Deficits Matter: Why Ignoring Them Could Cost You

Posted On Thursday, Mar 04, 2010

It`s a knee-jerk reaction again.

Back in 2008, when the financial crisis unfolded, we saw similar initial reactions from the financial community bringing in a sell off in gold along with other asset markets.

This time around, the crisis surrounds rising sovereign deficits and debt. There is a heightened fear of a sovereign default since many of the industrialized countries have been seeing their debt levels increase to an unsustainable "Debt to GDP ratio".

The risks surrounding sovereign debt are continuously being highlighted, and years of profligate spending and weakening economic activity are taking their toll. Earlier, we saw Dubai virtually on the verge of default and now it’s the "Greek Moment". In fact, the Euro region has a group of such nearly unsustainable debt carrying economies, called the "PIIGS" representing Portugal, Ireland, Italy, Greece and Spain.

Chart: Cumulative Increase in Real Public Debt Since 2007
Quantum Mutual Fund
Source: Draft paper "Growth in a Time of Debt" by Carmen M. Reinhart & Kenneth S. Rogoff

The European currency is increasingly weakening due to the fear surrounding the default risk of the countries in the Euro region and the realization that this can act as a contagion to further defaults as many of them face huge debt pile-ups.

However, the Dollar seems to be surviving due to lack of alternatives, and is gaining strength on account of weakness in other currencies- mainly the Euro.

Given that the Dollar is no different from the Euro, it is highly surprising to see it appreciating. The question is - Why?

Well, the U.S is clearly in a debt league of its own. Though President Obama has proposed a $3.8 trillion budget for the fiscal year 2011 which forecasts a stunning $1.6 trillion deficit, it is expected that the combined state and federal debt in the U.S will reach 94 percent this year.

Even rating agencies have recently issued warnings that the U.S will lose its AAA credit rating unless it acts to bring the budget deficit under control, citing a spiral in debt service costs and dependence on foreign lenders. Fitch expects the combined state and federal debt in the U.S to reach 94 percent of GDP in 2011 which has increased significantly from 57 percent at the end of 2007 on account of spending on stimulus and bailouts. Federal interest costs will likely reach 13 percent of revenues; this means that a one-eighth of all taxes will go only to service debt. Most fiscal experts view this level as dangerously close to the point of no return for debt dynamics.

The deficit amounts have been less dizzying in Europe, given that while the U.S and Japan both have a little more than 10 percent respectively, the average deficit of the Euro region has been around 6 percent.

There is little reason for the dollar to gain vis-à-vis the Euro.

But the fundamental question: How do deficits matter?

From a lay man’s perspective: If you are an individual or a company and say your debt has increased to near 100% of your revenues, then in this case, the individual / company will find it difficult to even repay the interest costs and would be in no position to repay the borrowing and would probably default. Also, it would become extremely difficult to further borrow for any requirements.

The same applies for a nation.

A recent study by Reinhart and Rogoff said that the "90% ratio of government debt to GDP is a tipping point in economic growth." This means that "debt to GDP ratios" above 90% starts hampering the growth of an economy; something similar to what inflation does.

Yes. Deficits do tend to increase especially when an economy struggles out from a recession.

But, here, it has become more of a habit for the policymakers to resort to spend excess money and run deficits which get piled over existing debt loads.

These debt loads would continue to weaken the purchasing power of fiat paper currencies.

Money backed by debt is no money. In such a scenario, "Gold", the ultimate currency is the only real form of money which would keep appreciating until these policymakers continue running deficits.

Going forward, it looks increasingly likely that gold would de-link itself from these paper currencies as investors realize that what they hold as money is no longer worthwhile. You could say that gold is in a process of re-establishing itself as a monetary unit.

One of the best options to invest in Gold is the Quantum Gold Fund. Click here to invest in the Quantum Gold Fund ETF


The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments.

Investment Objective: Quantum Gold Fund`s (QGF) investment objective is to generate returns that are in line with the performance of gold, subject to tracking errors. Asset Allocation: QGF will primarily invest in physical gold and if allowed under SEBI Regulations, also in gold related securities, but may invest in money market instruments to meet liquidity needs. Terms of Issue: QGF is an open-ended Exchange Traded Fund. Each unit of QGF will be approximately equal to the price of half (1/2) gram of Gold. Units will be issued at NAV based prices. On an ongoing basis direct purchases from the Fund would be restricted to only Authorised Participants and Eligible Investors. Units of QGF can be bought /sold like any other stock on the National Stock Exchange of India Ltd (NSE) or on any other stock exchanges where it is listed. Entry Load: Nil Exit Load: In case of QGF: Nil in case of Authorised Participants; 0.5% in case of Eligible Investors. Risk Factors: All Mutual Funds and securities investments are subject to market risks including uncertainty of dividend distributions and the NAV of the schemes may go up or down depending upon the factors and forces affecting the gold and securities markets and there is no assurance or guarantee that the objectives of the scheme will be achieved. Quantum Gold Fund, is the name of the scheme and does not in any manner indicate either the quality of the Scheme, its future prospects or returns. Scheme Specific Risk: QGF is the first gold scheme being launched by the AMC. The AMC has no previous experience in managing gold scheme. The QGF’s NAV will react to the Gold price movements. The Investor may lose money over short or long period due to fluctuation in Scheme’s NAV in response to factors such as economic and political developments, changes in interest rates and perceived trends in bullion prices, market movement and over longer periods during market downturns. Trading volumes, settlement periods and transfer procedures may restrict the liquidity of these investments of the QGF. It is to be distinctly understood that the permission given by NSE should not in any way be deemed or construed that the Scheme Information Document for QGF has cleared or approved by NSE nor does it certify the correctness or completeness of any of the contents of the said Scheme Information Document. The investors are advised to refer to the Scheme Information Document of QGF for full text of the ‘Disclaimer Clause of NSE’. Statutory Details: Quantum Mutual Fund (Fund) has been constituted as a Trust under the Indian Trusts Act, 1882.Sponsors: Quantum Advisors Private Limited. (Liability of Sponsor limited to Rs. 1,00,000/-)Trustee: Quantum Trustee Company Private Limited. Investment Manager: Quantum Asset Management Company Private Limited (AMC). The Sponsor, Trustee and the Investment Manager are incorporated under the Companies Act, 1956..The past performance of the Sponsor / AMC/ Fund has no bearing on the expected performance of the scheme. Mutual Funds investments are subject to marker risks. Please read the Scheme Information Document / Key Information Memorandum / Statement of Additional Information / Addenda carefully before investing. Scheme Information Documents /Key Information Memorandums/ Statement of Additional Information can be obtained at any of our Investor Service Centers or at the office of the AMC 505, Regent Chambers, 5th Floor, Nariman Point, Mumbai – 400 021 or on AMC website www.QuantumAMC.Com

View All

Get In Touch

Take small steps to achieve big dreams! Start your investment journey today!

@@[email protected]@