Predictions 2008

Ever since I started thinking about the global economic scene, I have been reading and hearing a lot of counter arguments and all of them seem credible. Now, I know why two economists always come out with three predictions. I being a novice will assume anything can come true and let me try to list down the various things that could happen.

US

Fed has cut interest rates: This will impact:

1. Inflation

Scenario 1: Inflation will go up

Lower interest rates and hence lower saving rates, will increase the supply of dollar leading to inflation.

Scenario 2: Inflation will go down, leading to deflation

a) Lower demand of Oil and Commodities will drive prices down.

b) Some people may settle debt and hence will decrease dollar supply because of money multiplier effect .

Conclusion: Inflation will remain under check.

2. Dollar

Scenario 1: Dollar will become strong

US Treasuries are still the safest instruments in the world. Governments invest in US treasuries not because they want to earn returns from it, but because they want to hedge their dollar. Also, China and India have strong internal demand and there is some decoupling from the US economy for both of these countries. Therefore, these countries will still demand more commodities and oil and to make their exports competitive, they will do whatever they can to keep dollar stable. Attractive valuations for US companies and US real assets will increase demand for dollar and will push it northwards. Cheaper US exports will increase demand for dollar too.

Scenario 2: Dollar will weaken further

Cut in rates will make US treasuries less attractive. Though countries that have trade interests with US like India and China will not take any steps that will make their exports unattractive, there are others who do not care. US dollar is the fiat currency and is used across the world for all international trade. Oil rich countries are raking in a lot of moolah because of higher oil prices. They have no obligation to invest in US and are looking at other emerging economies to get higher returns. If they have money invested in US, they may even withdraw it, further increasing supply of dollar and weakening it. China already is facing the heat of high inflation because of artificially maintaining Yuan at lower levels and will try to slow down its economy or may appreciate Yuan. If China will stop buying dollars, that will also decrease demand.

Conclusion: The dollar may fall a little bit, but there will not be a free fall. Dollar will stabilize near the current levels.

3. Stock Markets

Scenario 1: Stock markets will go up.

People will have less motivation for saving in Fixed Income instruments, they will

a) increase consumption - leading to higher revenues for companies; or

b) invest in stock market, making it cheaper and easier for companies to raise money.

c) borrow at lower interest rates and invest in stock markets.

d) Weaker dollar will make exports attractive and help US companies increase revenues.

e) Companies from outside may look at acquiring US companies because of depreciating dollar getting them higher valuations. Cheaper credit also available.

f) Weaker dollar will make imports expensive and demand for imported good will go down increasing domestic consumption.

g) Cheaper oil and commodity prices will make raw materials cheaper and hence decrease costs for US companies.

Scenario 2: Stock markets will go down.

a) People are more risk averse and will shy away from investing in risky assets.

b) No new inflows to stock markets.

c) Consumption will go down as people will have insecurity of losing their jobs.

d) Credit will not be available for investing in risky assets like stocks.

Conclusion: Stock Markets will be steady as both forces will play out.

4. Sub-Prime

Scenario 1: Worst is over

Worse may be over. Lower interest rates will help people settle their debt. Since the Adjustable Mortgage Rate is dependent on base rate, it will go down and hence lesser probability of defaults. Sub-prime crisis may be halted. Lower interest rates may encourage people to borrow and invest in housing assets including foreign countries bring the zing back to real estate market.

Scenario 2: Worst is yet to come

Worst may be yet to come. As the teaser period of loans issued in last two years would get over and AMR applicable, more cases of defaults and foreclosures may happen, further weakening the real estate market. More companies will have to write down the losses. Although rates are decreasing, slow economy and loss of jobs will prevent people from settling their loans. With no correct valuation available as no sales are happening currently, even foreign investors will shy away from investing in this sector.

Conclusion: While it still remains to be seen what will be the total effect of sub-prime, the Fed is doing every bit to minimize the pain. Most companies have already written off their losses and are now looking forward to future. No fresh loans are being given which are as risky. It may take a few years to come out of the whole mess, but the worst may be over. Nevertheless, 2008 will still continue to face the consequences.

Overall Conclusion: I believe, it will be interesting to see which of the above scenarios will play out. Also, it will not be either of the two but will be a mix of two. Most will depend of the public sentiment and the direction that Fed and the government will give. The Iraq war is close to over and the spending there will be cut. I strongly believe that US will be able to come out of recession by end of 2008 because all factors will play in its favor, Fed and US govt will go whatever they can, and most countries in the world want US to do well. Most countries do catch cold when US sneezes. The forces of the economy will play out and free fall of such well connected economy will be very difficult. US has a lot of thought leaders, many of them from India and these sharp brains will make it happen!

Inflation or Deflation and impact on India

Unlike most countries' central banks, The Fed, or the central bank in US is not government controlled. From Wikipedia, The Federal Reserve is:

The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States. Created in 1913 by the enactment of the Federal Reserve Act, it is a quasi-public (part private, part government) banking system^[1] composed of (1) the presidentially-appointed Board of Governors of the Federal Reserve System in Washington, D.C.; (2) the Federal Open Market Committee; (3) 12 regional Federal Reserve Banks located in major cities throughout the nation acting as fiscal agents for the U.S. Treasury, each with its own nine-member board of directors; (4) numerous private U.S. member banks, which subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks; and (5) various advisory councils. Currently, Ben Bernanke serves as the Chairman of the Board of Governors of the Federal Reserve System.

If you look at point 4, a lot of private banks are a part of Fed and they control most of the decisions. At the same time, these private banks control over 75% of Fortune 500 stocks. So, is there a conflict of interest?

It could be argued that these banks would like the stock markets to zoom. Given the happenings in the market in the last month, the argument seems credible. The argument goes, that by cutting the Fed rate, there is less incentive for the US consumers to save and they will have two options:

1. Increase their spending.

2. Invest in other higher risk instruments like stocks.

By increasing the spending, the US companies will have higher revenue and will help their stock prices. And by investing in stocks, the cost of capital for these companies will go down as more people will want to invest in stocks and that will also help the Wall Street. The Fed expects this to provide impetus to the economy and help US come of out recession, or rather avoid it. Whether, this is a good way to help economy is arguable because economic theory suggests that lower interest rates lead to more supply of money in the system (as people do not save it in banks) and leads to inflation. Higher inflation, higher commodity prices means curse for the end users. They will want to borrow more, given the lower interest rates, but with sub-prime ghost still looming finding credit will be difficult and economy may come to a stand still again.

Inflation or Deflation?

My friend, Pratap, argues that the lower interest rates will make more money available to the consumers. However, they will not spend because given the current economic conditions people will not want to spend but will want to keep it for a rainy day. Jobs are decreasing  (http://in.rediff.com/money/2008/feb/02us.htm), so people do not want to splurge yet. They have recently burnt fingers by investing in high risk assets (the whole starting point of subprime crisis), so they will be wary of investing in stock markets too. What they will most probably do is to use the money to settle the debt. With interest rates lower and subprime rate being calculated over that, people will have incentive to pay back the debt at lower rates and excess money supply.

The power of currency comes from the fact that, when a $100 is put in the bank, the bank lends the same to someone else, who will put $80 is the bank, which the bank will lend again and so on. So, the real liquidity of one $100 is much more than a $100. This is the money multiplier effect. So, if people start paying off the debt, the money multiplier effect will decrease because banks will not be able to lend the money as easily now. This will decrease liquidity and cause deflation.

Also, the commodity prices will decrease if US economy slows down. The demand for oil and other commodity like Iron Ore, Coal etc will decrease thus decreasing prices and hence causing further deflation. This will cause the dollar to remain strong and not go down further.

My argument against this reasoning is that, the assumption here is that that markets for US companies are all domestic. When fed dropped the rates, dollar becomes weaker because of excess supply. Also, the commodity prices have downward pressure because of lesser demand from China as was argument in my earlier post. This will decrease raw material cost for US, and make exports attractive. Rest of the world, will want to import from US because they can buy more for the same amount of their own currency that they will spend. China is purposely slowing down and this will also help US exports. This increased competitiveness may cause US economy to come out of recessions, increased jobs, better wall street profits, causing people to invest more, spend more and save more.

What will happen is anybody's guess.

Impact on India

Strong dollar is good news for India. So, if by any of the above arguments the dollar does remain strong, the Indian exports will do well. Also, the lower commodity prices especially oil will help Indian imports and will make Indian manufacturing exports competitive. India might be able to siege some initiative from China though it is light years away from catching up with China. India can also benefit by importing technology and machinery from US or by buying assets in the US. Indian companies can look at acquiring some US companies with a stronger rupee right now.

US Recession

The stock market in India has been making new this week, for a change for all the wrong reasons. The world markets are down and there was a quick solution required. The Fed responded by cutting the interest rate by 75 basis points and the markets responded by coming back to the green zone again. So, was it all this easy? Why wasn't it done earlier? Let's evaluate.

In the US, although the economy has grown, jobs have increased and productivity is higher, things are not as good as they seem. Currently there are three negative effects happening.

1. The oil prices are sky rocketing

2. the sub prime mess has left people feeling poor as the value of their assets (homes) has gone down. The sub-prime mess has also extracted the liquidity from the market.

3. The dollar devaluation

How did sub-prime extract liquidity? Who really lost the money?

When the times were good, the banks and other financial institutions offered loans to people to build their homes. China was also investing in real assets in US which made the realty market heat up. China maintains its currency at a certain level viz a viz the dollar because to keep its exports attractive to US. If Chinese currency appreciates then US consumers will need more dollars to buy the same good and hence make it unattractive. Therefore, China buys a lots of dollars hence creating an artificial demand for it and appreciating the price. Then China buys real assets in US with these dollars.

Now, when real estate was sky rocketing, banks offered loans to people even with lower credit scores. Why did the bank do that? They did it because they could charge a higher interest rate to cover for the extra risk they were taking. People found it attractive because now they could own homes and with the property prices going high, the value of their asset would go up. They could then refinance the loan at lower rates and pay off the higher interest rate mortgage that they originally took. On top of that, the banks offered lower interest rate for first two years and higher interest rate for period after that. The later interest rate would readjust based on certain factors. This gives enough time for the mortgage buyer to improve its credit score, and in the mean time the house prices will also go up. This was a nice business and many people took loans. This increased the demand for the houses and hence heated up the realty sector even further.

Now, banks couldn't keep so much debt on their balance sheets. They therefore, securities these loans and sold them to other financial institutions and hedge funds. These securities are like bonds with future payments coming from the mortgage payments. These securities were also categorized into higher, medium and low risk. These securities were then traded and there was an attractive market for these securities. There was another agency for the rating of these securities which for some reason, rated these securities as high and totally ignored the risk. The banks who didn't have these loans on their books were now safe. Since their incentive was linked to selling more of these loans, they blinded themselves and bypassed any due diligence.

The business kept on going, unless one day the bubble burst. The home market started declining. This meant when the higher interest rate period came, the home owners were not able to refinance it, as the value of their asset had gone down. They started defaulting on their payments. The banks were forced to carry out the foreclosure of loans and put up the house for sale. This now had a negative effect. The supply of homes became higher and prices went further south. This causes many more to default on their payments and more fore closures happening. All the money was used up in building houses. The ultimate loss was for the hedge funds and financial institutions like Citibank and Merill Lynch who bought the Mortgage Backed Securities.

Why recession?

Now, there was a liquidity crunch as explained above. There was no money available for companies to invest and grow their business. If business will not grow then there would be no jobs created. Therefore, the Fed decreased the interest rates. Ideally when the interest rates go down, people have less incentive to save and they increase their consumption. Companies can borrow cheap money to invest in their business. This makes economy do better and the consumption goes up. However, the down side is that the inflation goes up too because of increased supply of the money. Fed obviously does not want the inflation to go up. Therefore, it can not keep on decreasing the interest rates. 

Even the Oil prices are high. The crude has gone up to almost $100 per barrel. The gasoline is selling for $3 per gallon right now and any increase to $4 will impact consumer spending a lot. People are already battling with low house prices, and high prices with added inflation will cause the consumer spending to go down a lot, taking the economy into a recession. Most experts are divided right now as to US will hit a recession or not. Some predict a recession and some predict a slow growth rate for 1st half of 2008 with economy rebounding in the second half. Most depends on where the housing prices stabilize. If housing prices go down further, the sub-prime mess will get deeper, further reducing liquidity in the market. However, by reducing the interest rates, the Fed is helping because the interest rate for mortgage are determined from the base rate and if the base rate goes down, the subsequent rate will also go down and some foreclosures may be saved. However, most will depend on the overall housing prices.

China Factor

As mentioned above, China has kept its currency stable artificially by buying dollars. However, this also causes inflation in China. To buy dollars, China has to print more money and more money means higher inflation. This inflation has caused the prices go up very high. At the same time, China unquenchable thirst for Oil and Commodities like metals had caused a worldwide boom in prices. Now, China is in a precarious position and taking steps to cool down its economy. Any decrease in demand by China in oil and commodities will cause these prices to cool off a little bit and should help US avoid recession.

Dollar Devaluation

Fed has been cutting interest rates to add some steam to the economy. However, these rate cuts also make the investments in US Treasuries unattractive. Most people/investors/countries have option to invest their money somewhere else. With US Treasuries less in demand, the dollars to buy these treasuries is also less in demand. This decreases the valuation of the dollar. Lesser dollar value means US has to spend more to buy oil and hence adds to its recession. However, the good news is that weaker dollar will help US exports, discourage Chinese imports, encourage domestic consumption. Higher domestic oil prices may reduce demand for oil and hence bring down the world price for crude.

Summary

In summary, US recession seems eminent. There might be some probability that the turn of events and Fed's actions save it and reverse the trend, but until US savings rates go up, the economy seems to be going into a state of stagflation.