Monday, July 28, 2008 6 comments ++[ CLICK TO COMMENT ]++

Asian Subsidy Scheme Ready to Collapse

It has become evident over the last few months how disastrous the Asian subsidies for energy (among other items) is turning out to be. My opinion is that the subsidy scheme is about to collapse. Bloomberg has a story which almost seems to imply that stagflation is on the horizon for many Asian countries. I am not too sure about the stagflation case but I do agree with some items in the article.

One thing that is not clear to me is if the GDP growth rates quoted in the article are nominal growth rates or real growth rates. If it is real growth then there is a big flaw in the article. The article compares GDP growth to inflation and implies that inflation that is higher than GDP growth portends to bad things. That is only true if the GDP growth that is referenced is nominal growth rate. If it happens to be real GDP then inflation is already taken into account (i.e. real GDP = nominal GDP minus inflation). I'm too lazy to look up the original reference and see what is actually quoted but I would urge anyone reading the article to keep this potential error in mind.

Asian governments from India to Malaysia, clinging to budget-busting fuel subsidies, may end up paying an even higher price: saddling their economies with an extended period of stagflation.


Governments are being forced to choose between two unattractive alternatives: run up bigger deficits by continuing to shield citizens from soaring energy prices, or start to withdraw subsidies, fueling inflation and political backlash. Inflation has already reached decade highs throughout the continent and played a role in destabilizing politics.

Some investors seem to think the Federal Reserve and the US government are in a tough spot when it comes to inflation versus the slowing economy. Well, the ones caught in a tough spot are Asian countries such as China, India, Vietnam, Pakistan, Thailand, and so forth. These countries are seeing high inflation along with slowing growth and spectacular government deficits. On top of this, the vast majority of the citizens are very poor so removing a fuel subsidies can significantly hurt the majority of the population in the short run. In the long run, subsidies distort the market and actually hurt the poor but the short term is another story. It is extremely difficult to be a politician in those countries right now.

Below-market fuel and power costs made it cheaper for manufacturers in export-dependent economies to operate, giving them a competitive advantage over rivals in other markets. Subsidized prices also left consumers with more disposable income, boosting demand for goods and services.

Now, higher costs will erode the export edge. That may lead to more shuttered factories in countries such as China that already have more manufacturing capacity than they need to meet domestic and foreign demand, putting millions of people out of work.

One of the reasons I'm bearish on China, India, et al, is due to the reasons cited above for their growth. It's not clear how sustainable any of the the current growth is. Keeping the currency undervalued, subsidizing fuel costs, and so on, are not sustainable in the long run. Can China, India, et al, grow without such distortions in the market place? China bulls such as Jim Rogers seem to think so but I'm sitting on the sidelines for now.

As the Asian economies slow, commodity consumption should decline substancially. If I'm right then the high growth rates being projected for most commodities are going to be totally off the mark--just like internet penetration rates turned out to be wrong 8 or 9 years ago. I've been an oil bear for over an year--and been totally wrong--but my view has always been that oil will enter a bear market if and only if the Asian demand drops off (which will only happen if subsidies are removed.)

To see how unsustainable some of these subsidies are, check out India's fuel subsidies:

Even after India raised fuel prices, Prime Minister Manmohan Singh's government will still pay about $42.5 billion in oil subsidies this year, more than twice as much as last year, and about six times the entire education budget.

Six times the education budget. Two times last year's subsidies. Those are some wild numbers. On top of causing massive government deficits, these subsidies distort the market and result in inefficient use of energy.

Adding to his problems, Fitch Ratings this month cut its outlook on Indian debt to negative, citing spending on food and fuel subsidies. Standard & Poor's and Moody's Investors Service cut Pakistan's credit rating in May. S&P, Moody's and Fitch all lowered their outlook for Vietnam's debt in May and June.

I haven't looked at the prices lately but one of the biggest bubbles out there over the last few years, in my opinion, has been emerging market debt. I am not sure about right now but EM debt spreads over US Treasuries has been extremely low for the last 5 years. This has mostly been because investors have been ignoring history and assuming that EM debt won't default all of a sudden. This thinking was likely driven by the high growth in some countries (China, India, Vietnam, etc) and/or improving government balance sheets (Russia, Brazil, etc). Unfortunately, some are going to be in for a shock pretty soon if these countries slow down further and their government deficits keep deteriorating.

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6 Response to Asian Subsidy Scheme Ready to Collapse

July 28, 2008 at 4:27 PM

great news for us if Asia ends their subsidies. Energy demand would go down, lessening pressure on commodity prices.

July 28, 2008 at 4:27 PM

great news for us if Asia ends their subsidies. Energy demand would go down, lessening pressure on commodity prices.

July 28, 2008 at 5:03 PM

Interestingly if energy prices weaken (already many industrial commodities have sold off in the last few weeks,) the US economy should recover slightly. However, it might be one of the few times in history where the stock market does not recover. A lot of people don't realize that the stock market went up in the last few years due to energy and materials. If you strip out energy, S&P 500 profits as well as stock returns wouldn't have been as good as it seemed.

Although the market will rally initially if energy corrects, I think it will weaken eventually. It'll be interesting to see how this all plays out...

July 28, 2008 at 11:18 PM

Good god, Sivaram, if I am not mistaken, your outlook is actually now..... realilty-based.

Should I be worried that we _might_ actually be on the same side of a trade?

July 29, 2008 at 10:09 AM

LOL :)

Actually I have always held a view like that. My thinking had been influenced by Marc Faber, who pointed out years ago that practically all assets (gold, commodities, emerging market bonds, EM stocks, art, collectibles, US stocks, US bonds, etc) have gone up since 2003, so it is possible for everything to correct.

Having said that, I think we still differ materially when it comes to investing. Your view seems to rely on picking the bottom and selling at the top, so you keep taking a stance of avoiding these assets and staying on the sidelines (or maybe short--not sure if you endorse staying short or not.) In contrast, my view is that we should be investing throug this. I'm sure you view this as somewhat foolish but what happens on the macro front matters less than valuations of assets. My goal is to pick off assets at low enough valuations such that they will do OK even if, say, the stock market stays in a bear market. For instance, someone like Warren Buffett was long-only AFAIK throughout the nasty bear market in the 70's and yet made a killing. Even though the macro situation did not look that great, Buffett's investment in, say, Washington Post did well overall.

I'm not saying I'm a Buffett but that's kind of my goal. Invest through a bear market!!! This point will always separate us.

July 29, 2008 at 7:41 PM

Thanks for the assurance that we're still on opposite side of the trade!

I'm feeling much better.

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