The US economy will collapse and India IT will die afterwards

As the US economy collapses and dies screaming, you Baboos will lose your jobs. A word of advice to Baboo: do an internet search about the story of the goose that could lay the golden eggs. And just to add credibility to this post, I am posting an article written by a Baboo.

" Also a decline in corporate earnings in the US means lesser application development works outsourced to Indian vendors."

Who's Afraid of a US Slowdown? (India) By The Economic Times (India), Investing-News.Com Apr 28, 2005, 01:26 Email this article Printer friendly page

Russian President Vladimir Putin said this week that the fall of the Soviet Union was the biggest debacle of the 20th century. But isn't it too late to open your heart Mr President as the world is already under the cosy shade of capitalism? At a time when the global economy is getting used to living in a unipolar world, where the economics and politics is dictated by the US, Putin's confession doesn't hold any importance. But his views may make us to do a rethink on how safe are the global economies and multi-national corporations from an American economic slowdown.

The tech-boom of the 1990s and the general belief that the US has moved into a new economy era, where commodity prices and demand-supply imbalances are going to be negated by the huge money pumped in by the new digital kids on the block, may soon be proved wrong as the US economy succumbs to the pressure of balance-of-trade imbalances and money market fluctuations. It is clbuttic economic cycles in play.

The post-2002 economic boom triggered many multi-nationals to embark on wild investment programmes and global expansion. This out-of-scale boom shook the very base of corporate US as many big corporates fought to save their face from insider trading, accounting cover-ups and corporate scams to portray unrealistically high profits. Corporates involved in cases of corporate malfeasance include icons like ABB, AIG, Arthur Andersen, Elf, Enron, Halliburton, Hollinger, Parmalat, Shell and WorldCom.

IMF has predicted that burgeoning US trade deficit and a probable burst of the market bubble will force the US to deflate an already weak dollar and spur interest rate volatility.

These macro-economic crises in the US together with the slow pace at which the Japanese economy is recovering from the recent slump may further broaden global economic distress and international instability.

What are the current trends in the US economy?

US Treasury Secretary John W Snow described the US economy as being in a sweet spot, but there will be increased fears that conditions are now souring rapidly with evidence of slower growth and rising inflation.

Forex Capital Services reported that if the combination of weaker demand and price pressures continue, the Federal Reserve will face a very difficult task over the second half of the year and confidence in the US economy is likely to falter.

The earliest symptom of this fall in confidence would be a renewed weakness in dollar. As an anti-dote to this the Fed may stop rate hikes or even cut rates to support the economy. But this may not revive the confidence that the US market enjoyed with overseas investors.

The structural weaknesses in the US economy and high debt levels will make the US economy vulnerable to external shocks and high oil prices. Economic indicators are pointing to soft landing though there won't be any fall in short-term demand. However, a possibility of recession later this year can not be discounted.

Stagflation worries are still looming large in policy makers' minds as the latest economic data show the risk of rising inflation coupled with slow growth.

Retail sales growth was subdued in March with just 0.3% rise, the slowest increase for 12 months. The job data escaped unhurt as unemployment status showed some improvement though not too bright to feel comfortable. There was also a sharp 17.6% drop in new residential constructions for March.

The Insbreastute for Supply Management (ISM) indices released at the beginning of April indicated a sharp decline in manufacturing activity. Consumers are facing a slump in earnings. This coupled with high energy prices will sap spending. There was a 0.3% decline in real earnings in March and a 0.5% annual decline.

This trend will stop consumers from increasing their spending. Consumer confidence will further be derailed if there is a sustained decline in equity prices.

How is US trade and budget deficits threatening the global economy?

The record growth in the US trade and budget deficits is putting an additional pressure on an already weak dollar. Traditionally the US had taken pride in a strong dollar, which it perceived as a sign of US compebreastiveness and economic strength.

But now the US government tends to keep tight-lipped about the dollar fall. Partly it's the US policy of non-intervention to prop up its falling currency and partly US is seeing it as an opportunity to cool the trade deficit. But this numbness from US policy machinery is a cause of worry for the entire dollar-tied global economy.

situation rightly when he said, "We sit here absorbed in a debate about how to maintain Social Security when the baby boomers retire. But right now, those same boomers are spending like there's no tomorrow. Personal savings in the US have practically disappeared. In the space of a few years, the federal deficit has come to offset national savings. As a nation we are consuming and investing about 6% more than we are producing."

The US economy is witnessing a mbuttive flow of capital, running to more than $2 billion every working day, from the central banks of China, Japan and other South-east Asian countries. The US is absorbing about 80% of the net flow of international capital.

In 2000 the Bush administration inherited a $240-bn budget surplus. By 2001 the recession, which reduced tax receipts, plus mbuttive tax cuts voted by a Republican Congress and a sharp increase in defence and homeland security expenditure turned a substantial surplus into a huge deficit. The trade deficit had hit a record $618 bn or 5.3% of GNP in 2004 - a 24.4% increase over 2003.

The problem of budget and trade deficit is discussed in every other international conference. It's no more a domestic concern of the US. It's a global crisis. The proposed solutions like, tax increases, lower defence spending and encouragement of savings are hard for policy makers to implement as it clashes with the political interests of the US.

Is the US concerned of its surging deficit levels? The answer is, no. The US is viewing the trade deficit as an indicator of strength vis-a-vis their trading partners. US Treasury Secretary Snow said recently, "A large deficit shows our economy is growing faster than those of our trading partners in the euro zone and in Japan. The economy is growing, expanding, creating jobs and disposable income, and that shows up in the demand for imports."

So, the official solution for trade deficit is rapid economic growth, fuelled by tax cuts.

What's the impact of a cheap dollar?

The situation today is very different from 1971, when the then US treasury secretary, John Connally, said, "It's our currency but it's your problem" about a falling dollar.

Ibrahim Warde, a Fletcher School scholar, says that the US buys 50% more than it sells overseas. Foreign investors, through their acquisition of US treasury bills, sustain the lifestyle of the world's greatest power, he says.

A weak dollar makes US products more compebreastive, US buttets cheaper and more attractive to foreigners, and devalues a foreign debt estimated at $3 trillion. This is the principal reason why the US is keeping mum about the declining dollar. But this policy never clicked as a falling dollar never eliminated the deficit by helping exports and hindering imports. But, the gap widened due to the structural deficiencies in the US economy.

This landed the US in a strange situation of being both the world's greatest debtor and the issuer of the world's principal reserve currency.

The huge imbalances and the complexities attached with the economics of dollar was made further complex by the central banks of emerging economies who hold about $2 trillion.

The emerging markets did this like there was no tomorrow to prevent the appreciation of their own currencies and thus protecting their exports to the US, the largest market for most of these countries.

Another cycle followed this currency-pegging as these accumulated dollars returned to the US as investments in treasury bills, which kept the US interest rates at rock-bottom levels. It could be said that the structural imbalance in the US economy was helping the US trade deficits to create budget deficit which further created a low interest rate regime which contributed to low savings.

And emerging markets mercilessly refused their love for dollar as dollar began to slide. Central banks around the world began to diversify their currency reserves from dollar to euro.

So, a sliding dollar has now become everybody's problem. In the US a low confidence on dollar as a currency means the Fed will have to pay higher interest rates to attract insbreastutional investors to buy treasury bills and dollar receipts and a high interest rate regime will further hurt investment and spending thereby triggering a slowdown in demand and output and hence a recession. For the global economy the interdependence of economies, ensured by the globalisation regime, made sure that a US recession would drag down all the world economies.

The most interesting character in this economic circus is China. The falling dollar allowed China to maintain an edge in its trade with the US. The result is that the US is running a deficit of $207 bn with China, which is one-third of the total US deficit. And the Chinese renminbi or yuan is a pegged one.

Inflation or stagflation: where's the US heading?

The inflation indices for March recorded a huge surge. There was a 0.7% rise in producer prices in March. Consumer prices also surged more than expected at 0.6%.

The surging oil prices took its toll as transport prices rose strongly. Also an array of retail products like clothing saw prices rising strongly.

The high inflationary pressure is sending the US bond market into a lot of confusion. Treasury yields have fallen back to near 4.2% from highs of 4.5%. Bond markets are struggling to find direction as volatility remained high and falling yields suggested concern over a slowdown in economic growth.

The combination of rising costs and weaker demand has also been seen in sectors such as the car industry with a huge losses posted by General Motors and Ford. Although car demand has eased slightly, the main pressures on profitability have come from rising costs due in part to higher medical insurance and pension costs.

There will be concerns that the symptoms seen within the car industry will spread to the economy as a whole. If there are sustained cost increases and pressures on profitability, there will also be a risk that the corporate sector will not be able to maintain investment levels.

The US Federal Reserve will face difficult decisions if there is a combination of rising inflation and weakening growth leading to stagflation. Fed faces a scaled up problem due to its wider portfolio of responsibilities.

According to Forex Capital Services, the Fed's mandate is wider as there is the need to support employment along with overseeing interest rates, inflation and economic growth. In this context, there will be greater risks that the Fed will slow or stop monetary tightening if growth starts to slow. There will also be greater discussion over an inflation target over the next few months, particularly with Fed Chairman Greenspan's term of office ending early next year.

Why does the US slowdown worry IT companies?

The IT sector started the year with bumper expectations. Offshoring deals saw robust volume growth after US elections, many big corporates had raised their IT budgets for '05, prices were stable and the dollar was on a better position than '04; all this seemed a good outlook for the IT industry.

But everything turned head-on-heals when Infosys Technologies announced its earnings guidance on April 14. A combination of lower-than-expected earnings guidance of about 25% and a weak fourth quarter and a flat first quarter for FY 2005-06 spiraled a huge fall in markets.

This was followed by a host of low guidance from Wipro, TCS and IBM in the US markets. Software stocks were hammered in the markets around the world.

The reasons were obvious as 55%-65% of the IT majors' revenues come from the US economy and the US is pathetically out-of-shape.

Depreciating dollar can be very harsh on IT companies revenues. One per cent depreciation in the dollar can shave 0.4-0.5 percentage points from the bottomline.

There is also the worry of volatile policies concerning outsourcing. Because of this many clients built-up by the Indian IT majors over the years have switched over to a multi-vendor environment. The amount of projects that have moved over to such a management model may be around $40 million for each of the three Indian IT majors, namely, Infosys, Wipro and TCS. A multi-vendor environment helps companies to reduce dependence on the top vendors and thereby reduce their exposure to risks of price escalation and demand for more volume.

Also a decline in corporate earnings in the US means lesser application development works outsourced to Indian vendors.

But there is hope beyond the US. Emerging markets are witnessing an expansion of connectivity through broadband internet revolution. Individuals and organisations are logging onto voice and data communications more and more. A booming digital economy in emerging economies is holding promise for tech majors.

What are the policy options left with the US?

The concerns are too big to be ignored. Any further surge in oil prices, still above $50, will disappoint the US growth data further and will trigger a new economic cycle of higher prices-lower demand-lower production-lower wages and employment and ultimately lower growth.

The fiscal policy options available with the federal government are limited. The US vulnerabilities will be increased by the fact that the US consumer and government sectors have little scope to support demand. Consumer balance sheets are already stretched and savings rates are low.

Given these stresses, consumers will be looking to rebuild savings rather than increase spending. With the government budget deficit likely to be over $400 bn in the latest fiscal year, there is also very little scope for an expansion of fiscal policy.

But there is a different guidance projected by Fidelity Investments for emerging economies. It says slower global growth is not necessarily a negative for emerging markets. Slower global growth can lead to a fall in corporate earnings and this is a negative for emerging market equities.

However, many economists feel that a marginal slowdown is actually good for companies in the long-term. A marginal slowdown in the global economy can lead to marginally cheaper prices for commodities like steel, aluminium and cement. This can deliver sustained growth in consumption and corporate earnings.