Phoenix has risen

The events over the last few weeks only strengthens by belief that socialism is making a come back in political sphere of many countries. Increasing delusion with the way governments are approaching the problem of solving the various monetary and economic issues plaguing the world currently, is the prime reason for this increasing aversion towards unbridled capitalism. Anything in excess is always bad, and over the last decade we have seen the impact of unregulated free markets. We are still trying to come into grips with the same.

The growth of the last decade has been real and illusionary at the same time. The growth in the income levels of people has been strong but the real fruits of the growth has not been spread equally among the population. One of the strong belief's i always had was that the growth has only increased the inequalities within each country, with the sub section of the population taking the cake. This sub section resides in the top most tier of the society with respect to income. To verify if the above assertion is correct, lets have a look at the Gini coefficients of some of the countries,

1. USA : 45

2. Greece: 33

3. Ireland: 32

4. Singapore: 52.2

5. Portugal: 38

6. Italy: 33

7. Ireland: 32

8. China: 46.9

9. India: 36.9

10. Brazil: 56.7

The above data indicates the above countries already have a lot of inequality as far as income levels are concerned. It would be interesting to see how the Gini coefficients varied between 2004 to 2010, however there is no availability of such data. However the general trend among OECD countries has been that the income levels of the top percentage has grown at a rate higher than the rest of the population since 1980. Thus the lead has only increased. This increasing inequality has lead to resentment among the populace during the current downturn. The policies followed by various governments in overcoming the current downturn are inclined towards reduction of various government programs to reduce the deficits. However this decrease in times of low economic growth would only impact the lower strata of the society more that the upper strata. The government budget cuts coupled with the low job availability in increasing discontentment among the lower strata.

This group is increasing resorting to ways by which there thoughts can be heard. This is similar to what happened in Greece, namely the riots in Athens. As long the governments follow policies which are more inclined towards reducing losses for banks and other investors and less towards trying to find a sustainable policy which would lead to increase in job growth, the restlessness among the populace is only going to increase. The offshoots of this restlessness shall be revival of socialist policies and more countries becoming more inward looking. This would herald a stop to the Globalization phase. The earth shall again revert to becoming round from flat for a short period of time.

Fear....Chaos..Confusion..We have not learnt anything

Frankly I have been trying to make sense of whats going on over the last one week and its impact on the future course of events. I am more confused trying to get an idea of it all. Over one week we have seen a return to fears of economic slowdown, US government rating being revised and the intervention of governments to keep their currencies down. Before trying to anticipate the future lets understand what is the impact of each these.

1. Currency interventions

It was only expected that with the slow fall in value of dollar, people are looking at other assets like Gold, Swiss franc and yen. This is creating issues for people and governments of these countries. At the start of the financial crisis, I had commented that the current problems are due to structural problems created due to artificial currencies. Are we in the same mode now, with few countries struggling to keep their currencies in line ? Or are we seeing that the markets are now forcing the governments to correct the structural problem rather indirectly? Continued fall in dollar, would only increase inflationary pressures in countries which have kept their currencies low in order to keep exports competitive. Eventually these countries will have to let their currencies rise. This would mean they need to stimulate their domestic consumption in order to keep their gdp's growing. This is task easier said than done as it is a very painful exercise. an exception to this is EU. A strong euro would destroy whatever chances southern European countries have of having growth. This would only lead to increased pressures which would lead to the EU region breakup.

2. Derating of US

The impact of the fall in the rating of US by one notch will be driven by the need for these export surplus countries to keep their currencies low. This would only help to keep the yields low.But the greater danger is the reluctance of US to increase government spending to support the little growth. In case in face of increased pressures from the Congress, the US government starts decreasing government, spending, then the US economy is in for a big trouble. We will have a case of government de leveraging and public de leveraging happening at the same time. The only way this can be sustained without increasing pain, is if the country attracts investment or if its exports become competitive. Both of which are currently difficult to achieve. A slowdown in US economy would mean, that all the export oriented Asian countries would also face a slowdown.

3. Global slowdown

In case countries still follow the path of the same few countries exporting and the same few consuming as we followed in last decade, we will only aggravate the situation further. The time has come for governments to realise the export/consumption story has run its course. Now the tide has to reverse for equilibrium to be realised again. Consumption in asian countries has to increase and consumption driven countries of the west have to regain their competitiveness.

All the events of the last week are only indicating that the problems which had to be solved at the end of 2008 have only been postponed, we are again back to the same issues. What does this all leave various asset classes, my view is that Gold would keep rising...the fall has only been postponed. Emerging markets which are not balanced but dependent on consumption or export only would face issues.

One of the countries best placed to face the uncertain times in my view unexpectedly is India. The risks India economy faces are more internal than external. If the government gets its act together, in improving investment climate, then we are readily looking forward to a period of strong growth. The uncertain environment would only help in keeping commodity prices low, aiding Indian economy. The big question mark is the Government..what is it going to do?

Is Gold really a store of value?

What makes an asset a store of value? Is it the lack of supply or is its perceived value in the minds of the people. An ideal store of value is an asset which is limited in supply and it is expected to be so at any given point of time especially during times of crisis or afterwards. Lets write down the key features of such an asset,

1. It is limited in supply and its supply is not distorted by market dynamics

2. It is easily fungible and it is recognized across different markets

3. Storage costs are very low and it is easily transportable (not counting security costs)

4. Quality is easily verifiable and defined standards for its quality

5. Ease in buying and selling and has a liquid market (they both are different even though one does not exist without the other)

Now that we have listed down the qualities, lets see if gold is a suitable candidate in the current scenario,

Point 1 is the toughest one, which we tackle in the later part of the blog. Gold strikes "gold" when it comes to points 2,3 .4 and 5. It is an ideal candidate and it is compact and very easy to hold/transport. With increasing technology and growth of the ETF market, the liquidity of the market has only increased. It is very easy to buy gold these days, especially if it is "electronic gold", you just need a demat account to hold it.

Coming back to Point 1, lets have a look at the demand and supply statistics of Gold. The overview of the sector as stated in the Gold Council report for 1Q 2011 is,

" Gold Demand in the first quarter of 2011 totalled 981.3 tonnes, worth US $ 43.7 tonnes. Much of the 100-tonne increase in demand was due to strong growth in the investment sector. We believe suitable conditions remain in place to ensure that investment demand will maintain its sold growth path in coming quarters"

Demand for gold has been quite steady over the last 2-3 quarters at around 1000 tonnes. Important to note that demand fell after the financial crisis primarily driven by the fall in demand for jewellery. This loss of demand for jewellery is as expected. The total demand of gold for investment purposes has been steadily increasing over the last few quarters. The demand for gold bars had peaked during the financial crisis and has been on an increasing trend since then. Gold holdings of ETF's also has been increasing. It is important to distinguish this demand from demand for jewellery, jewellery demand is more consumption in nature rather than investment nature. The only other usage of gold is in the technology sector, which has seen steady demand over the last few quarters.

Lets have a look at the supply side, the total supply from mines has been constant at around 600 tonnes per quarter. The other main supply source is recycling of gold recovered from old fabricated products. One has to note the increase in supply of recycled gold after the financial crisis. This coincided with the rise of gold prices after the financial crisis. Over the last few quarter the supply has been around 1000 tonnes per quarter. This supply matches with the demand. But with increasing demand for gold as an investment, price rise can only be expected as the short fall has to be met by recycled gold.

Now lets envisage a scenario where we are currently facing a sudden economic/financial crisis, could be brought about by european crisis. Now as it has been stated that gold is a store of value, the demand for gold would shoot up, with many people buying gold to store their wealth. Now considering that the supply is limited, the price would shoot up. Till now the crisis proceeds along expected lines. Now once the initial fears become subdued, the supply of gold would shoot up...the supply would not only be from traditional sources but also from all the sources who have bought gold for investment purposes. People would liquidate their ETF holdings to make profits from the high prices and invest the proceeds in other assets to make use of low prices of other asset prices. This would put pressure on the price of gold. So it is it an asset which can store the value??

My view is that the current rise in demand for gold as an investment vehicle has distorted the supply demand dynamics. The price would be driven by investment rather than any other purposes, thus making its value dependent rather than independent. Point 1 has been distorted.

This is similar story of what happened to land as a store of value. Prior to 2008, land has always been viewed as an asset which never loses it value. But with the sudden increase in demand for land as an investment, distorted the value and demand supply mechanics. With a sudden supply coming up post the crisis, the value plummeted and the market became illiquid.

Debt restructuring: is it inevitable

The last two weeks has saw increasing interest in gold and silver among various investor classes. Even jewelery traders have climbed onto the bandwagon of ever increasing prices of gold and silver, you have advertisements by jewelers who have started promising customers "that if they book early then they can buy gold on akshaya tritiya at a price which is lower of the booking day price or the price on akshaya tritiya".

If this is not a sign of irrational exuberance then nothing is. It was only expected with increasing liquidity worldwide that the price of some asset classes is going to rise. So what is going to bring this party to an end,

1. Is it slowdown in growth in most emerging countries due increasing inflation/interest rates,

2. Rate hikes by central banks in EU and US,

3. Another shake up due to government defaults,

I believe this phase of rise in commodity prices is going to come to a end due to point 3 more that anything else. We are having a mismatch in inflation rates across the world, economies which remained unscathed by the 2008 financial crisis are facing increasing inflation and economies which have faced the brunt of the crisis are either facing low growth coupled with high employment and/or high government debts. We still have not fully recovered from the financial crisis and that is because we haven't allowed the crisis to reach its conclusions. The belief that infusing more and more money into the economic system is the only way of solving economic slowdowns has to be critically examined. Easy money increases demand in the short term but the costs of this easy money include increasing cyclicality.

Lets take an example of a company, the company has many subsidiaries, each one contributing to the topline. Each of the subsidiaries has certain level of debt. Now in case the subsidiaries revenue slows down and in case of high leverage this would impact the ability of the ability of the company to repay debt. Now the subsidiaries plans to raise more debt to cover the deficit on interest/principal payments to creditors. How ever these subsidiaries have a unique characteristic, the subsidiaries revenue is dependent on the revenue of the other subsidiaries and the expenses of one subsidiary is an income for other subsidiary. So in case of a slowdown, with creditors pressing for repayment or other conditions in one of the subsidiary, that starts to charge more from other subs and starts cutting its expenses. Because of the inter connectivity between the subsidiaries, this only reduces the topline of the stricken subsidiary and further increases pressure on the payments to creditors.

In case the creditor is one of the other subsidiary which has strong cash and its dependency on debtor subsidiary is not high, then is can raise additional debt to cover its expenses. However this is dependent on the creditor subsidiary not having strong dependency on debtor subsidiary.

In case the creditor is a third party and dependency of the subsidiaries is high, then in case debtor subsidiary tries to cut back its expenses and increase its revenue, then is only causes its revenue to fall further to due to the inter dependency among subsidiaries. This resurfaces the problem of debt repayment problem. One of the ways the subsidiary can solve the problem is to reduce dependency among themselves and restructure its debt so that there is not immediate repayment pressure in the short term.

Case 1 is an example of Japan, where the economy has a strong export economy and the government obtains funding internally due to high savings of the population.

Case 2 is an example of Greece, being a part of Euro, they have reduced chances of being an export competitive economy, this makes it even more difficult for it to reduced inter dependency. This makes it even more necessary for debt restructuring to happen. The earlier it happens the better as it reduces the pain.

However a voluntary debt reduction is not going to happen easily and this eventually would lead to a blow up later on.

Inflationary policies

Pic 2: CPI (source: labour department, RBI)

Pic 1: CPI (Source RBI)

When i was young, still in school, i was always troubled by one question. If government controlled printing of money then why do we have some poor people. The government could just print some more money and distribute it. Then everyone will have money and there shall be no poor people.

My father tried to explain to me the concept of inflation and money supply. Giving money to all does not solve the problem as we are only increasing the availability of money but the number of items available to buy are still the same. This only increases the prices and makes the poor people poor again. I could not understand at that time but now can really relate to the same.

The recent move of the government to increase the wage rates under NREGA and link them to consumer price index reminded me of the dilemma illustrated earlier. There does not seem to be any study done by anyone to understand the impact of NREGA on the purchasing power of rural sector. A search on google for such studies did not yield any result.

In order to understand the impact on NREGA on purchasing power of rural sector, one way could be to understand the rise in inflation in agricultural labour sector vis-a-vis city non labour force. There are two different CPI indices for rural sector, one is for a set of people who derive their income from agriculture and another is a for a set of people who derive their income from rural labour.

During the period from 1998-2005, there has not been much of a difference in these indices (Refer Pic 1). Pic 2 gives an idea about the CPI of agricultural labours, rural labours and urban non labour. Inflation in rural economy has been increasing faster than in urban economy, especially over the last 2 years. This should give a fair idea that the social programs being administered by the government are leading to a rise in purchasing power. The impact of which is being felt in the prices of goods being bought by the rural sector. In this scenario linking wages to CPI would only increase the inflationary pressures in rural economy.

Focus of the government should be in raising purchasing power through productivity, through infrastructure development rather than increasing it through wage rises.

However the observations made in this blog only indirect, a detailed study has to be undertaken to understand the impact of NREGA on rural economy.