Vijay Kumar Gaba

Early this year BRICS, a bloc of leading emerging economies, announced the induction of five new members, viz., Egypt, Ethiopia, Iran, Saudi Arabia, and the United Arab Emirates, to its fold. The ten-member bloc has a significant presence in global trade. More specifically, it exercises significant control over the global energy markets, controlling 42% of global oil production and 35% of total oil consumption.

In July 2023, the then President of BRICS, South Africa claimed that over 50 emerging nations have expressed their desire to join the group. Recently, Russia’s Federation Council Committee on International Affairs, stated that BRICS would be expanded further as more than 40 countries are desirous of joining the group.

The cooperation between BRICS members is free, and flexible and extends to a variety of subjects of common interest amongst members. The members and other countries desirous of joining the group, view BRICS as an alternative to global bodies viewed as dominated by the traditional Western powers and hope membership will unlock benefits including development finance, and increased trade and investment.

Defining the vision of BRICS, President Putin said, “BRICS is attracting an ever increasing number of supporters and like-minded countries that share its underlying principles such as sovereign equality, openness, consensus, aspiration to form a multi-polar international order and a fair global financial and trading system.

The expansion and strengthening of BRICS could, therefore, be interpreted from different perspectives. From the geopolitical perspective, it could be seen as a vote of no-confidence in the extant global order, dominated by Western developed countries (especially the US), by the emerging economies. A larger BRICS could undermine the dominance of NATO, the UN, and even the IMF.

From India’s perspective, it could act as a strong resistance to any material escalation between India and China. We have already seen the traditional rivals Iran and Saudi Arabia bridging the differences and coming together on the Palestine issue. We have also witnessed ineffectiveness of the NATO sanctions against Russia over the Ukraine invasion issue. BRICS and other developing countries have increased their trade with Russia materially in the past couple of years, as reflected in a larger current account surplus for Russia.

From an economic perspective, a larger and stronger BRICS could play a significant role in determining the terms of global trade. Its present and prospective members would control a significant proportion of the global human, mineral, and manufacturing resources. Besides, helping in securing better terms of trade, ensuring energy security is seen as another key advantage of a stronger and larger BRICS.

From a financial perspective, post global financial crisis, a large number of developing countries have reported a slowdown in financial aid from developing countries. The conditions appear to have deteriorated further post the Covid-19 pandemic. A deeper and wider cooperation between the enlarged BRICS grouping, the humanitarian aid to the developing nations could be restored.

From a monetary perspective, there is an intense debate about limiting the role of USD in global trade. A BRICS agreement on adopting a common independent currency or increasing the bilateral trade in local currencies could help in achieving this objective. There is strong evidence of a material rise in yen trade between Saudi Arabia-China and Russia and China. India has also made some advances in promoting INR trade with traditional trade partners like UAE and Russia. We might see more developments on this front in the next couple of decades.

These may be the early days to term BRICS as a foundation for change in the post-USSR unipolar global order to a multipolar world order that shall facilitate much-delayed reforms in the global institutions like the UN and IMF etc. Nonetheless, the developments are encouraging and offer hope.

Last month, in one of my posts (read here), I mentioned that “From the events of the past few years, it is evident that the era of peace and global cooperation, which started in the aftermath of two devastating wars in the first half of the twentieth century and flourished after the end of the Cold War in the late 1980s, may be coming to an end. In my view, the year 2024 will see a new paradigm unfolding in global economic, political, and geopolitical spheres. The new paradigm which would take a couple of decades to manifest fully, may inter alia see multiple axes and alliances emerging in the global order, competing with each other for supremacy. Consequently, global trade may get fragmented into multiple trade blocs.”

I also expressed a view that “The trend in the financialization of economies may reverse. Physical resource ownership and localized manufacturing may become the primary focus again.”

A team of the International Monetary Fund (IMF) analyzed the economic impact of the fragmentation of commodity trade, in a working paper titled Geoeconomic Fragmentation and Commodity Markets (Jorge Alvarez, et. al., October 2023). The conclusions of the research are pretty scary. The following are some excerpts from the IMF paper.

Concentration of Production

Unlike manufactured goods, the first stage of production of commodities depends on natural endowments that can be concentrated geographically. As a result of natural endowments’ concentration, there is a significant concentration of production at the country level, with the top three producers accounting on average for about 65 percent of the global output of agriculture, about 50 percent of energy, and about 75 percent of minerals commodities.

For minerals, production is concentrated both at the mining stage due to the geographic concentration of deposits, but often also at the processing stage, with a few countries (most notably China), having developed a strong comparative advantage through the deployment of capital intensive facilities, efficient technological solutions, lighter environmental regulations, and relatively cheaper labor.

Low Elasticities of Supply and Demand

Commodities exhibit low elasticities of supply and demand, particularly in the short run.

On the supply side, scaling up production often requires large investments and long permitting processes that can delay a supply response to price changes. For example, it takes on average 16 years from exploration to the opening of copper mines. Discovering new deposits is also costly and takes time.

On the demand side, many commodities are inputs for key technologies and products or are essential to household consumption, making them hard to substitute, and attenuating the demand response to price changes.

Trade Dependence

With production highly concentrated and demand often spread across many countries, commodities are heavily traded. Their homogeneity and fungibility also contribute to market integration. As a consequence, the share of production that is traded internationally across commodity types is consistently higher than the ratio of world trade to gross output. Across agricultural commodities, around 40 percent of output is exported, around 30 percent for energy and almost 50 percent for mineral commodities are exported. more than 80 percent of lithium, or potash produced cross borders, with the share increasing over time for most raw commodities.

Fragmentation and Commodity Prices

Events of the past few years suggest that the Western Economies and Russia/China led (or controlled) economies are drifting apart, getting divided into separate trade blocks. The Covid-19 pandemic exposed the fault lines of global manufacturing. If commodities cannot be transported between China, the West, and Africa, much of the modern manufacturing may halt. For example, Congo supplies two-thirds of the global Cobalt requirement. Disruption in supply chain could halt production in various manufacturing units that use cobalt as a raw material.

A model examines how much prices of 48 key commodities would change in the Western bloc and the Russia/China bloc if trading between the two blocks stopped altogether. In such an eventuality, the Western bloc would end up with a surplus of some commodities like iron ore or copper where there is more production than is needed in the region. Hence, steel prices would drop a lot in the West and rise dramatically in China, which undoubtedly would put an end to a lot of the growth in infrastructure and real estate in that country. Prices for magnesium and graphite, used extensively in the production of batteries and other renewable energy equipment as well as platinum, group metals, and rare earth metals would skyrocket in the West since we would be cut off from supply from China.

Prices of various commodities could move dramatically in the event of geopolitical decoupling of the West from China and Russia.

Obviously, the current geopolitical standoff is an invitation to mutually assured economic destruction for both blocs. The whole rhetoric of China+1; the isolation of Russia and China and the emergence of India at the expense of China appears fraught with danger.

Investors who are positioning for a secular growth of India’s economy over the next decade and the success of China+1 strategy may want to review their strategy in my view.

 Last weekend the already tense situation escalated materially in the Israel-occupied Gaza Strip area of the Palestinian state. Apparently, the Hamas controlled militia launched a massive ariel and ground attack on Israeli territories, killing over 700 people and injuring many more, including several civilians - women and children. In retaliation, Israeli forces attacked the Palestinian territories in the Gaza Strip, killing over 300 people, including women and children, and destroying several civilian targets. This is the deadliest episode since 1967, in the conflict that started in the late 1940s.

 Five months ago, I had highlighted the likelihood of a trading opportunity emerging in gold. (see here) The opportunity did present itself, though not exactly in the manner I had anticipated. Nonetheless, the gold prices rallied about 19% in USD terms; from a low of USD1630/oz in early November to a high of USD1950/oz in early February.

Since peaking out in early February, the gold prices have corrected about 7% in USD terms. It would therefore be pertinent to ask what traders and investors should be doing with their gold positions.

It has been my long standing view that gold is no longer an investment asset. (for example see here and here) The view is even strengthening with each passing year. I believe that it is highly unlikely that gold will stage a comeback as a widely accepted medium of exchange (gold standard); and it will be gradually phased out as a store of value as better digital options emerge.

In this context, the latest report of the World Gold Council (WGC) presents some interesting data that needs to be noted.

Demand structure of gold demand is changing

WGC highlights some important changes in the demand structure of gold in the past three decades.

·         The consumption demand of gold has declined structurally.

·         Gold demand in paper form (ETFs etc.) has turned negative in the post Covid period.

·         Demand for gold in bar and coin form has been sustaining since the Global Financial Crisis (GFC).

·         Central Bank demand that was negative for two decades has been sustaining since GFC.

It is therefore clearly evident that the demand for gold for social security, vanity and social status purposes is on the decline structurally.

Share of India and China in global gold demand peaking

India and China had emerged as major growth drivers for global gold demand during the 1990s and 2000s. The combined share of China and India in global gold demand had increased from ~20% in 1992 to ~55% in 2008. Post GFC this share stagnated and has declined to less than 50% post Covid.

Central Banks major buyers since GFC

In the post GFC period central banks have been a major driver of the global gold demand. The banks which were net sellers of gold in the 1992-2008 period, turned net buyers of yellow metal, buying close to ~1200tonne in 2022. Apparently, the unprecedented money printing prompted the global central bankers to diversify their reserves away from USD and EUR.

The major surge in central banks’ gold buying was also driven by the demand by central Asian and East European bankers for the fear of NATO sanctions.

Now since most central bankers are pursuing a policy of quantitative tightening and inflationary expectations are well anchored in medium term; the bond yields are expected to stay higher for longer; the sanctions on Russia and allies have failed to show the desired impact; global consumers continue to remain under severe cost of living stress; demographic indicators continue to deteriorate in the developed world and showing signs of population peaking in China; there are few demand driver for gold to sustain the current prices.

The short term trading opportunity in gold is therefore over in my view. The medium and long term outlook for gold continues to remain weak.

In the past one year, inflation has been one of the primary concerns for most countries across the globe. Rising prices of food and energy in particular have materially impacted the lives of common people on all continents. The central bankers of most major economies have hiked policy rates in the past one year to control inflation. In the current year 2023 so far, 13 major central bankers have taken policy action(s) and all of these actions have been hike in policy rates.

However, in recent weeks inflation has shown some tendency of cooling down. It is difficult to assess how much of this cooling down is due to tighter monetary conditions; and how much could be attributed to other factors like restoration of supply chains that were broken during the pandemic and warmer winters resulting in lower energy demand in the northern hemisphere, etc. Nonetheless, some central bankers have adjusted the pace of tightening to smaller hikes. Most of them, though remain circumspect about the persistence of inflation. While the debate continues over the trajectory of price hikes in the next few quarters; an overwhelming majority of experts believe that prices may remain high for much longer.

The global growth forecasts have witnessed some downgrades in the past six months as tighter monetary conditions and higher prices are seen hurting demand for consumption and investment. As per the latest assessment of the World Bank, in 2023 “the world economy is set to grow at the third weakest pace in nearly three decades, overshadowed only by the recessions caused by the pandemic and the global financial crisis….Major economies are undergoing a period of pronounced weakness, and the resulting spill-overs are exacerbating other headwinds faced by emerging market and developing economies (EMDEs).” 

With this background, three key issues that could influence the future trajectory of global prices and therefore interest rates are geopolitical situation; impact of China ending Covid restrictions and the impact of the emergence of El Nino on global food production.

Geopolitical conflict in Eastern Europe (Russia-Ukraine) has materially influenced the prices of energy and food in the past one year. Any worsening or this conflict or expansion to Western Europe could make things worse. Some events in the recent weeks have indicated that Sino-US relations may not improve anytime soon. NATO countries hardening their stand on Russia; Russia retaliating with a cut in energy output; and some key OPEC members openly expressing disagreements with US oil pricing has materially increased the uncertainty in the energy market.

China has been gradually relaxing the covid restrictions for the past many months. This has eased the logistic logjam across the world. The supply chains that were broken due to congestion at major ports, shortage of containers, short supply of key raw materials, and poor take-off have mostly been repaired. The freight rates that had become prohibitively high have eased to pre Covid (2019) levels. The debatable question however is whether China reopening will be inflationary (higher demand) or deflationary (complete supply chain restoration and consequent destocking; improved mobility of workers etc.).

As per the latest forecast of various weather agencies (see here), the probability of El Nino conditions developing in the coming summer could impact the agriculture production in major countries like India, this year. If these forecasts come true, we may see food prices remaining at elevated levels.

A variety of views prevail on these three issues and their outcome. In my view, China reopening will indubitably be deflationary for the global economy, especially metals and other raw materials).

I am however not sure about the geopolitical conditions. I would therefore continue to expect elevated crude oil prices through 2023. By the way, the RBI in its latest statement has assumed the price of Indian basket of crude oil to be US$90/bbl for FY24, against the current price of US$84.19/bbl (see here).

It is little early to talk about weather conditions in the forthcoming summer and its eventual impact on global food prices. For now, the Rabi crop in India appears to be good; and there is enough food in the Indian granaries. Thus availability of food should not be a problem for sure even if we had a poor monsoon year after three normal/excess monsoons.

 The toughest job in the present day environment is risk management. Of course, it has never been an easy job; but when we consider the proportion of moving parts, fragility of systems, disregard for conventions, total lack of mutual trust and disillusionment with the status quo, managing risk appears the toughest job. I can now appreciate the risk managers’ plight during the first half of 20^th century; when similar conditions were prevailing.

To illustrate my point, let me highlight the following instances which may not appear ominous to a common man, but could give cold sweat to risk managers.

• Interest rates have risen in most parts of the world in the past one year. In many cases the rise in rates has been rather steep, especially the developed economies. Most of these economies were struggling with deflation pressures for the better part of the past two decades. Obviously the rates were low (close to zero and negative in many cases). Many businesses were built assuming this to be a lasting phenomenon; or at least many investors valued businesses assuming this to be a lasting phenomenon. The pandemic however annulled this assumption. It now appears that we shall not have near zero rates for longer, even if inflationary pressures ease in the next couple of years. A large number of the businesses built on “lower for longer” assumptions are facing existential risk.

How would a risk manager handle this risk? If an investor changes the assumption of “lower for longer”, the basic case for investment in such ventures may collapse. An exodus that may thus result would only result in immediate collapse of such a venture. If the management guides change in assumptions about finance cost, cash losses and poor visibility of fresh capital, the valuations will collapse anyways.

·         The news flow in the past few days includes the following headlines:

1. “Iran fires missiles at Kurdish militias in eastern Iraq” (see here). This was to follow up 73 ballistic missiles fired by Iran in September 2022 (see here).
2. “Texas to send military armored personnel carriers to the border to escalate enforcement. The move comes days after Texas Gov. Greg Abbott invoked an 'invasion' clause to step up border enforcement.” This is part of the border reinforcement in the past 2 decades in which billions of dollars have been spent. State funding for border security has grown from $110 million in 2008-2009 to nearly $3 billion for the 2022-2023 budget cycle. (see here)
3. “Ukraine nuclear plant shelled, U.N. warns: 'You're playing with fire!” (see here)
4. “South hits back as North Korea fires most missiles in a day.” (see here)

Besides, news flow on Sino-Indian border tensions and China’s aggressive posturing on Taiwan has been consistent. A risk manager who is aware of the energy crisis of the 1970s; has been struggling to manage the fall outs of Russian invasion of Ukraine; and is aware of hardliners winning elections in Italy, Israel, Brazil etc. would find it hard to ignore these geopolitical threats.

• “Mumbai sees temperature dip, IMD issues cold wave warning for parts of Maharashtra.” (see here) This could be a worrying signal for risk managers worrying about inflation; supply of grapes, onions, pomegranates; public health etc.

Besides, in the mountains it started snowing earlier this year. Late rains have ensured late sowing for Rabi crops. If winter sets in early and nascent crops are hit by frost, we may have poor Rabi yield.

• I recently met with a company which earns substantial revenue from UN tenders. The management highlighted the substantial cut in funding of the UN as a key risk to their operations. They did not mind discussing the probability of the UN becoming redundant or even getting dissolved in the next 10-12 years.

The point I am trying to make is that in the present times investors should better avoid overconfidence in any investment idea. The black swans could emerge in flocks from nowhere. It is therefore a good idea to keep portfolios well diversified and liquid. Exposure to exotic, unproven, experimental, innovative, expensively valued businesses must be kept to bare minimum – ideally not more than what you could easily afford to write down fully.

 In the current year 2022, inflation in India has consistently remained above the RBI tolerance band of 2-6%. For the month of August Consumer Price Inflation (CPI) was 7%, led primarily by the food inflation of 7.6%. Both rural and urban inflation recorded a MoM rise in August. Unfavourable weather conditions apparently led to sharp rise in the prices of vegetables, fruits, spices etc. However, the core inflation (CPI ex food and fuel) has also persisted over 6% since the past many months; emphasizing the persistent pricing pressures. The IIP growth in July also moderated to 2.4% led primarily by consumer non-durables – indicating pressure on household finances. The sharp rise in household debt, especially the expensive credit card rolling credits, also corroborates the rising stress on household finances.

In view of the elevated price pressures, the Monetary Policy Committee (MPC) of RBI is expected to keep raising rates in line with the global peers. The market consensus is expecting the policy repo rate to rise to 6% (currently 5.40%) by the end of 2022. In his latest statement, the RBI governor stated that he does not expect moderate hikes in policy rates and elevated prices to hurt the growth materially and the economy may still retain the momentum to grow 7% in FY23.

The RBI estimate of growth may be optimistic in view of the poor Kharif crop estimates; challenges to exports; rising interest cost and poor consumption growth outlook. The risk of a global energy crisis in winter is also looming large and could have some negative implications for our inflation and growth outlook.

Inarguably, the claim of the finance minister that India faces zero chance of a recession is tenable. But a growth of 5-6% on a low base would be nothing to celebrate in our circumstances.

Obviously, the financial markets are disregarding the macroeconomic conditions and focusing on micro opportunities, especially the ones driven by policy impetus. In particular the following are some identifiable drivers of the stock markets in the recent up move.

1.    Strong emphasis on enhancing local defence procurement, especially in view of the global sanctions on our largest supplier (Russia) and elevated Chinese threat. The global sanctions on Russia have also presented an opportunity to Indian manufacturers to gain some foothold in global defence equipment and missiles markets; where the efforts of Indian entities, made in the past many decades, have started yielding results. The stocks of the companies that could be potential gainers from higher local defence procurement are favourites of investors as well as traders.

2.    Realignment of global supply chains in the post Covid world is expected to trigger a new capex cycle in Indian manufacturing sector. The potential beneficiaries of this capex cycle like capital goods manufacturers are also gaining traction with market participants.

3.    The most favourite sector in Indian markets is the financial sector. The cleaned up balance sheets after years of efforts and increased margins as the rate cycle turns up are attracting massive investor interest to the sector.

4.    The energy crisis in Europe and the US is also creating opportunities in Indian markets. For example, prohibitively higher energy cost has rendered significant industrial capacities (especially in high energy consuming sectors like chemicals) unviable. Closure of these capacities is allowing some Indian manufacturers to gain market share as well as better pricing power.

5.    The trends in energy security and climate control (green energy, electric mobility etc.) are also leading greater investor interest in the related businesses.

6.    Given the poor growth outlook in Europe and China, the FPI flows have turned towards emerging markets like India. Significant positive flows over the past couple of months have also helped Indian equities to outperform its global peers.

It seems the divergence between the equity market performance and macroeconomic conditions may continue or even widen in the short term. However, over a longer period, say 12-15 months, both invariably converge. Till then its happy times for the investors and traders.

It is a basic human tendency to long for what they do not possess. It is common to find people who have struggled very hard to achieve certain goals; but almost instantly feel dissatisfied with (or indifferent to) the outcome. They either realize that it was not something they actually wanted in the first place; or they immediately shift the goal post and begin to struggle/strive for a different/higher goal. This basic human tendency, that often manifests in a constant need to move, evolve and grow, is at the core of all economic growth and development. And perhaps this is the key factor that undermines the issue of sustainability.

Metaverse is nothing but a realization that humans never wanted to globalize in the first place. They like to remain confined to their caves and tribes. It was perhaps the starvation and disease that would have forced the first tranche of immigration.

Of course since the end of the stone age, this realization has taken more than 5000 years; many rounds of polluting industrialization; chopping of billions of trees; extinction of many species; killing of millions of people in wars, to dawn upon the mankind. And it may actually not be the full circle and we may still want something more once we realize the goal of living in a predominantly virtual world.

If I may put this hypothesis in a more recent context-

·         The people of USSR were sick of the central command economy and wanted a democracy that facilitates their participation in the global growth and development; besides making the governance structure transparent, corruption free and progressive. Gorbachev gave them an opening to the world they were struggling to live in. In less than two decades, they chose to hand over the power to an authoritative leader who is not even committed to any socio-political ideology; aspires to restore Tsarist colonial ambitions and cares least for the global order, transparency and accountability.

·         China, which has consistently supported Pakistan’s demand of self determination by Kashmiri people at all global platforms, refuses the same rights to the people of Tibet and Taiwan. The Chinese authorities and businesses demand equal rights for their companies from the governments of foreign jurisdiction where such Chinese corporations have established operations. However it refuses to allow similar justice and freedom to its own corporations and entrepreneurs like Jack Ma.

·         We find that for almost a decade the central bankers of the developed world struggled to create inflation and full employment in their respective economies. When the inflation finally occurred, it is now their biggest problem.

·         The farmers, agriculture experts and politicians in India clamored for farm sector reforms for many decades. But when a significant part of these reforms were delivered, people launched a movement for reversal of these reforms.

·         The industrialists and financial market participants long for accelerated economic and fiscal (tax) reforms. However a mere mention of withdrawal of Income Tax exemptions and concessions (e.g., LTCG) makes them apprehensive.

The simple point is that the investors should not get passionately attached to a new trend or event. Most of these could be ephemeral; and could evaporate as soon as these go out of media headlines.

 Some of the most popular video clips shared on social media in India in the recent past were of India’s External Affair Minister, Mr. S. Jaishankar, giving stern replies to the global media about India’s stand on Russia-Ukraine war. In these clips, the minister is seen ‘exposing’, the hypocrisy of European media and politicians in raising questions over India’s purchase of energy from Russia, despite sanctions imposed by US and EU, while the European countries continue to buy natural gas from Russia. Most social media constituents who shared these clips cited the confident and unabashed counteroffensive by the Indian minister as a harbinger of ‘rising India’ and ‘declining west’.

I personally have no disputes with the social media warriors on this issue. It does feel good to see a representative of the Indian government taking a firm stand against the developed nations on global platforms. However, the point I am presently more concerned about is ‘declining west’.

Worsening demography

With a total fertility rate of 1.6, the European Union’s population is on the decline. European Uinon, whose working population (aged 15 to 64) shrank for the first time in 2010 and is expected to decline every year to 2060. In contrast, the proportion of people aged 80 or over in the EU population is expected to more than double by 2050, reaching 11.4 %. In 2006 there were four people of working age (15-64) for each person aged 65 or over – by 2050 this ratio is projected to be just two people. Migration from other Eastern Europe is helping it to compensate for workers’ shortage to some extent, but it is far from adequate. Most European countries are therefore open to relax migration rules for the Asian immigrants. India’s demographic dividend may, to some extent, come from migration of young workers.

Climate change – Mother Nature showing no benevolence

Historians cite numerous reasons for the decline of the once Great Roman empire. Climate change and disease are also listed as prominent reasons from the Empire, once considered invincible (for example read here). European economy and strategic powers have been diminishing slowly in the post cold war era. The recent climatic disasters are threatening to acclerate this decline further.

As per a latest report by European Union Joint Research Center’s Global Drought Observatory (GDO) Analytical Report titled Drought in Europe – July 2022 – Europe Europe is experiencing its worst drought in at least 500 years. Hot and dry conditions are fueling wildfires and adversely impacting crop yields and electricity generation. About half part of the European continent is facing an alarming situation with a clear deficit of soil moisture. The summer temperature has risen to record levels disrupting transportation, displacing people and causing numerous deaths. Deficient rainfall has affected river flows across Europe – hitting the energy sector for hydropower generation and cooling systems of other power plants.

This climate catastrophe came soon after the Covid-19 pandemic severely crippled many European economies, besides causing numerous deaths and health complications.

Europe has already lost its technology leadership to the US and China. If the agriculture and energy dynamics change materially in the next one decade, the spectre of “the fall of Rome” might return to haunt Europe again. It is however too early to assess how this would  affect the rising Asian societies.

 In the past couple of months there has been a visible rise in the reports expressing fears of an implosion in Japanese, Chinese and Russian economies. The reasons behind these fears are quite diverse. Of course there is nothing new in these reports. Experts have been predicting an implosion in the Japanese economy since the early 1990s’ in the Chinese economy since 2008 and the Russian economy since 1917.

Personally, I do not subscribe to any of the theories that forecast implosion in the Japanese, Chinese and Russian economies in the near future. Nonetheless, I believe that the study of the growth, fiscal and indebtedness profile of Japan is important from two viewpoints, i.e., (i) impact on the global economy, should the BoJ losses control over the situation; and more importantly (ii) impact on the global economy if the US economy (consumption, growth, fiscal profile, etc.) follows the Japanese economy and gets trapped in this vicious cycle of high debt and low growth; and the consequences if USD loses its prominence as the global reserve currency.

I noted a few pointers for this study from some recent reports relating to Japan. These simple and most visible pointers indicate where the US economy could head if a new set of innovative monetary and fiscal policies are not implemented soon. This would be as imperative as the first set of innovative monetary and fiscal policies implemented in the wake of the global financial crisis.

Japanese Debt – the vortex

As per some recent reports the Bank of Japan (BoJ) now owns over 50% of $12.2trn debt issued by the government of Japan. The public debt of Japan is now 266% of GDP. The Public Debt to GDP ratio of Japan has consistently worsened since 1992, when it was below 70%. Considering that the GDP of Japan is rising at a snail pace of 1-1.5%, and the debt is growing at a faster rate, it is most likely that the debt situation may worsen further.

The sharp rise in debt has not been much of a problem so far as it has been accompanied by consistent fall in bond yields. In fact the yields have been negative during 2015-2020. Moreover, since most of the government debt is bought by BoJ and local banks and funds, Japanese yields have been insulated from global trends for the past 3 decades. Even during the global financial crisis, the Japanese bond market remained mostly unaffected by the global turmoil.

The BoJ has been struggling with persistent deflationary pressures for most of the past three decades. For most part of the past two decades, the inflation in Japan has been in negative territory. Inflation has persisted below the target 2% rate, except for a brief violation in 2014 in recent months.

Though the BoJ has not taken the path of monetary tightening to ward off the inflation, the local bond yields have risen to positive territory. Moreover, the reversal in the monetary policy of the global central banker has materially widened the gap between the Japanese and global bond yields. Nothing new in this, but the questions about sustainability of Japanese public debt are hitting the headlines again. Recently, it was reported that “The Bank of Japan may have been saddled with as much as 600 billion yen ($4.4 billion) in unrealized losses on its Japanese government bond holdings earlier this month, as a widening gap between domestic and overseas monetary policy pushed yields higher and prices lower.”

In recent years, the household debt in Japan has also started to rise. Household debt in Japan had reached a high of 78.7% of GDP in 2000. It subsequently declined to a low of 59.9% in 2015. As per the latest available data, it had again reached 67.4% of GDP in December 2021. Japanese households owe a debt of US$3.2trn; which is 23% of total domestic credit of US$13.5trn. A rise in lending rate could further slow the economic growth in Japan; besides enhancing the stress at household level.

I am pleasantly surprised to see an overwhelming response to my random thoughts on geopolitics, economy, businesses and markets shared through yesterday’s post (see Market’s tryst with reality). Even more surprising is the fact that all respondents are in agreement with my thoughts. This has happened for the first time since I started writing this blog.

The First World War resulted in the decimation of some large empires like the Ottoman Empire, Russian Empire, and Austro-Hungarian Empire. By the end of the war, the map of Europe had changed dramatically. The communists had taken over power in Russia and neighboring smaller states to form the Union of Socialist Republics (USSR). Many other states in the Eastern Europe also saw the rise of communism. Germany and Italy fell for an ultra-nationalist (fascist) propaganda. The European imperialists like Portugal, Spain, France, Netherlands (Holland) and Britain started to lose their grip over their colonies in Asia and Africa. The Spanish Flu and the Great depression also shaped the politics of Europe in the post war period. This war also saw the emergence of the USA as a formidable global power.

The Second War completed the transition to the new world order with the decline of the British Empire, division of Germany and Korea, destruction of Japan and strengthening of the USA and USSR. The process of decolonization that started post second war resulted in about 3 dozen states in Asia and Africa gaining autonomy or independence.

Many new institutions were created and multilateral treaties were signed, palpably to maintain peace and accelerate the process of rebuilding the countries destroyed by deadly wars, natural disasters, and colonial exploitation, many global institutions. United Nations, International Monetary Fund, NATO, Bretton Woods, WTO, Warsaw Pact, Vienna Convention, Paris Peace Accord, Geneva Convention are some of the prominent institutions and treaties.

Within a decade of the end of WWII, the world became bi-polar with the USA and USSR holding the pole positions. The USA was leading the larger non-communist world, providing technological and strategic support to the countries. Its currency US Dollar (US$) obviously became the preferred medium of exchange and also store of value. The USSR was extending its influence in communist Eastern Europe and Central Asia.

Colonialism was now reinventing in the form of economic and strategic dependence. The wars were now more driven by economic maneuvering rather than the movement of troops. The global energy crisis triggered by the events in Iran in the 1970s, led to the USA denouncing the gold standard (free convertibility of US into defined quantity of Gold) in 1974. The US and Saudi Arabia deal to price its oil only in US$ terms established the greenback as unquestionable global reserve currency, as most post war financial institutions were already under US control and dealing in US$ mostly; and major commodity markets (CBOT, LME, NYMEX etc.) were already pricing global commodities in US$ terms. Post dismantling of the USSR in the 1990s and China joining the WTO in the 2000s, the position of US$ in global trade and finance strengthened further.

However, post the global financial crisis of 2008-09, the unprecedented expansion of the US Federal Reserve balance sheet (implying quantitative easing or printing of new money) has triggered a debate over sustainability of US$ as global reserve currency. Emerging global powers like China and India have also been aiming for a larger role in the global institutions like IMF, to the detriment of US influence over these institutions.

The currency (and tariff) wars between US and China and US and Europe in the past one decade are other manifestations of the global reset. China has also been motivating its trade partners to deal in CNY. Covid-19 pandemic caused recession and lockdown has allowed time to global powers to rethink their strategies and plan their futures.

The recent Russia-Ukraine war shall give further impetus to the Reset. Russia engaging in non USD denominated trade with partners like China, India, and Iran etc. Reportedly, China and Saudi Arabia are meeting to discuss pricing of oil in non USD terms.

It is not WWIII or the nuclear threat that investors should be worried about in this decade. It is the diminution of the USD as a global reserve currency. If the US cannot borrow in US$ to fund its profligate fiscal and monetary policies, the inflated asset prices will face a reality test almost immediately.

Insofar as India is concerned, I believe that it would be the first time in the past 200 years that India would be participating in a global reset from a position of strength. In all previous resets (colonization, industrial revolution, post war realignments, fiat currency, etc.), India was mostly the adversely affected party.

This time however our exposure to the global economy and geo-politics is much wider and deeper; and so would be the impact of any material change in the global order. It is critical that India demonstrates its competence and willingness to play a prominent role in the global affairs, economic, strategic as well as geo-political, to be accepted as a main player in the game.

In my view India will not be a water boy in the next game. It will be included in the final playing XI as an all-rounder, i.e., an economic, strategic and geo-political major. Look forward to good times ahead, and brace for the turbulence.

 As I indicated last week (see here) to me markets are not looking good, at least for now. And it is definitely not only due to the latest episode of Russia-Ukraine conflict. This conflict has only added to the caution. My primary problem is the lack of adequate growth drivers for the Indian economy.