Are these economists the biggest threat to the world? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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Are these economists the biggest threat to the world? 

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In this issue:
» Staggering size of India's lost tax receipts
» Outsourcing not as lucrative as before
» India can have its worst growth in 3 years
» Don't bet on a significant decline in gold prices
» ...and more!

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00:00
 
No other report has perhaps received as much publicity in recent times as the one written by two economists called Carmen Reinhart and Kenneth Rogoff. Infact, their book, which is based on the same topic as the report has also become a huge hit. So, what is the report as well as the book all about? Well, these two gentlemen have studied financial crises going back as much as 800 years and have come to one important conclusion. The conclusion being that once the debt to GDP ratio of a country touches 90%, the economy reaches a sort of a tipping point. In other words, at this ratio, the GDP growth starts slowing down fast.

This ratio has gained so much popularity that policymakers across the globe are using it as some sort of a reference point. It is being argued that this ratio has been instrumental in Greece being asked to cut down spending and control deficits. Amazingly, even the US congressmen used this number to force the Government to curb its spending spree. Thus, while the debt ceiling has been raised, it has come with a strict rider that deficits will have to be reduced over the course of the next decade. However, not everyone is in agreement with the findings of Reinhart and Rogoff. Infact, one press report has even gone to the extent of calling them the two most dangerous economists in the world today. The 90% figure, argue critics, has been arrived at just arbitrarily. And there is nothing sacred about it. Infact, cutting debt at a time when the private sector is also reducing debt may backfire as per them.

One such criticism has come from none other than Robert Shiller, one of the most astute observers of financial markets. He has argued that investors are overreacting to debt to GDP ratios. And hence are demanding programs that cut spending at a time when recovery is still weak.

We agree that debt to GDP ratio of 90% may not be sacred. But we are also in disagreement with Mr Shiller and others with viewpoints similar to his. We don't think that Governments should increase debt as well as spending during times of economic weaknesses. This just postpones the problems according to us. Just as companies with high debt are assumed to be risky, we don't see any reason why it should be different for economies. Infact, the sooner the crisis is allowed to play out and taken out of the system, the faster will a ground be laid for renewed growth. Do not believe us? Just ask Japan.

What do you think? Do you think Governments should increase debt when private sector is reducing its own or leave the correction process to itself? Share your views with us or you can also comment on our Facebook page.

01:24  Chart of the day
 
If the world gold council's latest data is to be believed, India is the 11th largest holder of official gold reserves in the world. At around 558 tonnes, its holdings are just 7% of the biggest holder in the world, the USA. However, it should be noted that the data takes into account just the official gold holdings. We are certain that once all sorts of holdings are taken into account, India's standing is likely to improve a great deal.

Source: World Gold Council


01:58
 
A major part of the fortunes of the Indian IT industry has been driven by the flow of outsourcing. Companies worldwide realized that they could get work done at cheaper rates by simply outsourcing the work to countries like India. This helped them in reducing their costs. But the growth has now started to ebb away. As per the TPI index of outsourcing that measures commercial contracts of over US$ 25m, the total value of such contracts has fallen by 18% YoY in June 2011. One of the reasons for this has been the fact that the industry has become more mature. But another reason for this has been the hassle involved in outsourcing.

As per an article of Economist, companies have faced serious issues with regards to quality as well as timely delivery. There have also been cases wherein the delivering company has overpromised to bag the order but under-performed when it came to delivery. This has led several companies to rethink their outsourcing strategy. While they still agree that outsourcing can help in saving costs, however they are now looking at outsourcing only the non-core activities. This will help the Indian IT industry with continued order flows. But it is unlikely to give them the huge push in margins that they are all eyeing as the margins lie in the higher end work. To get that, the IT industry needs to spruce up its act. It needs to concentrate more on the quality of people they hire rather than just looking at the quantity of hires. It is time to start balancing the quantum with the quality.

02:46
 
Already 15% up in the year, gold seems well set to make new highs. Its demand as a safe haven is gaining momentum as the global economy is on the verge of another crisis. The global investors are losing faith in key global paper currencies on account of mounting debts and excessive money printing. Raising the U.S debt ceiling will be no consolation for investors as rating agencies can see through the ineffective cosmetic treatments to patch up a failing economy. With other signals showing the world economy in doldrums, gold continues to remain in demand.

It's not just Europe and US, the rising inflation concerns in China and the need for other countries to diversify their foreign reserves is pushing up the gold prices as well. Its use as a safe haven has lured even the Bank of Korea that is making its first gold purchases in more than a decade. With so many factors working in its favour, there seems to be nothing that can pull gold significantly back any time soon.

03:17
 
Although India's growth slowed down in FY09 at the height of the crisis, the economy recovered strongly in the subsequent couple of years to post a healthy growth in GDP. But now, there is a possibility that India's GDP growth may revert to what we had seen in FY09. And some economic data released over the past 3-4 months could be said to support this. For starters, there have been clear signs of a slowdown in car and two-wheeler sales and modern format retail sales. On top of that, investment and construction spending appear to be moderating due to lack of demand visibility and policy paralysis. That is not all. High inflation has been a bane for quite some time now and the RBI has responded to this by gradually hiking interest rates. This in turn has hampered demand and profitability of India Inc.

Further, the government has also not spent much on developmental activities. One reason for this being the high fiscal deficit, which has not given much headroom to the government to spend. All of this has then put a question mark on whether India will be able to grow at the same pace as it had in the last two years. Indeed, the Prime Minister's Economic Advisory Council (PMEAC) also cut estimates for growth to 8.2% from 9% earlier. Slowdown in economic growth could translate into lower jobs and salary cuts, which in a high inflationary scenario would act like a double whammy. All in all, quite a few headwinds for the Indian economy in the months to come.

04:02
 
Few readers may have had the experience of being amongst those in the highest tax bracket way back in 1971. But those belonging to that generation can tell you what it meant paying 97.5% of income as taxes to the government. Since then, several tax reforms and incentives to liberalise the economy has made tax payouts in India substantially lower. Individual income tax rate of 30% makes India's effective tax rates competitive amongst developing economies. The tax cuts that started since 1991 onwards may have certainly paved the way for individual and corporate prosperity. But several loopholes have meant a huge dent in government's tax receipts and a ballooning deficit. These if not corrected on time could be fatal for the economy's future prospects.

As per Bloomberg Businessweek, the report - The Black Economy in India - estimates India's annual loss of tax receipts at Rs 14 trillion! Also, the Indian government's tax revenue is an estimated 18% of India's US$ 1.5 trillion GDP, the lowest among the four BRIC nations. Tax holidays in economically backward states and fiscal exemptions on agricultural income have been the bane of contention for several years. Most often these have been used by the rich to evade taxes. A double tax treaty with Mauritius is a favourite with companies wanting to evade taxes on investment gains. Despite this, the government continues to turn a blind eye to most corrective proposals. After all, the black money is a major source of election funds too! With such conflicting interests, we wonder if the Indian government will ever be in a position to keep its deficit cut promises.

04:50
 
Meanwhile, indices in the Indian stock market continued to inch lower today as well with the Sensex more than 150 points down at the time of writing. Heavyweights like L&T and ICICI Bank were seen driving most of the losses. While Asian indices also closed lower today, Europe too was seen submerged in a sea of red.

04:57  Today's investing mantra
"Wide diversification is only required when investors do not understand what they are doing." - Warren Buffett
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12 Responses to "Are these economists the biggest threat to the world?"

kvm_mds

Aug 15, 2011

Using debt to create productive infrastructure can propel economies of developing countries like India forward. The developed world (most of them incl USA) have been boosting consumption with debt, both at house hold and government level. This is disastrous after a certain limit. The US and many EU countries have crossed the danger mark

Like 

Manish Banerjee

Aug 9, 2011

Not only just these two, economists generally has been a threat to national economies. We are told that this 90% threshold of debt to GDP ratio is good enough to for S&P cut down AAA rating there by bringing disaster in the stock market. While deficit economy is definitely undesirable, 90% cut off is definitely arbitrary. Problem is average politicians do not have the sagacity nor inclination to critically look or ask questions on these formulations. So they accept the current economic rage blindly more for reasons of politics opportunity rather for making economic sense. Derating of the US economy is case in point. It is dangerous approach for the Congress to refuse sovereign borrowing based on such fragile formulations. Not only the stock market throughout the world, most countries have stakes in US bonds. An appreciable run on these bonds will create further panic & the cascading effect may create havoc.

Like 

Mohan

Aug 7, 2011

I am not an expert to comment on this. For a starter in this area, equity master articles are of great use to get a quick view of market and invest at right time. Great attempt!!

Like 

knarayan

Aug 3, 2011

Governments should not increase debt. It is better to live in a period of degrowth for some time so that the future period may turn brighter. By increasing debt, one is only postphoning the liability to the future generation. It seems that Governments are also appartently concerned about the short terms just like the companies are worried about their quarterly performances. I remember Mr Deepak Parekh had once rightly mentioned that the reporting of quarterly performances puts a lot of pressure on the CEO to deliver profits on the short term, without having the larger picture in the long term. A similar phenomenon is happening in the governance in the public sector. Why can't the governments holistically take a look at all the non productive investments and dispose them off?
an example in India is the investment in Air India. the govt is pumping money in a dying company, which it may as well think of privatising.

Like 

Rajeev Ranadive

Aug 3, 2011

Reminds me of what Lee Icocca, the famed ex chairman of Chrysler has written how he managed to pull Chrysler out of bankruptcy.(not exact wording, but from my recollection)

He said that as an air-force pilot, he knew that when the aircraft stops climbing up and looses speed, the best way to recover is to dive.

He insisted that Chrysler spends MORE MONEY to develop new products and increase marketing / advertisement expenses.

Rest is history.

The present situation in US auto industry is the same. (being from auto industry, my insider views)

What do you think?

Like 

srinin

Aug 3, 2011

There is a fundamental difference between business and govt. Non performing business can be closed and investments (still left!) can be switched to something more profitable. Governance cant be shut down (parties may change.) So we really really need some deep thinking and innovation here. Thats long term.

In the short term, ideally govt shd strive to balance budget. Contracting debt against future receivables is acceptable (development funding as opposed to welfare funding) provided it is efficiently managed and closely monitored. The scandal a day in India is a case in point. Vision, ability and vigilance have to go hand in hand in this case.

Is 90% the tipping point? May be but it cannot be sacrosanct in a dynamic world.

Like 

Digambar Kulkarni

Aug 3, 2011

Rightly said, increasing the debt is postponing the liability for the Next Generation to clear!

What does a Son feel, who has to curb his expenses to clear the Debt left by his Father to clear.

There is a tendency even by Governments to sell the future rights to creat capital for the present.

The Governments and Public of future is going to curse the past Governments for this.
This is shameless behaviour.

The present generation should in fact leave balance credit for the future generations and be praised for it.

Like 

pinakin

Aug 3, 2011

Right below the above article, is a graph showing USA as the no.1 holder of Gold in the world. Why can't the US Govt sell some of its Gold & reduce its debts?

Like 

Kunal Kumar Kundu

Aug 3, 2011

I think it is important to understand that the recent crisis is different from all other crisis and should not be painted in the same brush. There is a big difference between a crisis cause by normal business cycle and one cause by excessive leveraging requiring substantial deleveraging to stay afloat. This crisis has been precipitated by excessive leveraging. In case of the US, too much focus on reducing the debt levels sharply by cutting down drastically on government expenditure can be counterproductive. Agree it is important to have a road map toward reduced debt, but if there is a sharp pull out by the government at this point in time when the private sector is deleveraging, the economy can go on a tailspin and recession 2.0 would stare at our face. Bottomline, I am all in favour of debt control and reduction of govt expenditure but the approach should be pragmatic and not too steep to the extent of acting as a shock.

Like 

jayesh Shah

Aug 3, 2011

Sir

U r analyst fundamentalist but yet I observed that u always quote somebody elses nothing we r getting innovative from ur self why sir

Like 
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