Unmistakeable trends

Unless one has discovered faith or purpose in something, it is likely that there is permanent feeling of being adrift. But we have a situation today where the entire nation seems adrift and has lost faith in its leaders. Unfortunately, a nation state does not have the luxury of drifting; it will result in political catharsis. However, it is not my intention to discuss the potential outcomes but the underlying trends which have caused this:

• Regionalism unconstrained: Political democracy has become a struggle for maintaining regional empires across the spectrum, where old geographical and other divisive fissures (caste, religion etc) have come to the fore. Old divided India governed by many regional kings which was constrained by the Mughal and British empires is re-emerging over the last 2 decades in the form of the regional political ‘kings’. The inability of the centre to enforce itself due to divided and factitious polity is creating this situation.
• Unemployment: Inability of the political class to find mass employment is resulting in ‘restless’ youth. The political class is unable to create consensus to open areas of the economy which can result in mass employment (i.e. retail) or change labour laws. Manufacturing technologies is evolving rapidly (e.g. 3D printers, robotics) to cope with the western world population pressures. This inability is finding manifestation in the form of programs like MNAREGA which are in turn creating their own negative dynamics of fiscal pressure, increasing wage cost disproportionately.
• Changing communication: The massive increase in telecom penetration and new communication mediums like twitter, facebook, sms etc are creating an explosion of awareness. Government and governance has been unable to keep pace with this sharp curve disrupting old models of decision-making.
• Rise of aspirational India: With rising awareness and high income growth of the past decade has come the rise of an aspirational class across the country where consumption patterns and views differ from the old India. This is a class which compares itself to people in other nations, has travelled, likes different cuisines, is connected online and shops on the web. Their political views range from apathy to changing the country to bring it in the league of developed nations. It is this aspirational India which has not only led to the rise of Arvind Kejriwal but also the one which finds great appeal in Narendra Modi.
• Pressure on water resources: Water will continue to be a point of stress especially in North / central India reinforcing poverty, creating migration & sparking differences regional differences.
• Destruction in values: Growth and greed of the past 2 decade multiplied by the democratization of corruption across the political class and created a cynical public view.
• Exceptional Indians: There will be Indians who will continue to do well globally. It a function of 2 things: we are 1/6^th of humanity and two the pressure and chaos of our youth breeds a mind-set which can deal with a rapidly changing world.
• Movies: India will never tire with movies and their offshoots - movies at the theatre, movies at home, film based programs, movie stars in advertisements, movie stars for marriage dances, as owners of cricket clubs….

In economic markets, there is a concept of equilibrium such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. Markets rarely find equilibrium but conversely markets rarely trade at 4 standard deviations. Similarly, a country is rarely in perfect state but like the markets massive dislocations (e.g. global crises of 2008 or 2nd world war created a new world leader in US) can create new reality. The political ‘stretch & vision’ of the country is being tested by some of these trends.

India Anti-Competition

If one looks at the political discourse, there is no discussion whatsoever over the last almost decade on what it would take to create and maintain India’s competitiveness in the long-run. First half of the decade we were basking in the glory of the global run and then in the second half dealing with the political drift of the government.

During this period the world has changed immensely, where while demand is local and can be altered by government (fiscal stimulus) and central bank (low interest rates) policies but the supply chains have become global. Steel plants compete with their counterparts in China, Textiles with Vietnam and Bangladesh, Paper from Malaysia and Indonesia and so on. Consequently, there are 4 key aspects which will determine long-term competitiveness of an economy:

• Infrastructure (e.g. container ships turnaround time at Indian ports can be 3-6x Singapore ports);
• Land & housing (e.g. land cost impact project costs, rentals, people cost);
• Healthcare (e.g. while in the US the high healthcare costs are a drag, in India the quality of impacts productivity);
• Education.

These are large costs (implicit or explicit) where international supply chains cannot replace Indian cost and efficiency. We have seen very limited government focus all these aspects with politicians (as globally) celebrating massive increase in land & house pricing as indication of Indian prosperity little realizing they are massive proportion of the cost (capex & opex) structure and sub-component of wages. While India has seen growth in educational institutions, industry continues to complain about quality of entry manpower.

In addition, we continue to shy away from opening variety of markets except consumption markets (cars, water, chewing gums, coffee etc) like:

• Agricultural markets;
• Education;
• Retailing;
• Power distribution;
• Coal mining;
• Defence production.

Each of the above examples imposes significant costs and holds back economic efficiency. While certain markets may require support from the government but support cannot be perpetual and to prepare industry it is best done with a clear roadmap. Then, we have reversals recently like power sector tariffs being subsidized in Delhi then in Maharashtra.

A good thing that has transpired in recent years is that some states have begun competing with one another for improving governance; however, there is no bench-marking one to international standards. It is India’s myriad of regulatory arbitrages that keeps a large part of the elite and the current power structure going and they play their role in keeping things in status quo.

A focus on the 4 key long-term competitive factors coupled with graded opening of markets will substantially boost employment and raise the long-term trend growth of the economy. Question, of course, will the self-interested political class act? This is in some ways a manifestation of the way Indian political party’s work where the political class seeks to avoid competition, running their parties like fiefdoms. Further, India needs to increasingly use its large market like the US (NAFTA) to create mutual self-interest with its neighbours.

Edward Luke in an interesting article written in 1990 titled, From Geopolitics to Geo-economics: Logic of Conflict, Grammer of Commerce, wrote,”…World Politics is still not about to give way to World Business….Instead, what is going to happen - and what we are already witnessing - is a much less transformation of state action represented by emergence of “Geo-economics”.”

We as a country wait for each economic crisis to act and seem to be happy with the given moment as long as it is going well with no desire or willingness to act for the future.

Musings on 2014

As the New Year has come in so have new hopes and anxieties been kindled. 2014 is likely to be the turning point for the world in more than one way. We will have two key events play out, one political and the other economic:

• America and Iran are on course for a rapprochement, which will change the geopolitics of Asia. Israel, Saudi Arabia and Turkey are likely to feel the pressure from the coming settlement in the short and long-run. This will also create pressure points for large oil producers for the next decade like Saudi Arabia and Russia and will be beneficial for large oil importers like India and China. Geopolitically, this and Afghan draw-down will release US energy in central Asia to focus on the Russian front. India will bear the brunt of Afghan un-wind unless it can quickly move in tandem with a re-invigorated Iran and Russia to neutralize an emerging Afghan problem;
• On the economic front we are beginning to see the first phase of the massive unwind by the 2 key players: US and China. The Federal Reserve has expanded its balance sheet from less than 9% of GDP in September 2008 to ~25% of GDP currently. This massive expansion has had a disproportionate impact on asset prices and less than intended impact on unemployment in the US. Finally, the Federal Reserve has decided to scale down its level of balance sheet expansion and reduce the expansion to zero by end of 2014. China on the other hand a massive expansion in credit post the 2008 crises with M2 expansion of 175%  as against a much slower nominal GDP growth. This credit growth has stimulated sectors like infrastructure, real estate, commodity manufacturing. But this has resulted in uneconomic projects or over-capacity creating bad debts. Shadow banking structures have kept the money flow going but at higher and higher rates. This has already created 2 inter-bank seizures in the last 6 months. The communist party and the PBOC realize the follies but will move slowly but surely to wean the economy off-high monetary expansion. While these two economies unwind, emerging markets and more so commodity oriented economies will face the music and potentially, as has happened historically, a crises in one or more emerging market over the next 12-24 months. While the first sight of crises, however, is also likely to tempt the Federal Reserve to reverse course partially from its path (of reducing its balance sheet).

As these two key events play out, India will have its own political issues to deal with. The emergence of AAP as a political alternative in the medium term will further fragment the vote share and create a government with a limited life. But is this the beginning of the end of regionalism, caste and religion based politics? But this will surely not happen in 2014 and will leave it for some other time.

Indian interest rates will continue to be high as the ‘unwind’ creates currency related pressure and off-shore interest cost continue to rise. This will force a reduction in overall credit growth (domestic plus foreign). This should result in an incremental swing of savings towards financial assets (bank deposits, corporate bonds and bit towards stocks) as real estate continues to see pressure from tight liquidity and high rates. Private investment cycle continues to be in the future by at least 12-18 months. Oil prices are the joker in the pack and any significant down move will result in a positive impact on inflation, CAD and the fiscal situation. However, a word of caution will continue to dominate as the massive unwind unfolds and any crises in an emerging market could spark a significant collateral damage on India at least temporarily.

I do not expect the stock markets to do anything great in 2014. Staple consumption story has been overplayed with rural demand expected to re-adjust given lower MSP growth. Exporting sectors like Pharma & IT (although 6-8 months already in play) and high quality cyclicals are the place to be.

Ranbir and Katrina will possibly marry in 2014. And, like Socrates said,” By all means, marry. If you get a good wife, you'll become happy; if you get a bad one, you'll become a philosopher.” Finally, there will be more philosophers amongst us.

Powerful plays

The performance of the Aam Aadmi Party (AAP) in Delhi surprised most watchers. Winning in an election is an important but small part of the overall journey of power. The ability to wield power and then govern does not come only from taking the throne. It is a journey of understanding the cocktail of governance structures, powerful elites and their vested interests and finally once actualized the ruthlessness to wield it to achieve national good.

Obama got elected with the slogan of change. If one were to come to think of it there is nothing he has changed than creating a greater welfare stage (i.e. Obamacare). US Congress is has been is stalemate for the longest time ever and Obama has not been able to break the logjam. Internationally, there has been not one path breaking move except retraction from the twin wars. So when history looks back he will be just another president but not who changed the direction of the nation. Back home, Manmohan Singh got the throne but does not wield any power nor has the ability to do so.

Look at Mamata Banerjee who won West Bengal elections after 3 decades of opposing communist rule. All she learnt was being anti-establishment, little constructive time understanding the power structures and building relationships with the elites. Even in government she is always seems to act like leader of the opposition. She did not understand what governing will mean when after 3 decades of communist rule – it is not a war on the past but building a future and bridging the chasm.

AAP will need to understand what governing is and how to wield power. One can clearly understand their hesitation in taking the step. It is easy to lay out strictures for the government of the day. I am in no way defending the governance deficit and inaction but in the end a state’s outcomes are not born out ‘complete and ideal freedom’ but the push resulting from needs and its constraining factors.

Most of us will feel we do not have good policing system in the country but that does not change things as the power structure in place constrains it. Same is the feeling for being able to shop in one retail outlet where all daily necessities are available and are cheaper than current options but FDI in retail has taken a long time coming. We may all believe that current level of corruption is corroding the system but Lokpal (or any other form) will not come until the power configuration changes where the hands are forced – the need to maintain minimum necessary power (seats in parliament) for the Congress to maintain a semblance of relevance.

The ability of true leadership is to negotiate the constraints put by the system. There will be compromises and promises broken but states are not given firm direction by idealists but by realists and great leader is one who is a realist led by ideals. Idealists just help maintain society conscience and serve as a check to power. AAP’s long-term political relevance will be defined by their ability to evolve from current idealism into realists.

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.