Imbalance

“Life is like riding a bicycle. To keep your balance you must keep moving” – Albert Einstein

In my October 2014 article (http://poleconomyindia.blogspot.in/2014/10/deflation-and-liquidity.html) I had pointed how the global imbalance in savings and investment was at the heart of the global slowdown. I had written “The other side of this coin of global slowdown and imbalances as I have pointed earlier is the saving-investment (S-I) mismatch. Globally, Savings has to be equal to Investments. But as country, if savings is greater than investments it manifests itself in the country having a current account surplus (exporting capital) and vice versa.” Another way of arriving at current account is (X-M)+NY+NCT, where X and M are respectively the export and import of goods and services, NY the net income from abroad, and NCT the net current transfers. The table below shows the trends in current account balances since 2007:

Country / CA ($bn)	2007	2012	2015E	2020E
US	–718.6	–449.7	–460.6	–746.9
Euro Area	10.6	154.1	364.6	326.8
Germany	232.5	240.8	286.3	270.3
France	–8.0	–32.0	–5.2	–7.9
Italy	–31.3	–8.9	37.0	10.1
Spain	–142.9	–3.8	10.6	22.4
Japan	212.1	59.7	124.3	130.7
UK	–81.3	–98.2	–135.8	–86.1
Other Advanced	192.8	266.6	319.7	312.7
Russia	71.3	71.3	61.8	80.5
China	353.2	215.4	347.8	95.3
India	–15.7	–88.2	–30.4	–86.5
Brazil	1.6	–84.4	–72.8	–78.2
Mexico	–14.7	–16.4	–27.9	–31.9
Larger Middle-East	264.9	419.1	–113.4	–14.2

Source: IMF

Quick takeaways on the past trends:

• US, UK, India and Brazil continue to be the demand centers of the world of which US is the outsized buyer of global demand;
• With the German imposition of fiscal discipline in the Euro area demand in the southern European states have contracted dramatically;
• Japan’s change in balance has been more due to the nuclear power shut-down post Fukushima and consequent increase in energy imports;
• Russian oil exports will contract dramatically but so will imports leaving the balance in place but with a contracting GDP;
• Middle-East will play out very similar to Russia only to the extent that given the outsized social spends they may not be able reduce imports as fast;
• China growth decline is having an outsized impact on metal exporting countries and the declining currency should continue to counteract the desire to rebalance towards a consumer economy. The data below plays out the dramatic impact of China’s slowdown will have on the commodity exporters:

Bilateral Metal Trade (US$ m)	2002	2014
Australia	1,043	52,153
Brazil	605	12,851
Canada	90	2,496
Chile	784	15,249
Peru	196	5,621

Just as an aside, this decline in global commodities will cause a dramatic shrinkage and asset problems in financial balance sheets across the globe.

Where I disagree with the IMF forecasts for 2020 is on four key linear un-said assumptions underlying these forecasts:

• Americans will continue to tolerate their demand being used by other nations to allow things to revert to 2007 (despite shale oil) and will not turn protectionist or have preferential trade deals (i.e. TPP is designed to exclude the Chinese and therefore changing supply chains);
• Technology innovations like additive printing or solar energy will make no impact on manufacturing locations (Germany, Korea, Japan) or on energy producers (Middle-east);
• Chinese will be able to generate significant domestic consumption in a short period of 5 years despite adverse demographics, currency decline and inequality (http://poleconomyindia.blogspot.in/2015/08/china-everything-overdone.html);
• Southern European countries will continue with the German mandated fiscal bounds and bear the high unemployment and internal cost adjustments (i.e. wage deflation).  

As we can see the global imbalances continue to be substantially where they were in 2007. A quote from T. S. Eliot summarizes it wonderfully, “We shall not cease from exploration, and the end of all our exploring will be to arrive where we started and know the place for the first time.”

Post-script

Oil ($)*	1997-2006	2007	2012	2014	2015E	2016E
	31.2	71.1	105.0	96.3	51.6	50.4

Source: IMF, *Simple average of prices of U.K. Brent, Dubai Fateh, and West Texas Intermediate crude oil

Oil prices have been on a downward tear since 2014 crushing inflation across the globe causing an estimated shift in resources exceeding $1 trillion. Current price for this resource in under $40, markets looking to push it under $30. This may, however, turn out to be the savior of global central banks if it completes its correction in 2016 and rises enough to boost global inflation to 2%. If it overshoots, it turn out to be nightmare but there is always cover available under Core CPI which the central banks may use but I as a consumer do not care.  (US example - “The BLS does track Energy as a separate aggregate index, which in recent years has been assigned a relative importance of 8.030 out of 100.”)

1979 and Middle-East

“How can you have a war on terrorism when war itself is terrorism?” ― Howard Zinn

Introduction

In 1902 Alfred Mahan is said to have coined or more commonly used the word ‘Middle-East’ to denote to the area between ‘Arabia and India’. This area which previously held significance only as a transit point to India and the Far East, acquired significance with the discovery of oil and its great need in the modern industrial age. Roosevelt sealed the partnership – American security for Saudi oil – in 1945 in a meeting with Ibn Saud in Egypt while the British held their Iranian oil interests through APOC.

While many events like the Israel-Arab war transpired in the Middle-East, it was held largely in status quo by US and Soviet Union. But three key events that occurred 36 years back, in 1979, planted the seeds of wanton destruction and instability we see today:

• Shah left Iran after domestic turmoil and Ayatollah Khomeini took over;
• Soviet invasion of Afghanistan;
• Seizure of the Grand Mosque (Mecca) by extremists, calling for the overthrow of the House of Saud.

We can trace back some of the these underlying tensions further back like for Iran the 1953 coup by the Americans and the British or Sykes-Picot for the divisions of the Middle-East post WW1 or the arrangement between the House of Saud and Al-Shaykh among a few. But I would like to argue that these three unrelated events of 1979 lit the fuse on what has always been a delicately balanced situation.

Then in 1989 came the fall of the Soviet Union which released energy in countries held in balance by the two global superpowers and September 11 attacks on the US which then led to Afghanistan and Iraq attacks. The 9/11 hijackers were 15 Saudis, 2 from UAE, 1 from Egypt and Lebanon.

The Events

First - From 20 November – 4 December 1979, the Al-Masjid al-Haram in Mecca was seized by insurgents led by Al-Otaybi from an influential family in Najd. He sought to declare his brother-in-law Al-Qahtani to be the Mahdi (or redeemer).  They claimed that the House of Saud had lost its legitimacy to govern due to its corrupt and ostentatious ways and its policy of westernization. The government evacuated the Mosque and officially the death toll was 255 pilgrims, troops and insurgents and 560 injured. The state responded not rooting out religious conservatism but by following a more puritanical form of religion – women were banned from newspapers and television, cinemas and music shops were shut, school curriculum was changed and more space was granted to the religious leaders. The coincidence of this with the ‘Jihad” in Afghanistan started increased organized funding for jihadi activities with the state encouraging its citizens to participate in these activities internationally. This spawned multiple generations with extremist beliefs and oil resources to back it. The result can be seen in Bin Laden and 15 of the 19 9/11 attackers were from Saudi Arabia.

Second - The Soviet Union despite its hesitations invaded Afghanistan and that too with inadequate force. This attack caused serious concern in US, Pakistan and Saudi Arabia. The key concern of all parties was the Soviet Union then invading Baluchistan to get to the warm waters of the Indian Ocean and that Soviet bombers were now 30 minutes flying time to the Persian Gulf. The counter action that started was US and Saudi Arabia providing massive financial resources to Pakistan to direct the insurgency in Afghanistan. The Soviets left Afghanistan after 10 brutal years in 1989, sparking a civil war with various countries then jostling for influence. Taliban backed by Saudis and Pakistanis put their government in place only to then changed post the 9/11 attacks by the US. The Soviet invasion ‘terraformed’ the Pakistan-Afghanistan theatre with arms, narcotics, extremist culture, sectarianism and multiple separatist movements which is now gnawing away the Pakistani and Afghan state. This also formed the hot bed for learning of such tactics which have then been replicated in Iraq and Syria.

Third – The Iranian state was taken over by Ayatollah Khomeini in 1979, sparking great fear in Middle-East. Iraq was worried that this might inspire insurgency in its suppressed Shia population as were some of the others like Bahrain and Saudi Arabia. Iraq attacked Iran in September 1980, in a war that lasted 8 long years sapping the strengths of both countries. The between these militarized states helped keep the Middle-Eastern status quo check. The US supposedly provided resources to both parties in the war directly and indirectly. The international community did not against Iraq’s use of chemical weapons against Iran and internally against its Kurdish population. As Iran recovered from the war, the global scenario had changed with the collapse of the Soviet Union. Iran, which runs one of the most sophisticated security apparatus, already had built links with Hezbollah in the Levant and the Syrian regime. But its true opportunity came with the US attack in Iraq. This finally settled the balance of power in Iran’s favor decisively. Iran now exercises influence in Iraq through its Shia majority population, in Syria through its association with the Al-Assad regime, in Bahrain (majority Shia but has a Sunni ruler), Yemen and in Saudi Arabia (Shia population centers are the key oil producing areas)         

Energy and Solar

I had written in November 2014 that a long slump in oil price with change the politics of the region (http://poleconomyindia.blogspot.in/2014/11/hope-and-kiss.html). Decline in global growth and efficiency of consumption had brought stability in demand in major developed markets. Slump in Chinese growth and increasing shale production changed both the pricing and politics of oil. Now given the advances in solar energy comes the next challenge for the Middle East. Saudi Arabia for example budget break-even is $85 (almost 2x the current price of oil) which has the lowest cost of production in the world (55% of its GDP is related to oil). IMF estimates at current rate of spending and oil price Saudi Arabia will run through its financial assets in 5 years. Now some statistics on Solar:

• PV cost is down 200x in the last 40 years (while all energy prices are up….oil, gas etc)
• Solar PV market between 2000 – 2014 has grown at CAGR ~42%
• If the current growth rate continues all energy by 2030 will be solar!!
• Grid parity for 80% of the markets expected by 2017 (Deutsche Bank)
• Cost of rooftop solar may become below cost of transmission by 2020 (some people refer to this as ‘God Parity’!!)

Now imagine what this does to Middle-Eastern energy dependent economies over the next 2 decades! Just as an aside when Saudi Arabia supplies oil to China at $100, the surplus the Saudi Arabia creates it buys machinery (assume from China) both have inputs to nominal GDP at $100. When the price declines now Saudi Arabians have lower surplus and therefore lower ability to buy Chinese goods, China has lower nominal GDP and industrial overcapacity as its customers disappears. Lower nominal GDP growth and deflation has its own implications (which I shall not discuss here) on debt laden economies.

Current and Future State

The region is in a state of complete disarray due to rising intensity of extremist movement like Islamic State which now controls large swaths of Iraq and Syria or Taliban in Afghanistan and Pakistan and second the increasing pressure brought to bear by the Iranians (http://poleconomyindia.blogspot.in/2015/04/re-engaging-ancient-empire.html) across many countries. The authoritarian regimes (e.g. Bahrain, Saudi Arabia) of the Middle-East have long been held together by a system of patronage. This patronage is made possible by the easy revenues of oil. As need for oil and its revenue declines over the next 2-3 decades, the geopolitics of this region is likely to re-frame the political landscape. Over time various artificial states have been created, Syria is just one prime example. Those like Saudi Arabia have been helped by security guarantees from external benefactor (e.g. US). When the rationale for such support disappears, the pressure on the state will multiply manifold. A likely outcome for the Pakistani state in a couple of decades is that it may be reduced to rump state of Punjab as extremism and religious / regional separatism overwhelm the state. The Afghan, Iraq and Syria body count is already estimated in excess of 1 million with no certain estimates and millions displaced. When Europe tore its heart out in the two World Wars, it lost 100 million lives. It is nowhere close but that is the horror we have capability for.  

For most time in history, there were only two consequential powers in the Middle-East, the Ottomans (or power controlling the Asia – Europe Bridge) and the various Persian empires (centered in the location of the current Iranian state) besides external super powers like Britain, French, Russia, US that may intervene from time to time. The Americans did not engage Iran in the nuclear deal out of love but an understanding of the current influence it brings to the table in Iraq and Syria and of the future possibilities. States competing for the same geopolitical space react to one another; the Japanese have started reacting to China, at some point Turks will to the rise of Iran, consequently restoring balance to the region. But these developments take place in decades and till then the seeds of destruction that were sown in 1979 will continue to be reaped.

Total Recall

Matthias: Mr. Hauser, What is it you want?

Doug Quaid: I want to help you.

Matthias: That is not the only reason you are here.

Doug Quaid: I want to remember.

Matthias: Why?

Doug Quaid: So I can be myself, be who I was.

Matthias: It is each man's quest to find out who he truly is, but the answer to that lies in the present, not in the past. As it is for all of us.

Doug Quaid: But the past tells us who we've become.

Matthias: The past is a construct of the mind. It blinds us. It fools us into believing it. But the heart wants to live in the present. Look there. You'll find your answer.

The present tries to forget the past. The past even if washed by the sands of time serves a reminder every now and then.

When Napoleon armies marched across Europe winning many wars despite adverse numbers his confidence in his destiny magnified. He was then the Emperor of Europe from the Atlantic to Poland (Austria in alliance), the largest Empire ever carved in Europe. Having won peace with Russia (however brittle) and the English beyond his reach, he tried the disastrous occupation of Spain across the Pyrenees and lost many men in the Spanish guerilla war before giving up. Lacking the naval force he tried enforcing a continental blockade on the English. When the Russians reneged from the blockade he took the largest force ever assembled to attack the Russian marching across all of Europe. The Russians did not give battle and when Napoleon occupied Moscow, they burnt it down. Over half a million men lost their lives. As Napoleon’s star dipped, old enemies rose to fight again. And, in the Battle of Waterloo, 1815 he lost it all. Creating an empire is one thing, managing it can be quite another.

Bismarck in the same way created Germany out of what were many principalities on the western and southern side of Prussia, maneuvering militarily and diplomatically the Austrians, French and the Russians as he did this. However, once this had happened, he was aware of the power of united German nation and sought to diplomatically assuage the fears of other powers on the continent.

In February 1888, during a Bulgarian crisis, Bismarck addressed the Reichstag on the dangers of a European war. He warned of the imminent possibility that Germany will have to fight on two fronts; he spoke of the desire for peace; then he set forth the Balkan case for war and demonstrated its futility: "Bulgaria, that little country between the Danube and the Balkans, is far from being an object of adequate importance ... for which to plunge Europe from Moscow to the Pyrenees, and from the North Sea to Palermo, into a war whose issue no man can foresee. At the end of the conflict we should scarcely know why we had fought."   

He left a marker for the future leaders of Europe. Ironically, World War I started with Austro-Hungarian Empire attacking Serbia (in the Balkans) leading from one conflagration to another and Germans were fighting the French and the Russians (two-front war). A leading historian of the era, William L. Langer sums up Bismark's two decades as Chancellor: “Whatever else may be said of the intricate alliance system evolved by the German Chancellor, it must be admitted that it worked and that it tided Europe over a period of several critical years without a rupture.... there was, as Bismarck himself said, a premium upon the maintenance of peace.”

We now see another nation rise to change the balance of power in Asia – China. As China changes the status quo, it is changing the behavior of all its neighbors – the bordering countries of its newly propounding maritime boundary (the nine dash line) like Philippines, Vietnam, Malaysia, Singapore; Australia; India; South Korea; and most importantly that of United States and Japan. Japan has as a consequence started reversing the limits it bound its military in post-World War II. This is like all the nations of Europe were aligned against Napoleon. One is already seeing some impact on military spending in the region, SIPRI reported, "Vietnam also continued its rapid rise in military spending, with an increase of 9.6% in 2014, reaching $4.3 billion. Since 2005 Vietnam’s spending has risen by 128%, reflecting tensions with China over territorial disputes in the South China Sea. However, Indonesia decreased its spending by 10% in 2014—a reversal of recent trends, which may prove to be only temporary, given Indonesia’s ambitious military modernization plans. Although military spending in Asia and Oceania remains on an upward trend—with all states in the region except Fiji, Japan and Laos increasing their spending since 2005—the growth rate for most states has been substantially lower since 2009, when the effects of the global financial crisis began to  be felt. For example, while China’s military expenditure doubled in real terms between 2004–2009, it increased by only 48% between 2009–14. Japan, meanwhile, approved a record budget for 2015.” China, however, has the benefit of geography, an ocean frontage of 9,000 miles in the temperate zone, which the other Eurasian power Russia never had, making it both a land power with access to the resources of central Asia and a capability to build sea power.

The Chinese have during the last 30 years tried to transition to proactive engagement with the international system and from a taker to a maker of international order. The ability to maintain the current trajectory of change is significantly dependent on it economic growth. As Kaplan points out, “Two debates are under way over China. The first, about Beijing’s aggression in the South and East China seas, is between naval strategists and diplomats who know little about economics. The second, about the fragility of the Chinese economy, is between economists who know little about naval strategy and diplomacy.” But depending on the trajectory one could see internal strife with Tibetans or the Uighurs or increasing friction at sea inspired by nationalism or a managed transition where US power gives way to Chinese in the South China Sea. The number of annual protests in China has grown steadily since the early 1990s, from approximately 8700 “mass group incidents” in 1993 to over 87,000 in 2005. In 2006, the Chinese Academy of Social Sciences estimated the number of annual mass incidents to exceed 90,000, and Chinese sociology professor Sun Liping estimated 180,000 incidents in 2010. These incidents are a marker of the break in social contract with its people as income divide widens, job security reduces or the environment degrades and this is what could seriously tear down internal political consensus of a single party rule. The downturn in the Chinese economy is already causing global pain; an implosion would seriously damage global economic stability and internal security. For my views on the Chinese economy please refer to http://poleconomyindia.blogspot.in/2015/08/china-everything-overdone.html.

It is not that the American Empire rose in complete harmony with world. Thomas Jefferson, in the 1790s, awaited the fall of the Spanish Empire "until our population can be sufficiently advanced to gain it from them piece by piece." In the late 19th century, foreign territories such as Hawaii and Latin America were sought after by the United States. Roosevelt supported the Panamanians to revolt against Columbia and in turn they granted US control of the Panama Canal Zone. The Teller Amendment and the Platt Amendment were used in unison to grant the United States the right to intervene in those territories if that particular government was deemed unfit to rule itself. The American government held the power to both criticize and occupy these nations if they were deemed to be unstable. But two things that were important through all of this - consistent growth in economic might (barring the great depression) and World War II which literally tore down the European empires and with it the old world order.

The Chinese may like to be like the Americans but are behaving like Napoleon when they ought to manage like Bismarck.

What made headlines?

“To read a newspaper is to refrain from reading something worthwhile. The first discipline of education must be to refuse resolutely to feed the mind with canned chatter.”

Liquidity unwind

Estimates suggest through various phases of QE starting January 2009 ~$500bn came into Asia ex-China, ~$40bn was lost during the 2013 taper fit the markets threw and ~$30bn has been lost in the last 3 months. The markets lost small sums compared to the noise factor in the press. But what this suggests is the level of potential unwinding that is possible if interest divergence were to be become stark. Already the reduction in dollar reserves across countries from Saudi Arabia, Russia or China is causing a quantitative tightening.   

In India, credit growth is getting constrained at the one end by the low levels of inflation - WPI was -4.1% in July and GDP deflator Apr-June was 1.8% and the other by very high bad loans – NPA and restructured assets have reached ~11%. Second, the choking of the capital expenditure in infrastructure or heavy industry in the last 4-5 years has created not only the bad loan issue but also ensured that equity capital in stuck in the these projects and potentially wiped out as a consequence of cost and time over-runs or now due to steep commodity declines. The third is from 2009 onwards physical savings continuously exceeded financial savings (historically physical was around 50%-55%) to the extent that in the last couple of years become almost 2x. This savings went predominantly into real estate which is now facing decline in value and transactions, consequently wealth effect and liquidity are both gone. Fourth, the focus on reducing black money in the economy by the government and the Supreme Court is beginning to bite. The recent decline in equity market valuations surely add to this but on the debt side we have lost only 1% of what we did in 2013. 

Inconvenience of election promises

Narendra Modi is a master of rhetoric and this was principal amongst other aspects that laid the foundation of his victory. The Indian constitution recognizes the Parliament as the highest decision-making body with the Prime Minister at its helm but does not in the same breadth take away the powers or allow the Parliament to override the state governments or the courts or the upper house which has representation of the states at the center. It is designed as a check to protect the basic character of the nation from violent majoritarian-ism. No leader would get elected if he points out his constraints to the electorate and no leader unless he steps in the chair understands these constraints fully anyway. Thus, the aspirational high before elections is designed to fail.

Having said this, the regionalism of India represented by many regional political parties, of which I have written many times, ensures a permanent divergence of views. And in this specific case the presence of overwhelming majority center, has forced regional parties to collaborate to protect their turfs while they live to fight each other another day. A declining Congress has limited stake in constructive behavior, as its victory is more likely to come from the BJP’s mistakes.  

Having said this, politics is the art of working with 'material at hand' and turning promises to reality. "In order to govern, the question is not to follow out a more or less valid theory but to build with whatever materials are at hand. The inevitable must be accepted and turned to advantage." - Napoleon Bonaparte

When it rains

If the twin crises of economic malaise and Ukraine were not enough for Europe, it has stepped onto the new crises brought by fighting and political instability across its southern arc from Syria to Libya. The migration of millions of people to Europe has sparked fear and guilt. Sweden has received the highest number of application (more than 8 / 1000 population), UK the least (under 1 / 1000 population). While Germany at almost 3 per 1,000, is receiving 68% of the EU refugees. In context the levels are the highest ever since the cold war – for example Germany has received ~2x the applications it did at the peak of the Yugoslav war which were the highest till date. The sharing of this burden is causing friction within the European Union and the fear of accepting large Muslim population from the war torn countries is also sparking demographic tensions at a time when Europe is facing a decline in its dominant Christian population.

Europe prior to WW II had hegemony over North Africa and this was the source of cheap labor. When they lost their empire, they had no choice but to allow controlled migration to ensure availability of labor. But they never assimilated this population which can be seen in the ghettoization of Muslims even cities which claim to be multicultural like Paris. This non-acceptance has its roots in the wars fought with Islam for over 1,000 years. This is was a period where Christian Europe had great evangelical zeal to kill and convert its enemies, be it Islam or different strains of Christianity. While Europe sapped its zeal to allow peace within Christianity, slivers of Islam maintain that zeal and continuously espouse that they speak for the rest of Islam. European nation states are about shared history, language and common values, the migrated Muslims share none of these.

Europe will turn again to welcome immigration in the next 2 decades as its population decline deepens but this would come out of need rather than the current burden of conscience.

Indrani Mukherjea…?

Incompatibility accentuated by decline in money flow leads to breaking of marital vows resulting in current mess. All the worlds’ problems seem to be in one microcosm and I am sure we can find more. Well hasn’t the media got it all…