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Over $3.5 billion was withdrawn from the debt markets in India this month on the back of statements from the US Federal Open Market Committee (FOMC) indicating that the US Fed may start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.

Electronic currency can potentially take away the ability of central banks to control money

My column on Bitcoins that appeared in the "Poke me" section of economic times.

The unedited version (less dramatic) is below.

The future of money

Have you ever redeemed your credit card loyalty points to purchase a product of your choice? Or converted air-miles received as a frequent flyer to get some free tickets? If you have, you have already been exposed to virtual, electronic money. After all, a key purpose for money to exist is to function as a medium of exchange. These loyalty points serve the purpose of allowing you to exchange them for tangible goods and services.

When we carry out any of the above transactions, we do not see it as an alternative currency. The loyalty points can typically be exchanged for a limited set of goods, and are not universally acceptable. But what if they were? What if they worked as electronic money and were widely accepted?

Fiat money – a promise to pay backed by “confidence”

In a “Fiat Money” system – on which all contemporary economies are based, the notion of money - often represented by currency notes - is based on “confidence” that users have on the issuing authority. With no real assets backing the currency notes, issuers can issue as many notes as they want. However, economic growth cannot be assured by just printing money – it must come from higher production of goods and services. Consequently, if an issuer continues to “print” money, it will fall in value compared to other currencies or commodities.

One way to increase confidence is to back up fiat money by another commodity. Gold served as money for centuries, before it was replaced by “representative money” – where paper (representing the underlying commodity) could still be redeemed for gold. This changed in 1971 – when conversion was disallowed by the USA. Since then fiat money has been the basis of most transactions the world over.

Bitcoin – digital currency

All currency systems so far have required an issuing authority – with the ability to issue or destroy currency. In 2009, a yet unknown programmer using the pseudonym Satoshi Nakamoto published a proof of concept of a crypto-currency called “Bitcoin”. As the website (bitcoin.org) explains “building upon the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context, Bitcoin is designed around the idea of a new form of money that uses cryptography to control its creation and transactions, rather than relying on central authorities.”

Interested readers can study the specifics in detail at the website, but in summary, a user can create an online “wallet” and receive and pay bitcoins from it. All data (including transaction data) is stored in a distributed environment on the web. Since there is no issuing authority, the algorithm for generation of new bitcoins fixes the total number that will ever be in circulation.

Transaction ease is tremendous – there are no transaction charges (or very small ones), payments are easy to make and receive – like sending e-mails. In effect there are no political boundaries, no bank holidays and no one to censor who can receive or make payments and for what.

With reportedly only one breach which was sorted out, the system seems to offer sufficient security for people to have “confidence” in it. Bitcoins can be exchanged for regular currency at an automated price discovered basis transaction history. At present, the bitcoin website reports that daily transactions exceed $1mn per day distributed over 40,000 transactions. 

Why now?

So what makes bitcoins attractive in the current market context – and popular they clearly are (see graph of USD vs bitcoin over the past 1 year).

 

The key driver for popularity of bitcoins is risk that investors face in the current global economic environment, with central banks engaged in competitive devaluation of currency, and large financial institution risk remaining unmanageable.

Imagine if the depositors in Cyprus’ failed banks had, been holding their money in the form of bitcoins instead of holding their deposits in Euro. The Cyprus government, and European “troika” that forcibly took away almost 60% of the deposits would not have been able to get their hands on the money.

Investors have, over the past few years been using Gold and Silver as a portfolio insurance against currency devaluation and systemic risks of financial markets. However, like money, gold and other precious metals too are available to governments to usurp – and therefore, in a Cyprus like situation, are not adequate security. Bitcoins are however not accessible at a single location and, like the internet, cannot easily be controlled.

Bitcoins - the glitches

So long as bitcoins are used as a medium of transaction or as a store of value, it is highly likely that their popularity will grow. Questions arise on how governments would react – will bitcoin transactions be taxed for example?

Bitcoins offer total anonymity. One can have as many accounts as one wants. With smooth transition across borders without the use of banks, bitcoins have the ability to facilitate illegal transfer and transactions. The fact the governments’ are waking up to the emergence of online currencies is affirmed by a new law passed by the US government in mid March. It now requires that transactions more than $10,000 need to be reported.

Lastly, if its popularity rises, it will not take long for markets to start offering derivatives and structured products around it. With no regulatory framework, that would mean risk rise manifold. Despite these obvious road blocks, markets needs to look at this innovation carefully. The challenge that it throws to established order of central bank controlled currencies will, over time, lead to a re-examining of the very concept of money.

Policymakers think global liquidity is crucial for markets. They're wrong

My column in the edit page of Economic Times . The unedited version is below.

Quantitative Easing(QE) – Markets saviour or economic bogey?

QE defined

Quantitative easing (QE) is an unorthodox way of increasing money supply in an economy. It involves the central bank increasing the size of its balance sheet and using the money to buy up assets. This provides banks more money to lend, and reduces interest rates – allowing fresh growth-inducing investments.

In the recent past three major central banks – the US Fed, the European Central Bank, and the Bank of Japan have used it to attempt to revive their domestic economy. Some economists suggest that the mild upticks we see in these economies are a result of this strategy working. Others worry that the consequences of large scale liquidity creation increases asset prices and causes inflation – especially in emerging economies.

QE effects are difficult to find

What has been the Indian experience? Ostensibly, yield seeking foreign investors should arrive in droves to arbitrage the growth (and returns) that may be achieved in India when their home country offers zero interest rates. This does not seem to have happened in the equity markets. A glance at the chart of nifty above would suggest that while QE1 seemed to succeed in raising the market, the subsequent actions of the US Fed have not. In rupee terms, the Nifty is up a measly 4% per annum for the past 3 years, while in dollar terms, the returns are a negative 2% compounded. Despite the much touted “liquidity” driver for Indian markets, atleast the equity market does not seem excited.

Liquidity infusion is supposed to increase asset prices, cause inflation, and lead to currency appreciation in the country which is the recipient of inflows. In the case of India, stock prices are up approximately 8% per annum since June 2007, real estate prices increased on average 10% per annum, and inflation (CPI) has been in the same ball-park, while currency has depreciated! Real returns from almost all asset classes seem zero or negative.

During the same time however, Gold prices have gone up approximately 21% compounded. Unlike other assets, India is perhaps a price maker rather than price taker when it comes to gold. The explanation that investors in India have chosen to use gold as a hedge against currency depreciation appears to hold water. 

Economic policy, not foreign flows, to blame for inflation

Can we blame inflation on foreign inflows? Over the past few years, M3 – a measure of money supply has grown approximately 16% per year. This fell to 14.2% in Q1 FY13, and post QE3, is now at 12.6%. Foreign inflows do not seem to have raised money supply in India.

The economic survey has identified that there are over Rs7.5 lakh crores worth of projects stuck in India due to policy issues – mining, environment, land acquisition being major problems. Inflation has mostly been caused by policy inaction leading to supply constraints and some policy action (increase of administered prices – energy and food in particular).

The Indian economy needs serious investment in infrastructure. Long term infrastructure projects are best financed by long term capital at low interest rates. The global environment offered India just such an opportunity. This was India’s best chance to increase productive capacity of the economy and allow growth without inflation. Lack of focus on “enabling” policy prevented investment in core sectors. In a world where increasing inflation is the target of most central banks, home-made inflation seems to be our own doing.

A world without QE

What could happen if liquidity were to tighten and if central banks were to reverse easy money policy? Well, if the above is true – not a whole lot! Interest rates would rise in the rest of the world as would global inflationary expectations. Since most currencies are engaged in competitive devaluation, the relative effect of currency movements would be neutralised.

Real interest rates in India may actually increase – leading to higher savings, lower dependence on foreign inflows, and better capital allocation.

Money is not a commodity that remains constant. When dealing with QE induced money flows, the question “where will the money go” is nonsensical. The money can remain on the balance sheets of banks (as happened in the initial stages of QE1 and QE2). It can also be lost when asset prices fall – like when the real estate bubble in the US burst. Investment activity should be and largely is, based on expectations of future returns. If QE3 works, it is entirely possible that developed markets will provide greater opportunities to investors than emerging markets. A case in point is the new high that the US equity markets have reached – while emerging markets like India remain below their all time highs.  Trying to guess the timing or direction of money flows is a fruitless activity.

India’s economic managers would do well to look at measures that would remove constraints in the real economy rather than focusing on financial markets. Financial markets are meant to serve as the barometer of investment outlook – fiddling with the barometer does not change the underlying reality of a poor investment climate.