the end of financial vandalism moving forward to the real economy

8/6/2019 The End of Financial Vandalism Moving Forward to the Real Economy

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Moving Forward to the Real Economy


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Contents

Introduction 4

Section 1 - The Perect Storm 7

- Rise o Fiat Money 8

- Demographic Tailwind 10

- Technology Explosion 12

- Globalization and World Trade 14

- Financial Innovation 18

Section 2 - The Crisis Years 23

- Global Credit Crisis 24

- Sovereign Suicide 26

- Emerging Market Bust 30

- Debt Destruction 34

- End o Globalization 40

Section 3 - The Real Economy 45

- Demographic Transition 46

- Resource Conservation 50

- Inrastructure Revival 52

- Technology Renaissance 54

- Consumer Evolution 56

Conclusions 59

Acknowledgements and Disclaimer 60



Youre entitled to your own opinion, but not your own acts. Author Unknown

History shows that the pace o change is generally slow but accelerates due to either a

technological breakthrough or a major crisis. The invention o the steam engine resulted in

a major rise in productivity while the Second World War led to the Bretton Woods monetary

system. What change has the recent nancial crisis brought? A ew months later we made our

peace by blaming it all on sub-prime debt, greedy bankers and the decision to let Lehman

Brothers ail. However, a lot o questions still remain unanswered.

Introduction

At Auvest, we believe that asking the right questions is as important as nding the answers and this is what we have

attempted to do in this report. The challenge we aced was to condense an internal research project that was much

bigger in size and scope into something that would be concise and yet do justice to the subject. We hope that this report

will raise a ew questions while providing a perspective on the past drivers o global growth, an analysis o the current

crisis and its implications and an overview o the opportunities and challenges in the coming years.

Financial Vandalism is a term we use to describe the current supremacy o nance over the real economy (the part o

the economy that produces goods and services) as refected in the era o excessive leverage, nancial speculation and

easy money. Finance, which is meant to acilitate the growth o the real economy by enabling the ecient allocation o

capital has become disconnected rom reality. This state o aairs is unsustainable, which is why we are making a call

or the end o Financial Vandalism and a return to the real economy.

As presented in Section 1 o this report, global growth over the twenty ve year period ending in 2007 was driven by

ve key engines: rise o at money and the ascent o the US Dollar as the worlds major reserve currency, demographic

tailwind with the US baby boomers and young emerging market population, technology explosion enhancing

productivity and impacting everything rom communications to healthcare, globalization and world trade with the

move in manuacturing and services rom the developed world to emerging markets and nancial innovation leading to

increased leverage with a consequent rise in global money supply, lower interest rates and higher asset prices.

Apart rom technology, which will remain a driver o growth going orward, the our other engines o the boom

period are losing momentum. The status o the US Dollar as a reserve currency is under threat as the scal situation

deteriorates and Americas imperial power wanes. Global demographics are turning negative with aging populations

in the developed world and China, while income inequality and high unemployment threatens globalization and worldtrade. Increased regulation and higher capital requirements in the nancial industry will suppress innovation, reduce

leverage and lead to lower returns.

This structural transition exacerbates the current crisis. While the massive amount o government stimulus seems to have

created a moment o calm, the global economy that emerges towards the middle o this decade will look very dierent

rom the one that entered the crisis in 2008. The illusion o prosperity created by the refation o risk assets has resulted

in the collapse being dismissed as an aberration, and now everyone is back to the party.

The level o debt in the developed world is unsustainable and signicant debt destruction is needed. Deleveraging o the

economy is critical or sustainable growth but it would involve a signicant asset price correction and mass bankruptcies

which the authorities are unwilling to allow. Despite the wishes o the nancial magicians in charge, this problem o too

much debt cannot be solved by taking on more debt.



Asset prices across the world have been buoyed by the huge increase in leverage during the last decade as well as the

current high level o liquidity. In the absence o real organic demand, the only way to sustain growth and keep asset

prices stable is to add more debt and keep interest rates low, a strategy being ollowed across the world. The utile

attempts at reviving the global economy through more debt will only make the problem bigger and the eventual bust

more painul and damaging to the real economy.

According to our assessment in Section 2 o this report, the current crisis will last until around the middle o this decade.

The rst act was the all o the highly leveraged entities like Lehman, AIG and others which caused the credit crisis. In

the second act, Sovereigns stepped in and took the bullet meant or the leveraged players through bailouts and scal

stimulus thereby leading to deterioration o their balance sheets.

Act three is where we are at present, with liquidity induced infation rom the developed worlds loose monetary

policies creating social instability in emerging markets which will orce interest rate hikes and a consequent asset price

correction. The developed world is importing this infation rom the emerging markets and central banks (especially the

European Central Bank and the Bank o England) may be orced to raise interest rates.

Act our will see the crisis come back to the developed world as the bust in emerging markets raises concerns about

global growth and the inability to service debt nally orces deaults and bankruptcies. This will be the most savage part

o the crisis and may lead to the nationalization o many nancial institutions. Act ve will be the last act o this crisis,with every man or himsel as governments realize that there is insucient global demand to create employment at

home and simultaneously engage in ree trade, leading to a major trade war and eventually a new monetary system.

Once the crisis is over and a proper monetary system is in place along with a sustainable model o globalization, the

world will be able to move orward to the real economy with a sense o optimism. Section 3 o this report presents

a broad picture o the post crisis return to the real economy around the middle o this decade in the context o the

signicant demographic transition that the world is about to witness. The consumer o tomorrow will look very dierent

rom the one o today due to the retirement o the baby boomers in the US, rapid aging in Europe, a decline in the

working age population in China and many more people in Arica and India. This new consumer will have dierent needs

and current business models would have to adapt and new ones emerge to capture the opportunity.

We hope you nd this report valuable and we welcome your comments and eedback.

Humayun ShahryarFounder and Chie Executive Ocer

March 2011



Section 1 - The Perect Storm

Rise o Fiat Money

Demographic Tailwind

Technology Explosion

Globalization andWorld Trade

Financial Innovation

The end o the Bretton Woods system led to the rise o at money and the

emergence o the US Dollar as the worlds reserve currency. The absence o a gold

standard resulted in large trade imbalances and excess liquidity globally.

The US baby boomers and a higher emale labor participation rate in the west

combined with a large, ast growing emerging market working age population led

to increased economic growth and wealth creation.

Rapid advancement in technology acilitated strong productivity growth and price

disinfation. Major strides in healthcare and biotechnology along with abundance

o resources like ood, water and energy enhanced lie expectancy worldwide.

Outsourcing o manuacturing and services along with growth in world trade led

to massive oreign exchange reserve accumulation, rise in money supply and large

oreign and domestic investment in installed capacity in emerging markets.

Financial innovations like securitization and derivatives along with the shadow

banking system led to rapid credit growth. Easy access to credit created a

consumption boom and resulted in an asset bubble which subsequently went bust.

The Real Economy2016 - onwards

The Crisis Years2008 - 2015

The Perect Storm1982 - 2007



Highlights

The end o the Bretton

Woods system led to the

rise o at money and

the emergence o the US

Dollar as the worlds reserve

currency.

The absence o a gold

standard resulted in large

trade imbalances and

excess liquidity globally.

The persistent weakening o

the US Dollar against most

currencies gave an articial

boost to global GDP and

lited asset and commodity

prices.

The Bretton Woods agreement was replaced in 1971 by the at money system and theUS Dollar became the worlds primary reserve currency. Under this system countries

can accumulate persistent trade decits as long as the shortall is unded by oreign

investors. This is in contrast to the gold standard which kept a lid on money supply

making trade imbalances both unsustainable and sel-correcting.

The at money system played a key role in contributing to the increase in world

trade and the resultant surge in global liquidity as a consequence o oreign

exchange reserve accumulation. This rise in global liquidity was a key actor

underpinning growth, with world Gross Domestic Product (GDP) growing by US$42

trillion between 1982 and 2007 (Exhibit 1). US$22 trillion (52%) o this increase

occurred in a short span o time between 2001 to 2007.

Rise o Fiat Money

The ability to expand money supply under the at money system enabled the US

economy to grow at a much aster rate than it would have under the constraint o

a gold standard. Americans were able to consume more o the low priced goods

produced by emerging economies as the US was able to run large trade decits.

Source: Exhibit 1 - Federal Reserve Board, Haver Analytics, Auvest Research

Between 2000 and2007, the cumulative

current accountdefcit o the USwas more than twicethe cumulative defcit

between 1980 and 1999.

Fiat Money Global Imbalances

Strong Growth

Forex Reserves

US$ ReserveCurrency

Exhibit 1


Rise o Fiat Money Demographic Tailwind Technology Explosion Globalization and World Trade Financial Innovation





Source: Exhibit 2 - China State Administration o Foreign Exchange, Bureau o Economic Analysis, Haver Analytics, Auvest Research

Exhibit 3 - International Monetary Fund, Haver Analytics, Auvest Research

Note: * Countries that use the Euro as their currency

The US current account decit reached a peak o 6% o GDP in 2006 whilst the Chinese current account surplus recordeda high o 11% o GDP in 2007. Between 2000 and 2007, the cumulative current account decit o the US was more than

twice the cumulative decit between 1980 and 1999.

A surge in exports to the developed world was a key driver or the increase in Chinas current account surplus with the

pace o export growth accelerating ater it joined the World Trade Organization (WTO) in 2001 (Exhibit 2). Chinese

merchandise exports to the US grew rom US$1.8 billion in 1982 to US$233 billion in 2007 and to the Euro Area* romUS$1.7 billion to US$184 billion during the same period.

The rise in the current account surplus o many emerging markets combined with monetary authorities keeping their

currencies competitive or exporters added to the surge in liquidity with global oreign exchange reserves

more than tripling between 2001 and 2007 (Exhibit 3).

The growth in global money supply acilitated by the at money system enabled world trade to expand rapidly.

The US Dollar was a major driver o growth during this period o prosperity, especially rom 2001 to 2007, as low

interest rates and high current account decits in the US supplied the world with large amounts o liquidity. The

persistent weakening o the US Dollar against most currencies gave an articial boost to global GDP and lited

asset and commodity prices.

Exhibit 3

Exhibit 2



Highlights

The baby boomers in the

west and a large emerging

market working age

population led to increased

economic growth.

The number o employed

women in the US increased

rom 25 million in 1965 to

68 million in 2007.

The working age

population ratio between

the emerging markets

and the developed world

increased rom 2.8 in 1982

to 4.2 in 2007.

The rise o the baby boomers, higher emale labor orce participation andincreased service sector employment in the west, combined with industrialization

in emerging markets led by a large, young and low cost labor orce created a

powerul tailwind or growth. As a result, world GDP per capita grew 3.5 times

between 1982 and 2007.

The size o the boomer generation in the US, estimated at 79 million people, is

large in both absolute and relative terms compared to other cohorts (Exhibit 4).

The average age o the boomer population over the period 1982 to 2007 ranged

between 27 to 52 years which coincided with the peak spending period or big

ticket items like housing and durable goods.

Demographic Tailwind

Source: Exhibit 4 - Talkin Bout My Generation: The Economic Impact o Aging US Baby Boomers, June 2008,

McKinsey Global Institute, p. 24

The greater participation o women in the labor orce was a key eature o the

boomer generation with the number o employed women rising rom 25 million

in 1965 to 68 million in 2007. The number o jobs in the service sector (generally

better paying compared to manuacturing) increased signicantly during the

working lie o the boomers.

Saety nets such as pension and social security and the evolution o health and

lie insurance led to reduction in saving requirements. Better paid, double income

households with enhanced saety nets were able to signicantly boost consumption.

The growth in emerging market working age population between 1982 and 2007

exceeded the total population in the developed world which kept wages low in

emerging markets. Higher government spending on education played a major role

in increasing literacy in emerging markets leading to a better skilled workorce

thereby attracting more oreign direct investment.

The growth in

emerging marketworking age population

between 1982 and

2007 exceeded thetotal population in the

developed world.

Exhibit 4







Source: Exhibit 5 - Haver Analytics, Auvest Research

Exhibit 6 - Stephen Roach, The Next Asia, Opportunities And Challenges For A New Globalization, John Wiley & Sons,

Inc., Hoboken, New Jersey, 2009, p.185

Enhanced use o technology aided globalization by providing connectivity and thereby removing distance as animpediment to the relocation o manuacturing and services to emerging markets (Exhibit 5).

Manuacturing wages in emerging economies like China and India were much lower than in the developed world

(Exhibit 6) due to the large size o the labor orce. The working age population ratio between the emerging markets and

the developed world increased rom 2.8 in 1982 to 4.2 in 2007. This wage dierential persists despite aster wage growth

in emerging markets in recent years compared to the developed world.

The symbiotic production and consumption relationship between emerging markets and the developed world as a

result o avorable demographics was a key actor driving global prosperity between 1982 and 2007. The emerging

market population were like the worker ants that produced and saved and then recycled their savings into developed

world assets while the developed world population were like the grasshoppers that consumed.

Exhibit 6

Exhibit 5



Highlights

Rapid advancement in

technology acilitated

strong productivity growth

and price disinfation.

Major strides in healthcare

and biotechnology along

with abundance o ood,

water and energy enhanced

lie expectancy worldwide.

The internet in particular

played a major role by

providing high speed

connectivity, acilitating

globalization and growth in

world trade.

Signicant advances were made in inormation and communication technologies.An abundant supply o natural resources (ood, water, energy and materials) aided

by the development o ecient extraction methods and sophisticated global

logistics networks, along with higher lie expectancy due to better health care

enhanced productivity resulting in lower infation (Exhibit 7).

Technology Explosion

The rise o the venture capital industry contributed to the fow o capital into

technology companies, especially in the US. The massive jump in the processing

power o computer chips resulted in the pervasive use o computers in every eldrom medicine to education. For example, the Human Genome Project would not

have made progress without the exponential increase in computing power.

Mobile phone and internet penetration rates strongly increased in emerging markets

since 2000 (Exhibit 8).The internet in particular played a major role by providing

high speed connectivity, acilitating globalization and growth in world trade.

Higher technology penetration and capital equipment investment were key

actors behind enhanced labor productivity with China registering average annual

productivity growth o 9% between 1997 and 2007.

Source: Exhibit 7 - Bureau o Labor Statistics, Federal Reserve Board, Bureau o Economic Analysis, Haver Analytics, Auvest Research

Note: *Inormation and Communication Technologies

ICT* Natural Resources Healthcare

EnhancedProductivity

IncreasedProduction

PriceDisinfation

Rise inLie Expectancy

Lower Bond Yields

Global ood productionalmost doubledbetween 1982 and

2007 while worldpopulation onlyincreased by 45% during

the same period.

Exhibit 7






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Source: Exhibit 12 - Stephen Roach, The Next Asia, Opportunities and Challenges or a New Globalization, John Wiley & Sons, Inc.,

Hoboken, New Jersey, 2009, p. 124, International Monetary Fund, Morgan Stanley Research, Haver Analytics, Auvest Research

Exhibit 13 - UNCTAD, Auvest Research

Global trade rose over seven times between 1982 and 2007 accounting or 30% o World GDP (Exhibit 12). This refectsthe impressive strides made by globalization enabling increased cross border movement o goods. The success o the

WTO in reducing trade barriers and improvements in transportation and logistics were major contributors to the rapid

growth in world trade.

Exhibit 12

Exhibit 13

As world trade went up substantially, the underlying imbalances widened due to exports rom the emerging markets

growing at a much aster pace than exports rom the developed world (Exhibit 13). The relocation o manuacturing to

emerging markets, especially rom the US, added to this growth in exports. The rise in emerging markets exports created

signicant employment opportunities in the manuacturing and services sectors and led to an improvement in the

overall standard o living.

Emerging markets oreign exchange reserves grew by around six times between 1995 and 2007 and represented 64% o

global reserves in 2007 (Exhibit 14). A persistent current account surplus along with oreign direct investment combined

with portolio and hot money infows led to the accumulation o reserves as emerging market central banks expanded

domestic money supply to prevent currency appreciation.



Source: Exhibit 14 - International Monetary Fund, Haver Analytics, Auvest Research

Exhibit 15 - International Monetary Fund, Peoples Bank o China, Haver Analytics, Auvest Research

Fixed asset investment as a share o GDP in Japan was at 32% in 1990 coinciding with the start o the lost decade. In

comparison, the ratio o xed asset investment to GDP or China was 39% in 2007 (Exhibit 16) having exceeded 33% each

year since 1998 as a consequence o money supply growth. Rapid investment led to signicant installed capacity in many

sectors contributing to lower infation in the developed world.

Exhibit 14

Exhibit 15

This de-acto quantitative easing was aimed at keeping the export sector competitive via an undervalued currency.Newly acquired US Dollars were recycled into assets ranging rom treasuries to mortgage backed securities which

helped underpin the US credit market and led to an expansion in leverage across the US economy.

Chinas oreign exchange reserves increased close to ten times between 1999 and 2007 due to rising trade surpluses

and capital fows resulting in its money supply growing at a double digit pace since 1999 (Exhibit 15).







Source: Exhibit 16 - Cabinet Oce Japan, China National Bureau o Statistics, Haver Analytics, Auvest Research

China accounted or only 6% o world GDP in 2007; however it represented 32% o the global demand or aluminum,

40% to 45% o iron, steel and coal and 10% o world oil demand. The scale o Chinas industrial production was equally

unmatched making up or hal o global steel and cement and one third o aluminum output. Chinas insatiable appetite

or commodities was a result o the large role in the economy played by investment and exports, which together

contributed 78% o GDP in 2007.

The WTO was a major actor driving globalization and world trade as taris were lowered. An era o abundant liquidity,

the desire o the developed world to consume and willingness o emerging markets to supply led to an apparent win-win

situation or the global economy with goods, services and capital moving seamlessly across borders.

Exhibit 16



Highlights

Financial innovations

like securitization and

derivatives led to rapid

credit growth.

Financial sector earnings

increased rom 11% o total

corporate sector earnings in

1982 to 21% in 2007 with a

peak at 33% in 2003.

Easy access to credit

created a consumption

boom and resulted in

an asset bubble which

subsequently went bust.

Low interest rates and nancial deregulation that led to the rise o the shadowbanking sector, derivatives and securitization resulted in rapid growth in credit

which in turn uelled a consumption and asset boom.

The Glass-Steagall Act 1933, which separated commercial banking rom

investment banking, was repealed in 1999 enabling commercial banks to take on

more risk. The explosive growth o the derivatives market (notional value o over

the counter derivatives in 2007 was 10 times global nominal GDP), especially the

emergence o the credit deault swaps market, justied greater risk appetite in a

low yield environment as risk was assumed to be insured.

Despite general wage growth, signicant disparity remained among US

households. Between 1976 and 2007 the income or the top 1% earning households

grew 4.4% annually while the income or the rest o the economy grew by a

mediocre 0.6% per annum (Exhibit 17).

This implies that or every dollar o real income growth that was generated

between 1976 and 2007, 58 cents accrued to the top 1% o households.

This income inequality was a key actor that prompted both the Clinton and Bush

administration to promote home ownership by enhancing credit access, especially

among lower and middle income segments, as they recognized the dangerinherent in large parts o society not participating in economic growth.

Financial Innovation

Source: Exhibit 17 - Raghuram G. Rajan, Fault Lines, Princeton University Press, 2010, p. 8, A. Atkinson, T.Piketty and E. Saez,

Top Incomes in the Long Run o History, NBER Working Paper 15408, National Bureau o Economic Research, Cambridge, MA, 2009

In 1985, the shadow banking system was less than hal the size o traditional

banks, but by 2007 at US$20 trillion it was twice the size o the traditional banking

system. The rise o shadow banking led to explosive growth o credit as evidenced

by the rapid increase in securitization (Exhibit 18).

In 2007, the US

shadow bankingsystem at US$20trillion was twice thesize o the traditional

banking system.

Exhibit 17







Source: Exhibit 18 - Securities Industry and Financial Markets Association, Auvest Research

Exhibit 19 - Bureau o Economic Analysis, Haver Analytics, Auvest Research

Rapid credit growth led to nancial sector earnings growing rom 11% o total corporate sector earnings in 1982 to 21%

in 2007 with a peak at 33% in 2003 (Exhibit 19). Employment growth in the nancial sector was more muted over the

same period increasing by only 60% implying enhanced protability per employee.

Exhibit 18

Exhibit 19

The rise in leverage was not a US centric phenomenon. The size o the nancial sector debt in the Euro Area and

the UK also expanded acilitating the growth o credit to households and rms. The UKs rise in nancial sector debt was

particularly pronounced, growing rom 111% o GDP in 1999 to 379% o GDP in 2007.

A large number o people, especially those in the lower income segment who could not previously access credit, were

now able to borrow. The majority o borrowing at the household level was utilized to nance property acquisition

which provided a boost to real estate markets and associated sectors (like urnishing, appliances, etc.), while

creating employment.

As a result, the ratio o debt to disposable income in a number o developed countries increased signicantly refecting

easy access to credit (Exhibit 20).




Exhibit 21 - Haver Analytics, Auvest Research

Note: * Household debt values are or 2002 and 2007

** Mortgage growth between 2000 and 2007

The rapid growth o credit resulted in signicant price appreciation across a number o asset classes including housing,

equities and commodities. House prices in developed markets like the US, UK, Spain, Ireland and Australia went up by

over 100% despite a smaller increase in the size o the population (Exhibit 21).

Financial innovation and the resultant rise in leverage was a major driver or asset prices and the consequent increase in

consumption in the developed economies during 2001 to 2007.

Exhibit 20

Exhibit 21

**

*







Global growth, especially between 2001 and 2007, was dependent on the expansion o debt and asset prices continuing torise uelled by benign credit market conditions. A number o central banks around the world started tightening monetary

policy in 2004 to combat infation which made debt servicing dicult or highly leveraged market participants.

The rise o at money, positive demographics, technology explosion and rise in world trade all made major contributions

to growth. However, nancial innovation and the rise in leverage were the lubricants that accelerated global growth.

Financial innovation in a deregulated world took on a lie o its own and created an illusion o never ending prosperity

through the drug o credit as consumers across the developed world borrowed and spent beyond their means. This

created a massive boom in housing, commodities and nancial assets and it was the ultimate bursting o this bubble

which led to the nancial crisis.


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Highlights

The build-up in leverage

and the subsequent asset

price collapse led to a

banking crisis resulting in

credit contraction.

A lack o liquidity and

panic selling by investors

exacerbated the collapse

in risk assets.

A sudden drop in consumer

demand and lack o trade

nance led to a sharp

decline in world trade.

The low interest rate environment and unchecked nancial innovation post the2001 recession led to a rise in leverage in many developed world countries. The US

Federal Reserve commenced tightening monetary policy in June 2004 to contain

infation resulting in higher delinquencies as highly leveraged households were

unable to service debt obligations.

The all in house prices was largely responsible or the run on the shadow banking

system causing asset prices to collapse and real demand to decline pushing the

global economy into a severe recession in 2008.

A deterioration in the value o mortgage related assets and lack o access to

credit due to the run on money market unds was primarily responsible or the re

sale o Bear Stearns and the bankruptcy o Lehman Brothers. AIG was bailed out

rom the brink o bankruptcy by the US government as payments on credit deault

swaps, mainly related to mortgages, triggered signicant losses.

The shadow banking system shrank massively with total liabilities declining rom

US$20 trillion in Q1 2008 to US$16 trillion in Q1 2010. This aected securitization

and deposit taking banks ability to extend credit since the shadow banking

system was their key source o unding.

The souring o mortgage backed assets also adversely impacted the ability oEuropean banks to extend credit (Exhibit 22).

Global Credit Crisis

Source: Exhibit 22 - Haver Analytics, Respective Central Banks, Auvest Research

The shadowbanking systemshrank rom US$20trillion in Q1 2008 to

US$16 trillion in Q1 2010.

Exhibit 22


Global Credit Crisis Sovereign Suicide Emerging Market Bust Debt Destruction End o Globalization



A lack o liquidity and panic selling by investors exacerbated the collapse in risk

assets and the combination o alling home and equity prices led to a signicant

decline in US household wealth (Exhibit 23).


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Highlights

Widespread state bailouts

and large scal stimulus

along with lower tax

revenues resulted in a spike

in government debt.

With scal policy options

limited, central banks

turned to unconventional

monetary policy to

generate growth.

Gross nancing needs or

Germany, France, Belgium

and the PIIGS amount to

3.3 trillion over the next

three years.

State bailouts o the private sector, large scal stimulus and lower tax revenuecaused an increase in the budget decit o many developed economies leading

to a rise in the stock o public debt (Exhibit 25). The untenable sovereign debt

situation has already orced Greece and Ireland to seek aid rom the European

Union and the International Monetary Fund and has pushed Portugal to the edge.

Sovereign Suicide

The US Treasury disbursed US$560 billion to bail out AIG, Fannie Mae, Freddie Mac,

Citibank, General Motors, Chrysler and others. In addition, the UK governments

support to the British banking system is estimated to be 850 billion.

In February 2009, the US Congress passed the American Recovery and

Reinvestment Act o 2009 (US$787 billion) to stimulate economic activity, create

employment and save existing jobs. Similarly, a number o other countries

including Germany, Japan, China, Australia and France also implemented various

scal stimulus programs to counter the all in private sector demand.

An increase in budget decits due to higher expenditure and lower tax revenue

resulted in soaring government decits in the developed world (Exhibit 26). It is

likely that urther assistance to troubled banks in Spain, Ireland and the UK and

lower economic growth in a number o countries like Greece, Portugal, Italy, the

US and Ireland will put urther strain on public nances.

Source: Exhibit 25 - OECD

Note: * 2010 and 2011 values are OECD estimates

42% ooutstandingUS treasury debt

needs to be

refnanced over thenext two years.

State Bailouts Fiscal Stimulus Lower Tax Revenue

BudgetDecit

Sovereign Debt Shock

Exhibit 25

*



Source: Exhibit 26 - International Monetary Fund, Haver Analytics, Auvest Research

Exhibit 27 - IMF Fiscal Monitor November 2010, Auvest Research

Note: * Ireland 2007: 0.051

The scal situation in most developed economies is dire and the bond markets appear nervous regarding the ability othese countries to honor their debt. Rising infation in many countries remains a wild card that could lead central banks

to raise interest rates which would add urther pressure on already stretched public and private sector balance sheets.

The average maturity o most developed government debt (as o August 2010) is between our and eight years, with the

UK being an exception with an average maturity o over thirteen years (Exhibit 27). Recently, a number o countries like

the US have been issuing longer dated paper with the aim o extending their debt maturity prole and to lock in the

current low interest rates.

Gross nancing needs (the sum o projected budget decits and maturing debt) or Germany, France, Belgium and the

PIIGS (Portugal, Italy, Ireland, Greece and Spain) amount to 1.5 trillion, 1.0 trillion and 800 billion in 2011, 2012 and

2013 respectively (Exhibit 28).

The unding needs o Italy and Spain alone until the end o 2013 are 819 billion and 467 billion respectively. Similar to

Greece and Ireland, it is quite possible that either one or both o these countries need external support to nance their

budget decit and roll over existing debt.

Exhibit 26

Exhibit 27

*



Source: Exhibit 28 - IMF WEO, Bloomberg, Citi Investment Research and Analysis, Auvest Research

Exhibit 29 - World Bank, Eurostat, ECB, National Central Banks, Citi Investment Research and Analysis

Assuming a bailout program or Portugal (estimated at 70 billion), the combined bailout acilities announced by theEuropean authorities and the IMF will likely have additional unding capacity between 345 billion and 420 billion,

which will be insucient to und even Spain or three years, let alone Italy. This presumably explains the recent rush by

European policy makers to expand the size o the rescue acilities.

As o June 2010, around two thirds o both Belgian and Portuguese sovereign debt is held externally which makes both

these countries dependent on the kindness o strangers to nance their decits (Exhibit 29).

The average cost o borrowing or Portugal, Ireland, Italy, Greece and Spain had been decreasing since 2000 (Exhibit 30),

until the disclosure that Greece was much more indebted than declared sent peripheral yields spiralling in 2010. The

low yields between 2000 and 2009 were largely due to these countries admission into the Euro Area resulting in yield

convergence with low risk countries such as Germany. This phenomenon encouraged and enabled these countries to

borrow much more than they would otherwise have been able to.

UK, German and French banks have signicant exposure to Greece, Ireland, Portugal and Spain refecting the intertwined

nature o the issues acing Europe. A sovereign deault or restructuring by one o these countries will increase losses at

banks, hamper credit growth and urther dent the already ragile European banking system.





Exhibit 28

Exhibit 29



Source: Exhibit 30 - Eurostat, Auvest Research

To date, the sovereign debt crisis has largely been conned to Europe. However, government debt is high and rising in

the US and Japan and both these countries do not appear to exhibit any scal restraint. Further, the US and Japan have

the shortest debt maturity prole in the developed world making them susceptible to rollover risk due to combined

renancing requirements or 2011 and 2012 equivalent to 42% and 38% o total central government debt respectively.

Japan has been able to und its scal decit at extremely low yields due to a captive domestic savings base. However, as

the Japanese population ages and draws down on its savings, the prospects o higher yields loom or Japan as oreigners

are unlikely to lend at the current low rates.

The unprecedented amount o monetary and scal stimulus was probably required to halt a complete meltdown o thenancial system and total collapse o the real economy. However, organic growth in the developed world remains tepid

and in the middle o 2010 it appeared that the US economy was likely to all back into a recession. In response to this,

the US Federal Reserve unleashed a second round o quantitative easing (US$600 billion) in November 2010 which has

urther bloated its balance sheet.

Similarly, the Bank o England pursued quantitative easing to revive economic growth while the European Central Bank

has been a buyer o peripheral European sovereign debt to contain yields.

Global leaders staged a coordinated intervention to prevent the credit crisis rom morphing into a depression. The

situation is now like a poker game and markets are testing the sovereign resolve to save the system at any cost. This

has resulted in authorities ollowing a loose scal and monetary policy stance which has released a surge o liquidity.

The absence o investment opportunities in the developed world combined with the markets perception that developed

world currencies will continue to weaken (thereby encouraging the carry trade) has unleashed this food o liquidity into

emerging markets creating an infation problem.

Negative real interest rates in most emerging markets have led to asset price appreciation urther encouraging hot

money infows. As these economies raise interest rates, asset prices will decline and lead to an exodus o capital thereby

exacerbating the all and leading to a bust.

Exhibit 30


30/62




Exhibit 33 - Haver Analytics, Auvest Research

Loose monetary policy in the developed world has been primarily responsible or the fow o capital to emerging markets

but capital fows (especially portolio and hot money infows) can reverse due to a number o reasons and this poses

signicant challenges or countries that run a current account decit and are reliant on oreign unding.

High infation and recent corporate governance scandals along with a scal and current account decit make India a

likely candidate or capital outfows similar to that witnessed by the Asian Tiger economies during the Asian crisis in 1997.

Reserve accumulation led to expansive monetary policy with a number o emerging markets registering double digit

money supply growth over the last two years. This was particularly high in the case o China with year over year

increases o 30% and 20% respectively in 2009 and 2010 (Exhibit 33).

Supply side constraints, especially in the ood and energy sectors, combined with the growth in money supply have

resulted in a spike in infation which will orce emerging markets to allow aster appreciation o their currencies.

Central banks in emerging markets have embarked on monetary policy tightening. However, real interest rates remain

either low or negative (with the exception o Brazil) implying urther tightening in the near term to contain infation

(Exhibit 34).

Exhibit 32

Exhibit 33








Negative real interest rates essentially act as a tax on cash thereby encouraging speculation in nancial assets. Between

March 2009 (when the US Federal Reserve embarked on its rst round o quantitative easing) and December 2010, real

estate and equities in emerging markets, commodities and gold have all experienced signicant price appreciation.

A key trigger behind the recent social and political unrest in a number o emerging markets like Tunisia, Algeria and

Egypt was a rise in ood prices. Food has a high weighting in emerging market infation indices and hence controlling

ood infation is critical to maintaining social order. As an example, a rise in the price o onions was responsible or the

ouster o at least two governments in India, once in 1980 and again in 1998.

There is a high probability that governments will impose export bans on commodities in short supply and even consider

imposing price controls. Governments are well aware o the dangers o spiralling infation and certain countries have

started to stockpile essential commodities like wheat and rice which has the potential to urther exacerbate the rise in

ood prices.

Rising infation in emerging markets presents policy makers with signicant challenges. Raising interest rates to combat

infation will attract urther capital infows which will put upward pressure on the currency. Also, higher interest rates

negatively aect the investment sector which has been a key contributor to GDP growth in emerging markets.

Allowing the currency to appreciate will adversely impact exports which are a primary source o GDP growth and

employment in emerging markets. Pressure rom the developed world (especially rom the US) or currency revaluationis likely to intensiy as its unemployment remains stubbornly high despite unprecedented amounts o scal and

monetary stimulus.

Hence, policy makers in emerging markets ace the dicult task o ghting infation, avoiding a slowdown in growth,

containing social unrest and preventing rhetoric over currency undervaluation rom escalating into a trade war. It is

likely that emerging markets will increase interest rates and allow appreciation o their currencies to tame infation and

to appease the developed world. However, substantial appreciation o emerging market currencies would result in global

liquidity tightening which would negatively impact risk assets.

Exhibit 34



The surge in liquidity leading to a rise in leverage was primarily responsible or the credit and banking crisis, but theUS Federal Reserve still continues to believe that keeping the liquidity spigots open will revive economic growth which

in turn will create employment and income. This is an untested and potentially dangerous strategy with possibly

unintended consequences. The recent spike in infation in emerging markets which is slowly spreading to the developed

world may be a case in point.

Emerging markets will suer rom the volatility created by policy experiments as their relatively smaller size makes

them vulnerable to any reversal o capital fows and to sudden spikes in infation and commodity prices. The dream o

emerging market decoupling will still take many years to materialize and will only come true ater large scale structural

reorms in these economies.

The end o the emerging market bubble will be swit when investors realize that these markets will take much longer to

move rom export and investment dependent economies to consumer driven ones. Investors will nd out that the risks in

these markets are much higher than they appear because they have been smoothed over by the excess liquidity in the

global economy.

The world is aced with the stark reality o too much debt which will weigh on uture growth. The strategy that everyone

seems to be ollowing today is to avoid any kind o debt write-o or conversion to equity in the hope that growth will

come back and lead to a reduction in debt over time. The irony is that any growth in itsel is now predicated on the

ability o consumers to borrow and spend rather than on growth in real organic income. The inevitable collapse o this

debt uelled strategy will end in deaults and bankruptcies.







Highlights

Debt levels have grown

dramatically in the

developed world and in

China since the start o the

credit crisis.

Large debt raising

requirements over the

coming years will lead to

an increase in the cost o

borrowing.

Many borrowers will

deault on or restructure

their debt obligations and

the resultant contagion

will cause asset prices to

collapse.

Sovereigns in the developed world have high gross nancing needs over the comingyears. At the same time these countries are contemplating scal austerity measures

to rein in budget decits, which combined with private sector deleveraging and a

ragile banking system will adversely impact economic growth.

The combination o signicant unding requirements and low economic growth

will exert upward pressure on government bond yields leading to a rise in deaults

and a decline in asset prices.

Total domestic debt in the US nearly doubled between 2000 and 2009. The private

sector, which consists o households, nancial and non-nancial businesses

largely accounted or the increase in leverage between 2000 and 2007. However,

since 2007 the government sector has been borrowing heavily to und the various

bailouts and stimulus programs (Exhibit 35).

Debt Destruction


Total domesticdebt in both the USand Euro Area almost

doubled between2000 and 2009.

Exhibit 35

The value o owner occupied real estate in the US declined by around 27% rom

the peak while the amount o outstanding mortgage debt remained constant

(Exhibit 36). This implies a ratio o mortgage debt to housing value o around

0.6 while the long run average o this ratio historically was around 0.4.

Assuming mean reversion and no urther all in home prices, US households have

to reduce mortgage debt by around US$3.5 trillion which indicates that the

process o household deleveraging in the US is still in its inancy. This process o

deleveraging is being slowed down by various government measures to prevent a

second collapse in home prices.




Exhibit 37 - Statistical Oce o the European Communities, Haver Analytics, Auvest Research

Exhibit 36

Exhibit 37

As o February 2011, the Congressional Budget Oce orecast that the US budget decit will grow by around US$9

trillion over the next ten years. This implies that a 1% rise in the cost o unding will increase interest expense by US$90

billion. Although core infation in the US remains contained, a rise in treasury yields cannot be ruled out as the size o US

government debt ventures into uncharted territory and bond investors demand a return commensurate with the level o

sovereign leverage.

Similar to the US, Euro Area domestic debt almost doubled between 2000 and 2009 with the private sector being the

primary driver o the increase between 2000 and 2007 while the government has been responsible or the rise since 2007

(Exhibit 37).

Gross nancing needs (the sum o projected budget decits and maturing debt) or Germany, France, Belgium and the

PIIGS (Portugal, Italy, Ireland, Greece and Spain) amount to 1.5 trillion, 1.0 trillion and 800 billion in 2011, 2012 and

2013 respectively. In addition, European banks need to renance 1.6 trillion o term unding (senior paper and covered

bonds) over the next three years which will require continued access to the capital markets.

A blow up in sovereign yields could result in banks being shut out o the wholesale unding markets leading to stress

within the banking system. Peripheral banks account or close to 700 billion (44%) o the renancing needs over the

next three years with Spain and Italy requiring the bulk.


36/62



Source: Exhibit 40 - Bank o Japan, Haver Analytics, Auvest Research

Exhibit 41 - World Bank, Haver Analytics, Auvest Research

Japans total domestic debt has remained relatively constant between 2000 and 2009. However, the composition haschanged with the private sector (especially households and businesses) deleveraging while the government accumulated

debt to und its budget decits (Exhibit 40).

Although Japans debt has been relatively stable, the ratio o debt to nominal GDP has been steadily increasing

refecting the impact o defation on the economy. Despite Japan having its own idiosyncratic issues due to a declining

and aging population, the Japanese economy arguably provides a good template o what could happen to a number o

developed world economies that have experienced a credit induced bubble and a subsequent collapse.

Exhibit 40

Exhibit 41

The notion o global decoupling was in vogue prior to the credit crisis with the assumption that the world economy,

in particular Asia, was not dependent on the state o the US economy. Asian exports during the credit crisis tumbled

highlighting Asias reliance on an export led growth model. Chinas exports declined by 17% in 2009 (rst yearly decline

since 1983) which led to a all in employment.

In order to create employment and maintain social stability, China signicantly ramped up its spending on xed asset

investment like real estate and inrastructure which led to investment as a share o GDP reaching a record high o 46%

in 2009 (Exhibit 41). In comparison, the same ratio or Japan was at 32% in 1990, coinciding with the start o the lost

decade whereas it has been above 33% or China every year since 1998.



Source: Exhibit 42 - Peoples Bank o China, China National Bureau o Statistics, Haver Analytics, Auvest Research

Exhibit 43 - United Nations, Haver Analytics, Auvest Research





Rapid loan demand to und the increase in xed asset investment has resulted in total loans disbursed by nancialinstitutions more than doubling between 2006 and 2010 (Exhibit 42). With the developed world consumer in deleveraging

mode China is increasingly dependent on xed asset investment and credit or its economic growth. However, the recent

increase in infation in China has led to a rise in interest rates (urther increases are expected as the real interest rate is

still negative) which will make debt servicing dicult or borrowers.

Over the last decade, China has been able to generate high economic growth while maintaining relatively stable prices

mainly due to a signicant increase in the working age population that has resulted in productivity growth outpacing

the increase in wages. However, over the next twenty years rom 2011 to 2030, the working age population in China is

only expected to increase by 3 million (compared to an increase o 206 million between 1991 and 2010) which will put

upward pressure on wages and infation (Exhibit 43).

The aging o China is likely to lead to a relocation o manuacturing to other low cost destinations like India, Arica and

South East Asia. The steep drop in new workers coming into the labor orce in China, consequent wage infation and

higher interest rates will make many businesses unviable leading to large scale bankruptcies. China has huge installed

capacities which have been unded through bank debt and the spate o bankruptcies will cause a banking crisis.

Exhibit 42

Exhibit 43



Total domestic debt in the US, Euro Area, Japan and the UK (all taken together) doubled rom US$78 trillion to US$158trillion between 2000 and 2009 resulting in a debt to GDP ratio o 466%. Despite the recent credit crisis being triggered

by excessive leverage, total debt has not decreased since the onset o the crisis largely due to the transer o private debt

onto the public balance sheet.

This high level o total debt makes the global economy vulnerable to a rise in interest rates. For instance, a 1% rise in the

cost o borrowing or the US, Euro Area, Japan and the UK will lead to a combined increase in annual interest expense o

US$1.58 trillion.

It is unlikely the quantum o debt outstanding will be serviced especially in a low growth environment that is

characterized by high unemployment in the developed world. In this context, debt must be purged rom the system

which involves debt write-os or conversion o debt into equity or a combination o both. The authorities have kicked the

can down the road but this is clearly an unsustainable situation that will only be resolved with either the bondholders or

the shareholders taking a haircut.

Debt destruction in Europe, the US and China will lead to large scale bankruptcies. Extreme levels o income inequality

globally and a rise in unemployment will make the current model o globalization untenable and ultimately lead to a

currency war culminating in a major trade war.







Highlights

A number o developed

world countries presently

have higher unemployment

than beore the nancial

crisis.

Lack o nal demand,

high unemployment in

the developed world and

infation in emerging

markets will lead to

protectionism and

eventually a currency and

trade war.

A new monetary system

will replace the current at

currency regime.

Growth in the developed world since the beginning o the crisis has mainly beena unction o aggressive scal and monetary stimulus with organic demand

remaining tepid. The high level o unemployment and income inequality will lead

to a rise in protectionism and eventually a currency and trade war as governments

in the developed world aim to eliminate the signicant amount o spare capacity

that exists, especially in the labor market.

The threat to globalization emanating rom protectionism and a trade war will put

the current system o at money under strain leading to a new monetary system.

Globalization is essentially the integration o the world through cross border

trade, capital, inormation and labor fows. In theory, it is meant to be a win-

win situation whereby emerging markets export low cost consumer goods to the

developed world and use the income earned to buy more sophisticated goods

rom the developed world.

The signicant growth in emerging market GDP per capita and consequent

improvement in the standard o living lends credence to the rst part o the

argument. However, income and employment in the developed world have

stagnated and the level o income inequality is globally at extremely high levels.

The level o US nominal GDP is above its pre-crisis level but the economy is stillshort o over 7 million jobs (Exhibit 44) compared to the peak in employment

despite the recent uptick in hiring. Firms remain reluctant to hire even though

economic activity has rebounded.

Despite several attempts by the authorities to stimulate the economy and revive

growth, real consumer spending on an annualized basis has surpassed 3% only

once since 2007.

End o Globalization

Source: Exhibit 44 - Bureau o Economic Analysis, Bureau o Labor Statistics, Haver Analytics, Auvest Research

The level o US nominal

GDP is above itspre-crisis levelbut the economy is still

short o over7 million jobs.

Exhibit 44



Source: Exhibit 45 - Bureau o Economic Analysis, Haver Analytics, Auvest Research

In contrast, exporting nations like Germany and China which run a large trade surplus have seen a rapid return to ullemployment on the back o export demand created by large scal and monetary stimulus, primarily in the US. This

stealing o demand has led to high riction between China and the US and between Germany and the peripheral

countries o southern Europe. As a result o these mercantilist policies China and Germany have been exporting defation

to the US and southern Europe delaying their recovery rom recession and hurting their eorts to create employment.

A breakdown o US employment by industry indicates that manuacturing, nancial services and construction accounted

or 62% o reduction in employment between December 2007 and December 2010. By comparison, employment in the

government sector which accounted or 17% o total employment as o December 2010, has barely declined.

The construction sector in the US has historically employed three workers or every housing start while currently the ratio

is over ten. Mean reversion implies the construction sector could shed anywhere between three to our million additional

jobs unless the housing market recovers which appears unlikely given the demand and supply dynamics.

Slower credit growth due to deleveraging by the household sector along with increased nancial regulation is also likely

to hamper job growth in nancial services. Job losses at the state and local government level will probably accelerate as

these scally challenged entities rein in spending by reducing payrolls.

A urther deterioration in construction, nancial services as well as local and state government employment will provide

signicant headwind or growth as these sectors account or a non-trivial 25% share o total US employment.

Adverse labor market conditions have kept organic personal income growth in check resulting in a steady decline owages and salaries as a share o personal income. However, larger government transers and lower taxes have to some

extent oset the impact o alling salaries and wages on personal disposable income (Exhibit 45).

Exhibit 45




The recent extension o the Bush tax cuts will lead to a temporary increase in household income, and possiblyconsumption, while worsening the governments already precarious scal situation.

High, sticky unemployment is not just conned to the US. A number o developed world countries presently have higher

unemployment (Exhibit 46) than beore the nancial crisis with the exception being Germany, which has recorded

impressive job growth due to a rebound in exports, especially to emerging Asia.

Countries that experienced signicant declines in house prices like the US, Spain and Ireland are the ones most impacted

by high unemployment. A meaningul reduction in the jobless rate in these countries in the short term is likely to prove

dicult given the signicance o real estate and associated sectors to job creation.

A lack o nal demand in many developed countries mainly due to high levels o debt and structural unemployment will

result in policy makers trying to steal demand rom other countries by manipulating exchange rates. Both developed

world countries and emerging markets are currently trying to lower the value o their currencies, the ormer through

quantitative easing and the latter through the accumulation o oreign exchange reserves.

However, expansive monetary policy will lead to accelerating infation in economies that have little or no spare capacity

and the recent increase in the price o energy and ood supports this argument. Also, many emerging markets like

Taiwan, Brazil, South Korea and Indonesia have imposed currency controls to moderate the fow o speculative capital.

The ollowing accounting identity indicates that the domestic private sector and the government sector cannot both

deleverage at the same time unless a trade surplus can be achieved and sustained.

Domestic Private Sector Financial Balance + Government Fiscal Balance = Current Account Balance

Most developed countries have a troubled private and government sector balance sheet which makes them

dependent on the external sector as the key driver o growth. A lower currency aids export competitiveness, so urther

unconventional monetary policy in the developed world cannot be ruled out. However, not all countries can devalue their

currencies at the same time and also run a trade surplus.





Exhibit 46



The job o maintaining credibility in the at money system rests with the central banks as they control the monetarybase. Ater unprecedented levels o stimulus administered to the global economy organic recovery remains elusive and

trigger happy central banks have resorted to the printing press with the intent to refate asset prices and revive growth.

The volatility in currencies resulting rom government manipulation will lead to trade riction and a major trade war

with countries ghting to keep high unemployment rom leading to social instability. The current monetary system has

led to a model o globalization that is unbalanced and unsustainable. A monetary system that needs a constant increase

in debt to sustain growth (through an expansion o money supply) and which requires the US to run persistent trade

decits in order to maintain the global supply o US Dollars will not last orever.

A sustainable model o globalization needs to create a win-win situation or both rich and poor countries. Unortunately,

the current model o globalization is unbalanced, and the at money system with the US Dollar as its lynchpin is a major

actor in its ailure. The trade war that will end the current mercantilist model o globalization will also lead to a major

overhaul o the current monetary system. This will draw the curtain on the era o Financial Vandalism and bring the

ocus back to the real economy.



Section 3 - The Real Economy

DemographicTransition

ResourceConservation

InrastructureRevival

TechnologyRenaissance

ConsumerEvolution

World population will increase by 1.3 billion over the next 20 years. Working age

population in Europe and China will start declining while India and Arica will see

the largest increase in working age population.

Signicant opportunities will arise in sectors linked to resource conservation and

environmental sustainability as people become more resource conscious due to the

rising cost o energy, ood and water.

Emerging markets will experience strong growth in hard and sot inrastructure

due to continuing urbanization. Major upgrades and additions to inrastructure

will happen in the developed world to cope with technological change and aging.

The new age o technology will make past achievements look small as major

progress will be made in tackling resource constraints. Developments in

technology will urther change how we live, travel, work and communicate.

Aging population in the developed world and China along with young, growing

population in India and Arica will create a new consumer class with very dierent

needs rom todays economy requiring new business models.







Demographic Transition Resource Conservation Inrastructure Revival Technology Renaissance Consumer Evolution



Highlights

World population will

increase by 1.3 billion over

the next 20 years.

Working age population in

Europe and China will start

declining while India and

Arica will see the largest

increase in working age

population.

The size o the above 65

year old population cohort

will increase signicantly in

China and India.

World population is expected to increase by 1.3 billion between 2011 and2030 with Asia and Arica accounting or close to 1.2 billion o the growth. The

population in North America is orecast to rise by a modest 55 million while in

Europe it will decline by 10 million over the same period.

Among the industrialized or newly industrialized countries, working age

populations (15 years 64 years) in Japan and Germany are already in decline

while they will start declining in Italy and France in 2011, South Korea in 2016 and

China in 2017. The working age population in the US and the UK will continue to

rise over the next twenty years making job creation even more critical to economic

growth and social stability (Exhibit 47).

Demographic Transition

Source: Exhibit 47 - United Nations, Haver Analytics, Auvest Research

India will add 226 million

people to its workingage populationbetween 2011 and 2030

while China will add only

3 million.

Exhibit 47

Countries like China, Germany, Japan and South Korea that have invested heavily

in industrial capacity will experience a decline or a small increase in working age

population which will put upward pressure on wages and consequently infation.

Population growth in the developing world over the coming two decades presents

major challenges and opportunities. For example, China will add only 3 millionworkers over the next twenty years compared to 206 million during the previous

twenty. This dramatic decline in the addition to the working age population,

primarily due to the one child policy, could result in companies relocating

operations, especially low end manuacturing, to places like India, South East Asia

and Arica.

In comparison, India will add 226 million people to its working age population

between 2011 and 2030 making it the single largest contributor to the growth in

global working age population. Arica will add 341 million people with the single

biggest increase o 52 million coming rom Nigeria (Exhibit 48).




Exhibit 48








Exhibit 49

The world population is progressively getting older with the median age increasing rom 29 years in 2011 to 34 yearsin 2030 due to a all in birth rates and a rise in lie expectancy. Aging will be more pronounced in Europe and North

America while Latin America and Asia will have a relatively younger population. The median age in Asia would be even

lower were it not or aging populations in Japan, China and South Korea. Arica will have the youngest population in

2030 with a median age o just 25 years (Exhibit 49).

The decline in the working age population in China will signal a signicant demographic transition or its economy as

abundant labor has been a key driver o growth in China over the last twenty years. The number o people over 65 years

o age will increase by over 100 million between 2011 and 2030 resulting in a higher dependency ratio.

The dramatic growth in working age population in India and Arica over the next two decades will provide them with

the opportunity to reap the demographic dividend by employing the large labor pool into productive economic activity

through urther investment in education and technology. The over 65 year old cohort will increase signicantly in India

over the next twenty years resulting in opportunities in sectors (e.g. healthcare) that cater to the older population.

One important aspect o the change over the coming two decades is a decline in the population o 0-14 year olds in both

China and India while Arica will add 94 million people to this age group (Exhibit 50).

The world is about to witness a transormation o the demographic structure which will have ramications or trade and

investment fows over the coming years. The regions o the world with the installed manuacturing capacities are aboutto experience a concurrent decline in working age populations impacting labor availability and wage infation.

This demographic transition holds important implications or resource availability and conservation and will result in

higher requirements or inrastructure globally.


49/62







Highlights

Rising ood prices since

June 2010 have driven an

estimated 44 million people

in developing countries

into poverty.

Demand or ood, water

and energy is expected to

rise considerably over the

next twenty years.

Signicant opportunities

will arise in sectors linked

to resource conservation

and environmental

sustainability.

The world will add 1.3 billion people between now and 2030 and the supplyo energy, ood and water will be inadequate to cater to everyone. Signicant

developments will occur in the eld o resource conservation and replacement as

investment fows are directed to capture these opportunities. Consumers will be

more open to resource conservation as the cost o energy, ood and water increases.

The recent rise in ood prices that triggered political unrest in a number o low

income countries highlights the importance o ood price stability. The World Bank

estimates that rising ood prices since June 2010 have driven an estimated 44

million people in developing countries into poverty.

The Food and Agricultural Organization (FAO) estimates that by 2050, ood

production must grow by 70% (with cereal production increasing by around 25% by

2030) to meet demand (Exhibit 51). In developing countries, 80% o the necessary

increase in production is expected rom enhanced yield and crop intensity which

would require signicant investment in arm technology. The other 20% increase in

production is expected to be achieved rom expansion o arable land.

A key concern or ood production is that much o the natural resource base

already in use worldwide shows signs o degradation. According to the Millennium

Ecosystem Assessment, 15 out o 24 ecosystem services examined are already

being degraded or used unsustainably as evidenced by soil nutrient depletion,erosion, loss o reshwater reserves and tropical orests. Hence, signicant

opportunities exist to implement methods that make agricultural land use

practices more sustainable.

Resource Conservation

Source: Exhibit 51 - FAO, How to Feed the World in 2050

Global waterrequirementwill grow rom 4,500

billion cubic meters

today to 6,900 billion

cubic meters by 2030.Exhibit 51



Source: Exhibit 52 - EIA, International Energy Statistics Database

Exhibit 52

Globally, a signicant quantity o ood gets wasted between production and consumption due to inecient supplychain and logistics. This is especially prevalent in emerging markets primarily due to a lack o distribution and storage

acilities and problems with rerigeration due to erratic power supply. This is again an area where large improvements

can be made with ar reaching consequences or ood supply.

World energy consumption is expected to increase by 39% between 2007 and 2030 with Non-OECD countries demand

increasing by 66% whilst OECD rises by 11% (Exhibit 52). Ecient extraction technology will be essential to ensuring

maximum utilization o available energy resources. A huge amount o electricity is lost during transmission and

distribution and an upgrading o these networks provides a major opportunity or energy conservation. Appliances

that consume less energy, uel ecient means o transport, energy ecient buildings etc., can all contribute to

energy conservation.

The 2030 Water Resources Group estimates that by 2030 global water requirement will grow rom 4,500 billion cubic

meters today to 6,900 billion cubic meters which is 40% above current accessible and reliable supply. The rise in

demand or water refects increased usage by the agricultural and industrial sectors predominantly in India and China.

Substantial investment into this sector will be required to ensure adequate supply is available to meet the demands o a

growing population. Conservation and ecient use o water will be a major theme in the coming years.

In recent years, the earths climate has turned more extreme with eleven o the twelve hottest years recorded between

1995 and 2006. Rise in the requency o droughts, hurricanes like Katrina and signicant heat waves in Europe provide

urther evidence o extraordinary weather conditions. Scientists believe that emission o greenhouse gases like carbon

dioxide, methane and nitrous oxide is the principal cause o climate change. Recent adverse weather conditions that

triggered a sharp spike in ood prices and increased social unrest highlights the catastrophic impact o climate change.

Weather related disruptions are expected to occur more requently in the uture and hence greater emphasis has to be

placed on the conservation o ood, water and energy to deal with sudden supply shocks.

BTU,

Quadrillion







Highlights

Emerging markets will

experience strong growth

in hard and sot

inrastructure due to

continuing urbanization.

Major upgrades and

additions to inrastructure

will happen in the

developed world to cope

with technological change

and aging.

The inrastructure sector in

both the developed world

and emerging markets has

the potential to create a

signicant number o jobs.

Emerging markets will urbanize at a rapid pace over the next two decades led bycountries in developing Asia like India and China. Post urbanization over the next

twenty years, Asia will be home to nearly 55% o the worlds urban population

(Exhibit 53) with India and China alone accounting or 30% o urban dwellers.

By 2030, China will have 221 cities with more than 1 million residents each while

India will have 68 cities*.

Inrastructure Revival

Source: Exhibit 53 - http://www.oreignpolicy.com/articles/2010/08/16/prime_numbers_megacities

Exhibit 54 - Farewell to cheap capital? The implications o long - term shits in global investment and saving,

McKinsey Global Institute, Auvest Research

* http://www.oreignpolicy.com/articles/2010/08/16/prime_numbers_megacities

Over the next twenty

years, Asia will behome to nearly 55%o the worlds urbanpopulation.

Exhibit 53

Exhibit 54

The process o urbanization will require signicant investment in inrastructure

like roads, ports, power plants, water systems and real estate which implies that

emerging markets are likely to increase their already rapid pace o investment

(Exhibit 54). As an example, India needs to build 350 to 400 kilometres o metro

rail every year to keep up with demand which is twenty times the capacity that

has been built in the past decade.

The construction sector will be a major employer o the large working age

populations in India and Arica which will lead to higher income and a better

standard o living.



Source: Exhibit 55 - http://www.oreignpolicy.com/articles/2010/08/16/prime_numbers_megacities

Exhibit 56 - Bruinsma (2009), FAO, How to Feed the World in 2050

Exhibit 56

The majority o arable land that is not currently used in crop production is located in countries in Sub-Saharan Arica

and Latin America (Exhibit 56). Although these countries have an abundant supply o labor, they lack the necessary

inrastructure or irrigation and transportation o agricultural produce rom the arm to the end consumer. Agriculture

and related sectors in Arica and Latin America will witness signicant capital fows rom countries like China that need

to ensure ood security or their population and have the ability to pursue major investments.

Countries like the US and the UK could witness a revival in inrastructure spending as they have invested at a slower

pace compared to other developed countries since 1980. Inrastructure spending in these countries could put a number

o unemployed people back into the work orce and create jobs or new entrants while enhancing the productive

capacity o the overall economy. This will be a better alternative to the current practice o simply extending the term o

unemployment insurance claims which doesnt incentivize people to look or jobs or enhance their skills.

Urbanization will lead to a signicant increase in carbon dioxide emissions with Indias expected to increase seven oldby 2030 while Chinas are expected to double (Exhibit 55). Managing the pollution arising rom urbanization will be a

key challenge or policy makers in emerging markets and will require considerable investment in the inrastructure or

pollution control.

Exhibit 55







Highlights

Major progress will be

made in tackling resource

constraints through the use

o technology.

Collaborative technology

and the power o networks

will change the uture

organization dramatically.

The coming Technology

Renaissance will lead

to one o the greatest

transers o wealth in

human history.

The exponential rise in com

the end of financial vandalism moving forward to the real economy

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