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Economic Research and Investment Strategy Volume XXVIII, Number 11 December 2012

In This Issue
India: Economically Better in the Long Run Than China 1 In the long run, India has many advantages for economic development, especially compared to China, thanks in part to the systems and traditions left over from British colonial rule. Recent issues such as the Great Global Recession and slow recovery and a poor 2012 monsoon as well as government policies that discourage domestic and foreign direct investment and government scandals resulted in leaping fiscal and current account deficits, a falling currency, warnings of a credit rating downgrade, falling stocks and reductions in Indians' ability to buy gold. Even if these reforms are instituted, India still faces long-run challenges to rapid economic growth such as land reforms; reduction in bureaucracy; business regulation and widespread corruption; much higher quality education and training; reductions in income inequality and poverty; dismemberment of castes and better relations among ethnic groups; reductions in rural subsidies and other measures to speed up urbanization; and vastly improved infrastructure. Investment Themes Summing Up 24 25

India: Economically Better In The Long Run Than China


In the long run, we ll bet on India as the leader of major developing countries and a significant player on the global economic stage. What Happened To China? Until recently, most saw China as the undisputed king of emerging world powers. Indeed, until the 2008-2009 Great Recession, the adulation of China reminded us of the fascination over Japan in the 1980s when many Americans thought they d soon be working for Japanese companies or run out of business by them. But the early 1990s collapse in Japanese stocks (Chart 1, page 2) and real estate (Chart 2, page 2) unveiled the earlier bubble economy for what it was, and Japan has been in a deflationary depression ever since. Those dazzled by China often forget that much of her rapid growth before 2008 (Chart 3, page 2) was caused by the shift of global manufacturing from Europe and the U.S. to China, not by domestic-driven activity. Indeed, China s economy remains export-driven, with consumers accounting for only 37.7% of GDP (Chart 4, page 5), almost off the low end of the chart compared with other developing and developed countries (Chart 5, page 5). As discussed in many past Insights and in our recent book, The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation, the global deleveraging of financial institutions, the unwinding of U.S. consumer debt and rebuilding of assets and the deleveraging in other sectors here and abroad will probably take

Semi-Annual U.S. Economic Outlook: Very Cloudy 40 A global recession in 2013 appears likely. The U.K. and eurozone are already in business downturns. Japan is in or close to recession. And China seems headed for a hard landing. Other countries, especially commodity exporters like Brazil, Australia and Canada, will be dragged along. In the U.S., the fiscal cliff will probably be averted. Housing, despite recent strength, is still plagued with excess inventories and a likely big wave of foreclosures. Capital spending is burdened by weak business confidence and excess capacity. Weak household income makes consumer spending suspect. Export growth is curtailed by economic weakness abroad. Commentary Noble Intentions 64

We thank you again for your understanding of the difficulties we experienced last month in connection with Hurricane Sandy that led us to decide not to publish a November 2012 INSIGHT report. The expressions of concern and support from INSIGHT readers were very much appreciated by everyone at A. Gary Shilling & Co. To make up for this loss, we're publishing a double report this month with an in-depth look at India, which we had planned for our November INSIGHT, as well as our normal semi-annual U.S. Economic Outlook.

INSIGHT (ISSN 0899-6393) goes to press by the third business day of the month. 2012 A. Gary Shilling & Co., Inc., 500 Morris Avenue, Springfield, NJ 07081-1020. Telephone: 973-467-0070. Fax: 973-467-1943. E-mail: insight@agaryshilling.com. Web: www.agaryshilling.com. President: A. Gary Shilling. Editor: Fred T. Rossi. Research Associates: Colin Hatton and Luke Henninger. All rights reserved. No part of this publication may be reproduced or redistributed without the written permission of A. Gary Shilling & Co. Material contained in this report is based upon information we consider reliable. The accuracy or completeness is not guaranteed and should not be relied upon as such. This is not a solicitation of any order to buy or sell. A. Gary Shilling & Co., Inc., its affiliates or its directors and employees may from time to time have a long or short position in any security, option or futures contract of the issue(s) mentioned in this report.

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another five years or so to complete. Meanwhile, the Eurozone financial crisis persists, the result of combining the Teutonic North with the Club Med South under one currency with no common fiscal policy and none likely. As a result, the major markets for Chinese exports will be subdued for many years. They Are Aware Chinese leaders are well aware of the necessity of shifting to a much more domestically-driven economy, and are working in that direction. They want Chinese households to spend more and save much less than the current rate of almost 30% (Chart 6, opposite page). They save because in a Confucian society, providing for one s family is important. Also, they save to educate their one child-per couple and to cover health care and retirement costs since China lacks the equivalent of Medicare and Social Security. In 2010, the Chinese government promised basic health care for all Chinese by 2020, but that s still eight years away, and basic care in China is pretty basic! In some rural hospitals, a practical nurse is the most highly-trained medical practitioner. China has also increased minimum wages 20% to 30% in the last year to enhance consumer incomes and purchasing power. But higher wages, notably for factory workers producing goods that foreign companies will export, are driving low-skilled manufacturing jobs to cheaper venues like Vietnam, Bangladesh and Pakistan. Furthermore, Western companies are increasingly resisting the requirements that they transfer technical expertise to Chinese partners as the price of getting permission to produce in China. Many believe that much of the success of Chinese manufacturers is due to voluntary tech transfers or stolen intellectual property.

CHART 1 Nikkei 225 Index


Last Points 12/3/12: 9,458
40000 35000 30000 25000 20000 15000 10000 5000 Jan-84 40000 35000 30000 25000 20000 15000 10000 5000 Jun-12

Feb-88

Feb-92

Mar-96

Apr-00

Apr-04

May-08

Source: Yahoo Finance

CHART 2 Japanese Urban Land Prices


six-city average; 1Q 2000=100
Last Point 1Q 2012: 67.9
300 300

250

250

200

200

150

150

100

100

50 1980-I

50 1985-I 1990-I 1995-I 2000-I 2005-I 2010-I

Source: Japan Real Estate Research Institute

CHART 3
year/year % change
Last Point 3Q 2012: 7.4%
12% 11% 10% 9% 8% 7% 6% 5% 2005 2006 2007 2008 2009 2010 2011 2012 12% 11% 10% 9% 8% 7% 6% 5%

Chinese GDP

Source: Chinese National Bureau of Statistics

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These forces probably lay behind China s recent significant reduction in her real GDP annual growth rate target from 8% to 7.5%. And that target is probably high for future years as her one child-per-couple policy spawns population declines (Chart 7, page 4), especially among new labor force entrants. Those 15-24 years old are already dropping in number and are projected to drop from 250 million in 1990 to 150 million in 2030. As a result, China s labor force age 15-65 is expected to peak in 2014. Estimates are that ample labor boosted GDP growth by 1.8 percentage points annually since the 1970s, but the contraction will knock growth by 0.7 percentage points by 2030. At the same time, better conditions in rural areas have cut the availability of cheap labor in coastal cities as fewer move there from the hinterland. India s Advantage In contrast with China, India has had no effective constraints on population growth and her number, 1.24 billion in 2011, vs. China s 1.34 billion last year will soon be bigger (Chart 7). Furthermore, the age distribution of India (Chart 8, page 4) is quite different than that of China (Chart 9, page 4) as a result of China s one-child policy which is now being reconsidered in view of its negative influences on longterm labor force and economic growth. Consequently, the dependency ratio, the ratio of children and seniors to the working-age population, is expected to continue to fall in India in coming decades but rise in China (Chart 10, page 5) Younger people, of course, tend to be more geographically mobile, flexible in terms of occupation and creative. But these advantages only translate into more productivity and economic growth if they have the proper education and training as well as job opportunities.
December 2012

CHART 4 Chinese Consumption, Exports and Investment


as a % of GDP
Last Points 2011: exports 29.3%; investment 46.8%; consumption 37.7%
55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 1980 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 1985 1990 1995 2000 2005 2010 Exports of goods and services (% of GDP) Gross fixed capital formation (% of GDP) Household final consumption expenditure (% of GDP)

Source: World Bank

CHART 5 G-7 and BRIC Personal Consumption-to-GDP Ratio


2011
U.S. U.K. Italy Japan Brazil India France Germany Canada Russia China 35% 37.7% 40% 45% 50% 55% 60% 65% 70% 75% 52.1% 64.4% 61.3% 60.4% 60.3% 58.0% 57.7% 57.3% 57.1% 71.1%

Source: World Bank and Organization for Economic Cooperation and Development

CHART 6 Chinese Household Saving Rate


annual average
30.0% 30.0%

27.5%

27.5%

25.0%

25.0%

22.5%

22.5%

20.0% 2003

20.0% 2004 2005 2006 2007 2008 2009

Source: Chinese National Bureau of Statistics

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Think what you may about colonialism, British control of India for several centuries left her with a vigorous democracy and a parliamentary form of government. As in the U.S., this form of government is very useful in running a large, religiously diverse country where the central government is constrained by increasingly powerful states and weak coalition governments. When India gained independence from Britain in 1947, there was no significant effort to return to Mogul Empire or other authoritative regime where , as in China, the Mao Dynasty simply replaced the dynasties of old in the name of the people, of course! The British also left India with a railway system that facilitated the relatively easy movement of people and goods in that vast country. In contrast, China does not grant resident status to farmers who move to urban areas in search of work. English Language And, of course, the British gave India the English language very useful in today s English-dominated world and a hugely unifying force in a country with hundreds of languages and dialects. In the Indian state of Karnataka, less than 50% of the people speak Kannada, supposedly the majority language. In the north, many speak Marathi, in the west Tulu and Konkani, Tamil in the south and Telugu in the west. And across the state, many speak Urdu. All these people are native-born Karnatakans. India also inherited her legal system from the U.K., very different than the Communist party-dominated courts in China, complete with show trials and forgone convictions, as demonstrated by the recent trial and conviction of Gu Kailai, wife of disgraced party leader Bo Xilai. India also has a number of large and

CHART 7 Population Projections for India and China


millions
1,800 1,600 250 1,400 1,200 1,000 150 800 600 400 50 200 0 2010 2015 2020 2025 2030 2035 2040 2045 2050 0 100 200 300

Total India - left axis Total China - left axis

15-24 India - right axis 15-24 China - right axis

Source: World Bank

CHART 8 India 2010 Population Distribution


millions

Source: United Nations

CHART 9 China 2010 Population Distribution


millions

Source: United Nations

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sophisticated companies such as the Tata complex that can compete globally. In contrast, China is burdened with government-controlled banks and other hugely-inefficient state-owned enterprises that still produce 50% of GDP and employ a quarter of the workforce. India s vigorous free press also came from Britain, although officials recently blocked the twitter accounts of some prominent journalists who had been critical of Prime Minister Manmohan Singh. The government said it blocked content that promoted violence between Muslim settlers and an indigenous group in the northeast of the country that killed 80 people. Furthermore, executives from Google and Facebook are facing criminal prosecution for not removing Web content that Indian officials consider objectionable even though both companies say they followed the letter of the law. Internet use in India is leaping but still tiny compared with the U.S. and even the other BRIC countries (Brazil, Russia, India and China) (Chart 11). Free Market Orientation

CHART 10
ratio of children (age 0-14) and elderly (age 65+) to working-age population
90 80 70 60 50 40 30 20 10 0 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 India China 90 80 70 60 50 40 30 20 10 0

India and China Dependency Ratios

Source: United Nations

CHART 11 Indian Internet Users


per 100 people
Last Point 2010: 7.5
8 2010 Internet Users/100 7 Iceland 6 5 4 3 2 1 0 1992 USA Russia Brazil China India 95.6 74.2 43.3 40.7 34.4 7.5 3 2 1 0 1995 1998 2001 2004 2007 2010 5 4 6 7 8

For the first half-century of independence, Indian politics were dominated by the Congress Party and its socialistic orientation and attempts to emulate the Soviet Union. In the 1950s, steel, mining, machine tools, water, telecommunications, insurance, electricity generation and other industries were effectively nationalized. Innovation was stifled by the Industries Act of 1951 that required all businesses to get licenses from the government before they could launch, expand or change their products. The licence raj reigned. The government imposed import tariffs in the name of encouraging domestic production, and domestic firms were prohibited from opening foreign offices. Foreign investment dried up under stringent restrictions. As a result, manufacturing never blossomed and the economy grew at what Indian officials accepted as the Hindu rate of growth of 3% to 4% annually, distinctly
December 2012

Source: World Bank

subpar for a developing economy while other Asian economies leaped. Between 1950 and 1973, the Indian economy annually grew 3.7% (Chart 12, page 6), or 1.6% per capita, while Japan s economy grew 10 times faster, and South Korea s five times faster. China grew at a sustained 8% annual rate. All that began to change dramatically in 1991 with the shift towards capitalism. Nevertheless, India has historically had a much more free market orientation than some other large developing countries, notably Russia and China. India s Bollywood freely cranks out movies that range from excellent to awful while in China, films are propaganda tools and their content is tightly controlled by the government. State-controlled enterprises in India account for only 14% of GDP compared to 50% in China.
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Free Trade Fortunately for India, the pharmaceuticals and especially technology sectors never suffered the burdensome regulations that visited the steel and airline sectors. And doubly fortunate, Indians have a natural bent towards technology, as was pointed out to us by the American Ambassador to India when we visited with him one on one in his New Delhi office in 1986. The English language facility of India s many engineers and scientists is also a big help. Furthermore, the booming information technology sector relies more on new technologies such as satellite transmission than Indianregulated utilities and inadequate basic infrastructure. American and European firms outsource many back-office and even legal and medical services to India. Outsourcing revenues there are now $69 billion annually and account for a quarter of Indian exports. The lower wage costs in India and English-speaking ability of call center employees has big advantages for this industry. Another advantage of India, as well as China, is a rapidly-growing middle class. PriceWaterhouseCoopers estimates that in 2010, 470 million Indians, or 38% of the population, had annual incomes between $1,000 and $4,000, big enough to permit some discretionary spending. That number is expected to jump to 570 million in a decade, with about $1 trillion in income. The household saving rate is high (Chart 13), but still last year 82% of Indian households had phones, usually mobile. Of the 247 million Indian households, 77% had TVs, 42% had bicycles, motor scooters or motorcycles but only 10% owned motor vehicles, according to the 2011 Census of India. Furthermore, much of Indian household saving is invested in gold and the trousseaus of yet-to-be married daughters.
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CHART 12
fiscal year/fiscal year % growth
Last Point FY 2012: 6.9%
10% 8% 6% 4% 2% 0% -2% -4% -6% 1951 10% 8% 6% 4% 2% 0% -2% -4% -6% 2011

Indian Real GDP

1961

1971

1981

1991

2001

Source: Reserve Bank of India

CHART 13 Indian Household Saving Rate


Last Point 2011: 29.4%
35% 35%

30%

30%

25%

25%

20%

20%

15%

15%

10%

10%

5% 1951

1961

1971

1981

1991

2001

5% 2011

Source: Ministry of Statistics and Programme Implementation

CHART 14 Chinese Yuan and Indian Rupees per U.S. Dollar


Last Points 12/3/12: yuan/$ 6.23; rupee/$ 54.66
9 8 7 6 5 30 4 3 2 1 Jan-81 25 20 15 10 5 Nov-84 Sep-88 Jul-92 May-96 Mar-00 Jan-04 Nov-07 Sep-11 60 55 50 45 40 35

Chinese Yuan per Dollar - left axis Indian Rupees per Dollar - right axis

Source: Federal Reserve and Thomson Reuters

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Large Diaspora As the World Bank stated in a 2005 report, India has a large and impressive Diaspora, creating valuable knowledge linkages and networks. This is increasingly clear to us in our New York suburb as we greet more Indian families as neighbors, see them in local restaurants and note the high achievement of their children in school. China is moving, but slowly, to open its financial and currency markets to foreigners. The yuan, however, remains tightly controlled (Chart 14, opposite page), allowed to appreciate in good times but held stable in the Great Recession and later as the economy again weakened (Chart 3). This year, the yuan had risen about 1% against the buck, no doubt China s attempt to deflect political pressure from the U.S. during the presidential campaign. But after about mid-October, Beijing kept the Chinese currency as flat as a pancake.
22% 20% 18% 16% 14% 12% 10% 8% 6% 4% Jan-07

CHART 15 Chinese Reserve Ratio and One-Year Lending Rates


Last Points 12/3/12: reserves 20.0%; loans 6.00%
22% 20% 18% 16% 14% 12% 10% 8% 6% 4% May-08 Sep-09 Feb-11 Jun-12

Required Reserve Ratio (major banks) - left axis One Year Lending Rate - right axis

Source: Bloomberg

CHART 16 Indian Consumption, Exports and Investment


as a share of GDP
Last Points 2011: consumption 58.0%; exports 24.6%; investment 29.5%
90 80 70 60 50 40 90 80 70 60 50 40

In contrast, and reflecting India s more 30 30 free market bent, the rupee has been 20 20 relatively free of government 10 10 interventions, despite its recent 0 0 1960 1970 1980 1990 2000 2010 weakness (Chart 14). As the IMF Consumption Exports stated in its April 2012 report on India, Investment The flexibility of the exchange rate Source: World Bank remains a useful buffer against external shocks. Since the GFC [Global Financial Crisis] and until August 2011, RBI [Reserve Bank of India, China, the central bank, is completely controlled by the the central bank] intervention was minimal and recent government. With the recent regime change in China, interventions have fallen within the RBI s stated policy of PBOC Gov. Zhou Xiaochuan was dropped from the list of intervening only to address severe market dislocations and 205 members of the Communist Party s Central Committee foreign exchange liquidity shortages. Recent measures by as he apparently is being forced into retirement. Politicians, the RBI to restrict banks net foreign exchange (FX) open not central bankers, call the shots in China. positions and corporates ability to trade in the onshore forward market seem to have contributed to stabilizing the As we ve noted in past Insights, interest rates are kept rupee. The authorities have continued to gradually liberalize artificially low (Chart 15) to provide cheap loans to inefficient capital flows, such as by freeing interest rates on nonresident state-owned enterprises that account for half of GDP and accounts, facilitating the refinancing of external debt, and employ a quarter of the workforce. Consequently, Chinese allowing foreign individuals to invest in equities. monetary policy is run mainly by reserve requirements, a crude tool long ago shelved by the Fed and other major RBI Independence central banks since it amounts to credit allocation. In contrast, when interest rates are raised, borrowing for the Furthermore, the RBI is relatively independent of most profitable investments still continues. government influence. In contrast, the People s Bank of
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India has the advantage, at least in the current world of slow growth and meager import demand in the U.S. and Europe, of being much more inwardoriented than China and the other exportled countries in Asia. After independence, Indian leaders advocated self-sufficiency and used high tariffs to keep out imports in order to encourage local production, as noted earlier. Rajiv Gandhi, Prime Minister in the late 1980s, believed that the U.K. had discouraged industrialization in India in order to keep her as a supplier of raw materials for British factories and a market for England s manufactured goods. In contrast to China s 37.7% consumer spending component of GDP in 2011 (Charts 4 and 5), India had 58% (Chart 5 and Chart 16, page 7) despite Indians equally high saving rate (Chart 6a). This is a better balance in a world where exports and the capital spending are no longer the easy route to economic growth for developing countries. Indian exports are sizable, 24.6% of GDP in 2011, and that percentage has risen despite the global recession and slow recovery. In contrast, Chinese exports in 2011 were a higher percentage of GDP, 29.3%, but much more volatile and down from about 40% in 2007 before the global recession commenced (Chart 4). The merchandise component of Indian exports in 2011 was 16% compared to 26% in China. And while Indian service exports have a high tech and high value-added content relative to Brazil and China (Chart 17), goods and manufacturing exports tend towards textiles, leather and other low valueadded products (Chart 18). Nevertheless, the sophistication of India s goods exports is rising and closing the gap with Brazil and China (Chart 18). Services vs. Goods Exports A key difference is that India s exports
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CHART 17 Sophistication of Services Exports


9.8 9.7 9.6 9.5 9.4 9.3 9.2 9.1 9.0 8.9 8.8 1990 9.8 9.7 9.6 9.5 9.4 9.3 9.2 9.1 9.0 8.9 8.8 1992 India China Brazil 1994 1996 1998 2000 2002 2004 2006

Source: International Monetary Fund

CHART 18 Sophistication of Goods Exports


9.8 9.8

9.7

9.7

9.6

9.6

9.5

9.5

9.4

9.4

9.3

9.3

9.2 1990

9.2 1992 India China Brazil 1994 1996 1998 2000 2002 2004 2006

Source: International Monetary Fund

CHART 19 India Services, Industry and Agriculture


% of GDP
Last Points 2011: services 56.4%; industry 26.4%; agri. 17.2%
60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 1960 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 1970 Services Industry Agriculture 1980 1990 2000 2010

Source: World Bank

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emphasize outsourcing and other services that tend to be much less cyclical than the manufactured goods that dominate China s exports. Manufacturing and other industry remains a relatively small and only slowly growing component of Indian GDP that accounts for about the same share of total production it did in the early 1980s (Chart 19, opposite page). Meanwhile, services gain at the expense of falling but still significant agriculture, which amounted to 17% of GDP in 2011 vs. 56% for services. In contrast, the industrial sector in China is much larger, 47% of GDP in 2011, while agriculture is smaller than in India, 10%, as were services at 43% of GDP (Chart 20). Not only do exports account for a smaller percentage of Indian GDP as in China, but also India s chronic trade and current account deficits are growing while export-led China had had consistently large surpluses until the Great Recession struck (Chart 21). We ll return to these troublesome Indian deficits later. India and Pakistan Like many developing countries, India spends heavily on her military (Chart 22) to the detriment of productivityenhancing and job-creating capital spending. India lost a border war with China in 1962 and still has boundary disputes. But her primary concerns are with Pakistan, which, of course, was part of British India and split off as the predominantly Muslim area and Hindudominated regions parted ways. Pakistan and India have fought three wars since 1947 independence, and are still at odds over ownership of Kashmir. Heavy military presence on both sides of the border is expensive and impedes cross-border trade. Both India and Pakistan have nuclear weapons, which have altered the military strategies of both. Pakistan can t
December 2012

CHART 20 Share of Chinese GDP by Sector


Last Points 2011: agri. 10.0%; industry 46.6%; services 43.3%
50% 45% 40% 35% 30% 25% 20% 15% 10% 1970 50% 45% 40% 35% 30% 25% 20% 15% 10% 1975 1980 1985 1990 1995 2000 2005 2010 Agriculture Industry Services, etc.

Source: World Bank

CHART 21 China and India Current Account and Trade Balance


as a share of GDP
Last Points 2011: India CA -3.1%; India TB* -5.4%; China CA 2.8%; China TB 2.6%
12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% 1982 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% 1987 1992 1997 2002 2007

India Current Account India Trade Balance

China Current Account China Trade Balance

* 2010 data

Source: World Bank

CHART 22 2011 Military Spending as a % of GDP

Saudi Arabia Israel Iraq U.S. Russia Pakistan U.K. India France China Egypt Italy Brazil Canada Germany Japan
Source: World Bank

8.4% 6.8% 5.1% 4.7% 3.9% 3.0% 2.6% 2.6% 2.2% 2.0% 1.9% 1.6% 1.4% 1.4% 1.3% 1.0%
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compete with larger and wealthier India in conventional weapons so she has beefed up her nuclear arsenal. In reaction, India has deployed her nonnuclear forces in ways that anticipate and offset Pakistan s nuclear capability, including detection and surveillance technologies that monitor Pakistan s nuclear preponderance and reveals conventional vulnerabilities. Better relations between Pakistan and India could curtail defense spending on both sides and spur growth-promoting trade. The two have been trying to improve relations through talks commenced in 2004, but suspended after Pakistani militants attacked Mumbai in November 2008, killing 160 people. Still, a year ago, Pakistan agreed to grant Indian most favored nation trading privileges, meaning her import tariffs on Indian goods will be as low as with any other country. India did the same for Pakistan in the mid-1990s, but Pakistan didn t reciprocate, maintaining that India has many nontariff barriers to trade. Instead, Pakistan limited imports from India to a list of fewer than 2,000 items. Early this year, however, Pakistan switched to a negative list that bans about 600 imports from India of strategic items such as defense equipment, but allows trade in all other goods. And the negative list is scheduled to be scrapped by the end of this year if India reduces nontariff barriers such as complicated labeling requirements. Indian exports to Pakistan are already climbing (Chart 23). Still, with past animosity, India s trade with Pakistan is rising from a very low base (Chart 24). Pressure To Change The turn from socialism toward capitalism in India in 1991 was not voluntary but forced by concurrent severe economic and financial problems. In the 1980s, persistent
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CHART 23 Trade Between India and Pakistan


$ billion
Last Points FY 2011-2012: imports 0.4; exports 1.5
2.5 2.5

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

0.0

Imports Exports

Data is as of 3/31, the end of India's fiscal year

Source: India Department of Commerce

CHART 24 India Trade by Partner Country


$ billion
UAE China U.S. Saudi Arabia Switzerland Hong Kong Germany Singapore Indonesia Belgium Pakistan 2.7 19.7 18.7 17.4 16.2 14.9 25.6 25.5 45.6 67.1 63.3

Source: India Department of Commerce and The Wall Street Journal

CHART 25
share of GDP; for fiscal year
Last Point 2012: 5.9%
10% 9% 8% 7% 6% 5% 4% 3% 2% 1981 10% 9% 8% 7% 6% 5% 4% 3% 2% 1986 1991 1996 2001 2006 2011

Indian Fiscal Deficit

Source: Reserve Bank of India

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budget deficits forced austerity actions (Chart 25, opposite page). In 1991, a foreign exchange crisis pushed the government to align spending with revenues and move away from fixed exchange rates. The overvalued rupee, which had discouraged foreign investment, fell. Led by Manmohan Singh, then Finance Minister and now Prime Minister, the government also opened the door to foreign investment (Chart 26) while Indian companies were allowed to borrow in foreign capital markets and invest abroad. Doubledigit inflation (Chart 27) was tamed. These new policies initiated the boom in information technology. Life expectancy jumped to 64 years in 2008 from 58 in 1991. Literacy has risen. GDP per capita grew from $925 in 1991 to $3,270 in 2009. Airline and telecommunications companies became privatized. Slow Progress Nevertheless, progress has been limited as shown by the slower growth in Indian real GDP compared to China (Chart 28). Also, India recently announced a new five-year plan with probably unrealistic goals for reducing the government deficit from 5.3% in the current fiscal year ending March 31, 2013 to 3% in fiscal 2017, but provided few details. Remind you of the Soviet s five-year plans that were always optimistic but seldom met? Changes come slowly in India, with a culture that s been around for millennia and heavily influenced by Hindu philosophy that doesn t emphasize urgency. Hindu belief is that after death comes reincarnation in another form of life. The process of birth and rebirth the transmigration of souls is endless until one achieves moksha, or salvation, by realizing that the truth liberates, that the individual soul (Atman) and the absolute soul (Brahmin) are one. Hindus also believe in Karma, the
December 2012

CHART 26 Foreign Direct Investment in India and China


net inflows; % of GDP
Last Points 2010: India 1.4%; China 3.1%
7 6 5 4 3 2 1 0 -1 1975 7 6 5 4 3 2 1 0 -1 2010

1980 India China

1985

1990

1995

2000

2005

Source: World Bank

CHART 27 India Wholesale Price Index - All Commodities


year/year % change
Last Point 10/12: 7.5%
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% Apr-83 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% Jun-12

Jun-87

Aug-91

Oct-95

Dec-99

Feb-04

Apr-08

Source: India Office of the Economic Advisor

CHART 28 Chinese and Indian Real GDP Growth


year/year % change
Last Points 2011: India 6.8%; China 9.2%
16% 16%

14%

14%

12%

12%

10% 8%

10% 8%

6%

6%

4% 2% 1980

4% 2% 1985 China India 1990 1995 2000 2005 2010

Source: IMF

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law of cause and effect that states that what one does in the present life will have its effects on the next life. Nevertheless, a Hindu doesn t need to get everything accomplished in this life since he can probably get it done in later lives. Also, belief in predestination gives Hindus a sense of fatalism. Hinduism also incorporates all forms of belief and worship without necessitating the selection or elimination of any. This results in a spirit of independence and lack of acceptance of authority among Indians that makes it difficult for the authorities to force family planning or much of anything else on the population. The chaos on Indian roads where cars, trucks, ox carts, bicycles, rickshaws, pedestrians and stray cows all compete for the right of way in a random fashion is ample proof of this independent spirit. The contrast with the disciplined Chinese society, where family planning is reinforced throughout the structure, is marked. This approach is very different than in the Western world, dominated by Christian philosophy. Christians believe there is an afterlife, but you have only one trip through your earthly, physical existence so you better make the most of it. Think of bucket lists, things people want to do and see before they die. Then there was the old ad for women s hair coloring with the tag line, If I have only one life, let me live it as a blonde. Tire Changing As Westerners, my wife and I were struck by the much more casual attitude toward death by Indians while on a trip there some years ago. We were being driven in a limo from Agra, the location of the Taj Mahal, back to Delhi when the car suffered a flat tire. It was a good road, only two lanes, but with wide berms on each side. Nevertheless, our driver, a well-spoken middle-class Indian, didn t pull over onto the shoulder but stopped right in the middle of the lane to change the tire. Traffic was moving swiftly, and vehicles traveling in our direction had to swing into the oncoming lane to pass our stopped car. As the brakes squealed and the horns blared, I turned to mywife and said, Peggy, we re getting out of this car immediately and retreating to that mustard field across the road until the driver is ready to move on. Still, the heat is now back on Indian leaders for reform due to economic12 A. Gary Shilling's INSIGHT

depressing external forces, bad policy decisions and the resulting declines in economic growth, the rupee and foreign direct investment while the trade and current account deficits mount (Chart 21). External Issues Despite her inward-looking nature, India has not been immune from the worldwide Great Recession and the more recent slowing of global growth (Chart 28). As mentioned at the outset of this report, huge amounts of the globe s manufacturing shifted to China in recent decades. Still, China doesn t produce goods for domestic consumption and exports from scratch, but imports raw materials, petroleum and other supplies and components. And weak Chinese imports (Chart 29) are negative for suppliers such as South Korea, Taiwan, Indonesia, Australia, Brazil and India. With the global glut in steel, iron ore prices are down about 50% in the last year, and shipments to China from Australia, Brazil and India are expected to drop to about 25 million metric tons this fiscal year from 60 million last year. Iron ore exports have been banned in the Indian states of Orissa and Goa. India s trade relations with China remain strained despite the trade talks launched when Chinese Premier Wen Jiabao visited India in late 2010. Her trade gap with China jumped to $28 billion in fiscal 2010-2011, the largest for any of India s trading partners (Chart 30, opposite page). India wants exports to China to shift away from raw materials like copper and iron ore, which account for about half of those exports, to value-added products such as pharmaceuticals (Chart 31, opposite page). India also wants more access to Chinese government procurement. But exports of drugs and fine chemicals to China have fallen 12% since 2007 to only $108 million per year due to Chinese regulations. It
CHART 29 Chinese Imports and Exports
year/year % change
Last Points 10/12: exports 11.6%; imports 2.4%

100% 80% 60% 40% 20% 0% -20% -40% -60% Jan-06

100% 80% 60% 40% 20% 0% -20% -40% -60% Nov-11 Sep-12

Nov-06 Sep-07 Exports Imports

Jul-08

May-09 Mar-10 Jan-11

Source: China General Administration of Customs

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takes three or four years to register a new drug in China vs. 10 months in India. Rare Earths Interestingly, India, the world s second largest producer of rare earth, has decided to challenge China, which accounts for 95% of global production (Chart 32). She wants to force electronics and green energy users of these minerals to establish production in China in return for access to those commodities. Stateowned Indian Rare Earths suspended mining in 2004 due to inability to compete with Chinese low-cost mining techniques Total

CHART 30 India's Top Trade Partners: FY 2010-2011

-----Imports----$ billion % of total 369.8 100.0% 44.5 35.0 32.8 20.1 43.5 9.4 7.1 20.4 24.8 12.0% 9.5% 8.9% 5.4% 11.8% 2.5% 1.9% 5.5% 6.7%

-----Exports----$ billion % of total 251.1 100.0% 46.0 35.7 33.8 25.3 15.5 10.3 9.8 4.7 0.7 18.3% 14.2% 13.5% 10.1% 6.2% 4.1% 3.9% 1.9% 0.3%

EU (27 countries) Eurozone United Arab Emirates U.S. China Hong Kong Singapore Saudi Arabia Switzerland

Source: Indian Department of Commerce

CHART 31 Selected Items Traded by India and China ($ billion)

Source: Indian Commerce Ministry

but is planning to build a processing plant in the eastern state of Orissa. Even if successful, that plant s 11,000 metric ton annual output would hardly dent China s dominance with 130,000 tons of production in 2010 compared to India s 2,700. Furthermore, China has about 55 million tons of rare earth reserves, half the global total compared to 3.1 million tons in India. And prices of average rare earths have dropped from the $148 per kilogram peak in 2011 when China limited exports to $56 on world markets and $33 in China. Until the mid-20th century, rare earths came
December 2012

CHART 32 2011 Rare-Earth Mineral Reserves and Production


millions of metric tons
60 0.14

50

0.12 0.10

40 0.08 30 55.0 20 13.0 10 3.1 0.00 0 China United States India Australia 0.003 1.6 0.00 0.00 0.04 0.02 0.130

0.06

Reserves - left axis Production - right axis

U.S. and Australia plan to boost production Source: U.S. Geological Survey and The Wall Street Journal

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from the sands of India s coast line, then shifted to the U.S. from the 1960s until China s low-cost production dominated, starting in the 1980s.

CHART 33 Rainfall During the 2012 Southwest Monsoon


millimeters
4-month mean - long-run average: 221.9; actual 206.2
300 300

250 250 Meanwhile, the quantity of Indian manufactured goods is no match for 200 200 China s, and Chinese goods pour into 150 150 India. In about a decade, China has advanced from India s seventh largest 100 100 source of imports to Number 1, even 50 50 exceeding the U.S. and the entire eurozone (Chart 30). In typical Indian 0 0 June July August September 4-Month Mean reaction, the cabinet in July approved a Long-Run Average 21% tariff on imports of equipment Actual for electric power projects in order to Source: India Meteorological Department protect local manufacturers from advanced Chinese producers that Policy Problems already supply 40% of India s power equipment and whose sophisticated gear is desperately needed to boost power Adding to externally-imposed detriments to economic generation. growth, Indian leaders recently have introduced a number of policy measures that may be necessary politically but still Monsoons discourage domestic and foreign investment and economic growth. Early this year, the government proposed taxes on Another external problem, or at least one out of the control transactions back to 1962 in which Indian assets were of policymakers, was the weak monsoon this year. The transferred between foreign entities. That would override Southwest monsoon comes to India via winds from the an Indian Supreme Court decision in January that U.K. Arabian Sea, and arrives in the southern state of Kerala in mobile phone company Vodaphone isn t liable for over $2 late May or early June. It gradually moves north and covers billion in taxes on a 2007 deal it made to enter India. the entire subcontinent by mid-July. About 60% of

farmland depends on monsoon rainfall. This year, rainfall was well below normal in June and July. There was some catch-up in August and more in September, but the fourmonth average was 7% below long-run averages (Chart 33).

The reaction of farmers was to plant less summer crops including staples such as pulses, oilseed, CHART 34 rice and cereals. They also pumped Share of Indian Electric Power Generation by Source more water from wells since reservoirs total capacity = 205,340 mw. that feed irrigation canals were low. But that required more spending on diesel fuel, and those added costs plus the anticipated poor harvests are squeezing farmers discretionary spending. Also, drawing more electricity from the power grid to run pumps may have contributed to the widespread summer blackouts in India. Over half of electricity generation is from coal, which is in short supply (Chart 34). About 19% comes from hydroelectric.
Source: India Ministry of Power and The Wall Street Journal

Another proposal would establish an anti-tax avoidance policy that investors worried would allow the government to tax investments in India from offshore tax havens such as Mauritius. It put the responsibility on investors, many of them foreigners, to prove that they didn t structure corporate

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CHART 35 Selected Indian Scams

Name 2G Coalgate Adarsh CWG Karnataka

Date 2008 2004-2009 2010 2010 2006-2010

Description Dodgy sale of mobile-phone licenses Shady allocation of coal blocks Mumbai home for war widows taken by the powerful Crooked contracts for Delhi Commonwealth games Illegal mineral pillage

Notional Loss* $39 bn. $34 bn. $ millions $ millions $3.6 bn.
Source: The Economist

* Maximum estimated by the Comptroller and Auditor General and others, as lost revenue or as stolen goods

deals to avoid taxes. In reaction, $692 million in foreign capital left the Indian stock market in the three days after that proposal was announced. Then there was the budget provision to increase taxes on oil production by 80% that would only hit Cairn India, whose major shareholders are British companies. Cairn India responded to the expected $2.5 billion tax hike by saying it would jeopardize its plans to invest $6 billion in India.

especially Coalgate in which 57 companies, between 2008 and 2011, illegally acquired coal blocks, some of those firms controlled at the time by senior members of the ruling Congress Party. India s Federal Auditor reports that the government lost as much as $33 billion by allocating licenses without transparent auctions. Losses from 2004 to 2009 were more than $200 billion. Corruption in issuing mobile-telephone licenses in 2008 could result in the potential loss of $39 billion in government revenue, according to federal auditors (Chart 35). Senior government officials, including a former telecom minister in the Congress-led government, are facing criminal trials for conspiracy. The government now promises to auction coal blocks rather than allocate them in private. But when the Congress-led coalition came to power in 2004, it discussed starting public auctions but nevertheless has yet to act. Transparency International ranks India 95th among

Another deterrent to foreign direct investment is the recent government proposal to extend price controls on pharmaceuticals from 20% of drugs to 60% of the 348 that the government considers essential. Price restrictions would extend beyond generics to patented drugs for the first time, and are in response to the government s concerns for the two-thirds of Indians who lack health insurance and the fact that Indians pay 70% of their health care costs out of pocket. In addition, India s patent CHART 36 authority is trying to force Bayer to license an Indian generic drug company Transparency International Corruption Perception Index 0 (highly corrupt)....10 (least corrupt) to sell a cheap version of its patented Last Points 2011: India 3.1; China 3.6; US 7.1; UK 7.8; Germany 8.0 cancer drug Nexavar.
9 8

And don t forget the 21% tariffs on imported power generation equipment aimed at sophisticated Chinese gear even though the chronic lack of generating capacity spawned major blackouts in India this past summer. Corruption Then there is the recent rash of scandals involving government officials,
December 2012

0 2000 2002 2004 2006 2008 2010

India China USA

UK Germany

Source: Transparency International

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182 nations in 2011 in terms of perceived corruption (Chart 36, page 15). India is not alone in suffering a lack of transparency and major corruption, with China close behind (Chart 36). Premier Hu Jintao in his last major speech before retiring recently acknowledged that corruption among Chinese officials is a major concern of the Chinese people. If we fail to handle this issue well, he said, it could prove fatal to the Party. With Prime Minister Singh s fragile coalition government under fire and losing public support while the opposition calls for blood, almost nothing is being done in Parliament. In the session that ended in early September, Parliament did no business during 13 days of the 20-day session and passed only four bills out of 30 the government hoped to enact. Furthermore, bureaucrats throughout the government are frozen into inaction, fearing that in a new era of active watchdogs, anything they do may boomerang on them. Nevertheless, one of the three commissioners of the Central Vigilance Commission that investigates corruption in effect told government officials to relax. He said that only a minuscule number of the CVC investigations lead to administrative punishment or prosecution. So it s graft and corruption as usual! An additional black eye for the Singh government is the recently leaping fiscal deficit in relation to GDP after a three-decade declining trend (Chart 25), suggesting that the government has lost control of its finances. As we ll discuss later, transfers to rural residents and energy subsidies increasingly outrun government revenues. Housing Housing bubbles and busts have not been confined to the U.S., Europe and now Canada (see "U.S. Semi-Annual Economic Outlook," page 40). Property prices in India soared in recent years, but slowing economic growth, high consumer inflation and elevated interest rates have pressed home owners and affordability. Financing from banks and private-equity investors has atrophied and foreign direct investment in real estate has declined. Funding is scarce. Developers are trying to prevent price drops, but new home sales fell 50% to
16 A. Gary Shilling's INSIGHT

60% in the six major Indian cities that comprise 80% of the residential market in the first half of 2012 from a year earlier. Record inventories will take two years to clear, and as we ve noted continually, excess inventories are the mortal enemies of prices. Nevertheless, house prices in15 major Indian cities continued to rise as of the second quarter, and were up 64% since 2007 (Chart 37). The condition of Indian houses is something else, however, at least by Western standards. Some 71% of households have tap water but 62% have water from treated sources, 73% have toilets and 93% have electricity for lighting. According to the 2011 Census of India, of the 247 million households, 95% in rural areas own their own abodes and 69% in urban locations. In rural areas, 39% of households live in one room and 32% in two rooms while 32% of urban households occupy one room and 31% live in two rooms. And 46% of the abodes of rural households were ranked as good while 48% were only livable and 7% were dilapidated. From urban households, 68% lived in good houses, 29% in livable homes and 3% in livable structures. The materials used in roofs, walls and floors of Indian households are interesting (Chart 38, opposite page). Note that 30.5% of walls in rural houses are mud/unburnt brick and 62.6% of floors are mud. Rural Subsidies Indian politicians are obviously sensitive to the rural areas where two-thirds of the population, 833 million, live in 640,000 villages. Government subsidies for rural residents are huge. Major subsidies total about $57 billion per year, and crowd out government spending on job-creating capital spending (Chart 39, page 18). Welfare spending has leaped from 1.6% of GDP when Singh became Prime Minister in
CHART 37 India House Price Index
15-city average; 2007=100
Last Point 2Q 2012: 164.3

170 160 150 140 130 120 110 100 Jun-08

170 160 150 140 130 120 110 100 Jun-12

Dec-08

Jun-09

Dec-09

Jun-10

Dec-10

Jun-11

Dec-11

Source: India National Housing Bank

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2004 to 2.5%. Farmers get subsidized fertilizer and diesel fuel to run water pumps. The government pays above market prices for wheat and rice and then sells it back to villages at discounts. The government s National Rural Employment Guarantee Act promises each rural poor Indian 100 days of work per year. These actions keep people on the land, but distort labor markets, delay urbanization (Chart 40, page 18) and encourage corruption. It s estimated that 44% of state-managed food vanishes as leakage. In contrast to the two-thirds of Indians living in rural areas, in China, it s around 50%. The combination of high demand and supply constraints in food, energy and elsewhere due to corruption, inadequate infrastructure, government regulation and inefficient land distribution keep inflation rates in India artificially high compared to China and other developing lands (Chart 41, page 18) and difficult to manage through fiscal and monetary policies. Subsidized rural food costs increased demand for food and shifts it towards proteins and away from grains, adding further to food price pressures, according to the IMF.

CHART 38 Building Materials In Indian Homes rural and urban; % of total

Total Households by Predominant Material of Roof Total No. of Households 100.0 grass/thatch/bamboo/wood/mud, etc. 15.0 plastic/polythene 0.6 hand-made tiles 14.5 machine-made tiles 9.3 burnt brick 6.6 stone/slate 8.6 G.I./metal/asbestos sheets 15.9 concrete 29.0 any other material 0.4 Households by Predominant Material of Wall Total No. of Households 100.0 grass/thatch/bamboo, etc. 9.0 plastic/polythene 0.3 mud/unburnt brick 23.7 wood 0.7 stone not packed with mortar 3.4 stone packed with mortar 10.8 G.I./metal/asbestos sheets 0.6 burnt brick 47.5 concrete 3.5 any other material 0.6 Households by Predominant Material of Floor Total No. of Households 100.0 mud 4.65 wood/bamboo 0.6 burnt brick 2.3 stone 8.1 cement 31.1 mosaic/floor tiles 10.8 any other material 0.5
Source: Census of India 2011

Rural Urban 100.0 20.0 0.6 18.3 10.4 7.2 8.9 15.9 18.3 0.4 100.0 1.9 0.3 30.5 0.8 3.6 10.0 0.5 40.0 1.7 0.6 100.0 62.6 0.7 2.3 6.2 24.2 3.7 0.2 100.0 4.6 0.6 6.2 7.0 5.4 7.9 15.9 51.9 0.4 100.0 2.7 0.3 9.3 0.5 2.7 12.3 0.9 63.5 7.2 0.6 100.0 12.2 0.4 2.4 12.2 45.8 25.9 1.0

The Indian government has also mishandled food distribution. The country has produced enough food to feed its 1.2 billion people since the Green Revolution decades ago introduced better seeds and fertilizers. Also, the government buys a lot of grain from farmers at high prices to redistribute in its subsidy programs, as noted earlier. But corruption and bureaucratic inefficiencies prevent food from always reaching the needy, so 200 million are undernourished. The International Food Policy Research Institute s 2011 Global Hunger Index put India 67th out of 81 countries. Some 42% of India s children are underweight. Meanwhile, food shortages keep prices high, with yearover-year increases in wholesale food prices of 7.9% in September and 6.6% in October (Chart 42, page 19). Recently, a government advisory panel recommended that India ease controls on sugar by stopping purchases of 10%
December 2012

of sugar mills output at a big discount and then selling it to the poor at even lower prices. The panel also wants to end the premium price that sugar mills are forced to pay farmers to please voters, and to stop fixing the quantity mills sell on the open market. These market distortions result in India flipping between sugar importing and exporting. She is the world s top sugar consumer and biggest producer after Brazil. Inadequate Warehouses The government, as of mid-2012, had 63 million metric
A. Gary Shilling's INSIGHT 17

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tons of grain warehouse capacity to store but 75 million tons of grain. In total, the government is storing about 20 million tons in makeshift storage spaces, vulnerable to weather and rodents. About 7% of annual Indian grain output is lost due to insufficient storage space and inadequate transportation and distribution. A fifth of storage warehouses are in non-grainproducing areas and rely on overloaded and delayed railroads for transport. Over a million tons of wheat in staterun warehouses from previous bumper crops will probably go bad because the government failed to distribute it over the past two to three years. Part of the food distribution problem stems from the 1980s law that requires that 100% of the wheat and rice crops must be packed in jute bags. That law was designed to protect 250,000 jute factory workers and 5 million farmers who grow jute from the mushrooming of cheaper plastic sacks. But booming wheat harvests, up 82% from 1990, antiquated jute industry machinery left over from the British era and frequent labor strikes have kept jute bag output well below demand. In Madhya Pradash, a major wheat-growing state in central India, the government was forced to allow 20% of the wheat harvest to be placed in plastic bags if jute sacks weren t available. The Indian government has belatedly begun to deal with the crisis in microlending. Mohammed Yunus of Grameen Bank in Bangladesh developed the system and for it received the Nobel Peace Prize in 2006. It has spread across emerging Asia, Africa and South America and involves loans of less than $200 to entrepreneurs, often women, who start or expand small businesses such as vegetable stands or bicycle repair shops. Microlending has surged in India (Chart 43, opposite page) and repayment rates tend to be extremely high. But the cost
18 A. Gary Shilling's INSIGHT

CHART 39 Composition of Indian Government Expenditures


% of GDP
20% 20%

15%

15%

10%

10%

5%

5%

0% 2000/01

0% 2003/04 2006/07 2009/10

Other current expenditures Interest, Pensions, Subsidies, and Wages Capital Expenditure & net lending

Source: International Monetary Fund

CHART 40 India Population Projections


billions
1.8 1.8

1.5

1.5

1.2

1.2

0.9

0.9

0.6

0.6

0.3

0.3

0.0 1960 1970 Rural Urban 1980 1990 2000 2010 2020 2030 2040 2050

0.0

Source: United Nations

CHART 41 India and China CPI


year/year
Last Points 2011: India 8.9%; China 5.4%
25% 25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

0%

-5% 1980

-5% 1985 China India 1990 1995 2000 2005 2010

Source: IMF

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of administering small loans in remote areas requires annual interest rates of 25% to 100%. So, in the Indian state of Andhra Pradesh, local government officials and politicians urged borrowers to stop paying even if they had the money. After dozens of suicides blamed on microlenders, the government finally imposed restrictions and arrested some lending agents for allegedly harassing debtors. Furthermore, India s Sahara Group, which sold small denomination bonds with promised payouts between 1.25 and three times the investment amount, is coming under intense public scrutiny. Regulators worry that it is growing too rapidly without government oversight. Sad Effects The sad effects of India s recent external problems and uneconomic policy decisions are many and substantial. The mushrooming foreign trade and current account deficits (Chart 44) are serious concerns because the foreign funds to finance them have largely dried up. The trade deficit jumped to $185 billion in fiscal 2011-2012, up 56% from fiscal 2010-2011 as oil and gold import prices jumped. The trade as well as current account deficits, about 4% of GDP, is significantly driven by oil imports, but barring a collapse in global crude oil prices, will remain high. India imports about three-fourths of her petroleum usage. Retroactive Taxes The proposal to tax asset sales retroactively to 1962 and other adverse measures have especially put the brakes on foreign direct investment inflows (Chart 26). Furthermore, European banks that have traditionally financed Indian debt have cut lending amidst the eurozone debt crisis. And there is relatively little foreign participation in India s government bond market. This is in part due to the foreign investment
December 2012

CHART 42 India Wholesale Price Index - Food Articles


year/year % change
Last Point 10/12: 6.6%
25% 25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

0%

-5% Apr-95

-5% Jun-99 Aug-03 Oct-07 Dec-11

Source: Bloomberg

CHART 43 Microfinance Loans in India


30 240 220 25 200 180 20 160 140 15 120 10 100 80 5 60 40 0 FY 2007 FY 2008 FY 2009 FY 2010 20

Number of Borrowers (mil.) - left axis Value of Loans (bil. Rupees) -right axis

Source: Intellecap and The Wall Street Journal

CHART 44 India Current Account and Trade Balances


$ billion; 4-quarter total
Last Points: current acct. 2Q 2012 -21.8; trade bal. 1Q 2012 -40.2
50 50

-50

-50

-100

-100

-150

-150

-200 Jun-90 Dec-92 Jun-95 Dec-97 Jun-00 Dec-02 Jun-05 Dec-07 Jun-10 Trade Balance Current Account

-200

Source: Directorate General of Commercial Intelligence and Statistics and Reserve Bank of India

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cap on government bonds, which was raised by $5 billion to $20 billion by the RBI last June 25, shortly after the rupee hit an all-time low against the dollar. The government also reduced the minimum holding period on some bonds from five years to three years. On the bright side of the foreign direct investment picture, liquor giant Diagea just announced plans to buy up to 53.4% of India United Spirits for as much as $2 billion. United Spirits is the world s largest liquor company by volume with an extensive distribution network in India and a major share of the market for affordable local booze such as Indian whiskey. High alcohol import taxes have impeded sales of higher priced Diagea brands such as Johnnie Walker scotch and Smirnoff vodka. Private Equity Retreat Private equity firms charged into India with India-oriented funds in 2005-2007 when the Indian stock market was booming (Chart 45). Now they re having trouble raising money for India funds in view of India s fiscal and current account deficits, slowing growth and uncertain outlook for stocks. Returns on Indianoriented private equity funds have been poor in recent years, and a decline in IPOs makes it difficult for investors to realize gains and exit. In 2011, private equity firms sold $3 billion via Indian IPOs or through mergers and acquisitions, down from $7 billion in 2010. With the trade and current account deficits high in recent years and foreign money abandoning India, the rupee, not surprisingly, has been falling on balance (Chart 46). The weak currency creates woes for Indian companies with foreign currency bonds as well as foreign investors in Indian debt. In the booming 2005-2007 years, when Indian real GDP was growing at 8% annually and the stock market jumped (Chart 45), the
20 A. Gary Shilling's INSIGHT

CHART 45 BSE 500 Index


Last Point 12/3/12: 7,489
9000 8000 7000 6000 5000 4000 3000 2000 1000 0 Jan-00 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Source: Bloomberg

CHART 46 Indian Rupees per U.S. Dollar


Last Point 12/3/12: 54.66
58 56 54 52 50 48 46 44 Jan-11 Mar-11 May-11 Aug-11Oct-11 Dec-11Feb-12May-12Jul-12 Sep-12 58 56 54 52 50 48 46 44

Source: Federal Reserve and Thomson Reuters

CHART 47 Indian 10-Year Sovereign Bond Yield


Last Point 12/3/12: 8.17%
9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0 Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 May-12 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0

Source: Thomson Reuters

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rupee was strong, reaching a record 40 rupees per dollar. So Indian companies sold huge quantities of bonds to foreigners. Many of these bonds were convertible to stock, and their issuers assumed they would be converted as their stocks continued to rise. But now with their stocks down, conversion is unlikely and the rupee has fallen 40%, making the cost of retiring foreign bonds very high. Rupee Support Attempts As noted earlier, the RBI has attempted to support the rupee by encouraging foreign purchases of Indian government bonds, hoping that investors will be attracted by yields (Chart 47, opposite page) that exceed even those in troubled Spain and Italy (Chart 48). Foreign investors are often only interested in India bonds, however, if they can hedge their currency exposure, but the RBI has also made it more difficult for traders to bet against the rupee with futures contracts. The RBI has attempted to attract money from offshore Indians by offering them higher interest rates on bank deposits in India. It also in May forced foreign exchange earners to convert 50% of their foreign currency holdings to rupees. None of these actions have produced lasting support for the beleaguered rupee.

CHART 48 Spanish and Italian 10-Year Government Bond Yields


Last Points 12/3/12: Spain 5.28%; Italy 4.45%
8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 Jan-07 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 Oct-07 Spain Italy Jul-08 Apr-09 Jan-10 Nov-10 Aug-11 May-12

Source: Thomson Reuters

CHART 49 India and China Foreign Reserves


$ billion
Last Points: India 10/12 295; China 9/12 3,285
3500 3000 2500 2000 1500 1000 350 300 250 200 150 100

500 0 Apr-01

50 0 Oct-12

Mar-03

Feb-05

Jan-07

Dec-08

Nov-10

China - left axis India - right axis

Source: Bloomberg and Reserve Bank of India

The central bank also spent $22 billion in foreign exchange reserves between September 2011 and April of this year to support the rupee. But the RBI has limited ability to repeat this exercise. Foreign currency reserves of $295 billion (Chart 49), equal to about six months of imports, compared with $3.3 trillion in China, which built them through years of chronic trade and current account surpluses, the reverse of in India (Chart 21). Standard Chartered Bank believes the RBI s foreign-exchange reserve adequacy is at a decade low, after subtracting a buffer for five months of imports and short-term external debt. The weak rupee does make Indian goods cheaper abroad, but the effect is limited because unlike export-driven developing countries, goods exports are a small part of the
December 2012

economy, only 16% of GDP compared to 26% in China, as mentioned earlier. Furthermore, the costs of exporting goods in India are more than twice as high as in China and exceed even those in the U.S. and U.K. (Chart 50, page 22). Once again, lack of infrastructure, normal bribes, etc. hype costs and impede trade. Rating Warning In April, as the Indian economy and financial market deteriorated, Standard & Poor s reduced its outlook on India s long-term debt to negative and warned of a possible credit downgrade. S&P pointed to political gridlock and said there was a one in three chance of a downgrade from triple-B-minus, the lowest investment grade, to junk over the next two years if the external position continues to
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deteriorate, growth prospects diminish, or progress in fiscal reforms remain slow in a weakened political setting. Moody s and Fitch, the other major rating agencies, did not join S&P in its negative outlook but rated India at their lowest investment grade, just above junk. S&P worries that India s budget deficit (Chart 25) hit 5.8% of GDP in fiscal 2012 compared with the government s 4.6% target (Chart 51). In contrast to S&P s view of India, Indonesian debt was raised to investment grade by two rating firms and S&P raised its outlook on the Philippines to positive last December. In early November, Fitch raised Turkey s credit rating to investmentgrade, the first such rating since 1994. Fitch cited a moderating debt burden, healthy banking system and sound economic management. Capital Spending Weak With a subdued global economy, investment-depressing government policy and dropping foreign direct investment, private corporate capital spending in India has been on the decline since the Great Global Recession (Chart 52). It has fallen from 14% of GDP before the crisis to 10% in fiscal 2011, and even more in recent quarters. In the past, growth in capital formation in India correlated well with global GDP growth, but recently has dropped below zero while global GDP growth is running about 4.5% year-over-year (Chart 53, opposite page). This suggests structural problems such as inhospitable government policy, and the World Bank s Doing Business Rankings put India consistently below Brazil, China and Russia (Chart 54, opposite page). According to the World Economic Forum, India s global competitiveness fell to 56th place in 2011 from 49th in 2009. Among other problems, this reflected deteriorating transparency in government decision22 A. Gary Shilling's INSIGHT

CHART 50 Cost to Export 20-Ft. Container by Country


$ per container
Last Points 2012: India 1,095; US 1,050; UK 950; Germany 872; China 500
1200 1200

1000

1000

800

800

600

600

400

400

200

200

0 2006 India USA UK 2008 Germany China 2010 2012

Source: World Bank

CHART 51 Indian Government Deficit


% of GDP
Last Point FY 2012: -5.8%
7% 7%

6% 5% 4%

6% 5% 4%

3% 2% 1% 0% 2004 2005 2006 2007 2008 2009 2010 2011 2012

3% 2% 1% 0%

Source: India Central Statistics Office

CHART 52 Gross Fixed Capital Formation by Sector


as a share of GDP
Last Points: FY 2011
35% 35% 30% 25% 20% 15% 30% 25% 20% 15%

10% 5% 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

10% 5% 0%

Household Public Private Corporate

Source: Reserve Bank of India

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making and the relative slow growth in infrastructure. Indian real GDP grew 8.4% in both fiscal 2010 and 2011, but slipped to 6.9% in fiscal 2012 ending last March 31. In the second calendar quarter of 2012, it grew only 5.5% from a year earlier (Chart 55), a low rate in a developing country that needs at least that much growth to accommodate the 13 million new labor force entrants each year. The IMF predicts 4.9% real economic growth in calendar 2012, lower than its July forecast of 6.1% and the lowest in a decade. Productivity In the last two decades, real GDP-toworking age population (those 15 to 64), a measure of productivity, grew an average 4.6% per year. If this rate of productivity growth persists, adding in the 0.9% projected rise in the workingage population implies 5.5% annual GDP growth in coming years, just enough to accommodate new job entrants. This real GDP growth rate also implies a 4.6% annual rise in real GDP per capita. That compares with the low 1.8% from 1960 to 1991 and 5.0% since then (Chart 56, page 26). The slowdown in population growth from 2.2% per year from 1960 to 1991 to 1.8% since then and 0.9% projected for future years obviously boosts the per capita economic growth rates. Also, future growth depends on productivity gains, and whether the 4.6% annual rise in the GDP /working-age population ratio of the last 20 years persists. Industrial production is falling (Chart 57, page 26) and the HSBC India Manufacturing Purchasing Managers Index (Chart 58, page 26) is still above 50, indicating expansion, but dropping. Compared to the other BRICs in 2011, India had the highest inflation rate, the
25% 20% 15% 10% 5% 0% -5% -10% -15% 1997

CHART 53 Real Global GDP and Indian Fixed Capital Formation


year/year % change
Last Points: global GDP 2011 2.7%; India GFCF 2Q 2012 0.7%
5% 4% 3% 2% 1% 0% -1% -2% -3% 1999 2001 2003 2005 2007 2009 2011

India Real Gross Fixed Capital Formation - left axis Global Real GDP - right axis

Source: World Bank and Reserve Bank of India

CHART 54 Headline Doing Business Rankings


composite rank amongst all countries
Last Points 2012: Brazil 126; Russia 120; India 132; China 91
80 80

90

90

100

100

110

110

120

120

130

130

140 2006

2007

2008

2009

2010

2011

140 2012

Brazil Russia

India China

Source: World Bank

CHART 55 India Real GDP


year/year % change
Last Point 3Q 2012: 2.9%
14% 14%

12% 10%

12% 10%

8% 6%

8% 6%

4% 2%

4% 2%

0% 2007 2008 2009 2010 2011 2012

0%

(continued on page 26)


December 2012

Source: India Ministry of Statistics and Programme Implementation

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INVESTMENT THEMES
Our Investment Themes section reflects the positions that are in or being considered for our managed portfolios. We may add or delete portfolio positions in the course of the month, but those changes will not be shown in Insight until the following report.

Unresolved eurozone financial woes have spilled into economies there, and a European-wide recession is well underway. With falling exports, the hard landing we forecast in China still seems likely despite monetary and fiscal stimuli and stronger data of late. Huge deficits and gridlock in Washington have curbed sizable U.S. fiscal stimuli but the fiscal cliff will probably be avoided (see page 40). The euphoria over the Fed's QE3 will probably end with a shock that will benefit our quartet of investment strategies: long Treasury bonds, short stocks, short commodities and long the dollar.
Treasury bonds (favorable) The rally in Treasurys resumed in March as a safe haven in a sea of trouble and in response to slowing economic growth and looming global recession. The likelihood that inflation fears will turn soon to deflation worries also may help. The yield on 30-year Treasurys actually reached our 2.5% target, the 2008 postLehman low, in early June. A 2.0% yield is possible as economic and financial conditions deteriorate. Income-producing securities (favorable) As many investors favor income over problematic capital gains, included are stocks of utilities, drugs and telecoms with high, safe and rising dividends. But all stocks are vulnerable to a likely bear market. Also, investment-grade corporate and municipal bonds and some Master Limited Partnerships are attractive. Income-producing securities, however, are subject to the fiscal cliff. The dollar vs. the euro, Australian dollar and yen. Also the Dollar Index (favorable) The buck is the world's safe haven. The eurozone financial crisis remains unresolved and the recession there deepens. Australia has become a captive mineral supplier to faltering China. We're reinstating our negative stance on the yen with further massive monetary ease in Japan in prospect (see page 40). Rental apartments (favorable) have gained favor by those who can't afford home ownership and are discouraged by falling house prices. Their stock prices seem overblown, but direct ownership of rental apartments may still be attractive. Medical Office Buildings (favorable). The aging postwar babies, the 2010 health care law and the migration of physicians from private practice to hospital employment will promote robust, steady growth in this real estate sector. But government regulations can be disruptive. North American energy (favorable) Americans have decided to reduce dependence on imported energy from high-risk foreign areas. We like conventional energy investments including natural gas, on- and off-shore drilling and Canadian oil sands. Natural gas prices appear to have
24 A. Gary Shilling's INSIGHT

bottomed, and pipelines are attractive. New nuclear facilities may be postponed in the wake of the earthquake and tsunami in Japan. Renewable energy is problematic since it depends heavily on unpredictable government subsidies amidst federal cost-cutting. Developed country stocks (unfavorable) With a hard landing in China and the resulting negative effects on commodity exporters, a major recession in Europe and a strong dollar, earnings of U.S. multinationals are being hurt. A moderate recession in the U.S. will also damage corporate profits despite more cost-cutting in response. We look for $80 per share in S&P 500 operating earnings in 2013 and a bottom P/E of 10 (see page 40). Homebuilders are unattractive if house prices tumble as we forecast (see page 40). Your house, second home or investment single-family houses aren't attractive. Excess inventories are likely to push prices down another 20% over the next several years. U.S. major and regional banks (unfavorable) Major banks are being bereaved of proprietary trading and other profitable activities and are being busted back to lesslucrative spread lending. Regional banks suffer from weak loan demand and bad real estate loans. Junk securities (unfavorable) Despite recent pre-borrowing from yield-hungry investors, default rates are likely to leap in the global recession we foresee while junk prices drop. Developing country stocks (unfavorable) China will probably suffer a hard landing. She and other emerging exporters are vulnerable to economic weakness in the U.S. and Europe. Commodities (unfavorable) The commodity bubble started to break in early 2011 due to a prospective hard landing in China and the global recession. Copper is already down substantially and excess inventories in China loom.
December 2012

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Summing Up
In the wake of November s elections in the U.S., stocks stagnated as investors focused their attention and their fears to the looming fiscal cliff and prospects for a favorable resolution. Tax rates will rise and government spending will be cut sharply come January if Congress and the re-elected Obama Administration don t reach an agreement to avoid a situation that could cut consumer spending and real GDP and put the U.S. economy into a recession. The Dow Jones Industrials finished November down slightly while the S&P 500 was up slightly and the Nasdaq gained 1.1%. Overseas markets, however, were stronger. The dollar moved sideways against the euro last month and rallied vs. the yen. Treasury rates gained slightly. The Federal Reserve s policymaking committee meets next on Dec. 11-12. The approaching fiscal cliff and prospects for a peaceful resolution were on the mind of Fed Chairman Bernanke, who said in a Nov. 20 speech that uncertainty about the fiscal cliff, federal debt limits and challenges of balancing the U.S. budget were already affecting private spending and investment decisions and may be contributing to an increased sense of caution in financial markets, with adverse effects on the economy. Consumer prices rose 0.1% in October and were up 2.2% year-over-year. Core CPI was up 0.2% in October and rose 2% over the year. Producer prices declined 0.2% in October as declining energy prices outweighed rising food costs. Core PPI fell 0.2% in October and is up 2.1% yearover-year. The core personal consumption deflator, the Fed s favorite inflation barometer, has risen 1.6% from October 2011 through October 2012, safely below the Fed s 2.0% target.

spending, in part due to the East Coast hurricane in the final days of October, fell 0.2%. The personal saving rate edged up to 3.4% in October from 3.3%. Retail sales fell 0.3% in October after three straight months of gains, including an upwardly revised 1.3% rise in September. Auto sales fell 1.5%. The Christmas shopping season seemed to get off to a solid start, with spending in stores and online over the four-day Thanksgiving weekend rising 13% over last year, according to the National Retail Federation. Online shopping on Black Friday rose 26% to exceed $1 billion for the first time ever, according to ComScore Inc., and Cyber Monday online sales rose 20% over last year. The retail group predicts holiday sales to rise 4.1% this year vs. last year s 5.6% gain. Early Thanksgiving weekend sales may have pulled spending forward. The jobs picture has revived in recent months, with nonfarm payrolls increasing by 171,000 in October while September s figures were revised upward from a gain of 114,000 to 148,000.. The national unemployment rate, which declined to 7.8% in September, rose to 7.9% in October. Housing starts rose 3.6% in October to a four-year high. New home sales fell 0.3% in October vs. September due in some part to the East Coast hurricane in the final days of October. Still, sales year-over-year were up 17.2%. The median price of $237,700 was 5.7% higher than a year earlier while unsold inventories stood at a 4.8-months supply. Existing home sales rose 2.1% in October. The median price of $178,600 was 11.1% higher than a year earlier. Unsold inventories stood at 5.4 months supply, the lowest level since early 2006. The S&P/Case-Shiller index of property values in 20 cities rose 3% in September vs. a year earlier and 0.4% from August. Eighteen of the 20 cities surveyed showed gains, led by Phoenix s 20.4% year-over-year advance. The National Association of Home Builders confidence index rose five points to 46 in November the highest level since May 2006. Consumer sentiment rose to 82.7 in November from 82.6 in October, the University of Michigan reported. The Conference Board s index of consumer confidence rose to 73.7 in November its highest level since February 2008 from 73.1 in October. Fred T. Rossi Editor
A. Gary Shilling's INSIGHT 25

Ample global supplies kept crude oil prices stable in the mid-$80 range throughout November despite renewed Mid-East tensions and the late October East Coast Superstorm INSIDE THE NUMBERS Sandy that led to local supply shortages and rationing for several Nov. 2012 Year-to-Date days. Oil and gasoline prices have % Change* % Change stayed put for the most part since Dow Jones Industrials -0.5% +6.6% +0.3% early October. S&P 500 +12.6% The first revision of third quarter GDP showed a gain of 2.7% vs. the original +2.0% estimate, thanks to increased inventories, more federal spending and strong exports. Personal income barely rose in October while consumer
December 2012

Nasdaq Composite Nikkei Average FTSE 100 Hang Seng 10-yr. Treasury note $= =$

+1.1% +5.6% +1.5% +1.8%

Nov. 30 1.62% 82.44 1.30


*through Nov. 30

+15.5% +11.7% +5.3% +19.5% Oct. 31 1.69% 79.78 1.30

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India
(continued from page 23)
10% 8%

CHART 56 Indian Real GDP per Capita


Last Points 2011: level 837.7; yr./yr. 5.4%
1000

highest unemployment rate, the worst current account balance and the worst budget balance as a percentage of GDP (Chart 59, opposite page). Weak Stocks The stock market is often a good gauge of a nation s economic and financial health, and the two-year slide in the Indian market indicates a sick patient (Chart 45). Individual investors have been dumping Indian stocks (Chart 60, opposite page). Falling stock prices are no match for bank deposit rates of 8% to 9% and more than 8% on government 10-year bonds (Chart 47). So the government is giving tax breaks to individual investors with less than 1 million rupees in annual income (around $18,000) who invest up to 50,000 rupees in stocks annually and hold them for at least three years. Interestingly, as stock trade values dwindle, the MCX Stock Exchange recently received approval to deal in equities, equity futures and options, interest rate futures and some types of debt instruments. It opened in 2008 but was earlier allowed to trade currency futures. Now it will compete with the National Stock Exchange and the Bombay Stock Exchange where average daily trading volume in May was $350 million, down substantially from $600 million a year earlier. Ironically, just as India sinks into essentially a recession, the U.K. announced that it is terminating direct financial aid, to be phased out by 2015. Britain cites India s rapid economic growth in recent years and increasing ability to finance her own development programs. The U.K. has been providing 280 million ($448 million) for malnourished child support, education
26 A. Gary Shilling's INSIGHT

6% 4% 2% 0% -2% -4% -6% -8% 1960 100 1970 1980 1990 2000 2010

Year/year percent change - left axis Level (constant 2000 US$) - right axis (log scale)

Source: World Bank

CHART 57 India Industrial Production


year/year % change
Last Point 9/12: -0.4%
20 20

15

15

10

10

-5

-5

-10 Apr-06

-10 Feb-07 Dec-07 Oct-08 Aug-09 Jun-10 Apr-11 Feb-12

Source: India Ministry of Statistics and programme Implementation

CHART 58 HSBC India Manufacturing PMI


Last Point 11/12: 53.7
59 58 57 56 55 54 53 52 51 50 Jul-09 59 58 57 56 55 54 53 52 51 50 Nov-12

Dec-09 May-10 Oct-10

Mar-11 Aug-11 Jan-12

Jun-12

Source: Markit

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and health programs. Hoping to shift from aid to trade, Britain will still provide technical assistance, worth 30 million per year, for trade and private sector investments to profitably help the poor. Love Of Gold In India, gold prices and purchases are also major indicators of economic wellbeing. Ornate necklaces, armlets, earrings, bangles, gold chains and finger rings are essential parts of a Hindu bride s trousseau and usually bought by her parents. Our tire-changing driver on the trip back to New Delhi told us that the cost of his daughters trousseaus was a major strain on his finances, and he had to work and save for years for each trousseau. The World Gold Council reports that 27% of global demand for gold jewelry and investment comes from India. Nevertheless, gold purchases in India has fallen dramatically, with demand for jewelry down 30% in the first six months of this year from a year earlier and investment demand off 45% (Chart 61). The weak rupee has pushed up the local prices of gold (Chart 62, page 28), a revolting development this fall and early winter when consumption usually is strong due to upcoming Hindu festivals and the wedding season. Indian farmers, in reaction to the poor monsoon this year, have also cut back on gold jewelry for their daughters trousseaus. The Bombay Bullion Association early this year forecast a 20% drop in gold imports due to the falling rupee, but switched to a 40% drop with the weak monsoon and widespread closure of jewelry stores for 21 days to protest higher domestic taxes on gold jewelry and on gold imports. The situation is so dire that the government was forced to rescind the tax increase on gold jewelry. Also, Indians are trading old gold jewelry for new as the festival season unfolds. About 40% of gold sales are through
December 2012

CHART 59 Selected BRIC Economic Indicators


2011; %

Brazil 2.7 Inflation 6.6 Unemployment 6.0 Investment/GDP 20.6 Savings/GDP 18.4 Current account balance/GDP -2.1 Budget balance/GDP -2.6
GDP growth

Russia 4.3 8.4 6.5 23.2 28.6 5.5 1.6

India 7.2 8.6 9.8 34.4 31.6 -2.8 -8.7

China 9.2 5.4 4.0 48.3 51.0 2.8 -1.2

Source: IMF and The Economist

CHART 60 Indian Net Domestic Equity Mutual Fund Flows


billions of rupees
Last Point 9/12: -25.2
30 30

20

20

10

10

0 -10

0 -10

-20 -30

-20 -30

-40 Jan-11

-40 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12

Source: Securities and Exchange Board of India

CHART 61 India Consumer and Jewelry Demand for Gold


metric tons
Last Points 2Q 2012: consumer 181.3; jewelry 124.8
300 300

250

250

200

200

150

150

100

100

50

50

0 2009Q2

0 2009Q4 2010Q2 2010Q4 2011Q2 2011Q4 2012Q2

Consumer gold demand Jewelry demand only

Source: World Gold Council

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exchanges for old jewelry, up from 20% last year. And India s two national stock exchanges had special trading sessions on Sunday, Nov. 11 exclusively for gold exchange-traded funds. That day is the Hindu festival of Dhanteras, considered auspicious for buying gold, and the first day of the five-day festival of Diwali, which is associated with wealth and giftgiving. The exchanges are also trying to direct investors away from physical and into paper gold, and as of September, gold and ETFs in India had assets of $2 billion, up 40% from a year earlier. Gold is not alone in suffering in India. Early this year, DeBeers reported lower consumer demand for diamonds in India and weaker prices in the second half of 2011. More Reforms Forced

CHART 62 Gold Price in U.S. Dollars and Indian Rupees


% change since Jan. 1, 2011
Last Points 12/3/12: dollar 21.3%; rupee 48.6%
60% 50% 60% 50%

40% 30%

40% 30%

20% 10%

20% 10%

0% -10% Jan-11

0% -10% Dec-12

May-11 Gold in dollars Gold in rupees

Oct-11

Feb-12

Jul-12

Source: Bloomberg and Federal Reserve

CHART 63 Diplomatic Corps by Country

Size (thousands)
20.0 6.5 6.3 6.0 5.5 4.2 1.2 0.9 0.9

Pop./Diplomat (1,000s)
16 12 10 10 23 321 162 1,341 6

U.S. As noted earlier, Indians tend towards Germany fatalism and often aren t in big rushes France while politicians have to balance many competing forces, especially the current Britain Congress-led coalition that depends on Japan a number of small parties for support China and is so unpopular that its re-election in Brazil 2014 is in doubt. But the situation India became so dire by last summer that new Singapore reforms were forced on the government, starting in July. The crisis was precipitated not only by external problems and the effects of recent policy errors but also by strategies left over from the pre-1991 Soviet-style planning era and the Congress party s socialist background and bent toward income redistribution in favor of rural areas vs. economic growth. Also, impending elections in 2014 added further urgency to action now since the next budget, in the spring of 2013, is bound to be populist in preparation for the election.

Source: Shashi Tharoor

As noted earlier, India, unlike China, has been inward looking despite the detrimental effects of the Great Global Recession. India s foreign service has only about 800 diplomats, less than a fifth of China s and about the same as city-state Singapore (Chart 63). A single official in Delhi has charge of 19 Latin American ambassadors. Indian companies have to fend for themselves abroad without much government help while state-owned Chinese firms have cheap credit and diplomatic backing.
28 A. Gary Shilling's INSIGHT

This inward looking bias and India s traditional zeal to protect local businesses, especially small shopkeepers, has prevented Wal-Mart, Carrefour and other large multi-line retailers from entering India in a major way. Single-brand retailers like IKEA and Nike have been allowed to own 51% of their Indian operations, and then 100% as of last November, but must source products worth at least 30% of their sales from small- and medium-sized Indian firms. In November 2011, the government proposed that foreign big-box retailers could enter India, but backed off due to opponents who said that would put small shopkeepers out of business. Wal-Mart s Allowed In In July, however, the plan to let foreign multi-brand retailers own up to 51% of local ventures was reinstituted
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in order to attract foreign direct investment, improve supply chain infrastructure, raise incomes for farmers by cutting out marketing middlemen and reducing costs for consumers. Nevertheless, individual Indian states also have to approve the plan, and only 9 of 28 states did so promptly. New Delhi also is now allowing single-brand foreign retailers to source from bigger Indian companies.

CHART 64 Indian Prices for Gasoline and Diesel Fuel


rupees per liter
Last Points 10/27/12: gas 68.19; diesel 47.15
80 70 80 70

60 50 40 30

60 50 40 30

20

20

With poor infrastructure, including 10 10 Jun-02 Oct-03 Feb-05 Jul-06 Nov-07 Apr-09 Aug-10 Jan-12 inadequate warehouses and cold-storage Gasoline facilities, and difficulties in buying land, Diesel Wal-Mart says it will take 12 to 18 Source: Indian Oil months to open its first Indian store, and profits may be much further off. A maze of sales taxes, local road taxes and other levies also local firms and spur capital inflows and infrastructure add to costs. Furthermore, foreign retailers are only investment, the government raised by 50% the limit on allowed in cities with over 1 million people in order to rupee loans that infrastructure and manufacturing companies protect small-town retailers. can finance overseas. Also, firms importing goods for With similar start-up problems in China, it took a decade for Wal-Mart to make money there. It may take even longer in India. In early November, the RBI asked the enforcement wing of the Indian Finance Ministry to investigate WalMart for illegally putting money into a local supermarket chain before the recent policy liberalization. Furthermore, Wal-Mart is investigating whether some of its employees violated the U.S. Foreign Corrupt Practices Act by paying bribes in India. Among other recent policy changes geared to help the Indian economy, foreign carriers will be allowed to own up to 49% of Indian airlines if they want to help prop up this troubled sector. Only one of India s six commercial airlines makes a profit due to high costs for fuel, taxes and jet leases. Furthermore, to introduce new buyers for long-term government debt, foreign insurers allowed share of Indian insurers will rise from 26% to 49%. To gain access to lowcost funds to finance chronic deficits (Chart 51), the Indian government requires banks to hold 24% of deposits in government or other approved securities, and has tight investment guidelines for pension and insurance funds as well. Also to encourage foreign direct investment (Chart 26), the cap for foreign investment in cable and satellite TV operations will rise from 49% to 74%. The government also plans to sell equity in several state-controlled firms for $5.56 billion in the current fiscal year and open the pension sector to foreign investors. In order to ease borrowing by
December 2012

infrastructure will no longer need government approval to refinance abroad. The proposal to further regulate taxdriven deals has been postponed for a year, but not the retroactive taxes on Vodaphone-type transactions. But, like previous similar efforts, these liberalizations may have limited impact in the face of a slowing economy and weak rupee. Note, however, that the rupee did strengthen briefly last July when this package of reforms was announced (Chart 46). Diesel Prices Up The government also raised the price of diesel fuel by 14%. Still, diesel fuel, along with kerosene, fertilizer and food, still remains heavily subsidized. The IMF estimates that freeing diesel prices and reforming other subsidies would eliminate about two-thirds of the baseline fiscal deficit (Chart 51). Also, the gap between gasoline prices, which were deregulated in mid-2010, and still-subsidized diesel (Chart 64) has created severe problems for Indian auto producers. In late October, gasoline prices were 68.19 rupees per liter ($4.66 per gallon) and diesel was 47.15 rupees, a 45% spread and the largest in the world. So sales of gasoline-fueled vehicles have suffered. The 12% interest rate on car loans has also depressed sales. Low diesel prices have also forced the government to subsidize the losses of state-owned oil companies. Labor disputes have disrupted the Indian auto industry, among others. In July, nine policemen and 100 managers were injured at a diesel vehicle-producing factory of Maruti,
A. Gary Shilling's INSIGHT 29

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India s largest automaker, when workers rioted over the suspension of a worker who beat up a supervisor. Sonia Gandhi, the widow of former Prime Minister Rajiv Gandhi, heads the Congress Party and has been persuaded by Prime Minister Singh to support the new reforms. He convinced her that only by attracting more foreign direct investment can India afford the social-welfare programs she favors. With huge subsidy costs, only 20% of government borrowing goes for growthgenerating capital projects. She told a big rally of Congress supporters that foreign supermarkets will benefit not just our farmers but also our citizens and youth.

CHART 65 Indian Deficit Targets


share of GDP
6% 6%

5%

5%

4%

4%

3%

3%

2%

2%

1%

1%

0% 2012 2013 2014 2015 2016 2017

0%

Source: India Finance Ministry

CHART 66 Reserve Bank of India Repo Rate

But not all politicians support the Last Point 12/3/12: 8.0% reforms, especially the diesel price 9.5 9.5 increase that they see as harming poor 9.0 9.0 farmers and others. The Trinamool 8.5 8.5 Congress, a coalition partner of the 8.0 8.0 Congress Party and headed by Mamata 7.5 7.5 Banerjee, also the chief minister of 7.0 7.0 West Bengal state, left the United 6.5 6.5 Progressive Alliance coalition over the 6.0 6.0 government s plans to let foreign 5.5 5.5 supermarkets operate in India. She said they would harm small retailers. 5.0 5.0 The loss of 19 Trinamool Congress 4.5 4.5 Jan-07 Oct-07 Aug-08 Jul-09 May-10Mar-11 Jan-12 Nov-12Mar-12 Oct-12 seats in Parliament cuts the ruling Source: Bloomberg coalition to 254, less than the 272 needed for a majority. But, although from discounted prices to direct cash transfers. The weakened, it can draw support from the independent Finance Minister believes that giving recipients cash to buy Samajwadi Party s 22 seats to maintain control. Still, the food and cooking gas and to cover rural job guarantees will parliamentary session that commenced November 22 will improve efficiency over price discounts and reduce fraud. debate the government's plans to open India to multi-brand The switch will result in huge savings, he said but we re retailers and could shoot them down. not sure why. He also hopes to hit the budget target for fiscal 2013 ending next March 31 of 5.1% of GDP, he said In any event, the government subsequently shuffled the in an interview. Cabinet with new ministers for foreign affairs, power, oil, law and commerce in an attempt to refurbish the The government s subsequent five-year plan targets the government s corruption-tarnished image and prepare for fiscal 2013 deficit of 5.3% of GDP and down to 3% by the 2014 elections. The Prime Minister promoted five 2017 (Chart 65). Nevertheless, the new road map lacked existing members and brought in 17 new ones. Seven details. The IMF, however, believes the fiscal deficit could ministers departed. rise to 9% of GDP this fiscal year from 5.8% in fiscal 2012 (Chart 51). Other Reforms The government also hopes to cut subsidy costs by switching
30 A. Gary Shilling's INSIGHT

The recent batch of reforms were clearly forced on the


December 2012

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government, but it remains to be seen if they will be pursued vigorously and effectively. But the coalition apparently has not convinced the RBI that the weak economy and new reforms warrant a further cut in interest rates (Chart 66, opposite page), even though the central bank set deficit reduction and encouragement of foreign direct investment as prerequisites for monetary ease. And that s despite the slash in the RBI s growth forecasts in July for the current fiscal year from 6.5% real GDP growth from 7.3%. Now it doubts even that lower number, and many forecasters look for growth as low as 5.0%. In the third quarter, the annual growth rate was -0.4% at annual rates (Chart 67). The central bank continues to worry about inflation, which rose to 7.8% in September vs. a year earlier the highest in 10 months. As discussed earlier, artificial demand created by food and fuel subsidies, and inefficient supply, give inflation an upward bias and considerably isolates it from monetary and fiscal policy control.

CHART 67
qtr./qtr. % change; seasonally-adjusted annual rate
Last Point 3Q 2012: -0.4%
25% 25%

India Real GDP

20%

20%

15%

15%

10% 5%

10% 5%

0% -5%

0% -5%

-10% 2000 2002 2004 2006 2008 2010 2012

-10%

Source: Haver Analytics

CHART 68 U.S. Current Account and Federal Deficits


$ billion; fiscal year ending in 3Q
Last Points: current acct 2011 $453; deficit 2012 $1,089
1600 1400 1200 1000 800 600 400 200 0 -200 1600 1400 1200 1000 800 600 400 200 0

-200 In any event, in justifying its decision in -400 -400 September to leave interest rates 2000 2002 2004 2006 2008 2010 2012 Current Account Deficit unchanged, the RBI stated, In the Federal Budget Deficit current situation, persistent inflationary Source: Congressional Budget Office and Bureau of Economic Analysis pressures alongside risks emerging from twin deficits current account deficit and fiscal deficit constrains a strong response of monetary market and deregulated and corruption-free orientation policy to growth risks. The RBI hasn t moved since it cut needed to move from current low 5% annual real growth levels to higher sustainable gains. Land reform is needed its policy rate 0.5 percentage points in April, but in September it did reduce bank reserve requirements by 0.25 percentage not only to allow foreign supermarkets to get established points to 4.5% of their deposits. but also to make it easier for manufacturers to set up factories. A national sales tax would encourage intra-Indian India does not have the luxury of the U.S. in running twin trade by replacing the tangle of state levies. But state deficits. Indeed, foreigners so value the dollar and U.S. governments distrust the central government to give them their fair share of the proceeds. Treasurys that they freely recycle the dollars they receive from the U.S. current account deficit. So, those recycled greenbacks help finance the federal deficit (Chart 68). Corruption needs to be reduced by shifting away from a system in which politicians allocate public goods and many Further Reforms Needed feel entitled to the lifestyles of the very rich. India inherited her bureaucratic system from the British and then, in unBritish manner, added corruption to the formula. The Even if the new batch of reforms succeeds, many more are needed if India is to acquire the efficiency, infrastructure, licencing raj system may have been weakened since 1991, attractiveness to foreign direct investment and the free but is far from dead. Deregulating the distribution of coal

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would be a big plus. The government could break up or sell Coal India, a huge and inefficient state monopoly. That would make a repeat of the Coalgate scandal much less likely. Financial market development would be aided by reducing the requirement that banks and other financial institutions hold large quantities of government securities, as mentioned earlier. As a result, the private sector credit and corporate bond markets are relatively small. Also, reducing government s control of three-fourths of India s banks would make capital allocation more market-driven and efficient. IMF Recommendations

CHART 69 Cost of Starting a Business


% of per capita income
Last Points 2013 estimate: US 1.4%; UK 0.7%; Germany 4.9%; China 2.1%; India 49.8%
18 16 14 12 50 10 40 8 30 6 4 2 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20 10 0 80 70 60

USA - left axis UK - left axis Germany - left axis

China - left axis India - right axis

Source: World Bank

In its new World Economic Outlook, the IMF, with its penchant for vague generalities, said for India, there is an urgent need to reaccelerate infrastructure investment, especially in the energy sector, and to launch a new set of structural reforms, with a view to boosting business investment and removing supply bottlenecks. Structural reform also includes tax and spending reforms, in particular, reducing or eliminating subsidies, while protecting the poor. The IMF has also called for more agricultural productivity and land reform to reduce structural pressures on food prices. And it noted that trade liberalization, an educated workforce, access to information flows and technology are all associated with increased sophistication of exports and productivity. Among all its generalities, the IMF did, however, make a statement that struck us as profound. India s labor regulation, which is tighter than in most OECD [major] countries, should move toward protecting workers rather than jobs. Entrepreneurs Many Indians have strong entrepreneurial inclinations, and the economic growth they can spark is vital to reducing high poverty rates and corruption as economic power is shifted from politicians to entrepreneurs. Small- and mediumsized businesses are the largest nonfarm employers and account for 45% of manufacturing output. They add around 3.3 million workers annually. That s still well below the 13 million new labor force entrants each year, however. But corruption with routine bribe demands, byzantine
32 A. Gary Shilling's INSIGHT

bureaucracy and poor infrastructure impede entrepreneurial activity. In recent years, China has added annually about 10 times as much power to her electric grid as India. Government reluctance to enact land reform and other spurs to agribusiness as well as barriers to intrastate trade inhibit entrepreneurial opportunities and rural productivity growth. And 80% of entrepreneurs, according to a survey, believe that corruption is increasing which it probably is as economic expansion creates more opportunities for graft. Furthermore, a culture that penalizes risk-taking impedes new ventures. Indian business is concentrated among longexisting and well-connected conglomerates with close ties to the government, much like the state-owned entrepreneurs in China and the chaebols in South Korea. No significant Indian government-owned businesses have been privatized in years. One entrepreneur who makes environmentallyfriendly inks found his traditionally arranged marriage blocked by the prospective father-in-law who doubted his chances of success. Compared to the U.S., U.K., Germany and even China, India is off the charts in the cost of starting a business (Chart 69) and only topped by China in the time it takes (Chart 70, opposite page). Of 185 countries in 2013, according to the World Bank, India ranked 132nd in the ease of doing business, behind even notorious Russia (112) and Brazil (130) while China was 91st down the list (Chart 71, opposite page). She s 173rd in the cost of starting a business. India is only four off the bottom at 182nd in obtaining construction permits, which cost 1,528% of per capita income. In the ease of enforcing contracts, she ranks 184th and it takes 1,420 days on average, another indication that
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bureaucracy, corruption and a no-rush attitude still prevail in India. In the administrative burden and size of corporate profits taxes, India is 152nd with 33 payments per year on average. And when it comes to closing a business, Indian bureaucracy pushes her down to 116th of 185 with an average 4.3 years to complete the closing. In Russia, it takes 2.0 years, 4.0 in Brazil, 1.7 in China and 1.5 in the U.S.

CHART 70 Average Days It Takes To Start A Business


Last Points 2013 estimate: US 6; UK 13; Germany 15; China 33; India 27
90 80 70 60 50 40 30 20 10 90 80 70 60 50 40 30 20 10 0 2004 USA UK Germany 2005 2006 2007 2008 2009 2010 2011 2012 2013 China India

Many businesses slash the cost of bureaucracy and taxes by operating off the books. A landmark study in the mid-1950s found that the underground economy accounted for 4% to 5% of Indian GDP. It s estimated to have risen to 40% in 1996 and 50% a decade later. Education

Source: World Bank

Opening the economy to entrepreneurs remains a longerrun challenge for India as does educating those people and other Indians. About 97% of children enter school but more than half drop out before completing high school. Cheating on tests and bribing teachers for passing grades is rampant.

The literacy rate in India, 63% in 2006, the latest data, only ranks above Pakistan s 2009 rate of 55% among major countries (Chart 72, page 34), but it s up from 52% in 1991. School enrollment is the lowest, in high school and college, among the BRIC nations (Chart 73, page 34). Even more of a problem is the quality of Indian public education. Business executives complain about overbearing bureaucracy in highly-regulated schools and emphasis on rote learning rather than critical thinking and comprehension.

CHART 71 2013 Doing Business Rankings


of 185 countries

Ease of Doing Business Starting a business Cost (% income per capita) Obtaining construction permits Cost (% income per capita) Permits required Enforcing contracts Days to enforce Paying taxes Tax payments per year Resolving insolvency Years to close a business

India 132
173 49.8% 182 1,528% 34 184 1,420 152 33 116 4.3

Russia 112
101 2.0% 178 129% 42 11 270 64 7 53 2.0
Source: World Bank

Brazil 130
121 4.8% 131 36% 17 116 731 156 9 143 4.0

China 91
151 2.1% 181 375% 28 19 406 122 7 82 1.7

U.S. 4
13 1.4% 17 14% 15 6 370 69 11 16 1.5

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Government-mandated low tuitions result in low school budgets and low teacher salaries. A survey of 13,000 Indian schools found that the percentage of fifth graders who read at the second grade level was close to 50% in 2011 (Chart 74, opposite page). Because of poor public schools, 40% of Indians are estimated to make some use of private education private schools or tutors. A 2011 survey found that Indians spend 7.5% of their income on education, more than Brazilians, Chinese or Russians. Of India s 1.4 million schools, 500,000 are private with about 300 million students. But many private schools, like U.S. for-profit colleges, lure students with hopes for jobs after graduation, but don t deliver. An Indian call center found that so few high school and college graduates can communicate effectively in English and have basic reading comprehension that it could hire only three of each 100 applicants. Students in India s engineering colleges now number 1.5 million, up from 390,000 in 2000. But 75% of technical graduates and over 85% of general grads can t pass the tests for jobs in India s IT, call centers and other high-growth global industries. These businesses employ directly only 2.5 million Indians and are constrained from more rapid growth by shortages of adequately-prepared workers. Train Your Own Major Indian outsourcing firms Tata Consultancy and Wipro are increasing their training program durations to bring newly-hired graduates up to speed. Both companies made on-site evaluations of India s 3,000 engineering schools. Tata says 300 made the cut, but just 100 did for Wipro. Only two Indian universities rank in the world s top 500 compared to 22 in China, two in Russia, six in Brazil and 154 in the U.S. Higher training costs are reducing the international competitiveness of India s important outsourcing industry that contributed $69 billion annually to the Indian economy and account for a
34 A. Gary Shilling's INSIGHT

CHART 72 Adult Literacy Rates - Age 15 and Older

Russia Canada France Germany Ireland Italy Japan U.K. U.S. Spain Greece Taiwan Portugal China Mexico Indonesia Brazil South Africa India Pakistan

2010 2003 2003 2003 2003 2009 2002 2003 2003 2010 2009 2003 2009 2009 2009 2008 2008 2007 2006 2009

100% 99% 99% 99% 99% 99% 99% 99% 99% 98% 97% 96% 95% 94% 93% 92% 90% 89% 63% 55%

Source: United Nations and Central Intelligence Agency

quarter of exports, as noted earlier. Furthermore, competition from other countries, such as the Englishspeaking Philippines, is increasing. A survey by the Royal Institute of Chartered Surveyors estimates that in 2010, India needed 4 million civil engineers, but had 500,000, and 45,000 architects are working against a demand for 366,000. Another survey found that 17% of new engineering graduates had basic skills, 92% were

CHART 73 Gross School Enrollment Rates


no. enrolled/no. of corresponding age range; 2010 or latest data
India

Brazil

Russia

China

OECD

20

40

60

80

100

120

Source: World Bank

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deficient in programming or algorithms, 78% lacked English skills and 56% didn t have analytical skills. There is hope for Indian education, however. The new Right to Education law promises to lift quality by setting minimum standards for school buildings, playing fields, student-teacher ratios, etc. Also, some wealthy Indians are endowing universities, financing higher salaries to attract good faculty, hiring Indian academics from abroad and promoting research as well as teaching in higher education institutions. Furthermore, the Indian government, in partnership with Canada s DataWind, just unveiled a low-cost tablet computer to be sold to students for about $35, part of the government s effort to enlist the Internet in expanding education. Income Inequality and Poverty Income inequality has always been prevalent in India. Think of the fabulous wealth and buildings of the maharajahs and Mogul emperors of old, including the Taj Mahal, the tomb built by Shah Jahan for his favorite wife Arjumand Banu Begum, called Mumtaz Mahal, Chosen One of the Palace, from which Taj Mahal is derived. But income inequality is rising in recent years (Chart 75). McKinsey & Co. estimates that households making over $34,000 per year have risen from 1 million in 2005 to 2.5 million. But those on the bottom, with less than $3,000 per annum, have increased from 101 million in 2005 to 111 million. Nevertheless, the somewhat fatalistic Indians, many of whom believe they will be reincarnated into a better life, seem more accepting of rising income inequality than Americans who face the same phenomenon (Chart 76). The caste system also encourages acceptance of social and income inequality. Rising obesity is a problem for highincome Indians while caloric intake for the bottom 50% has been declining
December 2012
60%

CHART 74
5th graders who can read at a 2nd grade level
Last Point 2011: 48.2%
60%

India Child Literacy

50%

50%

40%

40%

30%

30%

20%

20%

10%

10%

0% 2006 2007 2008 2009 2010 2011

0%

Source: Pratham

CHART 75
ratio of the wages of the top 10% best-paid workers to 10% least-paid workers
Brazil

Ratio of Top to Bottom Earners by Country

China

India

Indonesia

OECD

2 Early 1990s Late 2000s

10

12

14

Source: Organization for Economic Cooperation and Development

CHART 76 Share of Aggregate U.S. Income


by income quintile
Last Points: 2011
52% 51% 50% Highest Quintile 49% 48% 47% 46% 45% 44% 43% 42% Lowest and Second Quintile 12% 11% 24% 10% 9% 8% 20% 7% 6% 5% 16% 4% 3% 14% 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 4th Quintile 5th Quintile (Highest) 18% 22% 26% Third and Fourth Quintile

1st Quintile (lowest) 2nd Quintile 3rd Quintile

Source: Census Bureau

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CHART 77 Poverty and Income Inequality in India

% of Pop. Undernourished India Bangladesh Nepal Sri Lanka Avg. South Asia China Indonesia Malaysia Philippines Thailand Vietnam Avg. East and SE Asia Brazil Mexico Russia South Africa Avg. Selected Emerging Mkts. 19.0 26.0 17.0 20.0 21.0 10.0 13.0 5.0 13.0 16.0 11.0 11.3 6.0 5.0 5.0 5.0 5.3

Net Enrollment Infant in Primary Mortality Educ. per 1,000 (Girls) Live Births 93.6 93.1 na 95.6 94.4 na na 94.0 93.2 89.4 na 92.2 94.3 99.6 94.6 90.3 94.7 50.0 40.0 43.0 15.0 32.7 17.0 28.0 6.0 24.0 12.0 19.0 17.7 18.0 15.0 10.0 43.0 21.5

% of Pop. Earning Below $1/Day 41.6 49.6 55.1 7.0 37.2 15.9 18.7 0.0 22.6 10.8 13.1 13.5 3.8 3.4 0.0 17.4 4.7

Gini Coefficient 36.8 31.0 47.3 40.3 39.5 41.5 36.8 46.2 44.0 53.6 37.6 43.3 53.9 51.7 42.3 57.8 51.4

Source: United Nations and World Bank

than many other developing countries. Nevertheless, since 1987. Principally because of malnutrition, 46% of overcoming poverty and income inequality remains a longchildren under three years are too small for their age, according to UNICEF. Although poverty in India has been run challenge for India. falling, it remains high due to inadequate economic growth, government inefficiency, corruption, CHART 78 rising income inequality, poor food distribution, as discussed earlier, etc. 2001 Indian Population by religion Some 41.6% of Indians are living below the World Bank s international $1 per day poverty line (Chart 77). Conditions Hindus 827.58 million 80.5% are worse in Bangladesh and Nepal, but Muslims 138.19 million 13.4% much better in China, Indonesia and Christians 24.08 million 2.3% even Vietnam. Sikhs 19.22 million 1.9% Buddhists 7.96 million 0.8% The Gini coefficient in the last column Jains 4.23 million 0.4% of Chart 77measures income inequality Other religions 6.64 million 0.6% in each country. If everyone had the Religion not stated 727,588 0.1% same income, it would be zero, and if Total 1.029 billion 100.0% one person had it all, the coefficient would be 1.0. India s 36.8 Gini coefficient, although rising, is still lower
36 A. Gary Shilling's INSIGHT
Source: 2001 Indian Census

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Refugee Problems In a country where life at the bottom is already tough, it s much worse for refugees such as the 200,000 crowded into deteriorating makeshift camps in the Indian state of Assam, which lies between Myanmar and Bangladesh. They were driven from their homes by clashes between Muslims, including migrants from Bangladesh, and a local indigenous tribe called Bodos. Ethnic clashes in India go back centuries when the Muslim Moguls invaded and took over India from the indigenous Hindus. Some years ago, we were in Varanasi in eastern India, considered to be the oldest inhabited city in the world and located on the sacred Ganges River where Hindi pilgrims bathe and want to die since that improved their chances of getting into heaven. We couldn t enter the old city, however, because of riots over a temple that both Hindus and Muslims claim had been turned over to Hindus. The partitioning into Hindu-dominated India and Muslimcontrolled Pakistan following independence from the British in 1947 involved a bloody war, and the conflict over Kashmir persists. Due to conflicts between Hindus and Sikhs in the 1980-1995 years in the state of Punjab, 30,000 died. Nevertheless, ethnic identity in India is fading somewhat, especially in the political arena. Young, urban, literate, mobile and privately-employed middle-class voters are still a minority, but more interested in efficient, clean government than religious or caste identity. Prime Minister Singh is a Sikh, a group that represented only 1.9% of Indians in 2001, the latest data (Chart 78, opposite page), and his Congress party was founded and still is controlled by Hindus while the President of India is a Muslim. Castes The millennia-old caste system in India obviously impedes

social mobility and economic growth. Every India is the same before the law, but caste determines social status, who they marry and their occupations. The caste system inhibits belief in upward economic and social mobility through education and training as well as hard work as do the Hindu beliefs in reincarnation and predestination in this life. The government, for the first time in years, is conducting a caste census of India s thousands of sub-castes although some fear it will encourage discrimination. The priestly Brahmins, who we ve even seen getting paid to bless people, are at the top. Next come the Kshatriyas, who are the warriors and rulers, and below them are the Vaishyas, the merchant and peasant caste. The fourth caste from the top are Shudras, the laborers of society. The Dalits, or untouchables, are on the bottom. When India moved toward capitalism in 1991, it set out to create equal opportunity for all, regardless of caste. The huge number of lower caste Indians used their voting power to more than double the number of jobs and government positions reserved for them. Doesn t this reverse discrimination remind you of what s going on in today s American universities? K.R. Narayanan, a member of the bottom-of-the-barrel Dalit caste, was Indian President from 1997 to 2002. In any event, the Indian Supreme Court in April outlawed India s unofficial courts that sanction honor killings in which families murder young lovers from different castes rather than suffer the humiliation of marriages across caste lines. Regardless of 20 years of efforts to break down caste influences on the economy, they do contribute to the wage inequality in India compared to Indonesia, Brazil and China (Chart 75). In 2010, median household income of high castes was over twice that of the Dalits. And the higher the caste, the more access to water piped indoors, flushable toilets, electricity, vaccinations for children, and the higher

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the male and female literacy rates and English skills. Urbanization
1.4 1.2

CHART 79 China Population Growth and Projections


billions
1.4 1.2 1.0 0.8 0.6 0.4

With urbanization comes economic 1.0 growth and higher incomes as higher0.8 paid, higher value-added city jobs 0.6 replace lower-income farmers. When 0.4 farmers move to cities and gain enough education and training to work in 0.2 factories, call centers and other 0.0 nonagricultural businesses, their 1960 1970 incomes and spending go up with Rural multiplier effects in the economy. It s Urban estimated that India s 100 biggest cities with 16% of the population contributed 43% to national income. Conversely, 69% of India s population is rural (Chart 40) and agriculture, which employs 50% of the workforce, produces only 17% of GDP (Chart 19). Urbanization remains a challenge for India. As noted earlier, subsidies and other government policies, at least until now, have encouraged rural life. Gandhi set the tone when he said that The soul of India lives in its villages. The number of city dwellers now numbers 377 million, or 31% of the population (Chart 40), and is growing by about 5 million a year as immigrants from the hinterland add to natural urban population growth. But there s a long way to go to catch up with China, where 49% of the population in 2010 was urban (Chart 79), even though unlike India, migrants from rural areas are legally discouraged from moving to cities. High Value-Added Jobs And those Chinese urbanites are much more likely than Indians to be working in high-value-added jobs in industry, which accounts for 46.6% of GDP (Chart 20) compared to 26.4% in India (Chart 19). Reducing subsidies for rural Indians could encourage them to move to cities, much as the Enclosure Acts in England from 1750-1860 pushed landless rural people into factory towns to man the budding Industrial Revolution. Indian rural subsidies might be better spent on social services such as old age pensions and disability insurance, health
38 A. Gary Shilling's INSIGHT

0.2 0.0 1980 1990 2000 2010 2020 2030 2040 2050

Source: United Nations

care, unemployment benefits and training, lifting India from dead last on the OECD s list of public social expenditures share of GDP (Chart 80). While India has much less of its GDP produced in industry than in China, services account for 56.4% (Chart 19) compared to 43.3% in China (Chart 20). Services range from high-value-added segments like IT down to restaurant dishwashers and rickshaw drivers, and on average have much lower productivity and wages than industry. But as noted earlier, demand for goods is much more volatile than for services, especially in the export arena. So India s more inward-looking stance and orientation toward the production of services does protect her more than China and other goods-export-led economies encourages from the ongoing global weakness and resulting even-greater depressed demand for goods exports.

CHART 80
as a share of GDP; latest data
30 30 25 25

Public Social Expenditures

20

20

15

15

10

10

United Kingdom Slovenia Netherlands Poland

Source: Organization for Economic Cooperation and Development

Telephone: 973-467-0070

Slovak Republic Israel(3) Russia Iceland Estonia Chile Turkey South Africa Korea Mexico China India

France Sweden Austria Belgium Denmark Germany Finland Italy Hungary Portugal Spain Greece Norway Luxembourg

Czech Republic Japan Switzerland New Zealand Canada Ireland Brazil United States Australia

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Infrastructure Of course, urbanization must be combined with deregulation, bureaucratic restraint, a clean government and adequate infrastructure to result in high efficiency and rapid economic growth. As noted earlier several times, Indian infrastructure needs vast improvement, another long-run challenge for that nation. As of May, every one of 17 important roads in India was clogged. To drive 856 miles from Delhi to Mumbai takes about three days, averaging only 13 miles per hour. And the road network is growing 4% annually but traffic is rising by 11%. Railroads are also troubled since raising passenger fares is politically impossible. So freight rates keep being increased, pushing goods into trucks that travel on crowded roads. As noted earlier, electric power generation is woefully inadequate, resulting in periodic and last summer, widespread blackouts. The IMF advocated urgent reforms in the power sector. To improve infrastructure it also is pushing for simplified permitting procedures, more enforceable contracts and more predictable and equitable land acquisitions. Pollution India has limited natural resources, but the almost total lack of local raw materials has not inhibited Japan s growth nor has their abundance in Brazil propelled her to a high level of economic development. India is also challenged to take care of her environment. Like other developing countries, air and water pollution are major problems. The Ganges is scared but tanneries, paper mills and other industries dump untreated waste into it. While there, we saw dead animals and children s corpses floating by, and men squatting on the river s banks. Outdoor toilet, our guide explained. Plastic and other liter doesn t seem to bother Indians. In China, at least, they have men in row boats fishing out the floating debris that accumulates in front of the Three Gorges Dam. Ancient Indian monuments, which we Americans would protect with armed guards, are routinely damaged by guides and locals crawling all over them. Indians are yet to acquire a sense of responsibility for their environment,
December 2012

their national treasures and public spaces. This may be due to overreliance on government to fix things, a historic caste culture, religious conviction that the present is unimportant, a sense of fatalism because Hindus believe the current human situation is the result of deeds committed in former lives, and pressures from India s huge population. And it simply may be part of the early stages of economic development. We can remember back in the 1970s when smog in Tokyo was so dense that you couldn t see the midday sun on an otherwise clear day. Now Tokyo has one of the cleanest environments of any major city. Old And Deep On visiting India, we realized immediately that this is a very old and very deep culture with a built-in resistance to rapid change. After independence in 1947, these aspects were reinforced by stifling bureaucracy, corruption, economydistorting subsidies, veneration of rural life, Soviet-style central planning and acceptance of slow growth. Russia and China similarly had slow growing, agriculturaloriented economies, and it may be that the only positive aspect of Communism has been the totalitarian control that allowed forced industrialization in both countries. It will be fascinating to see if India s problems can be overcome and rapid and sustainable economic growth established in a robust democracy. We believe India will succeed in the long run.

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Semi-Annual U.S. Economic Outlook: Very Cloudy


The U.S. economic outlook is very cloudy, with severe storms threatening on a number of fronts. All of them are within the global climate of long-term financial deleveraging, discussed in detail in our recent book, The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation. Five More Years

process began in the fourth quarter of 2007, the average has been 0.5% and 2.2% since the recovery started in the second quarter of 2009. And note that recoveries from recessions typically show much stronger growth than longterm averages. We ve also noted in past reports that, by examining the trade-off between real GDP growth and changes in the unemployment rate, 2% real growth is far below the 3.3% it takes just to keep the unemployment rate steady. A 2% real GDP growth indicates that the unemployment rate will rise, chronically, a little over one percentage point per year.

Chart 1 shows the cumulative net outside financing of the This implies that the 7.9% rate in October would be about five major sectors of the U.S. economy, all in relation to 8.9% in October 2013, 10% in October 2014, 11.1% in GDP. The Nonfinancial Corporate and Financial sectors October 2015, etc. No government left, right or center issue debt and equity but the two Government sectors and can endure high and chronically-rising unemployment so the Household sector, of course, only issue debt. Chart 1 the pressure to create jobs will remain for the duration of reveals four important things. First, the Financial sector started its immense leveraging up in the 1970s as debt-to-equity ratios of some CHART 1 financial institutions leaped from 20 to Sector Cumulative Debt and Issuance-to-GDP Ratio 40, and the Household sector followed Last Points: 2Q 2012 140% 140% in the early 1980s. That s when credit card debt jumped and mortgage 120% 120% downpayments dropped from 20% to 100% 100% 10% to zero and even negative numbers 80% 80% at the height of the housing boom as home improvement ( piggyback ) loans 60% 60% added to conventional mortgages pushed 40% 40% debt-to-equity ratios over 100%.
20% 20% 0% 2012

Second, the deleveraging process for both these sectors has commenced, but third, it has a long way to go to return to the long run flat trends and we are strong believers in reversions to trend. If we simply extend the downward slopes, it will take the Financial sector 9.5 more years to return to trend as bank assets continue to be dumped and capital raised, and 8.3 more years for the Household sector while debts are repaid or written off and assets are rebuilt through a rising saving rate (Chart 2). We continue to suggest about five more years of deleveraging, however, since adding that to the 2008-2012 initial span would bring the total to about 10 years, the normal length of deleveraging after major financial bubbles. We ve consistently forecast average real U.S. GDP growth in the Age of Deleveraging of 2%, and since the
40 A. Gary Shilling's INSIGHT

0% 1952

1958

1964

1970

1976

1982

1988

1994

2000

2006

Nonfinancial Corporate Household State and Local

Federal Government Financial

Source: Federal Reserve

CHART 2
seasonally-adjusted annual rate
Last Point 10/12: 3.4%
16 14 12 10 8 6 4 2 0 Jan-59 16 14 12 10 8 6 4 2 0 Jan-67 Jan-75 Jan-83 Jan-91 Jan-99 Jan-07

U.S. Personal Saving Rate

Source: Bureau of Economic Analysis

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deleveraging. And so will the huge federal deficits that result (Chart 3). The Power of Deleveraging This brings us to the fourth conclusion from Chart 1. The power of private sector deleveraging is manifest. Despite all the fiscal and monetary stimuli here and abroad since 2008, economic growth remains slow at best. Federal deficits have been running $1 trillionplus, the result of weak tax collections, tax cuts and government spending surges with the resulting leap in federal borrowing (Chart 1). Meanwhile, the Fed and other major central banks pushed the short-term rates they control to close to zero with little effect (Chart 4). Quantitative easing has probably induced those who sold Treasurys and mortgage-related securities to the Fed to invest in stocks, commodities and real estate, but the effects have been temporary (Chart 5). Furthermore, when the payments by the Fed for those securities cleared through the system, they have simply remained as excess reserves in the accounts of the banks. They now total about $1.5 trillion, the difference between total and required reserves (Chart 6, page 42), since banks are unwilling to lend except to the most creditworthy borrowers, and few of them want to borrow. U.K. Poor Timing Beyond chronic deleveraging, cyclical economic drags are found throughout the world. In 2010, the Cameron-led U.K. coalition government embarked on a noble experiment to slash government spending and employment over a five-year period in the hope that the private sector would be energized and more than make up the cuts. So despite average cuts in government department budgets of 19% over five years, economic activity would leap and with it, government tax collections, dropping the deficit from 9.4% of GDP in fiscal 2010-2011 to 1.5% in
December 2012
1600 1500 1400 1300 1200 1100 1000 900 800 700 600 Jan-07
400 200 0 -200 -400 -600 -800 -1000 -1200 -1400 -1600 1980 1985

CHART 3 Federal Budget Balance


$ billion
Last Point 2012: -$1,089
400 200 0 -200 -400 -600 -800 -1000 -1200 -1400 -1600 1990 1995 2000 2005 2010

Source: Congressional Budget Office

CHART 4 Central Bank Rates


Last Points 12/3/12
6% 6%

5%

5%

4%

4%

3%

3%

2%

2%

1%

1%

0% Jan-07

0% May-08 Sep-09 Feb-11 Jul-12

U.S. Fed. Funds Target Rate ECB Repo Rate

UK Bank Rate BOJ Call Rate

Source: The central banks

CHART 5 S&P 500 and Quantitative Easing


Last Point 12/3/12: 1,409
1600
Euro Crisis /Fiscal Cliff Greece 2 / Fed. Debt Ceiling

1500 1400
QE3

1300 1200

Greece 1

Op. Twist QE2 +24% QE1 +42% +20%

1100 1000 900 800 700 600

Oct-07

Aug-08

May-09

Mar-10

Dec-10

Oct-11

Jul-12

Source: Thomson Reuters and A. Gary Shilling & Co.

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2015-2016. The timing, however, was unfortunate, coinciding with the sovereign debt crisis in Europe. The 26 other countries in the EU bought 53.6% of British exports in 2011, which in turn were a substantial 31% of GDP in the third quarter. The U.K. government is determined to stick to its austerity plan despite fading popularity among voters, and the Treasury chief recently said the government plans further cuts in welfare spending aimed at encouraging people to work. The British recession with three consecutive quarters of falling real GDP was interrupted in the third quarter by extra spending on the London Olympic Games, but probably only temporarily. Meanwhile, the Bank of England has pursued aggressive quantitative easing to at least partially offset fiscal restraint. The BOE has expanded its assets more than any other major central bank since the financial crisis commenced (Chart 7). But as in the U.S., this massive quantitative easing has failed to revive the economy. Eurozone Crisis The eurozone is a clear-cut drag on the global economy as the ongoing financial crisis there has spilled into economic recession. The root of the financial problem is the combination of the Teutonic North with the Club Med South under one currency, but no common fiscal policy, and none likely given the vast cultural and economic differences between northern and southern eurozone countries. Can you imagine the Southern Europeans, who believe that paying taxes is only for wimps, living by the same rules as the Dutch, who believe that illegally parking your bicycle is a major offense, as we know from personal experience? Continual bailouts, increasingly the responsibility of the European Central Bank, appear to be the only alternative to a very messy and frightening dissolution of the eurozone.
42 A. Gary Shilling's INSIGHT

CHART 6 Required and Total Reserves of Depository Institutions


$ billion; seasonally-adjusted
Last Points 11/28/12: req. $111.8; total $1,539.6
1800 1600 1400 1200 1000 800 600 400 200 0 Jan-08 1800 1600 1400 1200 1000 800 600 400 200 0 Oct-12

Dec-08

Dec-09

Nov-10

Nov-11

Required reserves of depository institutions Total reserves of depository institutions (excess + required)

Source: Federal Reserve

CHART 7 Central Bank Assets

May 2007 Nov.* 2012 Bank of England ( billion) Swiss National Bank (CHF billion) Federal Reserve ($ billion) 79.4 105.6 896.1 414.8 503.6 2,852.9 3,035.3 155,369.0

% Increase 422.4% 376.7% 218.4% 160.5% 49.7%

European Central Bank ( billion) 1,165.4 Bank of Japan ( billion) 103,755.8

* Swiss National Bank data is through Sept. 2012; its data is released monthly Source: various central banks

CHART 8 U.S. and Eurozone Real GDP Since 2007-2009 Recession Peak
peak quarter=100
Last Points 3Q 2012: EZ 97.6; US 102.2
103 102 101 100 99 98 97 96 95 94 2007Q4 103 102 101 100 99 98 97 96 95 94 2008Q4 2009Q4 2010Q4 2011Q4

Eurozone (Q1 2008 Peak) US (Q4 2007 Peak)

Source: eurostat and Bureau of Economic Analysis

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And as in the U.S., when European commercial banks receive deposits from money created by the ECB or otherwise, they don t lend them out but stash them at central banks. Twelve of Europe s largest banks hold a total of $1.43 trillion of deposits at central banks as of Sept. 30, the sixth consecutive quarterly increase and up 84% since the end of 2010. In 2011 and early this year, the ECB pumped 1 billion ($1.3 trillion) in cheap three-year loans into 800 of its member banks. The Great Recession started in the eurozone in the first quarter of 2008, one quarter later than in the U.S., with a peak-to-trough decline of 5.6% vs. 4.7% in America (Chart 8, opposite page). And while the U.S. economy was about 2% above the previous peak in the third quarter after a very slow economic recovery, the eurozone economy is again falling without ever getting back to the earlier top. Eurozone industrial production is falling at a year-over-year 3% annual rate. Unemployment is rising and reached 11.7% in October, well above the Great Recession peak of 10.2% (Chart 9). In Spain, it now is 25% and has even topped 10% in France. Following S&P s credit downgrade of France in January, Moody s dropped its rating from tripleA in November, citing the country s reliance on borrowing to fund generous social welfare programs and Socialist President Hollande s overly optimistic growth targets and plans for tax increases that will depress consumer spending. Eurozone consumer sentiment is dropping back toward Great Recession lows. Spain s unwillingness to knuckle under to austerity requirements has delayed her application for ECB purchases of her short-term government securities. Meanwhile, her housing sector is collapsing with far to go. Notice (Chart 10) that Spanish house prices leaped by 213% from 1995 to their peak, much more than the 144% jump in the U.S. Yet the fall so far in Spain, 25.4%, is much less than the 30.5% drop seen in
December 2012

CHART 9 Eurozone Unemployment Rate


Last Point 10/12: 11.7%
12.0 11.5 11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 Jan-07 12.0 11.5 11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-12

Source: eurostat

CHART 10 House Prices: U.S. and Spain


Last Points 3Q 2012: Spain 1,566; U.S. 133
2200
Spain U.S.A.

220
2008-I 2006-I Spain U.S. Peak Qtr: 1Q+213%1Q+144% 2008 2006 Peak-Current: -25.4% -30.5% 1995-Peak: +213% +144% Peak-Current: -25.4% -30.5% Peak Qtr: 1995-Peak:

2000 1800 1600 1400 1200 1000 800

200 180 160 140 120 100 80 60 2012Q3

600 1995Q1

1997Q3

2000Q1

2002Q3

2005Q1

2007Q3

2010Q1

Spanish House Prices (Euros per square meter) -left axis US House Prices (Case Shiller National HPI) - right axis

Source: Standard & Poor's and Bank of Spain

CHART 11 Real Greek GDP


Last Points 2Q 2012: level 43.1; yr./yr. -6.2%
54 52 50 48 46 44 42 40 38 36 2001 2003 2005 2007 2009 2011 8% 6% 4% 2% 0% -2% -4% -6% -8% -10%

Level (bil. 2005 euros, SA) - left axis Year/Year percent change - right axis

Source: Hellenic Statistical Authority

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the U.S. Hapless Greece


86

CHART 12 U.S. Dollar Index and Euro FX Rate


Last Points 12/3/12: $79.87; euro 1.305
1.20

In hapless Greece, real GDP is already down 18.3% from its peak in the first quarter of 2008, with more to go (Chart 11, page 43). No wonder there are continual riots on the streets of Greek cities. And no wonder that the dollar is in an uptrend vs. the euro for the past 20 months (Chart 12). As noted in past Insights, the U.S. is exposed to Europe through exports, with 11.9% going to the eurozone and 3.4% to the U.K. (Chart 13). Nevertheless, with U.S. exports only 13% of GDP, the exposure of Americans exports to the eurozone and Britain is just 2.6% of GDP, not enough to sink the U.S. ship even if they decline sharply along with those economies. The exposure of U.S. banks, however, is a different matter. As shown in Chart 14 (opposite page), 24.2% of their total foreign exposure through loans, leases, derivatives, etc. is with the eurozone and 43.9% when the U.K. is included. And derivatives in the calculation are on a net basis. But if a major European bank were to fail, it s the gross exposure, the counterparty risk, that matters. The Bank for International Settlements estimates that at the end of June, the gross, or notional, value of $25.4 trillion in derivatives globally was $639 trillion, or 25 times the net amount. Japan s Deflationary Depression Lingers

84 82

1.25

1.30 80 1.35 78 1.40 76 74 72 Jan-11 1.45

May-11

Oct-11

Feb-12

Jul-12

1.50 Dec-12

ICE U.S. Dollar Index (nearest futures contract) - left axis U.S. Dollars per Euro - right axis (inverted)

Source: Thomson Reuters

CHART 13 2011 U.S. Imports and Exports by Destination


$ million

TOTAL North America Canada Mexico Europe Euro Area European Union U.K. Pacific Rim Countries China Japan South America Africa OPEC

----Total Imports---Value % of Total 100.0% 2,187.0 26.5% 579.1 14.5% 316.4 12.0% 262.7 441.1 279.5 362.4 51.0 714.3 398.5 127.9 166.6 92.7 184.7 20.2% 12.8% 16.6% 2.3% 32.7% 18.2% 5.8% 7.6% 4.2% 8.4%

----Total Exports---Value % of Total 1,480.6 100.0% 393.7 26.6% 233.8 15.8% 159.9 10.8% 297.0 176.1 241.1 50.0 335.5 96.9 61.4 152.7 31.8 59.5 20.1% 11.9% 16.3% 3.4% 22.7% 6.5% 4.1% 10.3% 2.1% 4.0%

Source: Census Bureau

Japan remains another drag on global economic growth. She has been trying for years to exit her two-decade-long deflationary depression. Immense government debt has been built up in the process (Chart 15, opposite page). Monetary policy also has been aggressive. In fact, years ago the Bank of Japan was the first major central bank to embark on quantitative easing. Just last month, the BOJ increased its asset-buying binge by 11 trillion ($134 billion) to 91 trillion, and also initiated a plan to furnish banks with continued cheap long-term money, initially 15 trillion. The BOJ also set a 1% inflation target to combat chronic deflation (Chart 16, page 46), and wants 2% annual price increases in the long run.
44 A. Gary Shilling's INSIGHT

Nevertheless, the economic malaise persists with real GDP falling at a 3.5% annual rate in the third quarter, with the brief recovery from the March 2011 earthquake and tsunami now over. In export-driven Japan (Chart 17, page 46), the $6.7 billion trade deficit in October was the fourth in a row. As we ve discussed in past Insights (see A Faster Train Wreck, April 2011), Japanese consumers and businesses save enough to finance her chronic government deficits
December 2012

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CHART 14 U.S. Bank Exposure to the Eurozone and U.K.


$ billion; as of June 30, 2012

Claims on Banking Sector Belgium France Germany Italy Luxembourg Netherlands Austria Finland Greece Ireland Portugal Spain Slovakia U.K. Total Eurozone* Total Eurozone* + U.K. 10.4 118.3 98.8 11.4 2.9 29.0 3.9 5.4 0.8 15.9 1.8 18.7 0.0 155.9 317.3 473.2

Claims on Public Sector 7.1 27.2 117.9 32.9 5.8 12.2 7.3 2.8 0.6 1.1 0.9 6.8 0.3 73.3 222.9 296.3

Claims on Other Sector 7.8 95.7 72.8 19.1 23.6 78.8 4.6 2.6 3.4 39.6 2.7 24.8 0.6 516.9 376.1 893.0

Total Claims 25.3 241.2 289.5 63.4 32.3 120.0 15.7 10.8 4.8 56.7 5.4 50.3 1.0 746.1 916.4 1,662.5

Total Claims as a % of Global Exposure 0.7% 6.4% 7.7% 1.7% 0.9% 3.2% 0.4% 0.3% 0.1% 1.5% 0.1% 1.3% 0.0% 19.7% 24.2% 43.9%

* Data for Cyprus, Malta and Slovenia not available

Source: Federal Financial Institutions Examination Council

and still have excess funds to export, as reflected in her current account surplus (Chart 18, page 46). That s kept yields on government securities low and manageable. But the deteriorating trade balance is likely to push the current account into negative territory. Then Japan will have to import capital to finance government deficits and pay much higher, global interest rates, potentially setting off a self-feeding debt spiral. More GE Meanwhile, Japanese government leaders wrangle. Shinzo Abe, the leader of the Liberal Democratic Party and likely next Prime Minister following the December 16 election, wants much more stimulus, including a $2.5 trillion public works package the equivalent of a whopping 43% of Japanese GDP. He also wants to rescind the new doubling of the sales tax. He has called for the firing of the BOJ governor if the 2% to 3% inflation target isn t met, unlimited easing by the central bank to meet that target, cutting interest rates to below zero and having the BOJ underwrite directly government banks. Abe also questions whether the BOJ should remain independent of the
December 2012

government. It only became independent in 1998. In an unusual reaction by a major central banker, BOJ Gov. Masaaki Shirakawa responded to Abe s proposals, point by point. He noted that no central bank in an industrialized country is allowed to underwrite government securities, and if the BOJ did so, long-term interest rates would rise and eventually have a negative impact on the real economy. Negative interest rates, he said, would severely disrupt the money market and result in liquidity fears. He also said, 3% is unrealistic, and seeking such a high price level, not
CHART 15 Japanese Net Government Debt
as a % of GDP
Last Points 2011: 126.4

140% 120%

140% 120%

100% 80% 60% 40% 20% 0% 1980

100% 80% 60% 40% 20% 0% 1985 1990 1995 2000 2005 2010

Source: IMF

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seen for many years, would cause damages to the economy. Just as quantitative easing by central banks has hyped stocks in the U.S., U.K. and the eurozone, Abe s proposal for even more QE in Japan has energized equity buyers. At the same time, the yen, which has been a safe haven for investors despite the chronically miserable economy, has been falling vs. the dollar recently (Chart 19, opposite page). Japanese exporters, of course, cheer a weaker yen. They complain that its strength in recent years has put them at a huge competitive disadvantage in global markets and forced production to move offshore. Part of Japan's deteriorating trade balance (Chart 18) has been due to global economic slowdown but probably also partly due to the strong yen. This has allowed other countries to export at the expense of Japan. Abe's aggressive QE goals may be aimed at weakening the yen, to the advantage of exporters, as well as stimulating domestic buyers who will increase purchases as they anticipate inflation. If so, Japan would join other countries in competitive devaluations, which are troubling protectionist policies. And ultimately, these devaluations are all against the dollar, the world's major reserve, safe haven and trading currency. China Hard or Soft Landing? We ve been forecasting a hard landing in China with year-over-year real GDP growth retreating to the 5%-6% range seen in the depths of the Great Recession (Chart 3, page 2). Massive government stimuli in reaction to the recession, the equivalent of 12% of GDP, revived the economy rapidly, but also spawned major inflation and a property bubble. So the Chinese government slammed on the brakes, to the detriment of real estate and economic growth. Exports remain the driver of the Chinese economy, and with European recessions and slow U.S. recovery, their growth
46 A. Gary Shilling's INSIGHT
14% 12% 10% 8% 6% 4% 2% 0% -2% -4% Jan-90

CHART 16 Japanese Money Supply and Prices


year/year % change
Last Points 10/12: CPI -0.4%; M2 2.3%
14% 12% 10% 8% 6% 4% 2% 0% -2% -4% Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11

Yr/Yr Change in CPI Yr/Yr Change in M2 Money Supply

Source: Bank of Japan and Statistics Bureau of Japan

CHART 17 Japanese Real GDP and Exports


year/year % change
Last Points 3Q 2012: GDP 0.2%; exports -4.9%
8% 6% 4% 2% 0% -2% -4% -6% -8% -10% -12% 1990-I 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% 1993-I 1996-I 1999-I 2002-I 2005-I 2008-I 2011-I

Real Gross Domestic Product - left axis Real Exports - right axis

Source: Japanese Cabinet Office

CHART 18 Japanese Current Account and Trade Balance


100 million yen; seasonally-adjusted
Last Points 3Q 2012: current acct. 9,158; trade bal. -16,899
70000 60000 50000 40000 30000 20000 10000 0 -10000 -20000 1985 70000 60000 50000 40000 30000 20000 10000 0 -10000 -20000 1988 1991 1994 1997 2000 2003 2006 2009 2012

Current Account Trade Balance

Source: Japanese Ministry of Finance

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rate has swooned (Chart 20). So it s back to government stimuli, but this time through fiscal spending. The last round was done mainly through bank lending and resulted in the property bubble, oceans of bad debts and reluctance of banks to lend. China has cut bank reserve requirements and interest rates (Chart 15, page 7) but also approved 1 trillion yuan ($158 billion) in new infrastructure projects over four years, including railroads, roads, harbors and airports. But note the caution of Chinese officials amidst the once-in-adecade leadership transition. This trillion-yuan is only one-fourth of the previous program, which was spread over two years. So on an annual rate basis, the new effort is only one-eighth as big. Nevertheless, the growth rate in Chinese industrial production rose to 9.6% yearover-year in October after falling from rates close to 20% in late 2009. The HSBC China Manufacturing Purchasing Managers Index rose to above 50 in October, indicating expansion, for the first time since October 2011 (Chart 21). And export growth is back to 11.6% in October vs. a year earlier although well below the over 40% rates in 2010 (Chart 20). Blip Or Soft Landing?

CHART 19 Nikkei 225 and Yen Exchange Rate


Last Points 12/3/12: yen/$82.23; Nikkei 9,458
84 83 82 81 80 9200 79 78 77 76 Dec-11 9000 8800 8600 8400 8200 Mar-12 May-12 Jul-12 Oct-12 10400 10200 10000 9800 9600 9400

Yen per Dollar - left axis NIKKEI 225 Index - right axis

Source: Thomson Reuters

CHART 20
year/year % change
Last Point 10/12: 11.6%
60% 50% 40% 30% 20% 10% 0% -10% -20% -30% Jan-06 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% Nov-11 Sep-12

Chinese Exports

Nov-06 Sep-07

Jul-08

May-09 Mar-10 Jan-11

Source: China General Administration of Customs

Are these stronger numbers indicators of a soft landing with higher Chinese growth ahead, or just a momentary blip on the route to a hard landing? We re sticking to the latter forecast. The trend in all-important export growth is still down (Chart 20), and China is far from a domestic-led economy with only a tiny 37.7% of GDP accounted for by consumer spending (Chart 5, page 3), well below any other major developed or developing economy. Also, the stock market, the best of leading indicators, continues its downward trend (Chart 22, page 48). Net profits for the 2,500 companies listed on mainland China stock exchanges rose a mere 0.4% in the third quarter
December 2012

CHART 21 Markit/HSBC China Manufacturing PMI


Last Point 10/12: 50.4
58 56 54 52 50 48 46 44 58 56 54 52 50 48 46 44

42 42 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-12 Oct-12

Source: Markit

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year-over-year after falling 1.8% in the second quarter. Excess inventories are no doubt emerging. In the last four quarters, they averaged 20.4% of revenues, up from the peak of 18.3% in 2009 when inventories were leaping as revenues nosedived. With wages up 73% in manufacturing from 2007 to 2011, profit margins dropped from 12% in 2007 to 8% in the third quarter of 2012. Excess capacity also remains a major problem. Chinese gross debt of nonfinancial sectors government, households and business dropped from 207% of GDP in 2010 to 198% in 2011 but is likely to reach 206% this year, according to our friends at GaveKal. The increased leverage is not due to excessive lending, which is expected to rise 16% this year compared to 14% in 2011. Instead, it s slower growth in nominal GDP at about 14%-15% this year. Just as with job-creating, developing countries need rapid economic growth to keep up with expanding debt. External Effects

CHART 22 Shanghai Composite Index


Last Point 12/3/12: 1,960
6500 6000 5500 5000 4500 4000 3500 3000 2500 2000 1500 Jan-07 6500 6000 5500 5000 4500 4000 3500 3000 2500 2000 1500 Nov-07 Aug-08 Jun-09 Apr-10 Feb-11 Dec-11 Oct-12

Source: Thomson Reuters

CHART 23 Reuters/Jefferies Commodity Research Bureau Index


Last Point 12/3/12: 300.3
500 450 400 350 300 250 500 450 400 350 300 250 200 150 100 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

China is now the world s second largest 200 economy, and weakness there does have significant external effects. As we ve 150 noted in past Insights, it s probably no 100 coincidence that China s joining the Jan-00 Jan-02 World Trade Organization at the end of 2001 was followed by the commencement of the global commodity price bubble in early 2002 (Chart 23). And it has been a bubble, in our judgment, based on the conviction that China would continue to absorb huge shares of the world s industrial and agricultural commodities. The shift of global manufacturing toward China magnified her commodity usage as, for example, iron ore that previously was processed into steel in the U.S. or Europe was sent to China instead. As a result, China in recent years consumes 42% of annual world production of nonferrous metals such as copper, tin, lead and zinc as well as half of global iron ore output and huge portions of coal and other industrial materials. China s oil stockpiles are unknown but probably have leaped. She s also importing soybeans, grains and other agricultural production heavily as diets are upgraded to contain more meat. Chickens and hogs don t convert all of the corn they eat to meat, so more grain is needed than if it s eaten directly
48 A. Gary Shilling's INSIGHT

Source: Jefferies and Co.

by humans. Since early 2011, however, commodity prices have been falling (Chart 23), probably reflecting global economic slowdown or recession and a hard landing in China. The end of the commodity bubble is not only negative for commodity prices but also commodity-exporting countries such as Brazil and their currencies as well as suppliers to commodity producers. Australia Australia has, in many ways, become a Chinese colony as they dig up the island continent and export the iron ore, copper, coal, etc. to China. The Australian government planned to erase a $46 billion budget deficit with higher taxes on mineral producers. But with iron ore prices down
December 2012

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24% in August alone, they are about half the level the Australian government planned on. Coal prices are half their 2008 peak. So miners are retrenching and canceling expansion projects, leaving Australia with a potential $10 billion shortfall in tax receipts. Then on October 3, the Australian central bank cut its target rate by 0.25 percentage points to 3.25%, with a cumulative 1.50 percentage point decline since last November. In announcing the cut, Reserve Bank of Australia Governor Glen Stevens said, Growth in China has also slowed, and uncertainty about near-term prospects is greater than it was some months ago. Key commodity prices for Australia remain significantly lower than earlier this year. Australian exports to China equal 5% of GDP, and 60% are shipments of ore. Australian growth slipped to 0.6% in the second quarter from 1.4% in the first, payrolls were unexpectedly cut in August and business confidence is falling. Indonesia and Canada

CHART 24 U.S. and Canadian House Price Indices


Jan. 2000=100
Last Points: Canada 10/12 227.5; US 9/12 157.7
240 240

220 200

220 200

180 160

180 160

140 120

140 120

100 Jan-00

100 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10 Sep-11

Canada Composite 11 City U.S. Case-Shiller 10 City

Source: Teranet, National Bank of Canada and Standard & Poor's

CHART 25
as a share of disposable personal income
Last Points 2Q 2012: Canada 163.4%; US 108.9%
170% 160% 150% 140% 130% 120% 110% 170% 160% 150% 140% 130% 120% 110%

Canadian and U.S. Household Debt

Indonesia, another commodity exporter 100% 100% with 240 million people, is also 90% 90% 2000-I 2002-I 2004-I 2006-I 2008-I 2010-I 2012-I experiencing slowing growth. Real GDP Canada rose 6.2% in the third quarter, the U.S. slowest in two years. That country has Source: Statistics Canada and Federal Reserve flipped from a foreign trade surplus to a deficit recently due to weakening exports while imports leap. Worried investors are depressing Canada is also a major commodity exporter, and 70% of the rupiah currency. The government has enacted new her exports go to the U.S. But with more prudent monetary restrictions on foreign ownership of mines and is and fiscal policies, Canada was less affected by the Great renegotiating mining royalties with major foreign investors. Recession and has enjoyed a stronger recovery. Nevertheless, years of relatively easy credit and low interest Government transparency, protectionism, infrastructure rates fueled a Canadian housing boom. Home construction and corruption are problems for foreign direct investment. and sales constitute 21% of Canadian GDP, and house While Indonesia ranks in the world s top 10 countries for prices are up 125% since 2000 vs. 40% on balance in the mineral potential, it s in the bottom 10 in terms of government U.S. after their big crash (Chart 24). Furthermore, household policies on exploration. Only a quarter of U.S. companies debt continues to rise in Canada long after it commenced plan to expand operations there compared to 72% last year. its decline in the U.S. (Chart 25). The country has switched from being an oil exporter to an importer as aging oil fields have not been replaced. A Now, however, the Canadian housing boom is showing newly-enacted 44% rise in minimum wages to $228 per signs of deflation, and Canada may soon join other developed month in Jakarta may spread elsewhere in the country and countries in deleveraging. House prices in Vancouver are spawn inflation, also discouraging to foreign direct down 11% from their April 2011 peak as wealthy Chinese investment.
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buyers who drove that market retrench. House sales dropped 33% in September from a year earlier while listings jumped 14%.

CHART 26 2013 Effects of Fiscal Cliff

Eliminate Across-the-board defense cuts

Annual Difference Increase in ----------from Baseline---------- ----2013---Employment (mil) % of GDP Deficit ($ bil) 0.4% 24 0.4

Toronto s red-hot condo Cuts in discretionary spending & reduction in 0.4% 40 0.4 market, also fueled by Medicare doctor payment rates Asian buyers, has Extend attracted the attention of Expiring tax provisions & index AMT for government officials, and inflation 1.4% 330 1.8 the Finance Minister aims at taking the froth out of Payroll tax reduction for employees markets by limiting credit. & emergency unemployment benefits 0.7% 108 0.8 The maximum life of TOTAL 2.9% 502 3.4 home mortgages has been Source: Congressional Budget Office cut from 30 to 25 years, and minimum downpayments raised to 20% from CHART 27 15% for houses worth over C$1 million. Real GDP During Recessions $ 2005; seasonally-adjusted annual rate Condo and apartment sales in the third quarter dropped 21% from a year Real GDP Trough Peak-to-Trough Real GDP Peak earlier, but prices remained steady, rising % Change Recession Quarter Level Quarter Level 0.5%. 1948-49 4Q 48 1868.2 2Q 49 1835.5 -1.8% 1953-54 2Q 53 2366.2 1Q 54 2303.5 -2.6% With weakening commodity prices, a 1957-58 3Q 57 2616.6 1Q 58 2519.0 -3.7% vulnerable housing market and 1960-61 1Q 60 2845.3 4Q 60 2800.2 -1.6% overleveraged consumers, the Canadian 1969-70 3Q 69 4279.7 1Q 70 4252.9 -0.6% economy seems destined for slower 1973-75 4Q 73 4948.8 1Q 75 4791.2 -3.2% growth if not recession. Expensive oil 1980 1Q 80 5903.4 3Q 80 5771.7 -2.2% sands production in Alberta is being 1981-82 3Q 81 6025.0 3Q 82 5861.4 -2.7% subdued by cheap and abundant natural 1990-91 2Q 90 8052.7 1Q 91 7943.4 -1.4% gas in the U.S. The Finance Minister 2001 2Q 01 11361.7 3Q 01 11330.4 -0.3% expected real GDP to rise 2.1% this 2007-09 4Q 07 13326.0 2Q 09 12701.0 -4.7% year but reduced his 2013 forecast from 2.4% to 2%. In the third quarter, Canadian real GDP rose only 0.6% from the second quarter at annual rates, following 1.7% gains in the previous two quarters. The real trade deficit leaped from C$38.1 billion in the second quarter to C$50.7 billion, knocking 0.8 percentage points off real GDP growth. Residential construction was down at a 3.5% annual rate. Only the unusually large 3.8% annual rate rise in consumer spending saved the day. Fiscal Cliff Back in the States, going off the fiscal cliff on Jan. 1, 2013 would almost certainly precipitate a major recession. The nonpartisan Congressional Budget Office estimates that the expiration of the George W. Bush-era tax cuts, a drop in unemployment benefits from a 99-week minimum back to 26 weeks, reversion of payroll taxes on employees back
50 A. Gary Shilling's INSIGHT
Source: Bureau of Economic Analysis

to 6.2% from 4.2%, the sequestration of discretionary spending because Congress couldn t reach a budget compromise last year, etc. will take 2.9% out of real GDP in 2013 (Chart 26). This in itself constitutes a major recession by post-World War II standards (Chart 27). Analysis by the Tax Policy Institute, a joint venture of the Brookings Institution and the Urban Institute, shows that about 90% of American households would pay higher taxes in 2013. A working couple with a $350,000 income would see their federal taxes rise $13,847, or 20.3%. A lowincome couple earning $20,000 to $30,000 would have a 5.6% tax increase, or $1,423, while a student with $10,000 to $20,000 in income would pay $308, or 38%, more. Note, however, that because of progressive income tax rates, the top 20% with incomes over $244,576 would pay 60% of the increase while the bottom fifth with $11,290 average
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income would be hit for 3.7% of the total rise. And for those not working, 40%, or 2.1 million, of 5 million receiving unemployment benefits would lose them as the maximum payment period drops from 99 weeks back to 26 weeks. That number has dropped from 6 million getting extra benefits in 2010 as some got jobs and many exhausted their benefits.
25%

CHART 28 Social Security, Medicare and Medicaid


as a % of GDP
25%

20%

20%

15%

15%

10%

10%

5%

5%

Some, of course, don t take jobs they Social Security don t like or that pay less than their Medicare previous employment because Medicaid + CHIP + Exchange Subsidies unemployment benefits are available. Source: Congressional Budget Office and Socal Security Administration Estimates are that the lack of incentive created by extended benefits added about 1% to the unemployment rate at the peak of the jobs so he might agree to giving the President the revenue crisis. increase from top earners that he wants by limiting tax deductions or raising taxes on dividend income and capital Slope Or Cliff? gains. The fiscal cliff, however, is probably more of a steeply No Serious Restraints declining slope than a straight drop. Most income and payroll taxes are collected through withholding from For two reasons, however, we doubt that Washington will paychecks, and it takes time for the government and allow significant revenue increases or spending cuts. First, employers to change those schedules. Also, the Treasury politicians don t want to be held responsible for driving an might delay releasing new withholding schedules if it already weak economy in a distinctly subpar recovery believes that Congress and the Administration are soon to straight into the mud. Second, there is an alternative that reach an agreement. would show they re doing something without inflicting current pain and suffering. Politicians always prefer In any event, some observers believe that doctrinaire alternatives that delay any negative effects on voters, Senators on the left and right will let the economy go off perhaps until they re retired. the fiscal cliff. After all, the election resulted in the same President and little change in either house of Congress with To examine this alternative, we need to be clear about the the GOP still controlling the House and the Democrats two types of federal deficits. The current $1 trillion-plus running the Senate. So why won t gridlock continue? deficits (Chart 3) are cyclical, the result of depressed tax revenues in the Great Recession and weak recovery while Maybe it will, but inaction in Washington and the resulting tax cuts and federal spending jumps hiked outlays. As noted recession would only convince voters that they just elected earlier, these big deficits will persist until deleveraging is a bunch of irresponsible children. Congresses and completed and high unemployment recedes. Administrations in the past usually did what s necessary but often as late as possible. And avoiding the fiscal cliff strikes The other type is the structural deficits created by the us as necessary. mushrooming Social Security, Medicare and other entitlements as the postwar babies retire (Chart 28). Of Washington could simply extend all the tax cuts, etc., much course, the sooner the entitlement deficits are addressed, as they did a year ago as they, to use the current trite phrase, the better. Small annual increases in the retirement age kicked the can down the road. But to show responsibility instituted now, for example, are less painful than the bigger and leadership, they may tweak some of the provisions. rises that will be required if action is delayed. Rep. Paul The President is vehement on rescinding the tax cut on Ryan tried to use concern over cyclical deficits last year to incomes over $250,000 and Republicans are staunchly get action on the structural deficits, but unfortunately opposed. This is a Showdown at the O-K Corral issue. But failed. Until now, at least. House Speaker Boehner has hinted at revenue increases,
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0% 1970

0% 1990 2010 2030 2050 2070

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Medicare Later Washington might deal with at least part of the forthcoming huge entitlement deficits to show they re doing something, with no current pain to voters, and to address this looming major problem. There s been some talk already about gradually raising the Medicare eligibility age from 65 to 67. The explosion of Medicare outlays already $487 billion last year, or 13.5% of all federal spending is the 800-pound gorilla in the entitlements arena (Chart 28), and raising the eligibility age is reasonable given longer lives. Since it was established in 1965, the life expectancy of a 65-year-old female rose from 18 years to 21 years in 2010, and for a male from 13.5 years to 19 years. Phasing in the eligibility age increase between 2012 and 2021 would cut Medicare spending by $148 billion, the Social Security Administration estimates, and maybe more as people work longer and keep paying into the system. But other government health care provisions could reduce the net savings to $113 billion. Genuine attacks on the forthcoming entitlement deficits could boost voter confidence in Washington but would investors and the general public believe those reforms will actually take place in coming years? How many times have promises of great restraint on government spending proved fruitless? In 1967, the year after Medicare commenced, the House Ways and Means Committee forecast a $12 billion cost in 1990. Medicare outlays that year were actually $110 billion. Housing Beyond the fiscal cliff, the outlook for the major components of the U.S. economy is mixed. A number of housing statistics have strengthened lately while others indicate that homeownership is still under considerable pressure. New and existing home sales have risen. Existing home sales, including singlefamily houses, townhouses, condos and
52 A. Gary Shilling's INSIGHT

CHART 29 NAHB/Wells Fargo Housing Market Index


homebuilders sentiment index
Last Point 11/12: 46
50 45 40 35 30 25 20 15 10 5 Jan-07 50 45 40 35 30 25 20 15 10 5 Nov-12

Nov-07

Sep-08

Jul-09

May-10

Mar-11

Jan-12

Source: National Association of Home Builders

CHART 30
thou. of units; seasonally-adjusted annual rate
Last Points 10/12: single 594; multi 285
2000 1800 1600 1400 1200 1000 800 600 400 200 0 Jan 1959 2000 1800 1600 1400 1200 1000 800 600 400 200 0 Jan 1969 Jan 1979 Jan 1989 Jan 1999 Jan 2009

Single- and Multi-Family Housing Starts

Single-Family Housing Starts Multi-Family Housing Starts

Source: Census Bureau

CHART 31 Case-Shiller 10-City House Price Index


seasonally-adjusted
Last Point 9/12: 155.6
240 220 200 180 160 140 120 100 80 60 Jan-87 240 220 200 180 160 140 120 100 80 60 Mar-91 May-95 Jul-99 Sep-03 Nov-07 Jan-12

Source: Standard & Poor's

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co-ops, rose 2.1% in October from September and 10.9% from a year earlier, with limited impact from Superstorm Sandy. Of the 4.79 million annual rate sold in October, 12% were foreclosure sales at, on average, 20% discount to market value and another 12%, at a 14% discount, were short sales where the lender forgives the difference between the mortgage balance and the lower sale price. First-time buyers accounted for 31% of purchases in October and investors bought 29% of the total sold. New home sales have also risen. They fell slightly in October from the downwardly-revised September numbers, but were up 17.2% from October 2011. Furthermore, homebuilders confidence has been rising (Chart 29, opposite page), although it remains below the 50 level that separates positive from negative average sentiment.

CHART 32 U.S. % Living at Parents' Home vs. Homeownership Rate


Last Points 2011: at parents' 13.4; homeownership 37.8%
14.5% 14.0% 13.5% 42% 13.0% 12.5% 12.0% 11.5% 39% 11.0% 10.5% 10.0% 1983 38% 37% 1988 1993 1998 2003 2008 41% 40% 44% 43%

% of 25-34 Year Olds Living at Parents' Home - left axis Under 35 Homeownership Rate - right axis

Source: Census Bureau

CHART 33
change from year earlier; thou. of units
Last Point 3Q 2012: 1,146
2500 2500

U.S. Household Formations

2000

2000

Housing starts have also been climbing, especially for multi-family units (Chart 1500 1500 30, opposite page) as high unemployment and tight lending standards for new 1000 1000 homebuyers have spiked demand for rental apartments. But in the last three 500 500 months, single-family starts have jumped as well. Furthermore, single-family 0 0 house prices have been rising lately 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 (Chart 31, opposite page), and in Source: Census Bureau September, the 10-city Case-Shiller index was up 0.3% from August and 2.1% from a year earlier, although still down 31.5% from to household expenses and 35% pay rent. It doesn t sound its peak in April 2006. like they have a lot of incentive to leave home! During the recession and slow recovery, many foreclosed New Households homeowners doubled up with friends while young people returned home to live with their parents as their Nevertheless, there has been a recent pick-up in new homeownership rate dropped (Chart 32). A Pew Research households. A household is defined as one or more people Center poll found that 22% of those age 25-34 were living living in a separate dwelling unit, so all the things that make with their parents in 2010, up from 16% in 2000 and 11% people willing to rent or buy abodes their employment in 1980. situations, credit conditions, rising or falling house prices, etc. determine whether they form households. Of these boomerang kids, 78% were satisfied with their Consequently, household formation (Chart 33) is about as living arrangements, 77% were upbeat about their financial volatile as housing starts (Chart 30), rising in the mid-1990s futures, 72% believe their parents financial well-being had to mid-2000s boom and then falling during the housing a positive impact on their own financial situations and only bust. 24% thought that living at home was bad for their relationship with their parents. Some 96% not only enjoy Mom s Recently, more people are willing to form households but cooking but do chores around the house, 75% contribute
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most of them are renters while homeowners continue to drop in number(Chart 34). Renters have grown by 5 million since 2006 to 39.6 million while homeowners have dropped by 1.4 million to 75.1 million. In the second quarter, the national homeownership rate, which peaked at 69.2% in the second quarter of 2004 at the height of the housing boom, slipped to 65.5% from 65.9% a year earlier. With record low mortgage rates (Chart 35), mortgage applications for refinancing are up over the last several years but have flattened in the last six months. Applications for new purchases, however, remain stable as tight lending standards, depressed incomes, high unemployment and the realization that for the first time since the 1930s, house prices can and have fallen discourage first-time buyers. Fed Chairman Bernanke recently noted that housing is still plagued by tight credit, underwater borrowers and overdue mortgage loans. With renting preferred to homeownership by many, rental vacancy rates continue to fall while rental rates rise (Chart 36). Nevertheless, the rapid increase in rental supply and rises in home sales are slowing the rise in monthly rents and the fall in vacancies. As we discussed in More House Renters (Feb. 2012 Insight), the supply of rentals is being augmented by individual and institutional investors buying foreclosed single-family houses and turning them into rental units. Some banks are considering securitizing the rents of tenants living in foreclosed houses and selling the resulting securities to investors. Waypoint Real Estate Group, a major investor in foreclosed houses, recently borrowed $65 million from Citigroup to finance additions to its portfolio. As we noted in our earlier report, however, managing and maintaining single-family rentals is much more difficult and labor-intensive than managing apartment buildings, so the profitability of these institutional investments remains problematic.
54 A. Gary Shilling's INSIGHT

CHART 34 U.S. Homeowners and Renters


millions
Last Points 3Q 2012: owners 75.1; renters 39.6
77 76 75 74 73 72 71 70 69 2001 40 39 38 37 36 35 34 33 32 2003 2005 2007 2009 2011

Homeowners - left axis Renters - right axis

Source: Census Bureau

CHART 35 Fixed and Adjustable Mortgage Rates


Last Points 11/28/12: fixed 3.32%; ARM 2.56%
9% 9%

8%

8%

7%

7%

6%

6%

5%

5%

4%

4%

3%

3%

2% Jan-99

2% Dec-00 Nov-02 Oct-04 Sept-06 Aug-08 Jul-10 Jun-12

30-Year Fixed 1 Year ARM

Source: Freddie Mac

CHART 36 Apartment Vacancy and Rental Rates


Last Points 3Q 2012: vacancy 4.6%; rents $1,090
8.5% 8.0% 7.5% 1060 7.0% 6.5% 6.0% 5.5% 1010 5.0% 4.5% 2007-I 1000 990 2008-I 2009-I 2010-I 2011-I 2012-I 1050 1040 1030 1020 1090 1080 1070

Vacancy Rate - left axis Avg. Asking Rent ($ / month) - right axis

Source: Mortgage Bankers Association and REIS

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Dependence on Government Another cloud on the housing horizon results from the tremendous dependence on government entities that guarantee or finance about 90% of new residential mortgages due to the drying up of private lending during the housing bust and its aftermath. Taxpayers have already spent $137 billion to rescue Fannie Mae and Freddie Mac. Washington certainly doesn t want to see their support for housing disappear, but is debating whether Fannie and Freddie should be privatized, broken up or fully nationalized. Meanwhile, the 78-year-old Federal Housing Administration, which insured one-third of new mortgages last year, has suffered huge losses, largely because of downpayments as low as 3.5% that were wiped out when house prices collapsed. The loans it insures that are 90 days or more delinquent or in foreclosure jumped by 100,000 to 739,000 at the end of the September. That s 9.6% of the $1.08 trillion total it guarantees. About 25% of the mortgages guaranteed in 2007 and 2008 are seriously delinquent compared with 5% in 2010. FHA-projected losses hit $16.3 billion at the end of September, the difference between reserves of $30.4 billion and expected losses of $46.7 billion. The agency, however, has an automatic draw on the Treasury to make up any shortfalls.

CHART 37 Real Quality-Adjusted Home Prices


Last Point 3Q 2012: 123.25
200 180 160 140 120 100 80 60 1890 200 180 160 140 120 100 80 60 1910 1930 1950 1970 1990 2010

Source: Robert Shiller

CHART 38 Vacant Units Held Off The Market for Other Reasons
thousands
Last Point 3Q 2012: 3,807
4200 4000 3800 3600 3400 3200 3000 2800 2600 2400 2200 2000 4200 4000 3800 3600 3400 3200 3000 2800 2600 2400 2200 2002 2004 2006 2008 2010 2012

Source: Census Bureau

by the states in which foreclosure require court action. At the end of the third quarter, 4.1% of mortgage loans on 1-to-4 unit houses were in foreclosure, but 6.6% in judicial states like Florida and New Jersey vs. 2.4% in nonjudicial states such as Arizona and California where lenders can foreclose without a court appearance. In Florida, it takes an average of 1,034 days to foreclose compared to 646 in California and 486 in Arizona. Obviously, houses aren t maintained and property values fall as mortgages languish in foreclosure while previous owners live in them rent-free. Excess House Inventories A new wave of foreclosures will dump houses on the market at low prices, depressing the whole market if they become numerous. Several houses scattered around town that are sold at big discounts may not disturb the market,
A. Gary Shilling's INSIGHT 55

In past Insights, we ve discussed how mortgage foreclosures were curtailed, first in 2010 as mortgage servicers, largely unsuccessfully, tried to modify mortgages by extending repayment periods, reducing interest rates or cutting mortgage principals in order to keep homeowners in their abodes. Then, servicers held off on foreclosures while they worked out the $25 billion settlement reached last March with state attorneys general and the federal government over improper foreclosures the robo-signing flap. They had enough bad publicity without adding the media exposure of unhappy ex-homeowners. Now they are gearing up for many more foreclosures of delinquent mortgages, but the process takes time. One thing this housing crisis has taught us is how much depends on the details of mortgage origination and foreclosing. Furthermore, the process has been slowed but not stopped
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but one on each block makes the market. As noted earlier, foreclosed houses sell at 20% discounts and short sales 14% below nondistressed home prices. And house prices still have far to fall to get back to long-term trend. Chart 37 (page 55) corrects median single-family house prices for both general inflation and the tendency of houses to get bigger over time and, therefore, inherently more expensive. After these corrections, prices were essentially flat from 1890 until the mid1990s bubble. They ve come down but still need to fall another 20% to return to long-run trend. And corrections often overshoot on the downside just as bubbles exceed all rationality. With prices already down 31%, the total decline from the first quarter 2006 peak would then be 50%.

CHART 39 Units for Rent, Sale, Awaiting New Occupants or "Vacant for Other Reasons" as a Share of All Housing Units
Last Point 3Q 2012: 7.68%
8.5% 8.5%

8.0%

8.0%

7.5%

7.5%

7.0%

7.0%

6.5%
Avg. 1985-1999 = 6.25%

6.5%

6.0%

6.0%

5.5% 1985

5.5% 1990 1995 2000 2005 2010

Source: Census Bureau

CHART 40 Real Median Household Income


$2011
Last Point 2011: $50,054
56000

56000 Another house price-depressing problem is the excess inventories of 54000 vacant houses. As we ve noted in past reports, excess inventories are the mortal 52000 enemy of prices. Sure, listed inventories of new and existing houses are falling, 50000 and realtors in some areas complain of inadequate supplies of listings. But 48000 many foreclosed vacant houses aren t yet listed hidden inventories. Then 46000 there are vacant houses that were listed 44000 but withdrawn because sellers couldn t 1975 1980 stomach the bids they received. They still probably want to sell and will do so at higher prices or when their patience runs out. These two categories and related vacancies are contained in the Census Bureau s Vacant units held off the market for other reasons a very descriptive title!

54000

52000

50000

48000

46000

44000 1985 1990 1995 2000 2005 2010

Source: Census Bureau

This category has jumped by about a million units since the housing bubble burst in 2006 (Chart 38, page 55). It, combined with listed vacancies, is shown in Chart 39 in relation to total housing units. The ratio jumped with the house collapse and has been declining. Still, it will take another 1.9 million reduction in inventory to return to the long-run flat trend that we use as a measure of the normal working level for inventories. That decline is big, considering that in the long run, the U.S. builds about 1.5 million houses per year and now about half that. Overenthusiasm? Some recent housing data have been upbeat, and many take
56 A. Gary Shilling's INSIGHT

that as proof that the long housing bust is over. But similar optimism reigned in 2010 when prices rose in response to the tax credits for new homeowners, only to fall back (Chart 31). Many who bought houses then for a quick profit became landlords as prices dropped below their purchase prices. Until delinquencies are cured or foreclosed and the houses sold, and until excess inventories are liquidated, we remain skeptical on U.S. housing. Private residential investment is a small but volatile sector of the economy. At its peak in the third quarter of 2005, it accounted for 6.2% of real GDP. That sank to 2.4% in the first quarter of 2011, and the 3.8-percentage point decline in itself constitutes a major recession (Chart 27). It was 2.7% of real GDP in the third quarter. Furthermore, the effects of spending on new construction
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are broader, extending to the furniture and appliances put into new houses, real estate commissions on new and existing home sales, etc. Also, when new construction is falling, so are house prices, which destroys homeowner equity and depresses consumer confidence. The recent strength in house prices and sales as well as residential construction may be reversing some of these negative effects and, indeed, contributing to the recent rise in consumer confidence. But unless housing activity and prices leap, which we doubt, the effects are unlikely to be big enough to propel the economy, especially in the face of weak capital spending, exports and government outlays while consumer spending is muted. A 20% increase in residential investment by itself would add only half a percentage point to real GDP growth. Consumer Spending Retail sales fell in April, May and June and, as we noted in earlier Insights, in 27 of the 29 times they declined for at least three consecutive months since the data started in 1947, the economy was in or within three months of a recession. And revivals in subsequent months didn t change the outcome. Nevertheless, the increases in monthly retail sales since June challenge these statistics and could be the third time in 30 instances when no recession followed.

CHART 41 Avg. Real Weekly Earnings of Private Production and Nonsupervisory Employees ($1982-84)
Last Point 10/12: $290.90
300 298 296 294 292 290 288 286 284 282 Jan-07 300 298 296 294 292 290 288 286 284 282 Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-12

Source: Bureau of Labor Statistics

CHART 42 Revolving and Nonrevolving Consumer Credit


$ billion
Last Point 9/12: revolving $852; nonrevolving $2,737
1050 1000 950 2400 900 850 800 750 1800 700 650 600 Jan-00 1600 2200 2800

2600

2000

1400 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10 Sep-11

Revolving Consumer Credit - left axis Nonrevolving Consumer Credit - right axis

Source: Federal Reserve

Current data is being distorted by Superstorm Sandy, by the early start of Christmas sales on Thanksgiving Day and by the tremendous growth of online buying. We continue, however, to doubt that consumers are embarking on a spending spree and instead may retrench in the face of continuing slow growth in jobs and falling real household incomes (Chart 40, opposite page) and wages (Chart 41). In October, real after-tax income fell 0.1% from September. Real consumer spending dropped 0.3% in October and in the third quarter, real per capita after-tax income dropped at a 0.3% annual rate following gains of 1.5% in the second quarter and 3% in the first. In addition, banks are again tightening consumer loan standards. Retail sales recently would have been much weaker without the strength in auto sales, with many purchases driven by
December 2012

the necessity of replacing old vehicles. Their average age in has risen from 8.4 years in 1995 to 10.8 years in 2011, although some of this increase is due to increases in vehicle quality. This auto replacement phenomenon is also reflected in the rise in nonrevolving consumer credit, largely composed of the auto loans that finance most vehicle purchases as well as student loans. In contrast, revolving credit, which credit card loans dominate, has been relatively flat since the end of 2009 (Chart 42). Furthermore, as we ve discussed in past reports, unless consumers can live with their still-high debt levels and low net worth, their spending will be subdued for years as they increase saving (Chart 2) to work down debt and rebuild assets. American households are unlikely to voluntarily curb spending. A husband and wife don't wake up one morning
A. Gary Shilling's INSIGHT 57

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and say to each other, "Dear, we've been spending far too much and saving too little. We simply have to cut back." Oh, no! Consumers have been trained and we use that word deliberately trained by retailers, the media, peer pressure and even the government to buy as long as the financing is available. But now they are being forced to resist these pressures, and there are many concrete reasons for the household saving rate to rise back to double digits. The extreme volatility of stock prices since 2000 (Chart 43) has destroyed the belief that stock appreciation will substitute for saving out of current income as it did in the 1980s-1990s salad days. Witness the nonstop withdrawals from U.S. equity mutual funds since 2008. This is true even after offsetting those outflows by inflows in domestic equity exchangetraded funds. With home equity withdrawn and the nosedive in house prices, home equity of the average mortgagor has dropped from almost 50% of their abode s value in the early 1980s to 24%. Further, 24% of mortgages are under water with the principal exceeding the house s value. So this source of funding for oversized spending has evaporated. The postwar babies desperately need to save for retirement, and many can. They re in their 50s, their peak career earning years, and their kids college tuition payments are completed. Still-high unemployment rates should encourage those with jobs to save more for contingencies. And high student loans, especially for recent graduates with grim job prospects (discussed in Higher Education Needs a New Financing Model, July 2012 Insight), are a warning about the burdens of debt. Student loans now total almost $1 trillion, according to the New York Federal Reserve Bank, up from $241 billion in 2003, and default rates are appalling. Of those with loans due after October 2009, 9.1% had defaulted by
58 A. Gary Shilling's INSIGHT

CHART 43 Real and Nominal S&P 500


Last Points 10/12: real 620; nominal 1,395
1600 1400 1200 1000 800 600 400 200 0 Jan-80 1600 1400 1200 1000 800 600 400 200 0 Mar-84 May-88 Jul-92 Sep-96 Nov-00 Jan-05 Mar-09

Nominal S&P 500 Real S&P 500 (deflated by CPI, 1982-84 prices)

Source: Haver Analytics

CHART 44 Small Business Optimism Index


Last Point 11/12: 93.1
110 110

105

105

100

100

95

95

90

90

85

85

80 Jan-75

80 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10

Source: National Federation of Independent Business

CHART 45 Business Roundtable CEO Economic Outlook Index


Last Point 3Q 2012: 66.0
130 130

110

110

90

90

70 50

70 50

30 10

30 10

-10 2002Q4

-10 2004Q4 2006Q4 2008Q4 2010Q4

Source: Business Roundtable

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October 2011, according to the Education Department. It projects that 20% of those with federal loans for undergraduate education will default at some point. Capital Spending

CHART 46 Capacity Utilization and Output Gap


Last Points: capacity 10/12 77.8%; output gap 3Q 2012 -5.8%
90% 6% 4% 85% 2% 0% -2% 75% -4% -6% 70% -8% 65% Jan-67 -10% Jan-75 Jan-83 Jan-91 Jan-99 Jan-07

80%

The ISM index for nonmanufacturing remains above 50, indicating expansion, and the manufacturing index has climbed above the line of demarcation in recent months. Still, businesspeople remain depressed. Small business optimism has risen but remains in recession territory (Chart 44, opposite page) while the economic outlook of major company CEOs is falling (Chart 45, opposite page). A recent survey of Harvard Business School graduates found that 58% were pessimistic about U.S.-based companies ability to compete in a global economy and to pay high wages to U.S. employees over the next three years. Many big and small businesspeople express concerns about the fiscal cliff, but their worries probably run much deeper. Excess capacity (Chart 46) remains an inhibitor to capital spending that fell by 2.2% in the third quarter from the second at annual rates as outlays for structures dropped 1.1% and spending on equipment and software dropped 2.7% after rising at a 5% rate in the first and second quarters. Also of concern is the slower growth in exports in the last year as foreigners demand for U.S. products slides with the deepening recession in Europe and declining growth rates in China and elsewhere. New orders for nondefense capital goods ex aircraft a mouthful but an excellent harbinger of capital spending continues to fall and was down 8.1% in October from a year earlier (Chart 47). Commercial and industrial loans from banks are still rising, but at a declining rate in recent months (Chart 48). And industrial production growth is slowing (Chart 49, page 60). Excessive and unwanted inventories may also prove to be a major drag on
December 2012

Capacity Utilization - left axis Output Gap (as a share of potential GDP) - right axis

Source: Federal Reserve, Congressional Budget Office and Bureau of Economic Analysis

CHART 47 New Orders for Nondefense Capital Goods ex Aircraft


year/year % change
Last Point 10/12: -8.1%
30% 30%

20% 10% 0% -10% -20% -30% -40% Jan-94

20% 10% 0% -10% -20% -30% -40% Mar-98 May-02 Jul-06 Sep-10

Source: Census Bureau

CHART 48 Loans and Leases at Commercial Banks


year/year % change
Last Points 11/21/12: total 3.8%; C&I 12.8%
25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% Jan-07 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% Oct-12

Dec-07

Dec-08

Nov-09

Nov-10

Oct-11

Total Loans & Leases Commercial and Industrial Loans

Source: Federal Reserve

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the U.S. economy. In the third quarter, the jump in inventories accounted for 0.8 percentage points of the meager 2.7% growth. Inventories always build at the peak of business cycles as business sales fall short of expectations. Then, cutting production to get rid of excess goods constitutes a major part of the recession that follows (Chart 50). Government Spending Normally, government spending rises to offset weakness in the private sector. That was true earlier for the federal government as it embarked on massive fiscal stimuli and leveraged up (Charts 1 and 3). Nevertheless, real federal government spending on goods and services has dropped 4.1% since the third quarter of 2010 in the face of huge deficits (Chart 3) and gridlock in Washington. Meanwhile, state and local government spending, normally a very stable 12% of GDP, has been even weaker, falling 7.2% in real terms since the third quarter of 2009. Deficits and pressure on spending persists in many municipalities, and vastly underfunded pension funds are also taking their toll. Employment by state and local governments continues to drop and the 605,000 decline since its August 2008 peak has accounted for 20% of the total drop since then in payroll employment. 2013 Recession?

CHART 49 U.S. Industrial Production


Last Points 10/12: yr./yr. 1.7%; level 96.6
10% 102 100 5% 98 96 94 -5% 92 90 -10% 88 86 84 -20% 2007 2008 2009 2010 2011 2012 82

0%

-15%

Year/Year Percent Change - left axis Index Level (2007 = 100) - right axis

Source: Federal Reserve

CHART 50 Inventories In Recessions

Recession 1948-1949 1953-1954 1957-1958 1960-1961 1969-1970 1973-1975 1980 1981-1982 1990-1991 2001 2007-2009

Real GDP Peak-to-Trough Decline % Due to Inventories -1.8% 112.5% -2.6% 29.8% -3.7% 21.1% -1.6% 126.4% -0.6% 115.7% -3.2% 45.8% -2.2% 47.2% -2.7% 31.2% -1.4% 49.2% -0.3% 64.2% -4.7% 31.7%

Most forecasters expect faster economic growth, but they always do since they re paid to be optimistic. We, on the other hand, try to be realistic and continually probe their bullish scenarios for flaws. That's how we think we can add value since rehashing the consensus forecast adds none. Weighing all the factors and economic components discussed in this report, we believe that a moderate U.S. recession in 2013 is more likely than not. That's what is reflected in our U.S. economic forecast through 2014, as seen in the table at the end of this report. As usual, these numbers attempt to quantify our thinking, not pretend to be a precise guide to the future. And, as usual, they are positively, absolutely guaranteed to be wrong. We just don't know in which direction.
60 A. Gary Shilling's INSIGHT

We're not even taking a wild guess at economic forecast numbers for foreign countries, but we continue to believe a global recession is unfolding. It's clearly in place in the U.K. and the eurozone. Japan is close to or already in another business downturn. And China still seems poised for a hard landing with 5% to 6% real growth for at least several quarters. Few others are forecasting a 2013 global recession, but some are cranking down their growth forecasts including the OECD and the IMF. Three big ad agencies, WPP, Publicis Groupe and Interpublic group, are cutting their forecasts for 2013 advertising spending. They cite the recession in Europe and muted conditions in the U.S. Almost all forecasters, including Wall Street strategists, ad agencies and the IMF, reduce their positive growth forecasts
December 2012

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bit-by-bit going into a recession and never project negative numbers until the recession is well underway if not already over. Institutional investors talk about being nickel and dimed to death by Wall Street analysts who reduce their per share company earnings forecasts by a series of five- and tencent cuts, never by the dollar drops that ultimately materialize. We prefer to make one forecast jump to the final low in recessionary climates. This involves risks since we can't be sure a recession will unfold, but we believe this approach is more useful for our clients. In any event, the economy is certainly long overdue for a recession. In the down phase of the long cycle that we believe began in 2000 (Chart 51) and will persist until deleveraging is completed, complete business cycles average less than four years in length. The last business cycle peak was in December 2007, so this one is now five years old. Incidentally, the next recession, whenever it starts, is simply a recession, not a double dip. That term made sense in the early 1980s when the start of the 1981-1982 recession followed the end of the 1980 decline by only 12 months. It isn't relevant now, five years after the last business peak.

CHART 51 Secular Bull and Bear Markets


Dow Jones Industrial Average
Last Point 12/3/12: 12,966
100000
Secular Bear? Secular Bull

100000

10000
Secular Bear Secular Bull Secular Bear

10000

1000

1000

100

100

10 1925

10 1934 1944 1953 1963 1974 1984 1994 2004

Source: Churchill Management Group

CHART 52 10-Year Treasury less Effective Fed Funds Spread


Last Point 10/12: 1.49%
4% 4%

2%

2%

0%

0%

-2%

-2%

-4%

-4%

-6%

-6%

-8% 1954

-8% 1962 1970 1978 1986 1994 2002 2010

As noted in past Insights, a recession starting any time soon will be unusual in not being Fed-led as were all of its post-World War II predecessors. In the past, the central bank, worried about inflation, pushed up short term interest rates to exceed long rates and that inverted yield curve was a sure-shot indicator of a business downturn (Chart 52). Now, however, the Fed is more worried about deflation than inflation and still embarked on massive quantitative easing (Chart 6). The Age of Deleveraging is different than the earlier post-World War II era in many ways! Shocks A moderate U.S. recession may be aided and abetted by any one of a number of shocks. One would be a hard landing in China with its further depressing effects on global growth and commodity prices, especially now that most believe a
December 2012

Source: St. Louis Federal Reserve

soft landing is shaping up there. Going off the U.S. fiscal cliff also would turn a moderate recession into a major downturn. An oil price leap, triggered by an Iran-related blow-up in the Middle East, could add to economic weakness. That s what happened with the Arab oil embargo in 1973 and the Iranian revolution in 1979. Sure, the U.S. is becoming less dependent on imported energy and very few American oil imports come from the Middle East. But petroleum is fungible and price increases elsewhere will affect the U.S. as well as Europe and China. A huge energy cost spike would be a debilitating tax on already-stressed consumers. Failure of a major European bank would probably spread worldwide and generate a global financial crisis, much as in 2008. Banks are so intertwined through loans, leases,
A. Gary Shilling's INSIGHT 61

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derivatives, etc., as noted earlier, that a shot in Europe would be felt round the world (Chart 53). Major corporate earnings disappointments are another possible shock. Always-optimistic Wall Street strategists on average believe S&P 500 operating earnings will rise from $99.95 in 2012 to $107.73 in 2013. But suppose our forecast is correct and operating earnings drop to $80 per share next year due to global recessioninduced declines in corporate revenues, a drop in profit margins from record heights (Chart 54) and currency translation losses as the dollar strengthens? That $80 is 26% lower than those analysts estimates, and obviously would be a big disappointment to many bullish investors. Profit Warnings
70%
J.P. Morgan

CHART 53 U.S. Bank Exposure to PIIGS


percentage of tangible Net ($billion) common equity

12.5

9.6%

Goldman Sachs

5.2

8.2%

Bank of America

9.8

7.2%

Citigroup

10.6

7.1%

Morgan Stanley

2.4

4.8%

Source: Sanford C. Bernstein

CHART 54 Corporate Profits and Employee Compensation


as a % of national income
Last Points 3Q 2012: corp. profits 14.3%; employee comp. 61.6%
15% 14% 13% 12% 64% 11% 62% 10% 60% 9% 8% 7% 1959-III 1972-I 1984-III 1997-I 2009-III

In the third quarter, S&P 500 company revenues fell 1% from a year earlier, the first decline since 2009, due to slow growth abroad and the strong dollar. This is also foreboding since corporate revenue generally tracks nominal GDP, as explained in The Age of Deleveraging. In the third quarter, nominal GDP rose 4.2% from a year earlier.

68%

66%

58%

56% 1947-I

Excess goodwill is another troubling Corp. Profits with IVA and CCAdj - right axis issue for corporations, and 40 U.S. Source: Bureau of Economic Analysis companies with market values over $1 billion have goodwill and other intangible assets that are worth more than the company s Furthermore, even though corporations have huge amounts market capitalization. Recent goodwill writeoffs for of cash, they still have hyped their borrowing, maybe Microsoft, Hewlett Packard and Boston Scientific due to because of low bond yields and the desire to accumulate poor performing acquisitions bring out the stark reality: even more cash in uncertain times. In any event, the ratio When a company writes down goodwill, it s admitting that of debt-to-adjusted earnings of S&P 500 nonfinancial it overpaid for an acquisition. corporations stood at 2.02 in August, the highest since 2.28 in 2009. In recessions, debt is hardly desirable. The link between corporate earnings and stock prices, of course, is price-earnings ratio, which declines in secular A 2013 recession here and abroad would no doubt be bear markets such as the one that started in 2000 (Charts anticipated by falling stocks. With a nominal P/E of 10 at 43 and 51). Furthermore, in the third quarter, S&P the bear market low and our $80 per share estimate for downgraded 93 U.S. industrial companies while upgrading S&P 500 operating earnings, the S&P 500 index would only 36. In Germany, the U.K., France and Holland, there drop to 800. That s a 42% drop from its current level. have been 25 downgrades since July vs. six upgrades.

Compensation of Employees - left axis

62

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December 2012

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2012

Final Sales 1.9% 3.7% 0.8% -0.3% 78.5% 10.5% 26.6% 14.8% 2.7% 2.3% 6.2% 1.8% 1.9% -0.1% 8.1% Other Economic Indicators Saving Rate (%) Real Disposable Personal Income Industrial Production (% change) Capacity Utilization Rate (%) Unit Auto & Light Truck Sales (% change) Housing Starts (% increase/decrease) Pretax Corp. Profits with IVA and CCA adj. Chain-Weighted GDP Deflator Consumer Price Index Producer Price Index Compensation per Manhour Output per Manhour Unit Labor Costs Unemployment Rate (%)

0.5%

-0.3% 3.9% 1.0% -4.0% 71.0% -8.1% -9.9% -5.0% 3.8% 1.6% -2.0% 72.0% -4.4% -0.2% 5.0% 2.0% 2.0% 0.0% 1.5% 2.0% -0.5% 8.3% 1.8% 1.5% -2.0% 1.0% 1.5% -0.5% 8.5%

-1.1%

-1.5% 4.0% 4.1% -0.2% -0.8% -4.0% -4.0% 72.0% 73.0% -5.6% -8.4% -10.1% -10.4% -10.0% -15.0% 1.5% 1.2% -3.0% 0.8% 1.0% -0.2% 8.7% 1.0% 0.8% -4.0% 0.5% 0.8% -0.3% 9.0%

-0.5%

0.1%

0.5%

0.7%

1.0%

3.9% 4.2% 0.4% -2.0% 74.0% 0.0% -10.7% -10.0% 0.8% 0.7% -2.0% 0.3% 0.8% -0.3% 9.3% 4.3% 1.3% 0.0% 75.0% 6.1% -10.9% 0.0% 0.5% 0.4% -1.0% 0.0% 1.0% -1.0% 9.0% 4.4% 1.7% 2.0% 76.0% 6.0% 0.0% 5.0% 0.3% 0.0% -1.0% 0.2% 1.5% -1.2% 8.7% 4.5% 2.0% 3.0% 77.0% 12.0% 0.0% 5.0% 0.0% -0.2% -1.0% 0.5% 2.0% -1.5% 8.5%

-0.1%

-0.1%

insight@agaryshilling.com

4.6% 2.0% 3.0% 78.0% 5.7% 0.0% 5.0%

3.8% 1.4% 3.5% 78.6% 11.9% 23.0% 7.1%

4.1% 0.7% -2.6% 77.2% -3.9% -3.0% -2.9%

4.5% 1.0% -0.2% 76.5% 2.9% -6.8% -2.8%

0.0% -0.4% -1.0% 0.5% 2.0% -1.5% 8.3%

1.9% 2.1% 1.8% 2.3% 1.2% 1.0% 8.2%

1.7% 1.5% -1.2% 1.2% 1.4% -0.2% 8.9%

0.5% 0.4% -1.7% 0.3% 1.2% -0.9% 8.6%

December 2012

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Gross Domestic Product Personal Consumption Expenditures Durable Goods Nondurable Goods Services Gross Private Domestic Investment Nonresidential Structures Equipment and Software Residential Change in Business Inventories (bn $) Net Exports of Goods and Services (bn $) Exports Imports Government Purchases Federal National Defense Non Defense State and Local 2.7% 2.0% 8.5% 2.4% 0.8% 6.7% -2.2% -1.0% -2.7% 14.3% 61.3 -403.0 1.1% 0.1% 3.5% 9.5% 12.9% 2.9% -0.4% -0.2% 1.1% 2.0% 1.0% 1.0% -5.7% -2.8% -2.0% -3.0% 4.0% 40.0 -403.0 0.0% 0.0% -0.8% 1.0% 0.0% 3.0% -2.0% -1.7% -2.1% -0.6% -1.2% -7.0% -10.0% -1.0% -2.0% 1.0% 1.0% -10.1% -12.9% -6.5% -9.3% -5.0% -7.0% -7.0% -10.0% -4.0% -6.0% -20.0 -40.0 -387.5 -365.0 -2.0% 0.0% -4.0% -4.0% -1.2% -0.6% 0.0% 1.3% -2.0% 0.0% 4.0% 4.0% -2.0% -2.0% -1.5% 0.6% -2.0% 1.0% 1.0% -11.6% -4.5% -3.0% -5.0% 0.0% 0.0 -401.0 -2.0% -2.0% -1.3% -0.3% -2.0% 3.0% -2.0% 0.1% 0.0% -5.0% 0.0% 1.0% -0.8% -5.5% -4.0% -6.0% -4.0% -20.0 -353.9 0.0% -2.0% -0.6% 1.4% 0.0% 4.0% -2.0% 0.7% 2.0% 0.0% 1.0% 1.0% 1.4% -3.5% -2.0% -4.0% -2.0% 0.0 -353.9 0.0% 0.0% -0.6% 1.4% 0.0% 4.0% -2.0%

1.1% 3.0% 2.0% 2.0% 1.0% 3.5% -1.5% 0.0% -2.0% 0.0% 20.0 -359.4 0.0% 1.0% -0.7% 1.0% 0.0% 3.0% -2.0%

1.3% 4.0% 4.0% 2.0% 1.0% 5.1% 0.5% 2.0% 0.0% 0.0% 40.0 -370.2 0.0% 2.0% -0.8% 0.7% 0.0% 2.0% -2.0%

1.6% 4.0% 4.0% 2.0% 1.0% 6.8% 2.8% 2.0% 3.0% 0.0% 60.0 -381.2 0.0% 2.0% -0.8% 0.7% 0.0% 2.0% -2.0%

2.1% 1.9% 7.0% 1.1% 1.3% 9.3% 6.9% 9.4% 5.9% 11.3% 49.9 -407.2 3.5% 2.8% -1.3% 1.1% 1.6% -0.2% -1.5%

-0.6% 0.4% -2.1% 0.3% 1.0% -6.8% -4.5% -3.3% -4.8% 1.1% -20.0 -376.9 -0.4% -1.7% -0.4% 1.5% 0.6% 3.2% -1.7%

0.3% 0.6% -1.6% 0.7% 1.0% -0.5% -3.6% -2.1% -4.1% -2.3% 30.0 -366.2 -0.1% -0.6% -0.7% 1.1% -0.1% 3.4% -2.0%

A. Gary Shilling's INSIGHT

Selected Components of GDP (% Changes at Annual Rates)

III

IVE IIE

IE

2013 IIIE

IVE IIE

IE

2014 IIIE

IVE

Annual Averages 2012E 2013E 2014E

63

Forecast Table- Percent Changes in Real GDP and Other Economic Indicators

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Commentary

wide bank regulation and a central budget are problematic. Some past Peace Prizes have recognized genuine accomplishment. In 1906, Theodore Roosevelt received his [F]or his successful mediation to end the Russo-Japanese war and for his interest in arbitration, having provided the Hague arbitration court with its very first case. In 1917, the International Committee of the Red Cross was recognized [For undertaking] the tremendous task of trying to protect the rights of the many prisoners of war on all sides [of World War I], including their right to establish contacts with their families. In 1993, Nelson Mandela and F.W. de Klerk jointly got the Peace Prize for their work for the peaceful termination of the apartheid regime, and for laying the foundations for a new democratic South Africa. Nevertheless, Woodrow Wilson got the 1919 Prize [F]or his crucial role in establishing the League [of Nations] even though he couldn t convince Congress to let the U.S. join the League and it proved to be an abysmal failure. In 1973, Henry Kissinger and Le Duc Tho shared the Prize For the 1973 Paris agreement intended to bring about a ceasefire in the Vietnam war and a withdrawal of the American forces even though North Vietnam immediately violated the agreement and overran South Vietnam within two years. Two women, Protestant Betty Williams and Roman Catholic Mairead Corrigan were awarded the Prize in 1976 as Founder[s] of the Northern Ireland Peace Movement, but the religious strife persisted there for two more decades. The 1994 Prize went to Yasser Arafat, Yitzhak Rabin and Shimon Peres to honour a political act which called for great courage on both sides, and which

Noble Intentions
In October, the European Union got the 2012 Nobel Peace Prize because in the last 60 years, European countries have come together to promote peace and reconciliation, democracy and human rights at home and abroad, according to the awarding committee. In 1888, Alfred Nobel s brother Ludvig died while visiting Cannes and a French newspaper erroneously published Alfred s obituary. It condemned the Swede for his invention of dynamite and is said to have brought about his decision to leave a better legacy after his death. So he established the Peace Prize as well as Nobel Prizes in Physics, Chemistry, Physiology or Medicine and Literature. The Peace Prize is awarded to those who have done the most or the best work for fraternity between nations, for the abolition or reduction of standing armies and for the holding and promotion of peace congresses. Yet many awards seem more aimed at encouraging desirable behavior than honoring significant accomplishments. It s far from clear that the EU's plans to integrate Europe will be realized. The goal was for all 27 members of the EU to join the eurozone but a number of the 10 that remain outside it, including the U.K., have had second thoughts. And even the fate of the eurozone is in doubt with the seemingly unresolvable financial crisis and no end to the bailouts of individual countries. The union of the Teutonic North with the Club Med South under one currency but with no common fiscal policy has proved unworkable. Plans to create EU-

has opened up opportunities for a new development towards fraternity in the Middle East. Despite this encouragement of Mid-East peace, it remains as elusive as it has been for 70 years. Beyond these A for Efforts Peace Prize awards, some have been simply questionable. In 2009, Barack Obama got the Prize for his extraordinary efforts to strengthen international diplomacy and cooperation between peoples, even though he d been President only a few months and had few credentials or accomplishments in the foreign arena. Al Gore s 2007 Prize for work in climate change included rigged data from biased climatologists. But then he also said he invented the Internet. Anwar Sadat and Menachim Begin got the 1978 Prize for the Camp David Agreement, which brought about a negotiated peace between Egypt and Israel. Nevertheless, that peace treaty has really been no more than a frequently-violated ceasefire, and would not have been reached without the tireless efforts of Jimmy Carter. Despite the straying of the Nobel Peace Prize from rewarding accomplishment, its encouragement of constructive behavior may pay off occasionally. Aung San Suu Kyi spent two more decades under house arrest after her receipt of the 1991 Prize for her non-violent struggle for democracy and human rights in Myanmar (Burma). But this recognition of her efforts may have been instrumental in the recent liberalizations in her country to the point that President Obama visited there last month, the first ever U.S. presidential visit, and met with her.

If you enjoy reading Gary Shilling's monthly "Commentary," you may be interested in Letting Off Steam, a collection of more than 130 of Gary's "Commentaries" from 1989 through 2003. This 286-page book is available for $20 (shipping included). Call 973-467-0070 to order.
64 A. Gary Shilling's INSIGHT Telephone: 973-467-0070 December 2012

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