Lack of conviction by governments across the globe to pursue austerity measures in monetary and fiscal policies could continue to play havoc on the global bond markets. There is a clear decoupling emerging in the global economies when it comes to monetary policy. High inflation is forcing industrial producers to hike bank rates and tighten the purse strings. The latest move by China was to hike the CRR to 16.5% just before shutting shop for the lunar New Year. Rapid escalation in urban real estate prices due to the formation of a bubble inflated by lax lending policies is the root cause for consumer and food price inflation in China. The large inventory (about 50%) of empty commercial and office space in Beijing and Shanghai is a clear indicator that this is not the so called ‘healthy inflation’ that was witnessed in the region from 2005 to early 2008, brought about by rapid economic growth.
The interest rate on emergency loans given by the US Federal Reserve was hiked marginally from 0.5% to 0.75%. The AY team discounts it as an eyewash measure. A complete change of stance in US monetary policy at the first sign of serious trouble is what the fiscal hawks at AY expect from the US Fed in view of its recent history. The huge budget deficits brewing in more than half of the states in the US are putting pension funds in serious jeopardy and quantitative easing seems to be the only (albeit short term) painless solution that the US federal government could adopt to bailout the desperate states like California. “The days of ‘Alice in wonderland’ spending are over” opined the governor of the state of New Jersey, the second most bankrupt state in the US. A fresh bout of federal help with newly created dollars might help in prolonging the stay of bankrupt states in the profligate paradise.
The recently elected prime minister of Japan has not taken any concrete monetary or fiscal policy steps to steer the country away from the troubles that have plagued its economy for the past two decades. The latest growth numbers brought some cheer to the leaders but the Japanese know that such positive figures are ephemeral and that nothing is being done to eradicate the recession that has become endemic since 1989.Europe is in the news for all the wrong reasons. The European monetary Union (EMU) is in a transition as the divisions between the more prudent north and the profligate south also known as the Club Med countries (on the shores of the Mediterranean Sea) are becoming clear with every passing day. The bond vigilantes are those inquiring minds that sense financial weakness in any entity, be it a company or a country and tend to cull out the weaklings by shorting (betting against) the bonds (debt) issued by it.
The chart above shows the extent of gross government debts in terms of the gross domestic product (GDP) of a few countries in Europe including Germany (strongest) and Greece (weakest). The bond vigilantes have identified Portugal, Ireland, Italy, Greece and Spain (PIIGS) as the weaklings in the EMU sharing the Euro as the currency. They believe Greece could default first on its debt obligations as it is the weakest link with the highest gap disparity between its ability to produce and the ability to service those obligations as illustrated in the chart above.
The strongest economy within the EMU is Germany and everyone around the world is looking up to it to bailout Greece. The Euro could be significantly weakened in case of an all out bailout and the average German would have to retire at age 69 instead of the present age of 67 to pay for the past profligacy of Greece. Spain appears a bit healthy as per the chart above but the country is mired in a real estate crisis just like USA. However the toxic assets (mortgage based assets or bad loans) are yet to be owned by government in Madrid from the books of various Spanish banks. The bond vigilantes believe this transfer could happen in 2010 and hence they put Spain in the league of PIIGS. All the prudent nations in the EMU cannot bailout Spain when it is on the verge of default as it is not a minor economy like Greece. Latvia and other countries aspiring to join the EMU have bitten the bullet of austerity to achieve entry into the coveted euro currency club and they would be disillusioned in case of a bailout of profligate PIIGS.
A 50% cut in salaries of public sector employees is not an easy (much less popular) measure and still Latvia has taken the bull by its horns and it could be the investment destination of the decade for the enterprising entrepreneur. Similar austerity measures would be needed of PIIGS and other profligate members of the EMU to ensure the survival of the Euro. China could easily bailout Greece with just a fraction of its huge foreign exchange reserves. However the political and economic ramifications of giving China a foothold in a corner of Europe seem to be highly unpalatable for Germany and France for obvious reasons.
India is unable to take any concrete decisions with its monetary and fiscal policies. Half hearted measures include a slight hike in CRR to 5.75% and some talk about reduction of fuel and fertilizer subsidies are not helping tame the rampant inflation prices of food items (at about 18%) that has hiked inflation figures of the wholesale price index (WPI) to about 8.3% (January 2010). The union budget 2010 is not expected to have any significant measures to reduce the government’s massive debt burden. Yields on 10-year treasury bonds have surpassed the psychological level of 8% and the bond vigilantes are expected to ramp it up further in 2010. The government could shelve the Kirit Parekh report on the impact of fuel subsidies, as it is unpopular. Sales of stakes in public sector units (PSUs) could be the only easy option for the government to garner money to bridge the yawning budget deficit. Initial public offers (IPOs) and follow on public offers (FPOs) of PSU shares could be done by the government out of necessity in 2010 even in adverse market conditions.Dubai is back in the news raising the specter of default even as Greece is offered time until March 15th to adopt severe austerity measure to undo years of profligate spending. The threat of sovereign defaults by Greece, Dubai and other profligate nations continues to remain as a potential black swan in 2010. Major banks in US, UK, EU and China encountering heavy losses with defaults on commercial mortgage based assets leading to a banking crisis similar to the sub-prime crisis of 2008 could be another black swan event in 2010.