The mainstream media in India was busy analyzing the union budget in the first two weeks of March 2010. This annual event in India has lost much of its significance, as the Indian economy is not insulated anymore. Lack of fiscal prudence on the part of the union government was the salient feature of the budget as observed by the fiscal hawks at Arthayantra (AY).The government is all set to borrow more than US $100 billion in the ensuing financial year while a major chunk of its expenditure continues to be in the form of food, fuel and fertilizer subsidies. No major infrastructure projects were taken up in the past fiscal year and none is planned for the one commencing from April 2010. The revision in direct tax slabs is more out of pragmatism than philanthropy. Taxing consumption is much more cost effective and simple than widening the income tax net that covers about 3% of the population even after 62 years.
Inflation has become an intransigent problem in India. All the measures taken by the government have not made any significant headway towards containing inflation in wholesale price index as well as the food price index. As a last resort, the Reserve Bank of India has resorted to tame it by tightening the monetary policy with hikes in cash reserve ratio followed by a nominal hike in interest rates. Monetary tightening is expected to continue throughout the financial year. The financial markets in India will however continue to be driven directly by the actions of the Foreign Institutional Investors (FIIs). Recent upgrades in sovereign rating of India by some rating agencies has given a temporary reprieve to the bond market as the yields on the 10 year sovereign bonds crossed the 8% mark. Heavy government borrowing and intensifying threats of sovereign defaults in Europe and other places could adversely impact India’s bond market.
Greece continues to be the hot potato of Europe. Fierce opposition to any bailout of Greece in the German bundestag and grandiose posturing by the French president to counter his potential domestic political competitor presently heading the International Monetary Fund have generated more uncertainty about Greece and other profligate countries in the European Monetary Union (EMU).
The yields on sovereign bonds issues by Portugal, Italy, Greece and Spain (PIGS) are witnessing immense volatility with the uncertainty over a bailout by the EMU. The real test for Greece is expected to be on April 19 and May 20 2010 when it tries to borrow about 20 billion euros to refinance a portion of its short-term debt.
At present, Greece is borrowing money from the bond markets at almost double the interest rates paid by Germany. This difference or yield spread could increase as the uncertainty about a bailout drags on. Massive strikes by labor unions all over Greece are testing the resolve of Mr. Papandreou’s government in implementing the austerity measures required for any bailout either from within or outside Europe.
Greece is left with just two options going ahead. An outright default or a bailout either by the IMF (most likely) or the EMU (least likely) would definitely mean years, if not, decades of austerity and economic depression in Greece. The bank of England concluded that a similar fate awaits Britons in the near future. While the citizens inside the EMU are adopting austerity due to falling wages in a strong Euro, those outside the EMU like the Britons are being forced into austerity with inflation generated by massive quantitative easing weakening their currencies. Strangely a weaker currency is not encouraging the British exporters to cut down prices but to increase their profit margins to compensate for the loss of purchasing power of the pound sterling. The current macroeconomic situation in Europe can be summarized in just two words, ‘Flying blind’.
While legislators are completely occupied with the health care reform bill that is estimated to cost the taxpayers at least $800 billion, many states in the union are still considering the option of cutting numerous essential and non-essential services as their economies continue down the slippery slope of spiraling debt. The states are desperate for a federal bailout to prolong the ‘Alice in wonderland spending’ era. Very few states like New Jersey are serious about significant cuts in government spending at all levels.
Sovereign default is an option that was explored by countries with high levels of debt, Russia in 1999 and Argentina in 2002 (chart above). While the mainstream media portrays it as a financial Armageddon for the defaulting country, Russia has risen like a phoenix to become an emerging economy from a defaulter in less than a decade. Portugal, Italy, Greece and Spain (PIGS) with debt to GDP ratios comparable to those of Russia and Argentina at the time of their respective defaults (chart above) could explore that option and start with a clean slate. The Irish are the best of the lot as they are enduring severe austerity measures and an economic depression. The losers in the deal would be the greedy bankers who invested money in these economies and the winners would definitely be the denizens of southern Europe also known as the Club- Med countries.The world’s largest economy, the USA is flying blind at the speed of light as it continues to double its deficits every year and also monetize its debt with quantitative easing (printing money).
The private sector in the US is contracting as banks are slashing lending by the greatest measure since the end of the Second World War. Bankruptcies and orderly closures of small and medium size banks in the US continue on account of toxic mortgage-backed securities, residential as well as commercial. The tally is 177 ever since the collapse of Lehman brothers in 2008. Interest rates continue to remain low on account of massive intervention by the Federal Reserve (FED) with the tool of quantitative easing (QE), crowding out all private players from the bond markets. Most Americans led by their legislators are looking outside (at China) to find the cause of their hardships rather than looking inside and reforming their fiscally (and ecologically) unsustainable way of life. Some economists are suggesting an all out trade war with China, which could result in a hyperinflationary (Zimbabwean) solution for all the ills plaguing the US economy. This could be like an Australian bush fire that helps in the regeneration of the forests by clearing massive amounts of dead wood accumulated on the forest floor.
The rumors about a revaluation of the Chinese Renminbi (Yuan) are among the many news items that are influencing the direction of the global markets. The Chinese authorities quickly rebutted all such rumors to bring sanity to the markets. The economic worries in China could be summarized as ‘unity in diversity’. Asset bubbles in real estate and labor shortages are a reality in urban China, while inflation and unemployment are the issues plaguing the rural hinterland of the middle kingdom. Inflation is the price that all emerging economies are paying to ward off significant economic slowdown and massive unemployment. Bad loans and other non-performing assets owned by state controlled banks in China are in dire need of massive financial bailouts. Bailouts in China are expected to be discrete and covert unlike those in USA. Some war of words over the trade practices and freedom of information with ‘Google’ as the case in point are expected between US and Chinese governments but it could be business as usual between these two economies that are comparable to Siamese twins.
Japan continues to be the classic example for every economist predicting the future of the US economy. Albeit everyone professes that it would be different this time, no one knows for sure how different it could be. Price deflation is still widespread in Japan as the export sector is facing huge hurdles with an overvalued Yen. The Japanese prefer the ratio of US dollar to yen to be above 100 while the new government is having a hard time to keep it from falling below 90 despite another does of massive quantitative easing by the Bank of Japan.