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What happened?

Cyclical Issues:
Like other financial markets, currencies follow observable cycles. From the time of Bear Stearns collapse in March 2008 until April 2009, market stresses were so great that investors moved in dollars en masse, increasing its value by 23% compared to the basket of the developed countries.

By the second quarter of 2009, panic subsided and investor’s willingness to take risk increased. In order to redeploy the capital they had stashed in dollars for safekeeping, investors sold dollars (pushing down the price) to buy other currencies they could use for bond and stock purchases in emerging markets.

Over longer periods, the cycle that often derives currency movements are based on the differences in government interest rates. With US interest rates forecasted to stay low for long, many investors prefer higher yielding opportunities abroad. Exacerbating this trend is what is known as the carry trade, where investors borrow US and sell (short) it to buy (long) higher yielding currencies like Australian Dollar. As other countries begin the cycle of interest-rate increases and the Fed keeps rate low, more pressure will naturally fall on the dollar.

Structural Issues:
Budget deficits (difference between outlays and receipts) reached $1.4 trillion in 2009, three times 2008 deficit (the prior record). Projections by the Congressional Budget Office (CBO) and White House Office of Management and Budget (OMB) are for deficits over the next 10 years to total $7 trillion. This is before any unforeseen increase in spending and health care legislation that threatens to officially add $1 trillion to the tally. (If cost inflation seen in prior new programs like Medicare Part D is any indication, $2 trillion over time is a real possibility.)

The total outstanding gross debt of the US is about $12 trillion and is project to grow 6% per year to $22 trillion in 10 years. This is in excess of the forecast for nominal growth in the economy. Such a trend is totally unsustainable.

Current entitlement programs, as currently constituted, are heading for insolvency over the next 10-25 years. According to the 2009 trustee report, the present value today of what the government owes for Social Security and Medicare is $46 trillion. According to CBO estimates, federal spending on Medicare and Medicaid will grow from 5.3% of GDP in 2009 to 9.7% in 2035. To illustrate the issue another way, Social Security, Medicare and Medicaid received 43% of fiscal 2008 federal budget outlays.

Available Options to fix structural issues (Read the last one to understand how structural issues tie out to dollar weakness):

- Reduce spending to pare the deficits. Legislation that requires increase in spending should be made pay-as-you-go i.e. all increase in spending or tax cuts should be offset by savings elsewhere in the budget. Can politicians do it?
- Increase government receipts. Sadly, economy is not going to boom as it did during 1996-2000 and one can’t count on increase in income to increase government receipts. Instead, tax increases are the most likely way to increase receipts. Can politicians do it?
- Given the size of the entitlement programs, some changes in qualifications and benefits are inevitable. The retirement age for Social Security has already been increased and probably needs to be raised again along with changes to the benefits formula. Can politicians do it?
- The last option may be the one most palatable to Congress because it doesn’t involve hard decisions like cutting spending or raising taxes that could endanger re-election. This most dangerous option is to reduce the external (outside the country) value of dollar and repay the future obligations with much less valuable dollars. Such behavior comes with strong inflationary consequences.

Conclusion (Dollar deprecation is a train wreck in slow motion):
According to International Monetary Fund (IMF) data, 63% of central bank reserve holdings are dollars and the U.S. currency is the reference (on one side) on 86% of all foreign exchange transactions. It will take many years to replace the dollar as the world’s reserve currency. The total reserve holdings of central banks is currently 63% dollars, 27% euros and the remainder in sterling and yen. In 1999, dollar accounted for 72% of reserves. The process of diversification has been underway for the last decade. The momentum will only increase in pace over the next few years.

The most likely means for market forces to exert influence on government spending will be through higher interest rates. At some point, buyers of Treasury debt will begin to demand higher yields to justify purchases.

Back in 2004, the international markets began to trend down in the midst of wild fluctuations, as the exuberant economic expectations that had built up during the upswing of 2003 gave way to disappointment. The global economy was then rescued in late 2004 by the US consumer, whose deficit spending was encouraged by the bubble forming in the American real estate market.

Given the high volumes of liquidity still circulating, Q12010 could bring additional price gains for stocks and commodities, investment categories that are highly sensitive to the economy.

A comparable period in modern times is Japan where the economy lost 3 times the value of its GDP as asset values deflated, while the US only lost one times GDP.

Capacity utilization rates are extremely low in US. In most industries, they are running between 70% and 75%. Companies do not have any pricing power.

Labor market has a lot of slack. U6 (the broadest measure of US unemployment) is more than 16%. The state unemployment rate at 10% is expected to stay elevated for a very long time.

Consumption has remarkably stayed above 70% of GDP, but the fear is that the consumers can’t continue to spend unless the government continues to write the check.

Nonresidential construction should have come back under the stimulus program, but it didn’t. The government budgeted $787 billion, inclusing $40 billion for infrastructure, and yet very little of it has been spent.

How the GDP growth will look better:
In the current recession, inventories fell to about 9% of GDP. Government is spending around $400 billion. Government spending and replenishing inventories will increase GDP.

Going Forward:
In the next 5 or 10 years, US economy is facing three massive problems: Social Security, Health Care Spending and Interest on Government debt.

US Budget deficit is running at 10% to 11% of GDP. Government can’t cut taxes in the face of high deficit. In 10 years or so, the interest payment on Government debt will go upto 20% of GDP. This will result in massive tax increases to service the debt payment.

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Iron-ore industry is dominated by Vale SA of Brazil (33% market share), Rio Tinto of Australia (19% market share) and BHP Billiton of Australia (17% market share).

China wants to keep a lid on iron-ore prices and China Iron and Steel Association (CISA) doesn’t mind influencing price negotiations on account of being the largest buyer of Iron-Ore. For decades the annual price-setting negotiations between the big suppliers and leading steelmakers had been dull affairs: price rose only gradually. But China’s sudden emergence as a big buyer of iron ore (it now snaps up more than half of all exports) pushed prices up fourfold between 2002 and 2008.

Recently, Rio Tinto and BHP Billiton agreed to combine their Australian operation which is vehemently being opposed by CISA. By combining operations, the two companies would leapfrog to the top spot and have a tougher say in price negotiations.

Separately, Vale SA is moving to deepen its cooperation with China’s steelmakers by building huge shipping berths and iron-ore distribution centers that would reduce the cost of shipping ore to China, undermining the current advantage enjoyed by the Australian miners.

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Currently, only 5% of the India’s retail market is organized. Government reforms in India are opening up the market to foreign investors. US’s Wal-Mart (with Bharti Enterprises), France’s Carrefour and UK’s Marks and Spencer(M&S) (with Reliance Industries), UK’s Tesco (with Tata group) are making inroads.

Challenges:
International retailers have to keep their prices low while maintain the quality. For example, M&S relied on European products, which carry import duties of 40% which proved too much for the Indian middle class. M&S is now trying to source in products locally.

The end-product needs to be customized for the local taste. For example, M&S’s range of men’s polo shirts come in 16 colors, compared with the UK’s four, and linen shirts come in 12 colors, as opposed to the UK’s six.

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Bull Case:

• In the previous bubble in 06-07, Price-to-Earnings got up to 70. Ratio stands at around 25 this time. It is high compared to the developed markets but well below China’s long-term average of 37.
• China’s faster trend pace growth also means that the outlook for corporate profit is rosier than elsewhere.
• House prices are rising nowhere near as fast as they did during the previous boom in 2004-07. And in relation to income, average house prices in China have fallen or increased little over the past decade. High level of prices relative to income is partly explained by hidden subsidies as a high proportion of households live in apartments purchased at a fraction of their value a decade ago when housing market was privatized.
• Overinvestment may not be as big a threat as it is perceived. One yardstick of the efficiency of capital is the incremental capital-output ratio (ICOR) – the investment needed to generate an additional unit of output (i.e. annual investment divided by the annual increase in GDP). The higher the ICOR, the less efficient the investment. China’s ICOR has been fairly stable over the past decade.
• Three-fifths of the state directed stimulus investment has gone into infrastructure projects. Some of the money will be wasted for sure but the new infrastructure will help improve productivity in the long run.

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Nakheel, a prominent developer in Dubai is owned by Dubai World which in turn is owned by the Dubai government.
Nakheel had issued sukuk or islamic bond to finance its operations.
Duabi’s commercial property bust was well evident from falling property prices, empty buildings and suspended construction projects.
Dubail World announced on Novemebr 25th that it is asking for a standstill on the $4.06 Bn payment due to holders of sukuk bond issued by Nkaheel.
Dubai world also announced its intention to restructure $26 billion in debt in total.
According to Moody’s, total liabililities of Dubai government exceeds $100 billion.
Total debt also includes $15 billion that Abu Dhabi lent to Dubai earleir this year.
Abu Dhabi steppend in at the very last moment on December 14th to repay the $4.1 billion due the same day to holders of sukuk. These bonds had traded as low as 40 cents on the dollar.
Dubai and Abu Dhabi are the biggest and richest of the seven emirates that make up UAE.
Abu Dhabi is one of the world’s largest oil producer and it provides bulk of the UAE funding. It is blessed with 90% of UAE oil.
The hereditary ruler of Abu Dhabi serves as the UAE president while Dubai’s ruler serves as the deputy president and prime minister.

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India’s central government owns 246 enterprises. These companies employed 1.6 million people and accounted for 8.3% of India’s GDP.
More than 40 state owned companies are listed on the market.
Government is facing a 7% budget deficit and it plans to bridge the gap by selling stake in public enterprises.