The 'Brexit' dilemma

Before I write anything on this topic, let me just tell that I am not an expert on this particular scenario that is unfolding in Britain and the European Union (EU). Should Britain exit the European Union? – is what all this is about. There is a referendum to be held on June 23^rd, during which the British people will decide whether or not to stay in the European Union.

Like I said, I haven’t read into the minute details surrounding this question, but as far as I have read on this topic and analyzed some data points, it looks like there is validity on both sides – those who say Britain should exit the EU; and those who say that Britain should stay in the EU.

But when I looked at some of the arguments from both sides, to me it looked like Britain would be better off staying in the EU and making some of the changes to the whole EU policies and format by working from within the system, rather than just opting out of EU altogether.

For example, Britain is rightly concerned that some of the immigration rules of the EU favor EU citizens a little too much over the non-EU citizens, and that Britain would be able to tap into diverse non-EU talent if not for the strict quotas and restrictions of the EU immigration policy. As a very wealthy country, it makes perfect sense today for Britain to have full independence over its immigration policy and the kind of benefits that it would give to the immigrants. But at the same time, over the long run, a single common market cannot be achieved without free movement of labor.  So it would be wise for Britain to influence immigration policies, welfare policies to immigrants and other such policies by staying inside the EU, rather than outside it.

But why stay inside and suffer trying to influence? Good question! And here is one of the reasons – As in any developed economy, Britain will start to become an aging population within the next half century. It will need immigrants. While I understand that Britain would like to have full control over its immigration policies, it should also be noted that EU has 28 member states with more than 500 million people. Over the course of the long run, the free movement of these 500 million people within the EU will bring natural benefits to labor shortages and capital investments. It has to be noted here that out of total British exports, 45% of the goods and services are exported to the European Union. And more than a million Britons already live in the EU countries outside of the UK.

The free movement of people, goods and services across these 28 countries (and possibly more in the future) will create a dynamic economy that will outweigh the control and independence that Britain is trying to seek for itself by exiting the EU. Staying in the EU also brings a common platform of regulations for businesses to move goods across, deliver services and tap into the available labor pool that exists within the massive 500 million people. Here too, some British businesses have preferred to exit the EU because of the historical fact that Britain regulates its businesses much less than the EU. But here again, my view is that Britain can influence and streamline the regulations by staying within the EU, rather than completely opt out of it.

Some British businesses could be living in a fantasy that they could use the arbitrage in regulations, and profit more from it than their EU counterparts. But if they think that they can get away with such a simple strategy, then I am afraid that they are terribly mistaken. In my view, EU countries will still stress that British businesses follow and comply with EU regulations if they want to trade with EU. And in fact, I wouldn’t be surprised if the rules become a little stricter for a non-EU country in that case. But it should also be noted that a majority of the British businesses would like to stay in the EU – and they have openly advocated for it.

All the discussions about implementing a free trade deal with the EU, independent control over its immigration and regulatory policies – all that seem to be things that could be worked out by staying inside the EU – after all, what is good for Britain should also be good for Germany, France, Poland and Slovakia on a macro level - and for many other such countries.

I would be willing to change my opinion if I see more data that supports a Brexit from the EU, but so far what I have seen all point to the wisdom of staying in the EU – by looking at the EU membership benefits over the long run. And not to mention that the potential benefits of an “ever closer union” – both at the monetary front and at the political front – is a dream to be achieved in the future. If and when such a dream is realized to the full extent, it would be unfortunate to see Britain not be a part of that dream.

China, oil, panic and recession….(Part 2)

In this post, I am going to opine on another panic-spot in today’s global economy: Oil

Global crude oil prices have fallen more than 150% within the last year. And this has been a major source of concern throughout the world. People looking from the supply side are frightened at the prospect of supply spinning out of control and reaching levels that could crush many oil-exporting countries and companies – resulting in massive bankruptcies and sovereign defaults – which could then lead straight to banks that are highly exposed to the debt of these countries and companies. 

People looking from the demand side are even more frightened at the thought that the global demand is so weak that oil could plunge to such low price levels within such a short time frame. And then there are people who look from both the supply side and demand side and are equally frightened – especially from the threat of global deflation.  

Now, putting the supply and demand dynamics aside for a minute, I would like to look at this whole situation from a different viewpoint. This collapse in global crude oil price is the single largest wealth and cash transfer, in the order of trillions of dollars, from not-so-productive, not-so-innovative and not-so-creative economies to productive, innovative and creative economies. And that is a HUGE positive for the global economy which will pay off in the longer run.

For years, a country like India that is quite dynamic, creative and a demographically favored nation has suffered due to high oil prices. It suffered in the form of very high inflation in the last decade – to the point where millions of Indians literally went hungry because of soaring food prices – which was directly linked to soaring global crude oil prices (remember the $130 per barrel oil?). It suffered in the form of its government wasting hundreds of billions of dollars in subsidies and welfare programs to cushion the impact on the poor from sky high inflation. It suffered in the form of massive wealth-inequality. It suffered in the form of reduced demand for global products from these poor and middle-income Indians as all the productivity and income was spent on buying oil and other price-inflated basic necessities. 

But now, this fall in global crude oil prices have managed to reverse, to-an-extent, some of the problems that I outlined above. Billions of dollars of diesel subsidies have now been eliminated. Billions of dollars of losses on transportation of products have now been reversed. Inflation has come down considerably. Poor and middle-income people are rewarded through low diesel and petrol prices at the pump. All this savings has led to (and will lead to) an increase in demand for quality products – like motor-cycles, fans, air-conditioners, healthier food, better education, cars, mobile phones etc. From the government standpoint as well, these savings from diesel-fuel subsidy elimination and reduced welfare programs has given it the room to invest in public infrastructure like highways, rail lines, airports, sanitation infrastructure etc. 

Now compare what I said above to a wealthy oil exporting country like Saudi Arabia – which already has world-class infrastructure and where the population is so low that the many hundreds of billions of dollars of foreign-exchange from high oil prices in the past was just sitting in its coffers without any productive investment. That money mostly ended up as freebies to its people – who were already well-off and were generating less demand for global products.  

The case of India I presented above will also fit the narrative of many other productive/innovative nations – both developing and developed – like China, ASEAN nations, the United States and many European nations. These are also some of the nations that have a larger population with a considerable amount of middle-income people who will directly benefit from these low oil prices – and who will create an increase in demand for global products. 

Now, all this doesn’t mean that I discount the fear that many global investors have today – especially the threat of deflation – which stems primarily from the twin scenarios of oil crash and a slowing Chinese economy. But this threat, in my opinion, is manageable, and in fact, over the medium to long term, I believe the benefits that I outlined above from low crude oil prices will outweigh any negatives we might see today. 

Now, with respect to banks’ exposure to defaulting oil companies and sovereign-defaults (Russia, Brazil and Venezuela come to mind) – that is indeed a real concern, albeit something that can be contained. I don’t think that any of these default scenarios will affect the global economy as a whole and it possibly, in my opinion, will be contained to one particular sector and few possible companies and countries. 

I would urge that many of these oil exporting countries also take this opportunity to diversify their economies – especially Brazil, which has a sizeable population with a tremendous talent-pool. And I think that the G-20 countries should come together sometime this year and co-ordinate some of their fiscal policies. Such a move will once again inspire confidence in the global markets and more importantly, will help abate the fear that exists in the global markets today. And in my opinion, that fear elimination should act as a priority for these G-20 countries now if they want to sail through the current muddy waters of global economy without pushing any of its members down the ocean.  Will they do it? – is the billion-dollar question. If they do, they can sail smoothly, and if they don’t, the ride might be a little rough this year, but I still believe that they will sail through and reach the shores. 

China, oil, panic and recession….(Part 1)

The global equity sell-off has been brutal so far in the year 2016. Many global equity indexes have plunged into bear territory. There is enormous panic and fear about a forthcoming global recession. Are we going to have a recession? I don’t know. But I don’t think so. But then, I don’t know. And this is how investors worldwide are feeling right now – they don’t know. This “don’t know” phase is quite a dangerous phase for worldwide capital investments – because companies will be unwilling to commit to major investments if there is uncertainty, especially if there is uncertainty in global asset prices. 

But let’s examine some of the major panic-spots, as I would like to call it, right now:

China: Chinese economy is growing slowly. Now, there is a difference between growing slowly vs. no-growth or negative growth. In this case, Chinese economy is still growing, albeit quite slowly and understandably so. Because of this slowdown in the Chinese growth, there is a worldwide re-pricing of many major assets. For example, China consumed almost half of the global iron-ore production in the past decade. Now that China is growing slowly, how much will the fair value of a metric ton of iron ore be? And that question is exactly what is being answered by the markets right now – meaning, there is a strong re-pricing of assets going on globally, particularly of many commodities, based on supply and demand. And many global companies made a classic mistake of over-producing commodities during the boom time without forecasting a slowdown in the demand growth. This along with the often-generated market over-reaction, not to mention the gazillion modern leveraged financial products that have been created in the market, has caused an extreme downward spiral of many commodity prices. But if you wither out the market over-reactions, I believe that some of the slowdown in China will actually be compensated with a slight growth in a handful of other countries like India, Indonesia, South Korea etc. 

Now, with respect to the Chinese retail investors chasing the equities higher without any fundamentals to support them over the last two years – I think this is in the rear-view mirror now. After a more than a 50% plunge in the Chinese stock markets within the last year, the needed correction is almost done. There may be a little more shakeout, but I believe most of the correction on this front with respect to the crowding retail investors has been done already.

My biggest fear when it comes to China is their banks’ exposure to high risk loans within their domestic economy that could turn into bad debts. While China has massive forex reserves, with almost $2 trillion of them in liquid assets to handle any risk to their money-supply and credit markets, with sufficient capital controls in place, a mere sign of any major trouble to any major Chinese financial institution could have enormous unintended consequences with ripple effects across the globe. It is in this space one has to watch carefully, though the communication from the Chinese authorities has been almost nil, if not incomplete, in this space to re-assure global investors.

Now with regard to US banks, I don’t think there is much direct exposure on the loan-front to the Chinese economy. So any talk of a US banking crisis due to China is unwarranted.

The other major concern I have is how the Chinese authorities will manage their currency this year. China cannot steer its economy to its growth target this year without devaluing their currency. How they would devalue their currency is the billion-dollar question? If it is a major one-off devaluation, then there is a high probability that that will cause a jolt to world financial markets; and panic and competitive devaluation could follow, thereby risking global growth. If it is a gradual devaluation over the course of the year, then they might be able to sail through the muddy waters. This is something that we need to wait and see to get a little more data and to understand where exactly they stand with respect to their transformation to a more private retail consumption and services based economy. 

I will continue with my discussion on the current status of global crude oil prices and its effects in my next

Negative? Nah, nah, Janet!

The topic of negative interest rate is back again. The equity markets are getting pounded all across the globe. And the primary reason for this is: Panic! There is enormous investor panic out there about the ability of the global central banks to steer the world economy; about China; about oil; and about nations that rely primarily on commodity exports; and about banks that might have high exposure to some of the bad debts associated with all of the above.

And what is the one thing that central bankers should avoid doing during this climate? - Causing further panic! But that is exactly what some members of the Federal Reserve have been doing recently. They are succumbing to this investor panic and panicking themselves in some respect. They are worried if they will be blamed if something goes awry. But I also have to give them some leeway as markets, some economists and experts have been pulling them in all directions to do this, do that, say this, say that. And in that course, the words “negative interest rates” have been pulled out, rather forcefully, from the mouths of some members of the Federal Reserve, including its chairwoman Janet Yellen.

In my opinion, a negative interest rate, or a talk of it, will send the financial markets into a dizzy spin of chaos and panic, if not already - because a negative interest rate will seal the final nail in the credibility-coffin of the Federal Reserve and its ability to steer the US economy without causing another massive recession. Instead, I would suggest that the Fed keep its tongue steady and assure markets that they are in control; and that they would be flexible with regards to the timing of any further interest rate hike. Now, I have to admit that they have been saying that they are flexible, that they are data driven and have tried to assure that the US economy is in solid footing. But my problem is that in the same breath, they also talk of things like negative interest rates – which unnerves global investors – because this tells those investors that there could be something that they don’t know or don’t see that could be lurking behind the shadows of the global economy. And this has caused a flight to safety with all global equity indexes plunging into bear market territory in recent weeks. Ironically, in today’s sentiment driven financial markets, if the Fed panics about the state of the global economy, they will ultimately be blamed as I fear that their panic would be the trigger for the real panic in the real economy.

Bottom line: The Fed should weed out the noise from the panicking equity markets and communicate with a steady tongue.

In the next post, I will discuss about China, oil and their relationship to the current global panic in equity markets. 

It happened!

The Federal Reserve lifted the federal funds rate by 25 basis points today - the first in almost a decade. Congratulations. Good job. Right decision. 

Zigzag Fed!

I am really starting to doubt the credibility of the members of the Federal Reserve. Every serious policy maker should have known and did know that China was overheating this year, especially their stock markets. And predictably, the Chinese stock markets took a severe hit this year. And everyone should have known that such a hit in the Chinese stock markets would expose the excesses and balance sheet weaknesses in their state-owned enterprises. But all along, the heads at the Federal Reserve kept saying that any slowdown in China will not impact the United States’ economy in a significant way – and thereby, given their “reasonable confidence” in inflation and growth projections are met, they would start the normalization of interest rates starting from this year.

China took a hit. Emerging markets started showing signs of slowdown as a result. But this shouldn’t impact the US economy in any significant way, right – as per the Fed? But no! It does suddenly. Now the slowdown in China is dragging global growth down. And now that weakness in global growth has started to impact the inflation and growth projections for the US economy – and this is as per the Fed. Wow! I would have expected such a sudden shift in fundamentals from an under-grad student, but not from the world’s most powerful central bankers.

To make matters worse, different FOMC (Federal Open Market Committee) members come on different TV channels on different days and espouse different policy proposals for the near term monetary policy. Such a confusion and non-alignment in what should have rather been a consensus by now begs one to wonder if the world’s economy is safe with these experts. And by the world’s economy, I literally mean each and every world citizen who has any form of monetary wealth - as the decision by these monetary policy makers has a potential to impact everyone.

The Fed says that they are data dependent, but no amount of data seems to be enough for them to come to a conclusion or a consensus. If they need the data until a day before they make a decision to increase the fed funds rate by 25 basis points (0.25%) to be in sync with their “reasonably confident” projections, then there is something terribly wrong here. Either the data that they are looking at it is not accurate or their communication skills are terrible.

The point is – the Fed doesn’t know where the full employment is. They cannot understand why the core inflation hasn’t picked up even after the unemployment has fallen significantly. To an extent, they correctly blame the lack of fiscal policy support from the US Congress, but beyond that, their mystifying zigzag communication (and probably understanding) is very much disconcerting for a participant in the economy like me, who is just an ordinary person looking forward for a stable global financial growth. 

Infrastructure, not interest rates!

In the US, currently, inflation is very low (atleast as per the official data) and has remained and is expected to remain low for a considerable amount of time. And so some, like the Federal Reserve Bank of Minneapolis president Narayana Kocherlakota, have called for further easing of monetary stimulus. They even argue for a negative interest rate in the US, meaning, pushing the federal funds rate below the 0% bound (check this link). And with all due respect, I have to disagree with this proposal.

First of all, let’s take a look at the global economy today. The United States’ economy, in all parameters, has considerably rebounded from the recession era lows (not just the stock market – which has had a massive bull run for the past 6 years - but the real mainstream economy itself, has rebounded nicely).  In the last two years especially, the job market has been relatively healthy and quite resilient. Consumer spending has grown. Consumer confidence in the economy has grown. Services industry has grown. Manufacturing rebounded nicely last year, but has been quite badly hit this year (due to a stronger dollar and weak global growth – and I will get to it in a minute). All this happened at a zero bound interest rate setting. But was that the only factor that spurred growth? Absolutely not!  

As much as the monetary stimulus was effective, an equally important factor for the growth in the last 6 years was China. China’s fiscal stimulus was a boon to a large part of the world. Countries from Australia to Brazil, Thailand to South Africa, Japan to Russia, Indonesia to Switzerland and many more profited from the immense investments that took place in China. These investments not only contributed to higher commodity prices – which made nations like Saudi Arabia immensely rich in forex reserves – but also increased the sheer number of Chinese middle class consumers – whose purchasing power was a boon to many - like the Swiss watch makers and German car makers. So the global economy itself largely benefited from these investments in China, and that had a positive effect on the United States as well. Along with all these positives, a lot of mistakes were done (in terms of quality, size and credit) in these investments in China – for which China is paying a price now. And not just China, the world itself is paying a price now – not because China overdid things, but rather because the world under-did things. In other words, the major factor that is holding back global growth today is a lack of capital investments globally. What China overdid, was underdone by the rest of the nations.

Now this gets us back to the negative interest rate. Do we need it? In my opinion, no! – because the root of this problem goes back to a sudden slowdown in the Chinese economy. Naturally, the Chinese economy overheated and is going through a cooling phase. And along with it, all the nations that benefited from the Chinese super-growth story are going through the slowdown as well. During this phase, China is also, rightly, going through a transformation to shift its economy’s over-reliance on manufacturing, export and investment-led model to a decent reliance on consumer-driven, more services and innovation-based model. But this will take time. As a close observer of global finance, I have no doubt in my mind that China will ultimately be successful in this transition. But I have also no doubt in my mind that China will make a lot of mistakes during this transition phase – mainly due to their inexperience, and not necessarily inability, in managing such a heavy transition in such a massive economy.

A negative interest rate in US will do nothing more than provide a cushion, to a certain extent only, for currency instability in China and other emerging markets. But barring that small advantage, the negative interest rate will only lift up asset prices globally – which again goes to this thinking of monetary strategists that – if asset prices go up, consumers will feel more confident to spend and this in itself will provide a boost to the economy. But what kind of boost is that? A boost given by artificial demand! I call it “artificial” because the consumers will be forced to make use of their money even when they would have preferred to save. Such a strategy severely distorts the global supply & demand, investments, free markets and asset prices. We followed such a strategy at the depth of the global recession – as a temporary and a priority measure to reboot the economy and create sufficient demand. But we are well past that phase now. Repeating that again and again will only set us up for a long term pain through distorted capital flows and more recessions or setbacks.

Money is still cheap. That is not the problem here. It’s the application of money that is the problem. Where do we apply the cheap money available? Can we start with worker training /skill training programs? Or can we start with more affordable housing for the poor that would reduce their rent burden? Can we start with putting more money in the hands of families with children that will reduce their child care costs? Or can we resolve the immigration problem that will help lift business investments and thereby demand? Can we start with reducing the health care costs of middle-income and poor families by transferring some of the wasteful agricultural subsidies into the health care and medical research sectors? Or at the very least, can we employ the thousands of unemployed without a college degree by repairing and improving the transportation and sanitation infrastructure?

It all boils down to two words – “capital investments” or "fiscal stimulus" – not just in US, but also in countries like India, Indonesia, nations in Africa etc. (especially by commodity importing countries - now that commodity prices are so cheap). That is the right kind of stimulus needed now, not negative interest rates, to push the global economic growth to a higher and more sustainable trajectory.