed the euro.”
But as Lewis also said “If you put Germany together with Greece in a single currency, it’s a little like watching an Olympic sprinter and a fat old man running a three-legged race. The Greeks will never be as productive as the Germans, and the Germans will never be as unproductive as the Greeks.” So it’s best for PIIGS countries to exit the euro.
In the end let me quote my favourite economist John Kenneth Galbraith as a disclaimer: “The only function of economic forecasting is to make astrology look respectable.”
(The article originally appeared at www.firstpost.com on May 19,2012. http://www.firstpost.com/world/if-piigs-have-to-fly-they-will-need-to-exit-the-euro-314589.html)
(Vivek Kaul is a writer and can be reached at [email protected])
If you are the kind who reads the pink papers religiously, you would have come to conclusion by now that good times are back again for the stock market investors in India, now that the finance minister has deferred the implementation of GAAR to next year. But before you open that champagne bottle and say cheers, here are some reasons why the stock market will remain flat or fall in the days to come.
Pain in Spain:
The gross domestic product (GDP) of Spain grew at the rate of 8% every year from 1999 to 2008. This primarily happened because Spain went all out and promoted the Mediterranean lifestyle. As Jonathan Carman points out in a presentation titled The Pain in Spain “Millions flocked to its sun-drenched shores, buying houses along the way. As the demand for houses increased, construction became the industry. Housing prices exploded, tripling in just over a decade.”
So far so good. The trouble was Spain ended up building way too many homes than it could sell. Even though Spain forms only 12% of the GDP of the European Union (EU) it has built nearly 30% of all the homes in the EU since 2000. As John Mauldin and Jonathan Tepper point out in Endgame – The End of the Debt Supercycle and How It Changes Everything “Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the United States, even though the United States is six times bigger”.
All this building was financed through the bank lending. Loans to developers and construction companies amounted to nearly $700billion or nearly 50% of the Spain’s current GDP of nearly $1.4trillion. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion or that is double Spain’s GDP.
What makes the situation more precarious is the fact that the housing prices are still falling. Carman expects prices still need to fall by 35% from their current levels if they are to reach normal levels. This will mean more home loan defaults and more trouble for Spain. The Spanish stock market is already taking this into account and IBEX-35, the premier stock market index of the country is down a little more than 10% in the last one month. Banking stocks have fallen much more.
While countries like Greece may be in more trouble, they are not economically big enough to cause a lot of trouble worldwide. But if Spanish banks go bust, there will be a lot of trouble in the days to come. Spain has now emerged the basket case of Europe, but other countries in the European Union are not doing well either and this means trouble for China.
China’s After Party:
If things are not well in Europe, it has an impact on China because Europe is China’s biggest trading partner. The Chinese exports to Europe in March were down 3.1% in comparison to last year. Chinese exports had ranged between $475billion and $518billion in the last three quarters of 2011. In the first three months of this year the number has fallen to $430million. Falling exports are not the best news for China.
There are other things which aren’t looking good either. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracles “In the last decade the main driver of China’s boom was a surge in the investment share of the GDP from 35% to almost 50%, a level that is unprecedented in any major nation…The investment effort focused on building the roads, bridges, and ports needed to turn China into the world’s largest exporter, doubling its global export market share to 10% in the last decade.”
This spending spree which was responsible for its fast growth is now slowing down. New road construction is down from 5000miles in 2007 to 2500 miles. Railway spending is down by 10%.
The other major factor likely to pull down growth is wage inflation i.e. salaries are rising at a very fast rate. In 2011, the average wage was rising at a rate of 15%, in a scenario where the consumer price inflation was around 5%. As Sharma points out “In fact hourly wages are now rising twice as fast productivity, or hourly output per worker, which is forcing companies to raise prices just to cover the cost of higher wages.” This has led to manufacturers moving to cheaper destinations like Bangladesh and Indonesia.
Given these reasons it is highly unlikely that China will continue to grow at the rates that it has been. Since 1998, China’s economic growth has averaged around 10% and it has never fallen below 8%. As Sharma points out “China’s looming shadow is about to retreat to realistic dimensions.” Sharma expects Chinese growth to slowdown by 3-4% percentage points in comparison to its current growth rate over the next decade.
A Chinese slowdown will mean disaster for nations which have been thriving by exporting commodities to China. In 1998, when China was a $1trillion economy, to grow by 10% meant it had to expand its economy by $100billion. This could have been done by consuming 10% of the world’s industrial commodities, raw materials like oil, steel and copper. In 2011, China is a $6trillion economy. If this economy needs to grow by 10% or $600billion, more than 30% of the world’s commodity production would be needed. With growth slowing down, China’s commodity requirements will come down as well. As Sharma puts it “It’s my conviction that China – commodity connection will fall apart soon”.
China’s stock markets remain largely closed to international investors. But the Hang Seng index listed in Hong Kong has a lot of Chinese companies. This index has gone up 0.9% over the last one month.
The Kangaroo Won’t Jump:
In fact the Aussies are already feeling the heat with a slowdown in Chinese exports. Australian exports to China in 2011 stood at A$72billion (Australian dollar), up 24% from 2010, or around 26% of total exports. An ever expanding China bought coal, iron ore and natural gas from Australia, driving up Aussie exports. But exports for the month of February fell to A$24.4 billion, the lowest in an year. Coal exports were down by 21% to A$3.4billion. The S&P ASX/200 one of the premier stock market indices in Australia, has been flat for the last one month.
Brazil – God’s Own Country:
The rise of China has led to huge demand for Brazilian commodities. As Gary Dorsch an investment newsletter writer points out in a recent column “Brazil has been enjoying an economic boom based on soaring prices for its natural resources including crude oil, agricultural products, such as soybeans, corn, and cattle, and metals such as iron ore and bauxite-aluminum.”
The rise of Brazil was captured very well by Glenn Stevens, governor of the Reserve Bank of Australia. Stevens pointed out that in 2006, money received from shipload of iron ore could buy 2,200 flat screen TVs. In 2011, the same shipload could buy 22,000 flat screen TVs.
Since the start of the financial crisis a lot of money printed by Western governments to revive their economies has flowed into Brazil. This has driven up the value of the real, the currency of Brazil, and made Brazil one of the most expensive countries in the world. As Sharma points out “Restaurants in Sao Paulo are more expensive than those in Paris. Hotel rooms cost more in Rio than French Riviera”.
An expensive currency has meant that imports rising faster than exports. This situation is expected to get worse as China’s slowdown and the demand for Brazilian commodities falls. In fact the impact is already being felt. As Dorsch points out “Brazil’s economy stalled out in the past two quarters, showing near zero growth in Q’3 of 2011 and Q’4 of 2012. Factory output in February was -3.9% lower than a year ago.” The premier stock market index Bovespa is down 4.5% over the last one month.
On a totally different note the most popular television serial in Brazil is a soap opera called “A Passage to India” shot in Agra and Jodhpur and which has Brazilian actors playing Indian roles and as Sharma puts it, they could “pass easily for North Indians”.
India- Done and Dusted:
The economic problems of India deserve a separate article. But let me list a few. In the year 2007-2008 (i.e. between April 1, 2007 and March 31,2008) the fiscal deficit of the government of India stood at Rs 1,26,912 crore. Fiscal deficit is the difference between what the government earns and what it spends. For the year 2011-2012 (i.e. between April 1, 2011 and March 31, 2012) the fiscal deficit is expected to be Rs 5,21,980 crore.
Hence the fiscal deficit has increased by a whopping 312% between 2007 and 2012. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore. The targeted fiscal deficit for 2012-2013 is Rs 5,13,590 crore. This is likely to go up given the fact that the rupee is depreciating against the dollar and thus our oil bill is likely to go up, pushing up our fiscal deficit. This would mean that higher interest rates will continue to prevail.
The stock market obviously realizes this and hence has fallen by 1.8% over the last one month, yesterday’s brief rally notwithstanding.
Over the last few years stock prices all across the world have moved in a synchronized fashion because the international investors like to move in a herd. Whenever there has been trouble in the United States or Europe it has led to emerging markets all across the world falling. Now we are in a situation where the emerging markets themselves are in a lot of trouble. So it is a no brainer to say there will be no rally in the stock market in the near future. Unless of course a certain Mr Ben Bernanke decides to open up the money tap again and go in for Quantitative Easing Round Three or to put it in simple English, print some more dollars. If that happens, then investors can get ready to have some fun.
(This article was originally published on May 8, 2012 at http://www.firstpost.com/economy/the-pain-in-spain-will-get-us-too-so-forget-market-rallies-302278.html. Vivek Kaul is a writer and can be reached at [email protected])
Ravi Batra is an Indian American economist and a professor at the Southern Methodist University in Dallas, Texas. Unlike most economists who are in the habit of beating around the bush, Batra likes to make predictions, and he usually gets them right. Among these was calling the fall of communism in the Soviet Union more than ten years before it happened. Batra is also the author of many best-selling books like The Crash of the Millennium, The Downfall of Capitalism and Communism, Greenspan’s Fraud and most recently The New Golden Age. In this interview he speaks to Vivek Kaul.
You are a great proponent of the Law of Social Cycle. What’s it all about?
In 1978, to the laughter of many and the ridicule of a few, I wrote a book called The Downfall of Capitalism and Communism, which predicted the demise of Soviet communism by the end of the century and an enormous rise in wealth concentration in the United States that would generate poverty among its masses, forcing them into a revolt around 2010. My forecasts are derived from The Law Of Social Cycle, which was pioneered by my late teacher and mentor Prabhata Ranjan Sarkar. Lo and behold! The Berlin Wall fell in 1989 and Soviet communism vanished right before your eyes. And in 2011, the United States witnessed the birth of a social revolt in the form of the ‘Occupy Wall Street Movement’, which opposes the interest of the richest 1% of Americans. The nation now has the worst wealth concentration in history.
So what is this law?
It is an idea that begins with general characteristics of the human mind. Sarkar argues that while most people have common goals and ambitions, their method of achieving them varies, depending on innate qualities of the individual. Most of us, for instance, seek living comforts and social prestige. Some try to attain them by developing physical skills, some by developing intellectual skills and some by saving and accumulating money, while there are also some with little ambition in life. Based on these different mentalities, Sarkar divides society into four distinct classes: warriors, intellectuals, acquisitors and labourers.
Can you go into a little more detail?
Among warriors are included the military, policemen, professional athletes, fire fighters, skilled blue-collar workers, and anyone who displays great courage. The class of intellectuals comprises teachers, scholars, bureaucrats, and priests. Acquisitors include landlords, businessmen, merchants, and bankers. Finally, unskilled workers constitute the class of laborers. The division of society into four classes based on their mentality and occupations, not heredity, is at the core of Sarkar’s philosophy of social evolution. His theory is that each society is first dominated by the class of warriors, then by the class of intellectuals, and finally by the class of acquisitors. Eventually, the acquisitors generate so much greed and materialism that other classes, fed up by the acquisitive malaise, overthrow their leaders in a social revolution. Then the warriors make a comeback, followed once again by intellectuals, acquisitors and a social revolution. This, in brief, is The Law Of Social Cycle.
That’s very interesting. Can you explain this through an example?
Applying this theory to western society, we find that the Roman Empire was the Age Of Warriors, the rule of the Catholic Church the Age Of Intellectuals, and feudalism the Age Of Acquisitors, which ended in a social revolution spearheaded by peasant revolts all over Europe in the 15th century. The centralised monarchies that then appeared represented the Second Age Of Warriors, which was, in turn, followed by another Age Of Intellectuals, this time represented by the rule of prime ministers, chancellors and diplomats. Since the 1860s the west has had a parliamentary rule in which money or the acquisitive era has been prevalent.
What about India?
India’s history is silent on some periods, but, wherever full information is available, the social cycle clearly holds. For instance, around the times of Mahabharata, warriors dominated society, then came the rule of Brahmins or intellectuals, followed by the Buddhist period, when capitalism and wealth were predominant; this era ended in the flames of a social revolution, when a great warrior named Chandragupta Maurya put an end to the reign of a king named Dhananand, and started another Age Of Warriors. Dhan means money and ananda means joy, so that dhan + ananda becomes Dhananda or someone who finds great joy in accumulating money, suggesting that the Mauryan hero overthrew the rule of greed and money in society.
How do you see things currently through The Law Of The Social Cycle?
Today, the world as a whole is in the Age Of Acquisitors, while some nations such as Iran are ruled by the clergy or their intellectuals. Russia is in transition from the warrior era to the era of intellectuals, while China continues in the Age Of Warriors, which was founded by Mao Tse Tung in 1949 after overthrowing the feudalistic Age Of Acquisitors in an armed revolution. As regards Iran, applying the dictum of social cycle, I foresaw the rise of priests or the Ayatollahs in a 1979 book called Muslim Civilization and the Crisis in Iran. For ten thousand years, the law of the social cycle has prevailed. Egypt went through three such cycles before succumbing to Muslim power. Muslim society as a whole is now in the Age Of Acquisitors. Some Muslim countries such as Saudi Arabia, Kuwait, Jordan, Pakistan, Malaysia and Bahrain are still in the acquisitive age, while some others such as Egypt and Libya have recently seen a social revolution and are in transition to the next age. The wheel of social cycles has thus been turning in all societies, albeit at different speeds; not once in human history was it thwarted.
Any new predictions based on this law?
The United States along with India are now on the verge of a social revolution that will culminate in a Golden Age. That is what I have predicted in my latest book, The New Golden Age. The American revolution is likely to occur by 2016 or 2017, and India’s should arrive by the end of the decade. This is the way I look at some popular movements such as the Occupy Wall Street Movement in the United States, and those started by Anna Hazare and Baba Ram Dev in India. They reflect people’s anger and frustration with the corrupt rule of acquisitors. Such movements are destined to succeed in their mission, because the rule of wealth is about to come to an end.
One of your predictions that hasn’t come true is that about the Great Depression of the 1930s happening again
It is true we have not had another Great Depression like that of the 1930s, although the slump since 2007 is now being called the Great Recession. The difference between the two may be more semantic than real. The Great Depression was not a period of one long slump lasting for the entire 1930s. Rather, there were pockets of temporary prosperity. The first part of the depression lasted between 1929 and 1933. Then growth resumed and the global economy improved till1937, only to be followed by another slump. This time there has been no depression, but at least in the United States people’s agony has been nearly as bad as in the 1930s. Farming played a great role in society at that time so that the unemployed could go back to agriculture and survive. This time around, that has not been possible. Millions of Americans are homeless today as in the1930s. Still the 1930s were the worst ever, but my point is that American poverty today is the worst in fifty years. The wage-productivity gap, consumer debt and the stock market went up sharply in the 1920s, just as they did after1982. The market crashed in 1929 and then the depression followed. So I concluded that since the same type of conditions were occurring in the 1980s we would have another great depression. However, what I could not imagine was that, China, one-time America’s arch enemy, would lend trillions of dollars to the United States. Note that so long as debt keeps up with the rising wage gap, unemployment can be avoided. In other words, China’s loans postponed large-scale unemployment in the United States for a long time, but not forever.
Can a depression still occur?
Yes, it can, but only if countries are unable to create new debt. Such a likelihood is small but cannot be ruled out. On the other hand, if for some reason oil prices shoot up further to say $150 per barrel, the depression will be inevitable.
How do you see the scenario in Europe playing out?
In Europe and elsewhere the nature of the problem is the same, namely the rising wage gap, so that production exceeds consumer demand, and the government has to resort to nearly limitless debt creation. But the PIIGS — Portugal,Ireland, Italy, Greece and Spain — show that government debt cannot rise forever and when debt has to be reduced there is further rise in unemployment. The European troubles are not over and we should expect the debt problem to linger for years to come.
The dangers in Europe have suddenly taken away the attention from the United States. What is your prediction about the United States the way it currently is?
So long as the United States is able to borrow more money either from the world or from its own people, its economy will remain stable at the bottom. But there is a strong sentiment now among most Americans that the budget deficit must come down, and the laws already passed aim to bring it down from 2013 on. This is likely to raise unemployment in that year and beyond. 2012 could also see real troubles after June when the already rising price of oil and gasoline starts hurting the economy. If the speculators succeed in raising the oil price towards their goal of $150, there could be another serious slump by the end of the year.
Do you see a dollar crash coming in the years to come?
Yes the dollar could crash against the currencies of China and Japan, but I don’t see this happening before July. After that the global economy could be as sick as it was in 2008. The scenario would be reminiscent of what happened in 1937 when the global depression made a comeback. Something similar could materialise again in that the Great Recession could make a resounding come back. However, I don’t see an alternative to the dollar at this point because the whole world is in trouble. For the dollar to fall completely from grace, Opec would have to start pricing its crude in terms of a different currency and I am not sure if that is possible.
What do you think about the current steps the Obama administration is taking to address the economy?
The Obama administration has followed almost the same policies that George W Bush did, and in the process wasted a lot of money to generate paltry economic growth and some jobs. In fact, the government has been spending over $1.5 million to generate one job. This sounds bizarre, but here is what has happened since 2009. The administration’s tack is that we should keep spending money at the current rate to lower unemployment, even though the annual federal budget deficit has been around $1.4 trillion over the past two years. It seems apparent that the main purpose of excessive federal spending is to preserve or generate jobs. This is a point emphasised by every American president since 1976, and especially since1981 when the federal deficit began to soar. This is also how most experts defend the deficit nowadays.
Could you elaborate a little more on this?
In 2010, according to the Economic Report of the President, as many as 800,000 jobs were created, and the government’s excess spending was $1.4trillion, which when divided by 800,000 yields 1.7 million. In other words, the US government spent $1.7 million to generate one job. The economy improved in 2011, providing work to 1.1 million people for the same expense. So dividing $1.4 trillion by the new figure yields $1.3 million, which is now the cost of creating one job. Thus, the average federal deficit or cost per job over the past two years has been $1.5 million.
Is it prudent to be wasting precious resources like this?
I don’t think so. The trillion dollar question is this: where is it all going, when the annual American average wage is no higher than $50,000? Obviously, it must be going to the so-called 1% group or what the Republican Party calls the job creators, i.e., the CEOs and other executives of large corporations.
Could you explain that?
Let us see how the main culprit for the mushrooming incomes of business magnates is the government itself. This is how the process works and has been working since 1981. The CEO forces his employees to work very hard while paying them low wages; this hard work sharply raises production or supply of goods and services, but with stagnant wages, consumer demand falls short of growing supply. This then leads to overproduction and threatens layoffs, which in turn threatens the re-election chances of politicians. They then respond with a massive rise in government spending or huge tax cuts, so that total demand for goods and services rises to the level of increased supply. As a result, either those layoffs are averted or the unemployed are gradually called back to work. This way, the CEO is able to sell his entire output and reap giant profits in the process, because wages are dwindling or stagnant even as business revenue soars. In the absence of excess government spending, companies would be stuck with unsold goods and could even suffer losses. In other words, almost the entire federal deficit ends up in the pockets of business executives. With such a vast wastage of resources, the economy has to falter once again, and I think the second half of 2012 will be just as bad as 2008. The Fed will then revive Quantitative Easing III, but it will not help.
What about the entire concept of paper money?
Paper money is here to stay, but in the near future there will be some kind of gold standard as well, so that money will be partially backed the government’s holding of gold. This way there will be a restraint on the government’s ability to print money.
Any long term investment ideas for our readers? Are you gold bull?
Gold and silver may still be a good investment for 2012, but not for the rest of the decade. However, if there is excessive violence, then the precious metals could shine for a lot longer. I used to be very bullish on gold, but with the metal having appreciated so much already, I am now on the side of caution.
(A shorter version of this interview was pubished in the Daily News and Analysis (DNA) on May 7,2012. Vivek Kaul is a writer and can be reached at [email protected])
Ruchir Sharma is the head of Emerging Market Equities and Global Macro at Morgan Stanley Investment Management. He generally spends one week per month in a developing country somewhere in the world. Also he has been a writer for as long as he has been an investor. Sharma has put his two areas of expertise that of having an extensive experience on emerging markets and being able to write about them, into a new book, Breakout Nations – In Pursuit of the Next Economic Miracle. In this interview he speaks to Vivek Kaul([email protected]).
How do you define a breakout nation?
Let me tell you where this idea came from. The last decade was a very exceptional decade for emerging markets in the sense that every developing economy did well. This is not consistent with the history of economic development. We have got two hundred countries in the world, and only 35 are developed, everything else is emerging. So the consistent history of economic growth is that you get bursts of growth and then it falters. Very few countries are able to sustain these bursts of growth and develop and become fully developed countries.
So why was the last decade different?
The 80s and 90s was a very bad period and this was a catch up happening because of that. Also there was a lot of easy money that started to flow out of the United States (US) from 2003 onwards. And there was a boom in the global consumer. It led to this myth at the end of the decade that if you were an emerging market it was all about a time as to when you would converge with the developed world. As I surveyed the world I figured out that’s not going to happen. That’s not the history of economic development and after a decade of economic success many countries were beginning to falter. Other thing that sort of stuck me was that people would ask me, listen even if India grows at 6%, no harm done, because the US is growing at 2-3%. There are two things that are wrong about that argument. One we saw last year, when the Indian equity market fell by 35% in dollar terms last year. So if you undershoot expectations it has a very negative fallout.
You are referring to the Indian GDP growth falling to less than 7%?
Exactly! One thing that people don’t take into account is expectations. Like in China today all expectations are of the country growing by 8-9% and if China grows below 8-9% it leads to instant panic in the markets, especially the commodity markets. So one of the definitions for a breakout nation is that the expectations have to be exceeded. If your expectations are already high and if you are just about meeting them, it’s not going to feel like bang for the buck for anyone.
You say one of the definitions….
The second is this per capita income argument, which is that if India grows at 4-5% that’s a real underachievement because we are only a $1500 per capita income country whereas if a country like Korea grows at 4% it’s a huge achievement because it’s a relatively rich country with a per capita income of more than $20,000. It is still classified as an emerging market but it is fairly rich. So there are three things behind which went into defining what a breakout nation is. One that not all emerging markets are going sort of emerge, so to speak, or become developed markets. Two that expectations are key in terms of how you define a breakout nation and three that you have to take into account per capita income levels. The lower the base the easier it is theoretically to grow and the more you should grow to get out of poverty.
You also say “very few nations achieve long term rapid growth”. Why is that?
This is because most countries or most emerging markets reform only when they have their back to the wall. They enjoy some success and then they stop reforming and begin to fritter away their gains. That’s what happened to Brazil. Brazil used to be the China of the 1960s. Its growth rate was nearly in double digits and then it completely lost its way. It started to fritter it away in terms of huge government spending, subsidies, and massive amount of wasteful expenditure which led to hyperinflation. If you look in the high growth list of the 1950s and 1960s, there were countries like Yemen, Iran and Iraq. The odds of long term success like it is with companies is very low. How many companies are there today which were there thirty years ago, or twenty years ago?
So which are the countries which have grown consistently over the long term?
There are only two countries which have grown over 5% for five decades in a row, South Korea and Taiwan. Only six countries were able at more than 5% for four decades in a row. The list included Hong Kong, Singapore, South Korea, Taiwan and I think there was Malta.
What is it that these countries did differently that other countries did not?
In countries like South Korea, China and Taiwan, they consistently had a plan which was about how do you keep reforming. How do you keep opening up the economy? How do you keep liberalizing the economy in terms of how you grow and how you make use of every crisis as an opportunity. Like Korea was really down in the dumps in 1997-98 crisis. They really had their back to the wall. But they capitalized on the crisis to clean up their balance sheet and to emerge again as an economic powerhouse. It is just about the fact you need to consistently keep reforming and understand that odds are against you. In India’s case what concerns me is the attitude. Listen we will grow by 7%, no matter what happens. That is a given. Now why it is a given, I don’t know. Earlier it was 8-9%. Many businessmen also like to parrot the line that 7% growth will happen, no matter what happens. To me I find that very disturbing. Maybe it is changing now, but till at least a year ago, the attitude was very clear.
You have set many doubts on China becoming a breakout nation. Why?
In fact I admire China’s success and of what they have done over the past thirty years but my point is that expectations on China have become too high. To me that is the big thing. Even though its per capita income has reached around $6000, IMF still thinks that for the next five years the growth will be 8% per annum. Every time the growth dips below 8%, it leads to panic.
Can you elaborate on this?
Surveys are carried out where fund managers are asked will China have a hard landing. I find two responses interesting. Only 10% say that China will have a hard landing. And how do they define a hard landing, a growth rate of 7% or less. The breakout nation concept is that you got to beat expectations. So what I am saying is that if China records a GDP growth rate of 6% next year, trust me it will lead to a lot of panic in many circles.
There are lots of negatives that you point out about China, which we do not tend to here in the normal scheme of things. Like you talk about salaries going up at a very fast pace i.e. wage driven inflation…
Chinese costs have been going up at the rate of 15% per year, and as I argue at the back of the book, the US in fact is now seeing some reshoring (i.e. factories are moving back to America), as we call it. After all the outsourcing and off-shoring the new trend in the US seems to be reshoring because the wage gap is narrowing. It is still there. But the wage gap is narrowing. An anecdote that I found very useful was when one of my portfolio managers went on the ground and the companies told him was that three years ago we could shout at the workers but today they can shout back at us. I think that’s natural. For the first time in China the urbanization ratio has gone to 50%. So a lot of the workers have moved from rural to urban areas, and the scope of workers left for companies to tap from is diminishing.
Why do you call the $2.5trillion foreign exchange reserves, an illusion?
If you look at the total debt of China as a share of their economy it comes to around 200% of their GDP. The Chinese know that. And therefore they are reluctant now to keep stimulating the economy with debt and they are trying their best to clean up the banking system by sort of being careful about off-balance sheet transactions. When you talk to the entire world, when it comes to debt statistics, they don’t look at the entire picture, they just look at the narrow picture that China’s central government’s debt to GDP is low. But a lot of the debt sits on the local government’s balance sheets or on company balance sheets which are owned by the government, which is all the same if you put it together.
You say that the Chinese consumer not doing well is a big myth…
This is because the Chinese consumer has been doing well. And this myth has got propagated because the Chinese consumption as a share of their GDP is low. But my entire point is that it is low not because consumption is doing badly but because investment and exports have done exceedingly well. My entire point is that the Chinese consumption growth cannot increase further. It can continue at this pace.
I was surprised when I read that the consumer spending in China has been growing in China by 9% every year over the last thirty years.
Yes. It is comparable to what Japan, China and Korea achieved.
So it’s been growing as fast as the Chinese economy…
No. Just a bit below. The Chinese economy has been growing at 10% and the consumption has been growing at 9%. Because the overall economy has grown at 10% and the consumption has grown at 9%, consumption as a share of Chinese GDP has come down, which leads many people to believe that the Chinese consumer is suppressed. Yeah, maybe suppressed relative to exports and investments but not in absolute terms.
Another thing I found quite fascinating in your book is the portion where you describe your experience of taking the maglev train in Shanghai. Can you take us through that?
It was like going to an amusement park. I had heard so much about this train which travels at 400 kilometres an hour. I never thought of taking it because typically someone is there to pick me up at the airport. In 2008, when I was driving from the airport back to my hotel, I heard this train zipping past me like zip. I was like what is this going on? It really feels like a bullet passing you by when you are going by the car. So I decided I have got to try this thing out. When we tried it out, it was a fascinating experience though you have to go out of the way to take the train. In the business class cabin there was nobody else there other than me and my colleague. And you have this fancy stewardess who comes and sort of buys the ticket for you. When you are on the train because it’s a levitation act you just feel zero friction. Outside the train zips past you, but inside you don’t feel as if anything is going on. It’s completely still.
But what is the broader point you were trying to make through this example?
The broader point is that no other country in the world will think of experimenting like this. But they have been investing at such a huge pace that they try out these experiments as well. When I asked why has this not been replicated in other parts of China, and I got all sorts of explanations. One was that now we get environmental protests because it goes through very close to some of the places. This is very new to China that you have got people who are protesting and saying we don’t what this to happen. The fact they are not extending this train to everywhere because it does not make logical sense from the economic point of view. This shows the Chinese thinking also that listen that how much can we keep spending on these things.
You call India and Brazil very high context societies. What is that?
This is a term that the anthropologist Edward Hall came up with. It would always strike me when I went to India and Brazil about the commonalities between the two countries. Someone says you come for dinner and the dinner won’t start till 9.30-10pm. And everyone sort of came late. I go to Brazil every year and in 2008 I heard about this serial called A Passage to India which was a huge hit in Brazil. People were talking about it in the party circles and I was like I want to see this serial. I figured out that it is a soap opera, and people are hooked to it at nine o clock at night. The whole thing is a love story set in Jodhpur and Agra, and the actors were all Brazilians in Indian garb, and they looked pretty much North Indian to me.
The latest item girl in Bollywood is a Brazilian…
Really? You can’t make out the difference very often. And that’s my entire point. There are many parallels. So all this was fun but what was the economic point coming out of it? I hope India does not go down the Brazil way with similar cultural habits of having a welfare state where you want to protect people. At that point of time the government spending in India was beginning to really take off and now it’s clearly sort of very high.
You even hint at India going the Brazilian way of hyperinflation…
This thing of having minimum wages and having them indexed to inflation, all these are traits through which a country like Brazil went down. The fact is that we have found inflation to be more sticky than it should be. This is happening because of all these welfare schemes being put into place. My whole thing is that you just can’t take this for granted. But just because it hasn’t mattered in the past does not mean that it won’t matter in the future.
What is your view on the S&P’s change in outlook on India?
It’s consistent with the fact that we need to obviously get these things under control before we begin to lose the plot.
You also say in the book that India has too many billionaires given its size. What is the point you are trying to make there?
Wealth needs to be celebrated. It is an integral part of a capitalistic society to have billionaires. But when I look at the number of billionaires we have in comparison to the rest of the world, it does seem a bit high. If we had new wealth being created and had new billionaires coming up, that would be a healthy sign. But if it is the same set of people holding onto their wealth, it is not a healthy sign. In the last five years the churn has gone down in comparison to what used to be. And you want high churn to take place because you know then new people are coming in. Also you want billionaires to come from industries which are celebrated because of the general entrepreneurial talent like technology, manufacturing etc, and not from places where the government is issuing licenses . If you look at other countries which have a high share of billionaires compared to the size of their economies they are all countries where cronyism is rampant. Like Russia and Malaysia. And if you look at the countries which have made economic success models in the past, the wealth of the billionaires as a share of their economy is relatively low. This is because to create up an environment conducive for the opening up of the economy, for reform and for wealth generation, you have to have this perception that it is being done in a fair manner.
Can India be a breakout nation?
I think so. I give India a 50:50 chance because expectations have now become lower to 6-7% GDP growth and that at least lowers the bar from growing at the rate of 8-9%, which is a very high bar. Most countries I have categorical stand which is I like I don’t think that Russia and Brazil are on my list of breakout nations. It is a clearly a negative take on them. There is relatively positive take on many of the South East Asian countries and Eastern European countries. But I think in India I am sort of caught in the middle. I see the positives taking place when I travel outside of Delhi, I go to the states. The whole India chapter in the book is about the fact that as the Southern States have dropped off in the growth statistics, but the Northern States which you never thought would do well, from Bihar to even Chattisgarh, are doing well.
I have lived in Bihar for almost 20 years. It is growing from a very very low base, and that’s why the high rate of growth.
Exactly. That is my point on India to you, which is that India’s biggest benefit for becoming a breakout nation is the fact that its base is so low. It is true of India. So what you say of Bihar in an Indian context is true of India in a global context, which is what gives India a 50:50 chance even though the policy makers keep messing it up at the top. As you know with Bihar the base has always been low. But obviously something has happened in the last seven years that the state has started to change.
In the last section of your book you talk about something called the commodity.com. What is that?
My whole point is that the world has developed for years and years and centuries and commodities have followed a very predictable pattern, which is that they go up for one decade and they go down for two decades because new technology, human ingenuity always come up triumph any demand burst that comes through. Yet at this stage all people think that commodities are in some sort of a super cycle that And one sort of stunning statistic that stood out for me is that in 2001 the world has twenty nine billionaires in the energy industry, seventy five in tech. By 2011, the situation had reversed, with thirty-six in tech and ninety one in energy, mostly in oil.
What is the point you are trying to make?
Why should you have so many billionaires out of commodities because all you are doing is digging dirt out of the ground? You are not doing something that is really smart and innovative. This is complete nonsense when you have so many billionaires coming out this sector. You can have a few. These are signs at the peak of any trend when it looks like that this trend is going to go on forever. But those lofty expectations have their own undoing. Along with all this comes my argument that China’s growth is about to graduate to a lower plane. And China is the 800 pound gorilla of the commodity market.
Why do you see the China-commodity connection falling apart soon?
Basically everyone says that China has to grow so it needs commodities. My point is again about expectations. If China’s growth falls to 6-7% as I think it may on a medium term basis, a lot of the investments, a lot of things will appear to be excessive. So China may grow but the demand for commodities could come of very significantly. So steel, copper etc could all face oversupply in the coming years.
One of the things you talk about in your book is that while central banks can print all the money they want, they can’t dictate where it goes…
Exactly. Even in India this whole sort of thing spread…and till date I get some of these questions that we have all this liquidity in the world, central banks are pumping it, you know it has to come here in search of opportunities where else is it going to go. And my point is that it can go into all sorts of wrong places like a lot of it has gone into oil, lot of it has gone into commodities, has gone into people buying fancy wine, luxury goods, gold etc Central banks have put all that money out there because they want growth to revive that the reason for doing it. But you can’t control it. You don’t know where it ends up.
(Vivek Kaul is a writer and can be reached at [email protected] A slightly different version of the interview appeared in the Daily News and Analysis, April 30, 2012)
“Did I say I’ll be back, when I left?” I asked.
“No,” she replied. “’You just said, this is the end my beautiful friend.”
“Ah! Jim Morrison had me doped.”
“Never mind,” she said. “Hope this time you are back for good.”
“That time will tell,” I replied cheekily.
“You are still as fickle minded as the stock market.”
“Well, there is clearly some logic in the way the stock markets operate. Just that it is not obvious to everyone.”
“Ah. There you go V, blowing your own trumpet!”
“Let me explain.”
“Please go ahead.”
“Let’s start with Spain where all the trouble seems to be concentrated these days. There benchmark index IBEX 35 is down around 10% since the beginning of this year and is down 30% over the last one year.”
“Their banks are in big trouble. The stock price of their biggest bank Banco Santander has fallen 18% over the last one month and 45% over the last one year.”
“But why?” she interrupted again.
“Spain had the mother of all housing bubbles! It currently has as many unsold homes as the United States (US), even though the US is six times bigger than Spain.”
“Oh! I didn’t know that.”
“Yes. And even though Spain contributes only 12% of the gross domestic product of the European Union it accounted for 30% of all homes built in the EU since the turn of the century.”
“And all this construction must have been financed by loans from banks?”she asked.
“Yes. Loans to developers and construction companies amount to nearly 50% of the $1.4trillion Spanish gross domestic product (GDP). Of course, with homes lying unsold developers cannot repay their loans and this means the banks are in trouble. And Spain’s banks are too big. In fact the asset size of the three biggest banks in Spain is around $2.7trillion, twice of their GDP,” I explained.
“So if banks go bust, Spain goes bust!”
“Exactly! And Spain is not the only country in trouble. Other European countries are not doing too well either. This has an impact on China because Europe is China’s biggest trading partner. Exports to Europe in March were down 3.1% in comparison to last year. Chinese exports had ranged between $475billion and $518billion in the last three quarters of 2011. In the first three months of this year the number has fallen to $430million. The Shanghai Composite, China’s leading stock market index fell by 6.8% in the month of March.”
“So a slowdown in Europe is having an impact on China?”
“Yes madam! Profits of Chinese companies were also down for the first two months of 2012.”
“So a slowdown in Europe, slows down China. What happens next?” she enquired.
“That in turn has an impact on Australia. Australian exports to China in 2011 stood at A$72billion (Australian dollar), up 24% from 2011. Now around 26% of Australian exports are to China. An ever expanding China bought coal, iron ore and natural gas from Australia, driving up Aussie exports. But exports for the month of February fell to A$24.4 billion, the lowest in an year. Coal exports were down by 21% to A$3.4billion.”
“All because of a slowdown in China,” she concluded.
“Yes. The other country which has suffered because of a slowdown in China is Brazil, which has been enjoying an economic boom to a huge demand for crude oil and agricultural products. A slowdown in China impacts any commodity exporting country because prices tend to fall as China consumes less. But that is not the only reason by Brazil’s exports have fallen.”
“So what is the major problem?”
“The major problem is an appreciating Brazilian currency. The central banks of United States, Japan and Great Britain have been running zero interest policies, in the hope of reviving their own economies. But what this has done is that international investors have been borrowing in these countries and taking the money into emerging markets like Brazil to invest there. When they come to Brazil with their dollars, they need to sell those dollars and buy the Brazilian real. This leads to an increase in demand for Brazilian real and hence the value of the real appreciates against the dollar, which in turn means that the Brazilian exports become expensive. Hence, the Brazilian Bovespa, the premier stock market index of Brazil has fallen 7.4% over the last one month,” came a long explanation from my end.
“Interesting, the way it’s all linking up!”
“So Europe slows down leading to China slowing down and then Australia slows down as well. Brazil slows down because of China and the United States. In the United States elections are due in November this year. If Obama is re-elected tax on long term capital gains could increase to 20% and income tax rates are also likely to rise as tax cuts initiated George Bush junior may be allowed to expire. The stock market of course won’t like this.”
“But what about India?”
“Do I need to say anything? We are in a big mess to say the least! And the state of the Indian stock market is largely decided by the foreign investors. If they are not feeling good about things, the Indian stock market will not go anywhere. In the last one month the BSE Sensex has been almost flat.”
“Hmmm. As my former boss used to ask, so what is the takeaway?” she asked.
“Things are not looking good all over the world.”
“So, is there any hope?”
“Yup, there always is. Ben Bernanke may come to the rescue with another round of money printing, technically now called quantitative easing. That is possible because it is an election year in America, and past Chairman of the Federal Reserve have helped incumbent Presidents fighting elections by running an easy money policy before elections. This money could find its way into stock markets around the world and juice up returns,” I replied.
“But that may or may not happen. So what does one do now?”
“An old stock market saying goes “sell in May, go away! It is time to change that to April!”
(Vivek Kaul is a writer and can be reached at [email protected])
(The article appeared in the Daily News and Analysis on April 23,2012. http://www.dnaindia.com/analysis/column_sell-in-may-oops-april-and-go-away_1679339)
Endgame – The End of Debt Supercycle and How it Changes Everything, John Mauldin and Jonathan Tepper, John Wiley &Sons. 2011
Minefields that can Blow-up Global Stock markets in 2012, Gary Dorsch, April 12, 2012, www.sirchartsalot.com