Selling Government Bonds

An article I wrote for "Wealth Insight" for June. Still remains relevant, though much more retrograde measure have since been announced

 

Trouble in the foreign currency markets

The big story in financial markets over the past few days has been the withdrawal of over $3bn by foreigners from the Indian bond markets. Government bond yields increased, the rupee weakened significantly against the dollar, and the stock markets went into a funk.

The government response ranged from the inane – “we are watching the situation” – is it a spectator sport? to the pathetic – “other emerging markets with high current account deficits have suffered similarly”. Mismanaging the economy is alright if others do it too.

Knee Jerk reactions

The Finance minister addressed the market holding out the possibility of raising inflation in the near term. While that is not what he mentioned, that is indeed the effect of the policies he promised. A key promise was to increase prices of gas in India with consequent price rises in user industries. Another was allowing Coal India to offer blended prices of coal to its purchasers – perhaps over ruling many a contract and allowing for a general increase in power tariffs across the country. As if this was not enough, he seemed to suggest that making it easier for foreigners to invest would solve the problems of foreign investors exiting their positions – much like a hotel manager with poor occupancy - driven by poor service - seeking to increase the size of the door to allow guests to come in.

Arbitrage vanishes – driving away the bond investor

A fundamental driver of financial markets is the assumption that arbitrage cannot exist for sustained periods of time. If investors can borrow at 0.5% per annum, and cover currency risk at, say, 5% per annum, they would invest in a market offering a yield of approx 7.5% – since this leads to a risk free return of 2%, thereby narrowing the arbitrage. This, more than any action of the government, was what drove investors to India in the recent past. A lot more would have come if the investment climate was less murkier.

A slight change in interest rates globally raised the cost of borrowing. Couple this with lower interest rates in India, and higher forward rate for currency cover - and the arbitrage vanishes. No amount of credit rating upgrades, or the ease of investing is going to change the fact that arbitrage is no more – and with that, the bond investor.

 Restore the arbitrage?

If India really wants the bond investor back, we need to restore the arbitrage – ie, raise real interest rates. This flies in the face of the demand of industry and stock markets. Commentators, including government functionaries who should know better, have been blaming the RBI for being almost cussed in its slow lowering for policy rates. It is almost as if lower policy rates would magically restore the economy to health. The reality, as almost always, is far from perception.

RBI has actually maintained a negative real interest rate (nominal rates – inflation) for most of the past 5 years. It has been ahead of the curve in cutting policy rates. This amounts to a huge stimulus to the economy. Along with this, The Reserve bank has, through use of liquidity enhancement methods, resorted to an unannounced “quantitative easing” program in India – where its balance sheet has increased 50% in less than 3 years since 2010. In addition, the government has run a constant deficit – leading to pump priming economic growth. Yet, common wisdom, especially in policy circles continues to blame the “high interest rate” as a reason for “demand destruction” and poor GDP growth.

The need for higher interest rates

India has been suffering from high inflation for over 4 years. Low real interest rates have caused low deposit growth of about 13%, and caused credit to deposit ratio to rise to 79% -the highest in the last 15 years. Savers seek to protect their money value by investing in shadow “foreign currency” in the form of gold. The rupee is under pressure. All this would suggest that real interest rates need to rise. However, try telling this to anyone in policy formulation or market analysts. The demand for the punch bowl to be returned to those drunk on negative real rates is unrelenting as it is vociferous.

Address the disease not the symptoms

The attempt of Indian policy makers seem directed more at the symptoms than improving the reality of doing business in India. If India is such a compelling growth story why is it that every major Indian group has invested and continues to invest significant amounts of cash overseas? The latest acquisition announcement of Apollo Tyres of a take-over of Coopers is a case in point.

The reality is unpleasant. Policy nightmares continue to prevent large projects from coming to stream – leading to restructured loans – and reducing the capability of Indian banks to lend further. The judicial system moves at glacial speed preventing rapid resolution of commercial disputes. The government arms move in opposite directions – with the taxman prompting retrospective amendments, while some other departments attempts to talk up investments. Coupled with a dithering and corrupt bureaucracy and polity, the India growth story seems to be a chimera. Keep your fingers crossed on what the next elections will throw up.     

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.

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.

Globalising Pharma?

My article on the aftermath of India recognising product patents in pharma industry - published in Wealth Insight last month

Consumers should prepare for a price hike as foreign ownership increases & competition decreases

By Anand Tandon | Jan 5, 2013

The recent elections in the US could almost have been about a single issue - the cost of healthcare. In his first term, President Barack Obama made some radical changes in the US health care system - amongst the largest and costliest in the world. He brought in a policy (popularly called “Obamacare”) which made it possible for a large number of previously uninsured Americans to get some basic health care at a relatively affordable price. It can be argued that this was one of the key reasons for his re-election.

Healthcare in India – return of the multinational
The policy framework for health care in India has undergone substantive change in recent years. Before India abolished product patents in pharmaceutical products in 1972, the Indian pharma industry was small, and dominated by multinationals. Medicines were largely imported and expensive. Post 1972, domestic industry grew rapidly – to become the third largest in the world in terms of volume. India today has some of the most sophisticated manufacturing facilities (more US FDA approved facilities anywhere in the world outside the US). Foreign dominance dramatically reduced. In 2005, the Manmohan Singh government signed the TRIPS agreement – which re-introduced product patents. Since then the market share of foreign companies - which was in the early teens, has more than doubled. This has happened through a series of takeovers – Ranbaxy, Piramal, Dabur Pharma; and several marketing alliances – Orchid, Dr. Reddy’s. In addition, foreign ownership was allowed to the extent of 100 per cent. Foreign companies have increased holdings in their Indian subsidiaries – Pfizer now has a 100 per cent subsidiary in India, Novartis increased shareholding from ~51 per cent in 2005 to ~76 per cent by 2010, Aventis from 50 per cent to 60 per cent in 2010.



Foreign investment benefits?
When demanding greater market access, lobbyists are prone to offer a few arguments:
* Foreign investment allows access to new technology
* Foreign investment creates jobs
* Foreign investment increases consumer choice and affordability





These arguments were heard in recent times with respect to foreign investment in retail segment. Given that 100 per cent foreign ownership was allowed in the pharma sector almost a decade ago, it may be worthwhile to see what has transpired since. It may also be a pointer of the shape of things to come if the policy of FDI in retail were to stay.

Hoax 1: where is the investment?
Pharma is not a very capital intensive industry. Despite this, investment in manufacturing by the foreign companies decreased from 70 per cent of the investment made (1995) to less than 5 per cent of the investments made in the industry over a period of 15 years. Without investments in manufacturing, it is clear that multinational sales were largely driven by imports (see graph: Formulation trade) shows that while exports have stagnated of late (as foreign ownership increases) imports continue to grow at an annual growth rate of over 20 per cent. Without investment in physical infrastructure, it is debatable if any technology transfer would have taken place, or significant number of jobs been created.

Hoax 2: consumer choice and affordability
With Indian companies being prevented from manufacturing drugs which have been patented post 2005, foreign monopolies will increase in India. Consumer choice will be limited, not enhanced.
The impact of the 2005 policy is currently muted since many drugs where patents were granted post 2005, were already manufactured in India, and therefore continue to be produced. As time elapses, product pipelines will dry up – leaving monopoly producers to charge what they deem fit. Already, anti-cancer drugs cost up to Rs 20 lakh per person per year, while chronic diseases like rheumatoid arthritis have a single does costing between Rs 15,000 to Rs 40,000.

The impact of re-introduction of product patents, and increased foreign ownership is in fact extremely detrimental to consumers and their health – both of body and wealth!

Market Leaders are price leaders
Another defining feature of the pharma industry is that consumers do not determine the choice of medicine – it is decided by either the doctor or the chemist. In such a case, companies that have large marketing budgets, and can offer foreign trips for “educational seminars” for doctors, say, are more likely to find their products prescribed despite the existence of cheaper alternatives. Price of the most expensive brand of the same product can be higher by a factor of 50 times compared to the least expensive (see table: Price swings).




A new pricing policy
In November 2012, the union cabinet approved a new policy for pricing medicines in India. Set a time limit by the Supreme Court, the new policy has changed the basis of calculating price of drugs under price control. While earlier, drug prices were fixed on the basis of cost plus mark-up, the new policy posits average market price of a particular drug as the basis of fixing selling price. Ostensibly, this will lower prices of “essential” drugs (as defined under the ‘National list of essential medicines in India’ (NLEM)) – but will it?
As argued earlier, over the next decade or so, the number of drugs where monopoly pricing will prevail will only increase. With greater foreign ownership, dependence on imports too will go up – further reducing the ability of the government to correctly gauge the actual cost of drug production. As competition reduces, so will the effect of “averaging” the market price – in effect allow collusion among few players to hike up prices to unjustifiable levels.

Near term, expect to see the new pricing policy to reduce industry revenues by 2-3 per cent. However, even in the next couple of years, that is more than likely to be made up by galloping prices. Be prepared for higher health insurance premiums.

Did I hear someone say that the process patent regime was better after all? All “globalisation” is not a good thing necessarily.

Retail - End of the debate

Finally, the government of the day was able to get parliament to approve foreign investment in multi brand retail. It is indeed a sad reflection of  Indian democracy that while most speakers and parties in Parliament were opposed to the policy, fear of CBI and perhaps their own party calculations forced some to stage either a walkout, or as in the case of BSP, to actually vote in favour of the government.

MJ Akbar's latest article summarises the issues well.

Some related issues get highlighted -

1. Power of the central government to manipulate the smaller parties through a threat of CBI action. The "lokpal" proponents had long argued that an "independent" CBI, which does not require government approval to investigate and pursue the corrupt is needed to weed out the evil of corruption. The current vote shows the dangers of a CBI that is handmaiden of the centre.

2. The need for a "bipartisan" body that investigates and prepares the background paper for financial impact of government decisions - along the line of the CBO in the US Congress. Debates on policy in India are rarely backed by a common set of assumptions and figures. Consequently, there is little that the public is able to get out of debates - with most speakers talking AT each other rather with each other. Another by-product of this would be to restrict the discretion that the Centre has to offer largess to "compliant" states while holding back financial assistance to those who dont agree with them. 

And for those who continue to treat all foreign investment "liberalization" proposals as "reform" a shift is  happening in economic thinking  - a slow move away from the extreme right. As always, when there is a stress in society, "left" leaning thinking becomes more acceptable. Read Krugman here.

From Debate to Spin

My article published in "Wealth Insight" in Jan 2012 . Reproduced below as well:

Will consumers benefit from 100 per cent FDI in multi-brand retail? The author finds the benefits are not easily visualized

By Anand Tandon | Mar 10, 2012

If you don’t share the government’s enthusiasm for allowing dominant foreign ownership in Indian multi-brand retail, you must be a luddite – that’s what the media would have you believe. The spin doctors of the policy have simplified the issues to the level of “with me or against me” – and opposition to foreign ownership is being defined in terms of resistance to “reform”. But are the issues really as clear?

Waste reduction through improved supply chain
India’s supply chain is regarded as inefficient. This is particularly true for perishables. Improving this is one of the key benefits of foreign investment, we are told. However, a broad-brush assertion of this nature is only partially accurate. The supply chain of milk and milk products does not seem to suffer from this infirmity. Cereals, pulses, sugar, edible oil, spices too – which make up more than 24 per cent of monthly expenditure per person (NSSO study 2004) — are well handled. Fruits and vegetables seem to suffer the most, but make up less than 10 per cent of the consumption basket.

This graphic shows that per capita food loss in Europe and North America is between 280-300 kg/year. In South and Southeast Asia, this figure is 120-170 kg/year – about half! While it is true that a larger part of the waste in South Asia is in the “production to retailing” chain, it’s important to note that it is lower in absolute terms compared to the “more efficient” supply chains of Europe and North America. The loss in the “retail to consumer” segment is not even worth comparing. The assumption that foreigners do better at preventing wastage is not supported by facts.

Back-end investment is already allowed
Importantly 100 per cent FDI is already allowed in supply chain infrastructure. Actual investment has been insignificant. The DIPP (Department of Industrial Policy and Promotion) attributes this to absence of FDI in retailing. In other words, it is not worthwhile to invest in back-end infrastructure, even to service the “organised retail” outlets owned by Indian entrepreneurs – unless one owns the final retail outlet. How is this to be explained?

If the need for cold chain infrastructure is so compelling, returns on these investments should be attractive. Additionally, government incentives are available. There should be investors lining up to set up these. Discussions with large supply-chain managers – the likes of NBHC (National Bulk Handling Corporation) and NCMSL (National Collateral Management Services Ltd.) reveal that investment returns on supply chain infrastructure does not exceed single digits – unless one also factors in the appreciation in land value. Business returns are lower than domestic cost of capital, and returns are derived from speculative asset price changes. Perhaps, the issue is less to do with the availability of capital as with high land prices, and uneconomic land sizes which increase the cost of procurement and handling.

Better farmer prices – price discovery is more important
Another “benefit” that is ascribed to foreign ownership is better price realisation for farmers – at the expense of the intermediary. However, this is more a case of price discovery and its transmission.
Lately, price of processed pepper (garbled) has been lower than that of unprocessed pepper. First, this is unusual. But it does demonstrate that for commodities where there is an organised “price discovery” mechanism – through a functional exchange — the farmer is not being fleeced. In fact, today the farmer is well informed about prices across markets, and sells at a price that just leaves the intermediary with margins that equal cost of capital and transportation costs, leaving the aggregation risk to be managed by the intermediary.

Procurement issue is also about size
More losses occur due to farm holdings that are fragmented, leading to multiple handling and storage issues, than due to any “inefficiency” in the supply chain. To think that managers from ITC, Reliance and Tata’s, or for that matter, those from Olam, Cargill, or LD would not have sorted out supply chain issues if there was a way to do so, is to assume that Indian companies are poorly managed!
Yes, procurement is already 100 per cent FDI compliant – so if large efficiencies were to be gained by foreign capital, they already would have been. If despite being free to buy from India, large global retailers buy 20 times more from China, that tells you what is going to happen once they are allowed to sell in India – we will build a supply chain for Chinese products to be sold in India.

Lower consumer prices – but how?
With no likely improvement in procurement methodology, and with higher costs associated with supply chain (assuming that it is actually set up), how will the prices at the retail level fall? Perhaps by diverting more supplies to towns (cold storages will allow perishables to last longer) at the expense of rural India. But will higher cold chain storage and transport costs allow final prices for urban consumers to fall? And, importantly, what happens to the food supply to semi-urban and rural areas – they are left with less food diversity and poorer health perhaps.

Who gains?
Industry, in particular owners of retail chains, will benefit with expectations of large investments from foreigners at a premium to current prices. Real-estate mall developers will be direct beneficiaries in a sticky market. For the rest, the benefits are less easy to visualise. For retail investors, in the event that FDI in multi-brand retail is allowed, the run-up to the decision is likely to be more profitable than the post-event entity that is formed. Transfer pricing issues will take a long time to sort out, and domestic minority shareholders will find it difficult to make money. As with all investments, hype often does not mirror reality.

Good for the market - terrible for the country

A recent development in the stock market has the potential to harm India and Indians in the long term. The irony is that this is a result of "progressive policies". The development in question is the acquisition of Nicholas Piramal's pharmaceutical business by Abbott. In itself, the acquisition raises few issues. However, it portends a resurgence of multinational pharma companies in the Indian market, with consequent detrimental effects to the lives of Indians.
 
I have long been opposed to so-called "Intellectual property" - which, in my opinion, is just the latest way to exploit the poorer sections of society. Especially after physical assets/resources required for human existence have been captured by the "developed world". Using the power of lobbyists and under the guise of IP, poor countries like India have been forced to accept product patents. With this come expensive, and unaffordable medicines, and usurious health insurance costs - social costs we could do without.

India shook off its dependence on foreign medicines and developed a thriving domestic pharma business when it abandoned product patents and recognised only process patents. Consequently, Indian pharma industry today is well developed, with excellently developed chemistry skills and low cost production - benefitting not only Indian patients, but those around the globe - including those in "regulated" markets. This is now set to change - with India having succumbed to political pressure and signed up for product patents a few years ago.

Surprisingly despite countries like the USA drowning in health care costs, so-called free marketeers continue to push the case of "IP"  - and poor countries like India acquise. If the above seems overly leftist (after all the patent laws in India do offer compulsory licensing and price setting by the government) - well, read this