Rarely, if ever, has an economics Nobel laureate been as widely known before receiving the prize as Paul Krugman. His New York Times columns have been read by millions; he has argued economic policy eloquently in a large number of popular books. Yet these pursuits had little to do with the decision of the Nobel committee. They gave this prize to honor a truly seminal figure in economic trade and geography. Mr. Krugman’s fame as a public intellectual should not lead anyone to think that they understand his contributions to economic research just because they regularly read his columns.
The Nobel Prize citation highlights two distinct but connected contributions: Mr. Krugman’s development of the “new trade theory” and his work on the “new economic geography.” International trade has a long history in economics, and for the bulk of the field’s history, patterns of trade have been explained by factor endowments and comparative advantage. Why does England export wool and Portugal export wine? The cold winters of Yorkshire produce really fluffy sheep and the banks of the Douro produce splendid grapes. Yet comparative advantage does little to explain much of modern international trade, especially not trade within industries.
Mr. Krugman published two seminal papers in 1979 and 1980 that made sense of the fact that Toyota sells cars in Germany and Mercedes-Benz sells cars in Japan. Mr. Krugman started with a variant of Edward Chamberlain’s model of monopolistic competition. In this model, every firm sells a slightly different good — an Infiniti is not exactly the same thing as a BMW. There are fixed costs of production, which means that producers get more efficient as they sell more. Finally, consumers like variety, so that even if they live in the Land of the Rising Sun, with its abundant well-made cars, they still occasionally want something a little more Teutonic.These ingredients came together and provided a framework than can match the world’s trade patterns better than the 19th-century framework of David Ricardo, or the mid-20th-century models of Eli Heckscher, Bertil Ohlin and Paul Samuelson. The fact that two out of three of those 20th-century giants are themselves Swedes should remind us of how seriously the Swedes take their trade theory, and what a big deal it is for them to admit Mr. Krugman to the pantheon.
Mr. Krugman’s trade models became the standard in the economics profession both because they fit the world a bit better and because they were masterpieces of mathematical modeling. His models’ combination of realism, elegance and tractability meant that they could provide the underpinnings for thousands of subsequent papers on trade, economic growth, political economy and especially economic geography.
Mr. Krugman’s 1991 Journal of Political Economy paper, “Increasing Returns and Economic Geography,” is the first article that provides a clear, internally consistent mathematically rigorous framework for thinking simultaneously about trade and the location of people and firms across space. It is one of only two models that I insist that Harvard’s Ph.D. students in urban economics be able to regurgitate, equation by equation.
The model begins with the same basic elements as the new trade theory: monopolistic competition, scale economics, love of variety. To these elements Mr. Krugman adds free migration of workers across space and industries. Because workers are able to move, real wages equalize across space. People in New York City may be paid more, but they give some of that back in the form of higher housing prices. The paper provides economists with a clear framework that can make sense of where we all live. Firms and workers are pulled toward the same location to reduce transportation costs of shipping goods. For example, the garment industry located in New York City, in part because of the vast trade in textiles that was already moving through the city and because of the large number of customers already living in America’s largest city.
Of course, we don’t all live in the same city. A good model of geography needs both a centripetal and a centrifugal force. In Mr. Krugman’s model, populations are pulled apart by the desire to be close to natural inputs, like land or coal mines. Cyrus McCormick moved his reaper business from Virginia to Chicago to be closer to his rural customers in the Midwest. Later models incorporated traffic congestion and other forces that limit the growth of a single large urban area. Mr. Krugman’s model proved to quite adaptable; it has received thousands of citations.
In his public role, Paul Krugman is often a polarizing figure, loved by millions but also intensely disliked by his political opponents. I still chuckle over an old New Yorker cartoon with one plutocrat saying to another that he gets some satisfaction from the fact that his vote will cancel out the vote of Paul Krugman. Within the less divided world of the academy, Mr. Krugman’s economic research has generated plenty of light, but far less heat. His papers are universally acknowledged to be immense contributions that helped to create two distinct fields. His Nobel Prize is extremely well deserved and not unexpected. I, for one, had bet on him in Harvard’s Nobel Prize winner pool.
By:- Dr.T.V.Mathew
Monday, 2 February 2009
Tuesday, 20 January 2009
“Nobody borrows like us... nobody spends like us... and nobody prints like us.”
Fed Reserve under leadership of Ben Bernanke is busy in devising strategies to combat one of the most severe recessions US has ever faced। BB is busy printing currency; what is the rationale behind this. Let’s figure this out.
Throughout 1990’s US had been growing at spectacular growth rates as compared to its peers. US has been the growth engine of this world economy. Consumers in the world largest economy were confident of their future incomes and this certainty and their confidence could be seen in their consumption patterns. Throughout the 1990 decade, the US households have been associated with investments exceeding savings and their consumption exceeded their incomes. Animal spirits and interest rate stability further boosted the growth. Since US had a very high income elasticity of imports and on other hand a very low income elasticity of its exports, it lead to a continued trade deficits. This made US very attractive for foreign investors, who were willing to make a quick buck in the oasis of prosperity. The slowdown in Euro region and negative growth in Japan and string of events like defaults in Mexico, Russia, South East Asian crisis made money looking for safe heaven reach US securities and the increased capital inflows affected the trade flows and dollar appreciated there by harming the relative competitiveness of US exports.
One important lesson to be learned is: be it government, household or firms...they often don’t realize they might land into deep troubles by indulging in excessive consumption. There should be some mechanisms to check their spending whenever the capital markets are too willing to lend money. Because the demand for assets to a large extent depends on the expectations of risk and return expectations. Any changes in these expectations could severely impact the demand for an asset.
USD has been the reserve currency since long and US denominated debt was always considered as risk free and investment grade. Moreover, appreciating USD gave more incentives for people to invest in US financial securities. Growing US international debt reflected the confidence the investors had in the world largest economy and its productivity and on its ability to make the right use of the money. The capital inflows will continue and US can run a trade deficit as long as it services its debt and as long as US assets deliver higher risk adjusted return compared to their counterparts. The day, the investors feel, that US is incapable of servicing its debt and there is probability of default, there would be dramatic and abrupt changes in the portfolio composition which could influence the value of USD, growth, employment, household consumption and hence savings.
The Fed’s policy of aggressive printing currency will lead to depreciation of USD in forex markets. This is expected to accentuate the BOP situation in short run but in the long run US is expected to benefit from export of services, primarily because income asymmetry faced by US is low as compared that of goods. And other reasons are liberalization of services sector throughout the world and competitive of US services industry. The income asymmetry may be explained by composition of its population, immigrants etc who continuously make unilateral payments to their relatives in home countries etc.
Moreover, Fed may be attempting to reduce the impact of high debt on the consumption patter of US households. When the interest rates rise, the PV of debt increases, which in turn requires the households to make extra provision for increased debt, which in turn reduces their consumption.
US debt is dollar denominated, so when USD depreciates compared to GBP, Yen, Yuan etc, the foreign debt reduces. This is turn will reduce the pressure on US households.
Thirdly, when the government prints currency it raises the inflationary expectations. This clearly affects the real interest expectation; any changes in real interest influence the investment demand, When the real interest are low, investment demand will increase and thereby help in stimulating the economy and provide employment.
But the most important question is who will fund this investment. In past, strong capital inflows supported the investment demand. But, with such large bail out plans, probability of default increases and this source of money will no longer exist. And considering the past trend in domestic savings, I really doubt whether households can save enough to tide over this problem.
Throughout 1990’s US had been growing at spectacular growth rates as compared to its peers. US has been the growth engine of this world economy. Consumers in the world largest economy were confident of their future incomes and this certainty and their confidence could be seen in their consumption patterns. Throughout the 1990 decade, the US households have been associated with investments exceeding savings and their consumption exceeded their incomes. Animal spirits and interest rate stability further boosted the growth. Since US had a very high income elasticity of imports and on other hand a very low income elasticity of its exports, it lead to a continued trade deficits. This made US very attractive for foreign investors, who were willing to make a quick buck in the oasis of prosperity. The slowdown in Euro region and negative growth in Japan and string of events like defaults in Mexico, Russia, South East Asian crisis made money looking for safe heaven reach US securities and the increased capital inflows affected the trade flows and dollar appreciated there by harming the relative competitiveness of US exports.
One important lesson to be learned is: be it government, household or firms...they often don’t realize they might land into deep troubles by indulging in excessive consumption. There should be some mechanisms to check their spending whenever the capital markets are too willing to lend money. Because the demand for assets to a large extent depends on the expectations of risk and return expectations. Any changes in these expectations could severely impact the demand for an asset.
USD has been the reserve currency since long and US denominated debt was always considered as risk free and investment grade. Moreover, appreciating USD gave more incentives for people to invest in US financial securities. Growing US international debt reflected the confidence the investors had in the world largest economy and its productivity and on its ability to make the right use of the money. The capital inflows will continue and US can run a trade deficit as long as it services its debt and as long as US assets deliver higher risk adjusted return compared to their counterparts. The day, the investors feel, that US is incapable of servicing its debt and there is probability of default, there would be dramatic and abrupt changes in the portfolio composition which could influence the value of USD, growth, employment, household consumption and hence savings.
The Fed’s policy of aggressive printing currency will lead to depreciation of USD in forex markets. This is expected to accentuate the BOP situation in short run but in the long run US is expected to benefit from export of services, primarily because income asymmetry faced by US is low as compared that of goods. And other reasons are liberalization of services sector throughout the world and competitive of US services industry. The income asymmetry may be explained by composition of its population, immigrants etc who continuously make unilateral payments to their relatives in home countries etc.
Moreover, Fed may be attempting to reduce the impact of high debt on the consumption patter of US households. When the interest rates rise, the PV of debt increases, which in turn requires the households to make extra provision for increased debt, which in turn reduces their consumption.
US debt is dollar denominated, so when USD depreciates compared to GBP, Yen, Yuan etc, the foreign debt reduces. This is turn will reduce the pressure on US households.
Thirdly, when the government prints currency it raises the inflationary expectations. This clearly affects the real interest expectation; any changes in real interest influence the investment demand, When the real interest are low, investment demand will increase and thereby help in stimulating the economy and provide employment.
But the most important question is who will fund this investment. In past, strong capital inflows supported the investment demand. But, with such large bail out plans, probability of default increases and this source of money will no longer exist. And considering the past trend in domestic savings, I really doubt whether households can save enough to tide over this problem.
Wednesday, 17 December 2008
No distinction between a small Indian Entrepreneur and Madoff!
I hail from India, and I want to tell my readers how business is conducted in markets in India.
I was seating at my acquaintance shop in textile market of my city, which is supposed to be the manufacturing hub of synthetic fibre in India because of its sheer volume. If you see the functioning of the market you will be amazed to find the length of operating cycles (i.e. No of days of receivables + No of days of Inventory at hand). It ran into months and with the kind of volumes a shopkeeper had, I was wondering how much capital these entrepreneurs might have invested; keeping in mind the low margin on capital employed. My uncle explained me the trade secrets.
Everyone in the markets get credit. And what is important is to honour your commitments on time in order to be operative in the markets. Once you default, then your all doors for credit are closed. But if a trader somehow manages the cycle he can arrange money by selling goods borrowed from another shopkeeper on credit and pay off existing dues. This cycle continues ....The essence is ultimately the bubble is going to burst. The cycle continues as long as there is a greater fool to sell him goods on credit so that everything is in place. The day, trader is unable to find goods on credit; his game will come to an end. And the final person to give credit will be one who will face brunt. And in order to keep confidences going, these traders are very smart; they come in chauffeur driven cars wearing Rolex watches trying to signal their creditors that everything is in place and their money is safe. So the rules are keep cycle going in, and send signals indicating your solvency and profitability. Because market usually sees what you show; it’s very simple to fool markets. !!!!! If somebody can manage to show affluence and somehow keep running the cycle market will tend to believe that the trader is a big shot and doing really good and their money is safe. This will boost their confidence and they will lend more goods on credit with the view of increasing their sales.
Now let us compare this situation to one of the biggest scandals in USA...Madoff is no different to the small entrepreneur I was referring above.
Madoff was one of the most reputable hedge fund managers in US. A hedge fund manager concentrates on absolute returns and has to deliver it even in turbulent times. If the Fund manager is successful then investors will reward him by increasing subscription his fund. One negative point about the hedge fund industry is that they are not under the obligation to report their performance or make disclosures. They might do so on voluntary basis and for fund to fund and it doesn’t apply to entire fund house. So there is presence of survivorship bias, the hedge funds usually overestimate their performance and promote their best funds to collect money from market and do not report performance of their funds which are bleeding and are cash starved.
Madoff was one of these crooks. He used fund inflows to keep the fund afloat and pay off redemptions and show healthy returns of around 12% even in turbulent times. When the wholesale markets were not in tragic stage, the cycle was running. New fund subscriptions were used to pay redemptions and inflate fund earnings and in fact in this case to hide losses. But within past few months, due to credit crisis, investors flows into hedge funds have considerably slowed down and many hedge funds have gone bankrupt; even Alternative Investment Vehicles floated by CitiGroup have gone bankrupt. Now, due to lack of enough capital flows the cycle of floating hats from one head to another couldn’t continue. And now no person was ready to wear the hat....So then finally who had to wear this hat...Mr.Madoff nobody is ready to accept your hat...The fund has gone bankrupt and Madoff has been accused of siphoning more than $50 billion of investors. The impact could be far reaching as many investors, trusts including charities; clients of banks like HSBC etc were invested into these funds. This could further aggravate the ongoing credit crisis. Now the impact will be investors will lose trust in lending their money. This will reduce the investment climate significantly and there will be a global slowdown.
The only difference I see between my entrepreneur and Madoff is each one plays according to his stature and size. The small entrepreneur had exposure of around $200000-500000 while Madoff had exposure of around $50 billion. And in both cases, the people who entered in the chain last were the ones who suffered the most.
Conclusion: - Don’t believe on your eyes. No one can make a quick buck in the markets. If someone gives you information that gold is lying on roads, please don’t be allured and become a prey to it.
I was seating at my acquaintance shop in textile market of my city, which is supposed to be the manufacturing hub of synthetic fibre in India because of its sheer volume. If you see the functioning of the market you will be amazed to find the length of operating cycles (i.e. No of days of receivables + No of days of Inventory at hand). It ran into months and with the kind of volumes a shopkeeper had, I was wondering how much capital these entrepreneurs might have invested; keeping in mind the low margin on capital employed. My uncle explained me the trade secrets.
Everyone in the markets get credit. And what is important is to honour your commitments on time in order to be operative in the markets. Once you default, then your all doors for credit are closed. But if a trader somehow manages the cycle he can arrange money by selling goods borrowed from another shopkeeper on credit and pay off existing dues. This cycle continues ....The essence is ultimately the bubble is going to burst. The cycle continues as long as there is a greater fool to sell him goods on credit so that everything is in place. The day, trader is unable to find goods on credit; his game will come to an end. And the final person to give credit will be one who will face brunt. And in order to keep confidences going, these traders are very smart; they come in chauffeur driven cars wearing Rolex watches trying to signal their creditors that everything is in place and their money is safe. So the rules are keep cycle going in, and send signals indicating your solvency and profitability. Because market usually sees what you show; it’s very simple to fool markets. !!!!! If somebody can manage to show affluence and somehow keep running the cycle market will tend to believe that the trader is a big shot and doing really good and their money is safe. This will boost their confidence and they will lend more goods on credit with the view of increasing their sales.
Now let us compare this situation to one of the biggest scandals in USA...Madoff is no different to the small entrepreneur I was referring above.
Madoff was one of the most reputable hedge fund managers in US. A hedge fund manager concentrates on absolute returns and has to deliver it even in turbulent times. If the Fund manager is successful then investors will reward him by increasing subscription his fund. One negative point about the hedge fund industry is that they are not under the obligation to report their performance or make disclosures. They might do so on voluntary basis and for fund to fund and it doesn’t apply to entire fund house. So there is presence of survivorship bias, the hedge funds usually overestimate their performance and promote their best funds to collect money from market and do not report performance of their funds which are bleeding and are cash starved.
Madoff was one of these crooks. He used fund inflows to keep the fund afloat and pay off redemptions and show healthy returns of around 12% even in turbulent times. When the wholesale markets were not in tragic stage, the cycle was running. New fund subscriptions were used to pay redemptions and inflate fund earnings and in fact in this case to hide losses. But within past few months, due to credit crisis, investors flows into hedge funds have considerably slowed down and many hedge funds have gone bankrupt; even Alternative Investment Vehicles floated by CitiGroup have gone bankrupt. Now, due to lack of enough capital flows the cycle of floating hats from one head to another couldn’t continue. And now no person was ready to wear the hat....So then finally who had to wear this hat...Mr.Madoff nobody is ready to accept your hat...The fund has gone bankrupt and Madoff has been accused of siphoning more than $50 billion of investors. The impact could be far reaching as many investors, trusts including charities; clients of banks like HSBC etc were invested into these funds. This could further aggravate the ongoing credit crisis. Now the impact will be investors will lose trust in lending their money. This will reduce the investment climate significantly and there will be a global slowdown.
The only difference I see between my entrepreneur and Madoff is each one plays according to his stature and size. The small entrepreneur had exposure of around $200000-500000 while Madoff had exposure of around $50 billion. And in both cases, the people who entered in the chain last were the ones who suffered the most.
Conclusion: - Don’t believe on your eyes. No one can make a quick buck in the markets. If someone gives you information that gold is lying on roads, please don’t be allured and become a prey to it.
Thursday, 11 December 2008
Science of Financial Markets- Can it explain the current Credit Crisis ?
I am suddenly nostalgic being in Asset Management class at Warwick Business School…I remembered my science classes in school.. In 10th grade we learned about the Big Bang Theory and the concept of black holes, white dwarf, etc.
These concepts I guess I can relate to what is happening now in financial markets. A Big Bang has taken place. And the financial markets are shrinking rapidly and are pulled towards their origin by the strong forces of greed, contamination and deregulation. This will result in creation of black holes. In this black holes, the gravity of these forces will be so strong that not a single ray of light can pass through it. I am not exaggerating the magnitude of financial crisis, I am trying to show its impact. Its more than just a financial crisis.
Probably not many people will believe that few people in the industry had predicted this Sub-Prime crisis as early as 2005-2006. Warren Buffet and other notable experts in the filed have recorded their statements that USD will depreciate in future and is in a long term depreciation trend. To add to this, I had presented a similar report in my college in 2005 on the same issue of Sub Prime crisis and tried to evaluate the housing market in USA and tried to identify the asset bubble in making,. In addition, I extended my framework to include gold as an asset class rather than an commodity and pointed out the possible scenarios where gold would outperform the other asset classes. In my report, I clearly mentioned that the spectacular credit growth which led to inflationary asset prices could not be sustained in future and would lead to creation of circumstances which will lead USA and the world economy into a vicious cycle of recession. It would lead to a combination of depreciating dollar, rising interest rates, high unemployment rates, defaults in housing market. And now, the results are in front of us.
Rationale:-Behind Crisis
The reason is very clear whenever anything rises at alarming levels it has to come down at similar periods. Again, I would like to relate this to Newton ‘s Gravity Theory. Issac Newton discovered the Gravitational Theory and concluded that any thing that goes up has to come down back to earth and the speed at which it comes down is faster than it goes up. So please remember these theories and concepts, it has indirect applications in finance. So if you scored well in science, you would score good in finance. In past four years, stock markets experienced spectacular Bull Run and the equities zoomed as if USA & Russia were releasing rockets from earth. But every bull run teaches its own lesson. In 1990’s after the dot com bubble, people became wary of high P/E multiples as high as 100-400 times which were allocated to dot com companies. In fact, for some time when the returns were generated and people who bought these stocks at 100 P/E ratio were able to see it to another fool for 300 P/E ratio, even investor like Warren Buffet was astonished and made public statement that for the first time his research was wrong and probably market was right in its judgement. Soon after he made his confession, in few months the dot come bubble took place and stocks went crashing. After 2008 crisis, people in future will understand the importance of identifying risk involved in asset, its payoff and associated cash flows.
Had government exercised effective regulation and control on the financial system and imposed stringent capital adequacy norms, the present situation would not have arose. Hedge Funds in US were completely unregulated and there was no check on their activities such as speculation, high leveraging etc. In fact, hedge funds used to go to havens like Bermuda, Mauritius etc to escape from regulation. In past decade, the financial markets made easy for I-Bankers, Hedge Fund managers to earn quick buck. Most of the analyst were new and just experienced the bull run and had never experienced bear run. Thus any stock selected by them performed well in the bull run because of systematic return ie correlation with the index. So they never actually knew how to pick growth and quality stocks, nor could they read off balance sheet items and secret reserves build by the company. People like Warren Buffet understood financial statements and made money. To add to this, when Warren Buffet was asked what do you think your successor should be good at ? He said that my successor needs to be able to analyze the financial statements and especially the off balance sheet items.
Another reason is the unaccounted investments of Hedge Funds. This are specialized institutions that are willing to take risk and beat the market and generate excess return on investments and are looking to make a quick buck in short time. South East Asian Crisis is an example of how can these short term foreign inflows and outflows can distort the BOP of an economy. These funds invest money in un chartered territories and seek advantage of being first mover. Due to their high bulky investments, they attract market attention to that particular asset class. For instance, since 2005 the money flowed into the Equities, mortgage backed securities and other riskier assets. The result bull run in equities. Retail investors entered at peak and are in losses, while hedge funds exited at profits at peak. Then this money made way into commodities like Crude, Base metals, precious metals, agricultural commodities etc. And suddenly the commodities started experiencing a bull run. Crude rose from $70 per barrel and reached sub $150 levels in a short period of time. There were no fundamental reason that justified the magnitude of rise in such a short period of time. And as expected when on corrections, hedge funds were exiting and booking profits, retail investors entered and booked looses. Now the money has flown out of crude and will look at gold as its safe heaven. Gold., as in investment class will be looked upon by investors in next 2-5 years to beat inflation and for safety of capital. One of the reason for the large size of hedge funds was the sheer number of funds launched in short period of time. In Wall Street, any I-Banker with an Ivy League MBA could launch his hedge fund and within hours he would get several billions to start his fund. This unregulated industry presented data of its best fund to raise capital and the funds which failed were not reported at all and thus returns which were reported were biased and misled investors.
Another important reason for the crisis has been structured derivative products and its complexity. The main aim of the derivatives was to enable asset holder to hedge his risk. But the doctorates in physics, math, statistics and ones from engineering background created complex derivatives products whose pay off were not easily determinable and hence the clients-corporates could never understand the risk associated with the product and its pay off. Thus when markets reversed, as in case of Indian IT industry, on one hand they had windfall gain due to depreciation of ruppe on other hand losses from hedges. These left their balance sheet red. The creators of structured products themselves never understood the product and its implications and hence could not analyze the product because they lack the knowledge of financial concepts etc.
Impact of Credit Crisis
The impact of crisis can be measured from the following facts: Fed Reserve has injected 700 billion USD into the system, BoE has injected more than 400 Billion GBP into the system. Bear Stearns and Lehman Brothers have been bankrupt, AIG suffered huge losses and Fed Reserve had to intervene to protect counterparties which were predominantly pension funds, retirement funds etc. Iceland ‘s banking system has collapsed. Russia is seating on around 250 billion USD and is bailing out Iceland, but guess that wont be enough and Iceland is very angry as none of the Western Counterparts are willing to help. The reason is evident, Fed would handle its own economy or Iceland? ECB has asked its member nations to develop their own plans to bail out their domestic banks and central banks throughout the world have coordinated their monetary policy to ease the tight liquidity position in the money markets. The money markets have literally frozen. With LIBOR rising as high as 5%. Nobody is willing to lend in the money markets and after 2001 for the first time there have been such heavy withdrawals from money markets. The banks are trying to recapitalize themselves and holding every penny of money. This has adversely affected the expansion plans of quality corporates because the debt markets have literally frozen. Banks firstly don’t have enough money to lend and secondly they perceive the credit risk is too high.
Will Bail outs be effective? I doubt
I would like to point out that the bail out plans of Fed Reserve and BoE will not necessarily solve this issue. Market will take its own time to assess risk and adjust accordingly. In many of these financially important centers, the size of the banking system exceeds more than 5 times the size of the economy. Take for instance UK, the size of the banking industry is more than 5 times the size of the GDP. This means recapitalizing banking system by 1% requires 5% of GDP borrowing. Thus even a small 5% recapitalization plans would require more than 25% of GDP borrowing and that would take already high levels of Fiscal deficit to still higher levels leading to higher inflation and higher unemployment rates. So here one can see how much dependable these bail outs are. Moreover, higher levels of fiscal deficits would still requite high levels of taxes, which is not possible because slowing economy would reduce incomes and hence the tax collections. The more interesting part is to see how does government handle the defaults in newly nationalized banks like RBS. Will government exercise its right on the collateral to recover loans and ignore that it is responsible for the plight of its citizens.
The current situation relates to Liquidity trap as described in the Keynesian Economics. Eventually, the rate of interest will fall so low that this will lead to an infinite demand for money. As it has been in Japan, where the real rate of interest has been negative for more than a decade and property prices are at 40% of their peak in 1990’s. Until, the credit markets are not stabilized and the confidence levels are restored in the credit holders I don’t see any ray of light in the black hole. For the first time, have investors learned their lessons by not caring out proper risk identification. In last crash in 1987, only the equity holders lost money but the debt holders didn’t even when the bankruptcy was declared. So these were considered to be safe, for the first time has the write downs have been to such a large extent that they have completely wiped off bank’s balance sheets and curtailed their ability to raise capital. This has lead to default and for the first time will the credit holders will suffer losses on a wide scale. A research has even pointed out that sovereign bonds which are said to be risk free are essentially not risk free and more than 27 sovereign bonds have defaulted. Moreover, these carry interest rate risk, purchasing power risk, exchange rate risk for international investors etc. So essentially the concept of risk free rate does not hold true. And investors need to price in the extra risk premium. This will lead to re allocation of wealth among various asset classes. The rate of return required from a bond as compared to earlier (ceteris paribus) would rise significantly and this would have deep impact on the bottom line of highly leveraged companies and would render most of their projects unprofitable and may even force them to delay projects due to non availability of cheap and required capital. Thus only companies which have adequate capital to fund their expansion plans and have strong operating cash flows would survive. That’s why adage goes’ A money today is better than money tomorrow’ and every business should have enough cash to take advantage of market imperfections and opportunities.
Central Banks are cutting Discount rate steeply because they want to improve the liquidity in the system and ensure that there is enough capital in the system but it fails to realize that this money is just finding its way into the treasuries of banks and in reality wont be made available for lending. In fact, one school of thought believes that the rate interest should rise sufficiently to compensate the investors of credit and interest rate as well as purchasing power risk. Only when the rate rises significantly, will investors opportunity cost of money will rise and they part away with money. The speculative demand for money will reduce and money will be deposited with banks and made available for lending. The reason being that the demand for speculative money reduces as the rate of interest rises.
Paradigm Shift-From deregulation to nationalization
Few months back, inflation and rising crude prices was a big concern and suddenly the focus has shifted to more important events like nationalization of banks in UK, USA etc. See the irony, few months back developed economies like USA, UK, EU were advocating liberalization of financial services industry, free movement of capital, deregulation of financial services industry, denationalization of banks and privatization bla-bla . What has happened now? The same nations are now harping the tune of nationalizing banks and using tax payer’s fund to recapitalize national banks and save their banking system from collapsing. Few months back, London and New York were the teller counters of this world economy and whoever wanted money went to these counters and raised money; whatever may be the need speculative demand or investment or consumption demand.
These concepts I guess I can relate to what is happening now in financial markets. A Big Bang has taken place. And the financial markets are shrinking rapidly and are pulled towards their origin by the strong forces of greed, contamination and deregulation. This will result in creation of black holes. In this black holes, the gravity of these forces will be so strong that not a single ray of light can pass through it. I am not exaggerating the magnitude of financial crisis, I am trying to show its impact. Its more than just a financial crisis.
Probably not many people will believe that few people in the industry had predicted this Sub-Prime crisis as early as 2005-2006. Warren Buffet and other notable experts in the filed have recorded their statements that USD will depreciate in future and is in a long term depreciation trend. To add to this, I had presented a similar report in my college in 2005 on the same issue of Sub Prime crisis and tried to evaluate the housing market in USA and tried to identify the asset bubble in making,. In addition, I extended my framework to include gold as an asset class rather than an commodity and pointed out the possible scenarios where gold would outperform the other asset classes. In my report, I clearly mentioned that the spectacular credit growth which led to inflationary asset prices could not be sustained in future and would lead to creation of circumstances which will lead USA and the world economy into a vicious cycle of recession. It would lead to a combination of depreciating dollar, rising interest rates, high unemployment rates, defaults in housing market. And now, the results are in front of us.
Rationale:-Behind Crisis
The reason is very clear whenever anything rises at alarming levels it has to come down at similar periods. Again, I would like to relate this to Newton ‘s Gravity Theory. Issac Newton discovered the Gravitational Theory and concluded that any thing that goes up has to come down back to earth and the speed at which it comes down is faster than it goes up. So please remember these theories and concepts, it has indirect applications in finance. So if you scored well in science, you would score good in finance. In past four years, stock markets experienced spectacular Bull Run and the equities zoomed as if USA & Russia were releasing rockets from earth. But every bull run teaches its own lesson. In 1990’s after the dot com bubble, people became wary of high P/E multiples as high as 100-400 times which were allocated to dot com companies. In fact, for some time when the returns were generated and people who bought these stocks at 100 P/E ratio were able to see it to another fool for 300 P/E ratio, even investor like Warren Buffet was astonished and made public statement that for the first time his research was wrong and probably market was right in its judgement. Soon after he made his confession, in few months the dot come bubble took place and stocks went crashing. After 2008 crisis, people in future will understand the importance of identifying risk involved in asset, its payoff and associated cash flows.
Had government exercised effective regulation and control on the financial system and imposed stringent capital adequacy norms, the present situation would not have arose. Hedge Funds in US were completely unregulated and there was no check on their activities such as speculation, high leveraging etc. In fact, hedge funds used to go to havens like Bermuda, Mauritius etc to escape from regulation. In past decade, the financial markets made easy for I-Bankers, Hedge Fund managers to earn quick buck. Most of the analyst were new and just experienced the bull run and had never experienced bear run. Thus any stock selected by them performed well in the bull run because of systematic return ie correlation with the index. So they never actually knew how to pick growth and quality stocks, nor could they read off balance sheet items and secret reserves build by the company. People like Warren Buffet understood financial statements and made money. To add to this, when Warren Buffet was asked what do you think your successor should be good at ? He said that my successor needs to be able to analyze the financial statements and especially the off balance sheet items.
Another reason is the unaccounted investments of Hedge Funds. This are specialized institutions that are willing to take risk and beat the market and generate excess return on investments and are looking to make a quick buck in short time. South East Asian Crisis is an example of how can these short term foreign inflows and outflows can distort the BOP of an economy. These funds invest money in un chartered territories and seek advantage of being first mover. Due to their high bulky investments, they attract market attention to that particular asset class. For instance, since 2005 the money flowed into the Equities, mortgage backed securities and other riskier assets. The result bull run in equities. Retail investors entered at peak and are in losses, while hedge funds exited at profits at peak. Then this money made way into commodities like Crude, Base metals, precious metals, agricultural commodities etc. And suddenly the commodities started experiencing a bull run. Crude rose from $70 per barrel and reached sub $150 levels in a short period of time. There were no fundamental reason that justified the magnitude of rise in such a short period of time. And as expected when on corrections, hedge funds were exiting and booking profits, retail investors entered and booked looses. Now the money has flown out of crude and will look at gold as its safe heaven. Gold., as in investment class will be looked upon by investors in next 2-5 years to beat inflation and for safety of capital. One of the reason for the large size of hedge funds was the sheer number of funds launched in short period of time. In Wall Street, any I-Banker with an Ivy League MBA could launch his hedge fund and within hours he would get several billions to start his fund. This unregulated industry presented data of its best fund to raise capital and the funds which failed were not reported at all and thus returns which were reported were biased and misled investors.
Another important reason for the crisis has been structured derivative products and its complexity. The main aim of the derivatives was to enable asset holder to hedge his risk. But the doctorates in physics, math, statistics and ones from engineering background created complex derivatives products whose pay off were not easily determinable and hence the clients-corporates could never understand the risk associated with the product and its pay off. Thus when markets reversed, as in case of Indian IT industry, on one hand they had windfall gain due to depreciation of ruppe on other hand losses from hedges. These left their balance sheet red. The creators of structured products themselves never understood the product and its implications and hence could not analyze the product because they lack the knowledge of financial concepts etc.
Impact of Credit Crisis
The impact of crisis can be measured from the following facts: Fed Reserve has injected 700 billion USD into the system, BoE has injected more than 400 Billion GBP into the system. Bear Stearns and Lehman Brothers have been bankrupt, AIG suffered huge losses and Fed Reserve had to intervene to protect counterparties which were predominantly pension funds, retirement funds etc. Iceland ‘s banking system has collapsed. Russia is seating on around 250 billion USD and is bailing out Iceland, but guess that wont be enough and Iceland is very angry as none of the Western Counterparts are willing to help. The reason is evident, Fed would handle its own economy or Iceland? ECB has asked its member nations to develop their own plans to bail out their domestic banks and central banks throughout the world have coordinated their monetary policy to ease the tight liquidity position in the money markets. The money markets have literally frozen. With LIBOR rising as high as 5%. Nobody is willing to lend in the money markets and after 2001 for the first time there have been such heavy withdrawals from money markets. The banks are trying to recapitalize themselves and holding every penny of money. This has adversely affected the expansion plans of quality corporates because the debt markets have literally frozen. Banks firstly don’t have enough money to lend and secondly they perceive the credit risk is too high.
Will Bail outs be effective? I doubt
I would like to point out that the bail out plans of Fed Reserve and BoE will not necessarily solve this issue. Market will take its own time to assess risk and adjust accordingly. In many of these financially important centers, the size of the banking system exceeds more than 5 times the size of the economy. Take for instance UK, the size of the banking industry is more than 5 times the size of the GDP. This means recapitalizing banking system by 1% requires 5% of GDP borrowing. Thus even a small 5% recapitalization plans would require more than 25% of GDP borrowing and that would take already high levels of Fiscal deficit to still higher levels leading to higher inflation and higher unemployment rates. So here one can see how much dependable these bail outs are. Moreover, higher levels of fiscal deficits would still requite high levels of taxes, which is not possible because slowing economy would reduce incomes and hence the tax collections. The more interesting part is to see how does government handle the defaults in newly nationalized banks like RBS. Will government exercise its right on the collateral to recover loans and ignore that it is responsible for the plight of its citizens.
The current situation relates to Liquidity trap as described in the Keynesian Economics. Eventually, the rate of interest will fall so low that this will lead to an infinite demand for money. As it has been in Japan, where the real rate of interest has been negative for more than a decade and property prices are at 40% of their peak in 1990’s. Until, the credit markets are not stabilized and the confidence levels are restored in the credit holders I don’t see any ray of light in the black hole. For the first time, have investors learned their lessons by not caring out proper risk identification. In last crash in 1987, only the equity holders lost money but the debt holders didn’t even when the bankruptcy was declared. So these were considered to be safe, for the first time has the write downs have been to such a large extent that they have completely wiped off bank’s balance sheets and curtailed their ability to raise capital. This has lead to default and for the first time will the credit holders will suffer losses on a wide scale. A research has even pointed out that sovereign bonds which are said to be risk free are essentially not risk free and more than 27 sovereign bonds have defaulted. Moreover, these carry interest rate risk, purchasing power risk, exchange rate risk for international investors etc. So essentially the concept of risk free rate does not hold true. And investors need to price in the extra risk premium. This will lead to re allocation of wealth among various asset classes. The rate of return required from a bond as compared to earlier (ceteris paribus) would rise significantly and this would have deep impact on the bottom line of highly leveraged companies and would render most of their projects unprofitable and may even force them to delay projects due to non availability of cheap and required capital. Thus only companies which have adequate capital to fund their expansion plans and have strong operating cash flows would survive. That’s why adage goes’ A money today is better than money tomorrow’ and every business should have enough cash to take advantage of market imperfections and opportunities.
Central Banks are cutting Discount rate steeply because they want to improve the liquidity in the system and ensure that there is enough capital in the system but it fails to realize that this money is just finding its way into the treasuries of banks and in reality wont be made available for lending. In fact, one school of thought believes that the rate interest should rise sufficiently to compensate the investors of credit and interest rate as well as purchasing power risk. Only when the rate rises significantly, will investors opportunity cost of money will rise and they part away with money. The speculative demand for money will reduce and money will be deposited with banks and made available for lending. The reason being that the demand for speculative money reduces as the rate of interest rises.
Paradigm Shift-From deregulation to nationalization
Few months back, inflation and rising crude prices was a big concern and suddenly the focus has shifted to more important events like nationalization of banks in UK, USA etc. See the irony, few months back developed economies like USA, UK, EU were advocating liberalization of financial services industry, free movement of capital, deregulation of financial services industry, denationalization of banks and privatization bla-bla . What has happened now? The same nations are now harping the tune of nationalizing banks and using tax payer’s fund to recapitalize national banks and save their banking system from collapsing. Few months back, London and New York were the teller counters of this world economy and whoever wanted money went to these counters and raised money; whatever may be the need speculative demand or investment or consumption demand.
Emergence of ASIA-Middle East
I think soon the Economic power will shift to Asia (including Japan) and Middle East Region specifically. I would like to be say that in future I see Dubai, Egypt, Hong Kong, Singapore and Mumbai as the upcoming international financial centers. And among these specially Dubai, Singapore and Hong Kong. The cash rich OPEC countries are spending heavily on tourism and infrastructure. UAE has completely transformed itself in last decade, and is making most of its windfall gains from high crude prices. It is targeting itself to be one of the most sought after tourist destinations in the world. Most of the I-Banks and other industries are increasing concentrating on Dubai as its base to cater to the Middle East countries. They are hiring in a big way in Middle East and soon the senior management would handle the company affairs from Middle East base.
I think investing in Indian Stock markets are better than its Asian peers. I know, many of you may say I am wrong and China is the place. Please bear and give me a chance to justify my answer. China like other Asian economies viz Singapore, Malaysia etc is export oriented economy. India on other hand is a domestic consumption driven economy. It still has high Balance of Payments deficit, reason it imports crude in high volumes. And in addition, its exports don’t match its imports. Off late, the deficit in current account has been matched with surplus in the capital account, thanks to the FII and booming stock markets. But again, with FII withdrawing money, rupee has depreciated vis-à-vis dollar and foreign kitty has been reduced. But still, I feel rupee is in a long term appreciation trend and once the unwinding in the credit markets is done with, dollar will depreciate further. What makes India an attractive destination to me is its young population. It has a high proportion of its population who are in their middle ages and are spending high proportion of their income on luxuries and other consumer durables, making India less affected by slowing demand from export markets. The other thing, which has recently turned into India’s favour is 123 agreement. Since long, the shortage of energy has withheld the development of rural areas and there are power cuts in many parts of India and many areas have no access to electricity. Nuclear energy is a clean and green energy and will reduce India’s dependence on crude to some extent and make the demand for crude from inelastic to elastic in long run. Though the advantages of this deal will take 3-4 years to start accruing but it’s a positive step and this is Manmohan Singh’s greatest achievement I guess. He took a tough decision and even risked his Chair. He will be remembered as a man who single handedly turned Indian Economy, which was in a terrible state in 1991 to India which is looked upon by world as the fuel for the growth of world economy. Economics always says that the impact of policy decisions will accrue in the long run. His financial sector reforms in 1991 set the stage for growth in 2000’s and now 123 agreement will provide new impetus to growth in India.
I think investing in Indian Stock markets are better than its Asian peers. I know, many of you may say I am wrong and China is the place. Please bear and give me a chance to justify my answer. China like other Asian economies viz Singapore, Malaysia etc is export oriented economy. India on other hand is a domestic consumption driven economy. It still has high Balance of Payments deficit, reason it imports crude in high volumes. And in addition, its exports don’t match its imports. Off late, the deficit in current account has been matched with surplus in the capital account, thanks to the FII and booming stock markets. But again, with FII withdrawing money, rupee has depreciated vis-à-vis dollar and foreign kitty has been reduced. But still, I feel rupee is in a long term appreciation trend and once the unwinding in the credit markets is done with, dollar will depreciate further. What makes India an attractive destination to me is its young population. It has a high proportion of its population who are in their middle ages and are spending high proportion of their income on luxuries and other consumer durables, making India less affected by slowing demand from export markets. The other thing, which has recently turned into India’s favour is 123 agreement. Since long, the shortage of energy has withheld the development of rural areas and there are power cuts in many parts of India and many areas have no access to electricity. Nuclear energy is a clean and green energy and will reduce India’s dependence on crude to some extent and make the demand for crude from inelastic to elastic in long run. Though the advantages of this deal will take 3-4 years to start accruing but it’s a positive step and this is Manmohan Singh’s greatest achievement I guess. He took a tough decision and even risked his Chair. He will be remembered as a man who single handedly turned Indian Economy, which was in a terrible state in 1991 to India which is looked upon by world as the fuel for the growth of world economy. Economics always says that the impact of policy decisions will accrue in the long run. His financial sector reforms in 1991 set the stage for growth in 2000’s and now 123 agreement will provide new impetus to growth in India.
GLOBAL PORTFOLIO-THE NEW TREND OF THE DECADE
Date: 2 April 2007
Europe which was an earlier sign of slow growth rates, heavy government regulations and witnessed slow growth rates is slowly changing its image. The clear evidence of which can be drawn out from the following facts and figures , the euro is trading at almost all time highs, 1 euro is equivalent to 2$. Even the European economy is expected to grow faster than the US economy.
The dependence on US and US$ is slowly and slightly losing it luster and in the coming decade the European Economy and Euro will be a major share of all the global portfolios and foreign kitty’s. German DAX Stock index has returned a whopping 11% which translates into 14% return for US investors, as compared to it the S&P 500 US Stock Index has returned merely 3.8%. A positive trend to be noticed is the upsurge in the German Economy. As many as 50 small and medium sized German stocks have picked up by top US funds and have given a return of 22% in the past year 2006. Further looking at the German Funds it has been found that many funds have returned 35% during the past year , 38% annualized during the past three years and 27% per annum in past five years. The world economy will be fuelled by growth from other developing economies BRICS and from developed markets of Europe. In the coming years despite of strong appreciation of Euro currency and hike in the interest rates by BUNDESBANK of Germany, the central bank is quite optimistic of its growth being comparable to other developing and emerging market economies. This will create an opportunity in the near future for bullish investors in trading in Euro currency. Moreover the world economy is expected to grow at around 3% in the coming decade and growth seems to be more on balanced side. US economy slowing down can be well seen from the data shown in G7 meeting, earlier the US investors which were non stop shoppers. The imports from China are at 9 year lows and the trade deficit has also narrowed from $58.9 billion to $58.4 billion.
Global Portfolios and Country Mix is used by fund houses to hedge country specific risks. The same thing can be seen happening in Indian markets as well where Fidelity Management has recently launched its Fidelity International Opportunity Fund. The trends to be determined are its investing style. It plans to invest 65% of its equities in Indian corporate and the remaining 35% in overseas markets particularly the Asian Giants like China, Japan, Singapore, Hong Kong, Malaysia, Korea and others. But the cause of worry is the positive correlation between the Stock Markets in Asia. An evidence of it is the fall in Indian and other stock markets due to a fall in Chinese markets on Feb 27 2007. Similarly due to buoyant spirits and sustained capital inflows to other Asian economies, the Indian markets also went up. So it doesn’t make sense to diversify such a risk by investing in Asian economies which have positive correlation with India. Moreover Asian economies like Japan, China and Singapore are highly reliant on US exports for growth and with US economy taking a soft landing; it seems to be more profitable to include some European stocks especially of Germany and take long positions in Euro currency. A quick look at the performance of the MSCI Index shows that its returns were 26.6% CAGR in the last four financial years which is low as compared to returns sported by BSE 200 at 43.2%. Moreover most of the International Funds have taken high exposures in the Indian Markets primarily due to factors like strong domestic consumption, low reliance on US exports, large section of English speaking population, strong middle class represented with high earnings and spending capacity, streamlining of Indian taxation systems , continued Pension and financial sector reforms, capital account convertibility. In the past global asset mix was possible only for FI and FIIs but now with launch of global funds like Fidelity IOF, even the retail investors could benefit from investment overseas. In the coming years we see individual investors using their $50000 limit every year to invest abroad and this limit extends to $3 billion a year for Mutual Funds.
ELEPHANT ‘S GROWTH IS THREATENING THE DRAGON AND GIANTS LIKE USA, UK AND JAPAN.
DATES:-7 May 7, 2007
After the boom in all sectors like InfoTech, metals, telecom, engineering and others it’s now turn for FMCG and organized retail. India’s favorable demographics is already creating ax express high way for retail growth. Mc Kinsey report shows that in India middle class families having income between 2-10 lakhs will grow from 50 million to 583 million by 2025 registering an all around growth of 15% thanks to the rising salaries in the Indian markets. This population segment will be twice the population of USA and will form third largest country by its size. The income is set to rise from Rs.113744 to Rs.318896 in 2025 at a CAGR of 5.3%. Thus the PCI works out to be $7600 which looks meager but its PPP stands at $40000 which looks every attractive. India has been witnessing vast changes in its demographics. Firstly the number of earners per family is on a rise with women liberalization and becoming a part of the workforce. Secondly in India the number of dependents will fall drastically and ensure a larger income is available for spending. Moreover the major stimulant of growth is the rising income. Law of economics says once the basic needs are satisfied the consumers are willing to spend their rest of income on branded luxury and comfort and leisure goods because they provide higher marginal utility. Thus future is very bright for consumer durables and luxury goods manufacturers. Slowly and steadily the organized retailing will expand at the cost of unorganized retailers. The study by McKinsey also indicates that though the overall expenditure on food, tobacco and beverages will drop from 45% to 25% the reason being cited above. But FMCG companies will continue to grow at 4.5% annually creating a huge pie for them to cater to. India will continue to its robust spending to reach to 5th largest consumer in world after Japan, USA, UK and China. India’s consumption will rise more than 4 times from Rs.1500000 cr to Rs.70, 00,000 cr ($1.5 trillion). If PPP is considered India’s consumption will reach $8.2 trillion far ahead then US consumption which stands at $7.8 trillion. Economic reforms show results and often have a time lag of more than 10-15 years. For instance China made reforms in 1990s and its results started showing in the millennium. In India the reforms have already been introduced and their results will start showing in coming years. Further reforms being introduced will only hasten pace of growth but even if the process remains irreversible India is poised to benefit heavily from the sustained growth rate up to 2025.
Thus considering all these companies in the FMCG, autos, leisure and recreation and consumer durables are set to benefit. So one could consider investments in these sectors taking a long term cue. A correction of 5-10% in coming months should be looked as a buying opportunity especially in auto segment from a long term perspective of 3 years. The slow down has already been factored in prices and after a correction this stocks looks attractive. Moreover companies like Dabur and Marico in midcap space look attractive. These companies should use strategies for creating their brand name to survive in brand war against them posed by retail giants like HLL, Colgate Palmolive, P&G, Wal-Mart, Carrefour and others. A new kind of branding has already started taking place consider the brand creation process undertaken by MIAL (Mumbai International Airport Pvt Ltd). They have created their unique logo and creating vast retail outlets in airport vicinity to cater to vast population of 20-25 million clients visiting airport. These will house all International Brands and will help airport earn its revenues and reduce dependence from flight operations to 55%. Thus around 50% of its revenues will come from leasing out retail spaces at airports which will offer huge markets to retailers. As soon as one enters the airport, the airport brand will attract them, and only when the customer enters a shop the individual brand will takeover from airport brand. This brand will be given adequate promotions through bill boards, advertisements etc and could be looked as revenues by leasing them out to giant retailers.
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