The trillion dollar lesson from a tiny country

Dec 17, 2010

In this issue:
» Iceland's message to the world on economic recovery
» Consistent Bill Gross slayer takes a huge contrarian call
» Buy hard assets, says Jim Rogers
» Inflation still on the RBI radar
» ...and more!!

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Not very long back, Iceland, a small European island country had become the butt of all jokes. As a result of the global economic crisis, its economy was in deep, deep trouble. And just like its other counterparts in Europe and US, the country's banking system was on the verge of becoming dysfunctional.

Thus, the need of the hour for Iceland was to have a Government sponsored bailout. But it did something that was radically different. It did not follow the popular strategy of US and other European countries. Instead, it took the brave decision of letting its banks fail. Yes, that's correct. It did what the US and Europe even does not dare think currently.

Of course, the economy of Iceland had to pay a heavy price for it in the short term. Its currency fell by some 80% and inflation soared to 20% levels. What's more, its GDP also fell by 15% peak to trough. But things are vastly different now. After seven quarters of negative growth, things are looking much better. The balance sheet is in much better shape and the trade balance has actually turned into a surplus.

A huge, huge lesson for US and European countries we believe. It is certainly not the end of the world if a country lets is insolvent banks fail. Bail outs incur enormous costs and transfer the burden of the private sector to the Government and ultimately to the tax payer. It also does not purge sick and insolvent banks out of the system. To top it all, it creates a moral hazard. So far, Ben Bernanke and Co were hiding under the garb that letting insolvent banks fail means putting the entire system at risk. But the Iceland example has proved them completely wrong. It is time they abandon their foolish theories we believe.

Do you think bailouts are better or insolvent banks should be allowed to fail? Let us know

 Chart of the day
India may be one of the world's largest exporters of gems, jewelry and textiles. But the economy has never really been dependent on exports. Selling wares to other economies formed just 14% of the country's GDP at the end of FY10. No wonder, the economy has hardly had a trade surplus. The situation is unlikely to change dramatically over the next two decades. As today's chart shows, as per the IMF, the EU and China will remain the world's largest exporters well until 2030.

Data source: IMF

The legendary Bill Gross is not your ordinary fund manager. It does take a great deal of skill to be consistently ranked the world's best. Thus, if there is someone who has beaten him on a consistent basis, he should not be taken lightly either. No matter how contrarian his views. One such gentleman is Jeff Gundlach. And his views are indeed very contrarian as of now.

At a time when the whole bond world is betting against US Treasuries, Mr Gundlach sees the current sell off as a buying opportunity! And he has some solid reasons we believe. He is of the opinion that the debt burdened nations will not be able to take too much interest burden as of now. Hence, in view of this, there are very little chances that rates can go up too much from current levels. It should be noted that bond prices are inversely related to interest rates. Thus, if interest rates cannot go up a lot more, bond prices cannot fall further and hence, it is futile betting against them.

"I don't think the economy can take much of a rate rise above 3.5 percent....The economy, society and government are fueled by debt", Pragcap reports Gundlach as saying. He further adds that deflation is more likely in the next 24 months than inflation. Hmm, interesting thoughts indeed. We don't know whether it will be inflation or deflation but we certainly know that gold will keep going higher either ways.

Most economies have shown a common virtue in their highest growth periods. One that cannot be duplicated easily. Neither with wealth nor with technology. That of a growing population of young adults ready to enter workforce. Many of which are likely to remain employed for a reasonably long time. Economies in South East Asia, South America and Africa seem to be following such pattern. It is not just India where the onus of superior growth rate rests on the young population. But the potential of several other 'emerging' countries rest on the same laurel.

As per Fidelity, the ratio of population above the age of 40 in select emerging economies will not outstrip that below 40 for nearly three decades. What remains to be seen is which of the countries utilize the potential to the best of their advantage. We believe that having a young population is just the tip of the opportunity. Educating and gainfully employing them can be a challenging task. Probably it's too early for India and China to bask in this glory.

Indians cannot imagine farming as a lucrative proposition. No Indian middle class family would want their kids to get into farming. Even Indian farmers for that matter. However, the flamboyant global investor, Jim Rogers, thinks quite the contrary. He says that wealth will gravitate toward the producers of real goods- farmers and miners. Being productive, saving and owning hard assets are Jim Rogers' recipes for a bright future.

He continues to be bullish on commodities. This, of course, thanks to the fiscal irresponsibility of debtor governments and the printing of money. According to him, creditor nations like China and other Asian economies will thrive. He commends them because they save, work hard and invest in real infrastructure and tangible wealth. On the other hand, he foresees a bleak future for Wall Street and London.

The RBI's latest monetary policy review was based on the need of the hour. Liquidity was unusually tight in November with banks having to borrow Rs 1 trillion every day from the Reserve Bank. Big name IPOs and advance tax payments contributed heavily to the tightness. Thus, it kept benchmark rates unchanged. This temporarily arrested the RBIs run of successive rate hikes. It has increased rates 6 times already this year.

The RBI instead officially reduced the statutory liquidity ratio (SLR) by 1%. It also announced the purchase of government securities of up to Rs 480 bn next month. These two measures will help increase credit growth and address liquidity concerns. However, the central bank has not forgotten about the high inflation rates prevailing in India. Latest reports on food price inflation saw it increase to 9.5% in the week ended December 4th. Both food and crude prices have been increasing rapidly. Thus, the RBI is expected to start the New Year off with more rate hikes. But we can breathe easy for the time being.

Meanwhile, Asian economies ended mostly strong today on signs that US, the world's largest economy is recovering. European indices have also opened on a strong note today. Indian stock market remained closed on account of a public holiday.

 Today's investing mantra
"If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what's going to happen to the stock market." - Benjamin Graham

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53 Responses to "The trillion dollar lesson from a tiny country"


Dec 22, 2010

If I become insolvent then nobody will care to bail me out. If I ask help from Govt then I won't get a dime. Then why should Govt bail out the rogue Companies with money which actually me and billions other hard-working Tax-payers have contributed towards the Country's welfare??


V L Rao

Dec 20, 2010

Insolvent should be allowed to FALL.



Dec 19, 2010

I do agree with Mr.Diwakar comments that it may be right policy for small nation like iceland but US and india are big nations with huge population and allowing the banks to fail will affect the public at large Hence we have to deal in case by case basis as to what extend the impact would affect the common people and based on that the govt has to bailout the banks and once settled then the owners of the banks has to be penalised for the bail out cost involved.


Mohamamd Ali Khan

Dec 19, 2010

I feel that the failing banks should be allowed to fail, without unnecessary direct or indirect burden on tax payers. By solving wrong problems, we get more of wrong problems to solve.



Dec 19, 2010

The failure of big banks certainly has impact on the world financial system even if they are bailed out and we have already witnessed the results. whether the situation would have been better for the long term,had the banks were not bailed out is left to imagination. As the taxpayers are to be protected along with the depositors, the iceland experiment coupled with deposit insurance to a large extent of the deposits can definitely yield better results. The bankers can do with lesser returns and a bit less so called performance bonuses in the hay days to cover themselves and the other stake holders. Afterwards, if they go bust for their follies, let them go under by all means.


Vinay Binani

Dec 19, 2010

Before debating whether the abnks should be allowed to fail or survive, I suggest that we do a bit of introspection as why the banks who lent against assets with all safeguards run into these problems. The answer according to me is very simple. They fail because the underlying assets fall in value. First of all therefore the authorities should not allow a bubble to built up in assets (like we have in real estate now). Secondly banks should be allowed to lend very selectively and with increased margins against the assets where the prices have gone up irrationally.



Dec 19, 2010

nice and interesting artcile



Dec 18, 2010

It's a great lesson for countries in Europe & the US, that are reeling under debt. The insolvent banks should be allowed to fail. Bailing out a failed co. by the Govt. funds is just suppressing the ailment & not removing it. Good chances are that the ailment will surface again.
Indeed its a right step taken by Ireland.


K.G. Rao

Dec 18, 2010

Puhleese! While I haven't the foggiest notion as to whether allowing the big US banks to fail would have been better overall, I do know that anyone feeling that way 'cos it worked in Iceland couldn't have a very good feel for the situation. Given the differnce in sizes of the economies, how CAN u draw such a facile conclusion based on the Iceland experience. The effect of size has to be factored in.



Dec 18, 2010

Banks becoming insolvent are their own misdoings. As such supporting such banks with more monetary infusion means helping the inefficient at the cost of efficient system. This leads to further problem. The European and US authorities must let the inefficient banks fails, so that the QE1 QE2 which are fuelling world wide inflation can be rolled back. Thanks

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