One of the intrinsic theories is the ‘labor theory of value’. The value of a good is based upon the labor cost of producing it.  On the contrary, the subjective theory defines value as a perceived utility measure by the buyer. This buyer will trade either money or do a Barter trade for the good because he thinks that the offering from him is less in value as compared to the purchase, or else he will not go into the trade. Same is the case for the seller. Thus, as far as individual subjective valuations of personal wealth are concerned, both traders feel they have increased their wealth. Hence, the most important determinant of value is the perceived judgment in eye of the trader for a particular good or service. A strong perception is very much capable to drive price of the product to unprecedented levels beyond any rational explanation. A prime example of this is the ‘Tulip mania’ in the 17^th century where the price of tulip bulbs reached extraordinarily high levels and then suddenly collapsed. At a point, the price of a single tulip bulb was as much as 10 times the annual income of the craftsman. Another good example would be the inflated prices of premier paintings by renowned artists such as Michelangelo, since the painting is perceived to be a unique body of work. Marketing gurus thrive on Branding to maximize sales and command premium price for their product. This massively refutes the intrinsic labor value theory since the level of price achieved is solely due to the perceived value. In economics, the most basic and perhaps the strongest determinant of price is demand and supply. Demand arises out of the need to consume. As the discrepancy between demand and supply widens, the price increases. Since the product available is scarce as compared to the demand, the perceived value for the product increases. In case of mutually exclusive products, the one with the highest perceived value will prevail, irrespective of the intrinsic value. This war between the perceived and the intrinsic value is a very good explanation of irrational behavior of traders in stock markets and asset bubbles.

The US presently stands at record public debt of over $15 trillion. Engulfed with financial crises, confidence crises, high unemployment levels, deteriorating industrial prowess and economic uncertainty, experts question the future of the numero uno status of the US and its currency- the greenback. Applying the intrinsic value theory, the fundamentals seem doomed for Uncle Sam and not much value could be recorded. Now let us take the empirically proven and widely accepted subjective valuation theory. The US dollar is the international reserve currency accepted anywhere and everywhere on the planet, even the North and South poles. Commodities (Oil, gold) traded around the world between countries are priced in US dollars. General trades between countries also are settled in the greenback. Hence, governments, corporates in international trade, even individuals travelling abroad for leisure, business, etc need the dollar. As a result, the demand for the dollar is one which is prevalent, despite all the problems encountered by the US in the last 5 years. Although unrivalled, the dollar has the Euro as its closest counterpart. The US dollar appreciated during the financial crises as investors sought safe haven and parked their money with US treasury due to the widespread perception of being the safest place on planet Earth. It lost value when creditor nations like China and Japan were worried about US fundamentals and its humungous debt. From 2008 to 2010, the value of Euros held in foreign government reserves increased from $393 billion to $1.35 trillion, a 240% increase. During this same time period, dollar holdings only increased 11%, from $2.77 to $3.1 trillion. Dollar holdings only represent 61% of total measurable reserves, down from 2008, when dollars comprised 67% of reserves. Since the percentage of dollars is slowly declining, this means that foreign governments are slowly moving their currency reserves out of dollars. Some OPEC countries had also considered to trade their Oil in Euros. However, due to the recent Euro crises and some other interesting reasons and actions, the efforts went down the drain to knock the greenback of its perch. Also, after the Euro, there is no other alternative that can be termed as a potential successor for the US dollar.

A similar fate is being observed in Gold prices in the last decade. The perceived value of the US dollar is still high due to the reasons discussed above. Relatively less financial risk and lack of alternatives will ensure the strength of this premier currency. A general thought- ‘The fundamentals of a country determine the value of its currency’. However, in this case, the strength and perceived value of the dollar is more important to the not so robust American economy. Occasionally, fundamentals (Real value) become the better off perceived value. This rare occurrence is what economists call- ‘exploding of the asset bubble’.

Vishal Agarwal

The G7 government borrowing for 2012 amounts close to $8 trillion. Japan, an economy with a humungous debt to GDP figure of more than 200%, unveiled its largest bond issuance plan ever (149 trillion Yen) for 2012. And then there is Uncle Sam (United States) who just doesn’t want to listen about its possibility of being on course following Greece in the future, with the latest US deficit for last year again crossing the $1 trillion mark. It seems like the bureaucrats in the White House have only one priority at this point in time- raising the already so very high ‘Debt-ceiling’. Definitely grave but not strange, since we approach the Presidential elections there. On a very similar point, our (India) very own borrowing target for the year already crossed 90% of the planned figure in December 2011, and is expected to overshoot it by a mile or two. Sure, even we got elections coupled with the dire need of the coalition to restore its image after a bunch of corruption scandals. European countries face a daunting task in rolling over their debt at record high yields.  A Bloomberg survey indicates that borrowing costs for G7 countries will rise 39% from 2011. This increase is almost equivalent to the increase in borrowing for an average Indian citizen since RBI started increasing the repo rate in the last couple of years. The effect of such a dramatic increase on the economy is slowing Indian GDP growth, massive fall in investments and higher costs for corporations meaning margins and price pressure.

With all economies that matter in a huge burden of debt, one would argue that who pays. Major buyers of government debt range from institutional investors like pension funds, hedged funds and insurance companies, banks and financial institutions and foreign governments. The need to borrow money arises when the total revenue of the government in the form of taxes and duties are not sufficient to fund their public spending. Year on year, governments have been practicing this same phenomena and have kept on borrowing to fund their budget. Without the need to address growth, cut down the deficit and implement ways to increase government revenue, many nations in world today have a huge pile of debt in their books. Clearly, at a time of economic turmoil when the investors’ confidence is low and doubts creep about sovereign defaults after witnessing the Greece example, the risk to lend money to the governments have clearly escalated. Hence, owing to one of the prime economic theories, people demand higher rate of return on their investment if they see greater risk. The recent spike in yields of Euro zone countries namely Greece, Portugal, Italy and Spain is the example of such an episode. With governments borrowing billions and trillions of dollars every year, the rapid rise in yields witnessed in the last 6 months will have a grave effect on the individual and collective actions of the majors in the world economy to encourage growth, sustain a sturdy recovery and get their finances in line. To add to woes, the very banks that play a crucial role in the sovereign debt financing are themselves most vulnerable to shocks and are facing issues like higher cost of new regulations, large toxic asset book, liquidity crunch and falling revenues. However, the first problem that needs to be addressed by these private powerhouses is about their $1 trillion debt maturing in 2012. (Yes, pinch yourself in case you feel you are in the midst of a dream, because this one is for real!!) This is totally a different figure from the trillions which were mentioned in the earlier part, the government debt. Another addition to this would be the amount of capital that will be needed by banks to meet the new increased capital regulations in Basel 3. The Eurozone bank stress test conducted in December 2011 shows that 53 banks failed the test and to reach the target of 8% core Tier 1 Capital, the total additional capital needed to be raised by all banks in the sample amounts to 102 billion Euros. With liquidity crises and confidence shortage, the ECB with its recent LTRO funding of close to 500 billion Euros helped ease off the pressure on banks and yields on European sovereign bonds. The 2^nd version is to be held on 29^th of February with expectations about the magnitude ranging from 200 billion to almost a trillion Euros. However, this is just a temporary respite and does nothing to alter the direction of the 2 year long sovereign debt crises. It like a terminal cancer patient living on Homeopathy and life support, waiting for either a miracle or just watching the clock. A tweet from the PIMCO bond king Bill Gross said it all: “What does the LTRO stand for? 1- A shell game, 2-Cash for trash, 3 Three-card Monti, or 4. All of the above.”

Total redemptions as a percentage of total debt for G7 countries are 21%  ($7.6 trillion) in 2012, 35% for 2012 and 44% for 2014. A sovereign debt phenomenon is very close to a Ponzi scheme. New money raised is used to quash old liabilities without any ‘real growth’ or efforts to become self-reliant and the cycle goes on. The only time you encounter a problem or a danger to your Ponzi scheme is when it becomes increasingly difficult to raise new and cheap money. Unfortunately, or rather fortunately for the long term sake of it, we are in the midst of such a crises.  With increasing debt maturing over the course of coming 3 years multiplied by rising (already massive) deficits, the refinancing risk is at its perch. A natural reaction to this would be further spike in the interest rates, leading to a further increase in interest expenses which in turn would further increase borrowing needs. In troubled times where we see a global crunch, money printing seems as an easy and lucrative option, as it were the case in US, UK and Europe. However, it sure has its own perils in the longer term. The current situation requires some serious and prudent, innovative but sound reforms and actions to address the humungous problem the world economy faces at this hour. Such continued irresponsible borrowing and reckless spending without growth might well perhaps trigger an event as unprecedented in magnitude, like the Great Depression of the 1929.

Market really rallied upon the CRR cut announced by RBI in its January Monetary Policy. This will infuse almost 32,000 crores back in the banking system & ease some liquity pressure. This is been perceived as reversal of long continuing monetary tigtening policy. Though, the key rates like repo and reverse repo were left unchanged intentionally. RBI was seen satified on the moderating WPI inflation on expected trajectory but also sounded cautious on unequal moderation in different WPI components. It highlighted the risk to moderation from global crude prices, rupee depreciation, slippage in fical deficit. So currently, RBI wants to observe how the headline WPI pans out in the coming months before it touches the repo & reverse repo rate.

But while cheering the possible beginning of interest rate cycle reveral, the market has overlooked RBI’s cautious statement on decelerating GDP growth & deteriorating investment climate. The degrowth is cited to be effect of several factors like the uncertain global environment, the cumulative impact of past monetary policy tightening and domestic policy uncertainties. Accordingly, the baseline projection of GDP growth for this year is revised downwards from 7.6 per cent to 7.0 per cent. Yesterday’s policy action is expected to mitigate some of these downside risks to the economic growth.

So its too early to cheer or boast about any sustainable bullish trend. Recent drop in WPI is largely  sharp deceleration in prices of seasonal food items. In respect of other key components, particularly protein-based food items and non-food manufactured products, inflation remains high. Moreover, there are upside risks to inflation from global crude oil prices, the lingering impact of rupee depreciation, and slippage in the fiscal deficit. So if these risk factors materialise keeping headline inflation up or worsen due to poor winter or summer crops or shoots up due to rise in oil price after sealing of Strait of Hormuz by Iran or least inflation not falling along the RBI’s projected trajectile, we could see deferrement in rate deduction and deferrent in interest rate cycle reversal. These would in all put further pressure on growth momentum writing off the any chances of recovery rally in equity market.

So unless we see a resilience in GDP growth, my stance would be being cautiously optimistic. Infact, I would encourge investors to take the opportunity of risen interest rates and build their long term fixed income (debt) portfolio before the interest rate subsides. Don’t just get carried away with the equity market emotions on other side.

By Amit Kadam

Background: To overcome from the financial crisis of 2008 and bring quick recovery in the economy, governments of many countries had initiated several stimulus dosages in form of cash subsidy, cash infusion, equity bail out, reducing borrowing rates, lowering tax rates etc. Idea was to boost confidence and drive consumption. This was mainly funded by printing money or/and public borrowing programme. Already some of these countries were high on Debt to GDP ratio and the stimulus packages made it still higher. The assumption was – as the economies starts recovering consumption would drive production and thereby increasing the GDP of their nation. GDP would be then sufficient enough to service the increased debt. Textbook Economics!

What went wrong: The assumption went wrong and the plan misfired for few countries. As some European countries never recovered & their GDP failed to rise, they started filling short of funds to service their debt obligation. To service their earlier debt they raised new debt and then some more. The debt balloon expanded out of proportion w.r.t GDP.

Effects: Credit rating agencies became skeptical about the rising debt scenario and capability of these sovereign states to service their debts. As repayment guarantee came under question, rating agencies started downgrading bonds of these countries. E.g. Greece bonds were downgraded to ‘D’ (Default Category – junk bond). Greek Prime Minister Georges Papandreou asked the International Monetary Fund and the EU to put together a rescue package. The European Central Bank moved to shore up Greece, and the E.U. and IMF settled upon a $145 billion bailout, conditioned on Greece adopting austerity measures worth a staggering 13 percent of GDP. The E.U. also created the European Financial Stability Facility, a body intended to streamline future country bailouts. Other countries which carry similar threat of default are Portugal, Ireland, Italy, Greece & Spain. (PIIGS)

What it means for the euro zone: Many experts argue that the E.U.’s model, which concentrated monetary policy in the European Central Bank (ECB) while leaving fiscal policy to individual member states, is inherently unsustainable, as it denies member states monetary policy levers with which to help their recoveries. This also makes deficit-funded fiscal stimulus harder, as monetary policy can be used to keep borrowing costs low. When different countries are hit differently by a recession, as has happened now, the common monetary authority will act in ways that help some countries but not others. The ECB has pursued tight monetary policy that may prevent inflation in high-growth states like Germany but could also be worsening the recession in Greece, Spain, and other struggling states.

Most view one of two options going forward as likely. One is that the euro zone will lose members like Greece, Spain and Italy, either by them just leaving or by a default by any one of them, which could unravel the whole monetary union. Barry Eichengreen, a Berkeley economist, has said this would lead to a huge bank run and the “mother of all financial crises.” Another option is closer European fiscal union, so that fiscal policy can be coordinated at the continent level as well as monetary policy, bringing the E.U. closer to being a sovereign state.

What it means for India: Indian economy has lot to do how world economy does as US and Europe are our major trade partner. U.S. financial institutions hold considerable European financial assets that could plummet in value if the euro zone enters a full-on crisis. For example, European debt makes up almost half of all money-market fund holdings. Direct exposure to the so-called PIIGS countries profiled above is limited, but exposure to France and Germany is high, and given, for example, France’s tight linkages with the Italian financial system, a Italian default could roil France and the U.S. in turn. The crisis is also leading to heavy spending cuts and reduced borrowing that hurts our exports to Europe & US, further endangering the Indian recovery.