Thursday, May 31, 2012

Not Out Of The Woods Yet

I was asked to speak on "The Global Economy: Threats & Opportunities" at the CRN Virtual Expo earlier in the day today - A topic close to my heart and always at the top of my mind. I put a few thoughts together on a PowerPoint first and then decided to delve deeper into them, so I could actually provide some valuable insights to the participants (most of them Entrepreneurs and CEOs) attending the Expo. 

The idea was to learn from past mistakes made by our world leaders and prepare ourselves for any economic fallouts of the current events, which are shaping our destinies. As I started listing these out, I realised how bad a shape the world is in. So here go some thoughts which tell me that we are not out of the woods yet...


Shaky at best, since the US Housing Crash in 2007

The US Housing Market Crash of 2007 was the worst housing crash in U.S. history and resulted in the world’s most severe financial crisis since the Great Depression. The cause for this crash was like any other financial bubble, a result of greed, federal short-sightedness, financial innovation and poor regulation. It had its origins in the dot com bubble bursting in 2000, resulting in a shift of dollars from stock markets to housing. Cheap money available for new loans in the wake of the economic recession, made the Federal Reserve and Banks encourage people to borrow money against secured housing to help the economy grow. Financial innovation from lenders created new types of loans such as interest adjustable loans, interest only loans and zero down loans. This fuelled housing prices and the greed to make easy money got people to buy more by borrowing more, in an effort to take advantage of market conditions. With zero down loans to buy new homes, an unlimited supply of money was created. Each such loan was securitized by the bank, given a AAA Rating and the risk was passed off to someone else, notably foreign investors and pension funds. The total amount of derivatives held by the financial institutions exploded and the total % cash reserves grew smaller and smaller. Consequently from 2003 to 2007 the amount of subprime loans had increased a whopping 292% from 332 billion to 1.3 trillion. When credit markets froze in 2007, housing prices started tumbling from their peak, borrowers failed to repay their loans & the value of the security in a rapidly deteriorating, seller only market was inadequate to cover the lenders’ exposure.

Though the financial crisis was resolved by start of 2009 through some drastic & unforeseen measures by the US Federal Reserve & Senate, the housing market continued to decline throughout the year, with over 3 million foreclosure filings for 2009. Unemployment rose to over 10% and the housing market crash created the worst recession since the early 1980’s.

By 2011, after two rounds of Quantitative Easing in the US,  apparently the US economy had stabilized and was on a growth path with unemployment numbers coming down, GDP growth and corporate earnings recovering, even though housing prices were yet to recover and there was still a surplus of housing inventory.

Nascent recovery, nipped in bud by Europe Crises

These greenshoots of economic recovery were threatened by the unfolding of the Economic Crisis in Europe, where country after country reported a fall in GDP and was unable to meet the huge fiscal deficits that ensued on account of increased government spending in the aftermath of the US economic recession. The various causes attributed to the EU Crisis are the 2007–2012 global financial crisis & the resulting recession;  international trade imbalances; fiscal policy choices related to government revenues and expenses; and approaches used by nations to bailout troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

The underlying reason however, remains the greed of people and nations in tapping the availability of over US$ 70 trillion of global savings of fixed income investors in search of high yields overwhelming the policy and regulatory mechanisms in country after country, generating bubble after bubble across the globe. While these bubbles have burst causing asset prices to decline, the liabilities owed to global investors remain at full price, generating serious questions regarding the solvency of governments and their banking systems.

The PIIGS (Portugal, Ireland, Italy, Greece and Spain) as we know the failing European nations thus far, have created their own recipes for disaster, that threaten to break up the European Union. In Ireland, banks lent huge amounts of money to property developers, generating a massive property bubble. When the bubble burst, Ireland's government and taxpayers assumed private debts of the banks losing an estimated 100 billion Euros. In an effort to mask its growing fiscal deficit Italy from EU, Italy circumvented Treaty rules and debt levels through the use of complex currency and credit derivatives structures. In Greece, the government gave out extremely generous pay and pension benefits to public workers while hiding its growing debt from EU officials with the help of derivatives designed by major banks. In Spain, the crisis was generated by long-term loans (commonly issued for 40 years), the building market crash, which included the bankruptcy of major companies, and a particularly severe increase in unemployment, which rose to 22.9% by December 2011- all contributing to a negative GDP growth of -4.6% for 2010.

Most other constituents of the EU have similar problems at hand and despite the 1 trillion Euro European Financial Stability Facility or sovereign bailout, the fear of financial contagion is very real.

Recent downtrend in China real estate looks ominous

It is believed by many that China’s rapid development of infrastructure and recent GDP growth in excess of 9% make it the showpiece amongst emerging BRICS markets and are a result of meticulous planning and execution. It would be interesting to learn that China’s growth story revolves around property construction as much as its exports and domestic consumption. 

Local Chinese governments have mounting debt to fund infrastructure projects of 10.7 trillion yuan ($1.7 trillion) and depend on land sales to fund payments. According to sources, debt in Local Government Funding Vehicles amounts to around one-third of China's GDP. According to the China National Bureau of Statistics, property construction accounts for more than 13% of China's GDP (up from around 3% of GDP in 1999). Bank deposits are low yielding and the borrowing rate is either very low or negative which encourages explosive loan growth (also known as a debt bubble) and this has been prompting the locals to invest in property. By now many who could borrow have bought more than one property, which remains unoccupied due to high availability of new & under construction properties, and costs money to maintain.

However, starting September 2011, the demand for property started falling with many new projects being offered at 20 to 30% discounts by the developers. Certain markets fell by 30% in November alone, and by now have resulted in losses of as much as 50% over the past 6 months.
This looks ominous for the growth of the Chinese economy & its banking system, which UBS believes has an exposure of as much as 50% of its books to the Chinese property market. Remember, just like the subprime disaster in the US, the Chinese economy has wrapped itself around its bloated property market… so if it crashes, the whole system could come tumbling down.
Dark clouds of another oil war in Iran

Iran wants nuclear power and possibly the capacity to build a nuclear weapon; which is unacceptable to Israel and the U.S. Following the U.S. invasions and occupations of Iraq and Afghanistan, Iran has emerged as the principal power in the region, capable of further destabilizing either of its war-torn neighbours. The US has imposed sanctions including an oil embargo on import of crude from Iran, while, Tehran has led a move to ditch the U.S. dollar as the standard currency of exchange in the global oil market and cutting off supplies to France and the UK.

US President Mr. Obama, speaking at the American Israel Public Affairs Committee, in early March has declared that he would not tolerate a nuclear-armed Iran and would act — militarily, if necessary — to prevent that from happening.

If the situation spins out of control in any of several possible directions, oil prices could shoot to $200 a barrel. Of course, the downside of open hostilities could throw the entire Middle East into chaos and it is conceivable that even Russia and China could be drawn into the conflict in some way.

Fiscal deficits a big challenge for most economies 
Over the years Governments across the world have been mounting expenses by building unwieldy bureaucracy and appeasing public servants with wage hikes, while simultaneously reducing tax burdens and lavishing sops on the electorate. While this kept everyone happy as long as the economy was growing, it has thrown up several challenges with recessions & slowdowns over the past few years.
Amongst the OECD (Organization for Economic Co-operation and Development) some countries had severe deficits in 2011, including a -10.3% deficit in Ireland, -10% in United States, -9.4% in the UK, -9% in Greece and -8.9% in Japan.

Countries with high sovereign debt, fiscal deficits and contingent liabilities, in particular, are at risk of contagion, but current heightened market-uncertainty is leading to flight-to-quality, which could raise rates across countries. Credit Default Swap (CDS) spreads for Greece, Spain, Portugal, and Italy jumped to fresh record-highs and this year’s gains on global equities have been wiped out. Worries about elevated European debt, tightening credit, and Euro Zone cohesiveness led to further depreciation of the euro, which has hit a 14-month low against the U.S. dollar in May. Benchmark U.S. Treasuries have surged on a general flight-to-quality, which if sustained would lead to higher borrowing costs across nearly all countries. Already elevated sovereign debt levels are likely to rise over the near-term across many countries, given the degree of fiscal deterioration since the onset of the crisis.

Political unrest in several countries

Since the Second World War or probably the disbanding of the erstwhile USSR, the world has never seen as much political unrest as we are witnessing since 2011. Blame it on the loss of jobs, economic disparity, inflation, corruption, religion or systemic decay of governance – the economic crises that has swept the world since 2007 has resulted in political unrest of a magnitude not witnessed before.

What started in the troubled Middle East and African region spreading through countries like Tunisia, Egypt, Libya, Bahrain, Syria, Yemen has now reached Greece, Italy and Spain. In some countries at least, particularly those with upcoming elections, worries over further unrest will deter the government from more aggressive reforms. The propensity for civil unrest in France, Spain, Portugal and Italy will act as a check on their governments.

From the looks of it, political unrest will do nothing but increase throughout 2012 all over the world. Driven by labour groups, youth organizations, political parties, bloggers and tweeters and the poor and unemployed, we may see a growing movement of discontent. People will be demanding socioeconomic and political change. They will be protesting the things they don’t have and the things that are being taken away from them. People everywhere seem to be seething with discontent under the surface. They are angry at corrupt regimes regardless of where they are in the world.

Volatile commodity & currency markets
Building a business in volatile markets is one of the biggest challenges facing most global businesses ever since 2007, when volatility in both commodities and currencies reached new heights. We have seen crude fluctuate from US$50 per barrel in 2007 to US$146 in 2008, down to US$32 in 2009 and back to US$126 in 2012. Other industrial commodities like Copper, Steel, Rubber etc have seen similar swings. Gold itself has been equally volatile moving from US$640 per ounce in 2007 to US$1890 by late 2011, before falling to levels of US$ 1550 currently.
Rapid fluctuation in currencies on account of global funds alternating between seeking higher returns in emerging markets prior to returning to the supposed safety of the US$, have kept policy makers and businesses on tenterhooks. The Indian Rupee itself has fluctuated between 39 to over 56 to a US$ in this period, making the smartest & largest of Indian businesses with any international exposure lose large sums in currency fluctuations.   

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