New Rules of the Global Marketplace - Hindu Business Line Op-ed

By Adhvith Dhuddu
(Op-ed as appeared in the Hindu Business Line on January 13th, 2010)

A decade of boom and bust has culminated in a new set of global standards even as India's image has soared as a credible survivor of the financial crisis.

The first decade of the 21st century has been unprecedented in many ways with the tech bust in the early 2000s, the rise of the BRICs and other emerging economies, the commodity boom and of course, the global financial mess in the recent years. As we enter the last lap of this decade, there are many “new normals” that have been scripted in the Indian and global context.

There is a new normal in the global economic playing field: Regulatory shackles have resurfaced prominently in the western world and government is back amidst “free markets.”

Developed economies, led by the US, rewrote the rules of global finance during the crisis, which will have ramifications in the American, European and Asian continents. As countries, companies and individuals emerge out of this crisis, everyone can be sure that it's not going to be business as usual at least in the near future.

The Sunny Side of Climate Change - Hindu Business Line Op-ed

By Adhvith Dhuddu.
(Op-ed as appeared in the Hindu Business Line on December 8th, 2009)

In the US, discussions about climate change are often partisan and impassioned. While the Democrats, who control Congress and the White House, largely accept the potentially insidious consequences of climate change, Republicans continue to deny the climate change phenomena. I mention this political bickering about climate change in the US because, as they struggle to reach a consensus on this volatile issue, we in India have largely accepted that climate change is something to confront, but have perceived it as a threat to our economy rather than an opportunity.

What's Next for Gold? - Hindu Business Line Op-ed

By Adhvith Dhuddu
(Op-ed as appeared in the Business Line Hindu on Oct 21st)

Gold recently broke through the $1,000/ounce psychological barrier, generating interest among investors, traders and even the common man. Currently there are many factors abetting the price rise in gold. Although no concrete prediction can be made about the price, the outlook appears bullish. There are nine crucial factors that affect the price in the short and long term.

LONG-TERM DRIVERS

Forex reserve allocations: The Asian Financial Crisis in 1997-98 resulted in an accumulation of forex reserves over the last decade. After amassing forex reserves in US treasuries, many Asian economies and export-oriented countries have exhausted their appetite for US debt.

The slow divestment from US treasuries to gold and other precious metals will impact the price of gold. An increasing proportion of forex reserves is being held in gold as countries realise that this could also be a sensible hedge against a slumping US dollar.

Make use of forex reserves - Mint-WSJ Op-ed

By, Adhvith Dhuddu
(As appeared in Mint-WSJ on Sept 14th, 2009)

RBI’s primary use of forex reserves is twofold: As an emergency fund in case of a fiscal crisis or food crisis, and to help mitigate any significant volatility in the rupee

Recently, surpassing $2 trillion, China’s foreign exchange (forex) reserves make up close to one quarter of the total reserves in the global economy. Though a pittance compared with China’s reserves, India’s forex reserves have grown healthily over the last decade and a half and are in many ways a reflection of our success as an economy. With close to $260 billion—approximately 25% of our gross domestic product (GDP)—in forex reserves, our coffers are extremely well padded to tackle a crisis. But what’s disappointing is the Reserve Bank of India’s (RBI) reluctance to deploy these funds in creative and resourceful ways.

In his book, Making Globalization Work (2007), Nobel Prize winning economist Joseph Stiglitz dedicates a whole chapter to explaining how the global reserve system should be reformed for the greater good of the world economy. After analysing how Asian countries have accumulated significant reserves following the Asian financial crisis, Stiglitz says: “The money put into reserves is money that could be contributing to global aggregate demand; it could be used to stimulate the global economy. Instead of spending the money on consumption or investing the money, governments simply lock it up.”

India’s infrastructure woes

2009 AUGUST 6

As appeared in the Hamara Congrees site. Click here to visit Hamara Congress

- by guest contributor ADHVITH DHUDDU

The political and bureaucratic classes of India have finally manned up to accept the dilapidating state of our infrastructure. With all the right noises coming out of a rejuvenated Congress led UPA, the big question now is how words, plans and promises are translated to concrete action with long lasting impact. The Achilles Heel for policy decisions taken in India is the poor implementation of objectives, inefficient use of allocated resources and a lack of accountability. Whether its funds earmarked for rural food schemes or urban development of roads, capital often drips out unaccounted, from the leaky pipelines. What is originally envisioned by lawmakers and policy wonks seldom materializes on the ground.

Anyone would accept that a government cannot and should not function with profit as their motive; it’s just irresponsible and immoral. But an ironical observation here is the excellent accountability evident in every public-private partnership project with little or no leakage of funds. When private players are stakeholders with profit as their goal, accountability and responsibility reappears like magic. Government at all levels needs to take notice of this and try to replicate successful practices enforced in these partnerships. But delving into the critical infrastructure needs, one can easily identify many areas where long overdue development and improvement is needed.

Electricity (residential and industrial): India is replete with inefficient and outdated electric grids, a fatigued electricity transmission network and mediocre rural penetration. A lot of progress has been made in the power sector but its insufficient compared to what is required. Our archaic power transmission and dissemination methods contribute to huge losses in power, increased cost and needs desperate modernization. In many big metros, electricity is not a major concern as uninterrupted supply is somewhat reliable but rural areas continue to suffer as power generation and transmission still lags demand and power theft is rampant.

Industries bear the brunt of this problem as their costs surge and margins become slender. Manufacturing is a critical sector in any economy and its success depends heavily on how well the state abets them with uninterrupted and affordable electricity. Unfortunately many industrialists have shifted expansion plans abroad, and foreign players have scratched India off the list citing unreliable and expensive power as the deterrent.

Our government needs to recognize the tremendous benefits of having cheap, uninterrupted and reliable electricity. If the Congress led UPA can achieve this, it can usher in a new era of manufacturing in India as international players will relocate their bases to leverage inexpensive power with all the other advantages we already posses, i.e. affordable labor, language, technical skills, a growing market, etc.

Roads and highways: It’s a pity that the previous government’s brainchild and the NDA initiated Golden Quadrilateral (GQ) project was not pursued with rigor since 2004. This is why it’s important to leave political affiliations at the door when important national infrastructure issues are deliberated. The sluggish progress was evident after the NDA was voted out of power, which is disappointing.

Although the project is nearing its completion, tremendous amount of investment is required to maintain and expand the GQ and our complete highway network. Close scrutiny is required for all highway and road projects as contractors often try to make a quick buck by using cheap and low quality materials. Roads and highway networks need to be built for the future, keeping in mind the ever rising vehicular population and increasing dependence on highways for transporting goods.

Internet and broadband: Internet connectivity, broadband penetration and IT saturation is pivotal to the success of any nation in the 21st century. If India’s vision is to be a superpower in the coming decades, we need to equip our rural and urban population with the ability to leverage the internet in the most optimal way. Trying to win in this century without the internet is like trying to win a 21st century war with pitchforks and knives.

The internet is a productivity multiplier and the sooner it’s embraced by the population the better for the country. With this in mind, it’s disappointing to note that the rural penetration of computers and internet is poor and internet infrastructure in the urban areas requires extensive upgrading. Besides providing top quality IT infrastructure, tremendous investment is also required in training our rural masses.

City planning: There’s little talk about this in the mainstream media, but urban infrastructure planning is pivotal to the success of any large city. Many of our metros don’t even have up to date maps of sewage, drainage and sanitation lines, and rely on outdated maps for water and electricity lines. This often results in little or no coordination between different departments when roads are dug up for various reasons. Planning when it comes to the rural areas is downright appalling, as millions in villages still struggle to get basic sanitation facilities, good drinking water and electricity.

Infrastructure now: And for those still unconvinced about investing in infrastructure, here’s what a new, improved and modern India will look like: we can boast of efficient resource consumption, better capital utilization, soaring productivity which will lead to a higher GDP and incomes, accelerated growth, smart and agile supply chains for industries, faster movement of goods and equipment across the country, elimination of slack in the system, affordable travel for all, a highly educated population, an efficient marketplace, soaring foreign investments, and a country where superior infrastructure becomes so commonplace that citizens will finally focus on their jobs and stop complaining about the massive lags presently inherent in the system.

Our guest blogger Adhvith Dhuddu writes regularly for various publications in India and US about the economy and politics. He blogs regularly at www.AdhvithDhuddu.com and can be contacted at adhvithd@gmail.com.

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A BUDGET FOR YOUNG INDIA

By Adhvith Dhuddu

(Op-ed as appeared in Business Line Hindu)

There is much talk and anticipation surrounding the rejuvenated UPA’s interim budget expected in early July. While everyone’s discussing tax slabs, agricultural subsidies and fiscal discipline, it’s equally important that our Finance Minister focuses on presenting a budget with Young India in mind.

The demographics of our country calls for such progressive policies and young Indians have high expectations from a UPA that is partially spearheaded by Mr Rahul Gandhi and his young brigade. After all, young voters were crucial to the UPA’s thumping victory.

The 5 Es affecting young India are Education, Employment, Entrepreneurship, Environment and Energy.

Employment: Given the gloomy state of employment, tackling the labour problem first could mitigate fears of a prolonged slowdown with high unemployment. Thousands of graduates are added to an already strong Indian workforce each year, and if hiring does not gain momentum soon, it could be a source of problem for the Government.

The Finance Minister should consider providing temporary tax incentive to certain labour-intensive sectors (such as retail and manufacturing) which can have an immediate impact and alleviate some pain. But decisive and far-reaching action is needed soon or we could see many unemployed and disgruntled young graduates.

Education: The HRD Ministry has been asleep at the wheel for the last five years, adopting regressive policies when it comes to education reform. Caste and class have taken centre-stage for too long, overshadowing merit. Aimlessly increasing allocations and earmarking crores for more institutes will not ensure quality unless the ineffective command-and-control structure is comprehensively revamped.

Colleges and universities are not being allowed to make swift changes to meet 21st century requirements, and adding salt to our wounded education sector are laws that prohibit foreign universities, which are lining up to invest in India.

Mahatma Gandhi once said, “The youth of the nation is the salt of the country.” Our HRD Ministry’s inability to act is driving away thousands of talented and passionate students to other countries for graduate and postgraduate studies. If the Congress-led UPA is smart, it will enact extensive education reforms to leverage the favourable demographics of this country.

Entrepreneurship: A lot is said about the transformational reforms in 1991 that vaulted India into the global arena. But what Mr Manmohan Singh and his team did then was very simple: they provided an extremely conducive environment for entrepreneurship, which led to expansion in industries, innovation, employment, an enriched population and an active electorate.

The time is ripe for another entrepreneurial revolution, and policies favouring it. Even today corruption is rampant, capital is expensive, contracts are arduous to enforce and it’s tough setting up an enterprise. India ranks a dismal 122 out of 181 in the ease of doing business report published by the World Bank. The reforms in 1991 have shown us the right way; right policies today can foster entrepreneurship in a young population that will be the employers and employees of the future.

Energy: Energy consumption by individuals and industries is set to soar to unprecedented levels in the coming decades. Whether it is petrol, diesel, LPG or kerosene, it is critical to secure our energy future. Protecting and strengthening energy infrastructure is primary but, simultaneously, energy generating capabilities must be expanded. The Government should create a positive environment with sops for renewable energy projects and companies. Instead of choosing wind energy over solar or hydroelectric power over ethanol, we should adopt an all-of-the-above approach and promote all renewable energy companies.

The West has realised this and is rigorously trying to expand renewable sources of energy. We should create an energy infrastructure that is home-grown and self-sustaining. This issue is at the heart of every young Indian’s priorities, as energy shortages and rising prices loom ahead in the absence of long-term energy policies.

Environment: Although it may appear inconsequential at present, we will only be cursing ourselves (and our previous governments) in 2030 and 2040 if we fail to formulate and enforce concrete environmental regulations. India has experienced rapid industrialisation in the last 15 years and the pace is expected to increase in the coming decades.

The least we can do is leave the coming generations a clean and green environment. As Thomas Friedman points out in his book Hot Flat and Crowded, the 21st century will belong to leaders in Energy Technology. Energy and environment are strongly correlated and can be addressed through an all-of-the-above approach to renewable non-polluting energy.

With the right kind of policy focus, the Government can whet the youth’s appetite and simultaneously put the nation on the fast track to growth.

(The author is an asset manager and professional trader)

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PERILOUS STATE OF THE US DOLLAR

By, Adhvith Dhuddu

As appeared in the Business Line Hindu. 

The US dollar is bearing the brunt of the blame as critics reemerge to vilify its position as the world’s reserve currency. Concerns about many aspects of the US economy have resurfaced following the unprecedented financial commitments made by the Obama Administration to pull the economy out of a deep recession. US debtholders are becoming increasingly apprehensive about this and the trillions of dollars in long-term liabilities that the US government is saddled with .

Although this is nothing new, the momentum to give the world an option of another global reserve currency is picking up as more economists and central bankers come to this consensus, as the Chinese realise the $2 trillion quandary they’re entangled in, and as the US continues to print its way out of this recession simultaneously devaluing the dollar.

STEEP STRENGTHENING

As the crisis was unfolding at lightning speed, the dollar did strengthen considerably. This was primarily due to two reasons: The lack of another option as a safe haven currency and the forced asset sales all over the world to meet rising capital requirements in the US. So the quick and steep strengthening of the dollar immediately after the crisis should not be mistaken as a sign of long-term resilience. There are several other issues that have plagued the currency which will contribute to its steady decline.

Short-term liabilities skyrocketed to inconceivable heights as the US government committed $3.5-4 trillion in bailouts, guarantees and assurances to various institutions since September last year. Although a lot of this was required to prevent financial Armageddon, the numbers are mind-boggling as you realise that the total amount committed was 30-35 per cent of its GDP.

What’s more alarming are the long-term liabilities that the government is burdened with in the next few decades. Tens of trillions of dollars in entitlement spending towards social security and medicare are not only unavoidable but are rising steadily as average life expectancy rises, healthcare costs surge and inefficiencies in the system persist. There are some signs of hope as this Administration strives to modernise healthcare, and tackle long-term entitlement spending.

But here’s how the situation stacks up currently: China holds close to $2 trillion in US debt and has expressed concerns about the US government putting the printing presses on overtime. In some way this subtly implies that China will not purchase US treasuries at a rapid pace. This is where the dilemma arises, as the US issues treasuries at an unprecedented rate to finance its ever-expanding liabilities. If China either sells current treasuries it holds, or slows the pace of gobbling up newly issued treasuries, interest rates in the US will rise significantly; only to prolong the recession.

CHINA'S DILEMMA 

In an efficient marketplace, all artificially priced assets eventually get valued at the appropriate levels. This is where China’s dilemma arises. The primary reason its currency is artificially undervalued is because of its unabated appetite for US treasuries. In a way, the Chinese don’t have a choice but to aggressively continue purchasing US treasuries if they want to keep their currency undervalued. So the consequences for the Chinese if they sell US treasuries or slow down their purchases will be paramount as their currency will surge to choke export growth.

The Chinese government and central bank face an uphill task as they confront this complex challenge. With the limited amount of funds they posses, they have to simultaneously perform three critical activities:

They need to keep their currency undervalued to support their massive export industry;

Continued support for their internal growth through their ambitious stimulus plan is critical in assuaging any social uprisings in the rural and semi-urban areas; and

They need to continue purchasing US treasuries to prevent any drastic fall in the dollar’s value.

Clearly, the Chinese are in a multi-trillion dollar quandary as they appear stuck with US treasuries which are depreciating steadily. The US was able to finance its liabilities for years, and successfully bought cheap goods from the Chinese with cheap credit via US treasuries (which it sold to the Chinese), and is now actively pursuing to devalue the dollar as the Federal Reserve and US Treasury realise that’s the only way out. It increasingly looks like the US might have its cake and eat it too.

IF NOT THE DOLLAR...

But a few larger questions arise here: How can the dollar be a universally accepted global reserve currency when two countries, the US and China could potentially derail the currency? If the US was analysed as US Inc., would any banker lend it money after glancing through its balance-sheet?

The counterargument for all these questions is often the same: If not the dollar, then what else? It’s not a legitimate question, because, true there is no other currency that is as powerful as the dollar, but if an alternative is presented to the world, if a choice is given to nations, then the true resilience of the dollar will be discovered, because then there will be a choice.

This might not be an appropriate time as nations recover from this historic meltdown, but a clear roadmap must be drawn out in the next one year so that countries can finally choose in which form they want to keep their reserve funds.

The Stone Age did not end due to a lack of stones, similarly the petroleum age will end long before the world runs out of oil and the dollar’s status as the world’s reserve currency will end not due to a lack of dollars but because individuals, central banks, governments and nations will realise the increasingly perilous state of the dollar as the country’s liabilities get compounded with the passage of time.

(The author is a professional trader and asset manager in the US and India.)

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FREIDMAN VS. KEYENS: THE MULTI-TRILLION DOLLAR QUESTION

By Adhvith Dhuddu

 

The global economic crisis has rekindled the classic yet unsettled debate about government intervention, free markets and capitalism. Economists to this day are at loggerheads about this, and the most famous on either side of the debate are renowned economists Milton Freidman and John Maynard Keynes. Although the Economist magazine hailed Milton Freidman as the most influential economist of the 20^th century, Keynesian policies are being adopted all over the world by policymakers and legislators to pull the world economy out of an unprecedented crisis. It’s often said that the argument between Freidman and Keynes has long been settled and globalization, free markets and capitalism have vindicated Milton Freidman’s theories. But nothing less can be said of Keynesian economics as his deficit spending stimulus policies are rampantly being adopted in many industrialized nations as we speak.

Keynesian policy dictates that, “private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government, to stabilize output over the business cycle.” Clearly this crisis has unfolded just as Keynes envisioned: decisions by the private sector (like the over-leveraged investment banks and profit-thirsty mortgage originators) led to inefficient macroeconomic outcomes (declining GDP, rising unemployment, etc) to which governments all over the world are responding by fiscal and monetary stimulus trying their best to stabilize the business cycle.

This is also being echoed from the Obama administration who firmly believes that government is the only institution that can reverse the spiraling and reactionary crisis that is unfolding right now. Their argument is that non-government expenditure has slowed significantly and depleted close to $2 trillion in GDP leaving them no choice but plan billion’s in deficit spending to reverse a contracting business cycle. Although Keynesian policies have its drawbacks, they seem to be gaining momentum around the world as the right approach to alleviate some pain in the world’s economy now.

Keynes’s primary argument focused on utilizing government as a stimulant or a backstop during economic downturns. He claimed that aggregate demand for goods and services will decline drastically during economic downturns that will lead to high unemployment and significant losses in output. In this case only the government can step in to fill the vacuum to improve economic activity by increasing government spending and reducing interest rates. Keynes’s policies were widely adopted during the Great Depression in the 1930s-40s when the world was going through a deep contraction. To this day there are debates about whether or not massive government spending helped or prolonged the depression. Passionate cases can be made for and against the argument.

Freidman on the other hand was an extremely vocal cheerleader of a deregulated and free market economy and highlighted that government should have a progressively smaller role in the economy and the private sector. He vehemently opposed all types of government regulation saying it only contributes to lower productivity and adds costs to businesses. Many of his theories were questioned and challenged initially but in the second half of the 20^th century, the US and UK largely embraced his policies which materialized wholly during the Reagan administration (where Friedman was a top economic advisor to President Reagan) in the US and under Margret Thatcher in the United Kingdom.

His primary criticism of Keynesian policies was the threat of stagflation. He argued that too much government intervention and increased deficit spending will only spur inflation and keep productivity and growth levels very low.

So the trillion dollar question is whether the Keynesian policies adopted around the world will result in stagflation like Friedman predicts or just a slow growth period with little or no inflation. In the recent few decades, Friedman clearly had the upper hand as deregulation, opening of borders and globalization led to a flattened world, with consistent growth. Friedman, who passed away just over two years ago said as late as 2006 that the world economy is in great shape and many more years of sustained growth are foreseeable.

I only wish he lived to witness a rewinding of so many policies that were adopted over the past few decades. There are many disturbing trends that clearly show protectionist inclinations which are very worrying. The global economy is at a very critical point and the next few years might just see tectonic shifts in economic power.

Although we blame government time and again for their inefficiencies and red-tape, it is they who we turn to during times of crisis. But unfortunately, government intervention also means profits getting privatized and losses getting socialized. Friedman’s theories were celebrated, but one theory by another famous analyst, Nicholas Nassim Taleb (who predicted the economic disaster) says famously in his book, “The Black Swan,” that no math model can predict tsunami like economic events like the one we are experiencing now.

So only time will tell if the deficit spending policies being adopted will bear fruit and pull the world economy out of a recession. Personally, these policies are not the best given the current situation but we have no choice but to live with it. 

References: http://en.wikipedia.org/wiki/Keynesian_economics

http://en.wikipedia.org/wiki/Milton_Friedman

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How Wall Street’s crisis affects the Indian economy
By, Adhvith Dhuddu

Wall Street’s landscape and the face of the US economy changed dramatically in the past few months. It’s famously known that when the US sneezes, the world gets a cold, and it’s looking ominously similar this time around. Despite the resilience and growing strength of the Indian economy, these changes will significantly affect Indian business, trade and commerce. It’s also becoming clear that our economy is in fact intertwined with the world economy and has not decoupled with the US economy in any way.

Risky leveraging by investment banks and a slump in the real estate markets in US were the root causes of this quandary which put the financial system in peril. In the last few years, the ability to leverage gave institutions on Wall Street access to ample capital and increased their risk appetite (which increased fund flows to emerging markets). Momentum built up in leveraging was felt across the globe as capital was pumped continuously into emerging markets and unconventional assets. But this financial fallout and recent government intervention has forced many firms to deleverage and use cash conservatively. The ability to raise $600 million with $20 million collateral (1:30 leverage) is a thing of the past and this will drastically impact capital inflows to India. We will see a significant slowdown in foreign capital inflows and foreign direct investment as a direct effect of deleveraging, inaccessibility to new capital and higher cost of credit in the US and Europe.

It’s extremely important to recognize that the accelerated growth in our economy was driven significantly by foreign investments, which are sure to dry up in the short to medium term. Not because India is a less attractive investment destination, but because of insufficient capital and inability to leverage available capital. When investment banks, hedge funds and high net worth individuals could borrow $1 billion with only $50 million in collateral (1:20 leverage), the $1 billion could be distributed to India, China, Brazil and Middle East into equity, real estate, commodities and fixed income assets. But when the amount available is only $50 million (no leverage) or $250 million (1:5 leverage), any amount of distribution to emerging markets and asset classes translates to less capital inflows into India and other emerging markets. This credit crunch, or more appropriately, “capital crunch,” forces us to realize that there is less capital available for disposal around the world.

Consequences of this fallout will be far reaching and be felt in emerging markets at least temporarily. The US is a consumer driven economy (70 percent of GDP) fueled by credit and buoyed by cheap imports; Asian economies that export heavily to the US will feel the pain as spending slows down and credit gets expensive. Here in India and in Bangalore, IT bellwethers, who garnered major portions of their business from financial companies, could feel the brunt when US corporations delay IT spending plans. Financial firms are struggling to capitalize even their daily chores, so this environment will undoubtedly create less spending and reserved capital expenditure plans.

Not only will this crisis dampen the mood of investors, but will send many of them into hibernation. A lot of wealth has been eroded in this financial crisis, and investors in the US are worried more about wealth preservation than wealth creation for now. More individuals and funds will look for steady returns with less volatility leading to more conventional and safe haven assets. A rush to quality will attract many investors to established economies like the US, UK and Japan. One argument is that companies in emerging markets are undervalued now and offer good bargains which should attract investors. But this is also true in developed markets where global giants like GE, Boeing and Microsoft are trading at extremely attractive PE ratios (Click Here: DOW 30 stocks with quotes, charts and key ratios like PE, EPS, etc). The only bright spot from a foreign investor’s perspective is the weak Indian currency. This is the only factor which could attract investors to India. The fall in the Rupee is a classic sign of foreign investors exiting India, at least temporarily. This decline doesn’t necessarily imply a weak Indian economy, but underscores the temporary rise in demand for the US dollar, as assets are sold all over the world and money is sent back to US to recapitalize banks and companies.

The drastic weakening of the Rupee (Click Here: US Dollar-Indian Rupee Chart) will be short lived as federal intervention and an increase in money supply will eventually dent the US dollar. The US dollar’s rise is temporary and is not being driven by a strong fundamental economy. Usually when any country around the world has a financial crisis, it’s cost of borrowing sky rockets, except for USA. When the US was in a full blown financial and economic crisis, the cost of borrowing for the US government was at an all time low, reflecting the raw power of the US, and the fact that humongous amounts of debt are transacted in US dollars.

Companies should incorporate this outlook into corporate plans and use this opportunity to rein in spending, accelerate cost cutting and optimize assets and resources in their organization. The future isn’t all that grim as a slower growth rate of 6-7 percent per annum is much better than no growth or negative GDP growth which the US has to confront soon. Many factors like increased local consumption, favorable demographics and a driven population will keep our economy and nation buoyant.

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WHAT HAPPENED ON WALL STREET?

By, Adhvith Dhuddu

Shock and awe ravaged through the minds of millions from Wall Street to the Great Wall this week as tremors in the financial sector bought down industry giants Lehman, Merrill and AIG. An unfortunate convergence of ugly factors contributed to this saddening collapse leaving thousands jobless and millions a bit poorer. These are undoubtedly historic times with no precedent leaving many jittery about the future, which is why an elemental breakdown of the major factors that contributed to this crisis is vital.

The leverage factor: Investment Banks (IB's) over extended themselves with this luxury that many financial institutions used conservatively. The Bear Stearns collapse exposed the super leveraged nature of IB's where they could borrow $30-$35 for every $1 of collateral (1:35 leverage). This is primarily what IB's were armed with to maximize profitability and dampen the losses. Fearful of similar consequences Lehman frantically deleveraged their highly leveraged balance sheet by selling assets and raising capital impacting their profitability. It's important to remember that the new capital raised to decrease leverage could have been used as collateral for more capital which Lehman could have used to generate revenue.

Recapitalization and mark to market accounting: In addition to raising capital to deleverage balance sheets, Lehman and Merrill had to continue their daily activities which require large amounts of capital. Complex financial trades performed by IBs require them to put up and receive massive amounts of money (tens of billions) on a day to day basis, making them heavily cash dependent.

Because mark to market accounting forces investment banks to value assets at market prices rather than perceived or book value, it exacerbates the pain by damaging the balance sheet. These accounting practices are being heavily criticized and blamed for the crisis because they cloud the real values of assets, the balance sheets of these institutions and hence the value of these companies. This massive and unending need for cash to recapitalize and deleverage coupled with the high cost for credit literally strained these institutions to the last penny.

Access to Fed funds: Unlike commercial banks, IB's don't have direct access to federal funds. Their primary sources of capital are commercial banks for short and long term lending and cash infusions from customers, hedge funds and private equity firms. This again handicapped many IB's as the cost of borrowing surged, credit markets froze and their credit rating was slashed. For this specific reason, the existence of IB’s with the independent broker-dealer model is being questioned.

Failure of counterparty surveillance and "Self Regulation": Regulating IB's and hedge funds are complicated. The quantitative and mathematical nature of their operations require them to trade equities, bonds, debt, forex, futures and options in massive quantities at lightning speed. The positions on their balance sheet change literally everyday making the risky and highly leveraged nature of their positions tricky for regulation. Although the Federal Reserve knew of the threats posed by this due to their closely intertwined nature to the financial system, they never saw the need to regulate because of the high level of counterparty surveillance and, "self regulation" at IB's and hedge funds. Laissez-faire economists often hailed this development of, "self regulation," as something unparalleled. The unfortunate consequences of not regulating these IB's are what we now face and there sure is nothing unparalleled about the present crisis.

Credit rating agencies: The Moody's, S&P's and Fitch's of the world which are expected to be proactive and offer leading indicators were disastrously late to the party, reacting to the crisis by issuing warnings when it was no news to the financial community. These agencies share a massive portion of the blame simply because they failed to perform their fundamental duty: to accurately assess the quality of credit. A lot of pain could have been salvaged if these agencies were forthright in their assessments and exposed toxic balance sheets of troubled IB's.

Freddie, Fannie, and the underlying factor: The fall in real estate prices triggered this chain reaction, which is about half way through. Outlook in the real estate market doesn't look very sanguine either, which means this crisis could be painful and prolonged. A weak US dollar was an incentive for many overseas investors to explore real estate investments here and provide the much needed boost. But a steady strengthening of the dollar and apprehensions about the overall economy is now keeping these investors away. Local investment in real estate is not sky rocketing anytime soon as Americans are concerned more about wealth preservation than wealth creation for now.

Freddie and Fannie were taken over the by the government which could either be a boon or a bane in this situation. These two institutions are the primary sources of home mortgages underwriting a huge portion of them. If the federal government preoccupies itself in the takeover and transformation process and allows business as usual to continue at Fannie and Freddie, the required stimulant in the housing market will be absent. But if the feds recognize the need for a boost in the real estate market, ease regulations and churn out more affordable and flexible mortgages into the market this will undoubtedly attract buyers and spur the real estate market.

Financial models, illiquid markets and over the counter trading: Many of the troublesome assets that contributed to Lehman's decline were the toxic credit derivative swaps, and similar products. Most or all of these products had very illiquid markets forcing IB's to come up with complex mathematical models to price these securities. With no credible regulatory institution in place there was absolutely no accountability which led to pricing at will and pricing based on trust. The illiquidity in the secondary market only aggravated this as insufficient buyers and sellers led to a non-market math modeled and misleading pricing.

This recent implosion indicates a lot more than the dampened mood on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world).

Back to the basics: The last few decades saw the rise of a new type of bank: the investment bank. Well common sense now prevails and has proven that there is in fact only one type of bank: the normal bank where individuals park their savings which the bank then lends out at rate. Many wondered how the investment banking business model is sustainable, where short term loans are leveraged 1:30 and used in long term investments with no direct access to federal money. There was no credible regulator and the IB's had no oversight of any kind. Any venture capitalist would debunk these flaws in the investment banking business model if no IB ever existed and an ambitious entrepreneur draws up such a plan. There is talk about the new normal, because Wall Street's landscape has changed dramatically in the last six months. There will be a new normal: we will get back to the basics and have just one type of bank, the commercial bank.

The Future: Of the five major IB's which operated using the independent broker-dealer model, only two, Morgan Stanley and Goldman Sachs remain. It's very unlikely that Morgan could survive this crisis and the future looks uncertain even for Goldman in this fragile market environment. Leverage that was built up over years is hard to undo in a weeks or months. The deleveraging process will be nasty and unfortunate because the losses will be socialized and divided amongst taxpayers but profits will be privatized.

History has proven that our economy is one of the most resilient and nimble structures around the world. It has braved diverse problems from accounting scandals to bank failures and continued to roar forward. This is largely attributable to the strong foundations of America, competent regulatory institutions and the grit of the American worker. Although this down phase is looking ominously different, one can be sure that when the bad times pass, investment opportunities will open up.

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BEGINNING OF EXTENDED VERSION (ON BLOG):

The right remedies: Understanding the intricacies of the US and world financial system would take years. But here are some measures that the Fed and Treasury could have taken to diminish the volatility and lessen the panic.

1. The cost of credit for all the companies in question surged dramatically around rumors that credit rating agencies were exploring the option of downgrading their credit ratings. If some internal financial levers were pulled to stop these credit rating agencies from downgrading, this would have bought companies time, and saved billions of dollars of taxpayer money because credit could've been generated easily.

2. Mark to market accounting wrongly portrayed the balance sheets and hence the value of companies, which resulted in credit rate agencies downgrading debt and increasing the cost of borrowing. Practicing mark to market accounting when there is no market for securities is fundamentally flawed and this rule has to be scrutinized and reviewed.

3. Prevent hedge funds and investors from opening up naked Credit Default Swap positions that gamble on company's defaulting (i.e. no one should be allowed to purchase a credit default swap if the buyer of the CDS has no underlying asset to protect)

Financial or economic crisis: What started out as a financial crisis isolated to credit derivatives and the debt markets could soon transform to an economic crisis. The unfolding of events in this crisis has terrified normal folks and experts on Wall Street. For the first time in the history of Wall Street, brokers and bankers were actually asking for regulation and begging for intervention. These events have dented the confidence and questioned the sustainability our borrow-and-spend economy, which might result in a weaker US currency and the emergence of a multi-currency reserve system. In a consumer driven economy where prices of fuel, gas and food are on the rise, a simultaneous increase in the cost of borrowing will only intensify the pains on Main Street.

Large and small businesses depend on short term credit for their everyday transactions, and the dangerous freeze in the credit markets is harming the lifeline of corporate America as they operate with a broken backbone which is an illiquid credit market. Ordinary folks often use the stock market as a barometer of the economy which could be misleading sometimes. In this case especially, while the stock market recouped major losses by the end of the week, credit markets remained frozen and inaccessible which was scary and abnormal.

The Money Trail: Lots of hedge funds made massive profits in this financial crisis. Having mastered the system, there is a possibility that some firms legitimately exploited the loopholes for huge profits. With this basic understanding of CDS’s let me illustrate one instance of how this is possible.

CREDIT DEFAULT SWAPS (CDS) SIMPLIFIED
BUYER OF A CREDIT DEFAULT SWAP (or insurance): Hedge fund, investment bank or an accredited investor.	SELLER OF A CREDIT DEFAULT SWAP (or insurance): An investment bank, hedge funds and insurance companies.
Buyer purchases a CDS (or insurance) for an underlying asset (the underlying asset could be a loan, a bond, or any type of obligation). There is no requirement that the buyer of the CDS be the owner/holder of the underlying asset.	The CDS seller is selling the insurance for the underlying asset for which the seller will receive regular payments like insurance premiums.
The CDS buyer makes regular payments to the seller of the CDS, like insurance premium. So if XYZ hedge fund buys a CDS for Lehman Brothers debt from Morgan Stanley, XYZ hedge fund will make regular payments to Morgan Stanley, who in this case acts as the insurer for Lehman’s debt.	The CDS seller pockets the regular premium paid by the buyer and promises insurance in exchange. So in this case Morgan Stanley would have priced the CDS on Lehman’s debt based on complex models and sold that insurance to XYZ hedge fund. Morgan Stanley in turn receives and keeps the premiums.
XYZ hedge fund (the buyer of the CDS) is in effect, buying insurance and transferring the risk on Lehman’s debt to the seller of the insurance.	The seller of the CDS, Morgan Stanley, is in effect taking on the risk of the buyer’s underlying asset, Lehman’s debt, and is insuring it. So CDS buyer has transferred the risk to the CDS seller.
In the case of a credit event, the buyer of the CDS (XYZ hedge fund) gets a massive payout from the seller (Morgan Stanley), because the underlying asset has defaulted (i.e. Lehman’s debt defaulted).The payout can be a cash or a physical settlement based on the contract terms.	In the case of a, “credit event,” (i.e. bankruptcy, bond or credit default, obligation default, etc.) because the CDS seller has been collecting premiums and assumed the risk of the underlying asset, they are obligated to compensate the buyer for that. So Morgan Stanley compensates XYZ hedge fund proportionally.

Taking the same example used in the CDS illustration, where XYZ hedge fund buys a CDS for Lehman debt from Morgan Stanley, where the hedge fund in this case does not own or has no exposure to Lehman in any way, and it’s just a speculative play. When any bank, hedge fund or private equity firm buy a CDS on corporate bonds, on company short term or long term debt, this in turn lowers the price and value of these bonds.

Once XYZ hedge fund buys loads of CDS on Lehman’s debt, it is a good thing for this hedge fund if Lehman defaults on its debt. XYZ hedge fund can now short the stock (which was extremely easy to do before the present rules took effect, hedge funds and institutional players could short the stock naked, i.e. short massive amounts of the stock without actually owning it). Observing a rising short interest in the stock, other market players add to the downward momentum and drive down the stock price to depressed levels.

Depressed stock prices forces credit rating agencies to step in and downgrade the company’s debt, which could result in a bankruptcy filing (if sufficient capital cannot be raised for new collateral levels) or a default on their credit. Now, XYZ hedge fund, the buyer of the Credit Default Swap makes enormous profits because Lehman defaulted and Morgan Stanley, the seller of the CDS has to deliver a huge paycheck to XYZ hedge fund. Many suspect these practices could have been rampant in the last few months. One expert described this as, buying (or owning) your neighbors insurance and running his house over with your truck.

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BAD TIMING AT THE WTO

The recent collapse of trade negotiations at the WTO received widespread scrutiny from economists, public servants and industrialists. Some praised our commerce Minister, Mr. Kamal Nath’s unwavering stance to protect the interest of the Indian farmer and others warned that this breakdown in talks could reignite a protectionist era in modern trade and commerce. But the unfortunate finale of the WTO talks shed light on various macroeconomic and geopolitical issues that converged to result in a collapse in negotiations.

A pivotal factor was the severe and unpredictable surge in food and energy prices putting many countries in uncomfortable territory at the negotiating table. No country, developed or developing, wanted drastic changes in import or export policies fearing a sudden inflow or outflow of essential commodities and hence fueling regional instability. Clearly the global macroeconomic environment created temporary disincentives which were reflected in the rigid and inflexible nature of some negotiators.

The US always enjoyed the kingmaker position at global trade talks, often overpowering their way to pro-US policies. Clearly, other nations did not appear to be at the mercy of US negotiators this time around and showed resolve, not giving in to their demands. This does not symbolize the decline of American influence but instead reflects the growing clout of the BRIC countries. Emerging economies no longer have to compromise and can confidently voice their concerns not fearing any severe backlash.

Prominent voices have highlighted that this outcome could be detrimental to expanding global trade because agricultural and farming sector presented the biggest trading opportunity ever to strengthen ties between countries. These opinions cannot be discounted and our officials should ensure this does not take place.

One has to realize that food/agricultural subsidies are the most complex and sensitive areas not only for India but every country at the WTO table. Farming and agriculture is the only sector where every single government has some subsidy program in place. For example, the Americans have enormous subsidies for corn growers, China has subsidies in place for rice farmers, many European countries have widespread subsidies, and our farmers also get significant aid from the government. For this simple reason, no government wanted to risk a backlash from their farming sector, forcing them to be extremely cautious in their decision making process.

Going forward the failure of these talks should not deter economies to negotiate again, but this time exchanging ideas at a smaller scale and taking it one step at a time can help. More bi-lateral and tri-lateral trade agreements should be formed before embarking on multinational trade agreements.

THE NEXT THREAT: INFLATION

The demise of Bear Stearns, failure of IndyMac Bank, troubles at US mortgage giants Fannie and Freddie and the housing debacle coupled with the nasty deleveraging process saw our markets and economy on tenterhooks. Each time we escaped with minor setbacks, clearly reflective of the resilient and agile nature of our financial structure. But something more ominous is gaining momentum which could potentially rattle the economy if kept unchecked: Inflation.

Economist John Maynard Keynes once said, “Inflation is a form of taxation which the public find hardest to evade and even the weakest government can enforce when it can enforce nothing else.” Unfortunately, not much light is being shed on this issue and our Fed is under the illusion that inflation is under control. Something very significant is about to unfold because a variety of factors could converge to drive inflation to disturbing levels.

A post analysis of the most vicious inflationary periods in recent history has shown that inflation primarily finds its roots when money supply increases dramatically. This creates a condition where more money chases the same goods and services, hence driving up price. But now, in addition to an oversupply of money, other factors like high commodity and agricultural prices, imported inflation, rising producer price index and a weak US currency will contribute to drive up inflation.

Money Supply Exploding: The Fed and the Treasury have our printing presses on overtime and money is being printed and pumped into the economy at an alarming rate. The sharp cuts in interest rates from 5.25 to 2 percent in a few months accelerated borrowing by banks and expanded money supply in the form of credit. Amidst all the turmoil, Congress approved a $150 billion stimulus package adding more money into the system now in the form of cash.

Lost in all this noise was a disturbing and vital piece of news which received no coverage. The Treasury/Fed decided to stop publicly releasing M3 money supply information. M3 is an extremely important number because it the broadest measure of money circulating in the economy which is tracked closely by economists. This number gives a clear picture of how much money is in the system. Having been publicly available for decades no rational explanation was given for this retraction. Although less accurate measures of money (like M1 and M2) are still available, it severely hinders the capability to quantify the amount of money in the system.

Imported Inflation: Textiles, electronics, furniture, toys and now even inflation is made in China. Many developing Asian economies which export heavily to the US are experiencing high levels of inflation. Central bankers and regulators in India and China are fighting vigorously to tame inflation, sometimes even at the cost of growth. But inflationary forces are still largely at bay in those economies and a significant portion of that inflation gets imported into the US through their exports.

This unfortunate phenomenon significantly affects our inflation rendering the US government helpless because this inflation is imported. This particular source of inflation is not about to drawdown anytime soon and has to be tackled.

Rising Agricultural/Commodity Prices and PPI: Significant price rises in commodities, agricultural and food products are inciting widespread agitation here and around the world. The producer price index (PPI) is widely considered a leading indicator of where consumer price inflation or CPI is headed. Measuring inflation in primary input articles for a wide array of manufacturers, the PPI reflects the rising cost of production and manufacturing which will eventually be passed on to consumers. Even this number has been on the rise, raising several red flags, which the Fed has chosen to ignore. There seems to be no reprieve for the PPI, which are disturbing signs going forward.

Misery Index: Many economists track the famous Misery Index (unemployment rate plus inflation) which is currently at 10.72 percent (unemployment at 5.7 percent and inflation at 5.02 percent). The appropriately worded indicator basically reflects the overall mood of the economy and the signs don’t look very sanguine going forward.

All these factors will converge and drive inflation to outrageous levels, so now is an appropriate time to look at your portfolio for asset re-allocation.

Your Money: Usually high-inflation periods result in super-low real returns when invested in the stock market (if stock market is up 15 percent, inflation is at 10 percent, your real return is 5 percent). This is primarily because of US Dollar devaluation and loss of purchasing power. Majority of local and dollar denominated investments will drastically underperform and here are some ideal avenues to park your funds in this situation.

1. Buying foreign currencies via ETN’s like CNY and INR or best, buying foreign currencies directly.

2. Investing in commodity rich country’s government bonds with high yields like Australia: Here you are positioned to gain from both currency appreciation and bond yields.

3. Shorting the US dollar via ETF’s like UDN.

4. Purchasing TIPS or Treasury Inflation-Protected Securities.

5. Purchasing significant quantities of gold, silver or other precious metals as a hedge.

6. Buying ETF’s, ETN’s and their options that track inflation.

7. Generally divesting from dollar-denominated assets.

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Money WhizDom: Demystifying, debunking recent Bear Stearns fall out

Adhvith Dhuddu, CT regular columnist

Wednesday, March 26; 12:00 AM

The U.S. hasn't been confronted by an economic tsunami of this proportion since the Great Depression. Our financial report card looks bleaker than ever with declining stock and real estate prices, increasing food and commodity prices, increasing unemployment and inflation, weakening dollar, decreasing investment, stagnant productivity levels and, to top it all off, the failure the world's fifth largest investment bank, Bear Stearns.

Many on Wall Street were aware of the pessimism surrounding Bear Stearns, but the severity of the fallout shocked investors and caught them by surprise. The implosion of Bear Stearns indicated a lot more than the dampened psychology on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lockdown of the financial system in the country (and around the world).

To understand what exactly happened at Bear Stearns, one has to put together a few pieces of the puzzle. The crisis that unfolded here was primarily driven by a liquidity crunch or, in simple terms, a lack of cash to meet day-to-day activities. Complex financial trades performed by investment banks require them to put up and receive large amounts of money (tens of billions) on a day-to-day basis, making them heavily cash dependent. The fluctuating values of its investments are why large sums of money flow in and out daily.

Investment banks are unique in their practice of using extremely high leverage to maximize their returns. A Lehman Brothers or a Goldman Sachs can approach a bank, put up $1 billion in assets (cash, building, money in the bank, etc.) as collateral to receive say $30 billion dollars to invest with and this would be 1:30 leverage. Although it sounds outrageously risky, investment banks thrive on this luxury. Bear Stearns in particular was highly leveraged, as high as 1:40 in some sections of its business.

The commercial banks such as JP Morgan, Bank of America or Wachovia, which provide highly leveraged cash, can anytime call upon the investment bank to put up more collateral if they feel the investment bank has immersed itself in bad investments that are rapidly losing value.

Bear Stearns was whacked with a double whammy when distressed investors started to pull out cash and some of their investments started to decline rapidly, prompting the commercial banks to demand more collateral.

Bear Stearns slowly drained its cash reserves to meet collateral demands, handicapping them on a daily basis. Its cash reserves declined from $17 billion to less than $2 billion in just four days, sparking a bank run. Having run out of cash, it couldn't clear trades on a daily basis, was unable to provide more collateral and couldn't repay many investors. This is when the Feds stepped in via JP Morgan to bail them out by providing emergency funds to continue daily activities, without which the complete financial system could have gone into a seizure.

It's important to distinguish an investment bank from a commercial bank to understand JP Morgan's involvement. Individuals park their money in savings and checking accounts in commercial banks, which are insured by the Federal Depository Insurance Corporation for up to $100,000 per account. It's common knowledge that the Federal Reserve is the primary source of money, but only commercial banks have direct access to this money via the discount window. Commercial banks can borrow directly from the Feds, something an investment bank cannot do.

This is precisely why the Feds had to allow JP Morgan to borrow massively, which then turned around and lent to Bear Stearns just to keep the company afloat. The Feds couldn't have lent to Bear Stearns directly and had to lend via a commercial bank. One could ask, why not Citigroup or Wachovia or Bank of America, as they are also commercial banks? Unfortunately, these banks were preoccupied in cleaning up their own sub-prime mess, and JP Morgan was the only unscathed banking giant still standing tall on Wall Street.

If and when JP Morgan acquires Bear, it will primarily be for Bear Stearns' highly successful prime brokerage and clearing businesses. The other two divisions, investment banking and investment advisory, are of little value to JP, as its own investment banking division is a world-class setup.

One disturbing parallel this crisis draws with the Great Depression is that in both cases, banks caved in. The Great Depression saw widespread failures of commercial banks (this is when the FDIC was introduced), and this time, an investment bank that specialized in advanced investment strategies such as sub-prime mortgages and quantitative trading fell through. Despite their functionary difference, in both cases they perilously threatened to crumble the complete financial system and freeze liquidity.

Note that the Great Depression witnessed widespread failures of banks; in this case, we have only seen one investment bank fail. Any more nasty surprises could cripple our already strained financial system, fueling speculation of a depression or a longer-than-anticipated recession.

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