Ref : Financial Times February 27 2009
Indian economic growth slowed to just 5.3 per cent in the last three months of 2008, its lowest growth rate in the last six years. India’s economy seems to have been hit by the global crisis far harder than our ruling politicians have thus far admitted.
The turn of events suggests that a sustained period of 9%+ growth will not be easy for India. Just because China did it for decades does not mean that we are already there.
Even though we are different from China in that we are not so heavily dependent on global trade, the parts of the economy which have generated rapid growth in the past decade, namely the IT and BPO sector are global. At the same time, in the last three months of 2008, other sectors too have not done well. Manufacturing declined 0.2 per cent, owing to insuficient domestic and global demand. Agricultural output also shrank by 2.2 per cent.
The sharp slowdown will increase pressure on the RBI to cut interest rates. Although the RBI has lowered its benchmark rate by 350 basis points in the last few months, falling inflation means real interest rates are realtively high.
But for higher government spending, growth would have been even slower. But this is not a sustainable solution. We know that government spending in our country is highly inefficient. Moreover, the government has little room for further stimulus given its already large fiscal deficit, estimated at 11.4 per cent of GDP. And even this could be an understated figure as our politicians and bureaucrats are adept at playing with numbers.
Saturday, February 28, 2009
The pitfalls of low volatility
Ref The Economist, Jan 15, 2009
Volatility refers to the standard deviation of the returns of a portfolio. Volatility contributes to risk. Prudence demands that volatility is monitored and controlled.
But low-volatility should also ring alarm bells. Is the volatility low because the fund manager is buying illiquid assets. Because such assets are traded rarely, prices do not move much.
Or has the manager adopted a strategy with highly skewed returns; lots of small gains but the occasional catastrophic loss. Nicholas Nassem Taleb, the proponent of the Black Swan is famous for this argument. For example, the manager could be selling insurance against a big stockmarket fall. Most of the time such falls do not happen. But when the market falls, the insurer may have to pay out all his previous gains. Such strategies have been described as “picking up nickels in front of steamrollers”. Recall what happened to the monoline insurers last year.
Low volatility may also be the result of fraud. Many firms try to beat profits estimates by a small amount every quarter. Indeed one of the motivations of creative accounting is to reduce the volatility of earnings.
What we need is a change in attitude among investors. Life is volatile. Economies do not grow at a steady rate for ever. Markets do not rise at a steady pace and business conditions do not allow for a smooth rise in profits. So we must acccept volatility as a given in business. A portfolio manager who is committing high returns with low volatility may well be running a Ponzi scheme.
Volatility refers to the standard deviation of the returns of a portfolio. Volatility contributes to risk. Prudence demands that volatility is monitored and controlled.
But low-volatility should also ring alarm bells. Is the volatility low because the fund manager is buying illiquid assets. Because such assets are traded rarely, prices do not move much.
Or has the manager adopted a strategy with highly skewed returns; lots of small gains but the occasional catastrophic loss. Nicholas Nassem Taleb, the proponent of the Black Swan is famous for this argument. For example, the manager could be selling insurance against a big stockmarket fall. Most of the time such falls do not happen. But when the market falls, the insurer may have to pay out all his previous gains. Such strategies have been described as “picking up nickels in front of steamrollers”. Recall what happened to the monoline insurers last year.
Low volatility may also be the result of fraud. Many firms try to beat profits estimates by a small amount every quarter. Indeed one of the motivations of creative accounting is to reduce the volatility of earnings.
What we need is a change in attitude among investors. Life is volatile. Economies do not grow at a steady rate for ever. Markets do not rise at a steady pace and business conditions do not allow for a smooth rise in profits. So we must acccept volatility as a given in business. A portfolio manager who is committing high returns with low volatility may well be running a Ponzi scheme.
Debt is no longer chic
Ref The Economist, Feb 19, 2009
In 1980, more than 60 American non-financial companies qualified for the AAA rating from Standard & Poor’s (S&P). Now there are just six. In 1987 just 38.1% of issuers in the American bond market were rated as speculative, or “junk”. In 2007 junk-bond issuers made up most of the market for the first time.
Traditionally, debt has scored over equity in the sense that it reduces the cost of capital, creates tax benefits and most importantly imposes discipline. When managers know they have to pay back the capital they have raised, they will be careful. With equity, this pressure to pay back does not exist.
But as the Economist article explains, managers’ self-interest seems to have taken over at some point. Managers started using cash to buy back equity to boost earnings per share. They also favoured debt over equity to make the share price more volatile, and thereby make the option more valuable. Debt was also often used to finance acquisitions as part of empire building, a rtrend encouraged by investment banks, which had an incentive to recommend debt issuance and acquisitions, to earn fees. While all this was happening, activist shareholders such as hedge funds put pressure on companies to pay out surplus cash.
It is only in the current recession that the dangers of debt are becoming more apparent. The default rate is now rising rapidly. S&P believes that nearly 14% of bond issuers will fail to meet their obligations this year. It is difficult to roll over new debt, given the credit crunch. Meanwhile, suppliers are insisting on instant payment from companies with weak balance-sheets.
The problem for companies is there may not be much they can do right now to rectify the situation. A depressed market is hardly the time to issue equity. Also if an equity issue is announced, the share price tends to fall. For many American companies, the share price is in single digits. And any further fall may have catastrpohic consequences. After all the share price itself is a proxy for default risk as per the well known Merton Model.
In 1980, more than 60 American non-financial companies qualified for the AAA rating from Standard & Poor’s (S&P). Now there are just six. In 1987 just 38.1% of issuers in the American bond market were rated as speculative, or “junk”. In 2007 junk-bond issuers made up most of the market for the first time.
Traditionally, debt has scored over equity in the sense that it reduces the cost of capital, creates tax benefits and most importantly imposes discipline. When managers know they have to pay back the capital they have raised, they will be careful. With equity, this pressure to pay back does not exist.
But as the Economist article explains, managers’ self-interest seems to have taken over at some point. Managers started using cash to buy back equity to boost earnings per share. They also favoured debt over equity to make the share price more volatile, and thereby make the option more valuable. Debt was also often used to finance acquisitions as part of empire building, a rtrend encouraged by investment banks, which had an incentive to recommend debt issuance and acquisitions, to earn fees. While all this was happening, activist shareholders such as hedge funds put pressure on companies to pay out surplus cash.
It is only in the current recession that the dangers of debt are becoming more apparent. The default rate is now rising rapidly. S&P believes that nearly 14% of bond issuers will fail to meet their obligations this year. It is difficult to roll over new debt, given the credit crunch. Meanwhile, suppliers are insisting on instant payment from companies with weak balance-sheets.
The problem for companies is there may not be much they can do right now to rectify the situation. A depressed market is hardly the time to issue equity. Also if an equity issue is announced, the share price tends to fall. For many American companies, the share price is in single digits. And any further fall may have catastrpohic consequences. After all the share price itself is a proxy for default risk as per the well known Merton Model.
Friday, February 27, 2009
The Citi bailout
On February 27th, Citigroup and the Treasury reached a deal that took a big step towards partial nationalisation. Through conversions of preferred stock, the government will own 36% of Citi, though the final figure will depend on how many preferred shares private holders agree to swap.
As the Economist mentioned today, the latest bail-out will give the government real control of Citi. The government does not need to own a majority of the shares in a bank to wield whatever influence it likes. With somewhere near 36% of Citi, control of decision-making will be complete—if it is not already. Citi already has to clear strategic decisions with regulators.
Citi approached regulators about the conversion, worried that further losses would as the recession and housing crisis deepen. Citi will need more capital in the coming months. And its current market cap of about $ 14 billion looks really puny indeed.
As the Economist mentioned today, the latest bail-out will give the government real control of Citi. The government does not need to own a majority of the shares in a bank to wield whatever influence it likes. With somewhere near 36% of Citi, control of decision-making will be complete—if it is not already. Citi already has to clear strategic decisions with regulators.
Citi approached regulators about the conversion, worried that further losses would as the recession and housing crisis deepen. Citi will need more capital in the coming months. And its current market cap of about $ 14 billion looks really puny indeed.
The crisis in Iceland
Ref The Economist dt Dec 13, 2008
The collapse of the krona and nationalisation of the country’s three largest banks in early October, 2008 have left Iceland facing a huge financial crisis.This is probably the biggest banking failure in history relative to the size of an economy. How did this happen?
Iceland ilustrates the dangers of a large globalised banking system in a small domestic economy. In 2007 Iceland’s three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003. Only about one-fifth of those loans were in kronur; interest rates on these were very high. SO many Icelanders instead borrowed from their banks in cheaper currencies such as yen and Swiss francs.
But after the banks collapsed in early October, the currency slumped and domestic interest rates rose sharply. Exchange controls imposed in the heat of the crisis have severely restricted access to hard currency.
The IMF forecasts that the economy will contract by 9.6% next year. Many workers have been laid off. Many young Icelanders, who have never known unemployment, are expected to lose their jobs.
With unemployment rising, citizens talk openly about defaulting on their home and car loans. Principal payments on local-currency mortgages are indexed to inflation, which is expected to be 20% this year. This and their foreign-currency exposure means many households’ debts have roughly doubled in krona terms.
The failure of the banks may cost taxpayers more than 80% of GDP. Relative to the economy’s size, that would be about 20 times the Swedish government's banking rescue act in the early 1990s. The cost would also be several times that of Japan’s serious banking crisis a decade ago.
The crisis was fulelled by the aggressive business model of Iceland’s two largest banks, Landsbanki and Kaupthing Bank. These banks could attract only paltry sums in the domestic market. In 2006, they decided to use the internet to attract foreign deposits, using the cost savings from online banking to offer higher interest rates to savers. These banks were soon sucking deposits away from bricks-and-mortar banks across Europe. When Landsbanki collapsed in October, the country ended up owing $8.2 billion to foreign internet depositors of its banks, or about half of Iceland’s entire GDP.
Now the debate has intensified whether Iceland should join the Euro. Here opinion is divided among Icelanders. And even if the country decides to join the Euro zone, it will take quite sometime.
The collapse of the krona and nationalisation of the country’s three largest banks in early October, 2008 have left Iceland facing a huge financial crisis.This is probably the biggest banking failure in history relative to the size of an economy. How did this happen?
Iceland ilustrates the dangers of a large globalised banking system in a small domestic economy. In 2007 Iceland’s three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003. Only about one-fifth of those loans were in kronur; interest rates on these were very high. SO many Icelanders instead borrowed from their banks in cheaper currencies such as yen and Swiss francs.
But after the banks collapsed in early October, the currency slumped and domestic interest rates rose sharply. Exchange controls imposed in the heat of the crisis have severely restricted access to hard currency.
The IMF forecasts that the economy will contract by 9.6% next year. Many workers have been laid off. Many young Icelanders, who have never known unemployment, are expected to lose their jobs.
With unemployment rising, citizens talk openly about defaulting on their home and car loans. Principal payments on local-currency mortgages are indexed to inflation, which is expected to be 20% this year. This and their foreign-currency exposure means many households’ debts have roughly doubled in krona terms.
The failure of the banks may cost taxpayers more than 80% of GDP. Relative to the economy’s size, that would be about 20 times the Swedish government's banking rescue act in the early 1990s. The cost would also be several times that of Japan’s serious banking crisis a decade ago.
The crisis was fulelled by the aggressive business model of Iceland’s two largest banks, Landsbanki and Kaupthing Bank. These banks could attract only paltry sums in the domestic market. In 2006, they decided to use the internet to attract foreign deposits, using the cost savings from online banking to offer higher interest rates to savers. These banks were soon sucking deposits away from bricks-and-mortar banks across Europe. When Landsbanki collapsed in October, the country ended up owing $8.2 billion to foreign internet depositors of its banks, or about half of Iceland’s entire GDP.
Now the debate has intensified whether Iceland should join the Euro. Here opinion is divided among Icelanders. And even if the country decides to join the Euro zone, it will take quite sometime.
Tensions in the Eurozone
Spreads on the ten-year government debt of Greece, Ireland, Italy, Portugal and Spain over that of Germany have widened sharply. Rating agencies are closely watching the fiscal positions of the five countries.
The recession in the early 1990s saw various currency crises within Europe’s exchange-rate mechanism (ERM) , particularly in 1992, when Britain had to leave the ERM. One motive for creating the euro was precisely to avert such crises. Members of the Eurozone have at least been spared pressure from the foreign-exchange market.
But there is a price to pay for stable exchange rates. That is taking the shape of lost competitiveness, big current-account and budget deficits, and increasing concerns about creditworthiness.
In the 1990s the weaker economies in the euro zone made strenuous efforts, through fiscal tightening, wage restraint and product- and labour-market reforms, to satisfy various criteria and qualify for euro membership. But once they passed the test they relaxed, lulled into a sense of complacence that membership of the single currency would be enough to solve their economic problems. At the same time they enjoyed the benefits of a boom due to the euro’s lower interest rates. Once in the euro, and deprived of the chance to devalue again, they should have pursued structural reforms at home to make their economies more competitive. They should have emphasised fiscal discipline to offset the euro’s easier monetary policy. But they did not.
Now as these countires are entering a period of deep recession, the hidden costs are being exposed. In Spain and Ireland property bubbles that were inflated in part by the switch to low euro interest rates have burst spectacularly. In Greece, Italy and Portugal a steady loss of wage and price competitiveness is eroding growth. and in all these countries, public finances seem to be in a mess.
The bond markets are especially concerned about Greece and Ireland; but fears are growing even over such big countries as Italy (where public debt stands at over 100% of GDP) and Spain.
The recession in the early 1990s saw various currency crises within Europe’s exchange-rate mechanism (ERM) , particularly in 1992, when Britain had to leave the ERM. One motive for creating the euro was precisely to avert such crises. Members of the Eurozone have at least been spared pressure from the foreign-exchange market.
But there is a price to pay for stable exchange rates. That is taking the shape of lost competitiveness, big current-account and budget deficits, and increasing concerns about creditworthiness.
In the 1990s the weaker economies in the euro zone made strenuous efforts, through fiscal tightening, wage restraint and product- and labour-market reforms, to satisfy various criteria and qualify for euro membership. But once they passed the test they relaxed, lulled into a sense of complacence that membership of the single currency would be enough to solve their economic problems. At the same time they enjoyed the benefits of a boom due to the euro’s lower interest rates. Once in the euro, and deprived of the chance to devalue again, they should have pursued structural reforms at home to make their economies more competitive. They should have emphasised fiscal discipline to offset the euro’s easier monetary policy. But they did not.
Now as these countires are entering a period of deep recession, the hidden costs are being exposed. In Spain and Ireland property bubbles that were inflated in part by the switch to low euro interest rates have burst spectacularly. In Greece, Italy and Portugal a steady loss of wage and price competitiveness is eroding growth. and in all these countries, public finances seem to be in a mess.
The bond markets are especially concerned about Greece and Ireland; but fears are growing even over such big countries as Italy (where public debt stands at over 100% of GDP) and Spain.
Argentina on the Danube
This is the title of an article which recently appeared in The Economist.
Many East European countries seem likely to default on their debt. At least the markets think so. The financial system in this region has combined badly run local banks with loosely overseen subsidiaries of Western ones. During the boom years, this system absorbed credit from abroad, leading to big current-account deficits. Because of reckless lending, often in foreign currencies, bad debts are likely to increase. Some local banks have failed; many of the foreign-owned ones now depend on their parents’ willingness to keep financing them. Unfortunately for them, those parents have plenty of problems at home.
All the countries are not facing the same problem. Poland and the Czech Republic have cut interest rates to cope with the slowdown but this has sent their currencies tumbling. This has increased the burden on households that have mortgages in Swiss francs or euros. Some countries like Hungary ( 100% of GDP) have a big external government debt. For Latvia, Estonia, Lithuania and Bulgaria, the strong euro is a problem. They have pegged their currencies to it.
All in all, this seems to be the most turbulent period for Eastern Europe since the collapse of the Soviet Union.
Many East European countries seem likely to default on their debt. At least the markets think so. The financial system in this region has combined badly run local banks with loosely overseen subsidiaries of Western ones. During the boom years, this system absorbed credit from abroad, leading to big current-account deficits. Because of reckless lending, often in foreign currencies, bad debts are likely to increase. Some local banks have failed; many of the foreign-owned ones now depend on their parents’ willingness to keep financing them. Unfortunately for them, those parents have plenty of problems at home.
All the countries are not facing the same problem. Poland and the Czech Republic have cut interest rates to cope with the slowdown but this has sent their currencies tumbling. This has increased the burden on households that have mortgages in Swiss francs or euros. Some countries like Hungary ( 100% of GDP) have a big external government debt. For Latvia, Estonia, Lithuania and Bulgaria, the strong euro is a problem. They have pegged their currencies to it.
All in all, this seems to be the most turbulent period for Eastern Europe since the collapse of the Soviet Union.
Swiss private banking at a cross roads
The core of Swiss banking, namely client confidentiality and privacy is being challenged. In the rich world, the mood against all big banks has turned nasty. The US has already taken a belligerent stand. At the G20 meeting in April, European leaders may discuss potential sanctions against tax havens that refuse to hand over information held by their banks.
As the Economist recently mentioned , at risk is up to $2 trillion in offshore assets held in Swiss private banks. There are also important questions at stake about the reach of the state and a citizen’s right to privacy.
Those who press for an end to banking secrecy argue that people who hide their assets want to evade taxes probably as much as $255 billion a year around the world. However, private banking is not just about tax planning. Clients have other fears too - divorce settlements, expropriation by fickle governments and thieving criminals. Also much of the new money that flowed into Switzerland in recent years may have come from countries with low or no personal income taxes, such as the Gulf. Moeover, a rapidly increasing share of money coming from European countries with high rates of tax is declared to the authorities.
Whatever be the case, the Swiss private banking industry is fighting a grim battle for survival.
As the Economist recently mentioned , at risk is up to $2 trillion in offshore assets held in Swiss private banks. There are also important questions at stake about the reach of the state and a citizen’s right to privacy.
Those who press for an end to banking secrecy argue that people who hide their assets want to evade taxes probably as much as $255 billion a year around the world. However, private banking is not just about tax planning. Clients have other fears too - divorce settlements, expropriation by fickle governments and thieving criminals. Also much of the new money that flowed into Switzerland in recent years may have come from countries with low or no personal income taxes, such as the Gulf. Moeover, a rapidly increasing share of money coming from European countries with high rates of tax is declared to the authorities.
Whatever be the case, the Swiss private banking industry is fighting a grim battle for survival.
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