Global Market Perspective | A Fisher Investments Blog

Unmasking Russian Corruption

Fascinating piece in Wednesday’s Wall Street Journal on the many hurdles to Russian political freedom:

Fraud Cases Tossed by Russia Judges

Richard Boudreaux, The Wall Street Journal

Russia’s future seemed somewhat promising after the Soviet Union’s fall, but thus far the economy hasn’t quite lived up to that potential. Over time, markets tend to fare best in free countries, where the rule of law prevails, elected officials are held accountable and resources are allocated most freely. Governments with more consolidated power tend to redirect capital toward the individuals, industries and institutions they need to placate in order to strengthen their grip—think special privileges, subsidies and the like. This is what we’ve witnessed under Vladimir Putin, and it prevents money from going where it would otherwise go to boost economic growth.

 More political freedom would likely bring freer markets, benefitting all Russians in the long run. Unfortunately though, based on how Russian courts are handling the hundreds of allegations of election fraud, it seems the country has a long, long way to go.

Scaling That £1.004 Trillion Mountain

British debt dominated headlines on Tuesday, when the Office for National Statistics announced the UK’s net public debt reached £1.004 trillion in December 2011—an all-time high.

In a vacuum, a £1.004 trillion sounds huge, and that sheer magnitude has some commentators questioning its implications for the British economy. However, without additional context, the debt load’s absolute size doesn’t mean much—a better perspective is scaling relative to the size of the economy as measured by Gross Domestic Product (GDP) and viewing that figure with an appropriate historical frame of reference.

The UK’s final 2011 GDP tally isn’t in yet, but according to The Guardian, the December debt total is around 64.2% of GDP. How does that compare with historical figures? Exhibit 1 plots the UK’s net public debt as a percentage of GDP from 1700 through 2010.

 

Exhibit 1: UK Net Public Debt as a Percentage of GDP, 1700 – 2010

 

Source: HM Treasury, UK publicspending.co.uk; as of March 2011.

 

Relative to GDP, British debt has increased over the past few years, but today’s levels remain far below historical highs—the UK has regularly had higher relative debt over the past three centuries without ill effect over time.

For example, think about the historical context of the big hump from 1750 to 1850—the British Empire was the global military and economic superpower, all the while maintaining relative debt two to nearly five times higher than today. The Industrial Revolution began in Britain during this period, only later spreading to continental Europe and America—countless manufacturing and other technical innovations emerged from Great Britain. And the UK has remained a major global player in the century and a half since.

In short, if Britain could prosper then while regularly exceeding three times today’s relative debt, the current level shouldn’t necessarily prove problematic over time.  It’s possible Britain may go on to struggle, but if so it won’t be singularly due to their debt.

One Down, Two to Go?

After weeks of debating with EU and IMF officials, Hungary finally took the first step toward reversing some of its controversial (and EU treaty-violating) new laws on Friday. Prime Minister Viktor Orban said he’d modify recent central bank reforms, dropping the provision that merged the bank with Hungary’s financial regulatory agency, PSZAF (which indirectly politicized the bank, since Orban would head PSZAF and effectively be central bank chief Andras Samara’s boss).

 A word of caution though: The change isn’t a done deal. Orban said the right things, but that doesn’t guarantee he follows through. Any changes to the law need to clear Hungary ’s parliament, and Orban only committed to “make proposals to this end.” Parliamentary procedure could scupper those proposals. In fact, one shouldn’t discount the possibility of Orban manipulating proceedings to that end behind the scenes, ultimately getting his way while being able to tell the European Commission he at least tried to do as they asked (and hopefully still get his bailout).

Additionally, the central bank law was only one of three measures in EU officials’ sights. Last week, the European Commission formally warned Hungary it has one month to amend last year’s media and judiciary reforms, otherwise it faces treaty infringement proceedings in the European Court of Justice. If ruled guilty, Hungary stands to lose EU voting rights and billions of euros in desperately needed aid. Ongoing bailout negotiations are also likely contingent on these changes if the EU participates. However, addressing the European Parliament on Wednesday, Orban said he doesn’t want even one euro from the EU—only a provisional credit line from the IMF, which thus far has only targeted the central bank reforms. So it seems Orban’s goal is to concede as little as possible.

Still, wait and see—despite Orban’s Strasbourg address, his delegates continue negotiating with both the EU and IMF, so more reform reversals are still possible. Orban will probably continue making every effort to avoid further changes, considering these measures consolidated his Fidesz party’s grip on power. He won’t surrender easily. But the EU and IMF could still force his hand, restoring some of Hungarians’ freedom in the process.

For more detail on the reforms in question, see my recent MarketMinder column, “Hungary’s Crossroads.”

Inflation Watch

British inflation receded a bit in December, slowing to a 4.2% annual rate thanks to falling fuel prices and the fading effects of the early 2011 value added tax (VAT) hike.

Exhibit 1 shows how each category of goods and services contributed to the overall rate. Falling fuel prices are evident in transport costs, which slowed the most. Slower increases in clothing demonstrate the higher VAT’s waning impact—some firms began increasing prices before the higher tax took effect, and these early hikes are now dropping from year-over-year comparisons. This phenomenon should increase over the next couple of months, as the VAT-related price hikes continue falling out of the annual rate, and the inflation rate will most likely continue declining over the period ahead.

This should be positive for the UK ’s economy. Slower inflation should help boost real disposable income (disposable income adjusted for inflation, which has been negative for several months), easing the strain on British consumers looking forward. It also gives the Bank of England additional flexibility as they consider future monetary policy moves.

 

Exhibit 1: December Inflation Detail

 

Source: Thomson Reuters, as of 17 January 2012.

(Figures may not sum due to rounding)

 

Indian Insight

Tom Bawden at The Independent has a good piece on India ’s latest attempt to attract foreign investors.

Indian Tiger Fights to Regain its Bite

You may recall India ’s government ran into controversy when it tried to open its retail markets to foreign firms. We’ll see whether these new efforts are any more successful…

 

Hungary’s Endangered Freedom

For most folks, New Year’s Day is a time of celebration and optimism. But in Hungary, January 1, 2012 is more foreboding: On that day, Hungary ’s new constitution took effect, and that document strips much of their society’s freedoms. Inside Budapest ’s opera house, the government celebrated its “crowning achievement.” Outside, tens of thousands of Hungarians protested.

Since Prime Minister Viktor Orban took power in 2010, he’s been on a mad drive to consolidate power. The new constitution brands one opposition party as a “criminal organization.” The judiciary, central bank and press have all been brought under his Fidesz party’s control—much to the consternation of the European Court of Justice, considering these measures violate the Lisbon Treaty.

Orban has also angered officials with his economic policies, which include taxes and regulatory changes aimed squarely at foreign firms operating in Hungary —also treaty violations, pending judgment in the European Court of Justice. Meanwhile, the country remains mired in a three-plus year financial crisis, its currency (the forint) is near record lows relative to most major currencies, and it can’t finance debt on the open market.

All this means Hungary needs its second bailout in three years, which could be an opening for a return to freedom. Negotiations with the EU and IMF are scheduled to resume in January, and officials have said Hungary must make hefty political and economic concessions if it wants their assistance. The media, central bank and justice system all appear to be in European officials’ sights.

The economic severity of Hungary ’s situation means the country likely needs external aid, but whether Orban makes concessions is far from certain. His party leans heavily toward fascism, and his regime has become increasingly authoritarian—and though he toes the EU party line abroad, his rhetoric at home is alarmingly nationalist. And a law passed on Friday, which gives the government power to levy special taxes to fund any fines imposed by the European Court of Justice, suggests he’s not averse to making his citizens pay for his undemocratic policies. This continued defiance perhaps opens the possibility Orban could shun the EU and IMF and turn instead toward Russia , where Vladimir Putin might be more tolerant of ascendant authoritarianism.

Hopefully, for the sake of the Hungarian people, Orban makes a New Year’s resolution to agree to the EU and IMF’s requests to reverse his undemocratic, economically misguided policies. This is one to watch in 2012.

Life Imitates Monty Python…

Perhaps this isn’t a perfect analogy, but the latest spat between France and Britain brings to mind this classic scene from Monty Python and the Holy Grail:

Frenchman: You don’t frighten us, English pig-dogs! Go and boil your bottoms, sons of a silly person! I blow my nose at you, so-called Ah-thoor Keeng, you and all your silly English Knnnnnniggits!

Sir Galahad: What a strange person.

King Arthur: Now, look here, my good man—

Frenchman: I don’t want to talk to you no more, you empty-headed animal food trough wiper! I fart in your general direction! Your mother was a hamster and your father smelt of elderberries!

Sir Galahad: Is there someone else up there we can talk to?

Frenchman: No, now go away or I shall taunt you a second time!

In case you haven’t been following too closely, here’s what’s happening. The US-based credit ratings agencies (Fitch, Moody’s, and Standard & Poor’s) have put France ’s credit rating on a negative watch, suggesting a downgrade may be forthcoming. France ’s government introduced a fresh €65 billion austerity package in early November, but thus far it doesn’t seem to have quieted rumors of a pending downgrade. Now, France seems to be trying to distract the ratings agencies a bit.

It started last Thursday, when Bank of France governor Christian Noyer told a French newspaper (see The Independent for a partial translation) a downgrade “doesn’t strike me as justified based on economic fundamentals. Otherwise, they should start by downgrading the UK , which has a bigger deficit, as much debt, more inflation, weaker growth and where bank lending is collapsing.” French Prime Minister François Fillon chimed in, “Our British friends have a higher deficit and debt, but it seems the ratings agencies have not yet noticed.”

David Cameron responded diplomatically, reminding folks his cabinet has spent 18 months tackling deficit reduction. He also pointed out that low yields on British sovereign debt demonstrate the market’s faith in Britain ’s ability to service its debt. (If risk of default were higher, one would expect yields to rise accordingly. British 10-year gilts yielded a very low 2.04% as of market close on 16 December.*)

Undeterred, France’s new finance minister, François Baroin, shot back: “The economic situation in the United Kingdom is very worrying. One would rather be French than British at the moment.” A private conversation between Monsieur Fillon and UK Deputy Prime Minister Nick Clegg followed, moving the debate behind the scenes.

Heated politics aside, the real story here is the strange methodology of ratings agencies. As Mr. Noyer pointed out, ratings agencies seldom base their assessments on economic fundamentals. Fisher Investments’ editorial staff has written at length about the rather odd methodologies behind ratings agencies’ assessments, and in short, we don’t see why anyone lends them much credence.

So, with that in mind, what might the ratings agencies be looking at in this case?

Cameron’s statement perhaps offers a hint. The UK’s deficit reduction plans seem largely on track thus far, and the deficit narrowed more than forecast (thanks to higher revenues) in November. France has announced credible deficit reduction measures, but they’re not quite as far in the process. The UK also has the benefit of not using the euro—France, by contrast, is saddled with the perceived risk associated with being in the eurozone. France’s banks also have more exposure to peripheral Europe’s sovereign debt, raising the specter of state-funded bank recapitalizations (which could hinder France’s austerity efforts).

And then, there’s future growth prospects. Both countries have witnessed slow GDP growth this year. But looking longer term, Britain’s economy has some competitive advantages. The Heritage Foundation ranks Britain 16^th in the world in its 2011 Index of Economic Freedom. Business regulations are largely transparent, efficient and streamlined, according to the Heritage Foundation’s report, and labor markets are flexible. Britain also plays a major role in the global economy—London is one of the top-three global financial centers (with New York and Hong Kong), and the UK’s international trade totaled £906.5 billion in 2010.**

France’s economy, on the other hand, is somewhat less liberalized, though Sarkozy has introduced some measures to change this during his presidency. Several utilities remain state-owned, its agriculture is quite subsidized (largely by EU neighbors) and its labor market is heavily regulated. The Heritage Foundation ranks it 64^th in the world in its 2011 Index of Economic Freedom, citing the knock-on effects of a “rigid labor code.”  Certainly, as the eurozone’s second-largest economy, France is a major player and has plenty of economic prowess—its international trade in 2010 totaled £700 billion.*** But there are opportunities for further structural improvements.

So why might this factor into the ratings agencies’ assessments? Higher economic growth can make it easier for nations to service their debt over the years—higher GDP can lead to increased state revenues, which can make interest payments less expensive relative to revenues. Lower growth can make that a bit more difficult. Hence why Moody’s warned this week that slower economic growth in 2012 could impede Britain’s deficit reduction progress, though it affirmed its top credit rating is stable for now.

Again though, the takeaway here isn’t that one nation’s any stronger than the other or one side any more right, but that ratings agencies’ assessments should be taken with a healthy dose of cynicism. Both nations seem plenty capable of servicing their debt.

*Source: Bloomberg

**Source: Office for National Statistics

***Source: National Institute of Statistics and Economic Studies

 

Not-so-New Two-Speed Europe

Setting aside the British political debate over David Cameron’s decision to veto a Lisbon Treaty change at last week’s EU summit, here are some thoughts on the idea of a “two-speed Europe .”

Recent quotes by Nicolas Sarkozy and other continental leaders suggest Cameron created a two-speed Europe by opting the UK out of the new agreement on tougher budget oversight. However, if one defines a two-speed Europe as an EU where Britain opts out of some broad agreements, then a two-speed Europe has existed for decades. Cameron’s veto is just the latest instance of the UK not adopting an otherwise EU-wide measure. Here’s a brief historical recap:

 

·         In 1984, Margaret Thatcher negotiated a partial rebate of farm subsidies paid by the UK to continental Europe . The so-called “Thatcher rebate” is still in force.

·         Britain and Ireland are exempt from the Shengen agreement, which governs cross-border travel. The Shengen Agreement was first signed in 1985 and was later folded into the Amsterdam Treaty. Britain still maintains its own entry policies.

·         The UK doesn’t fully participate in the area of freedom, security and justice.

·         Britain did not adopt the Lisbon Treaty’s Charter of Fundamental Rights.

·         As we all know, the UK officially declined to adopt the euro during Maastricht Treaty negotiations, so neither that treaty’s “conditions for convergence” nor the Stability and Growth Pact apply to Britain . This is key, considering the budget pact agreed by the remaining 26 EU states is, essentially, a dressed up version of the Stability and Growth Pact.

Perhaps the divide between Britain and the continent seems wider because the stakes appeared so much higher this time around. But if you put Cameron’s decision in historical perspective, it seems to be more of the same.

For a longer take on this topic, check out my new column on MarketMinder.com, “In Defense of Britain.”

Britain’s Industrial Evolution

The Guardian has an interesting take on David Cameron’s mission to “fight for British interests,” as he put it, at last week’s EU summit. In most of his comments on this subject, the Prime Minister has said he’s focused on preventing European officials from implementing measures that would harm the City of London’s global competitiveness (such as the financial transactions tax). The Guardian suggests he take a different approach and devote “some tender loving care to British manufacturers,” citing Britain ’s proud manufacturing history and industry’s falling share of domestic output. In short, it argues, “British industry has been hollowed out.”

This view is also common in the US , which, like Britain , has evolved from a manufacturing-driven to service-based economy over the past several decades. In both nations, the manufacturing sector comprises roughly 22% of GDP (according to the CIA World Factbook). But that doesn’t mean British industry is dying; rather, it means the UK ’s economy is evolving normally. Throughout history, economic development has followed this pattern: agrarian to industrial to service-based (perhaps, in the future, we’ll see more phases, like intergalactic-commerce-based). Britain ’s at the far end of that progression (notice the absence of voices decrying that agriculture is only around 1% of total output). France , Japan , Australia and the aggregate Eurozone also have similarly portioned economies.

By contrast, many countries whose manufacturing sectors comprise a larger share of GDP are less developed and, in many cases, less economically diverse. These nations include Russia (36.8%), China (46.9%), Thailand (44.7%) and North Korea (47.8%). No one in their right mind would argue North Korea ’s economy is anywhere near as strong as the UK ’s. Developed Norway also has a relatively larger manufacturing sector at 40% of GDP, but its entire economy is less than one-fifth the size of Britain ’s. Lesson: percentage weightings alone don’t tell the whole story.

Here’s another way to look at this: According to IMF data, Britain ’s industrial output was approximately $490 billion. That makes it the eighth-largest single-country manufacturer in the world—well ahead of Taiwan , South Korea and Indonesia , which have reputations as strong manufacturers. Britain ’s industrial output is also larger than the entire economies of Poland , Belgium , Sweden , Austria and many others (if British manufacturing were a country, it’d be the world’s 20^th-biggest, which isn’t too shabby).

With these data in mind, it seems a stretch to argue British industry is dying. Its growth rate has fluctuated in sympathy with the recent recession and economic slowness, but when you take a broader, more measured view, it seems clear manufacturing is far healthier than some presume. (And a financial transactions tax won’t make it any healthier, but that’s a discussion for another time.)

 

India’s Retail Fakeout

Poor India has had a terrible time attracting foreign investment in recent years. Of the four BRIC nations ( Brazil , Russia , India and China ), it’s the only one whose foreign capital inflows fell in 2010, and the drop-off has continued this year.

Domestic economic reforms could change this, making India a more attractive destination for foreign capital. Prime Minister Manmohan Singh tried to move in this direction in late November, when he announced his cabinet’s decision to open India ’s borders to foreign retailers. Under the proposed new rules, foreign-owned hypermarkets, grocery stores and single-brand retailers would be allowed to open in India , provided participating firms invested at least $100 million, with at least $50 million going to infrastructure, transport and storage.

This could have carried huge benefits for Indian society over time. India has long struggled with high malnourishment due to its aging food storage and transportation infrastructure. Its agricultural sector is vast, but much of the harvest rots before it can reach households, causing supply shortages and higher prices. The government believes the influx of foreign investment could spur massive upgrades in agricultural productivity and efficiency, eventually putting cheaper food on people’s plates.

Unfortunately, this proved too tough a sell for the Indian public. Small business owners staged a national protest last week, and the opposition parties have forced Parliament to adjourn since the Prime Minister’s announcement (the new rules required only cabinet, not parliamentary approval). Why was it so unpopular? Small shops are the lifeblood of Indian retail, comprising around 90% of the $450 to $500 billion sector. It’s estimated there’s one shop for every 10 people. Naturally, these merchants fear they’ll be chased out of business by giant foreign superstores, and opposition lawmakers are rallying to their defense.

The government held its ground for over a week, but it has now bowed to political pressure, as a government official said the plans were on hold—no doubt a disappointment to the retailers that already lined up to enter. Whether the about-face is temporary or permanent is uncertain—the government understands the benefits of these reforms and wants to move forward, but if the political costs are too high, the changes may get stuck in limbo. Pushing the reforms through would likely use most or all of the government’s political capital, but backing off permanently could erode confidence in the cabinet’s ability to govern. We’ll be watching to see how this plays out.