Where is GOLD headed, and WHAT DETERMINES its direction?

Gold has been inching up quietly in the last few weeks, and not many are taking notice because there haven't been any monster moves. But the way it's shaping up on the charts, we could see some huge movements coming in the next few weeks. Coincidently, gold has been in an uptrend ever since November of 2008 (click on the chart below for a bigger picture in a new window), when the financial crisis was unfolding at a rapid pace. It' has formed higher bottoms, has never reached the November 2008 lows and is approaching the previous tops made in Aug-08 and March-09, which are all pretty bullish signs. Here are some things to watch out for when trying to forecast gold's future movements. 

1. The continued weakness of the US dollar is contributing heavily to the rise in gold. If the dollar continues to depreciate against major currencies, the uptrend in gold might continue. 

2. Gold is comfortably above two critical moving averages (the 50 day and 200 day moving averages) which is a very bullish sign on for commodity traders. 

3. The technical formation on gold is very bullish as volume has also been picking up slightly in the last 2 weeks. 

4. Gold has massive resistance between $1000-$1020 which is a very critical band. If gold consolidates there and lacks strength as it reaches that price, it can correct back to the $900 levels. The other scenario which is more likely is that gold will shoot through this resistance with good volume and reach $1100-$1120 very soon. 

5. Fundamentally speaking, if the, "green shoots," sprouting in different economies turn out to be weeds, i.e. a false signs of recovery, then gold is the safe haven that everyone will rush to, which should send the price of the yellow metal up another 15-20 percent. 

6. Many countries are slowly and silently divesting tiny portions of their US treasury holdings in their foreign exchange reserves and funneling them towards gold. In fact, if the dollar crashes gold prices will SURGE so this acts as a small hedge in many cases. 

7. If the commodity bull market resumes and initiates its second leg, then gold might see historical levels very soon. 

NOTE THAT THE CHART BELOW IS FOR THE GOLD ETF GLD. THIS ETF APPROXIMATELY REFLECTS 1/10TH THE PRICE OF AN ACTUAL OUNCE OF GOLD. CLICK ON THE CHART BELOW FOR A CLEAR PICTURE. 

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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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TV 9 INTERVIEW: COMMENTING ON THE IT SECTOR SLOWDOWN IN INDIA

I was recently interviewed by TV9 news (a local news channel) and gave my opinion on the slowdown in the IT sector, and how it's interrelated with the slump in the US economy. The main points discussed are breifly given here. 

1. The main sectors affected in the US during this recession are: financial services, insurance, brokerage and banking. Companies in these sectors outsource a significant amount of activities to Indian and other IT companies. Therefore the slowdown has affected their IT spending numbers leading to depressed revenues and profits. 

2. IT budgets in many mutli-national companies like Citi, JP Morgan, etc. have been slashed leading to lower IT capital spending. This again affects Indian IT firms. In FY 2009, tech spend in the US declined by 9 percent and in FY 2010, the outlook is not very sanguine either, as tech spend might stay the same or decrease marginally. 

3. IT budgets in Indian companies too have taken a hit. They grew at a healthy pace by 13-14 percent in FY 2008, and might grow only at 4-5 percent in FY 2009. IT budgets in the coming financial year might either stay constant or just grow marginally. 

4. IT spending is usually divided into essentail and non-essential IT spending. Essential IT spend usually consists of 60-70 percent of the IT budget, which has been steady. It's the non-essential IT spend that had declined. 

5. As a result, many Indian IT firms are accepting contracts at a lesser price.Projects that were usually done at a certian price, are being accepted at 10-15 percent less. 

From Public Gallery

From Public Gallery

From Public Gallery

WHAT'S NEXT FOR THE INDIAN AND GLOBAL ECONOMY? 

By, Adhvith Dhuddu

The dust seems to have settled from the tremors of the Lehman collapse, and the turbulent Sept-Nov period last year. More economists, businesspersons and governments are coming to terms with the true depth and nature of this economic crisis. Markets are still at relative lows even after a substantial rebound, and GDP and trade estimates are still very conservative; but what’s next for the global economy, and how do we know that we are truly recovering? Both here and in the US, volatility indices for major stock indices have subsided reflecting the departure of fear and anxiety in the markets. But here are some critical leading and lagging indicators that will shine more light on the economic picture going forward.

Velocity of Money: Although rarely discussed in the mainstream media, the velocity of money is vital in abetting recoveries all over the globeWW. The G-20 nations recently committed to pumping in billions throughout the global economy hoping to jump start the revival. This huge government spending spree will be ineffective if the velocity of money does not pick up pace. The velocity of money is basically the average frequency with which money is spent in a specific period of time.

The most recent boom periods during the 1990s in the USA and the last decade in India did not happen because of unprecedented government spending, or huge stimulus packages. During these boom periods, even though the amount of money in the system grew steadily, the velocity of money was extremely high leading to healthy growth rates. This is just another reflection of consumer sentiment; when the mood is sanguine, the consumer tends to spend more and save less (which results in a higher velocity of money) but the reverse is happening now. If the billions being ploughed in don’t initiate a rejuvenated spending cycle or if the velocity of money doesn’t garner momentum, this downturn can last a while.

Another vital component of the velocity of money is the money created in the system through securitization and the shadow banking system. The velocity of money increased gradually over the last decade because it was also aided by financial innovation and securitization. Even though it’s 6-7 months after the crisis the shadow banking system is still in tatters and will take time to recover.

Deflationary threat: Going back to the basics, we learn that inflation is caused when more money is chasing a limited number of goods and services. We saw this unfold in an ugly manner at the height of our recent economic expansion. Now, inflation is at zero levels and many speak of a dangerous deflationary spiral. Although our Planning Commission’s Deputy Chairman, Dr. Ahluwalia has dismissed these fears, they are real and present dangers for a simple reason, now there is less and less money chasing the same number of goods and services.

It’s an oversimplified explanation for a potentially complex problem. But this is true for many reasons; no banks here or anywhere in the world can now borrow with 1:30 leverage. In the pre-crisis days, $10 million could result in $300 million worth of investment/spending spread over the globe, and let’s say 25 percent of that is allocated equally to BRIC countries: India would probably see $18.75 million (Rs. 93.7 crore) worth of investments. But now, if investment banks or any investor can secure 1:10 leverage, the same equation would bring only $6.25 million (Rs. 31.2 crore) to India. This trickles down and when there is less money to trickle down, everyone has less to spend and less to save, which starts suppressing prices. This is already happening here and across the world. Consumers are either spending less or delaying their spending plans leading to lower sales and retailers cutting prices.

Recent data from the RBI and other private banks are only rubbing salt to the wound. Despite proactive measures from the RBI, lending growth in the latest fiscal fell by 5 percentage points from 22.3 percent in 2008 to 17.3 percent in 2009, way off their own target of 24 percent (non-food credit by scheduled commercial banks). This is relevant because credit is a form of money in the system; reinforcing the fact that now there is less money chasing the same goods and services.

Stock market rebound: In efficient markets, stock prices are reflective of the future earnings stream but in the current scenario, one needs to accept the global rebound in indices with a pinch of salt. Technical analysis is a passion of mine, and we learn in the basics of technical analysis that when any chart appears heavily oversold, there is eventually a rebound. So this mini-rally across the globe is primarily due to two reasons: It’s a snap back of the spring to rebound coupled with subtle signs of optimism in a few macro indicators. Helping the rebound along the way is short-covering; but this rally will eventually lose steam and test the recent lows of the Sensex and Nifty.

Success of TARP, TALF and PPIP: If a $13 trillion economy doesn’t get going in a $50 trillion global economy, we might have some serious troubles ahead. Yes, there are possibilities that one of the BRIC countries or emerging markets as a whole could dampen the overall blow and lead the way out of this crisis. One must cautiously accept this because it has never happened before and will be an unprecedented and monumental feat if achieved.

This is why the success of TARP (Troubled Assets Relief Program), TALF (Term Asset-Backed Securities Loan Facility) and PPIP (Public-Private Investment Program) is vital. These flagship programs designed by the US government to pull their economy out of turmoil has so far been progressing according to plan which is why US president Barack Obama recently said he saw, “glimmers of hope,” in the economy. 

These and other pivotal factors like better trade numbers, a flight from safe havens like gold and government bonds and how well the reformed securitization market serves the recovery will be keys to the recovery. But one thing is certain; the capitalist system that emerges out of this financial crisis will be regulated more closely, monitored more vigilantly and animal spirits will now have shackles to break. 

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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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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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