Reflections on Indian and European economies

India and the Euro Zone – a complete mess

What’s India and the Euro Zone got in common – well they are both a complete mess.

The Big Picture,

1 April, 2012

India

The political and economic situation in India is deteriorating. Continued corruption scandals (and we are talking serious money in respect of corruption – allegedly US$211bn in respect of just the coal sector), accompanied by worsening economic data, suggests that India will face increasing economic, political and financial pressures in due course. I am in the process of preparing a report on India, which I will send out in due course – late April. However, just one data point. India’s 4th Q 2011 current account deficit nearly doubled to US$19.6bn, from US$10.1bn, year on year. India needs a significant amount of capital inflows to address the current account deficit – however, if the markets become cautious about emerging markets (“EM’S”) and India in particular, as I believe they will, the current account deficit looks like a real problem.

The RBI’s policy of keeping interest rates high to address inflation (which has certainly not been brought under control and, unfortunately will worsen as oil prices increase), is clearly impacting the economy. India’s inflation basket is heavily weighted towards food and energy – well above 50%. However, with the government, for political reasons, keeping fiscal policy far too lose (in an attempt to shore up support for itself), inflation will rise further, which will limit the ability of the RBI to reduce interest rates, even though they realise that the high interest rates, prevailing at present, are hurting the economy. The Prime Minister seems incapable of dealing with the issue and is generally considered weak. In addition, there is a serious risk of political fragmentation, as Congress continues to lose support, with regional parties attracting support. In addition, coalition politics involves a number of murky deals, concocted in smoke filled rooms, at the dead of night.

The consequences are a worsening economic position – the Governments budget deficit (forecast at 5.1% for 2012/13, as compared with 5.9% for the year to 31st March 2012) is not under control and the recent budget is widely acknowledged as being both inadequate and unrealistic. Federal elections are scheduled for 2014, and this years budget was effectively the last opportunity (clearly totally missed) to address the rising imbalances.

The Government intends to borrow a significant sum (estimated at US$72 bn or 65% of its 2012/13 requirements, as compared with 49% last year), in the 1st half of the fiscal year starting 1st April – however, the Indian Government it borrowed US$17.6bn in January. The Indian Government has forecast that it needs to borrow Rupee 5.69tr for the coming fiscal year.

The consequence of all of this will be a weakening Rupee (though high interest rates are helping for the moment – YTD, the Rupee has been amongst Asia’s best performer with a rise of 3.8% against the US$, though is declining recently) and continued weakness of the Indian equity markets, especially on a Rupee basis. With Indian equity markets (quite/largely?) dependent on foreign buying, (which is tailing off – Indian investors have been sellers rather than buyers), I really cant see any upside there either. Foreign bond investors have been selling Indian debt – Bloomberg reports that they sold around US$902mn more Rupee denominated debt this month than they bought, the first net selling since last September and the largest amount of selling in 2 years. The 10 year bond is yielding around 8.50% and analysts expect a rise to possibly 8.70%.

The market has focused (quite rightly) on the serious problems in China, which I have been banging on for nearly 3 years and less so on India. Chinese markets have corrected materially (though I still would not be a buyer), though India, less so. Indeed, India looks particularly expensive.

As you know, I’m short India and see no reason to close my position.

Euro Zone

The EU is pushing out its begging bowl yet again – this time, it’s seeking money from the IMF, to help bolster the Euro Zone’s (“EZ’s”) bail out funds. The EZ increased the bail out fund by E200bn – not the E300bn, as some EZ politicians claim. In addition, EZ politicians keep stating that they “have done their homework”. I’m really getting fed up of this German expression – as far as I’m concerned they should remain in detention, hopefully for ever. Nevertheless, with the former French Finance Minister (Mrs Lagarde) in charge of the IMF and with the IMF’s Spring meeting due mid April – I continue to believe that the IMF will cough up. I’ve seen reports of the IMF contributing US$500bn, which seem absurdly high to me – yes Mrs Lagarde is seeking to raise US500mn, but only a percentage of these funds will be allocated to the EZ.

The US will not contribute, though it’s support is critical, as it’s the IMF’s largest shareholder. I don’t believe they will block any lending to the EZ – the US is desperate for Europe to recover, as otherwise its own fledgling recovery will be strangled at birth, particularly given a slowing China and EM’s generally. Japan is recovering – reconstruction spending post tsunami – but every time I look at the country, I just wonder how they have made it to date. An US Treasury spokesman stated that ” (the) announcement by the Eurogroup reinforces a trajectory of positive efforts to strengthen confidence in the euro area”. Ms Natalie Wyeth added, “Over the last several months, European leaders have made significant progress in addressing the crisis”. Oh yeah !!!, certainly could have fooled me. The ECB, well yes it certainly has acted positively, following the retirement of the lunatic Trichet, but the EZ – come now.

The German finance minister Mr Schaeuble and the French PM, Mr Baroin are leading the charge to grab as much IMF money as possible, most likely provided by the EM’s (China, Brazil, Middle East countries, the EZ, maybe even the UK, etc), with support from the Eurocrats, Mr Ollie Rehn et all. The EZ has committed to providing the IMF with E150bn. The EM’s, especially the BRICS, will have to provide financing as they don’t want a bankrupt Europe, as it sinks their economies, but are holding out for more voting power at the IMF at present. They certainly should be given greater voting rights, but not a hope in hell this time around. In any event, I continue to believe they will cough up.

OK great, so the IMF provides some financing – will not be enough to sort out Spain though. However, I continue to believe that Portugal and Ireland will be rescued – they are small enough and have tried to live up to their commitments. Just look at the deal done in respect of Ireland’s promissory note which I referred to in yesterdays note. Italy remains a problem, but is far more resilient than the market thinks, if they can keep up their structural, including their labour, reforms. Reports suggest that Mario Monti is coming under increasing pressure – need to watch this carefully. I continue to fear that Spain remains a serious problem and one that does not have a solution at present. The recent budget was indeed austere, but, unfortunately, I just don’t believe the numbers and cant see Spain meeting its forecast budget deficit of 5.3%.

The EZ desperately needs growth measures and not just hair shirt austerity policies, which will just make the situation more and more of a problem – essentially creating a debt spiral, leading to total bankruptcy. In addition, the EZ needs to sort out their insolvent banks – and boy a large number of European banks are insolvent.

The recent 3 year LTRO’s by the ECB has sorted out liquidity problems for the next few years (just one question – how are the banks going to repay the money borrowed at the end of the 3 years – remember it’s over E1tr. However, a number of banks need huge amount of new equity capital, in addition to coming clean and both writing off their bad loans and marking to market their “assets”. The European Banking Authority’s “stress tests” remain a complete joke and even on that basis, banks will struggle to raise the capital they need. It is clear that the market will not provide the equity necessary to refinance the banks (just look what happened to UniCredit) and, as a result, the EZ/ECB will have to intervene. Until that happens, banks will continue to deleverage and reduce lending, further depressing the EZ economy, ie doing exactly what you don’t want.

That is precisely why I was particularly interested in the FT’s reference to two allegedly secret reports – come now secret, within the EU/EZ – that’s impossible – the EU/EZ is as leaky as a sieve. Of particular interest is a 3 page “Assessment of key risks and policy matters” prepared by the EU’s economic and policy committee. To summarise, the report warns of dangers within European banks – even with the LTRO – as they may still need cash to operate on a day to day basis. The report suggests that these banks are resorting to unstable (and presumably expensive) sources of finance to fill the gaps. In addition, the collateral they used to pledge to the ECB in exchange for the 3 year LTRO loans, means that they do not have any more high quality collateral to pledge to get low interest loans from the market. Whoops. In addition, with Banks moving to the covered bond market for financing, unsecured financing is getting scarcer and scarcer. Finally, the report adds that even the EBA’s (pathetic in my humble view) requirement that some banks raise more capital, is forcing banks to deleverage and further tighten lending standards. Whoops, whoops and whoops again.

A second EU analysis reported on by the FT and titled “Economic Outlook, Financial Stability in the EU: Policy Challenges and Way Forward, raises the issue as to whether European banks are pressing ahead with cleaning up their balance sheets. It raises the question as to whether the banks have fully written off bad mortgages and other loans. The report suggests that banks are increasingly delaying “risk recognition” and pursuing “forbearance schemes”, which will limit lending to credit worthy customers.

Look this is not rocket science – the above was totally predictable. The “extend and pretend policy” re EZ banks has a sell by date, particularly if the EZ is pursuing “hair shirt” type austerity measures exclusively and without any pro growth policies – basically, the situation will just get worse and worse. Someone, please tell the Germans. At the end of the day, they will end up paying even more. The LTRO’s were important but, essentially, they principally buy time – but that time has to be used to sort out the banks – something which is just not happening

The Germans, at present, believe they are immune – I’m increasingly coming to the view that their confidence is misplaced, to say the least. Without a reasonable EU economy (Germany’s largest trading partner), their export machine runs out of oil. Yes, they keep banging on about EM’s and China, but I suspect we all have significant reservations on that front – I certainly do. The US is picking up, but cannot remain immune either. I’ve never believed the claptrap about decoupling, as it related to EM’s, but I also believe that DM’s are also impacted. This is a global economy after all.

Without referring to the “secret reports”, Mr Asmussen, the German member on the ECB executive board talked about a bank resolution fund on Friday. I have heard Mr Asmussen speak on a number of occasions and I rate him. It is clear that European banks will have to be cleaned up and subsequently refinanced and that a bank resolution fund is exactly what is needed. In addition, I continue to believe that at the end of the day, the Germans will both lean and, indeed, do the right thing – after all, they remain the most important paymasters in the EZ. The EU has been trying to address this matter for over a year, headed up by an incompetent Frenchman – can’t even remember his name. If the EZ either waits for him and/or his ideas, God help them.

Not a particularly cheerful report, I’m sorry to say.

The good news, is that as every day goes by, the nearer we get to that critical point where Governments will have to act, forced by the markets. I am a firm believer in the view that when it comes to a difference between financial markets and politicians, financial markets will win, though I accept, it will take time and cost.

In the EU, the appointment of Mario Draghi at the ECB has really changed the game – he has acted decisively and presumably in the face of severe opposition. It’s a pity that the EZ has to go through additional pain (and indeed cost) before the Eurocrats are forced to do the right thing. However, you now understand why I have been and remain totally opposed to the EU – how could you be otherwise.

Just one final thought – I’m beginning to get the feeling that the ECB will have to cut interest rates further – quite possibly (likely?) in the 1st half of this year.

I’m itching to short the Euro against the US$, but will wait for the IMF’s spring meeting and the (likely) contribution by the IMF of funds to enhance the EZ bail out fund.

Have a great weekend.

Kiron