So the state of a country’s economy certainly plays an important role in infrastructural needs of that nation. Infrastructure assets should always be forwarding looking because the rapid growth in population and economy especially in emerging countries will put strain on the existing infrastructure creating bottlenecks relatively quickly but at the same time parts of the countries experiencing lower or minimal growth may create a situation of overcapacity.

 Conceiving a smart and forward looking infrastructure asset and supporting it with the right capital is always critical.In the past federal, state, local tax bases other funding sources have been used to pay for vital infrastructure projects across the world. We have seen the business model for developing and funding infrastructure assets evolve in the last decade where a number of high profile infrastructure assets were built and paid for through Public Private Partnership or Initiative ( PPP or PPI). Although a number of high profile PPP projects have failed this model of developing and financing infrastructure projects is still considered one of the best way to pay for it.

 While emerging economies have the need to keep building vital infrastructure to support their growth and improve the living standards of its citizens, the developed nations especially the US are sitting on an aging infrastructure that needs to be updated. All this requires capital and with the ongoing financial CRISIS it is getting harder to source funding for infrastructure assets as banks are still struggling to fix their balance sheet. Also the asset-liability (ALM) mismatch is one of the major defects in the traditional business model followed by banks today which makes it tougher for them to commit more resources towards financing infrastructure projects. Most infrastructure projects require long term capital commitments ranging from 7 to 20 or more whereas banks own source of capital ( i.e. deposits) tend to be of much shorter tenure ranging between 1 to 5 years or less. There are also regulatory issues including of the overall exposure to the sector and the credit risk rating of the asset which limits the ability of traditional banks to commit capital. Alternate source of capital providers including of hedge funds dedicated to investing in infrastructure sector as an asset class tend to prefer investing in liquid assets and in most cases their exposure to the sector is limited to owning stocks or debts of listed utilities, toll road operators, constructions companies, ports operators among others.

 There is a strong need to diversify the source of capital base by making infrastructure an appealing asset class to a wide range of investors especially when governments including of developed as well the developing world are targeting infrastructure spending. Recently the ministry of finance of India announced an initiative called Infrastructure debt fund as to way to attract capital into the sector. This is a step in the right direction but having said that the proposal doesn’t address the core issue facing prospective investors when looking at infrastructure financing opportunities. The government of India is targeting an investment of over US$ 1 trillion ( around 10% of GDP) on infrastructure in its 12th five year growth plan for the country and the expectation is that the private sector’s share will be 50%. It is no doubt a highly ambitious plan and through Infrastructure debt fund the government’s objective is to facilitate the flow of capital from public and private sectors as well as foreign investors into infrastructure projects in India. The government figures suggest that there is a funding gap of over US$ 135 billion and this is based on the assumptions that there will be as much as 50% budgetary support for the planned investment in its recently announced 12th five year plan and the policy & regulatory reforms will mobilize over US $174 billions. Looking at the state of infrastructure in India and the balance sheet strength of the local banks it is safe to say that in reality the funding gap may be much higher than government’s expectation.

 In the developed world, UK chancellor has earmarked over GBP 30 billion in infrastructure spending in his speech delivered to the British parliament in November of 2011. The UK treasury is hoping that two-thirds of its earmarked for infrastructure investments will come from the National Association of Pension Funds and the Pension Protection Fund. It is also seeking investments in infrastructure from insurance companies and from China. The United States will need to spend over $2.2 trillion on updating and developing infrastructure assets across the country over a period of five years to meet the current needs and around $1.1 trillion of the overall spending would be new. This is according to the American Society of Civil Engineers (ASCE), and while private sector is expected to make its contribution most of the heavy spending will have to come from the government as evident from the previous spending on infrastructure in the US. The Congressional Budget Office figures suggests that the federal government, state and local governments spent over US$ 312 billion in 2004 on just water and transport infrastructure in the United states with very little contribution from the private sector.

 The current state of the global economy makes it extremely difficult for infrastructure projects to get funded. In markets like China banks are over exposed to the sector by lending to local government financial vehicles (LGFV) and most local governments are sitting on bad projects that aren’t making money and have also created overcapacity. There is also a lack of an efficient and developed secondary market for infrastructure loans in emerging market economies especially in countries like India, making it difficult for both public and private sector banks to refinance their loan books and in most cases the banks are as the end users of credit by holding the asset on their balance sheet until maturity   therefore becoming super exposed to the sector and minimizing their ability to grant more loans. Also Indian banks have recently been running a daily deficit of over INR 1trillion per day for the past few months causing a systemic liquidity deficit in the banking system further limiting their ability to commit more capital to the sector.

 Considering the above, Infrastructure debt fund (IDF) initiative of the ministry of finance of India does sound like an idea whose time has time come as it proposes to offer banks a platform to help refinance their existing loan book and by means of credit enhancement also be able to tap into low cost long term funding sources including of Insurance and pension funds. Having said that Indian banks will be competing for capital with their peers and there are no guarantees that foreign pension and insurance funds will pick Indian infrastructure assets over others. Money has no nationality and most investors will need to understand the structure better before committing capital. According to the public information released by the ministry of finance of India, the proposed IDFs will either be formatted as a mutual fund or a non bank financial company under modus operandi set out by the regulatory agencies including of SEBI and RBI.

 Although the case for IDFs has merit going forward the structure will have to evolve incorporating the realities of the market. Besides IDFs other plausible long term, simpler and sustainable solution will be for banks to set up their own independent infrastructure investment companies or in a consortium with credit guarantee agencies, construction & development companies, Institutional investors, regional development banks, multilateral agencies, utilities among others. As the promoter of the “ Infra Investment Company(IIC)” banks will inject their existing infrastructure assets and loan books along with the cash flows ( from the projects) into the balance sheet of the company and other founding partners will provide seed capital (in cash equity) of around 10% to 15% of the assets held by the company in order to secure a strong rating and valuation. The Infra Investment company(IIC) will have fixed and guaranteed revenue stream coming from existing infrastructure assets it owns and it will be relatively easier for such a company to secure a credit loss insurance cover on its pool of revenues further protecting its cash flow.

To access a diversified pool of investor base the “IIC” could do dual listing in local and foreign markets, issue bonds in local as well as foreign currency supported by its balance sheet and the strength of its credit rating. It can also act as a platform to deliver infrastructure related credit and assets to end users including of pension and insurance funds. Also through the “IIC” institutional investors such as pension and insurance funds could commit new capital into the sector removing the need for them to hire a fund or portfolio manager to manage their investment in the infrastructure sector across various asset class.

 Infrastructure assets are a vital support pillar of any economy and though some investors may consider the sector boring, good Infrastructure investments does create a positive cycle of growth, providing essential networks and services, stimulating economic growth and improving the standard of living for current and future generations. Also the investment in the sector tends to be less volatile than any other publicly traded securities.

 Although the Infra structure Investment company may not address all the existing issues in the sector but by adopting a flexible strategy the “IIC” should be able to tap into a wide range of funding pool including of retail equity investors, institutional investors, sector focused investors among others. It provides an opportunity to Investors who in principle do like infrastructure but are reluctant to buy into it because of the lack of liquidity that comes with it.

Going forward the policy makers in the government will have to take the baton from the tiring hands of the monetary policy makers and have the courage to take bold decisions that goes beyond party politics and is right for the economy.  The people on the streets especially those in the U.S. and Europe as well as the markets are increasingly losing faith in their political leaders’ ability to fix the CRISIS.  And it is probably the right time for the politicians to stand up and deliver. In a recent speech delivered by the president of United States to joint session of the congress Mr. Obama proposed tax credit to the SMEs under Obama’s American Jobs act plan as one of his own initiatives to encourage SMEs to hire more and create jobs. He also proposed common sense based regulations to remove the regulatory burden on the SMEs. Although these are steps in the right direction but the tax credits and the removal of unnecessary regulatory burden on the companies won’t do much on their own to create the level of jobs growth that US economy needs. Besides the tax credits and regulatory reforms the SMEs also need to have an easy access to capital at very reasonable and flexible terms. The government will also need to energise the supply and demand side. Consumers’ confidence is going to be one of the key factors in turning the economy around and the government will need to work closely and tirelessly with all the parties to bring the confidence and positivity back in the system.

It is important to point out that a CRISIS born in a globalised world will need a global effort to fully overcome it. Although it is unwise to expect the developing world especially the BRIC nations to bailout European states it is in the best interest of both the developing and the developed world to work together closely on finding a long term sustainable solution.

In the aftermath of the CRISIS high street banks especially those in Europe and the United States have so far failed to support the SMEs and in fact most banks have reduced their lending to the sector significantly while increasing the cost of capital at which they will lend to the SME sector companies. Banks as one of the beneficiary of the quantitative easing program have not passed on the cash to the real economy and they are still struggling with their risk management strategy so to expect them to do more to support the economy and the SMEs sector is probably unrealistic at least for now.

The small and medium size enterprises ( SMEs ) are an important integral part  and the supporting pillar of any economy. Generally the sector tends to lead a country’s new and fast growing industries.  Some of the success stories of developing world today including of Korea, Taiwan among others has been built on the dynamism of the SME sector. Also due to its inherent structure the labour intensity is generally higher in the SME sector companies hence the sector is usually the largest employer in a country. For example over the last two decades the SMEs sector has accounted for around 65% of new jobs created in the U.S. and overall it accounts for about half of non-farm U.S. employment and within Europe the SMEs sector employs around 68 million people which in percentage terms translate to around 72% of the workforce in the non-primary private sector.

Even though the SMEs are seen as an important part of an economy and play a very crucial role in jobs creation in general the sector is not serviced well by banks today. The banks who mostly play the role of an underwriter of loans or suppliers of credit to an enterprise are limited in their abilities to offer a flexible funding solution to the sector and provide the right support  to the SMEs due to a number of reasons, including banks being very cautious in their lending approach, uncertainty about the future and the changing market conditions, a changing mandate from their shareholders and the board, lack of commitment to the sector as well as the lack of the supporting secondary market infrastructure that will encourage and allow the banks to make good PRIMARY loans to the SME sector and be able to refinance in the secondary market if and when required. Financing SMEs do pose real challenges for the banks especially in the current environment where they are continuously feeling the pressure on their balance sheet and struggling to keep their heads above water. Also it is important to point out that while there is an immediate need to address the lack of capital availability to the SMEs it is important that the solution is sustainable and will add value in the long term.

The idea behind the new SME bank or the SME financing vehicle will be to work closely and directly with the sector as well as other banks, credit guarantee agencies, regional development agencies, usiness associations among others to provide direct and right funding solutions to the SMEs and also help in developing the secondary market infrastructure that will allow existing banks and lenders extending loans to SME sector companies to refinance their loan books.

Most Small and Medium Size enterprises require a flexible funding solution that is right for their business and will support them fully and won’t be called back or withdrawn living their business in limbo like an overdraft facility or credit line due to changes in the market conditions or a change in the strategy of the bank. SMEs like any other sector of the economy will prefer certainty and also a ring fencing of their funding commitments from the banks so they can make business decisions.

The inception & operational strategy of the proposed SME Bank

• The Central banks and the governments could create a SME Bank or SME Financing Vehicle in partnership with financial institutions including of development banks, private investors and other investors with focus on SMEs or similar investment asset class.
• The investment strategy and the role to be played by the SME Bank should be multifaceted and flexible to allow it to meet a range of capital requirements coming out of the SMEs. A single funding solution or investment strategy may not provide the right support to the sector.
• The SME bank should also be able to work with traditional and nontraditional lenders to SMEs including of high street banks.
• The SME bank should also provide a third party service to others and help other banks manage and monitor their existing SME loan books better and get paid a fee for its services.
• Buy off the existing loans from the balance sheet of the banks enabling them to refinance their loan book and use the new money to extend more loans.
• Also act as a guarantor to the SME sector companies that are looking to secure funding or provide performance bonds to their counterparties/clients if and when required.
• Be able to securitise SME loans under special tax free investment provisions for a limited period to attract investors into the asset class.
•  Provide advisory and consultancy services to SMEs and work intimately with the sector.

 Proposed Shareholders/Participants of the SME Bank (or the SME financing Vehicle) 

The government or the central banks, development agencies, multilateral institutions, local banks, credit guarantee agencies, private investors and financial institutions among others

Proposed Capitalisation and Guarantees

A part of the capital commitment to the SMEs bank could come from the Central banks using the government bonds purchased through their QE program and the remaining from its prospective shareholders. The capitalization of the bank should be based on the real funding requirement of the sector and should be sufficient to service good SMEs.

Benefits of the SMEs Bank

The SMEs bank will play a very important role with huge benefits to the SMEs sector companies, high street banks, lenders focused on SMEs, credit guarantee agencies as well as development banks and other market players. It will also act as an additional pillar supporting the market in the long run and will be a good value ADD going forward.

The local banks, credit guarantee agencies and other lenders or service providers to the SMEs by working closely with the SMEs Bank will be able to take a preemptive action on any loans or services extended to the SMEs that has a possibility of becoming a non performing loan. Also banks could easily offload good and performing loans to the SMEs Bank (or the SME financing Vehicle). While the SME Bank will do direct primary loans and investments to the SMEs sector companies it also will also help develop the secondary market for SMEs loans underwritten by the local banks and other lenders. It could also play the role of the credit guarantee agency to the SMEs sector.

Exit strategy for the shareholders

The shareholders could EXIT if and when required through an IPO in few years time when the markets are going to be much calmer.

The SMEs bank will energize the sector by providing a critical support to the SMEs with a range of financing solutions and will also add significant value to the existing system on a long term basis. It is an idea that needs to be seriously explored by the policy makers.

]]> http://sonykumar.com/2011/09/22/the-smes-bank-project-an-idea-that-could-energize-the-sme-sector-in-a-gloomy-outlook/feed/ 0 sonykumar http://sonykumar.com/2011/09/14/innovationideas-and-the-search-for-growth-in-a-market-disconnected-with-the-real-economy/ http://sonykumar.com/2011/09/14/innovationideas-and-the-search-for-growth-in-a-market-disconnected-with-the-real-economy/#comments Wed, 14 Sep 2011 09:22:26 +0000 Sanjeev Kumar http://sonykumar.wordpress.com/?p=113 ]]> The Best Innovative Idea can come from Anywhere Today.

End users need, market demand, availability of new technology and the search for growth are some of the Key driving forces behind innovation. FOR example Africa out of necessity is becoming the testing ground for new and innovative mobile banking experiments. The ongoing innovation in mobile payment and mobile banking is filling the growing demand generated from a part of the population that was once excluded from the economic activities and considered untouchables by traditional banks. Today mobile phone is allowing people to participate in the demand side of the economy. These mobile banking experiments could potentially change the traditional banking as we know it.  And going forward traditional banking models where if you were poor you are excluded will find it very hard to survive if they don’t adapt to the changing world around them.

Consumer lead innovation generally has a higher degree of success rate as it allows the corporate and entrepreneurs to fill in a growing demand.  Companies as wells as governments across the world have realised that innovation and technological advances are key to their long term sustainable growth.

While corporates are driven by profit, the governments have an important role to play in creating a platform that allows and encourages real value ADD innovation. The governments need to work very closely with companies, entrepreneurs and provide a supporting framework which facilitates Innovation and with it Research & Development (R&D).

Today the policy makers in the developed world find themselves aggressively competing with their counterparts from the developing nations in order to make sure they don’t lose the competitive advantage but who is to say that the NEXT BIG THING won’t come from a developing nation.

Technology has changed the world around us and without it some of us will struggle to carry out routine work. We live in a world of Facebook, Twitters , messengers, youtube and the list goes on. Today our world is so interconnected like never before. And there are legitimate concerns about the impact of ideas like Facebook, Twitter etc on the society. Going forward the society, the policy makers will continue debating the pros and cons but we can all agree that there is no turning back the clock.

The success of ideas like facebook is in its approach to innovation and its application. The scope of applications of a technology or innovations in terms of scale is far greater today than ever before.  Technologies and ideas that had more than 90% chance of failure some 10 years ago are in fact a SUCCESS story today.  Technology is evolving and in some cases too fast with significant affect on the society and the world around us.

Going forward Innovation and technology will be Key to success for developing countries especially economies and societies like China, India who run the risk of chocking on their own growth. For R&D Companies especially in Green Technology demand from countries like China & India will be at the forefront of their business strategy.

We have already seen the fast paced evolution in green technology especially in Wind and Solar.  Today the world wide wind capacity stands at around 251’000 MW and growing while the Photovoltaic production growth has averaged around 40% per year since 2000 and the installed capacity reached over 16 GW in 2011. Going forward the cost of power generation from green technologies like wind & solar will decline steadily as the technology gets better and more efficient.

The demands from developing countries for cleaner, cheaper, smarter, efficient and better technological innovations & ideas are coming out of sheer necessity and NECESSITY IS THE MOTHER OF ALL INVENTION. This growing demand will serve as a breathing ground for innovation. So it is highly plausible that the next BIG IDEA could come from the developing world or could be created for the developed world. And in order to make the most from the available opportunities companies, entrepreneurs, innovators will need to be based in markets that are generating the underlying demand.  The governments in the developing world including of countries like China and India will need to work closely with all the participants and provide the required and essential support to harness innovation and new ideas.

Some of the things the governments in the developing world could do to encourage innovation:

• Tax breaks over medium to long term to companies, entrepreneurs, innovators
• Encourage state or privately held companies to acquire R&D companies overseas to fast track innovation. Burning cash on duplicating the efforts already made by others in a competitive R&D environment may not be worth a while exercise.
• Promote Innovation & technology knowing well that (R&D) is a risky investment but this risk profile can change overnight with a single EUREKA moment.
• Promote Innovations and R&D that adds real value to the economy and bring simplicity with it
• Pick and target sectors where it can create a niche and support it by domestic demand.
• Have a collaborative approach to mitigate the risk profile of the development phase of a certain technology hence enhancing the return on investment
•  Be willing to share the development risk with the private sector
• Help with hand holding where necessary including with the implementation of the technological innovation in the market
•  Open the market to competition  attract overseas R&D Companies and support them with funding, risk sharing and establishment of a market ( if the underlying demand is not sufficient to support the bottom-line) by creating smart legislation and work with regional partners

While innovation and technology are going to be one of the Key drivers of sustainable growth it will be unwise to assume that all the innovations will add real value and provide growth. There are Innovations that add real value to the society and meet the growing needs and demands of the population but there others which may have an impact on the society but their real VALUE ADD is debatable.

Innovation and technology is a risky venture and not all of them will go on to become the NEXT BIG Thing. We live in a world where a company like Facebook with an estimated revenue of around USD 2 billion ( FY ending 2011 ) is valued at over US 100 billion and Twitter carries a valuation tag of around US 10 billon with an estimated revenue projection of approximately US 110 million ( FY 2011 ). Incredible valuation for private companies that may or may not exist after 30 or 50 years but whether or not we agree with the valuation and the methodology used for valuing these companies the fact remains that some in the market are happy to pay the price tag on these companies and ideas.

 In January of this year Goldman Sachs and Digital Sky Technologies (DST) paid US $ 1.5 billion  this investment valued the social network company at US 50 billion, a record valuation for a privately held company. Few months later General Atlantic purchased 2.5 million shares of Facebook valuing the company at US 65 billion.  The valuation jumped by over US 15 billion is less than 3 months without any fundamental improvement in the bottom-line of the company.

Growth projections of a business are mostly an estimated guidance but using it as a KEY ingredient in your valuation methodology is pretty much like assuming that a person is tall by looking at their shadow. The numbers are only as good the people who create and make them so it is unwise to take them as the gospel set in stone.

There is a strong disconnect between the real economy, society and the market. And the problem is if any of these overpriced investments go bad the market and the media will report this as the bursting of technology bubble depriving good and essential innovative idea & technology of capital. And the technology sector will become a no go area again. We saw a bubble burst in the 2000s and its aftermath.

 A sector could go from being attractive and undervalued to be overvalued in no time depending on the speed and the amount of capital flow it gets from investors around the world. There is a strong temptation among some in the market to ride on an in fashion trend and jump in the bandwagon. For example if emerging market is the growth story we are all tempted to ride it but the logic says if a country is growing at 9% percent it doesn’t necessarily mean that all the sectors of the economy are growing and attractive so committing capital based on the overall growth story is not just ill-advised it is how we build bubble and distort the reality.

While the markets are in panic mode I think it is important to look at the bigger picture to get some rationality. The US companies are sitting on over US 964 (approx ) billion in cash which is over 60% ( approx )higher than during the financial crisis. Employment picture is somewhat stable; households are relatively less leveraged than during the crisis, companies are paying out dividends among others.

The fundamentals of the global economy haven’t changed in the last 48 hours since S&P downgrade the US long term rating while affirming the top notch short term rating or we are missing something here? The downgrade was expected so nothing new in that and I believe no holder of US treasury will be running to sell their holdings. The impact on the US 4 trillion dollar repurchase ( repo) markets also been limited so far since the opening on Monday the 8^th of August 2011.  On relative terms US economy still looks like the better looking rubbish in a pile of rubbish.

Treasury officials in the US have already questioned S&P’s math and maybe there is some merit in their argument as some countries including of Austria, UK, France, the Netherlands, and Singapore holding AAA credit rating have a higher debt to GDP ratio than the US. The rating agency may argue that the debt curves in these countries are on a declining trend but it’s not entirely true.  So the math and criteria used by S&P may be a bit questionable but having said that S&P has shown a lot of SPINE and courage by downgrading the US long term credit rating. And there are some who would even suggest that in fact US is not even worth AA+ based on its fiscal situation.

I think it is important to remember that there is an afterlife post down grade. Japan didn’t die after they were downgraded in fact the local investors hold over 95% of the JGBs so they couldn’t care less about their external ratings. The policy makers made too many bad policy decisions which did the real damage not the ratings downgrade.

Markets reaction to a rating downgrade is nothing new and generally the move is not efficiently priced in although some may argue that rating agencies are often behind the curve and in most cases they are simply following or reflecting the market reality. I believe a rating agencies job is to report the findings as they see it and the rating reports should only be used as a reference / guidance. Investors should make their investment decision based on their own independent assessment of a credit but most managers have a restricted mandate built around rating reports issued by S&P, Moody’s or Fitch . So even though some investors say they don’t heavily rely on ratings to buy a credit I wonder how many of them do that in reality because the structure of the market is such that some managers find it easier to pass the blame on to the rating agencies for a bad investment decision.

I can understand the frustration of some of the holders of the US treasury especially the government of China who is one of largest US creditor but I don’t expect them to dump the assets in the market. China as a creditor is within its right to criticise the US government but also it is in the best interest of China, Russia, Brazil among others to make sure the US economy gets back on its feet.

In my opinion there is no AAA credit around today especially if you break the credit apart and bring in all the off balance sheet obligations of the governments. The world and the market dynamics are changing and so will the methodology used by rating agencies to rate a credit. It has to happen sooner or later.

Also I think the time of super powers are gone because we live in a very inter connected world and the era of Facebook. So no single country is going to be strong or influential enough to take the leadership role of the world on its own shoulders. Collaboration is going to be the name of the game going forward. And this is probably a better world order than one country or even two countries dictating the world order. We are looking at a multi polar world order. The financial crisis has managed to shift the paradigm in favour of the emerging markets country. And as a child of emerging market I may have a bias towards it but never in my dreams I would assume that China , India , Brazil etc are ready to lead the world. Their influence will certainly increase going forward and they will provide more input on the new world order which is good but the approach has to be based on collaboration because no country is strong enough to grow in isolation.

With regards to markets the immediate reaction was as expected but I hope people will look at the bigger picture. The downgrade was most definitely not priced in based on the reactions and shock we have seen so far. This downgrade will bring the reality home to the politicians and the hope is that the policy makers in Washington DC will now find a way to fix the broken American Political system and focus on getting the economy back on track because they will feel heat from all sides including their electorates and may even lose their seats.

The problem with the US economy is the shrinking middle class. It’s one of the core spending groups that drive the US economy forward. I believe the policy makers in the US will need to address the shrinking middle class issue in order to arrest the slowing momentum of the economy and create an environment that will give ample confidence to American and global business owners and help them put the cash they are hoarding back to work in the economy.

The political leaders both in the US and Europe haven’t really managed to get ahead of the CRISIS but it’s never too late. What’s happening to commodity and Oil can only be good for the economy and for the average folks on the street. There was simply no real economic justification for such a high pricing levels on commodities and energy related assets. If people were expecting the world to grow at pre-crisis levels than they were simply mistaken and are now they having to do a reality check. And with regards to Europe its problem will probably get solved by more fiscal and political integration of EU nations. But the question is. Are the Europeans willing to give away their own national identities and interests for the greater good of European Union?

The slowdown was expected but there is nothing in the visible data to suggest that we are looking at a recession again.

The solutions are simple but I wonder if the politicians will do what’s required. I personally don’t see the downgrade as all negative for the US economy in the long run.  I am starting to develop an opinion that this world is probably being RUN with very little WISDOM.

China and India are now leading economic stories on the world stage and this story may very well last through most of our life time.  And while some in the market regard the two countries as competitors in the years to come collaboration and not competition will take the centre stage. India and China’s trade relationship is historic going back 2,000 years under the thriving Silk Road trade. Relationship between the two countries has been thorny in the past and they did go to war over a border issue in the Himalayan region in 1962 which affected the trade and bilateral relationship negatively.

However from the 2002 onwards when the two countries agreed to work on normalising the relationship and spurring commerce, the bilateral trade between the two has steadily grown from a mere US$ 7.3 billion in 2003 to around US $ 62 billion in 2010 growing by more than 8.4 times in just 7 years at an annual growth rate of over 120% making China the leading trading partner of India, and India jumping 11 places from 20^th top trading partners of China in 2003 to be ranked 9^th among China’s leading partners in 2010. The two countries have already agreed to push the bilateral trade to USD 100 billion mark by 2015. Although China’s bilateral trade volume with ASEAN, Japan and South Korea is higher the annual growth rate of the INDO-CHINA bilateral trade is far greater and is set to continue as business to business contacts grow. Also the size of the economy, population and the geographic closeness of the two countries provide abundant opportunities for growth in bilateral trade.

Today a significant portion of the world trade growth is coming from China and India. And this trend is set to continue going forward. Intra – Asian trade has clearly been one of the biggest beneficiaries of the growth. According to IMF the interregional trade flows within Asia has grown at the rate of over 13.4% from 2000 to 2009 and is estimated to be valued at just over US 1 trillion. So far China has been the major driving force behind the interregional trade growth. And a noticeable change in pattern has been the increase in imports from Asia to meet the domestic demand coming from Chinese consumers whereas previously a bulk of the imports from parts of Asia were assembled in China and re-exported to the developed markets. The pickup in domestic demand is line with the government’s attempt to rebalance the Chinese economy. In its recent 12th five-year plan Beijing has set out a clear plan and set of measures to rebalance the economy and drive up domestic consumption.

The Government in China has realized that a vibrant domestic market is the only guarantee of a sustainable growth and long term success and relying heavily on foreign demand makes the country vulnerable to external shocks . So expanding domestic consumption is clearly a favoured long-term strategy for Beijing especially when its export based manufacturing seems to be slowing down and gradually may lose competitiveness mostly driven by rapidly rising high wages, higher input cost, shortage of low-skilled workers among others. Various projections suggest that the working age population in China will peak around 2015, so the labor supply is going to gradually decline and push up the wages even higher.

Historically wage growth and household income in China have not matched the overall GDP growth and some research suggests that in fact wages have actually fallen from 53.2% of gross domestic product between 1992 and 1999 to 49.7% between 2000 and 2008. So in its efforts to rebalance the economy the government has taken measures to allow significant rise in wages across the board. In line with government policy the municipalities across China have raised the minimum wage on average by over 20%.

Rising wage pressure, appreciating currency and high input cost driven by inflation may be enough to shut down a significant number of export houses in China especially in the low manufacturing sector where exporters’ average margin is around 3% or less.

Going forward the government in China will have to look at creating policies that will allow private sector to play a bigger role and drive the domestic demand. Having that said it is worth noting that since 1999, the share of State owned Enterprise (SOEs) has declined from 37 percent to less than 5 percent in terms of numbers, and from 68 percent to 44 percent in terms of assets as a result of the SOE reforms carried out in the past under “grasping the big, letting go of the small” strategy. That said still a huge portion of the Chinese economy ( in terms of GDP ) is under government control and it has been the major driving force behind the overall GDP growth whereas the private sector has been driving India’s growth.

 It is estimated that over 80% of the Indian economy is now in private hands and the private sectors is driving the investments story in the country. Private sector in India has benefitted hugely from the Indian growth and has accumulated significant wealth. It is estimated that the combined total assets of India’s wealthy is set to reach around US $ 6.4 trillion( the highest in Asia ) over the next 4-5 years.

India’s demographic profile is very attractive with a strong pool of young population adding to the workforce every year but it must be said that a good percentage of them may not be employable. So the government needs to reform its education sector and also increase the number of good universities and colleges across the country. One way to do it will be to encourage established foreign education institutions to set up campuses in India alongside or in partnership with the local universities and colleges.

As the Indian economy grows it is estimated that around 200-250 million people may be added to the consuming class in the next 7 to 10 years. This presents a huge opportunity to both domestic and foreign companies within Asia and other parts of the world.

 In the short to medium term China will still be at the centre stage like the sun in the solar system driving the interregional growth in Asia and parts of emerging markets. Having said that India’s share is gradually increasing and so is its annual growth rate. It is worth noting that India’s annual GDP growth rate for 2010 was slightly above China according to the recent IMF publications. This does not mean that India will anytime soon match China’s economy in terms of the overall GDP ranking. But both the countries are expected to be major driver of growth for the region and other emerging market economies. Based on this assessment the Intra-Asian trade flow is estimated to grow at an average rate of over 12% year-on-year until 2020 (according to HSBC and Asian Development Bank ) and the series of bilateral free-trade agreements signed recently by both China and India with others Asian countries will significantly boost the regional trade flows. 

However it must be said that said both the countries do face significant challenges going forward. There are some concerns that the Chinese economy is overheating and the increased investments in fixed assets especially infrastructure and real estate which shows no visible signs of slowing down in spite of the tightening measures will hinder the real and required rebalancing of the economy.  The latest Q1 GDP print for 2011 show the economy grew at 9.7% year-on-year which exceeds market expectation and also defy concerns about any slowdown in growth.

Some commentators have also suggested that China’s growth story resembles Japan in the 1980’s and ultimately like Japan the bubble will burst and the country will hit a wall. It is worth pointing out that most of the bold forecasts about China have turned out to be wrong. The funny thing about forecasting and making predictions is if you make enough of them on a regular basis there is a good probability that you may get some right eventually. And with the right marketing skills and a bit of luck you could turn yourself into a market GURU.

Due to its growing economic influence China does attract a lot of attention and there are many economic theories around China. It is worth noting that although China is the world’s second largest economy it still has a very high income disparity and a low per capita income. And unlike Japan in 1980’s the country is still a developing economy and has a decade or more of growth left in the tank. Chinese growth story today resonate more with the U.S. story in the early 1900s when the U.S. went through numerous boom and bust but each time the economy recovered and got bigger.

The market expects the government in Beijing to fast track the implementation of policies that drives up the house hold income in real terms; increase the role played by private sector, and incentivise domestic consumptions among others. Also currency appreciation and a collaborative approach to guard against commodity and oil & gas price volatility may be a useful method to fight against inflation driven by external factors.

The previous strategy under which Beijing encouraged its State owned Enterprise ( SOEs ) to acquire mineral & mining resource assets including Oil & Gas overseas to secure price stability and supply didn’t really deliver the desired result. While state owned enterprise (SOEs) profited from the government’s “equity oil “ strategy  the Chinese consumers and the policy makers didn’t see any real reward. And in the current political turmoil in the middle-east Beijing may have to re-visit the existing strategy and look at ways to increase global co-operation with other resources (including Oil & Gas) dependant countries to create a collective game plan for guarding against supply disruption and greater price stability.

Having said that commodities and oil & gas prices will remain vulnerable to speculation and a significant percentage of the pricing input and price movement of commodities including of OIL & GAS is based on speculation. It is worth noting that the world is not constant but changing where a useless commodity can become relevant overnight driven by innovation and technology. For example Crude Oil was once a useless commodity that became valuable overnight.  Also Bolivia’s Lithium reserves – Lithium is used for the production of batteries and was once considered useless but it is extremely valuable these days and with the explosive growth in hybrid and electric cars the demand is outstripping the supply on a daily basis. So all of a sudden Bolivia is becoming very important in the whole scheme of things. It must be said that evolution, innovation and technological advances are key to sustainability and survival. The saying “Necessity is the MOTHER OF INVENTION “clearly holds TRUE.

India and China together is home to over 2.5 billion people so food and energy security will always be at the forefront of government’s policy. And in line with this policy both India and China have allowed home grown companies to expand capacity by acquiring assets in other emerging markets. Indian Agro companies have acquired and leased various agricultural assets including of farming lands in Argentina, Brazil, Mexico and parts of Africa. India’s agriculture sector is need of serious investments and structural reform including improving farming methods in order to increase its productivity.

China has 10% less arable land than India yet its agricultural production is 25% higher. Also China implemented land reforms in the early fifties which resulted in enhanced agricultural output, establishment of agro industries whereas with the exception of some states land reforms were mostly half measures in India. Bad policies decisions further deepened the crisis and as a result thousands of farmers are committing suicides every year across the country. Having said that private sector in India is making serious investment in the agro based industry and some of them bearing fruits. Going forward the government and the private sector in India will need to work together to boost investments in agro infrastructure as well as upgrading of existing distribution system, irrigation, farming methods and technology.  New Delhi will have to look at liberalizing R&D in agriculture sector, create policies to encourage investments in the agro sector of the economy and this will have to include the much needed land reforms.

China’s ambitious development goals are an official target of reaching a 95 percent grain self-sufficiency rate. This policy is a pillar to establishing the country’s food security, and result in an increase in domestic fertilizer consumption. According to the governments figures China’s national grain consumption will reach 572.5 million tons around 2020, requiring an increase of around 50 million tons in domestic fertilizer production over the next 10 years.  In order to achieve these targets, the government has made clear that it plans to boost investment in agro infrastructure also upgrade existing technologies in irrigation systems as well as seedlings, while improving farming methods and increasing the level mechanisation in the sector.

While both India and China search for a more competent, healthier and sustainable way to develop their economy. They do face similar challenges and one of them is to find a growth model that is inclusive and able to deal with growing income inequality which could potentially create social unrest going forward.

The two great civilizations of the past are finding their way back to the world centre stage as economic powers and in the process reshaping the future of the global economy. Both countries can learn a lot from each other and through collaboration create limitless growth opportunities.

A combined population of 2.5 billion presents a huge market full of abundant opportunities that has a potential of creating a super- highway for growth. And linking to a super growth corridor will allow other countries especially the emerging economies to increase their growth speed limits significantly.  So there is a strong case for companies and economies to have a China- India strategy (aka CHINDIA ) rather than a strategy that focuses only on China or India.

Let us look at the last few months to get a good handle of where we are, shall we? To begin with I must say if we look at the events unfolding in the last couple of months there was no dull moment and it has been an action-packed rollercoaster ride which has kept us busy and entertained but this depends on how you look at it.

Shall we do a quick RECAP and look at some of the HIGHLIGHTS of the past few months?

Starting with China we saw Agricultural Bank of China raise a record US$ 22 billion in IPO. It was the world largest IPO, the previous record was held by ICBC- China after raising US $ 21.9 billion in IPO. Although some suggested that the reception for Agricultural Bank of China ( Ag Bank ) was lackluster and the IPO was apparently overvalued but most of the analysts surveyed by Reuters expect the stock to go up to RMB 2.81 relatively quickly.  Up to 40% of the Shanghai offering was sold to about 27 strategic investors including of China Life Insurance, China State Construction among others on a 12-18 months lock-in period. And from the Hong Kong listing a total of around US $ 5.5 billion worth of stocks were sold to Qatar and Kuwait’s Investment Authorities.  It is interesting to note that the bank which was considered by many as technically bankrupt with more than 24% in non-performing loans around 3-4 years ago managed to raise a colossal amount of money and also reported a 40% jump in net profit in the first half of 2010. I wonder how Ag bank’s turnaround reflects on the investors’ confidence especially those reluctant to hold bank stocks and may be other banks could take a leaf from Agricultural Bank of China’s book? .Let’s see.

In the short to medium term the market expects China based banks to raise more money as their balance sheet comes under pressure due to excessive lending to the property market.  The China Banking Regulatory Commission (CBRC) has instructed the Chinese banks to test the impact of a 50% fall in the house prices in major cities across China. This is in addition to an early nation-wide stress test that showed the local banks in China could sustain a fall of up to 30% in housing prices without a sharp increase in non-performing loan ratios.

It is highly plausible that the Chinese Government will continue with its controls to restrain the property market fearful of the social pressure that could arise from a BOOM-BUST in property sector as recently seen in the US and in Japan in the 80’s.  And this is already feeding into the overall demand from things like construction raw materials including of steel, cement etc to household products among others.

Most of the recently published figures show a softening in demand. The annual factory output in July slipped to 13.4 from 13.7 in June although above the consensus but still a decline. The Consumer price inflation fell to 2.9% in June from 3.1% in May. These figures along with the weaker retail sales indicate clearly a slowdown in the economic activities across which was reflected in the second quarter (Q2) GDP numbers. According to the National Bureau of Statistic (NBS )  the growth fell to 10.3% in Q2 from 11.9% in Q1 of 2010. The Q2 GDP print was below the market expectation of 10.5%.

Although there are different view as to where the Chinese economy is heading I believe the GDP and other data are in line with expectations and there is no alarm yet. The slowdown as expected looks moderate and I believe there will be no policy relaxation from Beijing in the immediate future especially based on these set of numbers. So going forward we may see the investments come down and the recent numbers out do point in that direction. Let’s look at them. According to the Central Bank the total loans for the month of July stood at RMB 533 billion, below the forecasted RMB 600 billion, the year-on-year credit growth has also slowdown sharply to 18.4% in July, well down from 33.8% of last year, also the annual growth in the broad M2 measure of money supply considered the lubricant of economic growth slowed to 17.6 percent in July from 18.5 percent in June.

What all this means is we may see further softening in demands in China which will reflect badly on imports including of commodities and machineries etc  going forward.  To add to that we are already seeing a significant buildup in inventories and this is not what you want to hear if you were a German machine manufacturer, a miner or a commodity driven company/economy. Some in the financial markets may worry that the policy makers in China are applying the brakes too hard to slowdown the economy which could take out a big chunk of the existing global demand especially because China has been a major driving force. And this may reflect badly on the overall global growth prospect and recovery.

There is no doubt that the slowdown in economic activities is in line with  Beijing’s  expectation and this is clearly a government engineered slowdown as the market feared an overheating of the economy earlier this year and some analysts even suggested that it may be too late for Beijing to a get grip over the runaway economy. This is why I keep telling my friends and colleagues never underestimate the policy makers in Beijing.

The other side of the story is that the economy is still holding up and even with the current slowdown in activities the consensus view is that China could still grow at 9% or there about in the FY 2010. This is by no mean the end of the world as some may fear. I believe it is worth noting that going forward the government may start to ease its credit policy especially if there are signs that the economy is slowing down too rapidly for Beijing’s liking and so by the end of the year they may speed up targeted investments in areas such as low-income housing, rural development and clean energy. Also we shouldn’t forget that one of the advantages of the existing political system in China is that it allows the policy makers to acts faster and swiftly unlike their peers in other parts of the world.

Staying with Asia the fact is many policy makers across Asia are starting to worry more about inflation and hot money flow than a double-dip. Most economies in Asia including of Hong Kong, Singapore, South Korea, India, China, Indonesia and Australia among others have all seen a very significant capital inflows in 2009 and the first half of 2010 mostly from investors attracted by their growth potential. And now there is a genuine concern that the amount of hot money committed to Asia and Emerging market as whole could create an Asset bubble going forward. In fact European and American equities markets are looking cheaper then developing markets and you wonder if some emerging markets may have already produced most of their gains.  That said the growth story of the emerging markets is still intact and investors looking for growth will remain extremely attracted to the EM.

So far this year Southeast Asian Markets has had a very strong run and as of the end of July, Indonesia was the best-performing market in the world in 2010, the Jakarta Composite Index up 26.2 percent; Thailand’s Main Index was up 19.7 percent; Malaysia’s 14.5 percent and The Philippines’ 13.0 percent. However, Singapore Straits Timex Index was only up by 6.3% in the first half of 2010 despite a second quarter (Q2) GDP print of 19.3% year-on-year. The city-state economy is benefiting from government investment in the bioscience, electronics and construction sectors among others and is expected to grow at around 15% or more in the FY 2010.

Moving on let us look at what’s cooking in Europe shall we?

The recent numbers out from the Euro Zone clearly point to a two faced growth in the Euro area. While Germany the largest economy in the Europe expanded at the fastest pace in over two decades reporting a 2.2% growth in second quarter (Q2) and was responsible for almost two thirds of the Euro bloc’s second- quarter growth but unfortunately its southern European counterparts are still struggling to recover from the CRISIS.

Germany’s business confidence data- Ifo index continues to be on the ascending trajectory showing the strongest increase since the reunification in 1990’s. The unemployment rate in June declined to 7.5 % from 7.7 % in May the jobless numbers was down by 88,000. This was mainly due to the government support for maintaining employees on the job with shorter hours instead of laying them off. The economy seems to be getting in shape and the export driven business model of Germany is in full swing. All the signs show that the Germans export benefitted heavily from the demands coming from Asia especially China but going forward it is highly plausible that the growth may lose momentum because of the strengthening Euro and softening in demands from countries like China. Also in the second half of 2010 the austerity measures will kick in hampering the growth further.

The austerity measures are already crippling growth in countries like Latvia, Greece and Ireland.  Take for example LATVIA –one of the first EU nations to implement austerity measures two years ago. The huge budget cuts have made the matter worst. Also Greece has been hit harder than previously forecasted after implementing the severe austerity measures and it is highly likely that the growth will remain negative for this year hurting the economy even further. According to a recent research published by the retail confederation ESEE about a fifth of small shops in Athens have shut down because of the downturn. The unemployment is expected to go higher from its current 12% level hitting the private consumption further. The ongoing recession is deepening consumers’ insecurities about jobs and debt, making them cut their spending and to try to wind down borrowings. It is highly plausible that the impact will become more pronounced in the second half of 2010.  We will have to wait and see. It is going to be a real test for the voters and politicians.

There is a genuine fear in the market that with the austerity measures kicking in around the second half (H2) of the 2010 some of the European nations including of Spain may slip back into recession after reporting a GDP growth of 0.2% in the second quarter (Q2 ) creating a growth gap and making it harder for the European Central Bank (ECB ) to correctly gauge the timing of its policy tightening steps. As things stand I think it is safe to assume that it’s too early for ECB to start thinking about tighter policies and one should not get carried away with Germany’s second quarter ( Q2 ) growth numbers. The reality is Euro Zone countries are still struggling to keep their head above the water and in most countries across the EU the wage pressure are downwards and the core inflation stand at just 1%. Also besides Germany other major European economies like Italy are struggling with the mountain of debt and raising money for them in the market is not getting any easier as reflected by recent jump in the spreads.  Based on Bloomberg data for the first time since June 28 the premium that investors demand to hold 10-year Greek bonds against a German government bond of same maturity rose to 800 basis points (bps) and the Spanish government bond yields climbed six basis points to 4.24 %.  Most investors are also shunning Spanish banks because of their record borrowing of 130.2 billion euros from the European Central Bank in July of 2010.

It is also worth noting that while Germany is forging ahead the others in the EU believe that it is doing so at their expense. By cutting the budget deficit and keeping the wages down Germany is in fact making it harder for other EU states to regain competitiveness. It will be interesting to see how all this plays out for the Euro Zone going forward.

The hope is that the European leaders will learn from their past mistakes and going forward they will look beyond their national interest and work together towards perfecting the Union. The Union was not designed or conceived to handle a CRISIS it clearly exposed the flaws and also the limits of EU integration and coordination.

Staying with the EU let us also look at the performance of the UK economy, a prominent EU member and a major trading partner, in the last few months.

According to the office of National Statistics the UK economy grew at 1.1% in the second quarter ( Q2 ) of 2010. The Q2 GDP print was well above the market forecast of 0.6% but as per my expectations. I wrote a piece in April of 2010 titled “Market Psychology and Investors Sentiment (mood of the market) – The Driving Force Behind the markets “. I have copied an extract from the post which explains the reason behind my assumption.

“ And in terms of growth, going forward we could see a market beating quarterly GDP numbers and the reasons for that is simple we simple don’t know how much spare capacity is left in the economy and the inventories are so LOW that even with the existing and basic demand you will see a pickup in growth and this could PUSH the market up”

So does that mean the UK economy is now getting back in SHAPE?

Well let’s look at the bigger picture to get a better IDEA. A recent survey done by the building society Nationwide puts British consumer morale at the lowest since May 2009.  According to Nationwide the rising food and fuel costs may also have played a part in the drop in consumer confidence indicator from 63 in June to 56 in July. The survey also showed a sharp fall in households’ sentiment about the economy, job market and income over the next six months. Consumers are growing increasingly concerned about their disposable income and the planed VAT rise from January of 2011 probably won’t help that concern going forward.

Also according to the Royal Institution of Chartered Surveyors the house prices fell for the first time in a year in July because of the buyers’ reluctance to commit as the sellers rushed to sell their properties. There is a risk that we may see this softer trend continue in the second half (H2) of 2010 as many prospective buyers are still struggling to raise mortgage finance. I believe it is worth noting that the high profits for banks in the first half of 2010 were also facilitated by lower impairment of existing mortgages and expectations that house prices would be stable. Going forward a slowing housing market along with the planned 25% government spending cuts, VAT rise, and a high unemployment  among others will add to the uncertainty facing the Bank of England as it tries to guess the growth prospects for the UK economy.

The new coalition government in Britain has decided to strip down to its bones as it prepares to cut the expenditures by more than 83 billion pounds over the next five years and drastically shrink its responsibilities. You can’t help but wonder if the economy can survive a starvation diet. Imagine an extra extra extra  large ( XXXL ) size human being decides to SLIM down dramatically and goes on a CRASH WEIGHT loss program. The commonsense tells us that he will SLIM down alright but in the process also runs the risk of crashing his/her heart. A gradual weight reduction is always the best advice which also leads to a long term weight control and a healthy system.

There is no doubt that Britain risks losing it growth momentum due to the planned spending cuts, VAT rise etc. And it is evident from the Bank of England recent downgrading of UK’s growth forecast for the FY 2010 the bank also raised its inflation expectation for the next year in its recent published quarterly growth and inflation forecast.

Staying with the spending cuts here is an extract of what I wrote in one of my post titled “Stimulus: The Exit Strategy and the road ahead” in January of 2010. I think it is still relevant.

“Although one understands that there is need to fix balance sheets (fiscal consolidation) and address the inflationary concerns by having a clearly formulated, defined and coordinated exit strategy in place. But that said Timing will be KEY here as exiting too soon or too late has its own risk. And also it is extremely important that the process should only begin when there is enough hard evidence to see that economy will keep growing on its own after the removal of the stimulus or in other words it is evident that the recovery is solid, financial markets are back to normalcy and credit risk spreads are at an acceptable level and there is a significant risk to inflation over the medium term”

In the same post there is another interesting point that I thought I’ll share again.

Here is an extract “ ……………….one has to also admit that the policy makers have managed to avoid a Great Depression type event by not adopting an extremely tight fiscal and monetary policy but a single policy mistake here could jeopardize the whole recovery process “.

I think it is important to point out that both the points are still relevant and we can only hope that the policy makers get it right and have a good foresight.

Moving on it is no secret that the global economy is still very reliant on the US and going forward an underperforming US economy will reflect badly on the overall growth prospect.  So let us check out how the US economy has been doing in the past few months.

The market was anxiously awaiting the Financial Regulation (FinReg) Bill  so the biggest news coming out of the U.S. for some was the passing of the FinReg bill in July of 2010 that is supposedly going to prevent future CRISIS. Whether it does or not well for that we will have to wait and see. The FinReg bill deals with a number of issues. Some of the important one’s are Systemic Risk – Under the proposed plan the Financial Stability Oversight Council chaired by the secretary of the treasury will identify firms that threaten stability of the system and subject them to tighter oversight by the Federal Reserve; Ending Bailouts -Firms would have a mandatory “funeral plans” or a living Will that describes how they could be shut down quickly; Supervising Banks – the Comptroller of the Currency will take over from the U.S. Office of Thrift Supervision and the FDIC’s deposit insurance coverage will be  raised to $250,000 per individual from the current $100,000 level ; Hedge Funds – All Private equity and hedge funds with assets of $150 million or more will need to register with the SEC and will be subject to more inspection. However, venture capital funds would be exempted; Insurance – A new federal agency/office will monitor the industry; Volcker Rule And Bank Standards – credit exposure from derivative transactions will have to be added to banks’ lending limits, Non-bank financial firms under the Fed supervision will now face limits on proprietary trading and as well fund investing etc; And Investors protection among others.

Now coming back to the performance of the US economy in the past few months, the recent data from the US has been mixed and also weak. So let us look at some of them.

 We saw the U.S. consumer-price index increase by 0.3%, the most in a year and above the market expectation. The Commerce Department data showed retail sales excluding autos, gasoline and building materials unexpectedly fell by 0.1 % in July. According to Reuters/University of Michigan survey of consumers the preliminary index of consumer sentiment jumped to 69.6 following a reading of 67.8 in July, the lowest since November. Also the U.S. second quarter (Q2) GDP growth slowed to 2.4%.

Based on the recent data coming out the US it is safe to assume that the recovery is softening.  Taking this into account the Federal Reserve has taken fresh steps to lower borrowing costs. In a recent statement the Fed announced that “ to help support the economic recovery in a context of price stability, the committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities”.  This is a significant policy shift as not long ago the central bank was eagerly debating the EXIT strategy from the huge stimulus delivered during the crisis. The Fed is also downbeat about the growth outlook going forward. A recent San Francisco Fed study suggests that there is a strong chance that the US economy will slip back into recession in the next two years. And to add to that according to the latest IMF’s annual review of the U.S. economy the fund observed that the U.S. fiscal gap associated with current federal fiscal policy is huge for probable discount rates.” And it claims that “closing the fiscal gap will require a stable annual fiscal adjustment equal to about 14% of U.S. current GDP. That basically translate into a constant doubling of personal-income, corporate and federal taxes as well as the payroll if the U.S. was to try to close the current fiscal gap from the revenues. So in short the country is living way beyond its means. Some would term this as a technical bankruptcy. Shocking isn’t it? But this depends on how you look at it. Remember the phrase when the U.S. sneezes the world catches cold well this still holds true so fear not. Also you go bankrupt only if others are not willing to lend you the money. It is in the interest of the world to keep the U.S. economy afloat and going forward it is highly unlikely that the foreign buyers of U.S. treasuries including of China, South Korea, Japan, Taiwan and others will abandon the US.  Although the US economy has performed a bit below the market expectations it will be unwise to write it off and underestimate its ability to come back.  But going forward there may be a significant rise in the poverty level across the U.S. and we are also going to see tax rises among other things.  It is worth noting that the Fed’s still have ammunitions at their disposal but we will have to wait and see how effective they are going to be.

There is no doubt that going forward the policy makers in the U.S. will have to find ways to make sure that credit worthy small and medium size businesses have access to capital. Banks, companies and individual consumers are all economically inter-reliant. So if the financial institutions refuse to provide credit to good businesses because of the fear that other lenders will cut down as well. This will create a shortage of credit hence extending the CRISIS and delaying recovery even more.

So how will all this reflect on the growth prospects in a wider context?

There is no doubt that the emerging markets have been leading the way and in general investors have so far been more optimistic about the emerging markets than the US or Europe. Also it is interesting to note that the performance of the Asian indexes has been reflected in the US and other developed markets. And the demand side of the story has been mostly driven by Asia especially China. Although all the recent data suggests that the economic activities in major Asian economies like China is moderately slowing down that said China, India, Indonesia and others have a lot of growing to do. And going forward a big chunk of the global demand is going to come from the developing world especially China and India. According to the Washington based Inter American Development Bank (IADB) the total economic output from China and India combined together is expected to be around 10 times bigger than Europe’s total GDP by 2040. While China is already a leading trading partner of most developing countries as well as developed nations across the world, India is now adding to the demand side. Going forward India – a commodity hungry country, may very well become a key demand side client for commodity driven economies like Latin America.

Also the economic growth outlook for Africa is improving and going forward the region does have the potential to become a significant growth provider. And it is in the interest of the world to foster growth in the region. The policy makers especially in the developed world should look at Africa as a prospective vibrant market that will create demand and work towards creating a long term partnership with the region. Some European companies especially Portuguese are already tapping into Africa and generating more than 50% of their revenues from the region thus compensating for the loss of revenue from their domestic market.

This is why I keep saying to my friends and colleagues that the fear of double-dip might be good for the markets in the long run as it will keep the policy makers awake and alert fearing a policy mistake here could jeopardize the whole recovery process and the global community will blame them for it. That’s the fun of living in a globalised world where your problem may become mine sooner or later. Also I am starting to think that this CRSIS is an opportunity to rebalance the world and comparing this crisis to the past recessions and deploying the old rules of thumb is probably unwise as today we have a number of other factors including of a very vibrant emerging market that could influence the outcome.

 Now some may say being positive is good but one has to be a REALIST too. Isn’t that just COMMON SENSE or maybe not. I believe human psychology plays a very important part in whatever we do as humans. And I do mean everything relationship, business, career etc.

Let us explore this more shall we?

Most of us who operate in the market or just watch the market have witnessed the markets going UP on bad news and vice-versa. And sometimes the strength of these irrational or unexpected moves will make you want to lose all your foresight, judgement, wisdom and commonsense. You will be tempted to abandon your own view and just follow the trend.  There are some who do follow the trend. And there is nothing wrong with that. You don’t need to beat the market consensus but just profit from it.  But sometimes bucking against the market consensus does pay well in the end.  We all know that the markets have a habit of getting either too optimistic or too pessimistic and this has a lot to do with the market psychology.  

Understanding the market psychology and how it affects the markets is never easy. But you can position yourself and also profit from it by simply looking at the bigger picture and not get carried away by the market sentiment.    For example there were folks who went into the CRISIS uncertain about the future and with a very negative frame of mind (who would blame them) but there were others who went into the CRISIS knowing well that eventually things will get better and thus had a POSITIVE frame of mind. In the aftermath of the CRISIS all the evidence shows us that the later did profit from the CRISIS and are better for it.

Things are looking and getting better. Across the globe (with the exception of few countries) in general we are seeing a positive turn in the inventory, the manufacturing sector is beginning to do better, exports are doing well, businesses are beginning to spend some money, we are also seeing signs of improvement in the job markets, consumer and business confidence in the future seems to be getting better and one could say that we may have turned the corner. Having said that we may still see some mixed numbers going forward and although the overall health of the economy is getting better it is difficult to say with certainty that we are heading into a self sustaining recovery especially in the developed world until we start getting hard evidence that the private sector has started driving the growth.  But based on the current state of the global economy where we are getting more positives then negatives I think it is safe to say that there are no tell tale sign or risk of a double dip recession going forward and the global recovery is gathering momentum with Asia leading the way. As I have said before in my post titled “Coming of Age: Emerging Markets – The Next Generation of Growth Engines “. A post that I wrote in July of 2009 the party is in the Emerging markets.

There is no doubt that the policy makers have managed to avoid a Great Depression type event by not adopting an extremely tight fiscal and monetary policy. Keeping a loose fiscal and monetary policy has surely helped. But that said the overall cost of the CRISIS on the Governments has been enormous as evident from their fiscal position. Their balance sheets are too stretched and they are getting calls from all the quarters to take immediate steps to FIX it.  Although one understands that there is an immediate need to fix the balance sheet and also address the inflationary concerns by having a clearly formulated, defined and coordinated exit strategy in place. But that said the Timing will be KEY.  I believe the policy makers would like to see credible and hard evidence that that economy will keep growing on its own after the removal of the stimulus or in other words it is evident that the recovery is solid and sustainable. And this is why I believe the chances of a double dip are now becoming extremely remote.  But that said there are still many challenges that lies ahead and any policy mistake here could jeopardise the whole recovery. 

 Although policy makers have done a good job but there is a lot that could go wrong especially if they start playing politics and listening to the popular demand. We also have the general election related uncertainties especially in the UK.  Governments are facing resistance from their citizens and labour unions on the austerity program designed to cut the huge budgetary deficit as evident in countries like Greece and other parts of Europe.  For example in Britain which has seen the worst recession since the World War II people are showing little or no appetite for the shrinking of a system that takes up almost half of the national economic output which is far greater than that of Greece, Portugal or Spain.  And all the political parties are mindful of that. So it is hard to envisage a situation where any government trying to come to power will promise the market a severe cut in the overall public spending and take radical steps to reduce the budget deficit even if they know that the markets may punish them for their inaction.

We are already seeing that European governments are taking decisions that are mostly political by design and targeted towards pleasing their own local electorate as evident from the stance taken by the German Chancellor Angela Merkel on Greece and the EU.  The message from the German Chancellor couldn’t be any clearer. It looks like if the EU nations want a currency Union with Germany then they will have to implement economic and budgetary changes and maintain a good fiscal discipline that brings their performance into alignment with Germany. Which is probably as a fair expectation but although the German proposal especially on Greece was approved by the EU countries however, it does make the future of European Union look somewhat uncertain and also undermines the common currency. No wonder why some the recent statements of the German Chancellor have been received with horror in most parts of Europe. But that said there is a merit in the German proposal especially if you look at how the EU has failed to supervise and monitor Greece effectively. At least with the IMF involvement and it playing an important role the markets should get some comfort knowing well that it will now be extremely hard for the Greek government to misrepresent the figures going forward and there will be independent supervision of the reforms and cuts proposed by the Greek Government. So a combined EU and IMF solution for Greece albeit perceived as political by the market may turn out to be a much better solution than the initial proposal.  

However, there is a genuine fear in the market that since Greece was not guaranteed explicitly by the EU there is a strong chance that Portugal , Spain or Italy won’t be helped either.  And if the EU is unable to fix its own problem or find an EU based solution for an EU problem then it surely reflects badly on the credibility of the whole European Union and undermines the common currency.  Also if the IMF decides to create a deeper austerity program for specific EU nations this may have a negative effect on the overall demand within the Euro Zone.  Which can’t be good for the German export industry but we will have to wait and see.  It is important to point out that to its credit IMF has shown a lot of flexibility when dealing with governments during this CRISIS so one can hope that we may see a sensible plan and in case of Greece they may even agree to the Greek austerity plan created by the Government.  But there is no doubt that speculators would surely try to benefit from this uncertainty by testing the market.

On the other hand we have seen the US dollar benefit on the back of the uncertainty in the EU and also the improving economic conditions in the United States. Central bankers (especially in Asia) and investors who were reluctant to buy US dollar few months ago have all of a sudden found a renewed attraction to the currency.  We have been long on USD and I am glad to say that our bets against EURO and British pound have paid off.  The reality is there is still a dark cloud of uncertainty hanging over Euro Zone and the UK which won’t help the EURO or the pound in short term and It is also very plausible that FED may start raising rates as early as third quarter of 2010 while ECB and Bank of England may have to wait a little longer.  And to add to that the upcoming elections especially in the UK are not going to help the situation. Having said that one could see the merit in the case for British Pound being undervalued especially against EURO, however, it will be hard to find a backer for British pound in the market.  But I believe a cheap pound is a blessing in disguise and it could in fact help the UK economy going forward. Although some in the markets may still hate the UK but we have had a different view based on common sense and reality. I am glad the market in now paying a lot of attention to the UK job story which I have been watching for the past six to eight months.  Here is an extract copy of the e-mail that I wrote to a dear friend ( I have edited the content and removed his name for obvious reason ) on the 20^th of January 2010. I thought it will be an interesting read.

 << Hi D,

 Hope you are well.

Picking up from our last conversation on the status of the UK economy I thought I’ll share with you and also get your thoughts on a piece that I am in the process of writing regarding the UK economy. I think bucking against the market consensus does pay well sometimes. We were expecting some positives numbers from the UK and I am glad that is what we got.

 The Market probably still hates the UK and I can  understand the reasons for it but the market does have a  reputation of getting it wrong ( sometimes ) because we  as  people  do tend to get carried away and discounting  UK will be losing out. I won’t say I am turning all bullish but yes there are plenty of opportunities to make money spread across various asset/investment class.

Going forward I believe the market will start paying attention to the Job loss numbers in the UK surprisingly the job LOSS numbers have stayed well below the market expectation unlike any other previous recession? And I believe the main reason for that has been the flexibility offered by both sides the employees and the employers. And in terms of growth, going forward we could see a market beating quarterly GDP numbers and the reasons for that is simple we simple don’t know how much spare capacity is left in the economy and the inventories are so LOW that even with the existing and basic demand you will see a pickup in growth and this could PUSH the market up.

Cheers >>

 I think it will be foolish to assume even for a second that the British economy is not in a pretty bad shape but I believe the market has been way too negative on the UK.  And we are already seeing some positive revisions in the official figures from the Government and government agencies. But that said the British pound and the economy will still be under considerable pressure for some time going forward especially because the UK economy is very closely linked to its banking sector.  According to Fitch ratings major UK banks may have to refinance more than US 448 billion of Government -backed guarantees and funding over the period of two to three years which could be a huge challenge depending on the prevailing market sentiment and this could reflect badly on the economy and the pound. What’s more the market is also very wary of UK’s budget deficit but one must add that this is not just a UK problem but today most developed countries including of the US are facing a similar challenge. 

Although one mustn’t underestimate the importance of shrinking the budget deficit to sustainable levels ASAP I think it is also important not to overlook a major problem facing all the developed economies going forward. Which I believe is a slow-motion train wreck and the governments would need to address it without further ado.  And I believe the Greek Crisis may be an early warning of troubles to come. The governments around the world especially in the developed world who are committed to providing very generous pensions over an extended period of time will now be pressed by the markets to re-examine or re-visit their pension program.

To get a perspective let us look at some of pension obligations of the developed world. According to a research recently published by Washington based Cato Institute if the Greek government was to bring its pension obligation on to its balance sheet the government’s total debt in reality will be over 875 percent of its GDP which is over 7 times the official Greek Government debt level.  And France for example will see its total debt rise to over 549 percent of its GDP, Germany will see it total debt soar to over 419 percent of its GDP from the current level of just around 69 percent, and the US total debt will rise to over 500 percent of its GDP.  There are some economists who would argue that having the pension obligations on balance sheet is the correct and appropriate way to assess a country’s total indebtedness.  To service and fully fund these pension obligations countries (especially in Europe ) will have to aside at least 7 to 8 percent of its GDP which seems like an impossible task and not practical to say the least but I think it is important to add that United Kingdom has the most favourable demographic developments among other in the EU.

There is an immediate need to fix this hole. And unfortunately there is no silver bullet the solution will have to be a right combination of higher taxes, benefit reduction, and increase in the retirement age among other measures. Some countries have already started raising retirement age but that alone won’t be enough. There has to be a reality check and going forward we may see generous pensions scheme being shut.  Some pensioners have already found a solution by choosing to retire in emerging countries with a relatively low cost of living. And this could be a part of the overall solution.

Americans, Europeans and others living in the developed world are already buying a record number of second homes in developing markets although some of these second homes could classify as investment but some are genuine second homes so may be the government and the pension funds in the developed world could create and promote “ Retire in your second home initiative”. But for that to happen there will be a need to commit to provide and deliver the entire essential and necessary services and this will require investment in infrastructure and other assets to raise the living standards attractive enough for people to retire with comfort.  These assets could be co-owned and funded by governments and pension fund in the developed world in partnership with their counterparties in the developing world especially in Africa and Latin American countries which are seeing a steady decline in the population and are in serious need for investment in infrastructure and other areas to improve the living standards of the population.  Though this may not solve the problem but it could be part of the combined solution and will surely reduce the burden and stress on the entire system.

The reality is going forward the tax payers may not be able to take any additional burden and lenders no longer willing to fund the excessive borrowings. Going forward the markets would require and expect changes in government programs in order to keep financing the shortfalls.

And with regards to the market itself I am now of the opinion that just like our body the market has its own immune system which is mostly driven by confidence, investor’s sentiment and market psychology (the mood of the market). And a positive mood with a quarter of positive numbers could BOOST that immune system significantly which could translate into surprises on the UPSIDE. In other words it is similar to a doctor getting pleasantly surprised by a quick recovery made by the patient.  Also the placebo effect is well documented and I believe the positive Investors sentiment and market psychology has a similar affect on the markets. As we know Investor sentiments, confidence and market psychology do play a major role in moving the market both ways and why  shouldn’t they  after all the markets are made up of human beings and run by human beings so it will be affected by the human psychology.

To investigate this further let us look at the various stimulus packages that were adopted during the CRISIS.

Obviously by the sheer size and percentage of National GDP China’s US $ 586 billion stimulus Package which accounts for above 12.9% its GDP stands out from the REST. It is possibly followed by Saudi Arabia, Malaysia, and the mother of all STIMULUS thrown by United States under its American Recovery and Reinvestment Act of 2009 which is the largest by any measures (US$ 787 billion). 

At the time there were market pundits who were debating the pros and cons and some even doubted if the stimulus packages will deliver and I am glad to admit that some of us including myself had a different view. Based on my judgement and commonsense I concluded in a piece that I wrote in March of 2009 titled “ Getting the Patient Out of Intensive – The Economy “ that it should deliver and put the US and the world economy back to growth. But having said we should have no illusion that the road ahead is still bumpy and uncertain.

In comparison to other economies most European countries with the exception of Germany and France have been reluctant to throw a bigger stimulus package (mostly because of their fiscal position ) with sizes between 0.3% of its GDP  in case of Italy and 1.3% in the case of the United Kingdom. Germany clearly stands out with its two fiscal packages summing up to US $ 110 billion (approximately) which is  2.8 % of its national GDP hence it is no coincidence that Germany and France were the first EU nations among the EUROPEAN UNION countries to get out of RECESSION.

I think it is interesting and also probably important to point out that an unloaded stimulus with mostly tax breaks as the first wave  of stimulus didn’t do much as evident from the one off tax rebate under the American Recovery Act of 08 of Bush Administration. It looks like the additional money was clearly used by majority of the Americans to pay off the existing debt. Also the experience of BUSH administration’s 2001 tax cut bill clearly shows that rebates generally wind up as savings or as debt repayment.

So taking the above into consideration economies like the US, Germany, Australia ,Spain and others who initially clearly favored tax cuts over  spending in their  respective first wave of stimulus packages in 08 decided in favour of an alternative measure that included more expenditure loaded plans in 2009 in combination with other incentives.

According to the IMF the total stimulus amounts to US $ 2 trillion ( approx) which is around 1.4% of the  world’s GDP still below the IMF’s recommendation of 2 % of world GDP, however, only 15 per cent of the overall fiscal stimulus was really allocated for 2008 and the remaining 85% to be allocated over a two year period  2009 and 2010 with 48 per cent and 37 per cent, respectively. Also an important point to note is that while most of the Asian and other economies focused on their fiscal expansions in 2009, China’s and also the US the fiscal stimulus will only reach its PEAK in 2010. It is hard to accurately estimate to which extent the stimulus will be implemented in 2010 especially as the economies are stabilising and getting back to growth. And the recent downgrade of countries like Greece, Ireland, Spain and Portugal also means that going forward the economies will start focusing more on fiscal consolidation or else they run a huge risk of being punished for their inaction.  The bond vigilantes are clearly BACK and they have all the reasons to be WORRIED. 

Let us look at a list of top five debtor nations to get some perspective

1. Ireland – External debt (as % of GDP): 1,267%
External debt per capita: $567,805
Gross external debt: $2.386 trillion (2009 Q2)
2008 GDP (est): $188.4 billion

2. Switzerland – External debt (as % of GDP): 422.7%
External debt per capita: $176,045
Gross external debt: $1.338 trillion (2009 Q2)
2008 GDP (est): $316.7 billion

3. United Kingdom – External debt (as % of GDP): 408.3%
External debt per capita: $148,702
Gross external debt: $9.087 trillion (2009 Q2)
2008 GDP (est): $2.226 trillion

4. Netherlands – External debt (as % of GDP): 365%
External debt per capita: $146,703
Gross external debt: $2.452 trillion (2009 Q2)
2008 GDP (est): $672 billion

5. Belgium – External debt (as % of GDP): 320.2%
External debt per capita: $119,681
Gross external debt: $1.246 trillion (2009 Q1)
2008 GDP (est): $389 billion 

 I should point out that I’ve taken the above numbers from various sources including of IMF, World Bank and others.

It is a pretty Ugly reading isn’t it? The only good news is that it looks like the policy makers and the central bankers are beginning to take note of the worries and as a result have increasingly started to talk about creating a credible exit strategy as a priority. 

Although one understands that there is need to fix balance sheets (fiscal consolidation) and address the inflationary concerns by having a clearly formulated, defined and coordinated exit strategy in place. But that said Timing will be KEY here as exiting too soon or too late has its own risk. And also it is extremely important that the process should only begin when there is enough hard evidence to see that economy will keep growing on its own after the removal of the stimulus or in other words it is evident that the recovery is solid, financial markets are back to normalcy and credit risk spreads are at an acceptable level and there is a significant risk to inflation over the medium term. We have already seen some of the central banks tighten in the later part of 09 and it is becoming increasingly plausible that others especially in Asia including of countries like India will follow suit as the real inflation starts to pick up.

Going forward the Central banks will need to explain clearly how they intend to use all the tools both conventional and unconventional that are available to them. But having said that, there is also a genuine fear that any preannouncement could possibly push the interest rates up prematurely thus derailing any chance of a ROBUST recovery.  The Q4 of 09 and Q1 of 10 numbers should give us a good estimate of the strength of recovery. The economic improvement has to be across the board and not just in one sector to justify any intervention.  We have seen some encouraging numbers reported from parts of the US economy in later part of 09 including of jobless claims falling to 432,000 – the lowest since September of 09 ,ISM Manufacturing Index rise 55.9 in December which is the highest level since 06, and also an improvement in business and consumer confidence etc but on the other hand the construction spending fell by over 0.6% in November of 08, US business loan defaults rose again in November of 09 and so did the US credit card debts write off. So we are still seeing some very mixed numbers come out which is what I have been expecting and this is why I keep saying to my friends and colleagues always look Beyond the Numbers, and dig deep. 

 I think it is extremely important not to overlook the human cost of this recession. According to the New York Times article dated 28^th December 09, New York’s state courts are closing the year with over 4.7 million cases- the highest ever.  The courtrooms are clearly seeing the aftermath of economic collapse on average folks on the main street and on businesses. I think from a judge’s perspective and also from the folks who are in the midst of all this it will be extremely hard to see signs of an ECONOMIC RECOVERY. But for some of the Wall Street guys it’s back to PARTY again as expected.  I did write a piece titled “Investing in 2009: Back to Basics “ in Feb/March of 09 and I thought I’ll just quote the last paragraph.  “The markets will come back at some point and there will be parties again on the streets, but the question is, will this happen again? I am sure it will. After all, we are human beings! “

Well, moving on even though we are still seeing mixed numbers I think it is probably safe to assume that we could see the US economy grow between 2.5% to 3.5 % in the year 2010.  And the reason for that is the economy has to grow from a very low bottom so even with a very basic and existing demand the economy will grow. And also it is also very plausible that the US may outperform other developed nations including the EU. But the party is going to continue in the Emerging Market. And among the Emerging markets you would see economies with deeper domestic base like Brazil, India, Indonesia and Turkey do better than export driven emerging economies.

While we are busy talking about growth prospect of the global economy and the road ahead one has to also admit that the policy makers have managed to avoid a Great Depression type event by not adopting an extremely tight fiscal and monetary policy. Also there is no doubt that the stimulus packages have delivered as it is becoming increasingly evident from the performance of the economies like China, India, Germany, France and the US among others.  That said there is no doubt that the road ahead is still turbulent and bumpy and a policy mistake here could jeopardize the whole recovery process. Monetary and fiscal policy changes will have to be coordinated. The main aim of any intervention should be to support growth and maintain price stability.

However, one of the safest open market operations could be raising the interest rate on banks’ reserves at the central bank as it will allow the central banks to mop up the excessive liquidity in the banking system by making sure the money is deposited back at the central bank and in so doing prevent excess credit creation and also inflation eventually. This is exactly what the Fed is intending to do through their term deposit program announced on December 28^th 2009.  The clear intention behind the program is to help mop up some of the $1 trillion in excess reserves in the U.S. banking system.  While this should be easily achieved the unwinding of the assets bought by the central banks during the CRISIS will keep them awake.  But that said it will depend on the timing, if they were selling to an extremely confident market they could even make money from the asset sales but let’s see.

And with regards to the performance/returns of various investment classes I think it is probably safe to assume that in 2010 bonds or any other investment class for that matter will not provide or to duplicate the excessive returns as seen in 2009. And going forward we may very well see people chasing the higher yields again and get into more risky asset class. But, however, we may also see people jump back into safer bets like US treasuries if we were to have another Dubai type event so I guess a lot will depend on the market sentiment and confidence. There is still a strong demand for US treasury as evident from the weekly auction in December of 09. If you look at the corporate world you would see that most of them are talking about issuing more public equity to help repay the debt and strengthen their balance sheet. And if the fundamentals keep improving then it will lower the default rate but one shouldn’t underestimate the risk especially if you consider that down the road a rate hike is on the cards so bond holder should position themselves for what is coming. That said I don’t buy the argument that a total meltdown is coming in the bond market and everybody should get out because I believe if the economy grows strongly then it should withstand a hike.  But for now let us hope the policy makers and central bankers get it right ……Fingers Crossed.

Even though things are GETTING and yes looking better. I still have a lot of questions and some of them still worry me.

Here are some of them:

- Banks (some of them ) are now making money but on the other hand they are still loosing money a lot of money each quarter on commercial real estate, credit card loans, consumer loans among other things. Most of the money banks have made is on their Investment Banking business but not on retail or on traditional banking business. And I am glad some of our analyst friends are beginning to notice that. Although things have gotten better but the PROSPECT isn’t that BRIGHT especially if you consider that we are mostly probably heading into a JOBLESS recovery and a recovery that will mostly likely be slow paced.

- The whole SYSTEM has managed to survive because of the LIFE LINE given to it by various Governments from around the World. The markets have gone up and I believe there are two main reasons for it. First- Because they were so badly beaten up that they could only go up; second – Stimulus package(s) have delivered just look at China, India, Korea, France, Germany and others for example.  Although many still doubt that it has but I have no doubt in my mind that it is delivering and this is why we have supported them even though it was not PERFECT. Having said that, we are now seeing a building up of Asset Bubble in the economy (especially evident in China) which needs to be monitored and controlled. My concern is how able and capable the central banks are in making sure the excess don’t build up and CLOG the system again. The other question is do we really know how to price an ASSET correctly or fairly without either over or under PRICING IT? Until and unless we do, we will keep seeing ASSET Bubble Building UP in the SYSTEM. Central banks around the world will have to learn to monitor and supervise asset prices.

- We have still not addressed the SYSTEM RISK ..TOO BIG TO FAIL issue. There has been a lot of TALKS from various corners but no real PLAN.

- The REGULATORS are talking a LOT but DO they really KNOW how to best regulate the MARKET ? They have so far played the BLAME GAME along with Government but do they have what it takes to get things right this time?

- It’s hard to envisage a situation where the WORLD starts growing at the Pre-Crisis levels. So may be the market needs to take a BREATHER?

We have been expecting things to get BETTER in H2 of this 09 so again there are no surprises for us but I believe some of us are getting too or shall I say overly optimistic. Which is not necessarily a bad thing because we do need the AVEARAGE FOLKS on the MAIN STREET to feel confident because CONFIDENCE is KEY to all this. But the PROBLEM with CONFIDENCE is that it can disappear in NO time. So we have to be CAUTIOUS. I must say I am beginning to like TRAFFIC Jams in big cities especially in CITIES like Dubai because it does give me CONFIDENCE that things are looking much better and people are feeling good. And I think it’s important that we look at beyond the numbers and this is why I keep saying to my friends and colleague ALWAYS look at the BIGGER picture and the STORIES behind the numbers. DIG DEEP and not get carried away by listening to the NON STOP sound bites that we get from the MEDIA or the market. I personally get a bit SICK and TIRED of a minute by minute analysis of the MARKET repeated over and over AGAIN on news channels but I do know that I have a CHOICE and I can SWITCH off my TV if I want to. And the reality is we always have a CHOICE (in most cases) so next time when I loose or make MONEY I know it was mostly because of the DECISIONS I made and the options I choose.  As someone said markets are run by human ideas and there is no certainty as to how it will react to an action or in action but you always do  feel PROUD if you get it right and hope that you have learnt something good from your mistakes if you got it wrong.

 Investors are now beginning to realize that developed nations are possibly faced with decades of very low growth and may need decades to work off the mountain of debt which is the biggest since World War II.  According to IMF recent forecast the total debt of developed nations used to fund various bank bailouts and stimulus packages could reach above 113% of GDP by 2014. This is more then three times the estimated forecast of 34% for developing nations. Though one could argue that developed countries have had bigger debt burden in the past ( post World War II ) reaching close to 250% of GDP in case of U.K., and over 100% in case of USA but these debts were repaid pretty quickly. On the other hand, we have to take into account that developed nations recorded decades of high growth just after the World War II ended which allowed them to get their fiscal house in order. In the current circumstances it is highly unlikely that the developed economies will see growth levels of post World War II era going forward.

 Developed countries are in a catch-22 situation if they spend more to keep stimulating the economy they risk running into a huge unsustainable fiscal deficit. The combination of low growth and ballooning budget deficit could be very damaging to developed economies. The talk of the town is now increasingly focused on getting the fiscal deficit under control.  It looks like the Governments in the developed world have resigned to the fact that they are entering into a low growth era. World Bank is now forecasting the GDP of high-income countries to shrink by over 4.2% in 09 and the overall global economy to contract by 2.9% in 2009. In terms of regional growth the World Bank is forecasting the growth in the Middle East and North Africa to fall to 3.1 percent, while that of sub-Saharan Africa to drop to 1 percent from an annual average of 5.7% and the LATAM to fall to 2% however, East Asia should post a growth of above 5%. Although the report suggests that economic growth in emerging countries could slow to 1.2% in 09 China and India should achieve a growth of above 6% in 09. We must also add that one of most interesting growth area of the global economy could potentially be rural India with its 700 million plus population. Some companies have already started to focus on rural area of the Indian economy as they see a very bright growth prospect going forward.  The recent Indian budget has rural India at the centre and it looks like the government of India is aiming to UNLOCK the growth potential of rural India which is most certainly a step in the right direction. 

It is becoming more apparent that going forward the growth is going to come mainly from the developing world. The ongoing CRISIS will mostly probably be recorded by historians as the event that triggered a POWER shift. The developing countries are already asking for more influence, oversight and control over how the global economy is managed, supervised and operates. The industrialized world’s clout to impose its policies will only weaken from here on. G-7 countries are beginning to realize that their grip on global affairs is slowly waning and they will have to give away a lot of their influence and control over how the global economy is run but that said it will be unwise to assume that developing economies are ready to lead the world. 

 We are already seeing signs of what could possibly be a shifting world order. We saw Russia host the first BRIC summit albeit a symbolic one. China, the world’s 3^rd largest economy seems to be promoting Yuan as a serious alternative to dollar and it looks like they have a Grand plan for Yuan’s role as a global reserve currency going forward. This is evident from People’s bank of China recent unveiling of rules on Yuan-settlement facility. The rules will apply to companies involved in trade with Hong Kong, Indonesia and Macau. As a trial the central bank is going to allow companies in Shanghai and four cities in the Guangdong province to settle their trades in Yuan with companies in Hong Kong, Macau and Southeast Asia. In a separate announcement on July 6 Bank of China signed clearing agreements for Yuan settlement in Shanghai with over 11 overseas banks, including Standard Chartered, Bank of East Asia and Bank Mandiri of Indonesia. As one of the major trading countries it makes complete sense for China to start reducing its reliance on dollar. Despite of the fact that the stage is being set to promote a real alternative to dollar by major developing economies including China, Russia, Brazil and now India one has to admit that in the short to medium term it is hard to envision dollar loosing its status as a global reserve currency. 

However, more and more investors are getting attracted to the emerging market story and who would blame them. We saw the MSCI Emerging Markets Index rise by over 35 % in June 09, beating a mere 2.9 % rise in the MSCI Index  of developed economies and increasing the value of stocks to $8.6 trillion from $5.1 trillion in 2008. We also saw the market capitalization of Brazilian equities reach close to US 950 billion while that of Indian equities reaching close to US one trillion and Chinese equities surpass the US 3 trillion dollar mark in June. It is becoming more and more evident that developing economies are now moving closer to the centre stage and it looks like the investors have formed an opinion that emerging market is where the PARTY is going to be and this probably explains why the Investors have poured in close to US 26 billion into emerging market equities in the 2^nd quarter of 09.

Although one understands the euphoria but we should not forget the fact that we live in a very interlinked world and any country on a stand alone basis is not capable of growing in isolation forever. It has to be said that not all emerging countries will fair well, Latvia is a prime example, but emerging markets have mostly certainly come of age and going forward without much hesitation one can safely conclude that they are going to be the next generation of growth providers.