Advantage India

What does faster economic growth of nations as a whole means to India and China? It first gets reflected in the commodity prices. Commodities and Stock indices have higher correlations during bull runs. Will India and China suffer the same impact? No! China with its pegged exchanged rate, suffers as the oil and other commodity prices zooms in terms of dollars (QE2 has a good chance of fueling dollar inflation w.r to international commodities). Whereas, the rupee which has a flexible exchange range, appreciates with the QE policy of fed and suffers very less in terms of commodity prices.

What does this means to U.S? Rising prices of commodities driven combined with the devaluation doesn't augur well for the US economy. Sooner or later, this might lead to inflation. The resulting spike in interest rate (there is a limit for the interest rate to be held down by Fed) to protect investment from inflation combined with the high employment might lead to another episode of stagflation. Fed which was already handicapped with exhausting most of its monetary policy tools, may have a tough time going forward!

The sinking ship

How long can one keep a boat with a leak afloat by pumping water? 

So long as the rate of pumping water out is more than that seeping in...

What in case, if the hole gets bigger and bigger?

.....

Fed's Open market operation with respect to its latest policy (QE2) is similar to the one mentioned above. Let us see how it is. 

It is essential that the government spends more (fiscal policies) to stimulate the economy in recession. In parallel, it also requires monetary policies to keep the interest rate low to boost consumption/ investment. But how long can these actions go hand in hand? 

In fact, these two actions are opposite in nature. As the government spends more by borrowing more, it naturally leads to increase in interest rates, which is in contrary to the objectives of the central bank,namely, to keep the interest rate low. To achieve its objective, the central bank has to buy back the bonds, which requires printing more money.

Is it possible to keep the interest just by printing the money? 

To an extent yes. Just like any other price discovery, by manipulating the demand vs supply, i.e., by buying more of government bonds (funded by printing more money), the interest rates can be artificially kept low. To the extent of printing money, the U.S dollar gets devalued against the other currencies (Dollar has appreciated so far by 7% against basket of currencies this year). By interest rate parity, a currency has to pay the rent (interest rate of U.S bond in this case), to the extent of its expected devaluation. So the interest on the U.S bonds has to give in ultimately.

At the same time, printing money has its own consequences, namely, inflation. At present, printing money doesn't lead to inflation because of 1) decrease in the velocity of money 2) Dollar being the reserve currency (which is questioned every now and then).

But in the long run, when the correction happens, the price has to reflect the fundamentals. Any moderate reverse in the direction of the economy and the subsequent increase in the velocity of money will result in hyperinflation. When such expectations starts kicking in, the status of reserve currency which supports the interest rates (to an extent) will give away, resulting in the investors asking for more rent for their investments. No amount of Fed's intervention can save the interest rates in that case.

To worsen the scenario, the U.S government has liability of over a couple of trillions in terms of social benefits without any matching assets which has to be funded again by more borrowing. The baby boomers who will be enjoying these benefits will start retiring in a couple of years. Let us see how long will the Fed be able to pump the water from this sinking ship.

Have they overdone it?

The stock markets have been rallying for more than a year now starting from March 2009 and have sprung back sharply. Did the fundamentals change so drastically? What explains such a high pull back in the stock markets? At least the emerging market’s movement can be justified by its long-term growth story (Again there is questions about its sustainability and the extent of decoupling). How about U.S?

It is true that many blue chips are showing great profit numbers. But if so shouldn’t it reflect also in employment generation? Most the employment generated in the last few months is by government hiring (For Census work!!! - Temporary) If the demand is really picking up, with the amount of money pumped into the system, shouldn’t it result in inflation? Isn’t something missing here?

So if the profits are not through increase in demand, then how come the companies are posting profit? True that, though criticized by many, the TARP, cash for clunkers, active buying of securities of the Freddie Mac and Fannie Mae and other stimulant measures have been helping in keeping the consumer demand alive. But does it explain the growth story fully?

So what really explains the growth in profits? Recollecting our basic accounting, we know that the profit can be increased by two ways – Increase the income or decrease the expenditure. You got the point! Exactly! The companies, other than the meager rise in demand, mostly showed growth figure driven by cutting down the expenditure (and hence the sustaining unemployment growth) rather than the required top line growth!!

With the official unemployment figures still at 10% (unofficially by various estimates more than 20%) and the so called growth for Q1 at 1.6% (a minimum of 2.5% growth is expected to just keep the unemployment from rising), what is the probability of pickup and with now, the open expression of the fear of double dip by top officials, could the growth really turn red?

Fed Chairman keeps talking about the extra ordinary power of the Fed to boost the economy if needed. If it had such extra ordinary power, why not execute it? What are they waiting for? And the acclaimed Nobel Laureate, Paul Krugman suggests to buy even more bonds of the mortgage institutions (of Freddie and Fannie well known AAA rated junks) and act desperate to the extent of putting money directly into the pockets of the people to keep the consumption going on. The interest rates already near zero at 0.25%. How more can the Fed reduce it?

This combination of high stock market, with sky high P/E inadequately explained by the fundamentals of the underlying was once observed in history – in 1980s in Japan. The stocks more than being driven by the fundamentals, were driven by the cheap cost of capital resulting in loss of discrimination between assets of various risks and very high correlation among them. What else can explain the PE multiples of the stocks today? Economists suggest an interest rate of at least 3% to have a sustainable economy. Have they overdone in reducing the interest rates?

Other than the stock markets, what are the ill effects of the low interest rates? U.S economy is structurally very different from Japan, which has a very high savings rate and are more banks driven. Even if there is an external shock, there won’t be much impact on the prices. Domestic savings and the bank’s holdings of the government securities can be used control the interest rates. The case is different in U.S. The low interest rates have effectively dis-incentivized the savers resulting in the abysmally low savings. Of the trade deficit of 29 billion suffered by U.S, approximately 27 billion is against China. Any supply shock (possible because of the govt. policies to control over heating) and adverse currency movement of Yuan against the dollar (China can effectively control the over heating by letting the Yuan appreciate) could severe impact the prices within the U.S. Given the structural deficits built up within the state over these years, it will be difficult to cope up. That too with the still continuing benefits for the people, by the government (approx. $1900/month as unemployment benefit per head), there is very good chance of inflation -what scares both the republicans and democrats and made them work together to bring in the austerity measures. In such a situation, Fed’s act to buy its own bonds will only add fuel to the fire by infusing even more liquidity. 

What is the way out? I don’t know! Let us wait and see what happens!!!

“I” or “We”

“Together we raise, apart we fall” – good and wise saying. But when it is not so complex to understand & follow and when the dividends are great, why are we still not able to reap the benefits of “we” and stay apart? This is well captured by the game theory – in “Prisoner’s dilemma”. There is an incentive to defect based on one’s insecurity over the decision of the other player.

This does not apply to just individuals and firms. This can be extended to nations too. Take the case of today’s world. What is keeping this ongoing financial crisis to continue? The prime reason, the problem with the asset bubbles and the following credit crunch is inherent to any capitalistic economy and history has seen many such events in the past. Even many economists suggest the solution to be simple – another bubble to be the solution for a burst. (Of course, they didn’t necessarily mean the path for another recession. To take it as a healthy credit growth or a bubble is circumstantial and difficult to demarcate at times. This is a separate discussion altogether. We shall leave it here.) If one observes the overall behavior of the nations, one can feel the growing insecurities of the nations. Then it won’t be too difficult to decipher, this weakness to be at the core of the growing problem.

The trade theories – Smith’s Absolute advantage, Ricardian’s Competitive advantage sounds perfectly logical. Even Adam smith’s Self correcting arm was accepted for centuries. Then why are the economies not adjusting? Remember, all these theories were posed well before the game theories came into existence. Probably they didn’t consider the human (read it as national) psyche and the dominant feeling of “I” over the “We” among the nations.

Ideally the appreciating Yuan should naturally adjust the rising surplus of the China and the consequential unemployment in U.S. And the problem with the Greece and the other PIGS nations could have been easily solved had the nations like Germany, which hugely benefits from the weakness of its neighbours (The trade deficit of the Greece, had it been a sovereign nation with independent monetary policy would have been reduced by the depreciating Drachma. Necessarily, the Euro is kept undervalued by the trade deficit nations and the Germany being part of this monetary Union is enjoying the undervalued Euro posting trade surplus) supports with a loose monetary policies. These exemplifies where the focus of the nations are. It is more inwards than outwards. This also explains the huge for-ex reserves to be maintained by many nations.

Another thing to consider is the movement of resources across boundaries. Here I don’t mean the natural resources. Rather the human resource. This is where the European union has failed where the “United States” of America succeeded. Mobility of humans doesn’t happen just with the needs. Culture, language and lot other forces act as  “transaction cost” in movement of labor forces. Despite major policy changes to allow free labor movement, Europe is not able to achieve what U.S had. Though Europe had achieved (to an extent) as a monetary union, it failed as an economic union. This is another impediment to achieve free mobility and perfect markets and the ideal capitalism.

The self-controlling arm is hugely restrained by the government policies, both internal (like wage protection) and external (currency manipulation and trade barriers). If capitalism is at the core of the policies and when “I” gets more preference, how else can we expect the nations to behave? As it goes with the prisoner’s dilemma, nations don’t have enough trust in its trading partners and the government’s are more bothered about the interest of its people and firms.

“All these are well known!! Of course, the governments are meant to be more concerned about its own people rather than its neighbors”. Yeah! True. That is why we need to look at the free market and trade theories under the lens of the human psyche’s manifestation as a nation. Is the modern “Behavioral economics” considering the behavior of the nations or is it stopping with just individuals and firms? Wikipedia explanation doesn’t look encouraging.

How stressed are the stress tests conducted on European banks?

Understanding of the stress test prerequisites a basic understanding of the Basel norms and the Capital Adequacy ratio. To put it in simple english, the Basel norms states that, the banks can’t build assets (lending) purely based on the borrowing (deposits). Rather, a portion of the lending is supposed to be backed by one’s own capital which will be proportionate to the risk of the assets

For example, if a bank has an exposure of 100 Cr. in a personal loan portfolio, and the value at risk for this portfolio is 20%, the amount of capital to be maintained to have an exposure of 100 Cr. in this loan portfolio is 20% * 9% * 100 Cr (9% is the Capital adequacy ratio advised by the RBI to the Indian banks) = 1.8 crore.

Having understood how the CAR is calculated, let us move to the next step of how this figure 20% is arrived at. Traditionally (Basel I norms), the central bank dictates this risk weight-age for various asset classes based on its analysis of the economy. (This has also been used by the central banks to restrict or enhance the flow of money to any particular sector).Basel II norms gives freedom to the bank to arrive at its own figure based on the borrowing characteristics of its customers and stop with just suggesting the mathematical model to compute this figure.

There are primarily two ways of calculating this figure. One is VaR method which calculates the value at risk for any portfolio in 99% of the case. This is done by mathematical simulation based on historical data. Another method involves, calculating key parameters like Probability of default (% of customers who will default in a portfolio), Loss given default (in case a customer default what will be the loss for the bank) and Exposure at default (The extent to which the customer would have utilized his/her credit line by the time he/she defaults). The product of these three parameters along with adjustments gives the risk of that portfolio. The Basel Committee advises to take historical data of at least 7-8 years to cover the variations in the business cycles.

The problem here is that, as you might have noticed, the banks hold capital only to the extent of value at risk 99% of the time or the average loss that may arise in a portfolio. Whereas today’s situation as evident is beyond this 99% range and certainly not normal. 

Also, the stress test is supposed to assume the worst case of defaults for all the portfolios and see whether the capital of the bank still holds good. Whether they have taken all the worst scenarios enough to make this test stressed? The most feared, the event of default of sovereign bonds is not at all taken! Though they assure that such an event will never occur, why should they be excluded? Shouldn’t the stress tests capture the worst case scenarios? 

Certainly, going by the basel formulas, most of the capital of the most of the banks should have been compromised by the ongoing economic crisis. This being the case, saying that just a few billion is enough to regain the cut off of 6% (set for this stress test) doesn’t sound convincing. Also while adjusting for the loses arising out of holding government securities, only trading books were considered and not the portfolio of bonds under “Held till maturity” (Bonds held under trading book constitutes just a fraction, usually in one or two tenths of the bonds held under HTM-Held till maturity). Is it appropriate to call this as “stress test”?

Is it possible for U.S to regain its trade balance? If at all possible, How?

As discussed in my previous post, “Why Yuan Devaluation won’t work?”, the problem can be easily understood with the lens of “International product life cycle” theory. The well established firms (as wisely put, the “nationless” firms) have started moving out to third world countries (will be more appropriate to call migrated) to achieve their objective, namely profit optimization, by availing low cost inputs.

In the era of globalization, no firm can retain its competitiveness by having its base in developed economies where factor costs are so high. It is true that companies like Apple need not have to go for low cost production and can command the premium they want. But this is true only if you are targeting high end customers who are ready to pay premium for the luxury they desire. It is obvious that only few companies have the R&D, capacity and vision to stay put healthy in this section and most other firms try to retain their position by covering up their weakness of low quality products through the volumes, i.e., by manufacturing in large scale catering to the needs of the majority middle/ lower income group. (A point to note, Even the premium product maker, Apple itself, outsources the manufacturing process to take the advantage of the low factor cost in China)

It makes no business sense for the firms to have their manufacturing base in U.S if you discount the other costs involved in Exports-Imports, Freights etc. In ideal scenario with minimal transaction cost, it makes perfect business sense to outsource most of the production work to the low cost countries and retain only the processes which involves lot of machinery and less of humans.

So how can they counter the heavy imports? They can add some more value to the goods they imported and export it back to the emerging economies. But as we have already seen, the products produced in western world can compete only in high income segment. So this option of adding value and re-exporting is not feasible. Then what is the solution? When the U.S opened up its economy for free trade, it also should have freed up the labor market. With the current defensive policies of the governments like minimum wage, etc., the American firms tend to lose their competitiveness vis-a-vis the companies having base in the emerging economies. It can only worsen their economy to tempt these giants to move out to get a cost advantage and that is what happening now, resulting in huge trade deficits in U.S. It now tries to solve the structural problem just by manipulating the currency, asking the China to devalue its currency.

Another problem with the U.S is its own currency. U.S, with its dollar being the reserve currency it is in a very similar position to that of Greece. Just how Greece cannot devalue its currency (The Euro which it shares with other member nation) and rebalance its economy, U.S also cannot easily devalue its currency so easily. Only way it can lose its value is losing the confidence in it, which can be very lethal making the issue very tricky.

Does it mean China is a winner in this game? No! China has its own structural issues. Just like how U.S firms have the problem of serving the high end customers in terms of the value it generates through its products, China’s problem lies in the purchasing power of its customers, who unfortunately are not its citizens rather U.S’s citizens. So it is not enough that China takes care of its citizens, but also have to take care of U.S’ citizens by supplying it with low-cost debt for its survival, in whose absence both the economies have to collapse.

Why is this imbalance? Shouldn’t there be a mechanism (invisible hand) which corrects situation? Exactly, that is what happening. But in a painful way. The Chinese can keep on subsidizing the U.S only to an extent. After which it can’t sustain and let the Yuan appreciate, thereby making its citizens wealthier (Pain for the U.S because, all the goods they enjoy at low cost will become costlier to the extent of their imports from China and Yuan’s appreciation. This may lead to further repercussions in the economy) But for that to happen, a lot of structural needs to be done, to let the citizens reap the benefits of the hard work they have put for decades while the currency appreciates. Else, the dispersion of benefits will be skewed, resulting in China returning back to square one with its citizens not having much purchasing power. It has to replay the game starting with export again. So it won’t let the Yuan appreciate so easily. It demands lot of patience in planning and execution and will take its own time so as not to hurt its economy.

Once the currencies regains its balance, the factor costs of inputs will also regain some balance and it will make business sense for the firms to come back and until then, the U.S will continue to have deficits.

Note: In the discussion, I have ignored the transaction and freight costs involved in exports and imports. In reality, the firms will return well before the currencies exactly balance each other.

Why Yuan Devaluation won’t work?

The problem with the US trade deficit is structural rather than caused by currency pegging. US claims that, it is at disadvantage vis-à-vis China because of inappropriate exchange rates and hopes to bring down the trade deficit by devaluing dollar vis-à-vis Yuan. But data of the last few years shows that though dollar gained strength vis-à-vis Yuan, it has significantly lost its value against other currencies (like Yen) but still hasn’t seen any improvement in trade deficit with the respective countries (Japan).

One thing to be noted is what happened during the 1970s and 1980s. Though Yen (America by then accused Japan similar to what does against China of currency manipulation) raised drastically from around more than 300 Yen a dollar to almost below 100 Yen dollar, the trade balance of U.S still suffered. Though by then the reason is altogether different (Business and manufacturing efficiency), the point I wish to stress here is that, U.S, instead of looking within itself, has tried and trying to solve its problems by manipulating others.

The problem here is that the bigger firms of U.S has altered their approach in business, either moving out the production shop out of U.S or outsourcing the job to other emerging economies in order to achieve cost advantage, while working only on R&D and strategically & technically important manufacturing activities in their country (as explained by the theory on International product life cycle). Until the companies move back to America, the country’s trade deficit will only continue to increase. What are conditions, which favor the companies, return to their motherland? Will they return? Will discuss these in the next blog entry.