The Truth about Subsidies

All investing concerns a bet on the future. To determine the future, investors rely on all sorts of economic and financial forecasting tools. Most of these assumptions are based on the normal market mechanisms of supply and demand. Around the world governments are making a determined effort to be sure these assumptions are incorrect. Their main instruments of distortion are subsidies.

Subsidies are as loved by politicians as taxes are loathed. What politician anywhere wouldn’t like to tell either constituents or restive populations that they are getting a free handout? It sounds great to most citizens, because they often only see the benefits without assessing the costs, which people assume are borne by someone else. The reality is that subsidies are always borne by taxpayers in one form or another. For investors, the dangers are always the unintended consequences that subsidies produce.

For example, the Baltic Dry Index (BDI) is a measure of freight rates for shipping iron ore, coal and grain. For much of its 26-year history, the BDI has accurately been described as the supreme cyclical indicator. Normally it tracks the prices of commodities, but over the past 4 years it has gone haywire. The cause is simple: China. As China’s economy begins to make up an ever larger share of the world’s economy, demand from China makes up an ever larger share of the demand for commodities. If Chinese demand were based on a straight market, it might be predictable, but it is not.

Freight rates have plummeted recently. Capesize vessels, those 1000 ft vessels that are too large to go through the Suez and Panama canals, used to rent for more than the smaller Panamax. But since July 2009, they have been launched from shipyards at rate of 15 a month, increasing the capacity of the global fleet at an average annual rate of 20 per cent. Although 3.7 per cent of the current fleet will be demolished this year, a record proportion, the Chinese state controlled and subsidized shipyards have increased new capacity by 15 per cent. Why? The Chinese government wants cheap freight. The result of this subsidy is the distortion of the index beyond all relation to the real state of the global economy.

China is also suffering a shortage of electricity. Some economists might conclude that this has to do with a vibrant economic growth, but it is really about a misguided subsidy. The Chinese electric companies are state-controlled as are the electricity prices. China is facing an enormous problem with inflation, the result of massive state mandated bank loans flooding the economy with money. The companies are facing financial pressure as the global energy costs increase. But Beijing keeps prices low to control inflation.

To avoid losses the companies tell the authorities that they will produce electricity at full capacity, but privately they cut back supply. Without reliable power, manufacturers and businesses use diesel generators for electricity. This, of course, increases the demand and the price for diesel and helps to fuel inflation.

Ethanol is subsidized in the United States to encourage the growth of local industry, farmers and to create renewable energy. However it distorts the market for grain because the subsidy diverts one-third of America's maize harvest. It also cannot compete with Brazilian ethanol made from sugarcane, which has been the cheapest biofuel for years. But with the billions of dollars leaking into emerging markets from the American Federal Reserve’s program known as QE2, the dollar is exceptionally weak and the Brazilian Real is very strong. So US exports of ethanol to Brazil have soared during the past year, which has undermined the competitiveness of Brazil’s domestically produced biofuel.

The Saudis subsidize petrol, which costs only 12 cents a liter; less than the cost of bottled water. As a result, the Saudis have no reason to use less, so petrol consumption is growing rapidly. This year they will use 3.2 million barrels a day domestically or about 36 per cent of present domestic production of 8.8 million barrels a day. If the current consumption rate continues, the Saudis should use up their entire production at home in 17 years.

Energy subsidies are common across emerging markets. Iran with its massive reserves of oil also spends 20 per cent of its GDP on subsidies. Indonesia spends $11.4 billion a year to subsides domestic energy, four times what it spends on health.

All around the world, governments are using subsidies to solve perceived social problems. What they do not understand is that the global economy is an interwoven ecology. By artificially warping demand they change things in not only their economies but in others often creating bubbles. The inevitable crash will create more problems when the subsidies have to stop and that is simply a matter of time.

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