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Friday, June 29, 2012

Notes from the USA (Jun 2012) - a guest post

Ever since the sub-prime crisis brought the US economy down to its knees 5 years ago, the equilibrium in the global economy got badly disturbed. Growth in China and India kept the global economic engine under control for a while, but once the sovereign debt contagion spread across the Eurozone, things have once again taken a turn for the worse. Stop-gap measures through quantitative easing and debt bail-outs have prevented a global economic collapse for the time being, but underlying problems are yet to be solved.

In this month’s guest post, KKP quotes from an IMF paper about prudent levels of debt-to-GDP ratios that different countries should maintain for long-term sustainability of their economic growth.

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Economic Prosperity based on GDP and Managing Debt

America used to be thought of as the land of opportunity, and we had a lot of debate lately on when US may lose this status. The fact that we are debating means that there is more agreement than disagreement. US constituents worked hard to create the popularly called “American dream of opportunity”, but today, that dream is becoming a dream that we see early in the morning (the one that comes true eventually)!

USA can become a land of opportunity but it cannot become one with the current state of the economy, jobs, politics, educational programs, government spending, and divergences of the top, middle and lower classes. So why do you think that US has got itself into this situation in the first place? To understand that, we have to get into the topic for this month: Gross Domestic Product and Debt Levels.

We had a ton of debate on gross domestic production measures, total ownership of debt by government and maintaining a healthy profile of a country. Well today, a lot of these values and absolutes are being challenged. So, what are the proposed prudential limits on public-debt-to-GDP ratios, and how important is its role for a bright future (of any country)? Based on work put out by an IMF study, a debt-to-GDP ratio of 60% is quite often noted as a prudential limit for developed countries. This simply suggests that crossing this limit will threaten fiscal sustainability/stability, as we are experiencing now in the USA. For developing and emerging economies, 40% is the suggested debt-to-GDP ratio that should not be breached on a long-term basis. Again, this is being challenged by many of the PIIGS and look where that has brought us with those countries (they have their hand out).

It is really a question about how a government, whether in a developed or a developing nation can sustain high debt levels (with respect to their internal production, a.k.a. GDP), and maintain a threat-free environment to economic growth in most sectors of the economy. Fiscal policy in any country has to ensure that its macro-economic model allows for the slow and upward slope of the business cycle, while sustaining an ability to pay for the debt within reasonable rate structures (bond yields); all of it without a major compromise on the underlying strength of the currency. If any of the three angles of the triangle are violated, there is a negative effect on the stock market, and the economic boom expected by its constituents, shaking the confidence of the society (business and personal).

The big question is if the 60% and 40% figures are optimal, sustainable and still works for the ensuing decade. Currently, we see a lot of countries violating these levels grossly, with no realistic target to improve its situation in any major way to return back to these levels recommended by the IMF. In fact, in my opinion, there are countries learning how to ‘challenge’ that thinking and create a domino of patch-work that will band-aid the problem, without resolving the root-cause. Let us look at the current levels of debt/GDP for a few countries:

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Prudence from the IMF paper dictates that countries target a debt level well below the limit on the grounds that getting towards the upper end will challenge the stability and also the solvency of a given country. We are experiencing this about Greece, and we had a lot of debate on various Indian Forums about solvency of USA in a similar manner. In reality two key factors affecting solvency are the response of primary balance (i.e. budget balance net of interest payments on the underlying debt) to increases in debt level and the possibility of adverse shocks to the economic system. As we have seen for Greece, it is assumed that when debt gets very large, it may be difficult to generate a primary balance (positive number) that is sufficient to ensure sustainability of the economy; the shock from which pushes a country beyond their debt limits. The underlying debt needs to be sold at unbelievable yields to attract risk-funds (who will give up their precious cash to buy the bonds of a country that may dissolve!). Hence, the advice is to remain well below the limit for the sake of prudence (liquidity levels, rollover risks and also future growth). Liquidity is not an issue for domestic debt as it can always be paid off by printing money, a sovereign right which households or firms do not have, and a practice that the US is teaching the rest of the world by putting its stamp of approval on its own practices.

On a side note, inflation necessarily does not result from doing so initially, but when the growth engine gets in gear, the amount of money in circulation from all the printing, availability of credit to businesses and individuals, and of course, the open money supply available, will totally wreak havoc to the nation’s future. Currency takes a dive and buying power get diminished (Zimbabwe is the poster child).

These are macro events, and do not topple the next dominos within weeks or months, and yet, when the Titanic does turn (in 1-2-3 years), it will finally face the boulder of inflation with a depreciated currency, which the US will not be able to avoid without some dramatic side-effects. Every country, however small or big, is a Titanic by itself. We all have to watch over our investments to ensure that we are not facing the zero to negative percentage returns as is the case for Japan for the last decade, which has grossly violated the prudent practice of being under the 60% marker (graphic above shows that they are at 200%+).

India has a long way to go, but it will face these times when it really gets into gear to ensure that its infrastructure, government/business practices and of course, the growth model produces high organic-growth with significant government borrowing behind it. Let us continue to watch for it and ensure our portfolios stay in check to ensure double digit positive returns to our portfolios in a low single digit inflation environment (with a stable currency)……..Is that a lot to ask?

Please post your views….

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

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