Had this phrase from the Spiderman flick been construed properly by the American leaders, the World would have been a different place. On the ethos of the new found all pervasive power of capitalism,the American leaders turned the non-believers of capitalism into their staunch protagonists. However, as has happened with the deterioration of religion by fragmentation into sects and sub sects over the years, the American leaders turned capitalism into debtism and eventually statism which is rightly reflected by Richard Duncan in his wonderful book “The Corruption of Capitalism”.Joseph Schumpeter,the Austrian-American economist had categorically mentioned that capitalism is the cradle of creative destruction,however eventually the same forces would work in such a manner that it will lead to the end of capitalism.In todays scenario, he would not have been very far from the truth. Though out of context, let me quote Lord Krishna in the Gita that'The path of happiness is the path of moderation'. However, I concede that while moderation individually is feasible, collectively is very difficult to practise. Hence all businesses/ economies inadvertently follow the boom and bust cycles which is a direct relation of excesses on either side. Let us now continue from where we left in the previous report and further explore the 2 periods that have changed the way the world does business.
1. Events post breakup of Berlin wall and upto the attack on WTC .
i) German stagflation due to unification and emergence of EURO.
ii) The curious case of the Japanese economy.
iii) The American way of Life-Boon or curse.
iv) The emergence of China and India.
v) The rise and fall of Nasdaq as well as the American real estate market.
i) German stagflation due to unification and Emergence of EURO
As we had discussed, the fall of the Berlin Wall symbolized the end of the Cold War. The unification of East and West Germany was however no smooth process. West Germany was a brilliantly run efficient economic machine whose population outnumbered the east by about a 4 :1. The West Germans in order to expedite the unification process agreed to an exchange rate of 1 deutschmark(DM) to 1 ostmark(OM), the later being the East Germany's currency which was practically worthless.
The result of this deal was that the east was flooded with DM from both short term welfare and long term development spending which led to inflation. As a result the now unified German government had to increase taxes in the west to deal with not only inflation but also the increased costs of helping the east. The event of unification also had long term implications as the East German citizens enjoyed a larger share of public finances and they also become a major vote bank for the parties, in fact they turned kingmakers in the election of now unified Germany. Angela Merkel,the current chancellor of Germany elected to the Bundestag from 22 September,2005 was born and brought up in East Germany.
While the Germans had been leading proponents of the Euro for essentially political reasons i.e in order to make sure their Country was firmly integrated into the European context and would never again face the isolation that had resulted in nazism; the actual decision on establishment of Euro was made possible by the Maastricht treaty in 1992 post unification of Germany.
Essentially ,the break up of Berlin Wall brought about a change in the political system of Germany and it led to the formation of Euro. This is of great importance as currently the European financial problems and the possible breakup of Euro which is threatening the world economy may be an indirect fallout of this 2 events which we would discuss in the second part.
ii) The curious case of Japanese Economy
Few of us know that Japan was a major beneficiary of the Marshall Plan initiated by USA after the World War II. Couple that with hardwork and industrious nature of Japanese people, Japan become the second largest economy in the world in the year 1967. The export centric Japanese model based on demand from the USA of standardized quality products mainly related to electronics and automobiles led to a boom in the Japanese economy. In the 1970's,the boom led to demand for housing loans catering to housing aspirations of Japanese people. Jusens on the lines of GSE's like Fannie Mae and Freddie Mac were established to Cater to such demand as the banks shied away from taking 20-30 years call on such loans considering them to be risky. The jusens were infact founded by the 21 major Japanese banks. In the later part of 1970's, the mortgage lending by the jusen increased manifold. In early 1980's,Japanese financial markets began to be liberalized and internationalised. This caused the previous large borrowers from Japanese banks to tap international markets for funds in the liberalized bond markets and euro yen capital markets abroad causing the banks to loose major business. The banks in a bid to maintain their income diversified into loans for the real estate sector thereby creating a glut of liquidity into real estate lifting the prices of residential as well as office premises. Furthermore the internationalization brought in more international players in the commercial premises space further increasing the prices. The land prices doubled and the stock market benchmark index tripled leading to bubbles throughout asset prices in Japan. However after the signing of Plaza Accord in 1985 by United States which provided for devaluation of the dollar against the Japanese yen and the German DM (the dollar depreciated by 51 percent against the Yen and DM making the Japanese/German exports less attractive) alongwith the black Monday crash of world stock markets in 1987,the Collapse in the Japanese asset prices was inevitable. The collapse of the Stock market came in 1989 and the land prices started to correct in 1990. The Japanese government had to intervene and the banks were supported by government to save them from going bust.
The expansion of government debts at near zero rates in Japan to more than 200% of GDP in 20 years has demonstrated that only printing of currency notes cannot lead to a sustained growth of economy . This example of Japan is of particular importance as the same stark problem is currently faced by the USA.
However, it led to the evolution of Japanese Yen currency trade commonly called as yen carry trade in which the borrower from a foreign country obtains a loan in Japanese yen at low interest rates and then converts it into home currency and utilizes the money for the designated purpose leaving him exposed to the currency risk. The study of Japanese yen carry trade which grew to 1.5 trillion dollars in the year 2008 is essential as it provided liquidity to the asset classes in general which alleviated the asset price. It led to the weakening of Japanese yen and thereby making Japanese economy more competitive by boosting exports. The Yen carry trade became a barometer of judging the risk taking appetite in international markets.
I am not very sanguine about the Japanese economy particularly due to its skewed demographics.More than 60 percent of Japanese are more than 60 years old,which basically means each young Japanese has to work and pay tax for the pension benefits of 2 older Japanese persons.God has novel ways to tell us that he is not on our side;this is one of them.
iii) The American way of Life- Boon or curse
The trumpet of capitalism and laissez faire economy and its virtues which was blown by USA from so many decades was now being heard by all countries around the World. Every great philosophy that is born has to be baptised by fire. The philosophy of capitalism as the only alternative to world economy gained acceptance on the annihilation of USSR. To prove a point the American leadership went on preaching spree around the world that each country can become like them provided they adhere to the principle laid by them. This was meant to help the USA more than anyone as it would lead to larger expansion by American business around the world.
Starting from the early 1970's post breakup of the dollar gold linkage by Nixon, international credit flows began to destabilize the global economy. One country after another was plunged into crisis as dollar denominated credit from abroad produced short term booms followed by longer lasting busts. Each crisis threatened the solvency of international financial system and in each crisis the large international banks that had made the loans were bailed out from their mistakes by rescue programs directed from Washington. The USA not only tolerated those credit flows it encouraged them by promoting capital account liberalization in those countries where it could exert influence. By bailing out the banks each time Washington rewarded imprudent risk raking and thereby encouraged the next round of foolish lending,the sum at stake grew from one decade to the next so that each successive crisis required a larger bailout from the one before. The latin American debts crisis, the Mexican peso crisis, the Asian crisis in 1998 and it contagion that subsequently spread to Russia and Brazil are all intertwined events and a part of one long crisis caused by unregulated cross border credit flows which was a direct result of the breakeup of the gold standard by President Nixon.Previously, the gold had to be shipped from one country to other to fulfill contractual obligations. However post breakup, in the mid seventies, large amount of dollars started accumulating around exporting countries more so in the oil exporting countries as now no gold was required to be transferred physically. This led to the increase in the oil prices as gold was replaced by dollar as the fiat currency. The economies of the oil exporting countries were too small to absorb the riches that had been granted by higher oil prices and thus they were absorbed by large American banks who dominated the international scene. These banks in order to create a credit market lent it to oil importing counties who were desperate for finance. This led to a short term economic boom in the oil importing countries. The capital flight of dollars ensued when it was apparent that these loans could not be repaid due to the slowdown of the economy. At that point the boom turned into bust and a balance of payments crisis arose. The IMF and other foreign banks which were directed from Washington extended emergency loans to the crisis countries that made it possible for the original lenders to withdraw their money. The countries in crisis devalued their currencies and developed a large current account surplus that allowed them to repay the emergency loans from the IMF. However all this was at a price which included
a) Increase in interest rates
b) Tighten fiscal policy
c) Closure of failed banks
d) Stop directed lending
e) Improvement in transparency
f) Opening the financial sector to foreign competition.
We have all heard as you sow,so shall you reap. The excesses created all over the world ultimately landed on the American shores post the burst of Nasdaq bubble. Ultimately, in the year 2008 when the crisis overwhelmed the United States, the American policy makers forgot all about the conditions they had pressed the IMF to impose on the countries affected by previous crisis and addressed their own crisis with radically different measures.
“Too big to fail” a sentence commonly used for large financial institutions nowadays originated in the year 1998 post the busting of a hedge fund Long Term Capital Management. Herein lied the seed of the concept of too big to fail of American banks and financial institutions which led them to undertake huge risks at the cost of tax payer's money and brought the World economy at the brink of catastrophe in the year 2008. It entrenched a feeling in the minds of bankers that irrespective of the amount of default by any of the financial institution, the Federal reserve and the American government would always rescue them.
Recently, Gerald Celente ,the man who predicted the
1987 stock market crash and the fall of the Soviet Union
is now forecasting a revolution in America, food riots
and tax rebellions - all within four years, while
cautioning that putting food on the table will be a more
pressing concern than buying Christmas gifts by 2012.
iv) The emergence of India and China.
INDIA. We still remember way back in the year 1991 our balance of payments was worth 3 weeks imports and we nearly defaulted on our obligation. Our government had to airlift its gold reserves to pledge it with IMF for a loan. Though we had our share of problems on other aspects,the Gulf War in Iraq was the primary cause of the crisis. Due to the war, the imports of oil bill had swelled and exports plummeted. With reserves nearly depleted the Indian government permitted a sharp depreciation of Rupee that took place in the year 1991 against major currencies.Late Shri P.V Narsimha Rao took over as the PM and brought in Dr. Manmohan Singh as FM to start a new era in Indian economics commonly known as liberalization process. The process that was started in 1991 was also done at the behest of IMF as was discussed earlier. Currently,the foreign currency reserves amount to more than 300 billions dollars which speaks a lot about Indian economic growth. The biggest asset of India is its demographics of the huge population of 1.2. billion. 50% of the population of 1.2 billion out of the world population of 6 billion are less than 25 years of age. Mark my words `Any democratic country with such demographics goes on to become the next super power in the world`. It has happened with Britain in the 19th Century,USA in the 20th century and it will happen with India in the 21st century. The Caveat is that the Indian politicians should learn a thing or two about economics as well as geo-politics. We all know that a majority of the population living in urban area is english speaking which has created call centre companies in India. Thousands of Engineers churn out from Indian universities which has led to the creation of giants like Infosys and TCS. Many jobs world over have relocated to India causing wide spread agitation in their own countries. However the biggest proponent of growth as well as risk in India is the flow of foreign capital. Inflows have driven the boom by pushing down interest rates and funding rapid credit growth. As credit grew more affordable, loans to the private sector increased by 240% between 2002 and 2010 and the GDP almost tripled to 1.8. trillion dollars today making it the 9th biggest economy in the world.
Goldman Sachs has predicted that by the year 2035 Indian economy is expected to overtake Japan to become the third largest economy in the world behind USA and china. India has a robust banking system and very efficient capital markets. I can visualise a huge bull run in the capital markets in India.As per my back of the hand calculations,I visualize the Indian GDP at around 5 trillion dollars and the earnings of BSE Benchmark Index Sensex in the year 2020 at 2500 conservatively.By giving it a multiple of 20 times I see the Benchmark Index at around 50000 by 2020.The opportunity from current levels is huge and hence the study of India finds its way in our report.
CHINA
After Mao Zedaong's death in 1976, Deng Xiaoping rose to the challenge and adopted reforms strategy to steer China into the growth path which has been further carried on by Hu Jintao. However, the real reforms started in China post the 1989 Tiananmen square debacle. The end of cold war alongwith the student uprising which was crushed made Chinese politicians accept that they would need to open up their economy to world trade for their own good. Post reforms from 1990 till date China has experienced one of the greatest economic booms in the history of Civilisation. It is the world's most populous country with 1.3 billion inhabitants and still China's economic model is based on export led growth which is heavily dependent on American consumption. The rise of China's economy over the past 20 years has change the world. In 1990, China's economy was approximately 500 billion dollars as compared to around 6 trillion dollars currently with combined Forex reserves of around 3 trillion dollars.China today is now the world's top consumer of crude oil, aluminium, copper, lead, nickel, tin, zinc , iron ore, coal , wheat, rice, palm oil, cotton and rubber. It is also the largest producer as well as consumer of steel. From the year 1990 its consumption of metals has increased 17% p.a. China has now reached a stage of industrialization, urbanization and infrastructure building that is the most commodity intensive. China's soaring demand has exerted a powerful pull on global commodity markets.Goldman Sachs has predicted that China would become the most industrious nation as early as the year 2025.Whether the rise of china is here to stay is a matter of open debate.China being a communist country information about China is often taken with a pinch of salt.However, Warren buffet recently mentioned that America took 100 years to build the infrastructure it has now by borrowing huge sums of money from European countries while China has achieved this feat in 20 years with large forex reserves still in place .Many critics argue that the growth of China was possible due to huge lending by local Chinese banks whose NPA's have now reached more than 50 percent and hence the downfall of China is just around the corner.Be that as it may, the moment we visit cities like Shanghai and Shenzen in China all doubts about the Chinese economy come to rest.Jim Rogers,the founder of Quantum fund alongwith George Soros has mentioned in his book'A bull on China' that he would ensure that his children learn mandarin,the Chinese language,as it is not only the largest speaking language in the world,it is the language of the future.I have googled for mandarin classes in and around my office at marine lines and have been tempted to join them but my conscience is asking me to wait for the Chinese authorities to accept and respect the basic principles of economics particularly about the floating of Renminbi against other currencies and ensuring full convertibility of Renminbi.A superpower status attained by China without full convertibility of its currency would tantamount to being a fish without water.However on my recent visit to China I did learn some of the words and sentences in Chinese.The one I am holding on to is'you yi sui de kaishi' which basically means'This is the beginning of the new age',whether it would be the Chinese age only time would tell.
vi) The rise and fall of Nasdaq as well as the real estate market.
Let us examine the 3 major factors that led to the rise in Nasdaq as well as the American Real estate market. :-
a) The PC and the Internet revolution :
The Radio hack TRS80 manufactured by Tandy Corporation way back in 1977 debuted as the first personal computer which could be mass manufactured and sold. Soon Apple and later on Microsoft entered the fray and PC's spread through business houses like Wild fire in the in the mid eighties. It was predicted that PC's would soon revolutionize many aspect of home and family life which never happened till the start of the next decade as the computers weren't powerful enough to perform any single task required to realize this vision. It took another 10 years for technology to mature, for the graphical user interface to make the computer approachable for non technical users and further for the internet to provide a compelling reason for most people to want a computer in their homes. We cannot deny that the PC revolution alongwith the internet was a path breaking event in the history of civilization. This technological innovation in the 1990's alongwith strict budget controls by the Clinton Administration (as discussed in the 2nd part) led to the revival of the US economy in the 1990's. The internet boom became part of the TV news. As internet fancy began to take hold in various houses across the world, internet Startup Companies began to garner billions of dollars in their initial public offerings.
b) Role of the Clinton administration and the reduction of trade deficits
Bill Clinton on becoming president in the year 1992 adopted a policy of financial restraint. Clinton was of the view that significantly reducing the American budget deficit would lead to substantially lower interest rates that would set off an investment boom and restore the high economic growth rates of yester years. This policy was implemented and it proved to be entirely correct. With the Omnibus Budget Reconciliation Act of 1993, Clinton signed into law a tax hike that took the top rate from 31% to 39.6%. The combination of higher tax rate and financial fiscal restraint had an extraordinary impact. It not only brought down interest rates and set off an investment boom it also led to a frenzied investment bubble. In 1998, Washington achieved its first budget surplus in almost 2 decades last being the year 1969. In the interim period particularly during the tenure of president Regan USA had run very large deficits every year and thus its foreign trading partners accumulated large trade surpluses. These surpluses found its way back in the US treasury bonds which bridged the gap in the budget deficits of the American governments. However as the surplus started accumulating in the coffers of US government they decided to stop selling new treasury bonds, in fact they started buying back bonds issued earlier. Meanwhile the strong dollar policy adopted by the US government led to an increase in imports on an unprecedented level. This led to a very precarious situation in which the balance between the supply of dollar denominated debts and the demand for that debts was profoundly disrupted. When the US government stopped selling new bonds foreign partners began buying treasury bonds that had been sold in earlier years which pushed up the prices of bonds and reduced the yields to around 5%. As the yields elsewhere were higher the money found its way into Fannie Mae, Freddle Mac and the balance went into stock markets.Would you believe that 3 trillion dollars were borrowed by Fannie Mae and Freddie Mac combined between 1998 to 2003. This was perhaps the single biggest reason for the irrational exuberance in the real estate market in the new millennium and also in the Nasdaq which increased by 100% from 1996 to 1998.
c) The Asian crisis, the Russian default and implosion of LTCM
As discussed the American economy at the start of the year 1998 was expanding at a robust rate with budget surplus on the back of investments in new technologies that were revolutioning computing and telecommunication. Inflation and unemployment were low. When the Asian Crisis spread and Russia defaulted on its debts, LTCM a big hedge fund went belly up. The American government was in no mood to have its dream run disrupted. The Dow and Nasdaq plunged 25% on the news of the magnitude of financial industry's exposure to the LTCM fund. Federal Reserve intervened to prevent a financial sector meltdown and announced three rate cuts in seven weeks. In the midst of an economic boom alongwith stock market and property bubble this acted as putting fuel on the fire of an overheated economy. Over the next years exuberance swelled into mass ecstasy. The Nasdaq which was at 450 at the start of the decade went on to reach 1000 in 1995 and 2500 in 1999 and then peaking at 5100 in 2000 itself. It was the mother of all bull markets and had to end badly. The Nasdaq fell nearly 80% from its peak. Hundreds of over leveraged internet and telecommunication companies disappeared and dozens of serious corporate scandal came into light ushering a complete collapse of business envoirnment.
As is discussed earlier private sector debts and debt driven asset price inflation had become the engines of economic growth in the United States in the 1990's. Economic growth around the world was largely a function of the extraordinary surge in American imports. By the busting of America's equity bubble, household net worth took a serious hit carrying imports to contract thereby halving global growth rate.
Joseph Stiglitz the Noble laureate in fact wrote a book `Roaring nineties' explaining as to why the world is suffering today on the back of the decade leading to the new millennium perceived as the greediest decade in the history of mankind. It is important to study the various events mentioned as all this factors had a great impact on the world economy and led it to the brink of destruction in the year 2008 which we would discuss in the last part of this series. George Soros has said' The truth never ceases to remain truth irrespective of the manipulations exerted to change its character, ALBEIT in the long run'. In the long run, the principles of sound economics always triumph, which the policy makers in the USA have completely forgotten. However as we have learnt that `The king can do no wrong', we will have to bear the idiosyncrancies of the king till he makes way for the new king which again makes me ponder about the phrase with which we started our note ,which actually should have been ........With great sacrifice and discipline comes great and sustainable power........ |