Ben Bernanke’s taper and India’s economy: Wait for recovery gets longer

My latest column of the 24 Jun in the Economic Times

The last few weeks were eventful in all the wrong ways for India. Floods in the north led many to suffer. Financial markets suffered too — though from fears of withdrawal of financial "floods" — now christened "tapering".

Over $3.5 billion was withdrawn from the debt markets in India this month on the back of statements from the US Federal Open Market Committee (FOMC) indicating that the US Fed may start reducing its bond-buying programme later in the year. The Indian debt market had to be shut as yields increased beyond the trading bands. NTPC pulled out its bond issue over pricing issues. The rupee collapsed to nearly 60 to a dollar.

Is Fed shutting off the tap?
Ben Bernanke was at great pains to explain that the bond-buying programme was not being shut down. Liquidity infusion (printing money) would continue — only slower. That too was contingent on reduced unemployment (targeted at 7%) and higher inflation. While the Fed has sounded off the market based on its forecast of recovery, it has also indicated that its policies remain dependent on the data as time passes. It is likely that the timetable for the "taper" may well be extended.

Rupee unlikely to recover except in short term:Our economic mandarins have suggested that the rupee fall has less to do with India and more to do with emerging markets as a whole. That is, indeed, partially true. Other emerging markets too have suffered a withdrawal of funds, and have had their currencies weaken. 

However, India is in a worse position than other Bric countries. Foreign exchange reserves are barely sufficient to cover seven months of imports — the lowest it has been in the last 15 years. As a comparison, the other Bric members have 19-21 months of import cover. The latest trade deficit figures reveal a weakness in exports. A decade of mismanagement with unfettered inflation, uncontrolled and wasteful government expenditure, falling savings rate and inflated asset prices have made India a high cost economy.


Fundamentally, the rupee is headed towards 70 to a dollar. However, this is unlikely in the near term. A sharp fall in gold prices globally will reduce the pressure on the rupee even if the demand for gold remains unchanged. Unilever's purchase of HUL's equity will bring in around $4.5 billion in the next few days. Combined, in the immediate term, this should shore up the rupee somewhat.

Need a driver at the seat
Last week, the Cabinet committee on economic affairs (CCEA) took certain decisions — some were aimed at improving coal availability to power projects. Coal will now be imported —and the higher cost will be passed to consumers. In itself, the decision is better than no decision at all. At least, the power situation in the country can improve.

However, the irony is that India needs to import coal, when known reserves are enough to serve the needs of industry for several decades. Coal India's mines are about 10% as efficient as mines of similar characteristics in say, Australia. What is really needed is management of public resources in a manner that maximises public benefit, not rent-seeking. But that requires leadership — and that is another story. Equities may partially recover for now, but the storm is not over:Over the next couple of months, the early onset of monsoons, coupled with sale of grain from the government granaries, may lead to lower food inflation. The pressure on the rupee will ease, as gold imports slow, and the fear of immediate taper reduces.

Commodity prices are likely to remain subdued. In India, this should lead to selective recovery. Export sectors should gain from the foreign exchange windfall, though with a lag. Domestic commodity producers will benefit from the additional protection, while power generators may start up production — making some of the investments productive. Lenders to power generation companies may see some benefits.

However, these gains are unlikely to be long-lasting. In an earlier column in this paper, I had mentioned the dichotomy between the macro (liquidity driven, hence up) and the micro view (slowing earnings-high valuations, down). With the markets dancing to the tune of "taper", the macro upside has become limited. The dominant theme will, therefore, be micro.

Inflation at the consumer level will start hotting up in the third quarter of the fiscal year as increases in power and fuel cost work their way through the system. Government deficit will rise as revenues lag projections due to a slow economy. Political parties will spend on voters to try and buy their loyalties. Welfare spend will likely rise too. The cash economy is likely to again fuel inflation in the second half of the year.

If the taper is on schedule, the external sector will remain pressured, with consequent negative effects on the Indian stock markets. The wait for a sustained period of economic growth just got longer.

Japan-led free money is pumping up stocks but Indian market will remain shallow

My article for economic times carried in the edit page on last month. The article is reproduced below.

In the first week of April, the Bank of Japan (BoJ) announced a massive balance sheet expansion - by 1% of GDP per month. This sparked a sharp global rally in risk assets with most equity markets rising sharply, a rally that has continued in the current month. India too has witnessed a 10% odd rise in the headline index.

Interestingly, this coincides with a fall in commodity prices - reflecting both an increased supply comfort but, more, a subdued demand outlook . All this, as global economies struggle to grow. How far can this dichotomy - poor fundamentals and high stock prices - continue?

THE NEW HIGHS
Stock prices, it is said, are a reflection of future earning capacity of a company. Corporate results in the current quarter have been weak - something the market already expected . Consensus estimates of FY14 earnings assume a 16% growth over FY13 - almost twice what has been the likely growth for FY13 over FY12.

Importantly, over 60% of the growth is expected to come from financials , energy, autos and metals. This seems to be too optimistic. Consensus earnings continue to change over the year as fresh data gets factored in. It is likely that earnings downgrades will continue this year too - as they have over the past five years.

Assuming that actual growth achieved by Sensex companies in FY14 is closer to 10%, the market appears to be trading at 15.5 times current year's earnings. This does not seem particularly challenging given a falling interest rate scenario. Against a historic trading band of 12 times to 18 times, the market currently seems to be priced in the middle. Coupled with the wall of global liquidity, it is not surprising that the market seems to be reaching for new highs.
 
HOPES, NOT REALITY
The opposite argument is equally easy to make. At 10% growth, earnings are slower than trend. Consequently , valuations too should remain below trend. Earnings yield at 7% and growing slowly are not much more attractive compared to debt yields of 7.5%. Debt too will yield capital gains if interest rates were to continue their downward journey. Equity risk is not being paid for.

The problem compounds when we start looking for stocks to buy. The rally has been led by financial, pharmaceutical and consumer sectors. The consumer sector is showing signs of fatigue. Pharmaceutical stocks too are overstretched.

The financial sector is interestingly split down the middle. While state owned banks seem to compulsively lend to companies prone to stress, the private sector seems to have developed an uncanny ability to side-step future "problem clients" . The "buy private financiers" is now totally crowded - with all institutional investors hugely overweight on it. Valuations are seriously stretched - but who will say the bubble will not grow bigger before it bursts?

The rotation trade has begun. Infrastructure and capital goods stocks have witnessed a rally. Energy stocks are doing better on expectations of lower oil prices, some increase in price of power and improvement in coal availability. The truth, however, is that these trades are still based on hope rather than reality. There is no reason to assume the next few months will be better, with the local polity focused on elections rather than economy. CONFUSING, ALRIGHT

Base metal continues to suffer from over-supply and is likely to remain subdued. Telecom companies are witnessing some revival in growth, but are priced for that. Technology companies offer some contrast. While growth has slowed, and the global environment to outsourcing is becoming more hostile, valuations are now more reasonable, and a stronger economy in the US would revive the growth numbers. The rotation trade will therefore be more positive for IT now than it has in the recent past.

Are we, therefore, set for a period of benign rotation, with the market trending upwards? Unfortunately, this is not likely. Unless "beaten down" sectors demonstrate growth revival, rotation will soon stop. Also, domestic retail investors are still wary of the market - and institutional investors will invest only in "liquid" stocks.

This means the market will continue to remain narrow and we will eventually be left with two pools - one a high-priced , high-liquidity institutional market, the other a lowvalue , low -liquidity market of smaller stocks. SEBI's ill-advised recent move to introduce auctions in thinly traded scrips will further add to this separation. The primary market too is likely to remain busy - with a slew of issuance lined up. Surplus liquidity in the form of foreign inflows will likely meet an equally strong issuance pipeline.

In sum, while the macro trade seems to be up, the micro does not seem supportive. That seems confusing , but that's how it is. To quote Charlie Munger, vice-chairman of Berkshire Hathaway: "If you're not confused by what's happening now, you don't understand it."
 
The author is the CEO of a financial services company. Views are personal.

Gold – a tale of two priorities

My submission for the May edition of Wealth Insight

What a fall!

Over two day - 12^th and 15^th April 2013 - gold prices dropped an astonishing 18%. Volumes on the derivative exchanges were twice that on a “normal” day. The effect of the short-selling (selling without owning the gold – in the expectation of buying it back at a lower price) was to force traders having “long futures” (buy positions using leverage) positions to sell. Their stop loss orders would be triggered.

Was this just a trade based on technical analysis of price movements, or was there some “co-ordinated” trading. For this, we have to see what happened in the physical market (physical or cash market is where the underlying gold is traded). Despite the fall in “futures” prices, physical gold and silver prices are relatively firm. The price of “American eagles bullion coins” was at one point 26% higher than what “futures” prices indicated. Despite the price fall, in the days following the crash, the US Fed had to deliver over 2 tonnes of gold in the physical market as demand from US investors for the metal rocketed. In Asia, anecdotal evidence suggests that gold markets witnessed “sell-out” crowds at jewellers. Further, physical gold prices remained stubbornly higher than the “futures” market. The price fall seems largely restricted to the derivatives market.

Is there a shortage of metal building up?

Germany has nearly 3600 MT of gold reserves – highest among countries, next only to the USA. 1536MT of this reserve is in the custody of the US Fed Reserve of New York. Germany also has 374 tons stored with the French Central Bank and some at the Bank of England.

Germany recently requested the US Fed to return 300 MT of their gold. It also requested the French Central Bank to return its holding. The USA has informed Germany that return of the 300MT demanded will be executed over a period of 7 years. Incidentally, 300 MT of gold can be “couriered” in less than 10 airplane trips. The US Fed apparently owns 6700MT of gold – so why does returning 300 MT pose a problem?

Central banks like all other banks often hypothecate client deposits as collateral against other lending. Could it be that the US Fed has rehypothecated gold so much and among so many counterparties, that it is unable to demarcate the gold that belongs to Germany?

In the first week of April, ABN Amro bank changed its precious metal custodian rules and indicated to clients that they will no longer allow physical delivery. Accounts will now be “cash settled”. In other words, you cannot now get your metal – just the difference in price between your purchase and sale price. At the commodity exchange – Comex,  gold vaults have witnessed a withdrawal of 2 million ounces of physical gold – the largest in one quarter over the past decade. Physical gold seems to be in short supply.

  

 The gold conspiracy theory

Gold bulls have presented data indicating volatility in gold prices as a result of central bank action. Since gold is often viewed as an alternate currency, and confidence in “fiat currency” is being undermined by repeated money printing, a rise in gold price signals a lack of confidence in printed money. This can have disastrous consequences for financial markets if the trend catches on. Increased volatility in gold prices will erode its acceptability as an alternate to fiat money. A sharp fall will shake the confidence of investors.

Central bank action is difficult to prove or disprove as it is shrouded in secrecy, allowing speculation to gain traction. The circumstantial evidence forwarded starts with the question - who else could sell 400 tonnes of gold futures in a few hours – except central banks? Falling prices are not good for a seller unless the idea is to create market panic. This costs money, and only a money printing bank can afford this.

Central banks too have to operate through “agents” – the banks. The gold market action started just a day after a meeting called by the US Administration where the top 14 banks were present – to help coordinate bank trading action say the conspiracy theorists.

Another view point is that orchestrated sales were necessary since physical stock of gold and silver were insufficient to make good contracts that banks had signed to deliver gold to clients – and they needed to stop the requests. Without the coordination among all banks, a price crash of this magnitude would have been difficult since traders would have entered the market on both sides. By forcing out the buyers, the demand for physical delivery has been reduced significantly – allowing banks to prevent what could have been a catastrophic default – and would have lead to further erosion of credibility of paper currency.

The impact on India

India remains the largest “consumer” of gold. Economists have celebrated fall in gold prices arguing that this will lower current account deficit and reduce pressure on the currency. While this may be true, there is another point of view worth considering.

Unlike other consumption goods, gold is really in the nature of an investment. It can be seen as an attempt by Indian savers to invest overseas. A fall in its value reduces the “wealth effect” for investors. This is similar to the case of a foreign investor investing in India. When the Indian currency depreciates, the stock market is cheaper for the new investor, but an investor who is already invested sees a loss. Very conservative estimates of gold holdings of Indian investors would value it at $500bn. This is almost 25% of India’s GDP. A fall in the value of these savings will have a direct impact on the wealth effect. This could have a serious and negative impact on domestic consumption. At a time when growth of GDP is already weak, a further drop in consumption can hardly be treated as “good”.

Another point to note would be the effect on gold loans and their lenders. The gold loan industry had witnessed remarkable growth over the past 5 years. It is likely that a sharp fall in gold prices if sustained, will lead to significant NPA’s with attendant risks.

The pressure on the rupee will likely ease as oil prices weaken in the face of continued global economic weakness. All countries are now engaging in competitive devaluation of currency to enhance their exports. In such a scenario, the rupee may not face significant downward pressure – irrespective of gold prices. In trying to “cure” Indian investors’ desire for gold, India’s western educated economists would do well to understand the viewpoint of India’s unwashed masses. Often the unlettered are wiser.