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Deleveraging before Emerging

Will the 'I' in BRICS be replaced by Indonesia, and will there be a BRICS left at all...

With Brazil dropping to 2.5 per cent GDP growth, Russia and South Africa dependent on (falling) commodity prices, only India and China are still above 5 per cent, the base rate of growth required to be an 'emerging' country, which actually emerges. Of particular interest to us, will the 'I' in BRICS be replaced by Indonesia, and of passing interest, will there be a BRICS left at all?

The debt supercycle seems to move in a wave form: before 2001, it was non-financial businesses that saw record levels of leverage; from 2001-2007 it was households and financials; and after 2007, there is an explosion in Government debt in most parts of the world. The turnaround (or, the start of the deleveraging process) may be round the corner, and it will likely happen with 'financial repression', i.e. high inflation with negative real interest rates that allow Governments to see growth in nominal tax collections, even as real incomes of their populace suffers a decline. Right now, markets are very kind to the US Government, as Treasury Bills are quoting at negative (real) yields, even as the US public debt ratios explode. This reduces real incomes in the private sector, slowing consumption demand.

Part of the emerging market (EM) 'slowdown' comes from stagnating demand in the developed world, which has to whittle away at its debt mountain. While global retail and corporate debt may stabilise in about 5 years, Government debt in the developed world will weigh on overall GDP levels long into the next generation. This slowdown has affected production (and some investment demand) in the EMs.

That leads us to talk about the new 'normal', which affects the export-led model of growth of South East Asia in particular. However, as this gets replaced by internally generated demand (especially in China and South East Asia), the 'new normal' will stabilise at levels comfortably above OECD levels.

EMs may not have a debt mountain to service and high savings rates to boot, but they have issues of governance, politics and (missing) infrastructure which are slowing down growth. Nobody is feeling happy these days, but things aren't as bad as we are making them out to be. Real growth will come from technological revolutions round the corner, in renewables, energy efficiency, biotech, agriculture, maybe water management. These inputs are at the core of productivity improvements in EMs, who will stand to benefit dramatically, unleashing unprecedented demand. As the real cost of such inputs drop to levels that bring millions out of poverty, we will see mini-booms and 'feel good' in a large number of industries. The expanding real incomes from such booms will chip away at the old debt, just as India worked away its old Indira Gandhi/ CK Jaffer Sharief (the "loan mela" king) debt after its post-1991 real growth spurt. Government will always misbehave and governance will not improve, at least noticeably. This will lead to very high levels of noisiness about unhappiness, but we should not confuse just a loud whine with the real pain.

In particular, an argument about India seems to have been overlooked (which puts us ahead of the EM pack). This impacts the risk perceived on Indian (solar) investment. Others have talked about the high irradiation levels in Indian deserts, which would increase 'technical' yield, but that is a small argument. In a business where the raw material/fuel cost is anyway near-zero, there is not much incremental advantage in further reducing the (raw material) cost.

My argument is a currency argument, that provides incredible return, irrespective of Government policies or the lack of it. Besides having both high irradiation levels and a huge pent-up energy demand (peak deficit 12 per cent, ie. 25GW), India has the only currency that is 'directly sensitive' to (high) energy prices. An investment in solar reduces raw material cost, replacing it with the cost of capital. If low-cost capital (read dollar-funded solar investment) were to come into India, it would bring in dollars on capital account, saving huge dollars on revenue account. Remember, India would quickly turn current account surplus, because almost 40 per cent of its exports are spent on energy imports.

Falling energy costs (or even stable energy availability) will kick off mini-booms in other energy-intensive sectors of manufacturing, pushing up economic growth, even while bringing down inflation in critical areas of food (through better water management) and basic consumption.

Once this virtuous cycle is set off, the country would become an ideal investment destination for almost everything else – red hot, pent-up domestic demand, which is kicked off by low energy costs that drop the cost of all manufactured products, leading to a consumption boom. Given its high services exports, the country stays current account surplus, which gives it currency appreciation over the long-term.

A continuously depreciating currency turns into a continuously appreciating one, on the back of sustained FDI flows into the rest of the manufacturing sector. An early investor benefits from all this; the returns from solar, good as they are, are telescoped by the long-term currency readjustment that the country goes through as it reaches energy independence. For the rest of the story, India already has most of the ingredients needed for long-term growth. Mind you, I have not assumed that the long-term problems of India (policy paralysis, poor governance, a scam or two after investments have started to flow) will ever go away. Yet, despite this, India has proved to be a far better investment destination than the rest of Asia.

None of this is true of any OECD country, simply because the pent-up demand is not there. High leveraging of the consuming population anyway reduces potential for economic growth. Were any important cost to come down, it would only go towards reducing household leverage. When you look at emerging markets, no other major EM has such a huge consumption demand, backed by a currency valuation entirely sensitive to energy prices.

This gives an overseas investor in solar a 'natural hedge', i.e. as energy prices fall, the currency will appreciate, leaving you wondering what to pray for...!!!

India remains the world's fastest-growing market for renewable energy (RE) technologies, growing at 52 per cent in 2011 (to $10.3 billion) over 2010. It is arguably the most promising solar market in the world. These twin trends have contributed to Indian FDI still growing at 30 per cent to $32 billion, in a year when the rupee depreciated 23 per cent. Total RE capacity is already 27,000MW, growing to 54,000MW by 2017, a shade under 20 per cent of total generation capacity.

The US Shale gas is already coming in at $15 per barrel of oil equivalent (boe), and if they start exporting the stuff, it will drive down energy prices here in India. As the economy is most sensitive to energy prices, India would suffer the steepest relative fall in overall inflation; its long-term bugbear.

The deleveraging cycle is already five years old, and is expected to take another seven years before the OECD countries get clearly falling public debt ratios. With interest rates close to zero, the only way their central banks will manage to keep negative real interest rates will be by keeping inflation targets high. This will increase the "financial repression" on savers, but create some real growth. If the rich get taxed disproportionately, we might even see some redistribution to the lower end of the pyramid, which will accelerate inclusive growth.

To summarise, while the developed world uses "financial repression" to inflate away its debt, emerging markets, particularly India, may see real growth whittle away their debt ratios with high savings rates. In either case, real interest rates are set to fall, but for different reasons. This will shift profits to the corporate sector, which is best able to capture the benefits of inflation and low real interest rates. All this is subject to food and agriculture not being the spoiler they have been.