Beware, many more Cypruses in the making!

Apr 3, 2013

In this issue:
» Is the BRIC story fizzling out?
» A bank for emerging economies may not be feasible
» US loses millions of clerical jobs
» Wage rises in Asia make high inflation the new normal
» ...and more!

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They say there is a silver lining to every cloud. No place better than the financial markets to get reassurance about this. Every asset bubble burst has led to messy state of affairs and losses running into millions. Every stock market crash sees speculators running for cover. Every sovereign crisis brings in reluctant bailouts. But each one of them teaches some important lessons. The latest one, concerning a tiny economy, has brought a massive problem into the spotlight.

Cyprus' bailout may not have caused too many creases on the global economic landscape. However, it was a notable one. It was the first time the euro zone penalized bank depositors for the government's poor fiscal management. To put things in perspective, consider these statistics. Cyprus had fiscal deficit of 4.9% and bank assets comprised 716% of its GDP in 2012. But don't make the mistake of thinking that Cyprus is a one-off case! There are many others, big and small economies, whose economic profile is as delicately balanced as in the case of Cyprus. Fingers are already being pointed at Luxemburg, Malta, Estonia, Slovenia and Slovakia. As seen in the chart, the first two have bank assets that are ridiculously higher than GDP. For Luxemburg, the bank assets are 2107% of GDP! The risk of a country's growing dependence on bank debt is that it becomes more vulnerable to economic and financial shocks. An economy with higher leverage is likely to see more business failures and loan defaults in a recession or steep rise in interest rates, all else remaining same. Slovenia and Slovakia are also on red alert as their fiscal deficits are 4.2% and 4.8% respectively.

Data source: World Bank, WSJ, IBT, Equitymaster

That makes us wonder how safe is India with fiscal deficit of 5.2% in FY13. Or for that matter, Ireland, Japan, US and China that have bank assets at 718%, 341%, 235% and 146% respectively. India' bank assets at just 75% of GDP assuage some concerns. For China too the robust fiscal position makes things look brighter. But the Cyprus debacle is a warning for every nation, big and small, to pay heed to. Unless the governments put their fiscal management in order and curb indiscriminate bank lending, a much bigger global crisis cannot be ruled out.

Do you think countries like the Ireland, Japan, US and India could also head Cyprus way? Please share your comments or post them on our Facebook page / Google+ page

 Chart of the day
After aviation, agriculture and construction, it is the power sector that has led to maximum stress on the asset quality of Indian financial sector. Funding to the sector is 50% financed by scheduled commercial banks. The other half comes from power and infrastructure financing entities (PFC, REC, and IDFC). Again, it is the PSU banks that have lent 80% of the money that has been given by banks to the sector. State Bank of India (SBI), ICICI Bank and Canara Bank are the ones having more than 10% of their loan exposure to the sector. It therefore remains to be seen how the sector's fortune impact these players in the banking sector.

Data source: Banks, Equitymaster

There have been periods of 10-12 years each in the past where a particular asset class has left most others in the dust. It was the crude oil in the 1970s and then the Japanese stocks during the 80s. While the 90s was marked by the tech boom, it was the BRIC group of nations that hogged the limelight during the first decade of the twenty first century. However, the economic force that was BRIC was believed to be more long lasting and hence, more rewarding than its predecessors.

But this belief is now being put to one of its toughest tests. As per reports, the stock markets in the BRIC group of countries peaked in 2007 but after that, it has underperformed the US markets by a huge margin. What more, shares of developing countries have even underperformed their developed counterparts during a global market rally, a first in 15 years!

So, is the BRIC story fizzling out or it is going through a temporary lull that will pass sooner than later. While we cannot speak for other countries, we are of the view that India's problems are of its own making. And once it fixes issues like governance and poor infrastructure, it can make a roaring comeback we believe.

Here's another one on BRIC with an extra S added at the end of the acronym to include one more country of South Africa. With so many similarities and the agreed cooperation amongst them, it is but natural that the BRICS want more economic power globally. With this in mind they have decided to set up a collective bank. A bank that will be similar to the World Bank and IMF but will lend to emerging economies. The 5 countries have agreed to set up such a bank with a capital of nearly US$ 50 bn. While the idea behind the bank is definitely good, one would wonder if the BRICS are capable of running such a bank successfully. The Financial Times seems to think that they cannot. And it has pretty good reasons to support its thesis.

The first reason is the dissimilarities between the 5 countries. They may have commonalities but in essence they have different political structures. They even have different underlying macroeconomic conditions. To add to this is the problem of size that would determine the voting power of each nation. Let's face it, China is much larger than the other countries. So it is natural that it may prefer to have larger control in the bank. But given its strained political relations with India and Russia, such a control may not be agreeable by them. Then there are also issues like staffing, decision making, etc. unless these are agreed upon, the bank cannot be a success. We do agree with what FT has to say. Unless the finer points are worked out, such a bank may not really see the light of the day. And if it is set up without resolving these issues, it would be a failure. Hopefully the BRICS leaders will think these things through before rushing to set up the bank.

The US economy has been facing problems of high unemployment. But that is not all. There are structural shifts in employment patterns. Consider this data from an article in the Financial Times. Since 2007, the US has added 387,000 managers to its work force. Fair enough. But at the same time, a whopping 2 million clerical jobs have been lost. Who is to blame for this? The answer could be technology, among other factors. New computing technologies tend to kill several middle income jobs. For instance, clerical jobs such as book-keeping, data entry, retail cash handling, typing and filing have been declining. On the other hand, technology also generates opportunities for highly skilled persons.

What does this lead to? Increasing income inequality! Median household incomes in the US have fallen 5.6% since June 2009 to US$ 51,404. This was despite the fact that the economy has witnessed some recovery since the worst phase of the crisis. This is another worry that US policy makers have to now grapple.

Japanese Prime Minister Shinzo Abe's cabinet has approved the plan to overhaul its electric power sector. The plan entails splitting up the generation and transmission businesses of the utilities. In addition, more players would be allowed to enter the residential electricity market. With the same, it is anticipated that power costs would move lower. And it would ultimately lead to increasing investments given that current high power costs have been dis-incentivising investing in Japan. This move is being considered as a major restructuring step since the 1950s, when Japan split its national grids into ten regional grids. And the pressure to boost competition and reform the sector intensified post the Fukushima disaster.

We cannot help but find similarities between the power sector situation in Japan and India. The high power tariffs (India has amongst the highest power tariffs in the world) are common to both economies. The urgent need of an overhaul within the sector - more so after the grid collapse last year. However, the need for overhaul in India's case seems more urgent and wider given the issues related with delays in decision making by the government; mining related issues; high T&D losses; power theft; poor financial conditions of SEBs; fuel supply related issues; amongst many others.

There was a time when global corporations rushed to Asian shores to capitalise on the low cost advantage there. But things have changed since then. While growth in many Asian economies has been robust, the wealth gap has also widened. As a result, governments in Asia have increased the minimum wage rate in order to curb discontent. Average pay in Asia almost doubled between 2000 and 2011, compared with a 5% increase in developed countries and about 23% worldwide, according to the International Labour Organization. This is taking its toll on the profitability of companies and factories. As it is, corporates the world over are struggling to grow in a weak global macro environment. On top of that, competition has also intensified. Because of this, so far none of them were keen to pass on costs to consumers and raise prices, lest they lose market share. But the situation seems to have now reached a head. Most companies believe that they are no longer in a position to absorb additional costs. Thus, rising prices of goods worldwide is most likely to be a reality going forward.

Profit booking in consumer durable , power and auto stocks have kept the benchmark indices in the red throughout the session today. Backed by weak cues across Asian markets, the key indices in Indian equity markets opened lower and languished in the red. The BSE Sensex was trading lower by around 239 points at the time of writing. Other major Asian markets closed lower while markets in Europe opened flat to positive.

Today's investing mantra
"As I look back on it now, it's obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics. Investing in stocks is an art, not a science, and people who've been trained to rigidly quantify everything have a big disadvantage. If stock picking could be quantified, you could rent time on the nearest Cray computer and make a fortune. But it doesn't work that way. All the math you need in the stock market you get in the fourth grade." - Peter Lynch

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1 Responses to "Beware, many more Cypruses in the making!"


Apr 3, 2013

Will look forward for some more of this material before giving any comments...

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Equitymaster requests your view! Post a comment on "Beware, many more Cypruses in the making!". Click here!