Wednesday, July 14, 2010

Current Situation of World Economy

The aftershocks of the financial crisis and meltdown of 2008 are still evident in the US as well as the world economy.  Let's look at a bit of recent history.

The US crisis was caused primarily by the collapse of a house price bubble caused due to cheap funds.  Central Banks across the world kept interest rates low to fuel credit off-take and growth. This money fuelled an asset bubble.  House prices also went through the roof.  People borrowed to buy houses. Institutions that had people's money (pension funds included) put their money into assets including stocks across the world.  The Indian market went to a level of 21000 in end-2007/ Jan 2008 primarily due to money flowing in from abroad.  When everything unwound we know what happened.  People lost in excess of 50% of their retirement savings – house prices especially in the US collapsed – asset prices including stocks across the world collapsed. What was different this time compared to previous financial crises was that the contagion had spread across the world into several asset markets due to (a) the phenomenon called securitization and (b) hedge funds, pension funds, and other funds moving money across the world to buy assets which had resulted in inflated asset prices all of which crashed.

The collapse of Lehman Brothers created a big scare. Several institutions could have collapsed along with it since they had a web of transactions with the company, all of which unwound.  This introduced a concept called "too big to fail" – if you are small and you take wrong calls, you are stupid and you deserve to die.  If you are big and you are greedy and take the wrong calls, in case you gain the money is yours, in case you fail the government is there to bail you out! Since you are too big to fail.  There is a big moral hazard inherent in all this if we reflect on it.

The governments of the world pumped in money through their central banks.  This has been happening through 2009 and 2010.  This has been done primarily in two ways. One is through keeping interest rates artificially low – US interest rates are close to zero today, the three-month LIBOR is at less than 0.5 percent and so on – remember the crisis of 2008 was caused by cheap money? – and the second is by printing more and more money. Running the printing presses results in reducing the value of money you hold in you pocket by creating more of it to chase the same goods and services.

Cheap money across the world is creating another asset bubble (as we speak) which is increasing prices of assets across the world.  The stock markets including the Indian stock market are back up – Sensex is at 18000 levels today – the rupee has appreciated (due to foreign money flowing in) – etc.  However, the rise in prices are not as high as seen in 2005 to 2007 since the world economy overall has slowed down now.  Which is why this bubble that is building up is a slower build-up. Currently the Chinese are slowing because of lack of demand for their products across the world and also, a scaling down of their infrastructure spends.  However, be sure of one thing – there is another bubble building – and all bankers and governments are aware of it – they just hope things somehow improve before there is any collapse.

 As to printing more money, the US is doing it – and now Europe too.  Greece is right now the sick man of Europe. They lived beyond their means in the last several years and now have to pay – or actually, the stronger Euro zone countries have to pay.  Portugal, Italy, Ireland, Greece and Spain (PIIGS) are the countries in trouble.  Smug Europe is now looking distinctly alarmed.  There is an additional complication due to the Euro – they are all now inextricably linked and they will go down together!

The slowing down of China has another implication on the US as well – the Chinese used to reinvest all their surplus export revenues back in to US treasury bills to fund the US budget deficit.  Which again could be hit now.

India is in a reasonably better position.  The economic growth is still in the region of 6% plus – and we are again projecting 7 to 8%. Our economy was insulated (due to sheer luck and the RBI) from the world and hence did not collapse in 2008 as much as others did, except the stock market which was dependent on foreign money.  RBI is talking of raising interest rates again (slowly) – it's a good thing they still want to follow a counter-cyclical policy.  Our population is very young and we do not have government social security obligations to increase government spends – on the other hand we do have corrupt politicians and wasteful spending…  We are as usual, muddling through.

So where does that leave us?  Opinions are divided right now. There is one camp (this is primarily the establishment) that desperately wants things not to collapse and are talking positive.  Even they, however, feel that there will be a lot of volatility in the next few months/near future/few years.  I am sure several of them are not sure themselves of what will happen but are not saying so.  There is another group, consisting of people outside the establishment and some famous hedge fund managers, who are warning that another collapse is imminent.  Which one do we think will happen?

It's difficult to say at this point – we'll have to cross our fingers and watch.  The Euro according to me is not going to survive in the long run – any currency to survive needs the support of monetary and fiscal policies that impact the local economy concerned – and hence it is likely to succeed only when one government is calling the shots.  The Euro was doomed to failure right from the start since no one government controls its fate and each of the countries has its own domestic compulsions.  The US is now at near-zero interest rates and running the printing presses overtime.  Asset prices have again gone up all over the world including stock markets.  In India, prices of real estate has gone up 15-20 percent in the last six months without any underlying increase in demand.

It is very likely that in the near future there will be a lot of volatility and all markets are going to swing wildly.  There is a possible collapse waiting in the wings. The Indian Economy is not insulated from the rest of the world and will suffer the uncertainty in consequence as well.  However, the swings here are likely to be muted compared to the rest of the world since we have some compensating dampeners like a conservative central bank following counter-cyclical policies.

As an aside, when it comes to your personal investment strategies it would be wise to invest some part of your portfolio on gold.  When things go well, gold does fine though not spectacularly.  If things go badly other things will crash and gold will still do fine, meaning it will do spectacularly.  If you are invested in the stock market, keep a watch for signs of impending collapse (very difficult since there is high volatility) and pull your money out before the big collapse comes. 


mukaam said...

This is a very informative post with lot of insights and great depth. Global perspective weaved together pretty well. Thank you!

Dinesh Gopalan said...

having said that - can we predict with any uncertainty where we will land up - no!