The world is coming out of the worst financial crisis it has seen in decades. The US is limping back to growth even though many investors are still sceptical. Europe, which had faced its worst sovereign crisis recently, is slowly getting out of the mess. Japan is in a perpetual recession. China and India are growing faster, providing some support to the global growth. There is some scepticism on the sustainability of China?s growth. The recent measures taken by the government to cool down inflation concerns will have some impact on the economy.
So, has the world passed its worst crisis and is it back on the growth path? I don?t think so. There are several headwinds for the world economy and some of it will play out in 2011.
First, let us look at the US. The gross external debt of the US today is close to $13.9 trillion. On an economy size of $14.4 trillion, the gross external debt is close to 97% of the economy. In comparison, the gross debt of Japan is slightly more than 200% of the GDP, even though most of the debt is internal debt. The US government continues to be a large spender and this is prompting the government to consider increasing the government?s debt issuance limit above the current $14.3 trillion. Also, under the laws in the US, the states need to balance their budgets. The finances of some of the states and local governments are so distressed that they resemble the subprime mortgage crisis. No states in the US have defaulted since the Great Depression in the 1930s, and municipal bankruptcies are very rare. But, looking at the enormity of the problem, such a scenario looks possible. States and municipalities today carry $2.8 trillion of debt and add to the nearly $3.5 trillion of pension obligations, which are off-balance-sheet. The only way to fund these shortfalls is by increasing taxes or cutting government spending. Both seem to be impossible in the current scenario. When investors start seeing this reality, we could see a Europe-like situation emerging in the US, with investors balking at lending to weaker states and local bodies. The yields on all the state and municipality bonds could increase dramatically, resulting in the federal government coming out with a bailout fund to rescue them. This will put enormous pressure on the federal government and could trigger another sovereign crisis. Already, we have seen the yields on the US government bonds going up due to growth expectations. If the growth does not come true, then the yields could shoot up further as investors factor in the risk of the sovereign. Most financial crises happen in unpredictable ways when the world is not looking. The US government has to do a balancing act in managing the impossible trinity?political expediency, fiscal prudence and economic growth. It can?t take harsh measures to cut government spending or increase taxes, as this will hurt growth. It needs to maintain fiscal prudence else the markets will lose confidence in the sovereign. It needs to have easy liquidity to maintain growth and create employment, as otherwise it will be a big political issue. In toto, I think there is a possibility of the European sovereign kind of crisis in the US in 2011.
Coming to Europe?it is sitting on an artificial comfort. The risk of a sovereign default has subsided but not gone away. The yields on the bonds of the so-called PIGS countries are still very high. The banks and governments need to borrow close to a trillion euros in the next 6-8 months. While most of the European countries are taking measures to cut down spending and increase taxes, it could backfire as the economic growth could slow down. This could further increase yields and trigger another sovereign crisis.
The government in China is worried about inflation and had increased interest rates sharply. If they overdo it, then it could impact their growth and dampen the booming commodity cycle. China could export inflation and this is not good for the rest of the world.
In India, we have a dysfunctional governance, with the corporate world cut off from the government. The recent news on various scams and the lack of governance has put some of the big ticket reforms?Companies Bill, DTC, IFRS, GST?on the back burner. While the current growth momentum is good, the continuance of the same is suspect, as the government is pre-occupied with fighting political battles on various scams.
So, for the world it is going to be great balancing act. We are going to see volatile markets with greater uncertainty. Risk will play a larger role and comfort zones will get abnormal valuations. For the world, the road ahead is not going to be a straight line but an action-packed one with many twists and turns.
?The author is CFO of Infosys