“The global economy has, in all probability, entered a period of stability after a fairly big decline,” says renowned derivatives expert Satyajit Das.
“The global economy has, in all probability, entered a period of stability after a fairly big decline,” says renowned derivatives expert Satyajit Das. His works include Swaps/ Financial Derivatives Library, a 4-volume, 4,200-page reference work for practitioners on derivatives, and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.
“Market sentiment seems to be shaped less by facts than the Doors’ song, “I’ve been down for so long, it feels like up to me,” he tells DNA Money’s Vivek Kaul in this interview.
We are more than 18 months into the financial crisis. Lately, there has been a lot of talk on various economies reviving; green shoots, as the world calls it. How do you see it?
Botanical commentators are finding ‘green shoots’. Strong rallies in equity and debt markets have confirmed the recovery for the ‘true believers’. It is useful to remember Winston Churchill’s observation after the British expeditionary force’s escape from Dunkirk: “[Britain] must be very careful not to assign to this deliverance the attributes of a victory”. There may be confusion between ‘stabilisation’ and ‘recovery’. The ‘green shoots’ theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets and a renewed belief in Decoupling (Release 2.0) also underpin hopes of a swift return to growth.
On 14 June 2009, Wolfgang Munchau writing in the Financial Times (‘Optimism is not enough for a global recovery’) eloquently summed up the developments: “Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world.”
Do you feel the western economies have started turning around?The puzzling thing is that real economy indicators continue to be poor. GDP forecasts for 2009 have steadily deteriorated with world growth expected to be a negative 2-3% with especially poor prospects for Japan and the Eurozone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China, expected to grow between 6% and 8% in 2009, experienced a fall in exports of over 20% over the last year.
The ‘wealth effects’ of the GFC on economic activity are unclear. In the US alone, $30 trillion of value has been destroyed. Pension funds have lost anywhere between 20% and 50% of their value. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be yet to fully flow through into consumption.
The financial system has stabilised but not returned to the ‘rude good health’. Good results for Goldman Sachs and JPMorgan are offset by less impressive performances by Bank of America and CitiGroup. The problems at CIT also highlight the problems for the financial system and the threat to availability of credit to small and medium sized businesses.
Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.
Bank risk levels have increased and in some cases to beyond pre-crisis levels. Goldman Sachs’ Q2 earnings showed an increase in risk levels as measured by Value-at-Risk (VAR). The increase in risk is probably understated as it takes into account diversification benefits that maybe overstated under conditions of market stress.
It is probably also understated because of assumption of trading liquidity that may be optimistic given recent experience. The higher levels of risk taking reflect increasing comfort in central bank support of financial institution’s liquidity and their ability and willingness to intervene to limit price risks
Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 to $2 trillion, equivalent to a credit contraction of around 20-30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit. The link between debt and economic growth is well established. The global economy probably needs around $4-5 of debt to create $1 of GDP growth.
IMF researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ((2008) “Credit Matters: Empirical Evidence on US Macro-Financial Linkages” IMF Working Paper 08/169) found that in the US, a 1% point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%. This means that global bank capital shortage may restrain credit creation thereby reducing economic activity and sustainable growth levels.
The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the ‘cash for clunkers’ deals (cleverly packaged as ‘green’ environmental initiatives) have boosted immediate demand for cars but the long-term demand effects are unclear.
The multiplier effect of the fiscal initiatives is likely to be low. Major infrastructure initiatives will take time to implement. Few projects are ‘shovel ready’. The rate of return on government spending programmes, some of which are politically motivated, is unclear. Government spending increasing capacity is likely to create problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.
In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors’ song: “I’ve been down for so long, it feels like up to me.”
A number of economists and financial market experts have been saying that Chinese demand will turn the world economy around. What are your views?
The phoenix-like recovery in emerging markets and China is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China’s growth of around 8% is attributable to government spending and increased bank lending.
The extraordinary increase in lending in China is fuelling unsustainable growth. In the first half of 2009, new loans totalled over $1 trillion. This compares to total loans for the full 2008 year of around $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China’s GDP. The combination of government spending and bank loans has resulted in sharp increases in fixed asset investments (over 30% up on 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% on 2008). Even Chinese government officials have admitted that the recovery is “unbalanced”.
The increase in industrial production in the absence of real end demand for products could result in a rapid build up in inventory. The availability of credit is also fuelling rampant speculation in stocks, property and commodities. Estimates suggest that around 20-30% of new bank lending is finding it way into the stock market, in part driving up values.
The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is a speculative element. Availability of abundant and low cost bank finance combined with a deep seated fear of the long-term prospects of US Treasury bonds and the dollar has encouraged speculative stockpiling of certain commodities artificially boosting demand.There is a lot of government spending and
currency printing happening across the world.
Is this the solution?
You are right. Much of the recovery has been underwritten by massive government spending. A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other ‘worthies’ means that many countries face large and continuing budget deficits.
Even countries with relatively healthy ‘balance sheets’, such as Australia, do not anticipate balancing their books for many years. If the problems of an ageing population and unfunded liabilities such as public sector pensions, healthcare and social security arrangements are included, then the budgetary position looks considerably worse.
In 2009, total sovereign debt issues are expected to total over $5 trillion, of which the US alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing — US around 300%, UK over 400%, Eurozone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.
Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP). As a comparison, the total amount of global investment assets under management, according to one estimate, is around $120 trillion. This provides some idea of the funding task ahead.
Long-term interest rates have risen sharply reflecting supply pressures. The US 30 year rate has increased by around 1.50% per annum. since the start of 2009. Maturities have also shortened increasing the re-financing challenges ahead. Participation of central banks in the US and the UK bonds, under their quantitative easing mandates, has helped keep interest rate rises down creating a somewhat artificial market.
A key issue over the coming months is the continued demand for increased sovereign debt issues. China, Japan and Europe historically have been major buyers of US Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China’s foreign exchange reserves are growing more slowly than before. China has continued to purchase US Treasury bonds but some purchases represents a switch from US Agency paper. As the US has increased its issuance programme, China’s purchases are now a smaller portion of the total.
In the best case, the government debt issuance programme is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits, setting off a new stage of the GFC.
As one anonymous saying goes: “Never in the history of the world has there been a situation so bad that the government can’t make it worse.”
Stock markets in emerging markets have been going up for the last few months. Are the stock market rallies because of all this money finding its way to various parts of the world? How do you see this playing out?
I think the current price levels have been driven by massive liquidity creation and short-term capital flows. The price rise in emerging market shares, debt and currencies reflects a blind belief that anywhere must be safer and more promising than the US, Japan or Europe.
This misses the point that these markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth. The adjustments are not being made.
It will be interesting to see whether current price levels can be justified by fundamentals such as earnings and growth over the next few years. Benjamin Graham, Warren Buffett’s teacher, used to say, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” At the moment, the voters are running the show.
What is your prognosis on India?
I think there are short-term risks, primarily in the funding of the deficit (both federal and state). It is useful to remember that India will need to raise money with deteriorating fundamentals and a weakening credit rating in a world where the amount of money available is shrinking. This will also restrict infrastructure developments, which the markets are relying on for the recovery. Many Indian companies with substantial debt will face challenging refinancing conditions.
Key reforms also have not and may not be undertaken. Reform of the public sector, the financial system and domestic saving markets, labour markets and specific industries is essential but I see no desire to take on vested interests. Without these fundamental changes, sustainable growth may be difficult to sustain. It is also unrealistic to think that countries like India and China will somehow stay the beacons of growth in a world where overall growth levels are falling.
What steps are needed to put in place a financial and economic environment that creates good conditions for a turnaround?
In my view, there are three conditions for recovery. First, the financial system must be stabilised. This requires reducing the level of overall debt, recapitalising the banking system and getting the flow of credit to a sustainable level. Secondly, the real economy must stabilise. This includes stabilisation of asset (e.g. US housing) prices, arresting falls in demand, consumption, investment and a recovery of employment levels. Third, global trade and capital flows need to stabilise and fundamental global imbalances must be addressed.
Has there been any progress on these issues?
Belief in the recovery story and sharp financial market rallies fail to recognise that little has actually changed since the GFC began. Fundamental failures have not been fully addressed.
The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in private sector debt. Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.
As I said before, the real economy has slowed its rate of decline, but key indicators such as unemployment may not have peaked.
Any lasting solution to the GFC requires this imbalance to be dealt with. A key component of the GFC was the problem of debt-funded consumption by the US that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded this consumption.
The glib solution requires the US to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable. Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and US Treasury Bonds, reveals the dilemma.
On the one hand, America needs the Chinese to continue and increase their purchase of US government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or US Treasury bonds or the need for China to liberalise its currency and open its capital account, allowing internationalisation of the Renminbi!
A cursory look at the respective economies highlights the magnitude of the task. Consumption’s contribution to GDP in the US is 71%, while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the US and average income in China is around 10-15% of US earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.
Additionally, over the last 25 years, Chinese consumption has declined from around 50% to it current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower US growth and declining consumption creates significant challenges for China.
Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talkfests that global leaders have shuttled to and from. The focus has been ‘NATO’ — no action talk only.
Reliance on Chinese foreign currency reserves is probably misplaced. Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilised without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects this ‘panic’.
In reality, China is trying desperately to switch its reserves into real assets —— commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and US Treasury bond to preserve the value of existing holdings in a surreal logic. On the other side, the US continues to seek to preserve the status of the dollar as the sole reserve currency (backed no longer by gold but by the 86th Airborne Division) in order to enable itself to finance itself.
In July 2009, at the G8 Summit in the earthquake damaged town of L’Aquila in Italy, Dai Bingguo, Chinese state councillor, was openly critical of the dominant role of the US dollar as a global reserve currency: “We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,”
Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the recovery in markets and economies. Gordon Brown, Britain’s prime minister, spoke on behalf of the West: “We don’t want to give the impression that big change is around the corner and the present arrangements will be destabilised.”
No sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC. The markets ability to avoid consideration of these issues reflects Mark Twain’s observation: “Ignorance more frequently begets confidence than does knowledge”.
What are the three biggest learnings for economists and economies from this financial crisis?
Firstly, the strong growth that the global economy has enjoyed has been driven by unsustainable levels of borrowing, unsustainable levels of emissions and pollution and accelerating consumption of scarce resources such as oil. Secondly, the ability of governments and central banks to control and “fine tune” the economy with a judicial mixture of monetary and fiscal policy is an illusion. We do not necessarily understand the workings and interactions of the global economy as well as we think. Thirdly, that there is always a day of reckoning and that we have to pay for everything at some stage of the cycle. We can’t defer this forever. This means we have to change our expectations and behaviours significantly going forward.
Interestingly, I don’t think any of these lessons have been learnt or even acknowledged. Actions to stabilise the global economy seem only to have created ‘new’ bubbles — in government debt and emerging markets. Government actions seem to be primarily designed to ensuring continuation of the Ponzi game. The only lesson learned is that no Ponzi game can ever be allowed to stop.
“Market sentiment seems to be shaped less by facts than the Doors’ song, “I’ve been down for so long, it feels like up to me,” he tells DNA Money’s Vivek Kaul in this interview.
We are more than 18 months into the financial crisis. Lately, there has been a lot of talk on various economies reviving; green shoots, as the world calls it. How do you see it?
Botanical commentators are finding ‘green shoots’. Strong rallies in equity and debt markets have confirmed the recovery for the ‘true believers’. It is useful to remember Winston Churchill’s observation after the British expeditionary force’s escape from Dunkirk: “[Britain] must be very careful not to assign to this deliverance the attributes of a victory”. There may be confusion between ‘stabilisation’ and ‘recovery’. The ‘green shoots’ theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets and a renewed belief in Decoupling (Release 2.0) also underpin hopes of a swift return to growth.
On 14 June 2009, Wolfgang Munchau writing in the Financial Times (‘Optimism is not enough for a global recovery’) eloquently summed up the developments: “Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world.”
Do you feel the western economies have started turning around?The puzzling thing is that real economy indicators continue to be poor. GDP forecasts for 2009 have steadily deteriorated with world growth expected to be a negative 2-3% with especially poor prospects for Japan and the Eurozone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China, expected to grow between 6% and 8% in 2009, experienced a fall in exports of over 20% over the last year.
The ‘wealth effects’ of the GFC on economic activity are unclear. In the US alone, $30 trillion of value has been destroyed. Pension funds have lost anywhere between 20% and 50% of their value. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be yet to fully flow through into consumption.
The financial system has stabilised but not returned to the ‘rude good health’. Good results for Goldman Sachs and JPMorgan are offset by less impressive performances by Bank of America and CitiGroup. The problems at CIT also highlight the problems for the financial system and the threat to availability of credit to small and medium sized businesses.
Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.
Bank risk levels have increased and in some cases to beyond pre-crisis levels. Goldman Sachs’ Q2 earnings showed an increase in risk levels as measured by Value-at-Risk (VAR). The increase in risk is probably understated as it takes into account diversification benefits that maybe overstated under conditions of market stress.
It is probably also understated because of assumption of trading liquidity that may be optimistic given recent experience. The higher levels of risk taking reflect increasing comfort in central bank support of financial institution’s liquidity and their ability and willingness to intervene to limit price risks
Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 to $2 trillion, equivalent to a credit contraction of around 20-30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit. The link between debt and economic growth is well established. The global economy probably needs around $4-5 of debt to create $1 of GDP growth.
IMF researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ((2008) “Credit Matters: Empirical Evidence on US Macro-Financial Linkages” IMF Working Paper 08/169) found that in the US, a 1% point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%. This means that global bank capital shortage may restrain credit creation thereby reducing economic activity and sustainable growth levels.
The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the ‘cash for clunkers’ deals (cleverly packaged as ‘green’ environmental initiatives) have boosted immediate demand for cars but the long-term demand effects are unclear.
The multiplier effect of the fiscal initiatives is likely to be low. Major infrastructure initiatives will take time to implement. Few projects are ‘shovel ready’. The rate of return on government spending programmes, some of which are politically motivated, is unclear. Government spending increasing capacity is likely to create problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.
In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors’ song: “I’ve been down for so long, it feels like up to me.”
A number of economists and financial market experts have been saying that Chinese demand will turn the world economy around. What are your views?
The phoenix-like recovery in emerging markets and China is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China’s growth of around 8% is attributable to government spending and increased bank lending.
The extraordinary increase in lending in China is fuelling unsustainable growth. In the first half of 2009, new loans totalled over $1 trillion. This compares to total loans for the full 2008 year of around $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China’s GDP. The combination of government spending and bank loans has resulted in sharp increases in fixed asset investments (over 30% up on 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% on 2008). Even Chinese government officials have admitted that the recovery is “unbalanced”.
The increase in industrial production in the absence of real end demand for products could result in a rapid build up in inventory. The availability of credit is also fuelling rampant speculation in stocks, property and commodities. Estimates suggest that around 20-30% of new bank lending is finding it way into the stock market, in part driving up values.
The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is a speculative element. Availability of abundant and low cost bank finance combined with a deep seated fear of the long-term prospects of US Treasury bonds and the dollar has encouraged speculative stockpiling of certain commodities artificially boosting demand.There is a lot of government spending and
currency printing happening across the world.
Is this the solution?
You are right. Much of the recovery has been underwritten by massive government spending. A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other ‘worthies’ means that many countries face large and continuing budget deficits.
Even countries with relatively healthy ‘balance sheets’, such as Australia, do not anticipate balancing their books for many years. If the problems of an ageing population and unfunded liabilities such as public sector pensions, healthcare and social security arrangements are included, then the budgetary position looks considerably worse.
In 2009, total sovereign debt issues are expected to total over $5 trillion, of which the US alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing — US around 300%, UK over 400%, Eurozone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.
Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP). As a comparison, the total amount of global investment assets under management, according to one estimate, is around $120 trillion. This provides some idea of the funding task ahead.
Long-term interest rates have risen sharply reflecting supply pressures. The US 30 year rate has increased by around 1.50% per annum. since the start of 2009. Maturities have also shortened increasing the re-financing challenges ahead. Participation of central banks in the US and the UK bonds, under their quantitative easing mandates, has helped keep interest rate rises down creating a somewhat artificial market.
A key issue over the coming months is the continued demand for increased sovereign debt issues. China, Japan and Europe historically have been major buyers of US Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China’s foreign exchange reserves are growing more slowly than before. China has continued to purchase US Treasury bonds but some purchases represents a switch from US Agency paper. As the US has increased its issuance programme, China’s purchases are now a smaller portion of the total.
In the best case, the government debt issuance programme is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits, setting off a new stage of the GFC.
As one anonymous saying goes: “Never in the history of the world has there been a situation so bad that the government can’t make it worse.”
Stock markets in emerging markets have been going up for the last few months. Are the stock market rallies because of all this money finding its way to various parts of the world? How do you see this playing out?
I think the current price levels have been driven by massive liquidity creation and short-term capital flows. The price rise in emerging market shares, debt and currencies reflects a blind belief that anywhere must be safer and more promising than the US, Japan or Europe.
This misses the point that these markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth. The adjustments are not being made.
It will be interesting to see whether current price levels can be justified by fundamentals such as earnings and growth over the next few years. Benjamin Graham, Warren Buffett’s teacher, used to say, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” At the moment, the voters are running the show.
What is your prognosis on India?
I think there are short-term risks, primarily in the funding of the deficit (both federal and state). It is useful to remember that India will need to raise money with deteriorating fundamentals and a weakening credit rating in a world where the amount of money available is shrinking. This will also restrict infrastructure developments, which the markets are relying on for the recovery. Many Indian companies with substantial debt will face challenging refinancing conditions.
Key reforms also have not and may not be undertaken. Reform of the public sector, the financial system and domestic saving markets, labour markets and specific industries is essential but I see no desire to take on vested interests. Without these fundamental changes, sustainable growth may be difficult to sustain. It is also unrealistic to think that countries like India and China will somehow stay the beacons of growth in a world where overall growth levels are falling.
What steps are needed to put in place a financial and economic environment that creates good conditions for a turnaround?
In my view, there are three conditions for recovery. First, the financial system must be stabilised. This requires reducing the level of overall debt, recapitalising the banking system and getting the flow of credit to a sustainable level. Secondly, the real economy must stabilise. This includes stabilisation of asset (e.g. US housing) prices, arresting falls in demand, consumption, investment and a recovery of employment levels. Third, global trade and capital flows need to stabilise and fundamental global imbalances must be addressed.
Has there been any progress on these issues?
Belief in the recovery story and sharp financial market rallies fail to recognise that little has actually changed since the GFC began. Fundamental failures have not been fully addressed.
The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in private sector debt. Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.
As I said before, the real economy has slowed its rate of decline, but key indicators such as unemployment may not have peaked.
Any lasting solution to the GFC requires this imbalance to be dealt with. A key component of the GFC was the problem of debt-funded consumption by the US that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded this consumption.
The glib solution requires the US to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable. Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and US Treasury Bonds, reveals the dilemma.
On the one hand, America needs the Chinese to continue and increase their purchase of US government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or US Treasury bonds or the need for China to liberalise its currency and open its capital account, allowing internationalisation of the Renminbi!
A cursory look at the respective economies highlights the magnitude of the task. Consumption’s contribution to GDP in the US is 71%, while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the US and average income in China is around 10-15% of US earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.
Additionally, over the last 25 years, Chinese consumption has declined from around 50% to it current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower US growth and declining consumption creates significant challenges for China.
Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talkfests that global leaders have shuttled to and from. The focus has been ‘NATO’ — no action talk only.
Reliance on Chinese foreign currency reserves is probably misplaced. Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilised without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects this ‘panic’.
In reality, China is trying desperately to switch its reserves into real assets —— commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and US Treasury bond to preserve the value of existing holdings in a surreal logic. On the other side, the US continues to seek to preserve the status of the dollar as the sole reserve currency (backed no longer by gold but by the 86th Airborne Division) in order to enable itself to finance itself.
In July 2009, at the G8 Summit in the earthquake damaged town of L’Aquila in Italy, Dai Bingguo, Chinese state councillor, was openly critical of the dominant role of the US dollar as a global reserve currency: “We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,”
Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the recovery in markets and economies. Gordon Brown, Britain’s prime minister, spoke on behalf of the West: “We don’t want to give the impression that big change is around the corner and the present arrangements will be destabilised.”
No sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC. The markets ability to avoid consideration of these issues reflects Mark Twain’s observation: “Ignorance more frequently begets confidence than does knowledge”.
What are the three biggest learnings for economists and economies from this financial crisis?
Firstly, the strong growth that the global economy has enjoyed has been driven by unsustainable levels of borrowing, unsustainable levels of emissions and pollution and accelerating consumption of scarce resources such as oil. Secondly, the ability of governments and central banks to control and “fine tune” the economy with a judicial mixture of monetary and fiscal policy is an illusion. We do not necessarily understand the workings and interactions of the global economy as well as we think. Thirdly, that there is always a day of reckoning and that we have to pay for everything at some stage of the cycle. We can’t defer this forever. This means we have to change our expectations and behaviours significantly going forward.
Interestingly, I don’t think any of these lessons have been learnt or even acknowledged. Actions to stabilise the global economy seem only to have created ‘new’ bubbles — in government debt and emerging markets. Government actions seem to be primarily designed to ensuring continuation of the Ponzi game. The only lesson learned is that no Ponzi game can ever be allowed to stop.
http://www.dnaindia.com/money/interview-no-ponzi-game-can-ever-be-allowed-to-stop-1280538
