Life in a shrunk global economy

The developed world is well on its way to facing up to an economy that will be shrunk in size in a manner unexpected by government, mainstream economy pundits, media and equity markets. It is clear that the ballooned scale of the economy that prevailed till about a year ago - on the back of low cost of money and excessive borrowing is not going to return for several years. If by chance, the massive liquidity being created across these countries works and the scale returns in the short-term, it will not be of a sustainable kind.

The still-shrinking and eventual shrunken state of the economy is what is now being referred to as the `new normal’ by those who saw this crisis coming. This world of new normal will have implications for emerging markets, including India. The long-term implications could be positive for India. But there is near-term pain that cannot be avoided, the ongoing liquidity-driven bear market corrective phase, which has created a feel-good factor, notwithstanding.

The tasks faced by people in the developed world: The crisis has been caused by the excessive borrowing over a 25- year period in the developed world, a process that gathered greater momentum over the past decade.

As a result, households in the developed world with the exception of Germany and Canada, to an extent, - have a mountain of debt. The processes of addressing this issue has just started and let us look at what steps are involved:

• Reduce consumption that was linked to borrowed money over the several years.
• Reduce consumption further out of own money in order to start saving.
• Wait a minute; this does not translate into saving immediately, as households have to first pay a pile of debt.
• The process of clearing debt to acceptable and prudent levels is going to take a few years (or if people walk away from debt, you are going to have new sources of pain for the financial system in the developed world),
• Households in the developed world would then need to continue to save to create a pool of savings that is close to the long-term average.
• Oh yes, they also have to contend with trillions of dollars of wealth destroyed in homes, equity and other asset classes; pension accounts are in tatters and so this increases the burden to restore, if possible, the nest egg.
• This process must take place in an economic environment where growth is likely to be a scarce commodity; do not be fooled by the feeble growth numbers you may get a few quarters from now that will be bankrolled by the trillions of dollars unleashed by the U.S Federal Reserve.
• This process must also take place when U.S unemployment is in excess of 15% and set to approach 20%-plus territory based on a measure that captures reality rather than official statistic that says it is just 8.3%.
• If the necessary adjustment is not carried to a logical end and people get tempted by the government efforts to induce them to borrow more to revive the economy, the pain is just postponed and will be more pronounced.
• Last, but not the least, the present environment is hurting badly for even those who have lived on a prudent basis. Their savings have suffered a big dent, courtesy decline in home prices (set to decline further) and equity. The Zero Interest Rate Policy does not obviously do any good to savings stashed away in the fixed-income asset class. Remember the government policy now is also to protect and reward those who made bad choices and this obviously penalises those who made the right choices in life.

Even as people in the U.S. U.K, Spain, Australia, New Zealand, Iceland, Ireland and most of Europe with the exception of Germany and the Nordic countries, go through this process, let us remind of ourselves of where is Japan now the only major economy to have gone through this process over the past few decades.

Remember the big contrast with Japan: When the Japanese bubble got pricked in 1989, households there were comfortably placed in terms of savings. There was no mountain of debt to climb. The one dent that households suffered was the consequence of decline in equity and home prices. Their brethren in the developed world are now facing a similar decline in wealth even as they are drowned in debt.

That debt mountain in Japan was for the corporate sector. There should not have been a threat to consumption and demand for goods produced by Japanese companies or imported. That is not how the story panned. Japanese household pulled away even more from consumption in order to save. Even more than a decade of close-tozero interest rate and a period of even negative interest rate were unable to kickstart the domestic economy in Japan.

What has this period of close-to-zero interest rates done in Japan? They have hurt savers badly. An aging society has drawn down the capital in the savings account  there has been marginal income accrual to bankroll requirements of life in old age. The level of household savings has dropped to about 2% of GDP. Also remember Japanese equity prices, are after 20 years, at 25% of the bubble level in 1989 when the Nikkei peeked out at close to 40,000 points. 

Variables that were/are in play in Japan and now in several parts of the world: To sum up, let us list the factors, policy and effects to have a clear idea of what happened in Japan and where the developed world may now be headed:

Factors & policy in Japan (1989 onwards): high household savings + low household debt + effects of decline in equity & home prices + banking crisis + debt-burdened corporate sector + localised crisis + ultra-low interest rates + several rounds of massive fiscal stimulus + unwillingness to face reality and clean up the system in an honest manner

Effects (1989 onwards): reduction in risk appetite + more savings plus ironically a dent in the savings pool as an aging society draws on capital due to marginal income accrual + banking system in disarray + two decades of low growth (whatever growth has been there was also helped by exports) + massive increase in government debt (Japan is most at risk here today as compared to other developed countries) + stock prices that have gone nowhere + enhanced vulnerability to any new crisis (as is the case now for Japan)

Factors & policy in U.S (2007 onwards): household savings close to zero + massive debt burden on households + trillions wiped out in equity and home prices + losses in other asset classes + pension system and savings in tatters + banking crisis + parts of corporate sector is debt-burdened + globalised crisis + ultra-low interest rates + massive fiscal stimulus + unwillingness to face reality and clean up in an honest manner + outright illegality at the level of the U.S Federal Reserve and Treasury as exemplified by their behaviour in the Bank of America- Merrill Lynch case + hostility towards U.S in several parts of the world (Obama may change the last aspect if he is in office for eight years)

Likely effects (2007 onwards): Japanese situation of now plus more unless there is an unexpected course of events (for instance, it was World War II that helped the U.S move out of the Great Depression of the 1930s).

You can read the U.S analogy as being relevant and applicable for most developed countries that are at risk now.

Debt replacing debt is no solution: The U.S government and U.S Federal Reserve have added their rather high dose of supposed medication for the disease. The problem is the medicine will aggravate the disease, and, at best, postpone pain now for greater woe latter. The thrust of the policy is to get the economy back to where it was in 2007 without bothering to consider if that was a sustainable state of affairs. This is not surprising.

For them to do anything else would be an admission of policy failure, especially over the past decade and more for any objective observer. So they want banks to lend. Who will borrow is the key question? The healthy parts of corporate America have strong balance sheets, which even as they get weakened in the ongoing deep recession, will help them to survive; they need not borrow.

If they are still borrowing as is the case in the past three months it is to have additional cushion of cash given the challenging times and for acquisitions.

The several weak parts of Corporate America will need to borrow but banks will not lend to them, as it will affect their already deep-in-trouble balance sheets. By all objective and honest views unaffected by vested interest, it is clear that the banking system is or getting close to insolvency status. Yet the U.S government and Treasury want this terribly placed system to lend more.

Households as a group are in no position to borrow. In any case, replacing debt or adding more debt is no solution to a problem caused by excessive borrowing in the first place. In the Japanese context, this risk did not exist for the household. So you add this policy-induced risk to the equation to get a more comprehensive idea of how the factors affecting the developed world stack up now. In a globalised world, the intended and unintended consequences will affect almost every economy.

Consumers are on a different trip now: Mercifully, U.S consumers have started to pull back over the past six months and have avoided spending to the extent of 4% of GDP. We have deliberately avoided using the word savings to describe this emerging state of affairs. It is because collectively for the U.S household, this money not spent would have (or should have) gone to pay a small part of the mountain of debt. Till such time, debt reaches to a level in line with the close-tolong average, any reduction in consumption spending must be viewed from this perspective.

There is impact on risk appetite: The overall picture is having and will continue to have an effect on ability and willingness of people to take risk in the developed world. Collectively, investors could become more risk averse. This will have an impact on quantum of portfolio flows into different geographies and asset classes. The massive liquidity created by the central banks is fuelling a temporary increase in risk taking linked to a belief that the world economy could get back to the status of 2007 and grow.

Sustainable basis is a must for any base and growth: For effective long-term investing in any asset class, it is important to kiss goodbye to this perspective of a world that quickly gets back to 2007 status and moves on from there. The world economy will get to move on eventually, but from a lower base.

For instance, the U.S GDP declined by about 12 per cent in the first quarter of 2009 on adjusting for the positive contribution made by the reduction in imports. (please note that in GDP computation, reduction in imports is a positive contributor). The official number was a decline of 6.1 per cent.

Production levels in several countries catering to the developed world are down by anywhere between 20%-70%. Now these are numbers that will take years to recoup. The likelihood of high inflation, courtesy the printing presses of the government that are working at full tilt to create money, could add a delay element to the timeline. High inflation will need high interest rates and the latter is not good for growth.

The world economy got to 2007 scale on an unsustainable basis. It will get back to that level several years out from now on a sustainable basis and then growth will also happen from there. This desirable course will come eventually, but it is not a story for the next three-to-five years at least.

In this period, expect a more domestic market focussed China to become an even more important player with a more desirable balance in its growth. Brazil and India will also be in a position of rising strength, but stay far lesser in scale as compared to China.

Global corporate majors could seek out emerging markets more: How will the healthy companies in the developed world, which manage to survive this deep downturn, look at this world of new normal? They would have to accept that growth in their till-now-preferred core of developed markets will remain anaemic for several years. There will be short periods of higher growth rate (Japan has gone through this a few times over the past two decades), but the secular trend will be sub-par growth from the new normal; this aspect actually makes the situation tougher as companies across the world are built to 2007-scale as base and for high growth from that perch.

Several global majors have started to look at emerging markets over the past decade. It is likely that they would focus even more on scaling up presence in these markets. Companies that have not placed emphasis on this opportunity are likely to follow suit. As one of the markets with growth potential enhanced by the power of democracy, India could figure even more prominently in the calculus of major companies in the developed world.

This could have positive implications for the economy in India over the long term. This is not, however, a story for now. In this prevailing backdrop, take care to play any bear market rally such as the ongoing one with a healthy dosage of prudence and scepticism; the more so, as we need to also keep an eye on the outcome of the Lok Sabha election that is underway and the formation that will make up the next government.

(Published in The Wise Investor (March 2008), a monthly publication of Sundaram BNP Paribas Asset Management.  The views expressed are personal and do not necessarily that of the organisation.)