Consumption Markets and Balance of Payments

Someone asked me the question how is the US able to create massively scalable e-commerce businesses? This got me thinking in a different direction but first a simple answer to the question.

US is by far the largest consumption market globally by a factor of 3-4x compared to any other country in the world. Supported by very high acceptance of the medium and confidence this has allowed for massive increase in the e-commerce market has allowed for this. VC funding and low cost start-up ecosystem is very supportive.

Country	GDP (Nominal)*	Household final consumption (“HFC”) (% of GDP)^	HFC (as % of US HFC)
US	16,244	72
China	8,221	36	25.3%
Japan	5,960	61	31.1%
Germany	3,429	58	17.0%
France	2,614	58	13.0%
UK	2,477	66	14.0%
Brazil	2,253	62	11.9%
Russia	2,030	48	8.3%
Italy	2,014	60	10.3%
India	1,842	61	9.6%

* Nominal GDP 2012 (IMF)  ^ World Bank 2012

Now the other direction, a closer look at the table above shows the key imbalances in the global economy:

• US is the key importing nation driven by its consumption markets, the next three countries on the list are leading exporters globally (China, Japan & Germany). How long will this Balance of Payment imbalances sustain? More of this later; and

• Chinese consumption is the lowest compared globally, significantly below global norms. Investment imbalance and financial repression are primary contributors.

Balance of Payments

The last 2 decades of global expansion has been driven to a large extent by liberalization of trade. The top 4 countries in the list are the principal participants in this exchange. But in the net impact it has been pretty much a one-way traffic. The global financial crises was in many ways a manifestation of the underlying cycle of very high savings in Asia driving cost of borrowing lower in the US which in turn supported the housing bubble. While trade liberalization allowed for continued reduction in product costs. While the financial crises passed the underlying causes were never addressed.

• Chinese followed the global financial crises by their own version of credit boom of which they are now witnessing the limits.The economic impact of faltering export engine was addressed by expanding domestic investment. The Chinese realize this imbalance cannot continue and are looking to take the first baby steps to address the issues. But getting local consumption going requires radical change and this adjustment will mean slower GDP growth (i.e. US in the late 1920s, Japan in the late 1980s). The Chinese & US M2 was ~US$8 trillion around the financial crises. The US M2 is ~US$10 trillion now and the Chinese are exceeding US$16 trillion. The highest money supply expansion ever in history in such a short period.

• Japan has adapted ‘abenomics’ to get their moribund economy moving. But adverse demographics means growth in the economy can only come through higher exports, to where, into the US?

• Germany whose export driven economy self-corrected before the Euro era driven by the exchange rate adjustment is currently finding the adjustment very difficult. >60% of German exports were into the Euro area. As this slows, the German economy will falter unless they can export more, to where, US again?

In my view US will witness a new era of growth driven by shale gas finds and, consequently, cheaper cost of production. This will result in the largest debtor nation pushing back on imports over the next few years. This reduction of imports will also be driven by reduction in underlying commodity prices as the Chinese import falters. However, as imports reduce, it will put structural limits on growth of China and Germany. Japan is trying to find a way in ‘abenomics’ and the Trans Pacific Partnership, which the US believes is in its political interest.

So will this change continue to be supported by currently high consumption in the US. I believe US consumption levels will continue to be high supported by the retiring baby boomers and medical costs, rising interest rates notwithstanding. Finally, production is easier to create which China, Japan and Germany have..but it needs the customers i.e. the US more than ever. 

Poverty of thought

Every passing day as we witness the debate culminating to the next year general elections, the populace is left more and more bewildered of the debate and policies of the respective political aspirants. Of course, the ardent fans of each camp do not care it is just a passing phase.

But there are underlying factors which drives this confusion in the political spectrum. After 10 years of Congress rule of which the last 3 years have been excruciatingly painful, a large part of the urban population is looking for a break from the past, especially the young first voters. The rural voters who have benefitted largely from the variety of largesse or poverty upliftment programs of the government may still vote to a certain extent with the Congress. While corruption may not be a big issue in rural India but where masses have been lifted beyond poverty, fulfilment of aspiration (the next phase after poverty removal) is the next big issue. If one looks at the Congress it is still stuck in the quick sand of poverty and therefore would lose ‘aspiration’ vote.

The BJP right wing politics does not allow for poverty doles and knows that Congress is the ‘champion’ of poverty programs. It is also wary of what happened in 2004 elections. Having said this, it believes rather than charting the true development agenda and articulating the free market policies it would undertake, it is playing anti-thesis to the Congress i.e. highlighting corruption, lack of effectiveness of the poverty programs, low job creation due to lack of governmental approvals etc.

While we may all blame the organizational issues that plague both the national parties, the key fact is they do not understand the unifying vote factor.  In fact given India’s fragmented polity there is none today and this trend has accentuated with the regionalism of the smaller parties.  It at this moment a nation, especially as large and diverse as India, needs a national leader who stems the fraying.

There are some critical issues at hand that the next government needs to address, (1) Restoring institutional integrity and framework starting from the PMO; (2) Regional security i.e. post-2014 Afghanistan, restoring regional trust in the Indian state from Bangadesh to Sri Lanka, relationship with a post-sanction Iran; (3) Economic growth, inflation and fiscal correction (in possibly winding down stimulus environment globally).

There is no one who seems to be talking about how these will be achieved. This period of non-governance, especially given the pressure on the Congress Party, will cause significant strain on other institutions like:

• RBI will be left alone to handle the economy but its hands are tied by foreign exchange markets and inflation. Consumer inflation is primarily driven by logistical issues (principally in food), high property costs and taxes. These are principally in government hands to deal with. For example, encouraging transport using inland waterways and coastal shipping can bring logistics cost down significantly (water transport cost is a 1/4^th or 1/5^th of road cost)
• Armed forces will be left to handle the Kashmir / Pakistan heat, where the hard diplomatic moves would reduce the pain. Changing Iranian equation (initiation of nuclear negotiations with EU and US) provide India with a significant opening to potentially create a counter-balancing situation with Pakistan

I do not think the quality of debate during this election will improve whether pre-manifesto or post. We live in the season of poverty of thought not because our leaders are unable think through the issues (at least in my view) but among the leaders there is no leader who has the conviction of thought to state it. It will be realpolitik all the way.

In the life of a nation, however, the quality of the election debate does not matter, governance post the elections will. If this were a true predictor of that, one would run scared..

The ‘Real’ Estate

Asia has been witnessing a credit boom of its own (nominal credit growth to nominal GDP growth >2x in HK, Malaysia, Indonesia and Singapore) with substantial part of the flows going into real estate with economies like Singapore, Indonesia, China and Thailand enacting measures to cool-off the real estate bubble. Of these economies, Singapore, Malaysia and Thailand have household debt to GDP in excess of 70% which could imply significant pain when interest rates rise. The low interest regime has created substantial interest in real assets.

In India, we have witnessed extremely strong housing credit growth where retail home loans are up over 10x in the last decade and developer loans by banks / HFCs are up >15x. This developer funding has been further supplemented by PE funds, capital markets and informal financing markets. Of the retail home loan growth, 70% of the growth has come from increase in ticket size of the loans, indicating the preponderance of price growth in the market.

Stretched affordability indices as a consequence have meant significant slowdown in absorption rates of apartments. IT sector which contributed most of the absorption through their massive white collar job creation have seen a decline in hiring levels and wage increases.

High housing prices have created their own cost on the economy in terms of knock-on effects on pricing of goods and services i.e. the local fruit seller charges higher as his shop rental and cost of living has gone up, cost of starting a business moves higher, malls suffer due to high rental costs.

Raghuram Rajan in his book Fault Lines wrote, “Easy housing credit has large, positive, immediate and widely distributed benefits, whereas all the costs lie in the future. It has a pay-off structure that is precisely the one desired by politicians, which is why so many countries have succumbed to its lure. It pushes up house prices, making households feel wealthier and allows them to finance more consumption.”

So question is will he act to address the issue as politicians given their interest will not. His first act at targeting consumer inflation is a step in the right direction.

The next question is what got us to the current state of affairs.

Indian RE prices expanded significantly in the post 2006 as the economic expansion resulted in massive increase in costs (i.e. cement prices) and second a belief in long-term prospects attracted massive dosage of capital. This capital was used to purchase land at higher and higher prices. The collapse of 2008-2009 was short-lived as government and the central bank coordinated a stimulus. This was helped by record low interest rates globally.

This stimulus ensured that no adjustment happened plus a short correction resulted in re-affirmation of the investor belief of continued price increases. Private financiers (many times with money diverted from their core businesses) poured in money into the market lured by the returns promised by the builders. Banks which have traditionally viewed real estate as the safest form of collateral kept financing the collateral at higher valuations forming a virtuous cycle. Lack of real returns in stocks and bank deposits and low cost of money for NRI’s ensured continued interest in the RE assets. Corruption proceeds during the last decade as their scale grew larger played their role.

With yields on residential property at record low of 2-3% (compared to lending rate of ~11%) and urban India with slowing incomes and high inflation, the final buyer has balked, investors no longer believe that they can make 20-25% returns from these price levels, banks are hurting with NPAs with no longer have the flexibility of expanding their belief in prices.

This will create an impact on not only consumption levels (consumer wealth) but also house building activity impacting GDP growth further. The central and state budgets have no room to be counter-cyclical measures and increasing interest rates globally will create pressure on the Reserve Bank to maintain spreads high enough to ensure no significant pressure on the rupee. It is likely, given the market structure where stressed asset disposals are not easy and banks do not want aggressive write-offs, we will see a combination of price correction and time discounting.

The retort we see from developers of input cost going up does not hold, even for basic agricultural commodities it is demand-supply model of price determination. It almost seems like a wish to hold on till one reaches the cliff.

Perversion of the State

India is a nation born out of high ideals. It is the first, and possibly, the last country in the world to get freedom through a non-violent movement (helped by the pressure on Britain post 2^nd world war). The group which led the movement had hoped for a country which would serve as a beacon of hope. Nehru said on August 14, 1947: “Long years ago we made a tryst with destiny….That future is not one of ease or resting but of incessant striving so that we may fulfil the pledges we have so often taken and the one we shall take today. The service of India means the service of the millions who suffer. It means the ending of poverty and ignorance and disease and inequality of opportunity. The ambition of the greatest man of our generation has been to wipe every tear from every eye. That may be beyond us, but as long as there are tears and suffering, so long our work will not be over.”

This was the aspirations on the basis on which our country was found. This honesty of purpose and idealism guided the first generations of politicians. But idealism is not and cannot be the basis of a nation’s action (non-alignment, non-violence). The outcome may be based idealism that but action may not be - Lincoln abolished slavery and united the US but the actions to secure this were driven by cold statecraft. The first priority of the leaders of any nation is to secure the national borders. Weakness in action enabled the loss of territory to both Pakistan and China. This continued even as geostrategic reality in on Indian borders underwent the change (i.e. Tibet, Burma, China and Nepal). This weakness in national posture has continued till date and even the high point of 1971 war resulted in restoring the status quo on the western border.

The fatal failure of Nehru to institutionalize and democratize of the Congress Party has ensured perpetuation of nepotism of the worst order. We are currently being ruled by the 4^th generation of the family trying to pass the baton to the 5^th generation. This is the lead that all major political parties have followed. Tyranny (absolute power) is the farthest remove of all the perversions from true constitution… (Aristotle).

The divisiveness of religion perpetuated in self-interest by our politicians has divided and sub-divided the Indian populace in a manner that would be a marketer’s delight. Ambedkar had warned, “The sovereignty of scriptures of all religions must come to an end if we want to have a united integrated modern India.”

The left leaning politics of our founders founded in the political fear of America who they saw as the inheritor of the British global leadership saw the emergence of planned economy aligned to the Soviet Union, which then moved to nationalism and then to economics of special treatment and special interests. The hope for salvation on this path crashed with the collapse of the Soviet Union but in this process 4 decades were wasted before a limited free enterprise was unleashed and large parts of the economy were occupied by then by special interests. Ambedkar said, “History shows that where ethics and economics come in conflict, victory is always with economics. Vested interests have never been known to have willingly divested themselves unless there was sufficient force to compel them.”

In effect the 4 key tenets of the state – security, governance, economics and unity - have been undermined, corrupting the functioning of the state. The tryst of the Indian state with its destiny continues to yearn for fulfillment…even in 2010 the World Bank reported that 32.7% of the total Indian people fall below the international poverty line of US$1.25 per day (PPP) while 68.7% live on less than US$2 per day.

An Indian Politician's 'Moral' Dilemma

Have politicians miscued massively? My sense is they have. As they gave financial liberties to people post the 1990s, the Indian economy did much better than the previous decades since independence. While the asset created by the political class till then and sometime after benefited hugely driven by access to international capital but with the change in the economic model and people's incomes came a few things:

• New regulatory authorities to manage a far more complex economy which encroached upon the power's of the executive (recall CAG on 2G, Election commission);
• Higher income levels made the middle class demand better governance (Anna movement or the Delhi rape outburst), social media accentuated these trends;
• The urban centers gained initially and in response to this can the various wealth transfer schemes (MNAREGA etc). This wealth transfer incrementally pushed the rural areas on the fringes towards greater urbanization. Now 1/3rd of India lives in urban centers demanding improved living standards. 

The political class and the bureaucracy which in the gravy of power had ossified and believed that 'politics has no relation to morals' (Machiavelli). It has been shaken hard by the changes, a change from the era of no answer-ability to permanent scrutiny. Politics is always fluid but in balance. Imbalance in the executive has been filled by the judiciary and other wings but this is not the state of equilibrium. 

The citizen's are demanding better services (infrastructure, policing etc) and higher accountability of the elected officials / bureaucracy. This can be only met by more decentralized but accountable system otherwise the edges will fray. Let's take the example of a small company run by an entrepreneur can do without IT systems, organizations, proper accounting etc. But as the company grows larger they need to address these basics otherwise it will fail. This is not to say significant errors do not arise in large companies but probability is far lower. Like here, the political executive is fraying as they do not want to evolve fast enough. The glue (corruption and self-preservation) that holds them will be re-wired and corruption proceeds will decline and sacrificial lambs will be demanded at least in the short run until the re-wiring is done. The political class may not achieve the Aristotle dream of giving people what they deserve, helping them achieve their highest nature and living a good life, but there is much between the two realms to aspire for.

Could they have avoided this outcome? Unfortunately, no. That would have required one leader or party with a long range plan for evolution. Democracies do not allow for it. But this schism has left serious gaps in governance creating both external and internal issues. The nation needs a leader of a different caliber to bridge the chasm. As they say, when law become despotic, morals are relaxed. We need a change in course...the nation needs to feel good.

Wealth of nature and unintended impact

Ancient civilizations were a agricultural based society. It was the wealth of the land which translated to well-being of a society. The table below shows the top 4 nations and the comparative land mass and the ratio of cultivated and arable land. It is clear that India was an extremely well-endowed country.

Rank	Country	Cultivated land (km2)	Cultivated land (%)	Arable land (km2)	Arable land (%)	Total land area (km2)
—	World	17,298,900	11.61	15,749,300	10.57	149,000,000
1	United States	1,669,302	18.22	1,650,062	18.01	9,826,675
2	India	1,535,063	51.63	1,451,810	48.83	3,287,240
3	China	1,504,350	16.13	1,385,905	14.86	9,640,821
4	Russia	1,192,300	7.28	1,174,284	7.17	17,075,400

This bounty of nature allowed India in early ages to develop and excel in science, culture, art, development of religions (Hinduism, Jainism and Buddhism) in the same manner that propelled the Europeans at the time of the industrial revolution. However, India never participated in the industrial revolution that took place in the west in the 18th and 19th century nor did it develop the industrial architecture post independence. We moved seamlessly to the services age from an agrarian economy in the late 20th century, skipping industrialization. The Europeans during the industrial age did not only massively develop their infrastructure to the support this change, mass production also pushed them for resources and markets outside their immediate neighborhood. India had no such compulsion, it continued to live in a self-contained world. Further, nature (harsh winters) enforced no compulsions to develop better infrastructure whether for transport or food.

A L Basham, Professor of Asian Civilization in the Australian National University, Canberra in his book The Wonder that was India published first in 1954 makes some interesting commentary in this regard, "It has often been said that the scale of natural phenomena in India, and her total dependence on the monsoon, have helped to form the character of her peoples. Even today major disasters, such as flood, famine and plague, are hard to check, and in older times their control was almost impossible. Many other ancient civilizations, such as those of the Greeks, Romans and Chinese, had to contend with hard winters, which encouraged sturdiness and resource. India, on the other hand, was bless by bounteous Nature, who demanded little of man in return for sustenance, but in her terrible anger could not be appeased by human effort. Hence, it has been suggested, the Indian character has tended to fatalism and quietism, accepting fortune and misfortune alike without complaint."

The incestuous nature of development where one segment allows the other segment to in turn develop has in the 'fatalism and quietism' completely escaped the India policy makers. Our anciently most evolved sector (agriculture) today suffers due to lack of industrial development - lack of irrigation and mechanization, new seed development, transportation infrastructure among other things. The growth in GDP which has been driven by services over the last few decades have been propelled significantly by technological changes globally (IT outsourcing and communication technology) and adopted in India which in turn has driven domestic demand in areas of local trade, real estate, financial inter-mediation.

Niall Ferguson talks about 6 killer apps of development (and my thoughts on where India is on each of them):

1. Competition - We have seen this only in the last 2 decades since the opening up of the Indian economy consequently a very limited period.
2. Scientific Revolution - India is not there in the list of 'patents in force' of top 20 countries 
3. Property rights - At best we have partial rights and extremely difficult enforce-ability
4. Modern medicine - We have seen significant leap in provider infrastructure but India is nowhere at the cutting edge of equipment, pharmaceuticals or education of medicine.
5. Consumer society - Our GDP has had a healthy mix of consumption. Availability of finance and choices in the last decade have further helped this.
6. Work ethic - This I will let the reader decide for himself..Indian labor is 10% of US GDP per person employed as of 2012 

The reason for historical success has constrained development in the more recent past. We became complacent. We had begun to make significant strides post-1991 but again our instincts failed us in the last decade - we cannot blame the bounty of the gods nor continue to live in the halo of our forefathers.

Failure of Strategic Thinking

When the Americans attacked Afghanistan, it was to send a message 'don't mess with us'. This was the first time after Pearl Harbor that American mainland was attacked, the response had to disproportionate. But post the collapse of the Soviet Union, the sole super-power also suffered from the belief in 'infinite ability' and, the consequence followed in Iraq attack. The two key strategic fronts of Russia and China weakened, allowing Russians to recover and Chinese used this time to gain in their near neighbor-hood and develop their area denial, space and cyber capabilities undeterred. The American actions significantly deteriorated the balance of power in the Middle-East, Syria is a consequence. Inability to punish Syria for crossing the line, is betrayal of this weakness. Americans are now trying to re-establish the balance of power structure they tore apart, re-balancing forces in the Pacific (to contain China) and play the fine balance in Syria for the fear of a further breakdown.

Here the chess player who played from a position of 'infinite' strength forgot that strategic moves are always limited, never infinite. Machiavelli writes in the Prince - "A Prince ought to have no other aim or thought, nor select anything else for his study, than war and its rules and discipline; for this is the sole art that belongs to him who rules, and it is of such force that it not only upholds those who are born princes, but it often enables men to rise from a private station to that rank. And, on the contrary, it is seen that when princes have thought more of ease than of arms they have lost their states." The Americans forgot the art of war and managing the politics (unilateralism) in this period post the Soviet collapse. It displayed a clear lack of strategic thinking.

I write the above to make a case on how a nation meandered, de-focused from its goals a little bit in the context of its history and its consequences. 

In the context of this minor deviation and its consequence, let's evaluate India's overall strategic imperatives and have we kept sight of them since independence:

• Control the Indo-gangetic plain - The Indo-gangetic plain is the core of India encompassing one of the most fertile lands in the world. The ruler of this patch has always been the most powerful force in the sub-continent and its center of gravity. Even today UP demonstrates its strength in the Indian parliament and setting the national agenda. 

• Protection of the the north western border - This has been the key access point for most attacks on India's except when the Europeans came by sea. The border continues to push with multiple wars being fought with Pakistan. The Chinese surely understand the geopolitics of the region and will continue to maintain a strong relationship with Pakistan. It is incumbent on India to break the mold, something it has not done for almost 2,000 years. 

• Ensure that the Center holds - The vast divisions in India driven by regionalism, myriad castes, cultures, languages etc have always driven localized systems that have not allowed themselves to be governed by a strong Center. The regions have had changing political systems which have partnered with others to ensure their relative independence. Recall the various Indian princes during the Mughal and British era which were happy to collaborate as long as their interests were served. Look now how the regional political parties work to ensure their interests are maintained while the Center does not gain adequate strength to subdue regionalism. We have had only four periods in Indian history when the Center was strong - Mauryan, Mughal (post Akbar), British, 40 years post independence and to some extent the Gupta period. The rest have seen mean reversion to age old 'regionalism'.

• Once the above key pieces were in place build a strategic vision for South Asia and the Indian Ocean. Curzon wrote - "The central position of India, its magnificent resources, its teeming multitude of men, its great trading harbors,... all these assets are of precious value. On the West, India must exert a dominant influence over the destinies of Persia and Afghanistan; on the north it can veto any rival in Tibet; on the north-east it can exert pressure on China, and it is the guardians of the autonomous existence of Siam (Thailand)." To this extent, maintain peace in South Asia through opening its markets to ensure strong interests of its neighbors and build a strong navy to project power in the Indian Ocean.

India caught in its regionalism and balancing the needs of its large population has continued to struggle in achieving these over-arching national strategic goals. Our politicians have deeply lacked vision. The Americans will likely come back and play the game to their strategy, the 'real' game of chess never started for the Indian elite, they are still figuring out who to play with...