Blunderbuss in Mumbai

The Real reform agenda

2014-02-21T10:49:00.004+05:30

My column in Wealth Insight Jan edtion is here. The unedited original follows:

Policy reform – different strokes

Speak to a day trader in India’s equity market, and government policy “reform” equals changes that help equity markets go up for the day. Removal of STT (securities transaction tax) is a significant “reform” measure. Speak to foreign brokerages (as the current finance minister often does) and reform implies allowing foreign investment without restrictions and without taxes in all sectors of Indian economy. But what reform would actually change the Indian economy in a meaningful and sustained manner – and would be good for Indian citizens and businesses? A possible candidate is “administrative reform”.

Administrative reforms fall in the category of “most boring” reforms. A paean on such reforms is unlikely to feature in the “must-do” list of any equity strategist. Importantly, a government order is often all that is needed to implement it – quite unlike many others that require “coalition dharma” to be violated. Of many administrative reforms, one that can make an immediate impact on the economic scenario of India is legal reform.

The economic effect of poor legal systems

A study carried out some years ago found that in India, for every 1000 citizens, only 1.2 cases were filed as against 17 in Malaysia and 14 in Korea. Does that mean that Indians are less prone to litigation? Details of pending cases do not suggest so. There are approximately 3.5 million cases pending in High Courts and over 20 million cases in subordinate courts. It appears that lower per capita cases files is a sign of fatigue - litigants do not expect to receive a judgement in their lifetime through the formal judicial system – and do not approach it for resolution. This fosters informal or alternate mechanisms – many that operate outside the legal system to “fix” problems. There are several consequences – societal and economic.

Higher borrowing costs, lower leverage

Consumer lending in India has suffered considerably due to lenders inability to recover dues from defaulters. Typically, lenders build in 6% or more as default risk. Borrowers of good credit worthiness are charged almost 50% much more than they would need to pay, if defaulters could have been legal proceeded against, and recovery achieved in a time bound manner.

Small and medium enterprises (SME’s) are even worse affected. Since a lender knows that loan contracts cannot be legally enforced, practices such as demanding a personal guarantee of a “promoter” for a limited liability company have become commonplace. The purpose of limited liability itself is lost – leading to slower growth in the organized sector.

Not only is lending cost padded up for potential losses, multiple collateral is expected for every loan. This reduces the borrowing power of small business in no small measure. Despite this, rising levels of non-performing assets with banks reveals that liquidating collateral itself may be a difficult legal process.

Delayed justice – slower development

India’s judicial system has civil suits lasting over 20 years. Decades old land disputes prevent development of prime real-estate, leading to artificial land scarcity and higher costs of living.

Commercial contracts require quick and just remedies for them to be effective. With no hope of achieving that in India, corporate India has to often agree to use international jurisdiction (say Singapore) for international contracts. This has an adverse impact on the legal business in India. Longer term, it restricts the sovereignty of the Indian State.

Cost of justice

Another deterrent for going to court is cost. Often, cases drag on through various levels of judiciary – with ever increasing costs of advocate fees. The reimbursement of fees in event of a win is totally inadequate compared to the real cost of legal representation in higher courts. Even a win will often represent a pyrrhic victory. More often, less well-to-do litigants will simply give up despite having a strong case – leading to miscarriage of justice – and increasing social disparity.

Economic and human loss

Despite several judicial reform commissions and studies, the problem of an ineffective judicial system continues to prove a drag to the Indian economy. While no study seems to have estimated the economic costs of delayed justice, it would not be difficult to accept that direct and indirect effects reduce GDP growth by 0.5% to 1% per annum – and that may be a serious underestimate.

The effect of this slower growth in terms of human cost of unemployment - and consequent poverty, and unrealised potential of Indian youth needs serious soul searching. Besides economic costs, demonstration effects of unscrupulous behaviour going unpunished results in erosion in faith in rule of law and leads to distortions in social behaviour and ethics that are far reaching.

Simple solutions can help

In the current calendar year, the Supreme Court was on “vacation” for 7 weeks – from 13^th May till 30^th June – (13.5% of the year). Other courts too have similarly long vacation periods. This is a colonial vestige and can be immediately removed.

While judges often lament the lack of resources and infrastructure, courts can utilise existing infrastructure in two shifts and manage the court calendar better to avoid having to postpone hearings repeatedly. Studies have suggested the need for special courts to take up cases of similar nature or requiring detailed domain knowledge. These can be implemented without significant cost or effort.

Other more elaborate methods have also been suggested by Judicial reform commissions. However, the urgency with which reform needs to be implemented is sorely lacking. Perhaps judges too need reminding that like politicians, they exist to serve the masses, not rule them!

Corruption and Economic progress

2013-12-24T18:34:00.000+05:30

My column for Wealth Insight Dec issue - here.The unedited version is below:

The scourge of corruption

N Vittal, former Central Vigilance Commissioner, in a recent book titled “Ending Corruption: How to Clean up India”, defines corruption as “the lack of integrity – whether intellectual, moral or financial”. International studies indicate that India falls among the bottom half of countries in the world in corruption rankings. Corruption reduces competitiveness of industry, leads to lower investments, misallocates capital, and increases income disparity – among other effects.

Measuring corruption – usually based on surveys

One of the key challenges to empirical research in the area of corruption is an appropriate measure of corruption. During the nineties, three different groups of measures appeared – indices like the International Country Risk Guide (ICRG), and Business International (BI) that were based on assessments of country experts. The next group were based on surveys of business people or the local public – these included indicators tracked by World Economic Forum (WEF), or the World Development Report (WDR). The last group was a set of “poll of polls” – the “Graft Index” of World Bank or Corruption Perception Index (CPI) of Transparency International. Given its amorphous nature, corruption measures tend to rely on surveys.

Survey of attitudes of Indian corporations

Between March and May 2013, E&Y along with FICCI conducted a survey among Indian businesses, and foreign companies operating in India. This survey was supplemented by inputs from private equity investors. The target companies surveyed had incomes between Rs5000crs, and Rs10,000crs. The report estimates that between October 2011, and September 2012, corruption related cases reported in the press (excluding large scams like 2G, commonwealth games and mining) led to potential loss to the Indian economy to the tune of Rs36,000crs.

Some of the report’s conclusions bear repeating:

- “Strain on ethical behaviour: Alarmingly, a large number of respondents appeared to be comfortable with (or were aware of) unethical business conduct, including irregular accounting to hide bribery and corruption, gifts being given to given to seek favours and third parties being used to pay bribes.

- Taking the easy way out: More than half of the respondents agreed that it is the lack of will to obtain licenses and approvals the “right way,” which leads to bribery and corruption.

- Need for greater enforcement of laws: Around 89% of the respondents felt that there should be greater enforcement of laws to curb the proliferation of bribery and corruption.”

The survey further goes on to point out that 44% of the respondents were in favour of legalizing “facilitation payments”.

The other end of society

Centre for Media Studies (CMS) – a not-for-profit think tank, has been studying corruption in India over years. In 2012, CMS revealed its 8^th study in the series - focused on slums and basic services availed by residents of slums – and the amount of bribes to be paid to receive such services.

The figures speak for themselves. The incidence of corruption is high, but more disturbingly has doubled over the period 2008-2012.

A lack of accountability

Vittal, in his book, identifies a lack of accountability as a key factor behind poor governance in India. He gives an example of dysfunctional governance – where policies, while existing, are not implemented. He states - “An example .. is the Benami Transactions (Prohibition) Act, enacted in Sep 1988. Section 5 of the Act says that benami property will be confiscated by the government. Section 8 says that the government will prescribe the rules under which the confiscation will take place. … Over 20 years have passed, and the government has still not issued such instructions.” He goes on to add that when he was CVC, he wrote to the Secretary of the revenue department requesting that the rules be framed. He received no response.

The most corrupt sectors

Chart: Sector wise corruption heat map

The E&Y survey referred to earlier, asked respondents to rank sectors based on perceived level of corruption. It is no surprise that sectors rated as most corrupt were those where government interface was the highest. Lowering government touch-points is definitely a way to reduce corruption.

Investment take-away

While making investment decisions, investors are forced to rely on financial statements as a source of information of how a company is performing. What happens when that document itself is not reliable? In the case of corrupt sectors, businesses, by their own admission tend to distort financial reporting. If a management is willing to color the accounts to adjust for bribes paid, is it likely that they will represent a true and fair picture in the account books for minority share-holders.

The irony is that even institutional investors who should know better are all too often prone to look the other way. The survey notes that “Around 93% of the respondents representing PE firms indicated that accounting fraud is the most common fraudulent practice observed in India.” Despite this, “73% of PE respondents’ organizations do not conduct anti-bribery and corruption due-diligence before investing in enterprises.”

As investors, it is important to realise that “audited” statements do not necessarily mean a true picture of a company’s health. Investing in real estate companies is, for example, more a macro call on the sector – rather than a careful analysis of the financial statements. The financial statements reveal nothing of importance – only a carefully crafted story that the management wants investors to see.

Correction has to start from the top

As India enters into another set of elections – first for state legislatures, and then for Parliament, it is important to realise that each one of us is impacted by corruption, and in most cases, negatively. If leaders we chose are honest, the system will start to correct itself. Each one of us has a stake in a corruption free country. When voting, as in investing, choose carefully and avoid the rotten apples.

A meeting of opposites - the nobel prize in economics

2013-12-24T18:26:00.002+05:30

My column for the Nov edition of Wealth Insight - here. The unedited version is below:

This month, the Nobel prize for economics was jointly awarded to Eugene Fama, Lars Hansen and Robert Shiller. In itself, the award to three economists is not comment worthy. What makes it interesting is the combination of individuals and the ideas they represent. Fama and Shiller represent opposite views on how prices of financial assets are formed.

The Chicago Tradition

Between 1940-43, Friedrich Von Hayek, an economist at the London School of Economics, wrote a book – “The Road to serfdom”. Having watched the takeover of Vienna by Nazi Germany, this book outlined his opposition to “Big government”. In the book, Hayek says “when economic power is centralized as an instrument of political power it creates a degree of dependence scarcely distinguishable from slavery.”

The book was published by the Chicago University in 1944, and became the basis of “libertarianism” which found its chief proponent in Milton Friedman. Along with a group of friends, Friedman went on to form the “Chicago School”. Friedman believed that markets worked better than governments. Over time, the Chicago school started to believe that markets were “perfect”.

Fama and Efficient Markets

Fama arrived in Chicago as a MBA student in 1960 – and started work on stock price movements. His initial work was statistical – exploring the statistical distribution of stock price movements. Fama soon proposed that stock price movements were random – and that any non-random movement would be arbitraged away by traders so that any non-random patterns were essentially fleeting. He argued that “the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value.” He called this the “Efficient Market“.

In 1964, Lawrence Fisher and James Lorie published a study covering data over 34 years – anyone who bought all stocks in the New York Stock Exchange and reinvested dividends would have earned 9% post costs over those 34 years. Subsequently, they demonstrated that a randomly selected assorted portfolio also performed as well. Monkeys with darts were as good as mutual fund managers. The markets were indeed efficient – and all available information seemed to be in the price.

Fama went on to teach portfolio theory and came across the work of Markowitz and Sharpe. He quickly realised that the Capital Asset Pricing Model (CAPM) was the model that proposed the economic theory of how stock prices moved – leading to efficient markets.

The analysis that mutual funds and fund managers rarely beat markets – especially after costs, led John Bogle to form the Vanguard Index fund. Indexed investing had come to the markets.

Behavioural Finance and inefficient markets

Later research into economic behaviour of individuals revealed that choices made by individuals were not all rational or “efficient”. People avoided certain loss while being willing to bet on uncertain gain. Somehow, efficient markets demanded that despite each individual decision being irrational, the collective was always rational. This was difficult to explain. Shiller, a PhD from MIT, started to test assertions of efficient markets. He found for example, that stock prices that were supposedly determined by future dividends, were way more volatile than the dividend paid. They were also more volatile than earnings, demand, replacement cost – or any other fundamental parameter. The “rationality” hypothesis of the market had no explanation for this volatility.

Shiller asserted that the leap from observing that stock prices were difficult to predict to that they were right, was “one of the most remarkable errors in the history of economic thought”. Lawrence Summers a Harward economist, constructed an alternate finance universe where investors weren’t rational and prices did not reflect economic fundamentals. He was able to show that over a simulated 50 year period, no test could determine statistically the difference between the two market constructs – real market vs simulated market. Summers at a speech to finance professors said “Financial economists like Ketchup economists work only with hard data and are concerned with the interrelationships between the prices of different financial assets. They ignore what seems to many to be the more important question of what determines the overall level of asset prices.”

Slowly, the realization that markets could remain inefficient for long periods was being accepted by academicians. Fischer Black in a lecture titled “Noise” said that noise made financial markets possible but also imperfect. Without noise, prices would stay at their fundamental value and there would be no trading. Unfortunately, noise also made the detection of fundamental value impossible.

As computers became more powerful, more instances of statistically significant “inefficiencies” started to be discovered. Some indicated that trends tended to persist – stocks prices continued to trend in one direction more often than random moves would imply. When corporate earnings differed from expectations, it took a while for the price to reflect the new expectations fully. The January effect and the “small stock” effect were also persistent.

Confronted with this data, Fama modified the CAPM to bring in factors other than just market moves to explain price behaviour. These were the 3 factor and 4 factor models. However, these turned out to be cases of data mining. Perhaps there was something to beating the market after all.

The Nobel committee in its press release summarises it thus “There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller....The Laureates have laid the foundation for the current understanding of asset prices. It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions”. The search for a perfect market model continues.

Inflation indexed investment – finally a possibility

2013-10-16T13:28:00.000+05:30

My column for Wealth Insight Sep edition

The RBI witnessed a change of guard on the 4^th of September with Dr. Rajan taking over as the new Governor. His first statement as Governor outlined a time bound policy program that enthused markets immensely. For the average retail investor though, the relevant point of interest was a mention that a new series of Inflation indexed government securities would now be issued – which would be linked to the Consumer Price Index (CPI) rather than WPI (wholesale price index).

This is indeed a big difference. In the past, the government has attempted to issue inflation indexed bonds (IIBs) several times but not met with success. Even the issuance earlier this year, while ostensibly a success, did not excite retail participants. After all, households are interested in insulating themselves against inflation as they see it – not as the government would like them to see it. The pedantic argument that WPI is computed more often than other inflation indices is not likely to cut ice with any investor who is receiving a return based on a number which is roughly half of what he actually experiences.

The mechanics of IIBs

In a normal bond, investors take a risk on inflation and interest rates. For example, investors have no incentive to buy a government security yielding say 8% today, with CPI at 9%. The investor has no incentive to save. Additionally, if inflation were to rise to say 9.5%, the saver would be further penalized. This behaviour forces investors to seek higher yields in real assets – gold and real estate – as we have indeed witnessed over the past few years.

IIBs offer an investor a “real” return on investment. The bond is initially issued with a face value of say Rs 100. The coupon rate would be a “real rate”, say 2%. If the CPI for the quarter is 9% annualized as in the example above, the interest rate of 2% would be computed on Rs102.25 i.e. Rs(100+0.25*9%). The face value at the quarter end would now stand at Rs 102.25. In other words, the inflation is factored into the principal, while the interest is paid on the enhanced principal.

The long term investor does not need to worry about the direction of inflation – since the position is hedged. Interestingly, it is possible that if inflation falls below zero (yes, it can), i.e. price levels start to fall, the bond principal would be adjusted downwards. In theory, it is possible that the bond may not repay the entire principal on maturity – if negative inflation persists. However, in India this is unlikely. Additionally, RBI has structured the bonds in a manner that in the unlikely event of this occurring, the investor still receives the principal back.

Nirvana or...?

When it is too good to be true, it usually is too good to be true. Let’s look at cases where the bond may not offer great value to investors.

In an environment where inflation rates are already high, and are likely to fall, an investor may be better served buying a fixed maturity instrument (a la FMP) which offers a high fixed rate. As inflation falls, the yield on the FMP may turn out to be higher than on the IIB – despite the real return. IIB’s therefore may make more sense in a rising inflation scenario especially where the interest rates are unnaturally subdued by government or RBI action.

Another key dampener is the presence of institutional investors subscribing to IIB issuances. RBI issued IIBs in Q1 of the current fiscal where institutional investors were expected to bid for bonds to determine coupon rate. Many such investors are entities controlled by government. This automatically skews the bids in a direction that suits government – lower payouts – the exact opposite of what suits the retail investor. If RBI is serious about involving retail households and offering them a real protection against inflation, it needs to be honest about the cost of doing so.

The tax angle

A possible confusion could be taxation on these bonds. RBI has clarified that IIBs are not tax free. However, it is not clear whether the increase in principal as a consequence of inflation indexing will be treated as capital increase or as income in the year.

The assumption is that only coupon will be treated as income, while the rest goes as capital and is treated as capital gains at the time of redemption. Since indexation is allowed while computing capital gains, for the sake of consistency, the tax indexation should be the same as that used in modifying the principal. In such a case, there should be no tax on redemption. This is not likely to be the case. The income tax authorities will likely use their own series for inflation adjustment, which will, in all probability, be lower than the adjustment factor applied to the bond – resulting in some capital gains.

Alternately the principal adjustment could be treated as income in the year of accrual. In either case, IIBs are no less tax efficient compared to tax on a comparable bond, in the first case, they are significantly better. Tax efficiency may be higher in the case of a debt mutual fund though – and this is something that could worry the retail investor. An early clarification on this would help.

An alternative to gold

Assuming that there are no attempts to downplay CPI, and investors trust that they are indeed protected against inflation, CPI indexed IIB’s are probably the most potent step that the government has taken to reduce Indian household’s love for gold. Quantitative restrictions or higher tariffs – both of which have been introduced - have a tendency to push the gold trade underground. Offering positive real interest to investors will go a long way in restoring viability of financial savings in the portfolio of Indian savers. Of course, this calls the bluff of all those who have been advocating lower interest rates – despite persistent negative real interest rates.

IIBs, if widely traded, offer a precise way to measure inflation expectation of investors. This, in theory, is supposed to push governments towards greater fiscal prudence – since the market signal will set the tune for other forms of government financing as well. If heeded, this would indeed be a great step. IIBs have the best chance of inducing genuine retail interest in government securities market. Let’s hope they work.

Forecasting – The art of being precisely inaccurate

2013-10-02T09:51:00.000+05:30

My column in the Economic times on the 30th of sep

The unedited version is here :

Of late, equity markets have behaved as someone with a multiple personality disorder – euphorically up one day, manically depressed the next. Much of this movement is attributed to market moving policy pronouncements. Equally, volatility arises when key economic numbers are released.

Talking heads on TV often attribute market moves to differences between forecast economic numbers (in particular, GDP growth and inflation) and the “actual”. But are the forecast figures really useful for market participants?

What makes a good forecast?

An obvious requirement for a good forecast is its “accuracy” - how good was the forecast compared to the actual outcome? Since the “event” is yet to occur, another important consideration is if the forecast is “honest”. In other words, was it the best prediction the forecaster could make when making the forecast, or was it deliberately coloured or biased. A third factor could be the “value” of the forecast – did it convey information that was useful in making decisions.

Understanding predictions

When dealing with the future, we deal with probabilities. In making a forecast, the forecaster deals with multiple scenarios, and, either explicitly or implicitly, assigns a probability to each scenario. A “point forecast” –a weighted average of future expectations – is, usually, less useful. An old joke goes – a statistician drowned while crossing a river that was three feet deep on average! Making dramatic statements with high degree of certainty makes for good television, and studies show that “bold” predictions make for better entertainment. They certainly do not guarantee greater accuracy though, or help in better decision making.

A wide distribution of possible outcomes best represents the uncertainty inherent in the real world. Our minds however tend to regard probability based forecasts as somehow not so satisfying –as if the forecaster is “hedging” his bets.

Professional Forecasting – dismal performance

Starting 2007, the Reserve Bank of India conducts a survey of professional economists. Those surveyed offer forecasts for a number of macro-economic variables. These forecasts are made every quarter, and the RBI publishes the results on its website. Among other variables, the professional forecasters offer their estimates for GDP growth, its key components, and inflation.

The forecasts for GDP are made in the form of a probability table. RBI combines the forecasts to yield a min and max forecast range, as well as the median. The picture summarises GDP growth forecasts made in April-May for the next 12 months for every financial year since the survey started.

A quick glance reveals that forecasters do not cover themselves in glory. In each of the 5 years where data is available, the actual GDP growth is outside the maximum-minimum range forecast. Take a minute to digest that – it is not just different from the median, it is outside the forecast range – and in many cases by a wide margin.

Governments own forecasters – even worse?

The prime ministers economic advisory council (PMEAC) too, makes estimates for the same figures twice a year. Unfortunately, it offers a “point estimate” instead of a range. While this gives the perception of being more decisive and accurate, as the table shows, their track record is equally poor – with some estimates having an error of over 10% from the actual - when made only 30 days before the end of the financial year!

GDP Growth
Date Of PMEAC Report				Forecast for	Actual
Outlook		Review
30-Jul-08	7.7	Jan-09	7.1	Mar-09	6.7
Oct-09	6.5	Feb-10	7.2	Mar-10	8.6
Jul-10	8.5	Feb-11	8.6	Mar-11	9.3
Jul-11	8.2	Feb-12	7.1	Mar-12	6.2
Aug-12	6.7	Apr-13	5	Mar-13	5
Aug-13	5.3			Mar-14

The one redeeming feature is that forecast directions seem to be correct – each subsequent forecast moving in the direction of the eventual number.

Important forecasts, but with spurious accuracy

Economic forecasting is important in that the forecast can itself affect the outcome as policies are adjusted to move the economy in the desired direction. What causes these forecasts to be as poor as they are?

Assuming that forecasters are not wholly incompetent, forecast errors can arise out of three possible factors–

(a) data used to make forecasts is of poor quality. Remember, revisions to the final GDP growth continue for almost 2 years – and advance estimates are notoriously poor. This calls in question the importance attached to near term data. When RBI/government say that they will formulate policy basis data, it is only fair to ask – what data?

(b) forecasts are biased. This is also a real possibility. Median forecasts tend to cluster around the 6%-8% growth. Forecasts are understated in years of high growth and overestimated in those of poor growth. There is a visible tendency to cluster around the “centre”. It seems no one wants to rock the boat. But then, this “conservatism” also reduces the value of forecast in policy formulation.

(c) models are poor – an economy is a dynamic system feeding on itself and other external stimuli. Models attempting to replicate economic performance have to factor in a large number of inputs. Additionally, models are likely to be susceptible to “initial conditions” – which themselves may be sources of errors.

In all cases, the important point that the investor needs to note is that market volatility caused by data releases is largely unwarranted. It provides the patient investor an opportunity to make abnormal gains by betting against short term moves. It is important to remember that the apparent accuracy of most economic numbers is a mirage – and the best one can use them for is to determine the direction of the trend.

The nuclear mess continues

2013-09-23T00:26:00.001+05:30

News reports in the last few days indicate the current government's penchant for bending all rules continues unabated. The government is in a hurry to sign up a deal with the US nuclear suppliers without due diligence. And, apparently, at the cost of signing an illegal agreement.

Chellaney tweeted about an article published at www.project-syndicate.org which yet again reveals the lack of logic in pursuing nuclear power. But then when was logic the strong point of the current dispensation

The dragon kings of Didier Sornette and the skill of predicting financial bubble bursts

2013-09-05T12:12:00.001+05:30

This article was carried in the economic times on 2nd august

Chances are you have never heard of Didier Sornette. Chances are that the next time you hear of him, you will be significantly poorer – unless you listen to what he says now!

Sornette is Professor of Entrepreneurial Risks at the Swiss Federal Institute of Technology (ETH Zurich). His research focuses of the prediction of crisis and extreme events in complex systems. His work covers earthquake physics, dynamics of success on social networks, and complex system approach to medicine. However, the part that attracts market attention is what he does at the Financial Crisis Observatory – which is – to test the hypothesis that financial “bubbles” can be diagnosed in real time and their termination predicted probabilistically. In other words, he attempts to find when the next big fall in the financial markets can occur.

The term “bubble” refers to a situation where excessive future expectations lead to rise in prices. Sornette identifies speculative bubbles as arising from a confluence of two factors – factors that drive initial demand – say, new technology, or perception of reduced market risk. This is followed by “amplification mechanisms”, where large increase in asset price is followed by higher demand as investor think that further large increases in price will follow. This “super-exponential” acceleration in prices due to a positive feedback (or “pro-cyclicality”) leads to formation and then maturation of a bubble in finite time.

In other words when expectations of growth rate itself grow, it leads to instability. Recent examples have been the crash of 2008, and the technology burst in 2000, among others. In Sornette’s world, the cause of the crash is unimportant. His research suggests that crashes have an internal origin – the unrealistic rise in expectations – and external factors only serve as catalyst for the subsequent burst. So why is all this important?

Of Black Swans...

In 2001, Nassim Nicholas Taleb, quantitative trader and academician published a book “Fooled by Randomness” where he outlined the theory of “Black Swans”. Taleb described “Black Swans” as events whose probability of occurrence was mathematically very low (like finding a black swan in a bevy of white swans). Taleb explained that these events occur with higher frequency than theory predicted, were hard-to-predict if not impossible to predict, and caused events of significant consequence and magnitude.

... and Dragon Kings

Sornette, on the other hand, makes an entirely contrary claim. Not only can he predict the probability of a bubble bursting, he can do it with remarkable accuracy and of course, before the event! He calls these “outlier events” as Dragon Kings. The graphs below show the predictions of the S&P500 US Index, and oil prices – made before the crash in 2007-2008. Similar other graphs can be found on the website of his Financial Crisis Observatory.

A matter of modelling

The broad basis of the prediction is based on “power law”. Most models of market prices use the “normal” distribution to model price behaviour. This model underestimates risk. Studies suggest that a better model, especially when markets are leveraged – which they often are – is to apply the power law.

Sornette’s model looks for “out-of-control” growth in asset price that vary from the power law. “When herding behaviour among investor’s ramps up, a stock’s or index’s growth rate can increase faster than exponentially, leading to more herding. This positive feedback brings the system to a tipping point. About two-thirds of the time, a crash results”, says Sornette in a paper in 2009.

To break away from allegations that his forecasts are self-fulfilling – after all, market participants who believe his forecasts are likely to start positioning themselves accordingly, Sornette’s team now makes forecast which are released in encrypted form on a website with a public key to decode the paper after the forecast period. . His most recent prediction was a “”Sell” signal on 21 May 2013 on the S&P500, when his Crash Risk Index jumped up (see graph). The market was down 9.5% in a month after that.

Sornette recently made a presentation at TEDGlobal 2013 – a talk worth viewing (http://www.ted.com/talks/didier_sornette_how_we_can_predict_the_next_financial_crisis.html). The upshot of the presentation and the subsequent interview (http://blog.ted.com/2013/06/17/turbulent-times-ahead-qa-with-economist-didier-sornette/)

is that he continues to foresee bubbles in financial and insurance sectors, as well as construction and realty sectors in the USA – the very same sectors that led the burst in 2008 in the first place. Ironically, the success of a model can also lead to its demise as participants adjust their behaviour to include the forecasts of the model. Till this happens, Sornette’s research needs to be taken seriously.

Funding the current account deficit - focus on the real economy

2013-08-20T22:21:00.001+05:30

My column for "Wealth Insight" for July 2013. It was a follow up on the earlier theme.

Rupee weakness continues

In July, a desperate RBI allowed asset financing non-banking financial companies (NBFC’s) to raise external commercial borrowings (ECB’s) under the automatic route for financing import of infrastructure equipment. This comes as part of a series of moves by the government and the RBI to raise foreign resources. The rupee continues to remain under pressure.

Earlier moves to “allow” investments in Indian debt have boomeranged. Starting in Jan 2013, India increased the limit for foreigners seeking to invest in government debt in India. Instead, by the end of June, foreigners had withdrawn $1.2bn from Indian debt in the calendar year. Most of the outflow happened in June. The rupee fall was collateral damage, but once it started, it added to the panic and the outflow. The government has blamed the current account deficit for the falling rupee, but is that the whole story?

A look at the theory

A country’s current account is defined by the following equation:

Current account = (private savings – Investments) + (Tax – Government expenditure)

If the government runs a fiscal deficit i.e it spends more than it earns as taxes, it has to be financed either by a fall in investments (for a given level of national income/savings) or, the country will run a current account deficit(CAD). In other words, domestic consumption has to be financed by foreign inflows. This in itself is not a problem. Countries like the USA and Australia have managed persistent CAD’s without negatively impacting growth rates, or pressuring their currency. India too has had many years of CAD without the rupee depreciating. Of course, these years had increased inflows from invisibles or investments.

Fiscal deficit too is not always bad. In fact for developing countries running below full employment of resources, it can be argued that the government can increase growth rate by running a deficit. Indeed, it must. In effect, an economy operating below potential will benefit from government spend and foreign investment. India has for long run these twin deficits. So why are the policy makers acting as if they have been caught unawares?

Perfect vision – imperfect solution

In 2010, the ministry of commerce put out a strategy plan and a paper. The paper was titled “Strategy for doubling exports in the next three years”. In it, the ministry, assumed that near term trend growth of exports and imports would continue. Based on this, it forecast that India would have a negative merchandise trade balance of $210bn by 2013. This has proved remarkably accurate (the actual figure is $196bn).

Interestingly, the paper also identified areas where India would have to improve to increase its exports – necessary to avoid pressure on its currency. To quote “Infrastructure bottlenecks remain the single most important constraint for achieving accelerated growth of Indian exports”. Specifically, it identified a shortage in port capacity of 600 Million MT, 4400kms of 6 lane and 66000 km of 4 lane highways, 750 million tons of cargo handling capacity by the Railways. The other areas noted for improvement were bilateral trade agreements, lowering of transaction costs by simplifying compliance and regulatory requirements, and a stable policy environment.

Anyone following the developments in the economy over the last few years would be aware of the lack of forward movement on most of these identified problems. In fact, significant problems have since been created, among them the uncertainty of application of tax laws to foreign investment transactions. The end result is seriously eroded investor confidence and investment climate. It is noteworthy that the likely pressure on the rupee was identified as a problem over 3 years ago, and the current blame attributed to the US Fed action is only perhaps a trigger for the inevitable. The real problem is high CAD and a decline in invisibles.

Trade Deficit worsens while invisibles decline

Government focussed on “foreign money”

Of late, it is rare to hear any pronouncements from the finance ministry without it being focussed on foreign direct investment (FDI). Ignoring the findings of the commerce ministry outlined above, North Block continues to believe that all that is needed to remove the pressure on the rupee is to raise FDI limits across various sectors. This appears a “solution” reflective of a mindset of a “command” economy. With India’s “growth story” seemingly in the past – “permission” to invest is no longer the constraint for international investors – “reason” to invest is!

Even this “liberalization” comes with micro controls. Having risked becoming a minority government by pushing FDI in single brand retail, the government has managed to ensure that there is not a single credible proposal for investment on the table. Among the most difficult to understand requirements in this case, is that foreigners cannot invest in an existing venture. If allowed, the local entrepreneur would release capital - which would have the same effect as foreign investment in fresh capacity. For some, money is not fungible. Perhaps “our” money is not as green!

Lack of consistency in policy and a persistent “central micro planning” mindset will ensure that the economy performs below par. Undue focus on financial markets while completely ignoring the problems of the real economy is not likely to make India an investment destination of choice. The faster our government understands this, the better for our unemployed millions.

Selling Government Bonds

2013-08-18T00:03:00.000+05:30

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.

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

2013-06-25T23:21:00.001+05:30

My latest column of the 24 Jun in the Economic Times

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

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

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

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

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

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

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

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

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

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

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

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

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

2013-06-22T22:18:00.001+05:30

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

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

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

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

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

Assuming that actual growth achieved by Sensex companies in FY14 is closer to 10%, the market appears to be trading at 15.5 times current year's earnings. This does not seem particularly challenging given a falling interest rate scenario. Against a historic trading band of 12 times to 18 times, the market currently seems to be priced in the middle. Coupled with the wall of global liquidity, it is not surprising that the market seems to be reaching for new highs.

HOPES, NOT REALITY
The opposite argument is equally easy to make. At 10% growth, earnings are slower than trend. Consequently , valuations too should remain below trend. Earnings yield at 7% and growing slowly are not much more attractive compared to debt yields of 7.5%. Debt too will yield capital gains if interest rates were to continue their downward journey. Equity risk is not being paid for.

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

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

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

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

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

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

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

The author is the CEO of a financial services company. Views are personal.

Gold – a tale of two priorities

2013-06-16T18:34:00.001+05:30

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.

Low brokerage alone will not bring investors

2013-04-20T00:22:00.000+05:30

My interview in Business Line yesterday. Since this is based on a face-to-face interaction, I have been quoted in brief. I am reproducing the article with some additions to clarify what I mean:

The regulator has made a major disservice by making exchanges ‘for profit’ organisations. — Anand Tandon, CEO, JRG Securities

The Government and capital market regulator SEBI’s effort to attract retail investment in equities has had little impact. Retail investors have incurred huge losses in the last few months. Even as broking firms are trying to woo retail investors with low brokerages, exclusive research reports and stock recommendations, the wild swing in the stock market has scared retail investors. The capital market is dominated by foreign institutional investors and domestic institutions, and needs a major overhaul to gain investors’ trust, says Anand Tandon, CEO, JRG Securities, in an interview with Business Line.

Excerpts:

Why are retail investors shying away from market?

It is actually a simple problem, but also extremely complex. It is simple, because an investor will invest if there is a chance of making money. If eight out of 10 times he makes money, the possibility of losing twice is acceptable. On the other hand, if you loses eight times and make money just twice it is not acceptable, even if you hit a jackpot twice and cover up all the losses. Essentially, retail investors have not made money.

What has changed dramatically for small investors in the market?

Intense competition. In fact, the regulator has made a major disservice by making exchanges ‘for profit’ organisations. The original function of exchanges was to provide people access to capital. As opposed to that, today, as a ‘for profit’ organisation, exchanges provide liquidity pools. In the process, they create their own transaction charges. With new exchanges coming in, there is no proportionate increase in liquidity. The liquidity pool is getting divided. So, there is more and more illiquidity.

What is the impact on market intermediaries?

The competition among exchanges will have a trickle-down effect on market intermediaries. Some 20 years ago, one had to shell out Rs 4.5 crore to become a BSE member. Today, you do not even need Rs 45 lakh. An investment of Rs 4.5 crore would have become Rs 20 crore, even if it was invested in a safe product. But by bring in more exchanges, you have to pay Rs 10 lakh deposit, and become a trading member. Essentially, my investment of Rs 4.5 crore 20 years back, is equivalent to Rs 45 lakh today.The entry barriers are lower, resulting in poorer quality of new members

But competition is good for investors …

It is true to a certain extent. However, If there is such a plethora of intermediaries in the market, clients will be induced to trade more. Effectively, the market will become more short-term in nature. Providing a quality service will become a big challenge. If my competitor is willing to provide a trading account for free, I will need to match it. Of course, the compliance cost has gone to the roof.

We have to provide the infrastructure, dealing terminals, telecom backbone, and watch through every trade and keep records for eight years. The return I get is decided by the next door mom-and-shop competitor. I feel we have got into this vicious trap of over capacity. Consequently, brokerages have gone to the suboptimal level. There is no incentive for providing advisory services which will benefit investors.

What is the remedy?

In the interest of banks, the RBI can restrict banks from competing on certain services offered by them. Public insurance companies are not allowed to under cut. The Aviation Ministry, which has no business of regulating tariff, can express its concern to airlines about under cutting prices. Why does SEBI not monitor the fees charged by intermediaries, so that service quality is maintained?

Lower charges are beneficial for investors. Isn’t it?

No, not always. Take the case of the power sector. All the companies have bid the lowest price at which they can supply the power. Now, they are struggling to fulfil their commitment. Lowering brokerage charges alone will not bring retail investors back. There was a time when you could not charge more than 2.5 per cent.Now, even 2.5basis points is difficult to retain. Development of the market cannot be done in the absence of intermediaries.

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

2013-04-16T18:01:00.001+05:30

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

The unedited version (less dramatic) is below.

The future of money

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

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

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

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

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

Bitcoin – digital currency

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

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

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

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

Why now?

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

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

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

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

Bitcoins - the glitches

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

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

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

The Promise of Power

2013-04-03T00:53:00.000+05:30

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!

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

2013-03-28T11:45:00.001+05:30

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.

BIG Pharma and costly medicines

2013-03-10T11:23:00.001+05:30

Zerohedge carried an article on medicines in Greek and the role of BIG Pharma - reported here. The first paragraph is reproduced below:
________________
Greece is facing a serious shortage of medicines amid claims that pharmaceutical multinationals have halted shipments to the country because of the economic crisis and, as The Guardian reports, concerns that the drugs will be exported by middlemen because prices are higher in other European countries. Rubbing further salt into the Greek (un-medicated) wound, the Red Cross slashed its supply of donor blood to Greece because it had not paid its bills on time. Pharmacies in Greece describe chaotic scenes as clients desperately search from shop to shop for much-needed drugs. Greece's Pharmaceutical Association said "around 300 drugs are in very short supply," adding that "It's a disgrace. The companies are ensuring that they come in dribs and drabs to avoid prosecution. Everyone is really frightened." The fear for the multinationals remains that wholesalers can legally sell to other nations at higher prices and a "combination of Greece's low medicine prices and unpaid debt by the state." Lines form early and 'get very aggressive' one pharmacy exclaimed, "We have reached a tragic point."
_________________
Recently, the "Intellectual Property Appellate Board (IPAB)" in India upheld the grant of compulsory license of a Bayer drug to Natco. Some more licenses are in the pipeline. However, what comes as a surprise is the attempt by the government to set up another committee for pricing drugs - which may effectively put a stop to this licensing. Is this a case of success of foreign lobbying. Already, price of drugs in India have risen steeply. It would indeed be unfortunate if another scam were brewing in as essential commodity as medicine.

Figures seem credible but what about the emphasis?

2013-03-03T23:57:00.002+05:30

My budget comment in DNA - the edited version. The unedited view is below.

The budget, as an exercise in accounting credibility, seems better than many in the recent few years. If we were to accept for a moment, the assumption that GDP growth for FY14 will exceed 6% (as forecast by the economic survey), a 15% increase in excise collection, or a 17% increase in corporate tax made in the budget does not appear to be very challenging. Some figures seem optimistic – a 35% increase in service tax, high growth in divestment and dividend income and high telecom license revenues. However, this is nitpicking. Largely, the budget seems to have a reasonably consistent set of assumptions – so where is the nub?

The issue seems to revolve around the question of growth. While it may be credibly argued that the budget is not expected to resolve all policy problems, one usually looks at the budget more from the point of view of the stated goal of the fiscal policy and not just from the prism of numbers. This is where budget fails to provide an inkling of government’s plans to increase growth. Why will growth rate go up – other than because it will?

If resumption of high growth is a major concern and the private sector is not investing, would it not be logical to increase government spend on capex? Instead, we see government reducing capital expenditure in the current year by 22% lower than the budgeted amount. Why the excessive focus on fiscal deficit in a cyclically weak year? The argument that interest rates will go up have been proven to be untrue – we continue to have negative or near zero real interest rates. And, inflation remains high because of government policy of passing on price of its inefficiency to the public.

The economic survey itself is confused on its understanding on interest rates. At one point, the survey states that household savings in financial assets have fallen since inflation reduces attractiveness of financial instruments and suggests that inflation linked bonds should be introduced – a suggestion which the finance minister too takes up. This would imply that interest rates should go UP.

However, the survey promptly then blames high interest rate for lower investment by the private sector. The survey itself admits that private investment is down because of Rs7500bn worth of stalled projects. “Analysis of 20 individual projects (making up 70% of the total cost of the shelved projects) suggests difficulties in land acquisition, coal linkages, and mining bans as major causes.” None of this suggests a problem with interest rates. Presumably, since this seems an implied criticism of government’s inability to frame workable policies, the problem must be laid at that door of monetary policy.

To borrow a term from Paul Krugman, the “confidence fairies” have made their way to India as well. Somehow, unless the fiscal deficit is contained, interest rates will go up – despite evidence to the contrary. So the path to growth remains shrouded in mystery.

Overall corporate earnings growth is likely to be downgraded by a couple of percentage points to accommodate the increase in surcharge and other changes in tax rates proposed. This will likely reduce sensex earnings estimates to below 1400 for FY14. With little likelihood for a rapid reduction in nominal interest or inflation in the near term, markets will continue to be in the grip of global shifts in risk perception. Unless we have more and better policy action following, the outlook for equity in the current year continues to remain subdued.

Energy – elixir of the economy

2013-02-17T17:48:00.000+05:30

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.

Welcome - the new year

2013-02-16T20:13:00.001+05:30

This article is rather delayed - I had written it for Wealth Insight Jan edition.

The equity market sentiment has suddenly turned bullish over the past few months. Unrelenting foreign inflows have pushed the nifty to deliver a >25% gain in the current calendar year. Readers of this column will recall that I had laid out a framework in the mid year which had pointed to a set-up for a rally despite the all pervading gloom. It is time now to bring out the crystal ball again.

One of the problems with gazing at a crystal ball is that it soon begins to reflect the thinking of the watcher. Since forecasting depends on the assumptions made, it is important to lay out the assumptions and the consequent possible outcome. Let us therefore start with the bull story – which, as I said, is the pervading sentiment.

The “Bull”

The bullish argument is predicated on two important hypotheses – (a) a lower interest rate (b) lower commodity prices, including that of energy.

The RBI in its last two policy statements has hinted towards being more open to lowering policy rates to boost growth. This, despite the fact that inflation has remained steadfastly high and above RBI’s stated “comfort zone” of less than 7%. Expectations are that with growth slowing to sub 5% in the last quarter (projected) of the current fiscal, policy emphasis will shift from controlling inflation to propping up growth. If interest rates were to fall, asset markets including equity markets will rise.

The second argument is also linked to the first. China has been witnessing slower growth. With China becoming slightly less dependent on exports and more on domestic consumption, it is expected that commodity intensity of its economy will reduce. Additionally, in many cases, production of commodities has increased with increased investments in production capacities across the globe over the past few years.

Consequently, with the world economy not recovering, a weaker Chinese economy, and fewer production constraints, commodity prices will remain under pressure. This too will play into lower inflation. Lower commodity prices are generally good for the Indian economy which is still a consumer of basic materials, and a large importer of petroleum.

1 yr forward P/E

If both the above were to materialise, we are looking at a consensus earnings growth of 15%-16% , taking the sensex eps to higher than Rs1410 (march 2014). At that level, sensex valuation (@19350) is lower than 14x, much lower than trend level of 16x-18x. Additionally, with lower interest rates, valuations can rise, yielding a sensex target of 22560 or higher – a growth of 16%. The other factor in our model is liquidity – and the postulate here is that with Japan joining the band wagon of countries willing to print money, and Europe having given up its earlier prudery in being “modest” about loose monetary policy, liquidity will not be a constraint. The “bull” seems to be alive and kicking – or is it??

The “Bear”

The bear too seems to have sharpened claws. Let us start with inflation. Despite the best efforts of the officials (the Indian economic data is extremely prone to manipulation), inflation that a consumer sees is still above 9%. Government economists therefore tend to focus on the WPI (whole sale price index). Unfortunately, this too remains stubbornly high – and above 7%. In addition, various government officials have mentioned in passing that in the next year, there will be increases in price of diesel, railway fares (including freight), power, fertilizers and perhaps an increase in service tax and excise rates. All or any of this will be inflationary. There may be a temporary fall in inflation in Jan, but anyone willing to push the figures will see that this is not going to last even for one quarter.

RBI may succumb to the enormous pressure it is being subjected to by the government and industry and cut policy rates. In such a scenario – depending on which inflation number you look at, the real interest rate will be either negative or just marginally positive. The impact on the credibility of monetary policy will be large and negative. This in itself will be inflationary.

A cut in interest rates is not a given, and even if it were to come through, has to be restricted to a marginal cut to get hawks off the back of RBI.

As mentioned above, with rising costs, it is very difficult to believe that corporate margins can improve. Passing on further price increase to customers is going to be really difficult. Consequently, a 16% growth in earnings against a single digit growth expected till March 2013 seems to be extremely optimistic, and will likely result in a lowering of consensus estimates over the next few quarters.

The fiscal deficit has been alarming and given that we enter an election year next fiscal, is likely to remain so, government protestations to the contrary notwithstanding. The current account deficit is also high – hovering around $20 bn for the past couple of months. With oil prices showing signs of increasing again, India has only 14 months of cover for our net imports. The rupee will likely remain under pressure and this pressure will be further exacerbated if interest rates were to be cut.

Portfolio flows may not be as robust towards emerging markets as we have seen this year.

Country Performance
MSCI Index (20^th Dec 2012)	3MTD	YTD	1 Yr	3 Yr	5 Yr	10 Yr
TURKEY	16.1%	57.5%	54.8%	8.1%	-2.7%	18.4%
PHILIPPINES	11.2%	43.6%	45.2%	22.7%	7.1%	19.8%
EGYPT	-8.5%	48.2%	45.1%	-7.2%	-12.1%	24.9%
POLAND	13.2%	33.8%	33.3%	2.1%	-8.9%	10.4%
MEXICO	6.8%	28.8%	30.3%	12.4%	4.1%	17.0%
THAILAND	5.6%	30.6%	29.3%	24.3%	11.5%	19.0%
COLOMBIA	9.3%	28.1%	26.5%	18.4%	16.3%	34.2%
INDIA	0.5%	24.2%	25.4%	-1.3%	-7.2%	16.4%
KOREA	4.7%	20.0%	23.9%	10.7%	0.3%	12.1%
CHINA	12.3%	18.4%	21.0%	0.2%	-5.3%	15.7%
CHINA 50	11.3%	18.3%	20.6%	2.0%	-5.2%
TAIWAN	0.3%	12.0%	19.3%	2.9%	-0.3%	5.2%
SOUTH AFRICA	4.1%	13.3%	17.1%	8.7%	3.4%	14.3%
MALAYSIA	1.8%	9.5%	14.7%	12.4%	4.6%	11.7%
RUSSIA ADR/GDR	2.3%	9.9%	8.8%	0.9%
RUSSIA	2.4%	10.0%	8.7%	1.2%	-11.9%	11.8%
CHINA A 50	7.9%	7.7%	8.0%	-6.8%	-11.6%
INDONESIA	-0.4%	1.3%	3.0%	11.7%	6.1%	24.6%
CZECH REPUBLIC	-5.0%	-4.3%	-3.4%	-7.6%	-12.2%	15.3%
BRAZIL	3.1%	-2.7%	-4.2%	-7.3%	-5.8%	21.0%
BRAZIL ADR	3.5%	-5.9%	-5.6%	-8.9%	-6.9%
MOROCCO	5.5%	-13.0%	-17.1%	-7.2%	-8.5%	10.1%
EM (EMERGING MARKETS)	5.0%	14.9%	16.9%	3.5%	-2.5%	13.3%

Source : www.msci.com

Sitting in India, we tend to forget that our markets too move in tandem with global markets. A look at the table above reveals that performance of Indian indices not extraordinary. It is in line with other emerging markets. More importantly, the last three months of so called “reforms” have yielded far less (see 3 mtd returns) than is being attributed to it.

Money is chasing emerging markets on the basis that there is “growth”. However, with slower growth, and a possible rebound in larger markets say the US where the low price of energy seems to suggest a resurgence in manufacturing activity (theme for another column) could make asset allocation shift back to developed markets

In summary, persistent inflation, expectations of higher prices of administered goods, an out of control fiscal deficit and a persistent current account deficit put various pressures on the Indian economy. It is reasonable to expect that consensus earnings will fall. A 5% cut in consensus could imply that the market is fully priced for next December. With no expected returns from the current level, markets will have to first fall and then rise to deliver nil returns over the year.

Chose your scenario and watch the assumptions

Investing is not about being brave or even being optimistic. It is about taking a view on the possible scenarios, and positioning oneself on the basis of what is the most likely outcome. Since the outcome is based on a probability, it is important to be clear on the assumptions being made, and to see if they still hold as time passes. It is very likely that two people given the same set of data will plump for completely different outcomes. There is NO “expert” view here – only one which you are comfortable with. I currently favour the second view – chose your own – and a very happy new year ahead.

Globalising Pharma?

2013-01-06T19:23:00.002+05:30

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.

A homage

2012-12-29T23:53:00.000+05:30

Today is a sad day in India’s history. A young girl lost her life having faced the bestiality of a group of animals in the form of Man. Unfortunately, she was not alone – it is an all too frequent issue in our country. Action needs to be taken against all who were responsible, including those in power. But that can wait for another day. Ghalib wrote a poem when his cousin Arif died young. I take his words to pay my homage to the one who died.

Aaye ho kal aur aaj hi kahte ho ki jaaun
mana ki hamesha nahi acchha koi din aur

Jaate hue kahte ho qayamat ko milenge
kya khub! qayamat kaa hai goya koi din aur

Tum kaun se the aise khare dad-o-sitad ke
kartaa maluk ul-maut taqaaza koi din aur

Haan ay falak-e-piir, jawan tha abhi arif
kya tera bigarta jo na marta koi din aur

आये हो कल और आज ही कहते हो कि जाऊं
माना कि हमेशह नहीं अचछा कोई दिन और

जाते हुए कहते हो क़ियामत को मिलेंगे
कया ख़ूब क़ियामत का है गोया कोई दिन और

तुम कौन-से थे ऐसे खरे दाद-ओ-सितद के
करता मलक उल-मौत तक़ाज़ा कोई दिन और

हां अय फ़लक-ए पीर जवां था अभी `आरिफ़
कया तेरा बिगड़ता जो न मरता कोई दिन और

How much time has passed since you came into the world? It's as if you came only yesterday, and today you're saying that you're going. I agree that you won't stay forever, but stay a few days more. Why are you in such a hurry to die?

At the time of taking leave of me, you promise to meet on Doomsday. From your saying this it seems that Doomsday has not come today, but will come some other time. For me, the day of your death itself is Doomsday

if the Angel of Death presented his claim on your life, so what? It was only the first reminder. You didn't have to pay him at once, that very instant! Since when were you so scrupulous about such things? Why did you show an appalling (and uncharacteristic!) degree of scrupulousness-- all too quickly you accepted his claim, and gave your life into his power.

O ancient Sky the one dying was young, he hadn't reached his natural lifespan. If he had remained alive for some days more, what harm would it have done you?

An update on the Cash Transfer "Scheme"

2012-12-25T12:42:00.002+05:30

Touted as a "Game Changer", the direct "cash transfer" program of the government is being tested in a few locations. Some initial comments:

1. Questioning the rationale
2. The early experiment
3. What's the rush
4. Identity yes but eligibility?
5. And a view from a recent government man

As usual, the FM, given to hyperbole, ignores the negative feedback and calls it "pure magic" ! He no doubt is referring to the programs ability to make money vanish like magic !

Some interesting articles

2012-12-21T09:20:00.002+05:30

Interesting reading:

1. The Nehru-Gandhi family's track record on freedom of speech
2. The in-effectiveness of the much touted "strategic partnership" India as with the USA

And this one from last week for a lesson in the worst form of logic and for having the temerity to suggest that not being literate in English also means lack of sophistication of thought !! If only the writer had a brain !

Retail - End of the debate

2012-12-09T21:45:00.001+05:30

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.