Afraz Zafar -

As we bid farewell to 2011, a quick look over our shoulder will remind us what a ride it has been. From global macro-economic situation to “Arab Spring” to Raymond Davis fiasco to Osama bin Laden’s death and to domestic police uncertainly and the emergency of another rising force in our political arena, it has been quite a ride. It is hard to disagree that times are very interesting.

It is imperative that we keep an eye out for what might be coming our way so that surprises can be managed, if not fully avoided.

European crisis might pick up peace and Portugal might ask for a bail out. It turns out that I was too optimist and fully appreciate that gravity of the problems facing the Eurozone. Not only did Portugal ask for a bail out, but also the crisis is now threatening the entire Eurozone. To make matters worse, the medicine that is being prescribed to deal with it is not addressing the fundamental problems.

Everybody is talking about too much debt in the peripheral countries. Yes. There is too much debt, but this debt pile is the symptom, not the cause of the disease. Euro was a political project, not an economic one. It does not make sense to have a single currency and one monetary policy for all, whereas budgets are still decided by independent sovereigns. On top of it, too many countries were taken into the fold of this single currency with very diverse economic. Anyone can easily say now that Greece should never have been a part of the Eurozone, and it does not make sense for Greek and Italian economies to have the same monetary policy as the Germans the architects of this single currency.  Knew these flaws, but they had hoped that a single currency of the Eurozone and a single market of the European Union will drive them towards closer economic union, something along the lines of united states of Europe.

This divergence in economies and convergence in interest rates led to strengthening of the Northern European economies (also helped by a lower Euro. If Germany had still stuck with Deutschemark, it would risen in value by quite a bit, and thus would have affected its exports) while the Southern countries lost competitiveness. This was being shown in persistent current account deficits in the South and persistent current account surpluses in the North. To address this loss of competitiveness, the government of the Southern countries expanded their spending to make up for the loss in private sector. To finance this spending, they borrowed, and convergence in interest rates really helped because it drove down the borrowing costs for Greece and Italy. This led to piling up of huge public sector debts.

Then came the 2008 financial crisis. It was there where political leadership started to falter in management of the crisis. Germany insisted that “each country to her own” approach be taken when it came to bailing out the banks instead of a blanket guarantee for the entire Eurozone banks. This stretched local budgets even more and was the reason why Ireland had to seek a massive bail out. The second major political shock came when Germany again insisted that private sector be a part in restructuring of Greek debt. Financial markets are driven by confidence and this move destroyed the confidence of private sector investors that sovereigns are risk-free. This was witnessed by massive selling of peripheral government bonds.

The medicine being prescribed again now is the wrong. Austerity will lead to recession. It is not rocket science to understand that if GPD goes down, debt/GPD ratio will increase and it will become harder to service those debts. Some economists are expecting that Greece might contract by up to 6pc. This will put a lot of pressure on an already high ratio of 160pc. Austerity upon austerity will worsen the situation and make it much harder for Greece to grow out of its debt pile. So either this debt will have to be restructured, hence Eurozone will have to become a transfer union where some members of the club write off the debts of other members through their balance sheets, or Greece will have to exit the Eurozone. Both of these options have huge costs, monetary and political. If Eurozone turns into a transfer union, then it creates the risk of moral hazard where incentives are destroyed to restore competitiveness. Furthermore, it will also raise the question of how long the voters of stronger economies will tolerate dolling out their tax dollars to their profligate neighbours. And break-up would mean a big financial meltdown. It will raise the question of who in next. Euro is the second biggest reserve currency of the world. It will have repercussions globally and could be as described by some analysts “the mother of all financial crises”.

Through the risk of a break-up is small, the probability is now there. The fundamental issue of uncompetitive economies is still not being addressed. Germany wants peripheral countries to restore their competitiveness through belt-tightening and structural reforms. But that will take years if not decades. It took Germany a whole decade for its labour market reforms. The medicine being prescribed will insure that next crisis would not happen but it does not solve the current one. This crisis has put a downward pressure on the Euro, but this will make Germany uber-competitive relative to the Southern economies. So, the fundamental problem has now worsened. Worse still, especially in Greece, the banking sector deposits are on a decline. This is like a quiet run on the banks. European Central Bank’s liquidity operations have bought them some time, but for how long it can last like this is anyone’s guess.

There are a host of other issues that have arisen because of this (for instance, stresses building up in the banking sector, credit and liquidity crunch), but that will make this letter very long and they will be the topic for next letters. I have no idea what will happen. But it is important to keep an eye out as this has the potential for one of those “black swan” events.

I think it will not be unfair to say that we have set records in macroeconomic mismanagement. I do not remember when about half of PIA’s fleet was grounded or the Railways nearly stalled. Public Sector Entities (PSEs) have become a massive drain on our resources. Circular debt is another elephant in the room. Add to this mix the fact that we are headed closer to election now, and the picture emerges. The will to charge any of this will be even harder to find. The government actually might come under harder pressure not to make any of the changes.

This will mean higher fiscal deficit. With private sector not borrowing to make new investments to increase productivity (also reflected in lower investment to GPD ratio), fiscal deficit is spilling over into trade deficit. On top of all this, we will have to start making payments to the IMF, which will further put pressures on our exchange rate. According to some analysts, devaluation will help us in our exports so it is good for us. I beg to differ from such a view. More than 40pc of our import bill is oil and petroleum products, and other than remittances, our major exports are textiles, rice and other commodities. In textiles, we basically are suppliers for major buyers; we do not brand out products. This means that we do not get to keep most of the margins. Therefore, we are buyers of commodities and sellers of slightly processed commodities. Devaluation helps on a consistent basis if one is selling value added products and with devaluation making oneself more competitive.

On the other hand, our energy mix is about 45pc titled towards thermal. Therefore whatever little competitiveness we gain from devaluation is eroded after a little time because our energy bills go up. We import inflation through devaluation. It is for this reason that even after consistent devaluations, we still run persistent trade deficits and require more devaluations. It was just three years ago that rupee lost tremendously against a basket of currencies and by 2011, we are needing another one. It is the work medicine for us. High energy bills resulted in higher inflation, which is more taxing on the middle and lower class. Lack of a robust middle class then becomes a drag on economic growth rate.

In 2012, our gas shortages are also expected to worsen. This will be another drag on our economic growth. Any solution to arrest this worsening supply-demand deficit is likely to take some time. Worsening energy crisis is also going to be a major drag on the economic growth rate.

Political situation is likely to remain volatile with some analysts expecting an election in 2012. What might happen is anybody’s guess but this uncertainly is likely to result in less attention being paid to macroeconomic management. There is a very famous saying. “People only accept change in necessity and the only see necessity during crisis. “This seems to have become the mantra of our managers. Not enough attention is being paid to structural issues until things come to a boil and even then we look for short terms easy fixes.

Our foreign policy is also in a flux especially after the recent Nato attacks. It remains to be seen what direction it will take and how much bargaining power we would have given the fact that we might have to resort to IMF financing if necessary reforms are not implemented.

I have discussed some issues in detail, some I have just mentioned which will be discussed in detail in the further and there are some that I might have missed. I think it is imperative to keep an eye out for all of these or any out of box events that might happen. This is important from an investment management point of view, as, in my opinion, asset allocation decisions should be based on these factors as well as other. Whereas they present us with risk, they might provide opportunities as well.

– The writer is CFA and Director Horizon Securities Limited