Vijay Kumar Gaba

 The issue of high and rising US public debt is a subject matter of public discussion in Indian streets. Using a common Dalal Street phrase I can say that every paanwalla, taxi driver, and barber is now discussing how unsustainable US public debt is. For example, listen to this boy .

From top economists, analysts, and global strategists to a common man on the street, all are worried about an imminent US default and its impact on the global financial system, especially the developing and underdeveloped countries.

Currently, the US public debt is close to US$35trn (Appx 125% of annual GDP) and is projected to double in the next eight years. The current US government's annual interest payments are more than US$1trn (Appx 20% of annual federal revenue; 14% of annual federal spending and 4% of GDP). The average interest rate on the entire debt is less than 3% p.a.

As of June 2023, 43% of this debt was owned by the Federal Reserve System and State and Local Governments. 32% of the debt was owned by various domestic institutions (MF, Insurance, Pension, and Depositories, etc.) The balance 26% was owned by other institutions including foreign governments. Almost the entire debt is denominated in USD.

This debt level is a matter of concern but does not prima facie appear to be at a disaster level. The worrisome part is that about one-third of US public debt is short-term (12 months or less maturity). However, considering that a large part of this debt could be owned by the government institution and the Federal Reserve System, refinancing of this debt should not pose a significant problem. In my view, US debt could be sustained with 3-4% inflation, 20% USD devaluation, 5% revenue growth (higher taxes), and rationalization/reimbursement of various war funding expenses, this debt could be sustained, reduced, and serviced. It is of course going to be hard for US savers and middle classes for a decade or so. USD losing its reserve currency status may be collateral damage.

For context, as per the interim budget for FY25, India’s central government debt was ~Rs172trn as of 31^st March 2024. This is approximately 58% of GDP. 3% of this debt is held by foreign entities. However, using the standard IMF definition India’s Debt to GDP ratio is ~82%. Since most of this debt is INR-denominated and RBI is holding a strong US$650bn forex chest, servicing is not an issue.

However, as per FY24BE, interest expense would account for 25% of total government expenditure, after material cuts in subsidies. For a developing economy, this interest expense to government revenue expenditure is considered worrisome, as it hampers investments, keeps fiscal deficit high, makes interest rate cuts difficult, leads to lower social expenditure affecting the quality of life, and hampers further market borrowing capability of the government.

The small point is that investors in Indian securities should be more concerned about seemingly unsustainable public debt in India rather than the high debt levels of developed countries.

As a small investor with zero risk appetite, I keep a cushion for lower subsidies, late payments of government dues, higher effective taxes, small probability of higher rates in my investment strategy.

 Last week I started a discussion (see here) on how the human race might already be in the process of obliterating the memories of the devastating wars fought during the first half of the twentieth century. These wars not only changed the global political map but also deeply impacted international relations, human psychology, demography, technology, and global economics.

 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.

The tremendous economic growth achieved by Japan in the post-WWII era is popularly known as “The Japanese Economic Miracle”. It was in fact nothing less than a miracle – a country totally devastated by war rose from ashes to become one of the largest economies in the world. Japan recorded a high rate of economic growth during 1950-1975. The growth was primarily led by strong capital accumulation, strategic initiatives to expand trade share in global markets, concentration on technology development & innovation, and development of a strong high-quality ethical workforce.

Supported by benign monetary policy, easy credit, and profligate fiscal policies, by the end of the 1970s, Japan had become a powerhouse of technology and finance. The 1980s however witnessed unprecedented heating of the Japanese economy. Asset prices ballooned to unsustainable levels. The Bank of Japan, in its wisdom, decided not to tighten the monetary policy to control the surging asset prices. Low rates and a stronger JPY, led to a prolonged phase of low growth and low inflation. Worsening demography, due to a variety of reasons, further exacerbated the deflationary pressures in the economy. 1990-2020 witnessed Japan struggling with low inflation and low growth. The Global Financial Crisis and Covid-19 pandemic made things only worse.

The present state of the Japanese economy has become a generic reference for economies struggling with low growth, low inflation, low rates, and high debt for a prolonged period; and is referred to as “The Japanification of Economy” in the popular economic lexicon.

Post the Global Financial Crisis (GFC) in 2008-09, the fears of Japanification of several global economies increased. Unprecedented monetary easing in the wake of Covid-19 further enhanced the risk of a prolonged phase of low growth in several developed and developing countries.

In the past couple of years, we have witnessed a strong spike in inflationary pressures across the globe. Initially, it was believed that this episode of inflation is mostly a consequence of supply-chain issues, which broke down badly due to the pandemic; hence it would be transitory. However, later it emerged that it may be more structural than transitory.

The quantitative easing in the wake of the GFC did not cause consumer inflation, because money printed during 2009-2011 was mostly given to banks, which did not lend much of it to consumers. The velocity of money remained very poor; thus the actual money supply did not increase materially. But during Covid-19, a large chunk of new money flowed into the hands of consumers increasing demand at a time when supply was seriously constrained. High inflation was a natural consequence. Erratic weather conditions globally and a war between Russia and Ukraine (major suppliers of energy and food to Europe in particular) added further to the food and energy inflation.

In the past fifteen months, the central bankers globally have tightened the money supply and efforts have been made to add production capacities to meet incremental demand. It seems for now inflation has been controlled; though the inflationary expectations remain high as it is commonly believed that slower growth and financial crisis (that looks imminent) would force central bankers to open the liquidity taps again – sooner than later.

Nonetheless, for now, Japanification of the US and Europe has not happened as inflation remains high, rates have been hiked and recession has been avoided.

On the other hand, the conditions in China eerily resemble the conditions in Japan during the early 1990s. After two decades of massive growth led by huge investments in technology, infrastructure, and manufacturing capacities, the Chinese economy is feeling the fatigue. The population is aging and employment conditions are worsening. The growth rate is consistently declining. The real estate market is in a bubble-like situation, with several defaults and a huge inventory. China is the only major economy, besides Japan, that has not cut rates in the past decade. Inflation continues to remain low. The financial institutions are weakening and fiscal support to consumers and the financial system remains high.

The risk of the Japanification of the Chinese Economy is real and material. Considering that China has been a major driver of global growth in the past couple of decades, a Japanified China cannot be good news for the world as a whole. However, on the positive side, it may be an excellent opportunity for India that may get favorable conditions for growth – what Japan got in two decades post WWII and China got after its admission into WTO.

 The fourth letter of the English Alphabet “D” has held a prominent position in financial market jargon, at least since the Great Depression in the late 1920s. In the past two decades the terms like Dematerialization, Demographics, Depression, Decoupling, Demonetization, De-Dollarization, Digitalization, Deflation etc., have attracted immense interest from the market participants. Some of these “Ds” have had significant impact on the global economy; while the others have been mostly limited to being topics of interesting discussions and statistical analysis.

In the current Indian context specifically, I find three “Ds”, viz., Digitalization, Deflation and Demographics most relevant for the economy and therefore markets.

The current global situation – investment mix, geopolitics, global trade and gradual shift in strategic power – implies that supply shocks could be more frequent and much more intense in the next decade or so at least.

·         The unusual weather patterns are impacting farm output across the globe. Unseasonal rains, floods, extended periods of drought and heat waves etc. have negatively impacted the food production and livestock. As per a research study conducted in 2021 (see here), due to severity of drought and heatwave crop losses tripled over the last five decades in Europe alone. In India also similar trends have started to emerge in the past few years and are expected to strengthen in the next decade or so.

·         In the past few years, the geopolitical situations in the world have shown marked deterioration. The prolonged war in Ukraine has exposed the fault lines in the strategic power structure of the world that has been prevalent since the demise of the USSR. A drift between the US, China and Russia has never been more conspicuous in the past three decades. This drift has led to the rise in speculation over further intensification of the “deglobalization” trend that has shown some presence in the past one decade.

·         In the past two decades the investment mix in the global economy has shown a marked skew in favor of services, technology and climate change. Accordingly, the investment in augmenting the supply of conventional energy, metals and agriculture, while the demand for these has remained firm. Accordingly, the inflationary pressures have built up in the global economy.

It is widely accepted that digital technologies are bringing in enormous productivity gains; and therefore, is a powerful deflationary force in an otherwise inflationary environment. To quote, Satya Nadella, Microsoft CEO, “the next 10 years won't be like the last 10 years. Digital technology is a deflationary force in an inflationary economy. It is the only way to navigate the headwinds we are facing today”. He added, “This is the age of AI. Hybrid work is here to stay. 73% of workers want flexible remote options to stay. Every organization requires a digital fabric that includes People, Places and Processes.”

The aging demography in the developed world and China is another deflationary force that is countering the inflationary pressures. Even in India, it is likely that the population will peak and begin to age much earlier than previously estimated.

Thus, Digitalization, Deflation and Demographics could be listed as three major trends that will significantly influence the direction of the Indian economy and markets in the next many years.

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.

 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.

 The localized lockdown and mobility restrictions in past 6weeks have led to scaling down of FY22 GDP growth estimates. The new estimates mostly imply that Indian economy may record marginally negative growth during two period from April 2020 to March 2022. These estimates though assume (i) No community transmission of infections; (ii) no nationwide lockdown; (iii) no wider shutdown of industries and construction work; and (iv) normalization of mobility restriction in 2HFY22. Any further worsening of pandemic situation may lead to further downgrade of growth estimates resulting in spillover impact over FY23 as well.

The global rating agency S&P, recently published a note saying, “The possibility the government will impose more local lockdowns may thwart what was looking like a robust rebound in corporate profits, liquidity, funding access, government revenues, and banking system profitability.” The note further stated that agency is “looking at two scenarios, both entailing a cut in its GDP growth forecast for India:

·         In a moderate scenario, new infections peak in May 2021. If that happens, the hit to India’s GDP growth is estimated at 1.2 percentage points, indicating that India’s GDP is likely to grow 9.8% in FY22 compared with 11% growth estimated previously.

·         In a more severe scenario, new infections peak in late June 2021. In this case, the hit is estimated at 2.8 percentage points, with growth of 8.2%.”

As reported by Bloomberg, the scenario projections by S&P assume that initial shocks to private consumption and investment filter through to the rest of the economy. For instance, lower consumption will mean less hiring, lower wages, and a second hit to consumption, the note said. The severe scenario, which assumes hits to economic growth and infrastructure sector cash flows, presents more downside risks. Leverage remains elevate.

Incidentally, the current estimates appear to assuming a fast normalizing developed world, and hence buoyant export sector and capital flows.

IMF has projected US and China economies to move beyond their pre-Covid levels in 2021 itself, led by sharp rise in both consumption and investment. Even EU that bore the brunt of pandemic in 2020, is expected to reach near pre-covid level in 2021. This essentially implies rising global inflationary pressures creating possibilities for an earlier than currently forecasted monetary tightening. The capital flows to emerging market may there get impacted, if these forecast come true.

What no one is forecasting is a re-lapse of pandemic in the developed world. Rationally, it does not look likely, given the speed of vaccination, development of preventive ecosystem and treatment protocols. However given that the virus is mutating itself fast, assigning zero probability to this occurrence in economic forecasts may not be fully appropriate. God forbid, if this happens, Indian economy may decline rather precipitously.

The government had surprised the markets by maintaining strict fiscal discipline in Union Budget for FY22. So far we have not heard any relaxation in budget estimates of fiscal deficit. However, any worsening of conditions from here may require another dose of fiscal stimulus. It is pertinent to note that the fiscal stimulus last year was mostly focused on capacity building and easing liquidity. The present conditions require strong social sector spending program, which primarily aims at cash handouts. The recent setback to the ruling BJP in UP local body elections and West Bengal assembly elections; and continuing farmers’ agitation may motivate the government to consider material cash subsidies to poor and farmer ahead of critical state assembly elections in UP, Punjab, Odisha, Goa and Uttrkhand. All these elections are due in February/March 2022.

Insofar as stock market is concerned, the consensus appears to be leaning towards the strategy that the localized lockdowns may not hamper the industrial and construction sector like 2020, as the government has spared the manufacturing and infrastructure activities from lockdown restrictions. The consumption may however get impacted materially. Cyclical over Consumers appears the preferred trade as of now.

More on this next week.