Business, Finance

US debt problem-Part 1

US lives on money borrowed from other governments. America’s budget deficit is not a new problem but has rapidly evolved to crisis levels .Expenses exceeded revenue in all but 5 of last 47 years. This is a problem, and the problem – measured by rising losses and a rising debt load – is getting worse. So let us look at this problem in detail:

1. US Debt problem is larger than you think:

See the actual numbers below:

(Image source:http://www.texasgopvote.com/issues/grow-economy/america-s-looming-debt-crisis-004800 )

Break up of US Government Spending:

As seen from the figure; social security, medicare and medicaid are biggest entitlements; almost 75%.

2. The size of the debt is highly sensitive to economic fluctuations :A deviation of 1 percent of average GDP growth over the next decade increases or decreases the U.S. deficit by roughly $3 trillion on a cash basis over 10 years. America’s reliance on short-term debt exposes it to interest-rate volatility.

3. Higher debt could affect American competitiveness:Federal debt may raise the cost of borrowing for domestic-based American companies.  When the government runs large deficits, it  competes for funds that could be invested in the private sector. Higher costs for capital and  limited access to investment will impact the  borrowing costs of companies as well.

In the next article we will explore possible solutions to this problem. Stay tuned!

Sources:( http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/Federal/us_fed_Election_Series_DEBT_010612.pdf

http://dealbook.nytimes.com/2012/11/01/mary-meekers-state-of-the-usa-inc-address/)

 

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Business, Finance

Why Quantitative Easing is not good for Emerging Markets?

Federal Reserve Chairman Ben Bernanke’s Federal Open Market Committee announced a third round of quantitative easing (QE) QE3  on September 13,2012  to stimulate the economy. Quantitative easing (QE) is basically a monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective.

The idea behind Quantitative Easing is that the central bank uses this supply of newly created money to buy up government bonds and other financial sector assets. The purpose is to drive down yields on bonds and provide more financial sector liquidity. It is used in economies where the use of normal expansionary monetary policies has become impossible. In such economies, normal monetary policies no longer work because  base interest rates have already been reduced to such an extent that it is not really possible to lower them any further . The need for such aggressive monetary actions in recent years can be traced to the U.S. real estate bubble, which burst in 2007, and to the more-recent sovereign debt crisis in the eurozone.

QE pumps money into the economy and increases liquidity. This  flood of new money due to QE won’t find a home domestically, it will find places to settle down in many of the emerging markets. Are investors going to want to keep their money in U.S. dollars that are earning nearly 0% interest when they could be shifting that money into emerging market currencies where they could earn 5%+ per year?  Hence, quantitative easing will significantly increase capital flows into emerging markets.Apart from this, Emerging markets have been a popular target of excess capital for a number of reasons:

  • Their overall ability to take on debt remains strong
  • They have experienced minimal balance sheet impairment compared to developed markets
  • They have relatively innocuous levels of pre-existing leverage

So what are the ill-effects associated with Quantitative easing in emerging markets?

  • Inflation and Currency fluctuation: If capital comes into emerging markets too quickly due  to QE, it drives up their currency exchange rate and has the potential to create strong inflation in a short amount of time.  Emerging markets are generally very dependent on their exports, and if a country’s currency gets very expensive, all of a sudden its exports are less attractive.  Therefore, there are many negative effects that U.S. quantitative easing has on emerging market economies.
  • Threats of retaliatory measures:The consequences of QE could be a first-order concern in monetary policymaking. This practice can affect foreign exchange in a way that may disrupt trade flows and prove counterproductive . QE  has led emerging markets to go on the offensive against the United States, and many countries have begun intervening in the foreign exchange trading markets in an attempt to devalue  their own currency values.  If country’s begin intervening in the market on a regular basis, it could create severe imbalance and dangerous conditions.
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Finance

Why is the US expensive as compared to India?

Ever wondered why a simple haircut in India costs much less as compared to the US? Or why nannies can be really expensive in US as compared to India?But a laptop costs almost the same in India and the US. Why this difference exists? Why are prices of some goods and services the same whereas they vary widely in case of others?

The reason for this can be explained by what economists term as the “Balassa Samuelson effect”. The Balassa Samuelson effect captures the relationship between real exchange rate and productivity.It states:

  • The traded good has the same price in both countries
  • Productivity in traded goods determines wages
  • Wages determine the prices of nontraded goods

Lets understand it in simple words:

The reason why the prices of some goods like laptop don’t vary is because if they vary, it would create opportunities for arbitrage. If you bought a laptop in India for $1,000 and sold it in US for $1,500; then eventually price in India will be raised to $1,500.Laptop is a traded good and hence its price does not vary much across countries.

But services like haircuts are not tradable. You won’t fly from US to India just because a haircut is cheap. Similar you cannot hire an India nanny to look after US kids. So for non –tradable services like salons, restaurants , baby sitting there is a local market. In case of US, the incomes are high and people can afford to pay more. So the price levels for these services are high in US. But how are incomes determined? Balassa-Samuelson effect states that productivity in traded goods determines wages. For countries with higher worker productivity, they can trade their goods abroad and hence get richer. Prices can also vary within a country. A haircut may cost more in places where rentals are high versus the place where rentals are low. This is because land is a key non tradeable good and prices of land vary widely across the country based on supply and demand.

Apart from Balassa Samuelson effect , price levels are also determined by exchange rate.  For countries who try to depreciate their currencies to make exports attractive, the services are cheaper than they would be without the depreciation. A classic example of this case is China.

If we had to boil all this — Balassa-Samuelson effect, exchange rate down to a simple statement: it might be this: All things equal, prices rise fastest in the places where rich, talented people want to be.

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Business, Entertainment, Finance, Public Issues

BP Oil Spill: Why even $20 billion isn’t enough?

BP has made a blunder. No doubt about that! So we shall not even discuss it here. Is only BP responsible? We shall also not discuss it here. Now that BP has agreed to pay $20 billion in payments to the US Government, the main question which people are asking is …. whether $20 billion are enough? Here are some arguments why they are probably not!

  • Tourism Industry in the Gulf of Mexico: According to CNN, tourism is about 46% of the Gulf economy i.e. over $100 billion! Has the spill destroyed the tourism industry? Yes, No, Maybe? If ‘maybe’ then till what extent and how much will the loss be? The state governments are saying that the beaches are not closed but will this save the tourism industry? With photographs of wildlife soaked in crude all over the internet, will anyone realistically go to the gulf for tourism? State tourism departments are saying that they are getting cancellations as far as 3 months out. Cancellation rates are being said to be around 50%. If we do back of the envelope calculations and assume 6 months of tourism disruption and 50%  cancellations then it give us $25 billion of tourism revenue lost!
  • Unemployment: In a state with 12% unemployement (according to CNN) the after effects of the spill will likely cause more layoffs. With a major overhaul of oil & gas industry and decline in tourism industry, unemployment will spike. This can have major impact on the society near the gulf and can cause various problems. Ofcourse Government will have to take care of the situation but the costs will be very high.
  • Real Estate Decline: A natural follow-up of this has to be another shake-up in the real estate valuations around the gulf. Just when US is recovering from 2008 recession, this is not something that anyone will look forward to.
  • Clean-Up Costs: Exxon Valdrez spill occurred in 1989 near Alaska and it was an oil tanker leak! According to Exxon they spent over $2 billion in clean up costs. Looking at the scale of current oil spill plus adjusting for inflation, this will amount to atleast $5-8 billion.
  • Wildlife Loss: One of the biggest losses caused by this oil spill is loss of wildlife and natural environment. This loss is invaluable and just can’t be measured. The loss of fishes, birds, vegetation and ecological balance cannot be brought back by money! If we can just learn a lesson from this tragedy of not taking nature for granted then it would be a small step towards redemption.
  • Oil & Gas Loss: The spill will probably cause stoppage of drilling in deep sea water! This is a good step for all of us in the long term, however in short term it probably means supply shortage and higher oil prices. Because of  negligence of one company, some poor soul will have to pay extra for travel!

Ofcourse too many issues and very little explanation. Hope you enjoyed the video though.

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Entrepreneurship, Finance, Human Resources, Planning, Politics

Losing the ‘Education’ edge

As some of my batch mates went from IITs to MITs and other US Universities around the world, the number of publications in their resumes started to increase at an exponential speed. To me this phenomenon really did not make a lot of sense as how can a student or his research change within a couple of months to take their number of publications from non-existent (in IIT years) to innumerable (in US Universities). The simple answer I got from my friends was funding and resources available. Ofcourse IITs being one of the best institutes in the world in terms of students still lack the resources for producing world class research.

I have always considered US Universities as one of the biggest assets of US Economy. The funding and prestige of these universities brings most of the world’s students pursuing PhDs into states and once they are in US they never leave. In turn these students do research which helps US and also start companies which get US billions in taxes. An example is when a macbook is made in China and sold anywhere in the world, the major portion of the cost is divided by US and China (China for manufacturing and US for designing) and in turn China’s contribution can move to any other country where a factory exists but US contribution is permanent simply because Apple designed this in US and is based out of California.

The research and intellectual properties created by US University graduates can probably be considered the single most important reason for making US the superpower it is today. So when I read this article in NYTimes regarding how the US is cutting funding to University of California at Berkeley, I was kinda astonished. Afterall no one should step on their competitive edge and most of all US should not do this. I guess for countries like India and China it might be a little positive as the much hyped brain drain might get a sudden stop from this. Ofcourse the world, innumerable students and research will face a bad consequence. I hope the problem gets solved but well lets see!

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Business, Finance, Marketing, Planning, Strategy

The Free Phone Concept and India

iphone3g-4678When iPhone 3GS was released in the UK and US a few months ago, the sales went soaring. The number of phone connections spurred! I was also one of those people who were able to get their hands on one and I am really quite happy about it. But lets consider in India, will anyone be able to buy such a device? A device worth Rs 35,000!

So lets try and see the concept of a free phone which exist in UK and US. A person signs a contract with a service provider like O2 or Vodafone for a duration between 1 to 2 years to pay a minimum fixed amount per month and in return gets an amazing phone and phone connection as well. So you can get an iPhone, a N97, any blackberry and most other phones for free!

Now it is widely known that there are no free lunches in this world! so there definitely must be some strategic concept behind this free phone deal right? Ofcourse there is one. The company is basically ensuring two things, firstly that you will not leave their service for next two years, and secondly the phone is not really free its just that its been spread over months just like buying something in installments. The catch is that people don’t mind paying a little extra per month but taking out a huge bulk of cash in one go is a problem. O2 allowed users to buy the iPhone for 375 Pounds and take a pay-as-you-go plan but most users went for the pay monthly plan. This can probably be related to the economics principle of instant gratification.

But coming back the the title of this article! India, probably the fastest growing market in mobile phones in the world! still does not really have the concept of free phones (except probably Virgin Mobile). But why?? Isn’t something missing in this picture? A market which is absorbing so many phones every month does not have a free phone concept. Actually there was a concept of free phone in India and it was started by none other than Reliance Infocom when it launched in India. By Paying Rs 501 and taking a 2 year contract could get you a brand new phone from Samsung / LG and wonderful calling rates. The marketing plan was a success but the execution was unbelievably dissappointing. People took the phones, unlocked it and started using Airtel / Hutch. The whole problem in India is that the legal system is a failure in terms of such contracts. Even if a consumer signs a 2 year contract the enforcability is quite dismal. Moreover there is no real concept of a credit history in India. In UK / US people will not default on any payment because of the risk to credit history and if a small payment ruins their credit history then their mortgage interest rates will go up! The companies compete but also communicate.

Thus we can view this both in terms of a virtue or a burden. If you do pay all your bills and fulfil all your contracts then probably it is a burden for you since you can’t use such wonderful schemes and are not getting any benefit of a good credit history. But if you don’t care and don’t keep your commitments then it is definitely a big big boon for you!

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Business, Finance, Planning, Politics

Why Obama’s plan can fail …

(This post is contributed by another guest strater who wrote to us on contribute@strat.in . The author is an IIMC alumnus currently working in the US. The post is a strat.in SPECIAL about the measures taken by the US government to tackle the recession.)

While the USA has entered its 3 year of recession, Barack Obama still enjoys record approval ratings but the euphoria over a Washington outsider returning the country to its people is dying out fast. Obama has the right ideas but he does not know how to fullfil them..Here’s why..

Let us look at his stimulus package and his financial advisors viz. Tim Geithner and Larry Summers. Summers was one of the architects who repealed the Glass Steagall Act and allowed investment banks to take on unlimited amount of risk, while Geithner famously allowed Lehman to collapse. After Hank Paulson scared the US House about an economic collapse without the bailout, the number of begging bowls at White House have gone through the roof. The 700 billion tax payer dollars with a modest leverage ratio of 10:1 (Citigroup’s was 33:1 quite recently) would have created 7 trillion dollars of investable capital. This would easily be enough to make USA energy independent within 4 years and create jobs in the private sector. Obama feels that banks would start lending once the toxic assets are cleared off their balance sheets. He is completely wrong, in my view. Banks have learnt a lesson they can never forget. Banks make money by lending to people who can pay back the money with interest. Americans do not have jobs and there can be no savings or loan paybacks without jobs. The ills caused by consumer spending over the last 30 years cannot be cured in one year. If Obama wanted to get USA out of recession through creating demand then the size of the stimulus had to be far larger and invested in creation of cash producing assets instead of bailouts. But that would have resulted in an immediate run on the dollar and staggering inflation(though that is  unavoidable now). Keeping the value of the dollar high would not have been a cornerstone of US policy had USA been a export oriented economy like China, Germany or Japan. But after losing its manufacturing prowess by 80s and relying on treasury sales after the IT boom and bust, USA has little that the world needs except fiat money. Strangely, a global recovery would mean a fall in value of the dollar as people begin to invest in more riskier assets.

Obama wants to make a downpayment of 600 billion dollars on healthcare today when he himself does not know how healthcare reform will pan out and what will be the eventual solution for this problem. GM and Chrysler are bankrupt. What was the point in giving billions more to burn earlier this year? That only prolonged their misery. Bankruptcy of GM and Chrysler will cost jobs but not all of them. They still have valuable assets. The airline industry in USA went bankrupt post 9/11. They never received a bailout. All airlines are operating today and the quality of service from Delta ,for example,is at par with the likes of Cathay Pacific. But it is a leaner airline today with far better management than in 2000. Same can be the case with the auto industry.

Would the dollar continue to remain strong as ever?

In my opinion, Geithner is an extremely indecisive man with deep connections to Wall St. Hence he is fine with pouring billions into Bank of America and Citigroup while all it will take to wipe out the cash injection is for the house prices to fall by 10%(which is bound to happen). An orderly bankruptcy (unlike the one for Lehman) for Citigroup,BankofAmerica was in the tax payers’ interest. These banks did not pay higher taxes when they made record profits and should take full responsibility for their mistakes. All banks did not have such massive losses. Many smaller banks in USA are in fact faring far better. Nationalising these banks for a period of 2-3 years like Sweden did in 90s is a far better solution than pouring billions into a hole hoping to hear the cash hit the bottom.The real reasons why Geithner does not want to nationalise banks is because his Wall St friends are still in charge. In addition to that, many investors and foreign countries including China and Singapore foolishly invested in American financial institutions. A bankruptcy would wipe out their holdings and prevent them from lending money to the USA in the future.USA needs these investors and countries to buy its debt today more than ever before.

Obama wants to invest 150 billion over 10 years to make USA energy independent while Steven Chu himself admitted that USA would not be able to meet its share of emission cuts due to pressure from the industry. He also said that biofuels and not hydrogen was the practical solution (he headed the biofuels department at Lawrence Livermore Labs) for USA to be energy self sufficient when the world still faces a food shortage and the time for biofuels is past. For a good example, we can look at Brazil. Brazil started the biofuels program in 1980 and it took almost 30 years for it to be a net  energy exporter. US energy demand is many times that of Brazil & the world’s food requirements are twice those in 80s. Many experts agree that the US economy can be converted into a Hydrogen based economy within 10 years with less than 5 trillion dollars – at the expense of Exxon Mobil, Chevron, Conoco etc and a funding cut for Steven Chu’s former pet projects!! (Wonder what will it take to make influential americans to give up their
vested interests)

The Obama administration  can only be characterised as one which is grossly misallocating resources which ultimately will lead to failure and hardship for future generations of Americans. This recession is an opportunity for a structural change in USA economy to consume less and produce and save more. It is also an opportunity to get rid of industries and businesses with outdated ideas and management but is not being used as such. The USA is still benefitting from the hangover of its superpower status.  Many commodities are priced in dollars which keeps dollar demand high inspite of it being a fiat currency. Almost all developing countries back their currencies with the dollar while the dollar is not backed by anything !!

To conclude, in my opinion, even if the US economy improves, it still suffers from the fundamental problem of borrowing and consumption for growth.

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Planning, Politics

US- China Trade Relations: Lessons from History

This post is the first post by Saurabh Sunil, currently studying at IIM Calcutta. He has been helping us with our web-design and strat.in gladly welcomes him in its fold.

A hundred years ago, in the first age of globalisation, many investors thought there was a symbiotic relationship between the world’s financial centre, Britain, and continental Europe’s most dynamic industrial economy. That economy was Germany’s. Then as today, there was a fine line between symbiosis and rivalry. – Niall Ferguson, The Ascent of Money

In the early 20th century, Germany was becoming very prosperous. The country already had its territorial ambitions. However, with the unification of Germany happening as late as 1871, the country had missed the imperialist bus. This meant that the country would have to capture some other empire’s colonies. The scramble for a series of alliances followed. In 1879, Germany formed the Double Alliance with Austria-Hungary. In 1882, it was made into a Triple Alliance with Italy included. Around a decade later, Franco-Russian Alliance was formed. This was followed by Entente Cordiale, Anglo-Russian Entente and Triple Entente. The world was set for a war in 1914.

The analogy for the early 21st century would undoubtedly be US-China. Just like UK-Germany, China produces things which the US buys. With the money, China directly or indirectly buys the dollar bonds. So the US (govt. and the citizens) could keep splurging and the Chinese could keep hoarding the dollar. It has been a brilliant symbiotic relationship. But what happens when the Dollar that China keeps hoarding starts losing its value?
It is then that the SDR and other such things crop up. Countries want the dollar to be removed from the reserve currency status. They say that instead of the Dollar, the SDR (which essentially is a mix of four currencies) should be made the reserve currency. So the Americans respond by saying that the dollar should remain the reserve currency. They concur that China could always sell dollars to buy the currencies in the ratio of the SDR. But then, the value of Dollar would fall further. But then, isn’t that China’s problem. They chose to not diversify their currency portfolio. The Americans should not be paying for China’s investment mistakes.

But essentially the issue is a bit different. If you want to buy oil, you better pay up in dollars. After the World War II, the US ensured such treaties. Now it keeps cuddling Saudi monarchs and other oil rich nations. Gulf War was about oil. It should not come as a surprise that China has been scouting for oil all across Africa (which has largely been untouched by the US treaties).

The reason behind explaining this meandering geo-political issue was to explain the similarity to the early 20th century. The world’s financial centre, US seems to be in a symbiotic relationship with the world’s industrial centre, China. However, this symbiosis is tenuous at best. In early 20th century, wars were for territorial ambition and pride. In the 21st century, wars would be for natural resource needs. The first sparks of conflict can already be seen. One hopes that the international consensus averts any such future. Let’s hope that we learn our lessons from History.

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Politics, Public Issues, Strategy

How to fool the Red Billion out of a Trillion

“You can’t fool all the people all the time.” Or so the saying goes. The question is can the American government swindle money from a billion people?

It probably can – China holds about $ 1.95 trillion in Forex reserves. An estimated $ 700 billion is in US government bonds. So what?

The U.S government has a strong case to justify that the interest rates in the market don’t rise. In other words, adopt a fixed interest rate regime. Now let us assume that the interest rates rise, this would also mean a drop in bond prices. To reduce the interest rates /yield (i.e. to increase bond prices) the US government can pursue a debt monetization strategy – In other words buying bonds from the market. This can mean injecting a large amount of liquidity in the market. This monetization of debt can cause inflationary pressures that will reduce the value of the Dollar.

So China, sitting on a huge pile of Dollars might find that the pile is worth a lot less because of the debt-monetization strategy of the US.

Now conventional wisdom would point out the strategic levers that the Chinese have. For example:

  1. The huge pile of Dollars that can be used to devalue the Dollar.
  2. Military might – Do I need to elaborate?

China has a volume of trade with the US second only to Canada. China has the largest Trade gap with the US. In other words they are heavily dependent on the US.  Now the above mentioned options are akin to cutting the branch that you are sitting on. It might hurt the tree but more importantly you are hurt worse.

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Planning, Public Issues, Strategy

Colonized Again?

Would you believe that the East has become the victim of imperialism twice?
“Imperialism : The policy of extending a nation’s authority by territorial acquisition or by the establishment of economic and political hegemony over other nations.”

The First Time:
This was the time when a Technologically superior British army swept though and colonized large regions and siphoned of large amount of gold and other precious resources from its colonies. What do you think they did with the gold? They funded production of goods. To put it simply, the rest of the world was funding the production in Britain. At times they were paying to produce and then buying it as well. This was the economic hegemony propagated during the 19th century.

The Second Time:
This time the West had to device a more subtle, cerebral attack. For in the modern world , wars of aggression are not looked upon kindly. To cut a long story very short…After the world war the $ became the world reserve currency. The demand for $ was always kept artificially high (Iraq war, SE Asian crisis).
This has culminated in the Hayekian Misallocation that exists today. America succeeded in creating a halo around the $. The rest of the world has disregarded the fact that the $ is worth nothing and has bought into the notion that $ is the panacea for all future problems. Asian savings economies started hoarding the $. For example…China started producing goods in large quantities and supplied it to America. They accumulated 2 trillion $ in forex reserves. 600 Billion $ out of these reserves were parked in US treasury bonds (loans to the US). These loans trickled down to the economy and stoked the flames of consumerism and the real estate bubble. To put it simply, we produced their goods and loaned them the money to buy it as well…and to top it all the collateral that they have given us (T-bonds) are probably useless.. (because the economy is not productive enough to repay the loans).

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