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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AN UNCERTAIN FUTURE

By Adhvith Dhuddu, Regular Columnist

 

U-Shaped, L-Shaped or V-Shaped recovery?

Governments and central banks all over the world have taken unprecedented steps in the last few months to reverse the global economic meltdown, so far yielding little results. Most economists have accepted that this crisis is so deep that an L-shaped recovery is inevitable. A V-Shaped recovery is close to impossible due to the unfortunate and destructive nature of deleveraging. What started off as deleveraging at investment banks and writing off bad loans has morphed into a colossal global economic, finance and trade crisis. GDP's are being revised down, international trade and investments are falling, confidence levels are at record lows and the tentacles of this crisis have extended to affect even philanthropic and aid packages. A U-Shaped recovery cannot be ruled out, but for this to happen; the animal spirits of corporations, capitalists and bankers all over the world have to be rejuvenated and trust and confidence in the system must be restored.

Usually when governments try to, "help," economic recoveries always slow down and take time. And with billions being pumped in by governments, it seems clearer that global economies will take a long period to recover. 

Disturbing statistics

It's widely accepted that the root of this economic debacle was a decline in US home prices. Even though real estate prices in the US and around the world have taken a beating, more downside is inevitable if home prices have to revert back to long term means. In the US, home prices rose at an annualized rate of 0.7 percent from 1930 to 1997, and at a startling rate of 8 percent per annum from 1998 to 2006. This coupled with the outrageous trade and fiscal deficits that the US is burdened with will only aggravate the current crisis. Total US debt as a percent of GDP is increasing at unprecedented rates and savings of households in the US is at near zero levels. Knowing how indebted the US consumer is, it's only more discouraging when you realize that 70 percent of the US GDP is consumer driven.

The current crisis is already dampening consumer spending, but as time goes by deflationary pressures could have even more aggravating affects on consumer spending. Deflation is a vicious cycle that leads to lower wages, lesser spending, less capital expenditure and a depressed economic environment. Wages and incomes are not rising anytime soon, and it will only be a matter of time before employees are willing to accept wage cuts instead of a total job loss. This is when a deflationary cycle initiates, and lower consumer spending forces businesses to cut prices. Anticipating price cuts, both consumers and businesses will postpone spending which will only lead to a depressed economic environment.

 

The Indian picture

It'll be interesting to watch how corporate India and the country as a whole manages this downturn. This economic slowdown is the first significant and full-fledged slowdown striking the Indian economy after liberalization. We have experienced consistent growth over the last 18 years (since liberalization) and have not been confronted by anything of this scale and magnitude. We were relatively immune to the Asian financial crisis during 1997-98, and the dot com bust of 2001 helped rather than hurt our economy.

The resilience of our economy will be tested and decreasing foreign inflows and trade, will also measure the power and sustainability of our internal consumption levels. But we are far better positioned than many other emerging economies and will not be victimized by downgrades on government debt, etc, like Spain or Greece. The era of cheap capital came to an end in the summer of 2007, and countries around the world will have to access to capital at a much higher cost. Again, we will partially be immune to this because our foreign exchange reserves will help pad any significant impact. 

There are many aspects that affect an economy at any given time, and although it is challenging to quantify future foreign investments and assess the overall confidence in a country’s economy, our own Home Minister (and former Finance Minister, P. Chidambaram), once outlined major factors that affect a foreign investors’ decision making process. There could not be a better time to revisit these factors and assess them individually to see how well positioned India is to tackle this crisis.

The eight major risk factors are: Political risk, Security risk, Policy risk, Commercial risk, Legal risk, Legislative risk, Judicial risk and Regulatory risk. Let’s briefly examine each one.

Political Risk: With general elections less than 5 months away, political risk does exist and is an important factor. The outcome of 2009 general elections will decide who will lead India out of an unprecedented global economic crisis. The possibility of a third-front at the center not only adds instability to the government but uncertainty in corporate India’s mind as to what policies will be pursued. During these testing times, a steady hand is required at the helm.

Security Risk: Without doubt the Mumbai attacks elevated security risk to a new level. The magnitude and audacity with which the attack was carried out sent shivers down all our spines. This crisis can be used as an opportunity to improve our security apparatus to thwart future attacks. But unfortunately security risk remains high and this is not a very comforting factor.

Policy Risk: Although policy risk is not as directly tied to general election results as legislative risk there will definitely be some impact on policy making with a new government. While our fundamental long term growth policies are deeply rooted, many policy changes will be driven by the new government and might affect the way certain sectors of our economy function. For example, the different ministries like, the petroleum ministry, telecommunications ministry, ministry of power etc, largely affect how businesses in those sectors function. So any drastic changes that significantly affect our long term policies will be unwelcomed.  

Commercial Risk: Commercial risks exist everywhere and the general risk of being in business and succeeding is something that the business owner or proprietor largely controls. However, the general business environment when it pertains to corruption, level of transparency, accountability, etc, has drastically improved from a decade or two ago. This should not be a deterring factor.

Legal Risk: In the wake of an extraordinary corporate governance failure at Satyam Computers, all eyes are currently on the legal and judicial system in India. Although some commendable action has been taken, it’ll be important to watch how the legal proceedings of the case unfold. The magnitude and extent of the Satyam saga will mean the decision taken by the courts will leave a dominant precedent. The only other factor in this area is the ability to enforce laws well. Having world class laws means little if they are not enforced with authority due to fear of retribution. 

Legislative Risk: Legislative risk is again interrelated with political and policy risk. All these three factors, legislative, political and policy risk hinge on the outcome of the general elections in the next few months.

Judicial Risk: Judicial risk largely pertains to how our courts apply and interpret the laws of the land. This is driven by how well separated the judiciary, the legislative and executive branches of government are. Although it is generally accepted in India that there is some intermingling between the three branches, over the years, the judicial independence practiced has improved dramatically. So even though a factor, it would definitely not be a risk.  

Regulatory Risk: The biggest fear given the current global economic scenario is widespread protectionism for India or any other economy. This will drastically affect the progress of our economy, and take us backward rather than forward. If populous policies are followed and over-regulation or misguided regulation takes over, then our economic growth will slow down and eventually stagnate. Although a valid fear, over the years the loosing up of regulators and the freedom given to the markets is an encouraging sign.

So one can think, analyze and assess for themselves how India ranks in all these categories and come to a conclusion as to how well we are positioned for short and long term growth. 

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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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TACKLING INFLATION THE RIGHT WAY

Economist John Maynard Keynes 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.” This invisible tax eats into the savings and incomes of the rich and poor alike, but impacts the lower rung more. In a developing economy like ours, the absence of a social security safety net and absence of income and employment insurance in the unorganized sector (which employs a significant portion of our population) severely aggravates the inflationary consequences for lower and lower-middle class families. The published inflation rate clouds the all important rate of increase in the price of basic food articles which affects the majority of our population.

Many attribute the current spike in inflation to global externalities like widespread commodity price rise, supply shortages, demand increases, etc. This is true only to a certain extent but there are various India specific factors that can be calibrated to tame inflation. Here are a few.

1. Money Supply Levels: When the supply of money increases, there tends to be a cyclical effect of more money chasing the same number of goods and services, directly inflating their prices. A post analysis of the most vicious inflationary periods of recent times (Germany and Japan in the 1970s, USA from 1973 to 1982) showed that the primary driver of inflation was high levels of money supply. By simply looking at RBI statements, it is clear that money supply in increasing at an alarming rate. This must be controlled, and RBI has been taking steps in the right direction in this department (by hiking CRR, SLR and other important rates). But the pace of tightening has to be accelerated even if it is at the cost of a slow growth rate for 1-2 years.

2. Currency Suppression: Despite the endorsement of many economists and other financial pundits, our Reserve Bank continues to control our currency, not allowing market forces to dictate the right price. This flawed approach to undervalue the currency to help only export-oriented industries is wrong and unsustainable in the long run. The government should slowly adopt a hands-off approach to currency management and let the Indian Rupee appreciate.

A stronger Rupee will automatically reduce food exports, keeping more food at home, hence increasing supply. The increased purchasing power of our currency will help us buy more food and essentials from abroad (increasing supply again) and the cost of goods and services at home will decrease (because of the increased purchasing power of our currency) coalescing to suppress inflation.

3. Other Temporary Policies: In addition to this, our Government should also announce some emergency policies like temporary food credit, or water/electricity subsidy for lower and lower middle class families to help them navigate these tough times. Raging inflation is also a disincentive to save and families that live on low wages struggle to make ends meet. This should be considered by the Center and some temporary measures to help our economically backward must be implemented.

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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FKCCI ARTICLE: JUNE/JULY 2008 ISSUE

GOLD WILL CONTINUE TO GLITTER

By Adhvith Muralidhar Dhuddu, Regular Columnist

There’s been much hullabaloo about investing in gold and gold related companies in the last few months. Although gold has historically been a low yielding investment in the long run, it has run up spectacularly and more than doubled in the last few years. With the stock markets in India, China and the USA in shambles right now and other asset classes drastically underperforming, investors are exploring safe havens like gold, silver (and other precious metals and commodities) to park their funds. But let’s look at some basic drivers of supply and demand for gold to see if it will continue to shine.

1. Inflation and Gold as a safe haven: Inflationary periods are detrimental to any economy and if high inflation persists for long, it consistently erodes the value of a country’s currency. Going back to the basics of money, we recognize that the primary function of money is: (a) to preserve value, (b) to be a medium of exchange and facilitate easy transactions, (c) to be a unit of account to help measure the value of an economy. The second and third function can be taken for granted as this is fulfilled irrespective of the type of currency or money used. But the most important function of money is to preserve and store value. If Rs.10 could buy you 5 tomatoes a few years ago, but can only buy you two tomatoes now, clearly the purchasing power of the currency has declined and it has failed to preserve value. Governments and central banks use politically appropriate verbiage and label this inflation.

When this phenomenon unfolds there is a rush to accrue assets that don’t decline in value and historically gold has been that safe haven. Gold is traditionally identified as a safe haven investment that preserves capital and increases in value gradually. But what is unfolding now is monumental because not only are emerging economies experiencing high inflation, slowly the US and the European economies will face inflationary problems. When this occurs, the rush to accumulate gold will drastically drive up the price with an increase in demand.

2. Gold investments via ETFs, ETN’s and increased access to retail investors: The only access individual investors had to invest in gold was jewelry and coins making it an illiquid and untradeable asset. But this is rapidly changing. Now, investors can buy, sell and trade gold with ease with the introduction of Exchange Traded Funds (ETF’s) and Exchange Traded Notes (ETN’s).

The boxed portion of the gold supply demand table below clearly reflects the rise in demand for gold by retail investors via ETF’s and other similar products. This is poised to increase tremendously as the demand to invest and trade gold continuously increases. The rise in popularity of these ETF’s and ETN’s is evident in the US markets and as other emerging countries’ financial markets mature to provide these instruments, the demand and popularity for them will increase. Another vital factor is that gold is considered a safe haven not just by US investors or households in India, but every individual, bank, and fund manager knows that gold is a safe haven investment and as access, liquidity and tradability increases, there will undoubtedly be more demand.

3. Role of Central Banks, Sovereign Wealth Funds and Foreign Exchange Reserves: As more wealth is created in third world and emerging economies and as foreign exchange reserves of export oriented countries continue to swell the demand for gold will continue to rise. The US Dollar’s recent decline has hurt the value of foreign exchange reserves forcing policymakers to identify another stable currency or any other form of capital preserving asset. And many central banks are slowly transitioning portions of their funds to gold, silver and other precious metals. Not only is gold turning out to be a safe haven for retail investors, even central banks and sovereign wealth funds want to park their funds in gold.

Nobel Prize economist Joseph Stiglitz clearly delineated in his book, “Making Globalization Work”, the flawed single currency reserve system. Many of the fears he outlined are slowly unfolding with the US dollar becoming a less favorable reserve currency. Allocators of forex reserves are prudently diversifying their funds by exploring other currency options like the Euro and Yen and safe haven commodities like gold and silver.

4. The Dollar Factor: The weakening of the US dollar has significantly affected the price of gold. Like crude oil, gold is a dollar denominated asset and its relative price has risen with the fall in the value of the US dollar. At least 15 to 20 percent of the price rise in gold can be attributed to the weakening of the US dollar.

Although the US Dollar/Indian Rupee relationship has been choppy, the overall strength of the US dollar (measured best using the US Dollar Index), which compiles the US Dollar exchange rates with the Yen, Euro, Pound, Swiss Franc and other major currencies has significantly declined. So the USD’s comprehensive weakness in the last few years helped inflate the price of gold, silver, steel, copper, crude oil, natural gas and many other US Dollar denominated commodities. Hence, going forward, the movements of the US Dollar will considerably impact the price of gold.

5. Universal demand and supply: Given below is a table outlining the worldwide supply and demand for gold in the last ten years. A comfortable balance can be observed in the supply less demand column which fails to explain why the price of gold has increased so much. What’s important now is not what the historical relationship was, but what will the supply demand relationship will look like going forward.

The increase in demand for gold going forward cannot be denied. Going forward, demand for gold to use in electronics, dentistry, and other industrial applications will only increase. But the supply picture for gold does not look very bright. Gold supply has increased at an average rate of 2-3 percent historically and this number is not about to change any time soon. One has to remember that the supply of gold is limited to how much gold is mined which limits the availability of this commodity.

6. Extreme Cases: Some economists have boldly predicted that the days of fiat currencies are numbered and the world will return to the gold standard. This could unfold if a major currency like the Dollar, Euro or Yen completely collapses or if inflation in developed economies like US reaches the stratosphere rendering paper money to be completely valueless. Although these are extreme cases nothing can be ruled out. In this case, the value of gold will also reach the stratosphere trading at eight to ten times of its current price.

Clearly, the current dire economic scenarios around the world, and other favorable factors outlined will send the price of gold higher. One should explore to see how they can diversify to include gold in their portfolio.