Friday, 4 November, 2011

Interconnected Nature of the Euro Debt Crisis

Interconnected Nature of the Euro Debt Crisis

Take a look at this pictorial representation:

I'm more concerned about the implications for India.

People, especially politicians, tend to claim that the crisis will be resolved "somehow". I certainly don't believe that's likely.

Let me explain with a simple hypothetical micro example of an indebted individual software engineer from Bangalore with 2-3 credit cards which have maxed out, with "a few months salary" worth of costly personal loans, EMIs due for his home loan and car loan, a home-maker wife and a 12-year old kid. The scenario, while undesirable, is not too uncommon.

Typically, his reactions would be along the following lines:

  • Seek further debt from friends and banks to overcome his financial mess
    • Implies greater debt
    • At a higher cost
    • Getting deeper into the financial trouble that he's created for himself
  • Put on a show of being problem-free or underplay the problem with his immediate family, close relatives and employer till the problem balloons to a size that he considers to be unmanageable.
    • Implies maintaining the same life-style, with the usual round of dining out, weekend movies, occasional parties, etc.
    • Will again result in greater debt and the other consequences mentioned above
  • Hide the problem temporarily from his immediate family & employer, who are perhaps most likely to come up with any meaningful suggestions to come out of the problem
  • Pay up the guys who create the maximum trouble and delay, default and run away from the rest
  • Try to restructure his debts with various organisations

All the above steps will ensure that

  • His performance at his workplace will suffer
  • He will be irritable at home.
  • This will create a situation where the probability of any increments, promotions etc. will reduce and the probability of being "eased out" in case of a recession will increase.
  • Different lenders will talk in different voices and come up with different suggestions, depending on their own self-interest.
  • While he keeps trying to come out of his troubles, the Debt Meter will keep ticking, and the magnitude of the problem will keep multiplying exponentially.

In a nutshell, his financial problems will NOT disappear easily.

Now take a look at the New York Times picture again:

You can guess the magnitude of the European mess by multiplying our typical indebted software engineer's problem by a factor of a few million ordinary individuals in different European countries.

Coming back to the Euro Mess, here is my own basket of predictions:

When the shit hits the roof, as it inevitably must, all hell will break loose. I'm not sure about the timing, but the default of a few European nations and possibly several large banks on both sides of the Atlantic looks increasingly certain.

Some likely consequences would include:

  • Countries and Banks across the world will become very wary about lending to anyone else.
  • Cost of credit FOR ALL will shoot up
  • Global growth rates will tumble, perhaps resulting in a global recession
  • NPAs (Non-performing assets) for banks will increase rapidly
  • Individual consumer confidence will take a mighty beating
  • All individuals across the globe will try to "save more, spend less", resulting in even greater reduction in GDP growth rates, possibly hastening the recession.
  • Many businesses will go bankrupt
  • All business will suffer a reduction in profits
  • Many jobs will be lost across the world, including in India. (However, the impact on India would be less due to the fact that we are far more dependent on the domestic market vis-a-vis many other nations like China, Russia, etc.)
  • There will be utter chaos in the commodity markets, with very wild fluctuations in the prices of key commodities ranging from Crude Oil to Metals to Agri-commodities.
  • The inflation problem will continue to remain a major head-ache.
  • Fund flows will shift away from risky assets towards havens of perceived safety like US treasuries, Gold, Silver, Government Bonds of countries thought to be safe, etc.
  • Share markets will show huge volatility, with a strong and definite downward bias. We'll see very sharp earning downgrades globally, resulting in a significant bear market. However, every promise of any meaningful end to the mess coming from the Political Class will result in sharp intermediate rallies.

Suggestions for Indian Investors:

  • Increase the frequency of reviewing your asset allocation
  • Explore the possibility of increasing your contribution to relatively safe asset classes such as Cash & cash equivalents, Gold, Indian real estate in locations where the prices have not shot up to crazy levels, Public Sector Bank deposits, etc.
  • Review your equity portfolio more frequently. Keep sharper stop loss levels and lower profit targets for the trading portion of your portfolio
  • Use your cash judiciously to accumulate high quality blue chips for your long-term investment portfolio whenever their share prices come down to panic bottom levels due to the violent swings in the market

Most important, be alert, be awake.

Regards,

N


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