China and the value trap

The above chart shows how value added (or alternatively excess returns) is distributed across the Global electronics industries. Although, it reinforces what we already know about it for long, the chart allows for more deeper analysis. After looking at the below chart, it strikes to me that most of the world's most successful businesses have followed this operating model for atleast past two decades and some for even longer, examples include Coca Cola; VISA, Qualcomm, Apple, Cisco, Nike, even Colgate and P&G, 

Strikingly, firms in the hi-tech business that were active across the value chain (including manufacturing) are experiencing or have experienced problems in the past, examples: Hp, IBM, Intel, almost all Japanese electronic firms. One reason being, their investors primarily value them as hi tech companies rather than low tech manufacturing hubs which is sometimes untrue when low value add is more of the revenue mix than high value add. 

A modern company contradicting this trend and still steeply overvalued is Amazon which is diversifying from high value added activities (its potent online platform) into lower value added and more capital intensive ones (company owned warehousing and now logistics). It will be interesting to see whether Amazon proves to be an exception to the rule or will its market price react to this trend over time (now that is a short idea!). 

(Aside: This also reminds me of our original investment thesis in Aramex (high on brand, low on capital intensity), and why Aramex is truly under-appreciated.)

Infact, in Emerging countries there are many instances of listed entities moving from high to low value added. Usually, the devil lies with the initial success, as cash builds up, management in companies with poor corporate governance and shareholder monitoring, are motivated to reinvest the surplus and grow the size of the firm than to distribute the same to shareholders. Expanding downhill is more easier and certain than uphill which makes the decision look prudent for time being and safer for incumbent management. 

It also tells me something interesting about China and how probable it is for that country to make into the upper echelons of the income pyramid. China over the past three and half decades has grown mainly by becoming the workshop of the world -the activity which has least value addition across the chain. That success was made possible with fortuitous combination of 1) large initial supply of cheap factors of production Land, Labour and Capital. Being a authoritarian state, the government owned the land, made capital cheap by repressing market clearing interest rate (which also explains the real estate bubble in China). In an urgency to get unemployment and poverty down for hundreds of million of unskilled people after "The Party" came to power, what better than create low skill, low pay jobs by creating subsidies manufacturing base. Externally, this process coincided with the trend of rising Globalization and economic integration in 80s. 90s and 2000s. 

However, China has not been able to move upscale to more value added activities and it is likely that when the wind is out of the sails on the initial trigger factors (labour, land and capital), China will increasingly face the same risk that other middle income countries face -of stagnant incomes. Infact China's case it will be even difficult because liberty and freedom are prerequisites for providing the environment to innovate. Now, that tell us that whether "The Party" will have to go or Chinese aspirations will have to settle for less. 

The GCC economic growth in many ways is similar to that of China, given almost all GCC countries are authoritarian states of varying degrees. A large percentage of non-oil, non-consumer services GDP comes from low value add manufacturing in industries such as petrochemicals, aluminium, fertilizers, steel, etc. These sectors are globally competitive as long as they have access to cheap feedstock. Though the GCC is lauded for its economic stability and growth rates in excess of 5% and the bureaucracy extolling the growing role non-oil sector. The concerning point is that the non-oil sector is viable to a large extent only due to the indirect subsidies and surplus from the oil sector. That dependence on oil and how fast non-oil GDP can crumble when oil is removed from the equation, justify why long dated GCC assets (high duration bonds, equities and real estate) should correctly trade at a discount to other countries with similar growth but without the oil induced distortion. 

This line of thought also explains why Mr. Alabaar's (Chariman of Emaar) proclamation of Dubai real estate trading at a discount to London or Singapore should be taken only with a grain of salt. A large grain indeed!

The state of Indian Democracy

India heads for the biggest and greatest democracy show in Apr-May 2014 as the country of 1.2bn and registered voters of more than 800M goes to elect its new government in the center.

The election this year is very unusual and interesting from the past precedents. This years election is focused more on individual personalities that would potentially lead this country of old civilization and young population out of the longest period of moribund since early 1990s. At the center of this high pitch drama is Narendra Modi, the decade old recalcitrant Chief Minister of the western Indian state of Gujarat largely credited with engineering one of the fastest state level GDP growth.

Narendra Modi has also other feathers in his hat than just Economic development ( a preception that is selling like hot cakes in India as the country rellies from one of the slowest growth in more than a decade, rising inflation, unemployment, and never ending goverment goof ups driving scarce capital). Mr Modi is largely perceived as having covertly been a accomplice of the 2002 pogrom of the Muslims (13% of the population) under his watchful eyes in his state in 2002. A accusation that he has neither accepted and never rejected. A Supreme Court enquiry let him off the leash largely due to lack of substantial 'evidence' though the US Govt revoked his US visa and banned him from travelling to the US due to his alleged role in the genocide.

The whole campaign of the right leaning, nationalist Bhartirya Janata Party whoes PM candidate is Mr. Modi is foused on this superlative economic performance of Gujarat attributable to solely and squarely to the leadership, vision and dicision making skill of Mr. Modi. We will not go into cross examining the authenticity, and statistical analysis of that perception  here. Though sufficient to add in this context, that Gujarat has historically been a state with GDP growth higher than that of the aggregate India and Modi's autocratic and dictatorial style has earned Gujarat capital investments from national and international businesses at the expense of sidelining (sometime by force and other coercive methods) other interest-such as displacement of poor, land acquisiiton, environment, etc. A heavy handed approach indeed has its benefits, particularly in terms of raw economic growth as reflected in the 'China Model'. However India's political and economic setup is very different from that of China (Indian is the worlds largest democracy and China is the worlds largest communist). Albeit the only similarity between the two is entrenched political corruption, rent seeking and the nexus between the businessmen and politicians.

What is very puzzling and equally disappointing is that millions of Indias support Modi (including millions who knew nothing much about him and his achievements before his candidature for the top post) with the same fevour as they support their national Cricket team (India has almost no sport to talk about except Cricket). What they fail to realize is that they are choosing a leader to head a democratic country as vast and diverse as India, someone whoes values, past track record and very achievements are precisely an antithesis of democracy. All that sacrifice, based only on perception and expectation of being able to bring India on track of enviable economic growth. That is indeed a great sacrifice, as it reflects the mentality of average, mostly educated, Indian of today. He is ready to overlook (almost forgotten) the governments role in the pogrom that killed over 1000 of his fellow contrymen only a decade back, plus countless other miseries such as rapes, displacement, illegal appropriation of assets, and discrimination at work place, education institutes, and public offices of the minorities. He is ready to overlook the fact that: long term development, that is more meaningful and equitable, than just raw GDP data; it is necessary for the goverment to tackle issues that pose challenge to the 'capital investment' based model in its policy making, and respect the rights and concerns of other stakeholders than just the capitalist. Sidelining those concern and stakeholder, though can create jobs and growth in the short -run, it will eventually extract its price: by mainly rising social and ecnomic inequality, threat to internal national security and harmony and a unbalanced, unsustainable growth path that will engender anothet set of political issues to deal with down the line, as China has realized in the past 3-4 years.

Another trait of this elections campaign mania has been the ease with which the Indian voter (educated and otherwise) can be obfuscated with glizty marketing and branding ploys. Though there are millions of Indians to harp about Modi's economic miracle in Gujarat and his leadership (most of them confusing leaderhsip with autocracy) very few and I repeat indeed very few actually can articulate what those 'achievements' indeed are and still fewer have any idea of how they have been achieved. Not much doubting the depth of critical mindset of Indian voters, the BJP campaign machinery has gone the 'end of the world' in marketing Modi strength as the sole purpose of it being the rightful candidate to form the government at the center without devoting much time and energy in communicating What and How the Economic Growth implicty proffered to the voters in exchange of their votes will be achieved. Nor Mr. Modi has made any attempts to articulate what his vision for the country is, what issues does he intends to tacke and how? to re-ingite the India Shining story.

Although, I have to concede here that the last of the problems mentioned in the prior paragraph is across the Indian political landscape where candidates promises are more friction than facts. Very few, even those running for the highest posts, make any attempts to go into detail of their game plan for the country and how they intend to achieve it. Candidate never debate with one another on the same stage on issues vital for the country and how they intend to tackle it (maybe they too have no clue on that!). Mass rallies are similar in analogy to religious sermons where its sacreligious to ask questions and you have to use your emotions more than your head to believe that your candidate tells you. As much as 50% of the time is spend in only jibbing at and belittling the opponent on issues that are sensational rather than of national importance.

The Modi led BJP govt seems to be likely at the center after the May elections and that is what the polls suggest. It will be interesting to see what and how much Mr. Modi delivers when the rubber meets the road. I will endevour to update this article after the May election results outcome.

Yen and how it may impact global asset classes

Originally written on 16th May 2013

BoJ’s ambitious plan to simulate domestic economy by sloshing the system with monetary easing (printing yen and exchange these yen to buy bonds and mortgages of all maturities) in order to stimulate domestic demand and inflation (2% inflation in 2 years by expanding the monetary base by 2 times) will have repercussion far beyond Japan

For one, printing money to artificially sequester real interest rates will at some point make investors in JGBs reluctant to either buy more JGBs or continue holding existing ones in the portfolio-consider the plight of an investor who has sacrificed consumption in the past to buy these bonds now find its claims at par with those who have brought the bonds by simply printing the money!-That scenario, if it comes to pass, will spell doomsday for Japan as the country currently has the highest Debt to GDP ratio (>200%) in the world (to put it in context, struggling Italy and Spain have debt to GDP ratio near about 100% but unfortunately cannot print their way out of the problem) and public debt is mainly financed through domestic savings.

After the bursting of the real estate and stock market bubble in early 1990s’ Japanese retail investors have mainly preferred to invest savings in bank deposits which in turn are channelized to buying JGBs. Loosing investor confidence may result in steep rise in yields –no matter how much more the government keeps printing money. On the other hand, retail investors were comfortable buying JGBs near zero return given that inflation was negative in Japan for a very long time and stagnant economy subdued outlook for other asset classes (such as domestic real estate and equities), that may now change with inflation outlook becoming positive and Nikkei at 5 year high giving investor more options than putting money in boring JGBs

The aggressive stimulus may have unexpected impact on Japan something with which the world has no prior experience in recent history, If I were to make a wild guess, I suspect the impact will be mainly on driving up steeply Yen yield curve (the trick is plain to see for JGB investors) and the associated problem Japan may face to funds its unbridled public debt –a scenario which will see yen depreciating much more

What would this mean for global asset classes

1.   First and foremost, selling one currency to buy another one eroding its value at a slower pace is not a solution, the ultimate hedge will remain hard assets such as real estate, commodities and metals

2.   Secondly, even though global economic growth may be sluggish, equities are placed relatively better than bonds fundamentally, as they are natural hedge against hyperinflation, as well as, share any upside that monetary stimulus is purportedly suppose to achieve. In that case, equity valuation multiple may remain higher than can been the case in recent past even without encouraging topline or bottomline growth

3.  Gold price correction in the recent past is puzzling when juxtaposed with the debasing of currency in Japan / US and maybe soon in EU due to competitive pressures. Gold has always and will remain a hedge against monetary debasing and threat of future inflation

4.    As lower yen conquers market share at Germany’s expense, EUs incentive to debase euro further which will meet the interest of both northern and southern members will rise, the question is if all three major currency blocs (EU, Japan and US) desire a lower exchange rate for itself,  the depreciation will be relative to which currency?

5.   An event / catalyst which can trigger market to reject buying QE prone currencies and nominal bonds denominated in those currencies will be a milestone event for world monetary policy. And possibility of countries once again reverting to fixed exchange rates or exchange rates tied to gold reserves cannot be ruled out in next decade or so. Although this may sound far-fetched now, such arrangements and reversion from free floating to fixed exchange rates and vice versa have happened multiple times over the past 200 years. With each episode of reversion from floating to fixed exchange rates being subsequent to sharp episodes of inflation usually after rising wartime public debt

6.   That view also explains why holding gold as long as printing presses at major central banks keep humming (and a few years after that to confirm status on ensuing inflation) is a good idea even though there may be opportunity costs involved here.

7.   Also for the first time in a generation, equities might actually be a safer assets than the risk-free asset called government bonds we grew up learning about 

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Near term prospects for Bahrain goverment debt yields

Originally written on 20th May 2013

Bahrain faces a steep challenge relative to its other oil rich neighbors in the GCC over the medium terms in putting its fiscal health on a more sustainable path. In a nutshell concerns over Bahrain’s fiscal health have their provenance in two sources

1.  Generous state subsidies (including those on fuel, electricity, water, selected food items)

2. High dependence on Bahrain’s limited hydrocarbon production to support fiscal spending and generous subsidies

The political unrest which began in early 2011 and continues to this day-albeit having stabilized progressively-have put further pressure on state coffers to increase spending in order to both simulate a stagnant private sector, as well as, create employment on urgent basis. Secondly, subsidies tend to be sticky with steps to control / cutting back remaining highly unpopular with the constituencies, reform in that direction though urgently needed will be extremely challenging politically given the already stressed relationship between the government and a large majority of its countrymen.

Bahrain’s current break-even oil price at $115 is already above the market price and perhaps the highest among all oil exporters in the world.(breakeven price is the price of oil, keeping export volumes constant, would be required to fully fund budgeted state expenditure without resorting to borrowing or liquidation of past reserves). To me that would imply that the country will continue to run fiscal deficits persistently since my subjective judgment is for that expenditure on other hand will be extremely difficult to cut back and near term oil prices have probabilistically more downside risk rather than upside.

Given the small size of the economy and flagging private sector growth, a incrementally rising debt to GDP ratio will not be quite appeasing for both existing investors as well as prospective investors in Govt. of Bahrain paper. I consider the prospect for credit premium on Bahraini debt and CDS to increase over the next 2-3 year horizon from current levels than to decrease. Once the exigency to control ballooning government debt becomes a consensus opinion, a downward revision in Bahraini dinar-USD exchange rate (devaluation of the BHD) cannot be ruled out either.

On the positive side, Bahrain remain geo-politically important to contain Iran’s influence in the Arabian peninsula and has historically shared very strong relationship with regions big boy Saudi Arabia. A GCC bailout or soft financial assistance (as the current $10bn 10 assistance) is also a quite likely scenario in case of sudden distress. That would make investing in short term Bahrain government debt (after the yields have spiked in tune with new information) a attractive proposition in future if the country goes through a financial panic in coming years.

Key economic statistics of Bahrain

1.  GDP  2012 – 2.7% p.a.  (Historically, from 2000 until 2012, Bahrain GDP Annual Growth Rate averaged 4.61 Percent)

2.  Current account to GDP – 15.4%

3.  Government Debt to GDP – 31.6% (Historically, from 2000-2012, Bahrain Government Debt To GDP averaged 19.84 Percent)

4.  Yield on Bahrain (2020) government USD bond – 4.12% p.a. (USD 10yr T-Bond 1.95%)

5.  5 years CDS spread –c.2.05% p.a.

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When in Investing, why worst is best

Originally written on 19th June 2013

Interesting chart on yearly and 10 year cumulative return delivered by different Asset Classes…..the exhibit underscores one often touted characteristic of the markets…That it is nearly impossible to predict the best performing or for that matter the worst performing asset from one year to next (Remember, safer and less volatile assets are usually at the bottom in return ranking, but that does not mean that you can predict their outperformance or underperformance relative to riskier asset classes from year to year). A equally weighted allocation across all asset classes as represented by the ‘Asset Allocation bloc (in Grey) is one best method to both remain reasonably well diversified and making sure your portfolio does not end up at the bottom (but will also preclude its possibility of ending at the top). A second observation, is that asset classes (particularly risk asset classes) that performs worst on relative basis in given year(s) usually has a higher probability of outperformance in subsequent period(s). Hence a strategy of buying losers and selling winners may result in long term outperformance.

Below i present a mechanical asset allocation strategy that:

1.   Invest in the subsequent year in the best performing asset of the previous year (eg. invest 100% in MSCI EME in 2004 after the asset class being best performing in 2003)

2.   Invest in the subsequent year in the worst performing asset of the previous year (eg. invest 100% in Cash in 2004 after Cash being the worst performing asset class in 2003)

3.   Invest in three best performing assets of any given year in subsequent year on an equally weighted basis (eg invests in MSCI EME, Russell 2000 and MSCI EAFE in 2004 on equally weighted basis)

4.   Invest in three worst performing assets of any given year in subsequent year on equally weighted basis (eg invests in Cash, Barclays Aggregate bond index and Market Neutral in 2004 on equally weighted basis)

The results of this exercise tabulated below are rather interesting, The contrarian strategy of holding worst performing assets in subsequent period is more than twice as profitable than the strategy of holding the best performing assets. Secondly, on risk adjusted basis, the sharpe ratio of the contrarian strategy is better than that of the momentum strategy. Thirdly, the portfolio model (three best and three worst) approach is more superior than holding 100% of single asset in both absolute return and risk adjusted return terms.

	2003	2004	2005	2006	2007	2008	2009	2010	2011	2012	Cumulative Return	Std Deviation of Return	Maximum Drawdown	Sharpe Ratio
Best performing asset previous year		1.26	1.12	1.33	0.84	0.47	1.06	1.19	1.08	1.20	20.8%	26.2%	-53%	0.79
Worst performing asset previous year		1.01	1.03	1.04	1.16	0.62	1.79	1.00	1.05	1.19	74.8%	30.5%	-38%	2.45
Three best performing assets classes in previous year (Eq wt)		1.22	1.20	1.21	1.12	0.56	1.03	1.18	0.95	1.08	39.6%	20.8%	-44%	1.90
Three worst performing assets classes in previous year (Eq wt)		1.04	1.04	1.09	1.09	0.79	1.47	1.02	1.04	1.12	76.6%	17.4%	-21%	4.39

I have highlighted the year 2007, 2008 and 2009 to draw special attention to another interesting observation. As one would notice, the previous year best performing asset and equally weighted portfolio usually have a return in double digit whilst the worst performing asset and portfolio of worst performing assets has a low single digit return in most periods. So why does the worst performer come out best over the 10 year period?

The answer lies in 1) the sharp volatility of best performing but more riskier assets such as MSCI EME index (-compare Maximum Drawdown statistics). The best performing assets after three years of double digit return were cut into less than half in the financial crisis of 2008/09 while the worst performing asset of 2007 were trading at a depressed valuations going into 2008 and logically were relatively less impacted. Also the worst performing asset of 2008 were grossly undervalued  going into 2009 due to duress in the market at that time (having being cut in half or less in just one year time) and hence recovered sharply in the subsequent year.

So what lesson does the above study holds for an average investor?

1)   Not losing money is more important than making money due to the power of compounding (see the compounded performance of best and worst performing assets between 2004-2009). Every dollar invested in best performing asset and rebalanced annually was worth only 21 cents in 2009 despite three years of double digit growth. On the other hand, every dollar invested in the worst performing asset in 2004 was worth 41 cents in 2009 twice as much as its counterpart

2)  Dislocation in asset prices due to duress in the market can be good time to accumulative worst hit assets as prices are riddled for reason other than the long term earning capacity of the asset and investor outlook on valuations of such assets is at the nadir. Such dislocation provide opportunity to earn excess return in subsequent periods while valuation recover back to its historic average. This strategy is also safer as reflected in maximum drawdown and sharpe ratios.
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Why rising rates is not necessarily a bad news as framed by market action past week

23rd June 2013

Asset prices and volatilities across the world surged in the past week (ending Friday, 21^st June) after FED comments that it would consider ‘gradually’ tapering its massive $85bn a month bond buying program by the end of the current year (most likely in Dec) or beginning of the next year. Bonds and stocks plummeted globally and dollar appreciated against all major currencies.

The common reason provided for the correction in asset prices is mainly

As the FED intervention at the long end of the yield curve recedes, bond yields (long term interest rates) should rise sharply

Rising rates are bad for the economy as it would impede borrowing (mainly recovery in housing through higher mortgages rates) and consumption

Lesser liquidity would translate into reduced demand for other risk assets

Additionally, the above reasoning and sudden change in sentiment spurred capital outflow from EMs bonds and equities resulting into sharp depreciation in asset values and currencies of many EMs.

We find the above reasoning and its subsequent implications as they have unfolded over the past week to be surprising rather close to surreal. Our reasoning is as below

The QE was a emergency measure and was expected to be withdrawn at some point, its colloquial to an individual on a life support who has subsequently recuperated enough to get off the life support, this would be regarded as an incrementally good news. However, the market action past week was as if, the news was incrementally negative

Secondly, The argument with interest rate going up and the economy being stifled at the same time is one that is internally inconsistent. The Fed intends to roll-up the printing press only when it is satisfied that the economy is on path of sustainable recovery and has categorically stated that as a precondition to determine the timing and extent of the tapering. If the incoming data on the health of the economy were to be weak, long term rates will remain muted irrespective of the monetary exercise continuing or not.

For one, US economy has plenty of spare capacity as reflected in its current and targeted unemployment rate. Secondly, stronger dollar would pull down any tendencies in imported inflation, both developments keeping domestic inflation in control. Fundamentally, long term rates have been guided by two major forces 1) expected inflation and 2) growth prospects, with many economist now penciling the trend GDP growth rate at 1.5% and current inflation expectations at 1.5% long term rates (currently at 2.5%) have limited room past 3.5-4.0% in the medium term (c.2015). Thirdly, improvement in fiscal and current account deficit (stronger dollar; shale gas; and fiscal sequestration) should reduce run rate of Treasury issuances this and next year. It is also pertinent to note that T-Bond demand from overseas Central Banks is irrespective of the yield and will likely remain strong.

We also tend not to agree with the argument that rising rates will suffocate the benign recovery in housing through higher mortgage rates. It needs to be noted, that the recovery in US housing is broadly location and sector specific. Housing market in US has structurally changed between now and 2008 in terms of both financing access and demand. And is coming out after way-warding at the bottom for three straight years! As long as the expected return on the asset is above its costs, high interest rates in itself are not sufficient to stifle demand.

Lastly, the fear that lesser liquidity will be bad for risk assets is logical deduction but may not be factual in the current situation. Globally, prices of commodities, precious metals, equities (mainly EMs) are down YTD and many parts of the world are seeing correction in real estate prices. The general mood among market participants is more of gloom and towards safety than optimism and adventure. Asset bubbles are more likely to arise in the later state than former. The only asset class that we believe should logically be pricked by rising in interest rates is credit spreads trades such as Corporate and Junk bonds, USD denominated non-US Sovereign debt and TIPS where credit spreads were it lowest and may expand in coming days as the attractiveness to take advantage of higher yields available with T-Bonds adjusted for expected inflation surpasses the risky credit bet in credit spread products.

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3, Jan 2013 -The fate of fiscal cliff and my expectation

3, Jan 2013  -The fate of fiscal cliff and my expectation

Equity and bonds markets not only in US but world over have been fixated over the impending fate of fiscal cliff. Given that the US public debt has reached a particular ceiling (i think its USD 16tr) the ruling govt has to determine between two equally distasteful options, either increasing the debt ceiling further or reducing the rate at which debt is accumulated, which would consequentially require reduce spending, increase taxes or both. Increasing the ceiling will provide room to increase debt and hence allow the government to follow expansionary fiscal spending mainly unemployment doles and medical bills for the uninsured. Reducing spending will have immediate repercussion in terms of riddling an already soft economy and govt balance sheet delevaraging at the same time that the private sector is deleveraging after bust in equity and house prices (primary measure of household wealth) and a high level of structural unemployment (reduces current income). Doing so would risk higher dissatisfaction among the constituency and contracting growth will put more pressure on loosing monetary policy further. With current short term rates close to zero and long term rates below expected long term inflation, every incremental dose of program to loose monetary policy further will be lesser and lesser effective.

I believe the most important goal for the govt at this moment is reducing unemployment and the monetary policy has explicitly made it clear that monetary base will keep expanding until unemployment reduces from current 7.8% to 6.5%. Any attempt to cut back on spending will not only put the future growth at risk but will also undo a large portion of what the monetary policy has been trying to incessantly achieve over the past  four years. Another important point, is that given the low real interest rate and subdued inflation expectations, its is advantageous to increase public spending now. Also any multiplier effect of higher or same public spending now relative to reduced spending will allow the economy to better cope up with higher fiscal austerity in future than reducing the spending now and pushing the economy back into a recession, reducing its earning and paying capacity in the future which will also endanger the sustainability of a tighter govt wallet in the future ineffect offsetting the primary objective of the fiscal discipline in the first place.

On the other hand, increasing the debt ceiling further will cause holders of govt debt more jittery which should be lead into selloff of govt debt, specifically, longer term debt and hence increase in yields. Additionally, the costs of selling new debt may be higher than what has previously been the case, resulting into higher and steeper yield curve in future.

But how practical is the above scenario.

for the sake of simplicity, lets classify the holders of govt debt into domestic and foreign investors. For foreign investors to disdain US govt debt would require taking a big loss on the existing value of its reserve currency, depreciating dollar (as investors dump US denominated assets and repatriate capital) would put upward pressure on their own currency and downward pressure on exports (but if all currencies appreciate in general against the dollar, the disadvantage in terms of export competitiveness may not be much). But countries particularly those that are more export oriented may be incentivised to manage their currency vis a vis dollar limiting the amount of depreciation possible with respect of atleast some currencies and the need to keep shoring up USD reserves. In a alternative scenario, lets say the many export oriented countries of today become consumption oriented and hence may benefit from higher domestic currency than in the alternative scenario. Rising domestic consumption will require progressive development of social, financial and economic infrastructure similar to that of what US and other developed world has achieved which in many countries is away by many decades if not more . Rising consumption in rest of the world plus a weaker USD will be a boost for manufacturing in US, also weaker USD will induce inflation and hence reduce govt debt burden through implicit default (since principal is to be returned in nominal not inflation adjusted dollars). Also, lack of confidence in dollar assets will require some sort of new mechanism for global monetary arrangement (where the influence or atleast the desire for influence of the large developing nations like China, India, etc. will be stronger, but almost all developing nations lack the depth and breadth of financial markets as well as respect for property laws that US has and are years way from  doing so. also none of them look like being in a consensual leadership position as of now). To conclude, the outcome or atleast the immediate outcome of increasing the debt ceiling in terms of foreign investor action is uncertain at best, though a gradually depreciating USD is favorable for both US consumers, businesses, govt and foreign holders (to the extent that they limit overtime the building of USD bubble through their own actions and ultimately own peril). The fundamentals or the disequilibrum that has caused USD strength and lower borrowing costs for US govt inspite of a deteriorating credit profile has not changed drastically now so as to warrant a selloff in the bond market by foreign participants atleast in the short term. Rising debt ceiling will raise voices about the unsustainability and prudence of doing so, but its impact in terms of market disruptions will be limited. to summarize, raising the debt ceiling has benefits that cannot be ignored

1. supporting the economy when its needed the most
2. future recession due to cut in govt spending will undo efforts of the monetary policy and may leave little option but to resume fiscal spending in future again
3. low real interest rates make it an opportune time to borrow
4. There are incentives for the foreign holders of US debt to continue the status quo atleast for time being even when real returns may be low in future from rising yields and depreciating dollar or both given the lack of feasible and consensual alternative to the dollar presently

From the perspective of domestic investors

The relevance of domestic investors appetite to hold domestic government debt is a bit of a puzzle (for the want of better word). Let say, domestic investor are wary to hold govt bond given the fiscal imprudence. in that case, bond yields on govt debt would increase (keeping foreign investor mute for time being) but that scenario would lead to higher incremental yields on all semi and non government bonds. So the question faced by domestic bond investors would be one of asset reallocation from domestic credit products to international credit products. Major developed country bonds markets outside US include Europe and Japan and maybe Australia and Canada to lesser extent.. Europe and Japan are no better than US in terms of their own fiscal prudence. Most other bonds markets even in big economies are not much liquid to accommodate trades worth billions of dollars daily. Also many countries outside US and Europe who have debt denominated in their own currencies may not be able to stand the high level of volatility that foreign capital flows may entail. Another alternative to domestic investors would be to increase allocation to equities and other asset classes at the expense of domestic debt holding, that would have implications on the portfolios price and cashflow characteristics and would engender other more complicated asset allocation challenges for large institutional investors. The above alternatives can be implemented at the periphery of the core portfolio with the extent of reallocation decision based on constrains over liquidity, volatility and price risk tolerance for given domestic investor. Also if higher yields were to destroy asset value it would simultaneously reduce present value of future obligations for domestic pension funds who are the largest domestic holders of government debt. Finally, there is nothing stopping the government from hand wringing domestic savers from financing the government through coerce policies and regulations. 

To sum it up, the near terms benefits of rising the debt ceiling are apparent and objective however the expected unfavorable outcomes of doing so in terms of investor confidence (both foreign and domestic) are a bit convoluted given the current situation. 

The risk of cutting down on spending are too great for the government and the economy to sustain. Also a contractionary fiscal policy will run opposite to the goals and objectives of a expansionary monetary policy which may do little to simulate business investments and consumer spending (given the concerns about future taxes and lower subsidies). this phenomena is currently playing out in Europe most notably in Spain. 

In case the US government decides to increase the debt ceiling versus implement fiscal austerity, the main challenge will be communicating this intention to the market as the initial response of market commentators will be on the unsustainability of the growing debt pile which could lead to further credit rating assessment and rise in yields. Hence, one possibility could be talking about spending cuts while not implementing one (remember it will be the implementation that will risk de growth in GDP) and doing some spending 'under the table' ie to say, disguised spending. 

All in all, my predictions is that the US govt will prefer rising the debt ceiling than cutting down on spending to the magnitude required to keep deficit under control (which is other way of saying rising the debt ceiling) but it may find innovative ways to communicate or not communicate this to the market. that would nevertheless result in rise in government bonds yields this year, but only modestly and I see no major dislocation in the US bond market in terms of foreign and domestic investor action even if the above scenario were to play out. 

Overtime however demand for non US bonds and equities across the world should increase its share at the expense of the US bond market but that is a steady progression and also hinges of the fate of economies and regions outside the US. 

Siraj,

Jan 2013