Factual Implications

“The first week at August's was a consolation, a pure relief. The world will give you that once in a while, a brief time-out; the boxing bell rings and you go to your corner, where somebody dabs mercy on your beat-up life.” ― Sue Monk Kidd, The Secret Life of Bees

Brexit

Now that majority (not overwhelming) members of the British public have voted for any exit from the European Union, the elite are unable to comprehend, including those in the leave campaign, about the ‘new’ relationship that they want with the European Union.

The age old British relationship with the continent has been the one of maintaining adequate distance and intervening on the side of the weak to ensure that no strong power emerges to pose a threat to Britain across the challenge. With the end of the World Wars, Britain while engaging in the European project kept away from the institutions till the 1970s by their own volition or the French under Charles De Gaulle keeping them away to ensure leadership in European affairs. But the Soviet Union cracked and Germany united, it was only a matter of time when the superior geography and skills of Germany organized over a century ago under Bismarck over took the French dominance of affairs. While the French maintained military leadership in Europe, the Germans overtook economically. Britain in matters of defence coordinated with the French (which the Germans given their Nazi history never stepped up to) and with the Germans regarding economic matters against the protectionist tendencies of the French. The broader relationship framework will not change, in my view, but the political vibrations of Brexit may create disturbances in it in the next 3-5 years. And, these are instances where democracies fail to comprehend the long-term. Tocqueville wrote in 1945,”But a democracy can only with great difficulty regulate the details of important undertaking, persevere in a fixed design, and work out its execution in spite serious obstacles.”

Britain is the ­2^nd largest economy in the European Union. Germany the largest economy and the most powerful member of EU has an export to GDP of 46% and GDP growth of next to zero. If there is one thing that the German politicians are afraid of is loss of access to the single market and UK is the 3^rd largest buyer of German products. Now behind all the bluster this one dynamic that will ensure that despite all the turns and uncertainty we may see in the negotiations, the likely outcome is reciprocal preferential market access will continue. The largest tug-o-war will be around the “passporting” of financial services and the question is despite the bluster can Frankfurt or Paris be an alternative to London people skills and financial and legal architecture in 2-3 years. There may be some migration but imagine a substantial base shifting!!      

The real fear that the Europeans have is not the relationship they will have with Britain it is the implication of this vote across core member countries like Italy, France, Spain and Germany itself as they go into elections over the next few years. The rise of nationalist right wing parties (https://en.wikipedia.org/wiki/List_of_active_nationalist_parties_in_Europe) since the Global Financial Crises of 2008 owing significantly to high joblessness, is a massive threat to the European experiment. Brexit, also, does not change the key challenges Europe faces:

• Immigrations from the Middle-East and North Africa;
• Deficit spending beyond EU mandate by member states;
• Ultra-loose monetary policy;
• Italian banks with Eur400bn of NPLs;
• Catalonia (part of Spain) or Lega Norde (part of Italy) would still be looking to secede;
• Or for that matter Deutsche Bank, the largest bank in Europe, would still be under stress and labelled by IMF as such in its recent report.

US Dollar

The dollar index had almost touched 100 December 2015 and then it corrected down to 92 in May as US Fed interest increases became less and less definitive as Fed uncertainty around Brexit and other international issues came to the fore. Since then it has moved up to 96 tightening global market monetary conditions. The strength of USD comes from the fact that relatively it’s is the “cleanest” cash flows in the world with 10-yr T-bills at 1.35% when >$12 trillion worth bonds is at negative rates. It does not have the issues of Brexit or the financial crises of Europe, the BOJ manipulated bond markets of Japan or closed markets of China. The fact that it is the largest consumer market with a huge trade deficit ensures availability of USD for international trade. While the Chinese may desire to create a global currency how does a significantly restrictive economy make the currency freely available - provide huge loans internationally or becomes a net importing country to make its currency widely available and, therefore, less controllable by PBOC.

But the USD rise is creating renewed issues across the world, including the US itself:

• Renewed pressure across commodity markets including Oil. The destabilization that continued oil weakness can cause is the break of the Saudi-USD peg as Saudi Arabia finds the pressure of continued capital flight too much to handle, a doomsday scenario for oil prices. Expect the unexpected to happen…think Swiss Franc peg to the Euro which broke when it was not expected to happen;
• Gold is on an upward tear despite the USD strengthening, a consequence of unprecedented expansion in central bank balance sheets and negative interest rates – a divergence with negative correlation with USD. Gold was base money for thousands of years, it is signalling a break-down in global monetary structure;
• Emerging market USD debt to non-banks outside the US is USD>10trillion and borrowers’ resident in emerging markets owe >1/3^rd of this. This will create added pressure in times of significant commodity weakness and growth slowdown. “Since 2008, dollar credit has grown more rapidly outside the United States than inside. Although there is only one dollar yield curve, the two stocks of dollar credit behave differently. Dollar credit to non-US residents grew faster owing not only to more rapid growth in emerging market economies (EMEs) over the last six years. Dollar credit also expanded owing to its substitution for local currency credit given favourable dollar interest rates and exchange rate expectations (Bruno and Shin (2015a,b)) as EME firms leveraged up (IMF (2015)).”;
• While on the one hand Fed is worried about US corporate growth due to strengthening of USD rates and fall-out of Brexit, the Chinese are worried about potential strengthening of USD and incremental demand weakness in Europe forced by Brexit will put more capital flight pressure.

Endgame of Debt mountain

The significant government leverage built across markets post the global financial crises is crushing global government finances.

Country	Debt to GDP
US	104%
Japan	229%
China	44%
UK	89%
Euro Area	91%
Germany	71%
France	96%
Italy	133%

 

For examples, US budget will turn negative post entitlements, defence and interest rates by 2019. It cannot manage with an increase in interest rates unless productivity growth perks up dramatically. If interest rates were to rise by just 2%, it would take 80 to 100% of all tax revenues of Japan. Similar case exists in key European markets. Interest rate increases would be radioactive.

The total balance sheets of all major central banks have expanded almost 3 times since 2008 to excess of US$17 trillion:

• Fed holds >US$4 trillion of US Treasuries, Agency Debt and Mortgage Backed Security;
• ECB holds ~EUR1.6 trillion of securities and >Eur500 billions of lending to Euro area credit institutions;
• BOJ has presided over an unprecedented expansion over the last 3 years, driving their balance sheet over 5x with 10yr interest rates crashing below zero.

This extraordinary expansion is what is keeping interest rates at current levels. And, the balance sheets are only likely to expand:

• UK easing in response to Brexit;
• Italian banks bail-out;
• China’s recapitalization of banks given the high level of NPLs – recently there was news that COSCO ordered 11 ships in this depressed environment of global trade encouraged by government subsidies to keep shipping yards occupied.

The next phase of money printing will be “more printing”. As I have stated in the past, Fed will threaten to raise rates and then back off – the global balance sheets are too precariously structured to threaten them with capital losses or interest increases. What will follow the money printing binge is a likely forgiveness by central banks of government debt. An uncoordinated forgiveness by major central banks will spark a crisis, a new synchronized arrangement will need the large economies to coordinate the levels of debt reduction and a global monetary arrangement to agree on relative exchange rates.

“All great beginnings start in the dark, when the moon greets you to a new day at midnight.” ― Shannon L. Alder

Four by Four

“Be less curious about people and more curious about ideas.” ― Marie Curie

“Ideas are more powerful than guns. We would not let our enemies have guns, why should we let them have ideas.” ― Joseph Stalin

One of these days I was by myself thinking about what are those path breaking concepts or thoughts that have captivated men and societies for hundreds of years if not a millennium. As I thought about it, it was important to reframe the question to address what it meant to today’s world rather than to any other time. Even then, there have been so many ideas and thoughts since the beginning of time that it would make any representation difficult. This consequently got me to a more limited set - identifying one idea from each of the last four millennia that have a disproportionate impact today.

Democracy (1,000BC to 0 BC)

Athens in the 4th to 5th century BCE had an extraordinary system of government, where all male citizens had equal political rights, freedom of speech, and the opportunity to participate directly in the political decision-making. The citizens not only participated but they also served in the various institutions that were in place. While this idea did not survive the Peloponnesian War, it was revived fully in the 19^th century. In some form they existed in various times as advisors to rulers.

The Athenian assembly met at least once a month, more likely two or three times, on the Pnyx hill in a dedicated space which could accommodate around 6,000 citizens. Any citizen could speak to the assembly and vote on decisions by simply holding up their hands. The majority won the day and the decision was final. They evolved a system whereby a body could prioritize the discussions, developed executive councils and law courts.

Pericles, one of the leading men of the time, described the basic principles of democracy in his speech, "Our constitution is called a democracy because power is in the hands not of a minority but of the whole people. When it is a question of settling private disputes, everyone is equal before the law; when it is a question of putting one person before another in positions of public responsibility, what counts is not membership of a particular class, but the actual ability which the man possesses.  No one, so long as he has it in him to be of service to the state, is kept in political obscurity because of poverty. And, just as our political life is free and open, so is our day-to-day life in our relations with each other… We give our obedience to those whom we put in positions of authority, and we obey the laws themselves, especially those which are for the protection of the oppressed, and those unwritten laws which it is an acknowledged shame to break.”

At the time it was a unique and revolutionary concept that realized its goals in an unprecedented manner (Athens was the strongest state of the time) and the seeds of which lay dormant but strong to spring up more than 2 millennia later.

Christianity and Islam (0BC to 1,000AD)

Between the two religions 2/3^rd of global population is covered. While they have within them multiple factions but undeniably the idea espoused by Jesus and the Prophet encouraged the masses to give up their earlier beliefs they had of worshipping various natural phenomena’s like the sun, moon, birds or trees for a supreme power that was responsible for occurrence of these including human beings or for that matter some of the earlier existent Byzantine, Sassanian, Zoroastrian or other political identities.  

For the polytheistic and pagan societies, apart from the religious and spiritual reasons each individual may have had, conversion to Christian or Islamic "represented the response of a tribal, pastoral population to the need for a larger framework for political and economic integration, a more stable state, and a more imaginative and encompassing moral vision to cope with the problems of a tumultuous society."

Christianity emerged in the Levant in the mid-1st century AD. It spread initially from Jerusalem to large areas of the middle east like Mesopotamia, Jordan and Egypt. In 313, Emperor Constantine issued the Edict of Milan, officially legalizing Christian worship. The loss of Western Roman Empire dominance coincided with early missionary efforts into areas not controlled by the collapsing empire. In the 4th century it was successively adopted as the state religion by Armenia in 301AD, Georgia in 319AD, the Aksumite Empire in 325AD, and the Roman Empire in 380AD. Roman Catholic and Eastern Orthodox Christianity spread to all of Europe in the Middle Ages. Then the next burst came as it expanded throughout the world during Europe's Age of Exploration from the Renaissance onwards, becoming the world's largest religion. Today there are more than two billion Christians worldwide.

The expansion of the Arab Empire in the years following Prophet Muhammad's death led to the creation of caliphates, occupying a vast geographical area and conversion to Islam was boosted by missionary activities particularly those of Sufis, who easily intermingled with local populace to propagate the religious teachings. These early caliphates, coupled with trading and the later expansion of the Ottoman Empire, resulted in Islam's spread. Trading played an important role in the spread of Islam in several parts of the world, notably southeast Asia, like Indonesia. Muslim dynasties such as those of Mughals in India and Safavids in Persia and Ottomans in Anatolia were among the largest and most powerful in the world.

Verify and Believe, Individuality (1000AD to 2000AD)

While the ancient civilizations of India, Greece, Egypt or China had pushed the frontiers of science and philosophy, but it was in next phase in Europe that the next giant push to understand the natural world came. Until this time the belief was that the priests knew the laws of the natural world interpreted from the holy books. While it grew and became extremely influential by the 18^th century, in almost as early as the 13^th century Thomas Aquinas rediscovered Aristotelian logic to question the dogmas by the Church. He said, “The Study of philosophy is not that we may know what men have thought, but what the truth of things is.”

In 1521 Martin Luther is said to have declared, “Unless I am convinced by the testimony of the Scriptures or by clear reason (for I do not trust either in the pope or in councils alone, since it is well known that they have often erred and contradicted themselves), I am bound by the Scriptures I have quoted and my conscience is captive to the Word of God. I cannot and will not recant anything, since it is neither safe nor right to go against conscience. Here I stand, I can do no other. May God help me. Amen.”

In the 16^th and early 17^th century, scientists or natural philosophers like Galileo and Sir Issac Newton discovered the existent natural laws contrary to the Bible. Galileo, regarded now as the father of observational astronomy, science and modern physics, championed heliocentrism (Sun is at centre of our solar system) which undermined the biblical belief that Earth is at the centre. Sir Issac Newton formulated the laws of motion, gravitation, mechanics among other accomplishments. All these drove towards a greater understanding of the natural environment through measures of proof and not belief. Then there was Michel de Montaigne, French Renaissance philosopher, who lived from 1533 to 1592, who in his work Essais which was to inspire many writers after continuously asked the question, “What do I know?”   

Thomas Hobbes in Leviathan written in 1651, which is supposed to have established the agenda for significant portion of Western philosophy, wrote, “Science is the knowledge of Consequences, and dependence of one fact upon another: by which, out of that we can presently do, we know how to do something else when we will, or the like, another time.” Locke defined the state of nature as a condition in which humans are rational and follow natural law; in which all men are born equal and with the right to life, liberty and property. With this they declared that true understanding could not happen without consonance with human reason and experience. For centuries, the Church had characterized human beings as naturally sinful and in need of forgiveness through religion. Enlightenment philosophy was in direct opposition with an emphasis on the importance of the individual. They did not think the Church was necessary to make people behave morally. The concept of favouring individual liberty over the power of an institution became prevalent in France, Britain and the United States, leading to revolutions in two of those of those countries, as well as a concept of "basic human rights" that shaped the U.S. Constitution.

With the need for empiricism grew the scientific endeavours. Science during the Enlightenment was dominated by scientific societies and academies, which had largely replaced universities as centres of scientific research and development. After 1700, a tremendous number of official academies and societies were founded in Europe, and by 1789 there were over seventy official scientific societies. In reference to this growth, Bernard de Fontenelle coined the term "the Age of Academies" to describe the 18th century. Another important development was the popularization of science among an increasingly literate population. The 18th century saw significant advancements in the practice of medicine, mathematics, and physics; the development of biological taxonomy; a new understanding of magnetism and electricity; and the maturation of chemistry as a discipline but what followed in the later century with the seeds sowed here was dramatic (https://en.wikipedia.org/wiki/Timeline_of_scientific_discoveries).

Communication People to People (2000AD+)

In a society driven by commerce, individuality and knowledge the most important element is to have the ability to communicate instantly free from interference. The advent of internet and telecom networks in the late 20^th century provided the foundation for the massive innovation in communication we have witnessed. There is no longer the need for a book to be published or a newspaper to be written.

The concept of “instant messaging” finds its origins in 1960s, when Multi-user operating systems or Compatible Time-Sharing System (CTSS) was created at Massachusetts Institute of Technology Computation Center in 1961. It allowed up to 30 users to log in at the same time and send messages to each other. This further evolved to peer to peer protocols between universities. In 1996, Israeli company Mirabilis (acquired by AOL in 1998) launched ICQ - it allowed for multi-user chats, file transfers and a searchable user directory.

The turning point occurred in 1997, when AOL launched AIM. AIM allowed users to send messages to each other, and included user profiles, away messages and icons for more engagement. With AIM also came the development of bots – StudyBuddy, SmarterChild - with whom users could interact. By 2005, AIM dominated the instant messaging market with 53 million users.

Yahoo launched Yahoo! Messenger in 1998. Pidgin, founded as "Gaim" in 1998 as an open-source instant messaging client. Microsoft released MSN Messenger in 1999. Microsoft renamed the service Windows Live Messenger in 2005, adding photo sharing capabilities, social network integration and games. In 2000, Jabber, a multi-protocol instant messenger that acted as a single gateway for users to chat with friends and access their buddy lists on all of the big networks at the time: AIM, Yahoo and MSN. Apple developed iChat for its Mac OS X operating system in 2002. In 2011, Apple announced iMessage. Founded in 2003, Skype allowed Internet users to communicate with others through video, voice and instant messaging. In 2005, Google released Google Talk. The service includes text-based messaging, voice calls and video conferences. Most recently, Google Talk has been integrated with Google+, allowing users to chat while in the social network. Facebook released Facebook Chat in 2008, allowing users to instant message one friend or multiple people through the groups feature. In July 2011, Skype announced integration with Facebook.

Then, there is Linkedin (launched in 2003) which also allows users to communicate with one another and the ubiquitous messaging channels on smartphone like Whatsapp (founded in 2009) and now less used Blackberry Messenger.

Between some of the main channels ~1.5 billion of humanity is now connected - Google+ (estimated 90m users globally with 80% being active), Facebook (1.6bn users), Linkedin (400m+ users), Whatsapp (1Bn+ users) and networking platforms like Twitter, Flickr, Tumblr and Instagram.

John Lennon once said, “A dream you dream alone is only a dream. A dream you dream together is reality.” This togetherness is creating more active and aware societies within nations aspiring for change based on global benchmarks. It is enabling Arab Spring, innovative and cheaper product launches, awareness in heavy censorship society like China, money transfers, solution to and creation of medical problems, getting jobs to fulfilling the basic elementary level human need to feel connected.

Just as the Athenians gathered on the Pnyx hill once or twice a month, these tools are ensuring a gathering every second of some group or another. Imagine the impact on human society!!

“For good ideas and true innovation, you need human interaction, conflict, argument, debate.” ― Margaret Heffernan.

Power Shortage

“I am somewhat exhausted; I wonder how a battery feels when it pours electricity into a non-conductor?”

― Arthur Conan Doyle, The Adventure of the Dying Detective

Post World War 1, when there was significant exhaustion from battle across the world; in 1921-1922 the Washington Naval Conference was held.  The conference leveraged upon the popular global mood for disarmament. However, the real objective was to limit Japanese power – limit naval expansion in western pacific and acknowledge the ability of all global powers to trade with China. A ten-year agreement fixed the ratio of battleships at 5:5:3 - 525,000 tons for the USA, 525,000 tons for Britain, and 315,000 tons for Japan. Smaller limits with a ratio of 1.7 applied to France and Italy. However, given the limitation of tonnage it ensured that the Americans despite an overwhelming economic lead in having economic size more than twice that of Britain (Annexure) could be strong in one ocean or weak in two (Atlantic or Pacific). While this limitation prevented a major outbreak for the next 15 years, it laid the foundation for Japanese naval expansion prior to the 2^nd world war and the inability of allied forces to potentially preempt the war due to balancing force availability i.e. strong force to land in Europe post German belligerence or threaten supplies of the Axis countries. The shortage of balance of power in the global theatre had laid the grounds for World War II.

Post World War II, US and USSR covered most of the world under their influence, thereby checking regional aspirations. The superpowers fought at the edges of the world in Vietnam, in Middle-East or in Afghanistan but never in the core area of their interest, the European peninsula. This balance of power ensured almost 5 decades of peace. When the Soviet Union collapsed under the burden of arms race and the collapse in oil prices (its principal export), the world was left with one overwhelming super power. But no wars followed given this imbalance because Americans given their endowed lands and the security of the two oceans have not coveted foreign land but influence across the globe and that they did enforce. But then came 9/11 and the great financial crises of 2008.

It unraveled many underlying glossed over pressures across the globe and created new ones.

First, the attack on Afghanistan and Iraq by US created a vacuum which the Americans were in no position to fill. This vacuum in Afghanistan was slowly filled by competing interests like Pakistan (backing the Taliban) again, Iran, India, Russia and China (in concert with Pakistan). It reverted essentially to a pre-Taliban and post-Soviet period where surrounding states jockeyed for interest. A destabilized Afghanistan in turn destabilized Pakistan with multiple terrorist groupings waging internal and cross-border warfare while its intelligence agency found it increasingly difficult to manage the shifting loyalties and synergies these groups derived from the ecosystem. An as serious one got created in Iraq as Iran and the Kurds moved in. As this spasm pulsed it enveloped neighboring Syria as Alawites (a branch of Shia Islam), Sunnis and Kurds backed by their respective regional brothers surged to claim leadership. In this midst emerged the Wahhabi-strain of the Islamic State. But the more longer term chasm, is the one playing out across the Middle-East (Iraq, Syria, Bahrain, Yemen, Egypt, Lebanon and more) is the chasm between Iran and Saudi Arabia battling for their interests. As this battle plays out Turkey is feeling the pressure from a potential creation of Kurdish state across Iraq, Syria and its own territory and from Russian actions on the ground in Syria to protect the Assad regime. It’s a quagmire that involves the four regional powers of Israel (fighting to stay away from the situation), Saudi Arabia, Iran and Turkey, and ultimately Iran and Turkey. This happens at a time when oil prices are causing serious stress to the budgets of this exporting region.

Second, the global financial crisis exposed the imbalance in the European Union. The Germans are an efficient export engine but the export engine needs buyers and rest of Europe buys ~60% of its exports. The Germans continued to lend to Southern European banks even post the 2008 crises to ensure availability of buyers. With slowdown in Asia and massive unemployment across Southern Europe, any export decline (currently at mid-40% to GDP) will trigger a recession in German growth (which is barely keeping its head above water at 0.3% - 0.4%). While this is the situation with the largest economy of Europe, Italy the 3^rd largest economy in Europe is officially reporting NPL’s at 17% and unemployment rate in excess of 11% or more than twice Germany’s. It is this dichotomy that is currently wound in a single currency. As German growth recesses, its ability to sacrifice for the benefit of the Eurozone will be under stress, leave alone the impossibility of an Italian bail-out. The recent immigration crisis has only helped increase support to right wing and euro-skeptic parties across the continent. An experiment to hold together a continent in Eurozone rising from the burden of two world wars is likely to fragment as national interests reign supreme.

Third, in North Asia the global financial crises sparked two different trajectories in two different countries. Japan, the hegemon of Asia in the two world wars, which had peaked economically in 1989 and has been largely mired in deflation and no-growth since then, threatened by a rising China has become a process of re-arming itself. And to revive its economy to pay for this, started an economic experiment where its central bank owns almost 60% of the government bond market and has ensured a 40% decline in its currency. China which had been growing rapidly till 2008 crises suddenly realized that the global markets for its goods had evaporated. In 2008, China exported 32% of GDP which fell to 24% and 26% for 2009 and 2010 respectively. This resulted in massive 4x Chinese expansion of credit to stimulate internal markets through infrastructure and real estate construction. Now limits to debt fueled growth has been reached. As one key element of the social contract (economic growth and employment) creates pressures on the Chinese leadership, President Xi is consolidating power through his anti-corruption campaign to limit fissures. This will lead China to be more nationalistic and aggressive internationally.  

Fourth, when crude was under $40 for most of the second half of the 1980s, Soviet Russia collapsed. Oil was and is the largest contributor of hard currency. Oil is almost 2/3^rd of its export and 30% of its GDP. When the price of this commodity falls to current lows, the ability of the Russians to fund its internal budget and in turn internal regional control becomes strained. Given the internal strains and the conflict in Ukraine and Syria, Putin will seek to play in a manner that suggests great strength in face of underlying weakness. It has successfully done so successfully in Syria by ensuring the survival of the Assad regime. One could see potential incremental moves in Ukraine in the coming future.

Finally, the Americans have stabilized their economy post the 2008 crises but tired after the Middle-Eastern wars have retired to their safety behind the two oceans. But by 2019, barring a recession, as per current trajectory their entire revenue will be consumed by interest, defense and entitlements. This will create the next of pressures on the Federal Reserve for easing and the new President and Congress to act to alter this course.

Simply put, there is great destabilization of the Eurasian landmass that predict the next cycle of great change. There is a deep inability in the participants exhausted by the course of events and the only superpower in the world has withdrawn tired of the wars and unable to manage this tumultuous change.

“Because of the power shortage and lack of replacement parts there was only one elevator running in the Empire State Building, and this one went only as high as the twenty-fifth floor. After that you walked.”

― Harry Harrison, Make Room! Make Room!

Annexure

Share of Global GDP	1913	1950	1973	2001
US	18.9	27.3	22.1	21.4
Britain	8.2	6.5	4.2	3.2
Germany	8.7	5.0	5.9	4.1
France	5.3	4.1	4.3	3.4
Japan	2.6	3.0	7.8	7.1
China	8.8	4.5	4.6	12.3

Volatility and Intervention

“A certain amount of volatility and drama can be healthy and keep things fun and interesting if you're willing at any moment during a fight to say, 'This means nothing. I love you, let's forget about it.”

― Anthony Kiedis, Scar Tissue

Since the Global Financial Crises of 2008, the tempo of intervention has only increased. First the Fed’s intervention came as a response to the deep destabilization caused by the decline in housing prices in the US and transmission of this shock globally broke the honeymoon of the Eurozone where the Southern European countries were being funded by the Northern Europe principally Germany in a unsustainable way. This led to decline in demand in developed countries. European Central Bank and the Bank of Japan also launched unconventional easing in response. It propelled China to intervene and propel a never before expansion in credit. This resulted in commodity and oil exporting markets growing dramatically since 2009-2010 in symphony with Chinese credit expansion. In the last 2-years a persistent decline in commodity and energy prices in response to the slowdown in China and expansion in shale production, have led to further decline in global growth. Consequently, the fight for demand and initiatives to boost consumption for global production has become even more acute. In addition the pressure of significant leverage is pushing central banks to unchartered territory to generate inflation. This is more than evident in the trend of interest rates across markets – even the Fed recently signaled that they may back off from the expected 4 quarter point hikes in 2016.

Since the Global Financial Crises, the lead has been taken by central banks to manage the system while the various political constituents have been largely dysfunctional in this sphere with attention taken up by the developments in Ukraine, South China Sea, Middle-East, Migrant crises, potential break-up of EU among other issues. In essence the intent of the central banks has been three-fold:

• Generate inflation;
• Push asset prices to generate wealth effect and propel consumption;
• Devalue the currency to capture external demand.

Given the benign commodity prices, excess industrial capacity and population decline inflation has been running below the target range of 2% run by ECB and the Fed. The currency decline as one can see from below has been largely absorbed by the USD and asset prices gains having reversed to markets now to 2014 levels. The funding currencies - Euro and Yen - appreciated in 2016 as Fed rate increase curve turned benign resulting in significant unwinding in the asset markets besides hedge fund margin lending running at all time high levels. The market positioning has been a bigger driver in decline and asset prices adjusting faster than change in fundamentals.

Country	Depreciation vs USD			Stock Market
	2014	2015	YTD 2016	2014	2015	YTD 2016
US				13.4%	-1.3%	-7.2%
Euro / DAX	12.7%	11.2%	-1.2%	3.5%	8.1%	-12.9%
Britain	5.9%	4.9%	3.9%	-2.1%	-5.4%	-4.5%
Japan	14.4%	0.1%	-6.3%	10.1%	5.3%	-14.9%
China	2.5%	3.8%	0.9%	50.3%	14.9%	-21.2%
Russia	64.2%	32.1%	10.1%	-42.7%	-6.7%	-6.1%
Turkey	7.6%	25.9%	1.4%	33.0%	-12.7%	-1.6%
Brazil	14.2%	47.9%	2.7%	-2.2%	-12.2%	-6.3%
Australia	9.2%	11.4%	2.8%	0.9%	-2.1%	-4.7%
India	3.0%	3.6%	4.1%	29.9%	-4.1%	-8.3%

The central banks, after an estimated 637 actions of rate reduction, easing, asset purchases etc since the financial crises globally, are now pushing the next frontier via negative interest rates in Sweden, Denmark, Eurozone, Switzerland and Japan. This represents a very large proportion of the global economy. With flattening of the yield curve and the shorter end going negative, the banks are practically at sea – international bank stock prices have corrected dramatically (15-30%). Imagine this being taken to the next phase of customers being charged for keeping money in the bank – it may restart a business of vaults.

I had pointed in my December article (http://poleconomyindia.blogspot.in/2015/12/imbalance.html) on how deficient global demand is at the heart of the current crises. We are likely to see increased intervention by central banks and increased resistance from the markets which are increasingly wary of implications of these moves – BOJ starts negative rates and the yen appreciates or Fed backs off from interest rate increases and the markets decline in response, PBOC assures the market of its USD3 trillion firepower but the foreign exchange markets react in disbelief. With practically no solution in sight central banking experiment to transmit policy through asset markets that are controlled by asset managers of whom central bankers have limited experience is beginning to fail.

The fact that USD has been weaker against the Yen and Euro is a temporary phenomenon. Mario Draghi has already said he willing to take the next steps while BoJ may wade to increase the stock of JGB’s and stock ETFs – it was anyway their actions which drove significant USD strength in 2015. Japan’s economy is weak facing a significant decline in exports and currency led gains by the corporate sector has not resulted in any investment or wage increases. Eurozone continues to grapple with the two big crises of migrants and Brexit besides the inherent weakness of the financial system. For example, Italians have been liquefying their banks by doing sale and lease back transactions of government assets which are then pledged with the ECB for liquidity lines as they have sovereign guarantee cover. The Chinese will not tolerate significant bleed of the foreign exchange reserves with just US$3trn left in pocket (US$1trn is illiquid, US$1trn is required for short term debt repayment, $200m is monthly import bill). Given the global pressure on China against devaluation and potential capital flight driven by fear of devaluation, some element of capital controls is likely during the year.

The central banks unfortunately have no real solution to the issue at hand – aggregate demand – but their unprecedented actions, while keeping the system alive, are infusing volatility. The pace of intervention will only increase in 2016 as global growth declines.

Indian Banking

What was thought of as an old man’s game with limited excitement, Indian banking at cross-roads with 5 key aspects impacting it at the same time:

• Technology – The advent of tech disrupters which will eat incomes of the banks by directly selling wealth products or life insurance policies, bring greater transparency to retail loans or offer payment solutions on cheaper platforms;
• Non-Performing Loans – The system NPL’s are exceeding 11% with true number possibly in the 15% zone, the PSU and Corporate banks are seeing massive write-offs and share prices being pummeled. With real capital levels being extremely low, growth and equity raise are becoming a challenge;
• Macro – Banks are in unknown territory, they have never possibly witnessed industrial good deflation in their living memory causing significant dent to corporate lending business. In addition, excess global capacity is ensuring no significant private capex. Residential real estate and rural are also in deep slowdown while exports suffer due to decline in trade weighted competitiveness;
• Regulatory change – We are witnessing an aggressive regulatory regime - advent of CPI based real interest rate regime, aggressive focus on cleaning up NPLs, change in competitive landscape, attempt to push longer term lending to the capital markets, base rate being set as per marginal cost…  
• Shifting Competition – The competitive landscape has added payment banks, small finance banks and tech start-ups in the recent 2 years with significant capital and entrepreneurial energy. 

While the current environment will offer significant opportunities in multiple spaces, the better risk adjusted strategy would be investing in assets with significant moats rather than creating one in an environment of unprecedented change. For example, HDFC Bank is following a simple strategy of staying in low risk corporate assets while pushing to double the retail bank on the back of already scrubbed customer base – of the 35m odd customer a third (~13m) are high quality based on track record but the bank has significant asset relationship with only 4m. In addition pushing the customers to digital assets will reduce costs. Another example is Cholamandalam, a strong understanding of the commercial vehicle (CV) segment with ~70% of AUM in the segment rides on the uptick in CV cycle. While valuations maybe high for such players, in this period of excess liquidity and market participants with ever lower cost of capital, quality growth at low volatility will always command a premium.