The Case For Selling Gold Against Something For almost a decade, Gold has been the ‘trade of the decade’. Buy the dull metal against almost anything: stocks, currencies, debt, anything but ‘precious commodities’, i.e. commodities in short supply, because India/ China are big incremental users of it. The relative movement of Gold has always been with lower risk/ volatility and it has always given higher risk-adjusted returns. Importantly, Gold was the best place to be in, during the desperate days of late 2008- early 2009. Does it deserve such a standing in the world of Investment? It has no productive use; the only feature that speaks for it, is that its (incremental) supply is not in the hands of man. If some alchemist could suddenly find a way to produce Gold, it would have disastrous consequences for the world economy. The USD used to be the world’s ‘gold’ for a while, until fiscal and monetary indiscipline by the custodians of the Dollar’s reputation, brought about this current pass. So has Gold reached bubble territory? A ‘bubble’ happens when asset prices rise, with a corresponding rise in debt levels, used to buy/ hold the asset. In case of Gold, its prices are rising at a time when worldwide leverage is falling, especially in the developed countries. So the most important defining condition of bubble territory is not met. Hence, you should not expect a sudden collapse in the price of Gold, like it happened in the mid-eighties. But you can expect (and should be prepared for) a slow letting out of air, as its relative movement to some other assets (principally currencies) shows a drop in outperformance. This might even look like a price drop, especially if you think nominally (i.e. in terms of the home currency, say, Euro/ Rupee), but it will not be a bubble collapse. Gold does well when Governance does not. When Nixon delinked the USD from Gold, he gave unlimited cheque-writing powers to the US Fed. The powers got progressively misused, but there was some tolerance, until Greenspan happened. Then came ‘helicopter Ben’, who may have had no intentions of actually dropping Dollar bills from helicopters, but was forced to virtually do the same, since he took over as Governor at the Fed. It took almost a generation, 30 years, for its reputation to catch up, but the USD today is a shadow of its former self, in terms of credibility vs Gold. Has US fiscal and monetary credibility reached its nadir? Is it time to buy this ‘value pick’ called US credibility? Is the US so chastened, that it will give up its entitlements, stop running a (Budget) deficit and get its public debt in order? Already, individual Americans are behaving better, domestic savings are up and private sector leverage is falling, but it will take time to work away the excesses of the past. The US Govt, however, continues to try and spend its way out of trouble. It is trying to replace falling private (domestic) demand, with more debt-fuelled Govt spending. Even as tax revenues fall, and the Govt Revenue Deficit balloons, its Public Debt ratio is doubling in the next 3 years. Yet, the US Govt is not ready to clamp down because its Bond markets have not revolted…yet! So the drunkard is still at the bar, quaffing his 14th peg, and asking for more. The bartender is worried on both counts: can this customer pay his bills, and can he stand steady enough to go home? At some point in time, the bartender will call in the bouncers, usually the foreign country that is subscribing to the deficit in the bond markets. China puts in 8% of its 55% savings rate, into US bonds. That is not a small amount, even though it is reducing steadily. Which brings me to the central question of this column. Gold has to be sold, simply because it has gone up for too long. Maybe it has still not gone too far, but it has gone up for too long….it should be time to worry now! So where in the world has Governance reached its nadir? That would be the country/ currency to buy, against Gold. Let me try a hypothesis: it could be Greece, maybe Argentina (which has twice gone to the cleaners). Who else has a bankrupt Govt, no tax revenues, huge Govt spend and banana republic politics……all set to change!!! In effect, if Bihar was a separate country with its own currency, that is what I am looking for…I would be buying Nitish Kumar’s governance! To make the picture even clearer, I am looking for “the next Indonesia”. Remember Indonesia in 1997: a tinpot dictatorship, huge spending imbalances (both private and public), large real estate investments, all funded with short-term foreign borrowings. The result: food riots, and a currency that went to nothing. An 83% drop in nominal currency rates against the USD, led to a monthly 83% drop in GNP, and a cumulative 43% drop in per capita GDP. Interest Rates went to 65%: in other words, a Great Depression that ensured that the economy in 2005 was still smaller in PPP terms, than it was in 1997. No ageing population, no structural deficiency in demand, yet enormous political and economic upheaval, that will stay embedded in the psyche of its populace (and its politics) for at least a generation to come. India went through something much smaller, but similar in 1991. Remember the Loan Melas of the 80’s and the subsequent NPA crisis of India’s banking sector? From that nadir, which hit us 20 years back, we now claim to have one of the most stable banking sectors in the world, a level of prudence that you don’t see elsewhere in Indian business/ politics. So great disasters create huge psychological scars, which create sudden, corrective behaviours in populations: nobody even whispered about Indonesia, 10 years after the Asian Crisis in 2008. The US saw Paul Volcker in the Fed, shortly after the 1982 recession. The hardliner Guv, who took Fed Funds rates to 14% to combat inflation down from 12.8% to 3.5% is an example of how human behaviours can change dramatically and diametrically (opposite). The profligacy of Indonesia, has been replaced by fiscal and monetary prudence, even as the “next thing to Gold, i.e the USD” is a picture of fiscal and monetary imprudence. These contradictions have been captured in the concept of the “historical process” enunciated by George Soros. One of the behavioural rules of “the historical process” is that every (behavioural) trend reaches an irrational crescendo before completely dying out, or reversing ‘permanently’. The Nazism of Germany was followed by democracy for the next 3 generations. Lebensraum is now a dirty word in Germany. The Berlin Wall came down under one of the most Stalinist leaders of Communism, one who spent his entire life in the KGB. For a generation, India (and Asia) has been terrified of a Forex crisis, which has pushed up savings rates and the propensity to export (forex) surpluses, either through capital flight or through Central Bank investments. So what is the answer to the questions I have posed at the beginning of this column? I do have an (instinctive) answer, but I want to arrive at it through a structured process of exploring all viable alternatives. Somewhere among the basket cases of Govt imprudence lying around the world, is a country that is going to come back very strongly. That country has some intrinsic competitiveness, but has got ‘caught in the crossfire’. Either it was growing, investing into Capex at the wrong time, and suffered an asset-liability mismatch, which has driven it to insolvency (Iceland? Ireland?) Or it had too much savings, and lent it to the wrong part of the world (Austria? China? Japan?) Such a country would be now gritting its teeth and putting in place an attitude towards savings and investment (or borrowing and consumption), that will see its governance improve dramatically. It would help if the said country was currently in serious crisis, because its currency/ bond markets would be reflecting that. Otherwise, there is no point in taking a contrarian position on Gold (i.e. sell it). If you buy Gold, at least you will be rich(er) in Dollar terms; so what if the currency is discredited by the end of the decade? You can always shift to the US and enjoy yourself…. Until next time then! Sanjeev Pandiya teaches, trades and writes. spandiya@hotmail.com. Dying, dying….debt!!! The Destiny of Japan Let’s see now…Japan now sells more adult diapers than baby diapers. It total population peaked in 2004, its working population peaked in 2009 and it has 40,000 people above the age of 100. Its population is set to drop by 40 mn people (30%) by 2050. That same 25% is the proportion of the population above 65. Total debt, household, private and public combined is running at a whopping 530% of GDP, up from a bad enough 387% in 1989. At 1.4% Interest cost, it means that 7.4% of GDP goes for Interest payments, while household savings, that big generator of worldwide surpluses, is down to 2% of GDP. In fact, it is expected to enter dissavings by 2014, as retirees start to pull in their savings. A banker once told me that one of the indicators of (corporate) Bankruptcy is the no of CFOs a co has had in the last 3 years. If we use the same ratio for Japan, it has seen 7 Finance Ministers in the last 3 years. Even our Real Estate cos have not done as well… Now look at Govt finances. 28% of revenue goes to Interest, at an average Interest rate of 1.4%. If the rate doubles, the Govt is now spending 56% of its revenue on Interest; at 40%, you are a basket case equivalent to Argentina, Greece or Zimbabwe. Quite simply, the zero interest rate regime is a one-way street; like the famed Hotel California of yore, “you can check out any time you like, but you can never leave”. So how do you get out of a mess like this? I fancy myself as a turnaround expert, but I can’t see a civilised solution to this mess. The Austrian (school) economist would prescribe debt destruction on an unprecedented scale, or a ‘reset’, wherein the savers who ‘invested’ the excess savings (say, 400% of the 530% of GDP outstanding as debt) just see a gargantuan (sovereign) default. There are many ways of doing this: • Inflate away the debt. This seems obvious and to many, the only solution. The only problem with this, is that a sudden 400% inflation (assuming the same human activity in the economy, with some 400% of GDP added to the stock of money) will have a multiplier. So the actual inflation seen may go into the 1000s, which will completely erode the credibility of Govt, raising Interest Rates into the stratosphere. Once that happens, Interest Rate increases will far outstrip the Inflation Rates, creating a vicious spiral, that will go out of control, Zimbabwe (and Argentina) style. Remember, I am compressing all the above numbers into a short time frame just for ease of understanding. This will actually have to be stretched over at least a decade, if not more, to bring down the average annual inflation indicators to sensible numbers. Exactly when the number gets past the red line, triggering panic among Japanese savers/ investors is the dangerous end-game that is awaiting some legendary Finance Minister….a Bismarck to young Japan, a Hitler to old Japan. • Otherwise, after Bismarck….Hitler! I say Bismarck, because one of the lesser things he is known for is the creation of the Welfare State, which started this business of robbing the unborn voter/ Peter to pay the ageing voter/Paul. If the country just initiated the voting reform of disenfranchising the aged voter (above 65, say), that would be a start. From there to the fascism of Hitler. Just shoot the problem, or send it to the gas chambers of Auschwitz…the savers of Japan, who are now mostly over 65, have trusted the Govt with their money. If you want to default, and still remain in power, you have to do away with your creditor. The $20 trn that needs to be defaulted on by a $5 trn economy, belongs to a set of people who have been saving 32% of GDP for the last 35 years. They have already been getting near zero interest, so they are used to being gypped for the last 20 years at least. Now, when they start asking for their principal back, why not just shoot them? One way of doing that is to make medical services very expensive (with steep service taxes, otherwise the Doctors will take over the Govt), and take away State funding. People might choose to die quietly in their homes. If they come out on the streets, use the principle of patriotism to promote hara kiri (or was it kamikaze) for the country. Ok, this train of thought is not for a family magazine, so I shall desist…but not before making the point that debt destruction is best done with death and destruction!!! • Demonetisation is a dangerous game, and would need a long-term co-ordinated effort that would need a visionary in power. First, you issue new currency at a ratio that is unfavourable to the accumulated stock of money, i.e. the savers. Then, you keep issuing new money, which keeps the inflation rate high, but back it up with high taxes (especially indirect taxes). For God’s sake, don’t spend the money now; smaller Govt and no further highways to Hokkaido! That will put the Govt back into a surplus, with which it will pay back its accumulated mountain of debt (now reduced to a molehill). The Fx markets will figure it out, and the currency will go through a huge shock, the minute the markets figure out the debt (and currency destruction) strategy of the BoJ. A generation of young Japanese will live through a ‘soft Depression’, with high taxes and low real incomes. They will take care of their now-in-penury older generation, praying they die, but unable to kill them because of high real estate prices (which will go through the roof, during the demonetisation). Family ties will be closer, glued together by the high prices of real assets. Inheritance will be the only hope of the young, for home ownership. • Last, and the most likely….something that nobody expects….nothing!!! This might just turn out to be much ado about nothing! Outsiders are going to town about debt destruction, assuming street riots and civil war. But that is the Western paradigm, where money matters a lot, savings even more, simply because consumption and lifestyle is the objective of life. But in a world where saving is habitual, the marginal utility of savings is zero (and therefore, the marginal disutility of dissavings is also almost nothing). Inside Japan, life goes on as usual. Young Japan continues to save, corporate Japan continues to run up large Current Account surpluses and the Govt continues to run deficits and borrow with impunity. Interest Rates might well go even lower, shocking the Western trading floors into covering their Yen and JGB shorts yet again. The best way to understand that is to look at India, a country of continental proportions with myriad cultures interacting with each other, in the same way that the world economy functions. If the Jains of Jaipur are inveterate savers, the Punjabis of Lajpat Nagar are inveterate consumers/ borrowers. Now look at debt destruction, when it periodically happens in India. Jaipur is at the receiving end of every scam, from Harshad Mehta, to CRB, Prudential Capital, Ketan Parekh, et al. It periodically contributes a fifth of the scam losses every few years; the rest is provided by Gujaratis. Inside Jaipur, there are these ‘domestic defaults’, as big jewellers routinely go bust or decamp with private savings from the black money market. So what happens? Nothing… Some newspapers see an increase in circulation, the dust settles down and everything goes back to ‘normal’. The city returns to saving for the next blowout. The key point that economists are missing here, are the different behavioural reactions to the same stimulus. A debt default is a big deal in an economy (like US/ Europe) where savings are short, but it is not a big deal in an economy which not only has a large stock of savings, but also a continuous flow of savings to replace the stock lost due to debt destruction. Ask the Jaipur Jain whether he remembers the many scams where Jaipurians have lost money. This is incomprehensible to Western thinkers, but is easier to understand by us Indians. The Indian Govt has been forever looting its citizens (remember Indira Gandhi’s Loan Melas, the NPA crisis and 16% inflation), without much loss of credibility. It has forever had low international Credit Ratings, but its Govt borrowing program has never seen a hiccup. Even its international borrowing programmes has found NRI savers in the worst of times. The ratings did not matter. Sanjeev Pandiya teaches, trades and writes. spandiya@hotmail.com. Unlikely Winners When Doing Nothing Is Better Than Doing It Wrong So onto China, which is much easier to deal with. It is just a larger version of Japan. If Greece could be ignored, simply because it was 2.6% of European GDP, Japan can be ignored in tomorrow’s developing picture of the world economy, simply because their remaining 90 mn population will be just 1% of the world’s 8 bn people. So whether Japan sorts itself out or not, it will not matter by 2050. China has everything that Japan has, but king-size. In Dollar terms, its economy has just beaten Japan to become No.2 in the world. Its huge pool of savings (55% savings rate compared to Japan’s peak of 32%) has already created enough trouble around the world; its Fixed Asset formation has swamped the world with excess capacity, its trillion dollar surpluses will create tsunamis when they come onto the currency markets. It is ageing prematurely, although thankfully, without the welfare state entitlements of the West. The problems it has created are not too old, but it can just look at Japan to see how it will all end, if it continues with its current trajectory. It has to get its domestic consumption up, because there are simply not enough people in the rest of the world to consume what it can produce. Just think of what would happen if we take current trends to their logical conclusion. Suppose all of China’s people, 14% of world population, were to shift into manufacturing. With manufacturing set to go below 15% of world economic output, and assuming that Chinese productivity is at the world average, we would have a world swamped permanently with Chinese goods. Now just assume a doubling of Chinese productivity (which is not very far away), and we have the same situation as I have outlined above. So if Chinese consumption does not pick up, the country most hit will be China itself. That is just Japanese history repeated with bigger consequences. To promote a consumption oriented economy, China will have to first build its services sector, which calls for a cultural change. Remember, these services will have to be non-tradeable services, otherwise we will end up with the same glut in worldwide (service) output that we have in manufacturing. But non-tradeable services cannot be increased by Govt fiat, which is what China has traditionally been doing. The roadside entrepreneurship that you see in India, where every new colony in Delhi already has a milk supply, an electrician/ plumber and quack doctor, before anybody has even started living there, is completely missing in China. There is no concept of ownership of assets, and private ‘enterprise’ at the lowest level is missing. This is what shows up in the GDP numbers. The momentum that Indian growth has, is internally driven and funded, with Udupi restaurants providing employment, income and a self-generating savings rate, enough to take care of capital costs. In a village economy, a single Udupi restaurant will multiply itself every 5 years, thereby generating a 20% growth rate after depreciation and notional interest. Chinese investment is mostly state-funded and ‘mandated’. That is why its growing parts look so good, while India’s growing parts look so chaotic. On every office block in Shanghai, there is no defacing paint that shows you how much of the building has been built by adding to banking NPAs; in India, you see entrepreneurial ‘jugaad’ everywhere, which must be done to keep the cost of assets within the purchasing power of people; there is no Bank NPA to fund the difference. India will never see a Xanadu come out of the wilderness, like you see Chinese cities come up in the provinces for no apparent logical reason. There is an ‘evolutionary’ process to India’s development: a Lavassa can only come up in Maharashtra, not in Bihar. At the same time, there will always be many Indias, but there may only be 2 Chinas: the one we see and the one we can’t. In this worldwide scan. I am going to ignore the resource economies (Russia, Australia, Canada, Brazil, Chile, South Africa), because their fundamentals are dependent on the growth and stability of India and China. Governance does matter, especially in Russia, Brazil and Chile, where improvements (in governance) will telescope economic growth coming from new resource finds and better exploitation of old ones. I fear that these economies will be prone to sudden bouts of volatility coming from the pulls and pressures of commodity price movements, which will exacerbate the movement of gold prices. Even if they do well, it will be with very high volatility, making the ride no fun at all. Which brings me to the last and most important region: Asia. I have already mentioned that I am looking for the next Indonesia, so it is obvious that it (Indonesia) qualifies. Singapore is just a ‘broker’ to Asia’s trade and investment flows vis-à-vis the rest of the world. The Middle East will be rendered irrelevant because of Clean Tech, which has already become an inexorable ‘big trend’ that will destroy anybody who tries to resist. The cost of energy will go to zero; any country that has not prepared for that, will see its economy marginalised. The survivors will be those who have the people to build on free, clean energy, and use it to build a 21st century economy. That is one of the reasons why I have ignored any economy that is entirely dependent on non-renewable resources, e.g. Chile and Russia. With zero cost energy, recycling will become so viable that commodity prices of virgin resources will be capped. God is probably Indian, he just got lost in the melee of the Kumbh Mela. With the background of the Commonwealth Games, it might sound ironical to talk about Indian Governance actually improving. But just think about it: about Rs.10,000 cr wasted on the Games (out of about Rs.30,000 cr actually spent) is actually very quickly recovered by the Govt cutting down on Energy Subsidies of Rs.30,000 cr per annum. Diesel and LPG will contribute another Rs.20,000 cr, besides the Rs.100,000 cr ‘windfall’ from Telecom. The Govt has got out of a range of (economic) activities that used to contribute to leakages back in the bad old days: how much money used to leak in the building of an airport/ port/ road, etc. Today, a chunk of this is in private hands. Can you imagine a world class airport like the Delhi/ Mumbai/ Bangalore airports, ever being built by the Govt? If you thought the Govt did a good job with the Delhi Metro, watch what Mumbai is doing with its JV in the Mumbai Metro with Reliance ADAG… The RTI has ensured that numbers are real, otherwise, there used to be the hyperbole that political parties would mouth about the country being taken to the cleaners: hypothetical numbers, like the estimated Rs.20,000- 70,000 cr of ‘revenues’ lost because of 2G, as if that is the amount of money given as bribes. The important ‘big trend’ is: that the Govt is getting out of business. From an Indira Gandhi Govt that wanted to get into banking, to a Sonia Gandhi Govt that is getting out of even the provision of basic Infrastructure and city building, we’ve come a long way, haven’t we?! Rural Telecom infrastructure is now in the hands of the new private telcos, and the public sector telcos are going bankrupt, have you noticed? Agricultural markets are now impacted by grain trading models run by private companies, not the Food Corpn. Believe it or not, I dream that Govt corruption will actually be marginalised if we get 2 generations of good governance. The UID Project will reduce corruption and leakages, cleaning up the food subsidy model that we have been following. Next will follow the Fertiliser Subsidies, and we are on our way. Govt will not get smaller, but it will do other things: provide regulation, for example. Individuals will still make their money, but the wastage embedded in the Govt actually ‘doing’ things rather than regulating them, will be reduced. And growth will take care of the rest….
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