Rahul Deodhar's Blog, page 22
October 15, 2011
Can China become a Consumer-economy quickly?
In its latest issue The Economist says
I contend that it is not easy to create a domestic-demand focussed economy or consumer economy as we call it. In my June 2009 post titled "China domestic demand and other notes", I explained:
What is a consumer economy?
I must reiterate that consumer-economy is not a simple concept. It represents a system with various parts many contradicting the political climate in China.
Principle of Choice: Consumer economy is under-pinned by a principle of choice. The consumers get choice and their choosing creates a feedback loop that allows such preferences to be incorporated into national manufacturing and service capacities. Let me give and example.
Imagine a population that fancies, say, sour cream flavoured potato chips, but without any chips manufacturing capacity it does not yet know of it. Manufacturers must experiment with various flavours and then, by trial and error, or through research, arrive at this conclusion. This implies a cycle of investment in various flavours which gets wasted, stock outs of preferred flavours and large inventories of less preferred ones etc.
Principle of Consumer orientation: A consumer economy must necessarily be consumer oriented. I am sure you have noted the pun but people often forget this. Existence of choice necessitates competition and, hopefully, benefit of the consumer rises to the top of priority list. This seemingly simple mechanism is very difficult to implement. Milk producers can collude in using hormones or additives that may be detrimental to consumers and rival producers should feel free to expose such practices rather than cower and join forces with them.
Institutions of dispute resolution: A mechanism of choice and consumer orientation, as discussed above, leads to disputes and conflicts. A system of institution is required for resolution. Independent courts and free press are part of such institutions.
Political implications
Thus we observe the congruence between democratic principles in political systems and consumer orientation in economic systems. Both these systems feed off each other and reinforce each other. In the democratic world, we almost take this congruence for granted. It is this congruence that is critical problem for Chinese authorities. Therefore I don't believe the process of reorienting China into a consumer economy is going to be easy without corresponding political reform. But we can always wait and watch, I will be happy to be proven wrong.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
It would hasten the reorientation of China's economy from exports to consumer spending, give its central bank more freedom to fight inflation, and divert demand to depressed Europe and America, catalysing an essential rebalancing of the global economy.
I contend that it is not easy to create a domestic-demand focussed economy or consumer economy as we call it. In my June 2009 post titled "China domestic demand and other notes", I explained:
Creating domestic markets is not easy and does not simply happen by throwing capital. Domestic tastes and preferences, as we see in India, are lot different than we anticipated. Same logic should hold for China. It is easier to customize goods (and services like restaurant services) are easy to manage – but inflexible goods (capital goods e.g.) take long time. The changes cascade from consumer side till they reach the top end. Examples:
A large part of textile industry may be geared to service cotton clothes – whereas Chinese might prefer silk. (OK I simplified it a bit too much)
You take milk, some producers added some hormones to aid milk production. Resulting milk was not safe for children. Now we need institutions, legal, regulatory etc that create a feedback system to discover and curb such practices. These complex frameworks anchors in democratic setup – leading us to political minefield.
If someone clarified the entrepreneurial scene – we may actually get better clues about domestic demand. Large entrepreneurial pool backed by venture funds experimenting with products and distribution is the best way to create (and an indicator for thriving or potentially thriving) domestic market.
The easiest part of domestic demand stimulus is to allow top brands to enter the domestic market and give them some price leeway through currency appreciation. Louis Vitton bags, Chanel perfumes etc will kick start domestic consumption faster.
What is a consumer economy?
I must reiterate that consumer-economy is not a simple concept. It represents a system with various parts many contradicting the political climate in China.
Principle of Choice: Consumer economy is under-pinned by a principle of choice. The consumers get choice and their choosing creates a feedback loop that allows such preferences to be incorporated into national manufacturing and service capacities. Let me give and example.
Imagine a population that fancies, say, sour cream flavoured potato chips, but without any chips manufacturing capacity it does not yet know of it. Manufacturers must experiment with various flavours and then, by trial and error, or through research, arrive at this conclusion. This implies a cycle of investment in various flavours which gets wasted, stock outs of preferred flavours and large inventories of less preferred ones etc.
Principle of Consumer orientation: A consumer economy must necessarily be consumer oriented. I am sure you have noted the pun but people often forget this. Existence of choice necessitates competition and, hopefully, benefit of the consumer rises to the top of priority list. This seemingly simple mechanism is very difficult to implement. Milk producers can collude in using hormones or additives that may be detrimental to consumers and rival producers should feel free to expose such practices rather than cower and join forces with them.
Institutions of dispute resolution: A mechanism of choice and consumer orientation, as discussed above, leads to disputes and conflicts. A system of institution is required for resolution. Independent courts and free press are part of such institutions.
Political implications
Thus we observe the congruence between democratic principles in political systems and consumer orientation in economic systems. Both these systems feed off each other and reinforce each other. In the democratic world, we almost take this congruence for granted. It is this congruence that is critical problem for Chinese authorities. Therefore I don't believe the process of reorienting China into a consumer economy is going to be easy without corresponding political reform. But we can always wait and watch, I will be happy to be proven wrong.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
October 8, 2011
Understanding the behaviour of the US Dollar
I have often written about mainstream media missing the bigger picture about the US Dollar. I always wondered how some of the astute commentators, some I respect highly, would miss the bigger picture. I have been asked why, despite my talk about US macro weakness, does the USD appreciate in times of risk aversion. I think I should take one more shot at explaining one aspect of the US Dollar issue.
Dollar behavior is aggregate of multiple forces
The US dollar is influenced by following forces:
Adjustment of US economic activity in terms of skill, ability and productivity of the population.
With rising capital intensity the minimum qualification requirements are changing. This change is not in sync with the US population in terms of availability of skill, ability and productivity.
I know some people will react to inclusion of productivity in the list, but careful assessment will indicate its aptness.
This adjustment is rather complex and will take years to play out. Thus the effect of this force, my guess is, will be rather small at the moment. However, once the realization is complete, there may be a drastic impact on the US Dollar.
This force will augment a devaluation of US dollar.
In geek-speak, since force is a vector, both the magnitude and direction of this force are not manifesting itself effectively as yet. The magnitude is small and direction may be opposite to what can be expected.
Forces creating adjustment of prices.
The term price has two elements to it. First one represents the information about how relative value of goods and services stack up against each other, or simply inter-goods comparison. The Second and more relevant for us is the information about how the value of goods stack up in relation to those in other countries, or simply, price comparison between countries for similar goods.
My sense is that relative prices of non-food goods and services are far cheaper in developed economies than in emerging market economies (though not for all products and services).
As we establish clarity in this, we will see inflation in USD terms while deflation in other currencies if they let their currencies float to their natural level. However many countries have pegged currencies, particularly those with large dollar reserves. The pegging process will create inflationary forces in these countries as well. Their central banks thereafter will be forced to choose between inflation and losses on external account. It appears they will prefer losses than inflation.
This will be devaluing force for the US dollar.
Risk Aversion forcing the US Dollar denominated money to return home.
One of the tenets of risk aversion is that during such times investor feels safer at home, keeping money in her own currency. It is a fact that US has been biggest investor for some time now and hence risk aversion creates a demand for dollars.
The fact to be noted is that this is mostly private investment and hence more fickle.
This force is supporting the US dollar.
At the moment, this force has the right magnitude and direction to support US Dollar appreciation.
Subdued Capital withdrawal by those with US Dollar reserves - particularly China and Japan.
For reasons best known to them China and Japan have continued to pledge their support to the USD. China with nearly 3.2 trillion USD and Japan with 1.1 trillion hold considerable sway in the market.
Here the investments are initiated by the respective governments and thus more stable but changes can be abrupt. It is sort of a dormant volcano, if it erupts, there will be tremendous loss. Similarly, if, for any reason, any tiny bit of doubt crops up in these governments, we will see tremendous meltdown.
Interpreting US Dollar movement
It is important to know the forces above and what impact they have on the US Dollar movements. We realize that most of the devaluation forces are diffused and their magnitude is small. However, a keen investor will realize that the alignment between these forces is increasing and we may soon reach a tipping point in favor of devaluation. Further, the forces supporting the US Dollar are fickle and may reverse quite quickly.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
Dollar behavior is aggregate of multiple forces
The US dollar is influenced by following forces:
Adjustment of US economic activity in terms of skill, ability and productivity of the population.
With rising capital intensity the minimum qualification requirements are changing. This change is not in sync with the US population in terms of availability of skill, ability and productivity.
I know some people will react to inclusion of productivity in the list, but careful assessment will indicate its aptness.
This adjustment is rather complex and will take years to play out. Thus the effect of this force, my guess is, will be rather small at the moment. However, once the realization is complete, there may be a drastic impact on the US Dollar.
This force will augment a devaluation of US dollar.
In geek-speak, since force is a vector, both the magnitude and direction of this force are not manifesting itself effectively as yet. The magnitude is small and direction may be opposite to what can be expected.
Forces creating adjustment of prices.
The term price has two elements to it. First one represents the information about how relative value of goods and services stack up against each other, or simply inter-goods comparison. The Second and more relevant for us is the information about how the value of goods stack up in relation to those in other countries, or simply, price comparison between countries for similar goods.
My sense is that relative prices of non-food goods and services are far cheaper in developed economies than in emerging market economies (though not for all products and services).
As we establish clarity in this, we will see inflation in USD terms while deflation in other currencies if they let their currencies float to their natural level. However many countries have pegged currencies, particularly those with large dollar reserves. The pegging process will create inflationary forces in these countries as well. Their central banks thereafter will be forced to choose between inflation and losses on external account. It appears they will prefer losses than inflation.
This will be devaluing force for the US dollar.
Risk Aversion forcing the US Dollar denominated money to return home.
One of the tenets of risk aversion is that during such times investor feels safer at home, keeping money in her own currency. It is a fact that US has been biggest investor for some time now and hence risk aversion creates a demand for dollars.
The fact to be noted is that this is mostly private investment and hence more fickle.
This force is supporting the US dollar.
At the moment, this force has the right magnitude and direction to support US Dollar appreciation.
Subdued Capital withdrawal by those with US Dollar reserves - particularly China and Japan.
For reasons best known to them China and Japan have continued to pledge their support to the USD. China with nearly 3.2 trillion USD and Japan with 1.1 trillion hold considerable sway in the market.
Here the investments are initiated by the respective governments and thus more stable but changes can be abrupt. It is sort of a dormant volcano, if it erupts, there will be tremendous loss. Similarly, if, for any reason, any tiny bit of doubt crops up in these governments, we will see tremendous meltdown.
Interpreting US Dollar movement
It is important to know the forces above and what impact they have on the US Dollar movements. We realize that most of the devaluation forces are diffused and their magnitude is small. However, a keen investor will realize that the alignment between these forces is increasing and we may soon reach a tipping point in favor of devaluation. Further, the forces supporting the US Dollar are fickle and may reverse quite quickly.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
September 17, 2011
A World Central Bank
An esteemed group of economists' has recommended:
While this is still recommendatory in nature, it has pricked a few ears already. The implied loss of sovereignty is the usual contentious issue. However there are a few issues.
The global nature of banking and finance implies that regulatory and policy mechanisms be equally global. Such realities compel a kind of global cooperation that may not work without appropriate legal support. The financial system, in this regard, has become similar to international navigation, global climate or such other global systems.
The legal support, possibly in the form of treaties accepting the global policy direction, may indeed reduce the sovereign freedom a nation enjoys.
A solution, I believe, will be to create a global monetary policy with a new two-level global currency system. This system should allow the national central bankers to create a monetary policy based on specific national requirements.
The global currency to signal confidence in national monetary policies. Each national currencies will be valued in terms of a global currency based on various factors. One of the factors will be their alignment with global monetary policy. Thus a country that has a relatively expansionary policy will see a currency devaluation.
Such system incorporates, to my mind, the benefits of a gold based currency system while limiting (or possibly eliminating) its deflationary effects.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
the creation of an International Monetary Policy Committee composed of representatives of major central banks that will report regularly to world leaders on the aggregate consequences of individual central bank policies.
While this is still recommendatory in nature, it has pricked a few ears already. The implied loss of sovereignty is the usual contentious issue. However there are a few issues.
The global nature of banking and finance implies that regulatory and policy mechanisms be equally global. Such realities compel a kind of global cooperation that may not work without appropriate legal support. The financial system, in this regard, has become similar to international navigation, global climate or such other global systems.
The legal support, possibly in the form of treaties accepting the global policy direction, may indeed reduce the sovereign freedom a nation enjoys.
A solution, I believe, will be to create a global monetary policy with a new two-level global currency system. This system should allow the national central bankers to create a monetary policy based on specific national requirements.
The global currency to signal confidence in national monetary policies. Each national currencies will be valued in terms of a global currency based on various factors. One of the factors will be their alignment with global monetary policy. Thus a country that has a relatively expansionary policy will see a currency devaluation.
Such system incorporates, to my mind, the benefits of a gold based currency system while limiting (or possibly eliminating) its deflationary effects.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
September 7, 2011
Limits to total capital in the system
One of the implication of the crisis is that there is a limit to total capital in the system. While the statement is simplistic, it has more sophisticated underpinnings. In a sense, we collectively found that there is too much capital in the system and too little stock of assets, goods, services etc (hereafter simply referred as assets and goods) to show for it.
Clearly at some point we realized that our stock of assets and goods contains too many derivatives and too few real assets and goods. At such point the capital locked in or residing in some of these derivatives (the bad ones specifically) was under risk. Economists would call this misallocated capital. This capital should have evaporated in a true capitalist system so as to keep the Darwinian selection mechanism healthy.
Yet, what happened was transfer of this mal-investment to government and hence to public shoulders. By virtue of the fact that governments cannot be obliterated, the capital must also continue to burden us till the government sees light of the day.
Whatever the reality, the crisis does indicate a threshold for level of capital in the global economy where things are at equilibrium. The questions are many.
How can decipher the exact amount of capital stock existing in some secular value terms? How can the world estimate the collective stock of assets and goods to correspond to this stock of capital?
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
Clearly at some point we realized that our stock of assets and goods contains too many derivatives and too few real assets and goods. At such point the capital locked in or residing in some of these derivatives (the bad ones specifically) was under risk. Economists would call this misallocated capital. This capital should have evaporated in a true capitalist system so as to keep the Darwinian selection mechanism healthy.
Yet, what happened was transfer of this mal-investment to government and hence to public shoulders. By virtue of the fact that governments cannot be obliterated, the capital must also continue to burden us till the government sees light of the day.
Whatever the reality, the crisis does indicate a threshold for level of capital in the global economy where things are at equilibrium. The questions are many.
How can decipher the exact amount of capital stock existing in some secular value terms? How can the world estimate the collective stock of assets and goods to correspond to this stock of capital?
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
September 4, 2011
Importance of Jobs and certainty
The recent US job report had zero new additions. In that context, I would like to discuss a briefly about importance of jobs and certainty.
Time and again I have emphasized that it is the certainty rather than specific level of income that is important objective of stimulus. Any stimulus directed elsewhere is of little significance. Thus, tax breaks, cash-for-clunkers kind of programs have little meaning as tools of stimulus. Both, as the population is aware of their limits, create an incentive to save the gains rather than kick start the consumption engine.
Jobs, specifically long term permanent jobs, are indicators of certainty of income available to the population.
It is also possible for the economy to add transient jobs in large numbers. In other words, there would be a high turnover. Such a situation will have high uncertainty and high job creation at the same time. Thus, I presume, the impact would be similar to tax-breaks or cash-for-clunkers type of program.
The real point of improvement of the economy will be when permanent job addition bottoms out and starts rising. At such point the consumption engine will restart sustainably. This process will happen eventually if economy is left to its own devices. The objective of stimulus is to hasten the process.
A debt-ridden economy take a little longer to reach the bottom after permanent job addition has bottomed. The time lag is explained by the debt repayment that takes place subsequent to job addition. A debt restructuring program can hasten this process. HAMP and other programs can be classified in this family.
Now intelligent readers will note that unless BOTH things happen we won't see noticeable recovery in the economy. I hope the political intelligence catches on this reality.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
Time and again I have emphasized that it is the certainty rather than specific level of income that is important objective of stimulus. Any stimulus directed elsewhere is of little significance. Thus, tax breaks, cash-for-clunkers kind of programs have little meaning as tools of stimulus. Both, as the population is aware of their limits, create an incentive to save the gains rather than kick start the consumption engine.
Jobs, specifically long term permanent jobs, are indicators of certainty of income available to the population.
It is also possible for the economy to add transient jobs in large numbers. In other words, there would be a high turnover. Such a situation will have high uncertainty and high job creation at the same time. Thus, I presume, the impact would be similar to tax-breaks or cash-for-clunkers type of program.
The real point of improvement of the economy will be when permanent job addition bottoms out and starts rising. At such point the consumption engine will restart sustainably. This process will happen eventually if economy is left to its own devices. The objective of stimulus is to hasten the process.
A debt-ridden economy take a little longer to reach the bottom after permanent job addition has bottomed. The time lag is explained by the debt repayment that takes place subsequent to job addition. A debt restructuring program can hasten this process. HAMP and other programs can be classified in this family.
Now intelligent readers will note that unless BOTH things happen we won't see noticeable recovery in the economy. I hope the political intelligence catches on this reality.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
August 18, 2011
India view: Brace for flood of money
I must be sounding ridiculous but that is exactly what I expect to happen in near future. If the developed world investors are keen to retain their wealth, which they are, they will want to move to economies where conventional growth is still possible.
Conventional and unconventional growth
Conventional growth refers to well understood process of growth. In the emerging economies, we know what needs to be done. We need to build infrastructure, power plants etc. That investment will trigger efficiencies which will push EM economies on to a growth path. The history of development of the western world provides the understanding of this process and there is ample evidence as to what works and strategies for growth. This is the opportunities wealth retaining funds will eventually seek as compared to unconventional growth in developed markets.
I have argued previously that growth in developed markets will depend on two forces. The first is renewal and maintenance of infrastructure that already exists and second refers to the new kind of infrastructure and development that is essential. The new kind is uncharted territory and requires patient capital the likes we deploy in R&D. Possible candidates are Water-related infrastructure and forestation related investments. I call them Green and blue options. These investments are more of the Private equity variety than what normal funds would like.
The coming money flood in EM
The money eventually has to move to EMs before EM economies adjust their currency regimes reacting to resultant imported inflation. That implies funds will compete to reach EM shores, in all probability, creating a sharp uptick in EM equity markets.
My strategy
I am going all in as the markets decline. My focus is domestically driven revenues. It means I am avoiding Indian IT companies for strategic reasons. I find Indian consumer goods firms a bit over-valued, though I own telecom stocks as proxy for consumption story for short term. My focus is on infrastructure stocks (GVK, L&T) and banks. I am not very sure about Indian asset valuation story so I am staying away from real estate (except for occasional short term high risk investments in Unitech which appears to be below its liquidation value). I expect the sector to start turning around when housing deals start happening on ground. I believe that should take 3-5 years at least. However, I do like Indian Hotels which, I believe to be a well managed company with sensible management. I do expect domestic auto firms (Tata Motors, Ashok Leyland and Maruti) to become big players in the coming decades and their current valuation provides a good entry point. In all above cases I am betting on liquid names and large volume stocks only.
It is possible that I am early and will need to hang on to the strategy for a little while. Let us see how things go from here.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
Conventional and unconventional growth
Conventional growth refers to well understood process of growth. In the emerging economies, we know what needs to be done. We need to build infrastructure, power plants etc. That investment will trigger efficiencies which will push EM economies on to a growth path. The history of development of the western world provides the understanding of this process and there is ample evidence as to what works and strategies for growth. This is the opportunities wealth retaining funds will eventually seek as compared to unconventional growth in developed markets.
I have argued previously that growth in developed markets will depend on two forces. The first is renewal and maintenance of infrastructure that already exists and second refers to the new kind of infrastructure and development that is essential. The new kind is uncharted territory and requires patient capital the likes we deploy in R&D. Possible candidates are Water-related infrastructure and forestation related investments. I call them Green and blue options. These investments are more of the Private equity variety than what normal funds would like.
The coming money flood in EM
The money eventually has to move to EMs before EM economies adjust their currency regimes reacting to resultant imported inflation. That implies funds will compete to reach EM shores, in all probability, creating a sharp uptick in EM equity markets.
My strategy
I am going all in as the markets decline. My focus is domestically driven revenues. It means I am avoiding Indian IT companies for strategic reasons. I find Indian consumer goods firms a bit over-valued, though I own telecom stocks as proxy for consumption story for short term. My focus is on infrastructure stocks (GVK, L&T) and banks. I am not very sure about Indian asset valuation story so I am staying away from real estate (except for occasional short term high risk investments in Unitech which appears to be below its liquidation value). I expect the sector to start turning around when housing deals start happening on ground. I believe that should take 3-5 years at least. However, I do like Indian Hotels which, I believe to be a well managed company with sensible management. I do expect domestic auto firms (Tata Motors, Ashok Leyland and Maruti) to become big players in the coming decades and their current valuation provides a good entry point. In all above cases I am betting on liquid names and large volume stocks only.
It is possible that I am early and will need to hang on to the strategy for a little while. Let us see how things go from here.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
August 8, 2011
Realignment: Ratings and relative risk stack
Investors think of risk associated various assets (across classes) in relative terms. We have a notional relative assessment - A is riskier than B but C is more risky than A etc. This applies to asset classes and specific assets within them. So Manhattan land parcel may be riskier than NY state debt etc.
Thus, we have a stack of assets. We can imagine this as a deck of cards that the investor carefully aligns according to their risk profiles. On one side, lets say the bottom of the deck of cards, we have less risky and they get progressively more risky as we reach the other end, i.e. the top.
The S&P ratings change signals a change in the order of this stack - sort of shuffling of the cards. Some investors believe that shuffling happened a long time ago and S&P is just highlighting it. Others believe there has been no shuffling of the deck and previous order remains valid.
In essence, each investor is making his or her own assessment. We are all on our own.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
Thus, we have a stack of assets. We can imagine this as a deck of cards that the investor carefully aligns according to their risk profiles. On one side, lets say the bottom of the deck of cards, we have less risky and they get progressively more risky as we reach the other end, i.e. the top.
The S&P ratings change signals a change in the order of this stack - sort of shuffling of the cards. Some investors believe that shuffling happened a long time ago and S&P is just highlighting it. Others believe there has been no shuffling of the deck and previous order remains valid.
In essence, each investor is making his or her own assessment. We are all on our own.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
August 6, 2011
Answers to Barry Ritholtz's 10 questions about S&P downgrade
Barry Ritholtz asks 10 questions about S&P downgrade and I answer most of them below:
Here it goes:
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
Here it goes:
1. The change in trajectory of US debt was in service of Banks: It began with TARP, and continued with every other bailout/stimulus/economic plan. What was S&P's role in creating that crisis?
S&P is centrally responsible. So are US regulators, banks and those crying hoarse. Let us remember there is plenty of blame to go around for GFC.
2. How will non-US investors (Private and Central Banks) view the downgrade?
Most non-US investors already discount the news. However, investment strategies will compel some to act if another agency downgrades.
4. What does the downgrade do to US currency — is that the true impact of the credit downgrade?
Over 5 year horizon I think USD will begin to decline. A declining dollar is in the interest of US. It will reinforce US manufacturing. Immediately, though, flight to cash and commodities seem to be possible options.
5. Will borrowing costs likely increase for the US? What about consumers?
Borrowing costs for US entities will increase. I suspect the ability to pass on these cost to consumers will remain under pressure. Consumer rates, after accounting for all adjustments, a quite high. It will impact borrowing cost of investors, leverage will be difficult to come by.
8. Why did the rating agency not wait until the special committee / debt ceiling deal was completed later this year?
I think the rating rationale was more political than financial – more related to "willingness to pay" rather than "ability to pay". The debt committee would have done more related to "ability to pay". The statements by politicians about "debt ceiling debates hereafter should be conducted this way", "maybe default is a good option" etc. makes one really skeptical of US governance. You see such things in banana republics not US – definitely not a behaviour of AAA rated sovereign.
9. The Rating Agencies were downgraded by Dodd-Frank, with all regulatory and legal references to be removed. Was S&P's move retaliatory?
I don't think so.
10. How will US markets open on Monday in response to the downgrade?
Move to cash and commodities could be a good idea to bet on. Though one can never be adequately sure.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
Impact of the US Rating downgrade
The rumours of a downgrade had started during US trading hours, but the actual S&P announcement came post market hours, so Friday's market closing does not reflect the ratings impact.
Immediate impact - is it the last straw?
With concerns on US growth slowdown and EU debt crisis already troubling markets, this is another nail in the coffin. The immediate reaction should be negative: equities sell off, commodities fall, bond yields rally, dollar weakens, safe haven assets (gold, CHF, JPY) appreciate. However, it is not clear if this impact will persist beyond the near term.
On bond yields
Some are arguing that since it was well known that the US would get downgraded, this is priced in and that there may not be much lasting impact. Moreover, Moody's and Fitch still have the US at AAA for now. Analysis of the impact of past rating downgrade of other countries on their long-term yields has shown that yields rose in the days before the downgrade and then either fell or were unchanged after the actual downgrade.
Over a few years, one can expect yields to trend upwards, till the US regains its AAA ratings. If the situation deteriorates further, there is likely to be sustained uptrend in the bond yields.
Money moving out of US treasuries
The US downgrade raises two medium-term issues with respect to money movement.
First, the downgrade will accelerate the already ongoing trend of reserve diversification away from the US dollar. Confidence in dollar's reserve status will be tested by the markets. This may be a slow moving process or in the worst case scenario, this can trigger panic reaction.
Second, some funds may start taking money out of US as they are mandated to invest in AAA only. However, a lot of funds rely on ratings of two agencies and not just one, so this effect may be more prominent if one other ratings agency follows S&P.
Further, the question remains, where will they invest? None of the other AAA rated countries have the size and liquidity that the US markets offer. Norway, Singapore, Australia, Sweden are some of the AAA rated countries where investors could flock and put pressure on their currencies to appreciate.
In such a scenario, people expect this money to move in emerging markets through a diversified investment approach. Thus, post the initial risk aversion shock, they expect EM markets to show positive reaction over the medium term. I do not agree with this. There is no reason to trust Indian or other treasuries over US treasuries.
I think people may shift into commodities. Commodities will start acting like stores of value. Thus, we will see an increase in commodity prices. This will adversely impact EM inflation leading to weakness in EM. EM central banks will be forced to revalue their currencies with respect to USD, triggering the realignment process.
In sum
A lot depends on whether beyond the near-term negative reaction, there is further panic or sanity prevails at some point.
July 20, 2011
Who is a rich?
How do we determine which nation is richer? Normally, we use metrics like GDP, GDP per capita etc. By many metrics the west and developed countries are rich. But are they really rich? I am not sure.
We evaluate wealth or richness at a point in time. As a concept, we have create this utopian set of goods and services that the richest nation must ideally consume. This rich consumption basket includes high quality healthcare, regular electricity supply, cars and automobiles etc. In other words, this basket comprises necessities and comforts. We measure how much a nation needs to spend to achieve this utopian consumption basket, how much it earns and that difference gives us how rich it is.
I disagree.
Let us imagine a nation of chronically ill people. The median income in this nation is 100 units. However, their illness implies that they require 110 units for consumption - 10 units for their needs and 100 units for medications. Now since all the other nations earn a maximum of 20 units, we can say this nation is rich. But other nations are healthy and they only need 10 units - they save 10 units of their earnings. In this case, the other nations are actually richer. Very simply, a nation of savers should be richer than nation of borrowers.
I think at all times, we should be net savers, in high investment phase, the level may be low or nearly zero with positive bias. I think a nation of savers has the option to stop consuming comfort goods while those who borrow set in motion a negative spiral that reduces jobs, hence consumption potential of both comforts and necessities. Importantly, it impairs repayment potential. It is difficult to initiate a turn around.
Asset ownership and dispersion - median asset ownership
Another aspect of debate is asset ownership dispersion as against asset ownership alone. This works just like employment intensity. The more dispersed the asset ownership within the country richer the country. Ideally, median household asset ownership makes more sense. If we look at asset ownership of household and find income generating assets then the country is definitely richer. These could be, saving deposits, equity shares (positive on MTM or yielding reasonable dividends), house that can be rented (fully paid up or rent greater than mortgage payment), vehicles for hire, etc. The consumption goods are TV, computer (used as consumption good rather than income generating asset), vehicle (personal use - not for hire), etc. These consumption goods should be expensed rather than be treated as assets.
Thus, a nation that has higher net assets (total assets less debt) at a median level should be richer.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
We evaluate wealth or richness at a point in time. As a concept, we have create this utopian set of goods and services that the richest nation must ideally consume. This rich consumption basket includes high quality healthcare, regular electricity supply, cars and automobiles etc. In other words, this basket comprises necessities and comforts. We measure how much a nation needs to spend to achieve this utopian consumption basket, how much it earns and that difference gives us how rich it is.
I disagree.
Let us imagine a nation of chronically ill people. The median income in this nation is 100 units. However, their illness implies that they require 110 units for consumption - 10 units for their needs and 100 units for medications. Now since all the other nations earn a maximum of 20 units, we can say this nation is rich. But other nations are healthy and they only need 10 units - they save 10 units of their earnings. In this case, the other nations are actually richer. Very simply, a nation of savers should be richer than nation of borrowers.
I think at all times, we should be net savers, in high investment phase, the level may be low or nearly zero with positive bias. I think a nation of savers has the option to stop consuming comfort goods while those who borrow set in motion a negative spiral that reduces jobs, hence consumption potential of both comforts and necessities. Importantly, it impairs repayment potential. It is difficult to initiate a turn around.
Asset ownership and dispersion - median asset ownership
Another aspect of debate is asset ownership dispersion as against asset ownership alone. This works just like employment intensity. The more dispersed the asset ownership within the country richer the country. Ideally, median household asset ownership makes more sense. If we look at asset ownership of household and find income generating assets then the country is definitely richer. These could be, saving deposits, equity shares (positive on MTM or yielding reasonable dividends), house that can be rented (fully paid up or rent greater than mortgage payment), vehicles for hire, etc. The consumption goods are TV, computer (used as consumption good rather than income generating asset), vehicle (personal use - not for hire), etc. These consumption goods should be expensed rather than be treated as assets.
Thus, a nation that has higher net assets (total assets less debt) at a median level should be richer.
My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.
