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.     

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.

The Promise of Power

My latest article on nuclear power written for wealth insight

Nuclear power has been projected as the energy on which future growth will depend. But, it's neither feasible nor desirable...

Earlier this month, I had the opportunity to attend the book launch of "The Power of Promise" by MV Ramana. The book discusses Nuclear Energy in India and its outlook – a subject that needs greater public debate. In the context of an energy deficient India, nuclear power has often been projected as the panacea, the energy fount on which future growth of the economy will depend. The case for nuclear power is based on two major argument (a) it is cheap (b) it is non polluting and abundant.

Marshalling rare facts from a secretive nuclear establishment, Ramana argues that nuclear power as a major source of India's energy plan is neither feasible nor desirable.

Nuclear power: more expensive than coal
In 2003, an interdisciplinary study by researchers at MIT came to the conclusion "In deregulated markets, nuclear power is not now cost competitive with coal and natural gas". This study was updated in 2009. The conclusion remains: "the prospects for nuclear energy as an option are limited, the report finds, by four unresolved problems: high relative costs; perceived adverse safety, environmental, and health effects; potential security risks stemming from proliferation; and unresolved challenges in long-term management of nuclear wastes."

Ramana's conclusion is similar. He compares cost of power generated from coal to that generated from nuclear plant – using assumptions that are grossly in favour of the nuclear alternative. He assumes that coal fired generators last a decade less than nuclear reactors, have to pay more for fly-ash disposal (they don't). Simultaneously, the radioactive waste disposal in nuclear power plants is supposed to cost only 2 paise per unit (it will likely cost a lot more). Additionally, he assumes that coal travels 1,400 kms to reach the power plant (over 33 per cent of coal fired generators are either at the pit head or increasingly near ports where the coal can be imported). Despite all these assumptions, at any cost of capital over 4 per cent, coal based power generators are cheaper than the nuclear alternative on the basis of levelised tariffs.

Safety: a significant concern
None of the above factors in the cost that needs to be paid for security, and potential health issues. It is pertinent to note the response of various government departments with regard to preparedness in case of nuclear accidents. While reacting to the Parliamentary standing committee discussing the nuclear liability bill, the ministry of water resources remarked "The Secretary, water resources, was of the opinion that any nuclear incident may induce radioactive contaminations in surface, ground water bodies, and other water resources. However, he stated that the Ministry does not have any facility for testing water quality".

The Secretary, Ministry of Health and Family Welfare while deposing before the Committee mentioned that her Ministry is "nowhere (ready) to meet an eventuality that may arise out of nuclear and radiological emergencies." She further mentioned that while drafting the Bill the Department of Atomic Energy did not consult them. She added: "Since the response system to deal with any kind of emergency of such type, the hospitals are not well-equipped, it is natural that mortality and morbidity due to multiple burn, blasts, radiation injuries and psycho-social impact could be on very high scale and medical tackling of such a large emergency could have enough repercussions in the nearby areas of radioactive fall out."

Proponents of nuclear power maintain that the likelihood of a nuclear accident remains remote – not so. Incidents like the recent accident in Japan illustrate that the best systems are prone to failure and in a densely-populated country like India, can lead to disastrous consequences. As Ramana pointed out in his speech – if the manufacturers are really so confident of their equipment being safe, why are they insisting on shielding themselves from nuclear liability – clearly there remain a real and non-trivial risk of nuclear disaster.

Is the DAE plan feasible?
In 1964, Bhabha stated "There is little doubt that before the end of the century, atomic energy will be producing a substantial part of the power in India, and therefore practically all the addition to our power generation will come from it at that time". In 1972, Homi Sethna, chairman AEC, predicted that India would have 43GW of nuclear generating capacity by 2000. In reality, in 2000, India had 2.7GW.

In September 2009, the PM stated that India will have 470 GW of nuclear power capacity by 2050. To put this in perspective, out of the total generation of over 200GW in India, less than 5GW is currently nuclear. Can we really expect almost a 100 fold increase in nuclear power generation capacity over the next 40 years?

India's plan for rapid growth of nuclear power is contingent on using fast breeder reactors (FBR). FBR's generate plutonium and are supposed to provide fuel for the next reactor – a sort of chain reaction allowing unlimited amounts of fuel! However, Ramana's analysis reveals that when adjusted for the time taken for a reactor to generate enough fuel to power up the next, the theoretical rate at which reactors can be built, reduces by 60 per cent of what the DAE estimates. In other words, "a fast growth of breeder reactors is not even theoretically, let alone practically, achievable."

Rosier in the future
As with many government estimates, the future seems rosier than history would suggest. A recent example is the criticism that the government's economic mandarins are reserving for CSO's advance GDP growth estimate of 5 per cent for 2012-13. Responding to the CSO's decade low figures, the Deputy Chairman of the Planning Commission reacted "I think it (growth projection of 5 per cent in 2012-13) is very low. I have been told that CSO has taken data from April to November (2012-13) and they just projected it (advance estimates)". Hasseb Drabu's comment is worth noting - "The sources and methodology adopted by the CSO are laid out by the System of National Accounts 2008, the latest version of the international statistical standard for national accounts, adopted by the United Nations Statistical Commission (UNSC). ...In this context, it will be enlightening to know which system of national accounts in the world is not based on past data. Also, what other data can official national accounts possibly be based on?"

There cannot be a better time to warn of rosy projections based on views, not data, as we enter the Budget Session. As investors, we need to keep assumption firmly rooted to reality. And yes, India's quest for renewable energy needs to be strongly focussed on the solar option – where paradoxically, the government plans to impose an additional import duty!

Energy – elixir of the economy

My column for Wealth Insight - Feb edition:

Core inflation is down state the headlines. Manufacturers don’t have pricing power parrot the economists. There is one sector that beats this trend – the energy sector.

A few days ago, the government allowed oil marketing companies (OMC’s) to increase the price of diesel. Stock prices of OMC’s as well as upstream exploration companies (which share the marketing losses with the OMC’s) have rallied smartly.

Over the next three months, 23 states will increase the price of electricity –10% to 35%. It would appear that the energy sector provides adequate opportunity for investment. Despite this, Anil Sardana, Managing Director of Tata Power is quoted as saying “At this stage, we are not looking for any tangible business opportunities in India. I don’t see anything moving on the fuel side (or) project side.” What gives?

 Oil – slippery slope

The past two decades have seen successive governments follow a “one step forward, two step back” approach to fuel (oil) pricing. In the 90’s, the government operated an “oil pool” – whose only purpose was to allow the government to keep its liabilities “off balance sheet” while it tried to control the final consumer price of oil on the one hand, and simultaneously increase tax on it on the other. The resultant gap was parked in the “oil pool”. When the pool was dismantled, there was a reasonable expectation that market prices would rise. For some time it did. However, as global crude prices started to rise, and consumer pressure build up, government again intervened to stop OMC’s from increasing prices – the alternative would have been to reduce taxes on this highly-taxed commodity. This resulted in the OMC’s reporting losses and the government having to bail them out through use of “oil bonds” and other mechanisms.

In this context, the recent decision to allow prices to rise has been welcomed by economists. The assumption is that there is a “subsidy” that is being removed. With higher prices, government deficit would fall, reducing its need to raise additional debt. This in turn would allow interest rates to soften, and provide a strong impetus to economic growth.

Experience however does not suggest that such a simplistic situation is likely to play out. Even if the government is willing to face public ire by keeping the price of diesel going up month on month, its own borrowing is unlikely to fall – the food security bill likely to be tabled in Parliament soon, will take care of any reduction. The motive of deregulation of the sensitive oil sector in a pre-election year needs to be examined carefully.

As part of its deficit reduction plan, the government needs to divest stake in public owned companies. Among others, OIL is one such on the divestment list this time. The finance minister is wooing investors. Free pricing of petro products is likely to go down well with potential investors. The timing of the oil price hike suggests that it is not driven only by administrative “reform”. The question is – will the government stay the course and allow retail price of petro products to move in tandem with global crude prices.

Investors will recall that just prior to the previous year budget, the government had divested a significant chunk of ONGC – mostly to LIC. Within days of this divestment, the budget imposed an additional tax on ONGC, which reduced its profitability – not something the new investor would have anticipated. Aspiring participants in petro company divestment programs need to keep in mind the political sensitivity of the sector especially in the context of increased user charges in many other sectors – that too coming on the back of sustained consumer inflation. Will the government remain “unpopular” or will it re-impose a cap on price rise closer to election?

Power sector – elusive coal

Fuel linkage remains the bane of the power sector. 57% of overall installed capacity is coal based. Coal India (CIL) is almost a monopoly supplier in the country – and as with most government run monopolies – is extremely inefficient. Despite having over $10bn in cash reserves, coal India’s automation levels are abysmal.

CIL has among the lowest productivity per head among its peers around the globe. CIL uses private contractors to extract coal from its mines – at a productivity which is almost 4 times its own. International benchmarks would be perhaps 10x as much. If CIL were to use its ample cash reserves to increase its production from its mines that are currently operating, shortage of coal in India would all but disappear. The clamour for easier environmental norms is redundant – what is needed is better productivity and deeper drilling. 

In the current context however, availability of coal remains a challenge. In a report dated march 2012, Credit Suisse had pointed out that despite increased allocation to power, the “shortage” of coal at 80% of capacity would be “eliminated” only in 2017. 

Chart1 : Coal Supply to power sector increased                                     Chart 2 : supply available to 60GW capacity addition

 

This means that only 80% of the coal needed by these power plants would be made available from Coal India. It also means that 49GW of delayed projects of XI and earlier plans would not receive allocation from CIL till 2017.

The generating capacity addition of ~55GW in the XI plan (2007-2012) was the highest in any plan period. Capacity currently stands at around 207GW. ICRA estimates that 85GW of thermal capacity is under construction. Of this, 54GW is likely to come on stream in the XII plan period (2012-2017) in the private sector.  Domestic coal is likely to be available for only ~60% of the requirements of the power producers who already have fuel supply agreements (FSA). Overall dependence on coal imports is estimated to go up from 12% in FY2012, to almost 25% by FY2017 – increasing the risk in fuel supply, and therefore project risk for producers.

Gas based power plants have suffered even more, with those in South India operating at a plant load factor of less that 40% as gas availability has declined (48% all India average). With gas prices likely to go up in the next year, power prices will need to adjust for fuel costs.

All this implies that over 40GW of private sector power producers are vulnerable from a credit perspective.

In this scenario, it is not difficult to appreciate the concerns of the power producers. Until the policy makers work out a solution whereby producers (and their lenders) face reasonable certainty of projects being viable and consumers are not constantly faced with rising prices, the energy sector will remain stressed. Without energy, India’s growth objectives will remain a pipedream. The government has to work towards greater efficiency and focus on productivity to increase the availability of energy rather than to focus on increasing project investment without ensuring either the fuel or the off-take. Not a glamorous proposition – just plain old hard work.