The European Central Bank Finally Learns From The US Federal Reserve...

The former US Treasury Secretary, John Connally, had once famously remarked to a group of worried European Finance Ministers that "the US dollar is our currency, but your problem"

In spearheading a (banker friendly) bailout of the US economic and financial system, the US Federal Reserve Chairman Ben Bernanke has made ample use of this dominance - the facts that the US dollar is the most traded currency in the world, the largest reserve currency as well as the largest currency of denomination for assets.

Finally, the European Central Bank under Mario Draghi has realized that all those things are applicable to the Euro as well - just add "2nd".

Through quantitative easing, Bernanke weakened the US currency to keep domestic US interest rates low. Effectively, the credit risk premiums on US assets got reflected in the weakening of the currency rather than in the rising of interest rates. This improved the situation for US entities - Govt, Banks, Consumers - to borrow.

Who suffers in such a case? It is the creditors / investors in US assets who do. China, Japan, Middle East et al And because the US dollar is their problem (the TINA factor - There Is No Alternative), they don't have much of a choice. They can't diversify out of their US dollar assets because the holdings are simply too large. Of course, they have held US assets for their own benefit - China to keep its own currency undervalued and boost exports, the Middle East for political ties and so on.

Now, the ECB through its 3 year Unlimited Repo has done pretty much what the Fed did, with a European flavour of course.

Unlike the US which is fiscally and monetarily integrated, Europe isn't. Hence, while the Fed could lend to the US Govt by buying US Govt Bonds through pure money creation, the ECB has been unwilling to do so (at least in the same form)

What it is willing to do is lend to banks. Under the guise of liquidity support. Unlimited loans at 1%, for 3 years.

The numbers don't make sense. The Italian Government borrows from the market at 7%, while Italian banks can borrow from the ECB at 1%. Clearly, 1% seems to be a ridiculously low rate at which to lend money to banks.

Further, I don't understand how a period of 3 years constitutes liquidity support. Basically, its a medium term loan, given very cheaply.

What happens when banks get funds at very low rates (lower than what they should be)? They get into carry trades - use those funds to buy or speculate on higher yielding assets. We have seen massive carry trade cycles with the Yen & the US Dollar in past years (The Subprime Crisis being partially a fallout of this).

Surely the ECB would know that banks are no angels. Then why is it doing this?

The answer is that by doing this, ECB can lend to the European Govts, which it otherwise has been unwilling to.

Banks, flush with cheap cash, can now buy more of Eurozone Govt Bonds. Ideally, going by pure economics, they wouldn't want to. But there will be other considerations which will make them buy. For one, the banks and governments are very closely aligned in Europe. Further, the fortunes of the two are inextricably linked. Both have to display confidence in each other to survive.

And the number lent is quite staggering, for a Central Bank that professes to follow the lineage of the inflation-killing Deutsche Bundesbank. The amount as reported is a whopping 489 Bn Euros (nearly 650 Bn USD). That exceeds the amount of QE2. And there's another auction still to go, in February.

What will be the effect on the EUR of this? Slightly tricky question to answer. In case of the USD, the answer was more straightforward - it had to weaken. However, in case of the EUR, the effects could be mixed.

And this will pan out very differently from a normal carry trade. In a normal carry trade, the growth outlook is good, so people use funds raised in the low interest rate currency and invest in higher yielding assets. That weakens the low interest rate currency.

In case of the EUR, I can think of 4 sets of flows which could take place;

 - Due to repressive measures or otherwise, a large portion of the loans availed could end up getting deployed in assets (Govt Bonds etc) within the Eurozone itself, rather than being used to buy international assets (effect on EUR: Neutral to positive)

 - People could sell the Euros raised in exchange for dollars and use it to pay off dollar liabilities (EUR weakens)

 - People could sell the Euros raised in exchange for higher yielding currencies (EUR weakens)

- Due to more confidence or whatever, Eurozone assets see more investments from international investors (EUR strengthens)

The relative extents of these 4 factors will determine what happens to the value of the EUR.

RBI's Severely Regressive Foreign Exchange Regulations

Today, the RBI has notified a new set of rules for foreign exchange, which are to come into effect immediately.

I glanced over them, and I am glad that I am not longer in FX markets, if only because I don't have to deal with them!

Among the key measures:

- Companies can no longer rebook forward contracts for FX exposures (with INR as one leg)

- Past performance underlying has been reduced to just 25% of the average 3 year exposure for importers. For both importers and exporters, settlement can only be on a deliverable basis

The regulations take a very narrow and static view of market risk management, and India's needs in that regard.

Market risk management is not and cannot be a fire & forget type function. It is dynamic in nature.

This is because as the state of knowledge evolves, prices fluctuate in markets and views and expectations keep changing accordingly.

Thus, even genuine hedgers need flexibility in entering and exiting into hedges.

The RBI is letting a temporary slowdown in the Indian economy affecting its broader vision for the economic internationalization of the country.

Consider, for one, the sheer size of India's international dynamics. We are aiming for exports of  USD 300bn in 2011-12 (might not be met, but gives a sense of the order of magnitude).

We hope to finance half of our fabled USD 1 trillion investment in infrastructure over 2012-17 through the private sector, with much of it by foreign investors.

How can such numbers be achieved if the RBI adopts policies more suited to the autarkic pre-1991 days when every economic parameter in India was less than a 10th of what it is today? For further internationalization, controlled sophistication in financial hedging instruments is the need of the hour. You can't tell a person he should avoid diabetes by starving himself.

The timing and lack of warning is another issue.

In an already challenging period such as the current one, how does the RBI expect companies to have the resources and manpower to spare on changing their risk management functions depending on the vagaries of the venerable gentlemen on Mint Street?

They may say this is a short term measure, but that is precisely the point - market participants cannot be made to bear such heavy costs and policy uncertainty when short term volatility is to be addressed. That is the job of the regulator - a job which the RBI is clearly shirking from. They could have intervened verbally, supplied OMCs directly with dollars and so many more things. But they choose to take a great leap backward.

And if they think this will curb speculation - they are completely wrong. This will, if anything, only increase speculation. Most hedgers will hesitate in taking hedges now, knowing that they have zero flexibility once they take the hedge. Speculators meanwhile will continue to run amok on the exchanges, in the NDF markets and other avenues.

Liquidity will go completely for a toss. There will be huge mismatches between the exchange rates in the OTC market and those on the exchanges.

A very retrogade step indeed, and one which will further dampen the international community's confidence in the Indian economy.

The Return of Sales & Marketing?

For many years now, Finance has ruled the roost as the sexiest career alternative for MBAs in India. As far as my conscious memory permits me to remember, it was the insane $2,25,000 salary offered by Lehman Brothers to an IIM A graduate back in 2001 that had become the talk of the country. Before investment banking took off, however, finance was seen as a staid, boring alternative - primary to do with capital budgeting, accounting, loan appraisals etc (I don't mean to demean anyone working in these fields; Just that they were not seen as glamorous career areas). Financial Markets & M & A were the new kids on the block, the sureshot ticket to an Audi and a Spanish Condo before you turned 30.

Sadly, the model has now gone bust. The 2008-09 Global Economic Crisis and its aftershocks are transforming the Financial Services industry. The Financial Services space is shrinking globally, while in India it never really took off anyway (and is unlikely to take off in a big way now, given the enormous backlash worldwide against the financialization of economies, though definitely small incremental steps will continue given India's huge scope for expansion)

That doesn't necessarily mean, however, that there are no longer opportunities for Indian MBAs. Two recent developments make me optimistic that Sales & Marketing roles will return in a big way. All that is needed is the mental flexibility to be willing to enter them.

The first development is the de-regulation of the Savings Rates for Indian Banks by the RBI. I think we will see tremendous activity once the full implications of this far-reaching move are realized. Banks will need to compete for deposits, competer for funds from Consumers. Smarter Sales & Marketing will have a definite role to play here. It will require out of the box thinking and some pioneering approaches, because for decades Indian banks are just not used to such competition - with one fixed rate, there was no market! The smartest will survive. Consequently this space can through up many opportunities for MBAs.

The second development is the opening up of the retail sector to FDI. Yes, its very tightly controlled and restricted, but for what is worth, a start has been made. The scope for organized retail in India is simply enormous. Most foreign companies that aim to enter will find it easier to work with local Indian talent than with expatriates, because retailing has high specificities to geography. Even in the heydays of 2006-07 we used to see a lot of noise about retailing in India, but back then the regulatory conditions werent sufficient for the sector to take off. They could be now.

Both these sectors will offer tremendous opportunities, across a wide range of areas within Sales & Marketing. Marketing Research & Analytics, for example, will explode. Banks & Retailers will come up with newer products to retain customers. Branding will be important. SCM & Operational aspects will be important.

As they say "It is not the strongest of the species that survives, nor the most intelligent; It is the one that is able to best adapt and adjust to the changing environment" Current & prospective MBAs would do well to remember this.

Gold, Money & Bubbles...

Gold is a funny asset class to handle. For most asset classes, they say that when your taxi driver starts telling you to buy that asset, its time to sell. Gold is the only asset class I can think of where even the (Indian) taxi driver has been a buyer - and not just now, but since a long time.

And yet the sharp rise & corrections in Gold prices raise the B-word (bubble) in our minds.

In the context of analyzing Gold prices, it is useful to look at Money. We can think of Money as a good with some special characteristics.

We may have studied at some point of time about the basic functions of money. It is used to denominate the value of goods & services, it acts as a store of that value and it is used as a medium of exchange.

Often, we say that Money has no intrinsic value. I don't entirely agree. Money, so long as it's credible money, has value in terms of the functions that it provides. In particular, the most useful functions that it provides are the storage of value and the elimination of the need for double coincidence of wants. It's a very big convenience. In the absence of money, suppose you wanted to eat an apple and you had oranges to pay the apple seller, but he wanted shoes (which you don't have). You would need to run around till you found someone who had shoes and needed oranges. Money derives its value from the fact that it eliminates this running around. In this sense, its a good.

However, it has some special characteristics. Firstly, in most countries, Money is a monopoly. The supply is controlled by the Government through the Central Bank. No one else is allowed the right to produce Money. Secondly on the demand side, the citizens have an obligation (not just a right but an obligation) to use only that Money and nothing else.

Now, the single most important hypothesis on which gold buying has been predicated is the fear that modern monetary systems will get replaced.

Such replacement can be voluntary or forced.

Voluntary replacement is, to put it mildly, out of the question. The modern monetary system is an outcome of over 40 years of expanding economic activity. Global GDP now is around 70 trillion USD, give or take a few trillion. The world's stock of financial assets, if assumed to be roughly 2.5 times this, would be around 175 trillion USD. I have no handle on the world's stock of real assets (which are not tied to financial claims), but it should be a few hundred trillion I guess. All of this would need to be denominated in Gold.

The world's supply of Gold is simply not enough to meet this. The annual physical market turnover of Gold at today's prices would be very roughly around USD 250 billion. The outstanding stock of Gold in the world is estimated to be around USD 8.5 trillion to 9 trillion. That's less than 15% of Global GDP.  For the world's economic claims to be denominated in Gold, Gold prices will need to increase at least 40 to 50 times. In it's sterling rise so far (No pun on the Bank of England which sold Gold at 300 dollars an ounce) Gold prices have increased around 6 times in slightly over a decade. The increase would be much less when you consider the ratio of the value of Gold outstanding to that of the GDP or to that of Financial Assets outstanding.

Monetary replacement can be a forced one. Such a forced replacement, however, will happen after a severe, severe disruption. It will happen when people no longer have the faith in the currencies issued by Governments. It will happen in the total collapse of law and order. It will happen when people no longer want to denominate their claims in the Government's currency.

That can be a time for gold to really really shine. However, even under such a scenario, I do not imagine Gold being the only medium of exchange. It will be too expensive and inconvenient to do that. Try buying a loaf of bread with Gold. You will need to literally have it in particle form. Hence, each person will have a basket of goods - food grains, clothes, cattle etc which he will try to exchange. Gold will be one of them, albeit the most prized one. This is because among physical assets, Gold is the most efficient one in eliminating the need for double coincidence of wants and as a store of value.

Money has value only when money preserves value. If it doesn't preserve value, it loses value. It will start losing value when people lose faith in it. And the warning indicator that people are losing faith, is hyperinflation. I don't know exactly at what point inflation becomes hyperinflation, but basically it is the point when people start selling a currency due to lack of trust and start buying anything else that they can lay their hands on.

Do we see hyperinflation yet? Hardly. Headline inflation in the UK, Europe & US is between 3% to 5%. India is at 10% (high, but not hyper). China is around 5%. Asset markets such as Equities, Housing & Commodities have been declining in value. Government Bonds have rallied.

Clearly, there's a dissonance. Interest Rates are still low in the US, UK, Europe and Japan. Fiscal dynamics are horrible. And yet there is no hyperinflation. Do people by and large still seem to have enough faith in the currencies of their respective Governments? That's what developments so far seem to be telling us.

One reason why this is happening could be the mismatch between the global financial markets and global economic activity. Mismatch, in terms of financial markets being most developed in those countries which have the least economic growth taking place, and vice versa. For example, China & India present growth opportunities, but their financial markets lack depth and are not developed enough. Consequently, investors in the Developed World are forced to put money in Government Bonds & Cash, due to a lack of options. And its not about China & India presenting growth opportunities alone. The point is whether they have enough institutional development to allow such returns to be gained with less risk. That is not the case yet.

Greater institutional development in Emerging Countries will increase the decline in value of Developed World currencies. But such development is far from being a given. And even if it happens, it will happen over a long period of time.

Another reason, which I think is important, is that faith in a currency is not a function of monetary and fiscal dynamics alone. It is a function of many other things, such as the faith in the maintenance of law and order by the Government, its efficiency in promoting economic equality, it's ability to handle external threats and so on. Looking at monetary and fiscal dynamics alone and saying that faith in currencies will evaporate is too narrow a view. The Government derives its faith in the currency from a number of reasons. In a world which is inherently uncertain and volatile, status quo is at a premium. As long as Governments can deliver status quo, faith in currencies will be preserved. And the upside to Gold will be capped.

Is Gold in bubble territory? I frankly don't know. What I do know is that we see several elements common across bubbles, which can be seen in Gold as well (Think IT, Housing etc etc):

1) Low-Short Term Interest Rates For Funding Positions
2) Lack of Visible Cash Flows From The Asset (Investment Hypothesis Based Solely On Capital Appreciation)
3) Unquestioned "Long Term Buy" (Bigger Fool Theory?)
4) Herd Mentality: Its Now or Never; Buy Now Or You Will Never Get To Buy It! (This One's Almost A Clincher)
5) Initially, a Tendency to Buy Even After Violent Corrections
6) Ok, Even If Its a Bubble I Will Be Smart Enough To Exit Before Anyone Else (Ex-SuperBoss called this the Jallianwala Bagh situation)

Faites Vous Jeux...

Macro Risks, Micro Opportunities...

Economically speaking, we are currently in a world which seems to be filled with "macro" risks. These are broad, global risks which have the potential to seriously inhibit economic growth

1) Bad Sovereign Debt Dynamics in the US, Europe, Japan, UK, India & to some extent China

2) Increasing Monetary Debasement/Credit Expansion, led by the US & China and followed to a lesser extent by a number of regions, including the UK, Europe & Japan

3) Geopolitical Conflicts: These are most visible current in the Middle East & North Africa region. However there are a number of potential hotspots, such as Pakistan

4) Political Instability: Europe is unable to speak with one voice. The Indian government is unable to move forward with reforms because of corruption scandals. The US plays a game of brinkmanship in fiscal consolidation. China is poised for transition to the next rung of leadership in 2012. Japan has a new Prime Minister every year!

5) Resource Crunch?: Marginal costs of extracting natural resources have been increasing. Demand-supply cushions have reduced across commodities. There is a real danger of commodity supply proving increasingly inadequate to satisfy the needs of the world's population. The only reason I have put a question mark is because (to me at least) the medium term global demand for commodities is not fully clear, particularly when the impact of the risk factors mentioned above is neither fully know, nor fully factored in.

What the combination of these macro risk factors does is that it creates an environment wherein the set of possible global economic outcomes cannot even be fully articulated, much less modelled and estimated.

In such an environment, it becomes tougher to conduct business. It becomes tougher to invest. Projections based on past data will not suffice. Past correlations cannot be taken for granted.

While no business or investment shall be completely invulnerable to these macro risks, there will be businesses which are more susceptible, and those which are less susceptible. The trick is to be able to identify them. In abstract terms, the qualities of such businesses would be as follows:

1) Visibility of Demand / Cash Flows
Every bubble that the world has seen - think IT, US Housing, Chinese Real Estate - has had certain common features. These include the use of cheap short-term funds for investing in a "compelling long-term growth story" without the clear visibility of demand / cash flows from that business. Such a story has always ended in pain and misery. The first starting point for any business in the current macro environment should be visibility of demand. Entrepreneurs will find it difficult to flourish, though there will always be geniuses who manage to make a mark.

2) Tight Supply
It is obviously helpful if the goods sold by the business have tight supply fundamentals relative to demand. A shining example (so far) has been the Commodities sector.

3) Integration With Raw Material Supply
In a world which is facing weaker demand for low-margin finished goods, the profit margins of companies which process raw materials get squeezed particularly when raw material costs are higher due to supply constraints & higher marginal costs. Thus, true value will be created only by the lowest cost manufacturers which have backward supply linkagers.

4) Less Government / Policy Dependence
There are industries which are highly vulnerable to Government decision-making. The nuclear power industry in India is one such example. If the political & policy-making environment is not conducive then such industries will go belly-up when push comes to shove. Of course, the amount of control that the Government or Regulators exercise over industries is itself a variable that needs to be monitored. A classic example is the Indian Banking Treasury space wherein the Regulator through continual (& somewhat unexpected) tightening has drastically reduced the scope for business.

5) Global Diversification
This is a bit of a double-edged sword. Global diversification, when it reduces the correlations between various facets of the business, is a good thing. When it maintains or amplifies the correlations, however, it is a bad thing. It is not enough to say that a business is global and be happy. The extent of correlations needs to be considered. For example, a globalized Bank is much more vulnerable in the event of a global downturn than is a a global Consumer Products company.

A Few Good Economists...

Couldn't resist this one after reading the ones on Traders & Central Bankers...

You can't handle the truth! Son, we live in a world that has GDPs. And those GDPs have to be predicted by men with models. Who's gonna do it? You? You, Dr Krugman? I have a greater responsibility than you can possibly fathom. You weep for Greece and you curse the Economists. You have that luxury. You have the luxury of not knowing what I know: that Greece's default, while tragic, will probably save economies. And my existence, while grotesque and incomprehensible to you, saves economies. You don't want the truth. Because deep down, in places you don't talk about in dealing rooms, you want me on that GDP. You need me on that GDP. We use words like inflation, unemployment, consumption; we use these words as the backbone to a life spent modelling something. You use them as an algorithm. I have neither the time nor the inclination to explain myself to a man who trades and profits under the implications of the very forecast I provide, then questions the manner in which I provide it! I'd rather you just said thank you and went on your way. Otherwise, I suggest you pick up a model and predict a variable. Either way, I don't give a damn what you think you're entitled to!

The Auto Rickshaw Problem - An Informal Economics Perspective

At the risk of being considered obsessed with auto rickshaws, I just thought of putting across some thoughts on the economics of the auto rickshaw problems that everyday commuters such as myself in Mumbai face.

Consider the profit structure of an auto-rickshaw driver:

1) Revenues - Fares from plying on different routes around different areas. This is a function of distance and waiting time.

2) Costs - Most drivers don't own their autos. They are typically owned by fleet owners. As far as I know the drivers have to pay a certain fixed sum to the owner and they keep what they make over and above that. The other costs, of course, are fuel and maintenance

3) Constraints: Fares are standardized (at least by law) on a cost plus basis. Also, drivers are not supposed to refuse any passenger (though that never happens!)

Note that standardized fares do not take the "illiquidity premium" of the destination into account. If the destination is such that it's difficult to find a fare, the driver will balk at going there. If pricing was free, the driver could ask for a premium over and above the metered fare. However, the monitoring in this regard (at least in the Bandra to Vile Parle belt) is quite strict i.e. Enforcement deters free pricing. This is not to say that meters themselves are not manipulated - that can still happen. But no one asks straight up for a fixed fare - they still go by the meter. Therefore, for such places, drivers simply refuse to ply.

Drivers also refuse to ply to places with heavy traffic. There are two reasons for this. The first is that the waiting time compensation is not adequate vis-a-vis the distance traveled. For example, drivers get approx 7 rupees per km. In an area with moderate traffic this distance can be covered in 3 to 5 minutes. For 5 minutes of waiting time they would get only around 1.5 to 2.5 rupees (again, with an ideal meter; However even with the best of manipulations they can't get more than 2.5-4 rupees). Hence, the aversion to heavy traffic.

Now look at the driver's optimization function. The best destination for him is the one which is at a long distance, in areas with less traffic and which will give good fare options at the end. Consequently, the worst destination is the one at a short distance, in areas with heavy traffic and which doesn't give good fare options. Another factor influencing his decision making is the place where has to deposit the vehicle.

Cost plus pricing proves to be inadequate because it treats all destinations as the same, not factoring in the fares potential. It also doesn't take into consideration the distance-waiting time differential.

An important behavioural hypothesis to consider - I believe most drivers are profit-satisficing, but not necessarily profit-optimizing. This is the piece de resistance in understanding why they have become so frustrating in the last one year or so in particular. I believe the major change that happened was the roughly 30% hike in fares in June 2010.

I was initially happy because I thought that with the fare hike there was no reason for drivers to refuse to ply even to unattractive locations. They would get adequately compensated. But because many of them are satisficing agents, not optimizing, they realized that they could make the same amount of money as before with fewer trips. Accordingly they could afford to be more choosy about where they wanted to go. And thats what we have been seeing ever since!

Another point - with respect to the queuing time at places like the airport, again the cost plus method is inadequate. A fixed charge over and above the metered fare, for queuing, would help in mitigating the problem.

How do other places address these problems? The example of Singapore is most instructive. The fares are non-linear. They are extremely high for short distances. The first km or so costs 3 Singapore dollars! The next costs only some 60-80 cents (if I remember correctly). This serves two objectives. Firstly, people are dissuaded from using cabs for short distances and are likelier to use the MRTS etc (I believe this is the primary objective of the fare structure). Secondly, the driver is incentivized to service people even for short distances (this is more of a secondary objective - in any case the monitoring is much stricter and no one is supposed to refuse fares)

Thus two things can be done:

1) The fares for shorter distances can be made a bit higher (They shouldn't be made too high, or else the reverse problem will happen - drivers will only want to ply short distance!)

2) The waiting time-distance differential can be reduced (However one caveat is that meters will need to be monitored strictly!)

3) The problem of unattractive destinations is tough to solve, because its difficult to price the premium of not getting fares from a location. It will vary with a lot of factors, such as for example, the time of the day. Standardizing this will be even tougher. One (admittedly imperfect) solution could be to allow passengers to give the driver a mutually agreed premium above the metered fare subject to a maximum percentage cap. This would have to be agreed beforehand. Of course, one would argue that the driver would ask for the maximum while the passenger would want to give nothing. However, the magic of demand-supply kicks in here. If the passenger truly believes that some incentive is justified, he will give something more than 0, and if the driver believes that the maximum is too much to ask for, he will reduce it.

To Trade OR Not To Trade...

We are in an economic and financial environment of heightened uncertainty (or, to quote Ben Bernanke, the environment is "unusually uncertain")

While this is not entirely new (since we have had many instances of episodic volatility in the past 3 years), increasingly there seems to be a belief that we are reaching the endgame of the 2008-09 recession.

I believe markets trade on perceptions of fundamentals. And it is precisely those perceptions which are significantly muddled and unclear right now.

Trading is a significantly different ballgame from investing. In trading, the path of price movement is important. The swings in prices (volatility) are important - both in frequency and amplitude. And hence, timing is important.

We base the decision to invest in an asset on its expected returns, adjusted for expected risk.

Similarly, the decision to trade in an asset should be based on the expected movement in that asset and how much of that movement we reasonably expect to capture. And this is where the problem lies. Right now, the environment is uncertain.

The use of the word 'uncertain' to characterize the environment in financial markets is important. Frank Knight famously made the distinction between risk and uncertainty. In both cases, the outcome is unknown. However, in case of risky situations, the probability distribution of possible outcomes is known beforehand. In case of uncertain situations, the distribution is not known.

Today's environment undoubtedly belongs to the latter category. And that has major implications for any trading strategy.

Trading is based on the application of some logical system to the movement of asset prices. Some sort of set of possible outcomes, with expected probabilities, needs to be defined. Note that it is not necessary to have a rigorous quantitative probability distribution in place always. Most humans in fact have subjective qualitative distributions for asset price movements. They use bounded rationality and inductive reasoning, biases, judgmental shortcuts and many other behavioural aspects to arrive at the same.

However, if the movement of asset prices is uncertain (i.e. if the probability distribution of the set of possible asset prices cannot be determined in advance), then trading will fail. 

Thus, ANY trading model, post the structural changes and dislocations that we have witnessed in the 2008-09 period in financial markets, should first attempt to answer the question: To Trade OR Not To Trade - is the current market environment suitable for trading?

To answer this question, a model would need to evaluate whether asset price movements are uncertain. I am not sure of the exact mechanism or mathematics that will be needed to prove this. It's quite possible that the proposition is indeterminate. However, I believe measures of volatility, market transaction volumes, idiosyncratic movements / noise could be some quantitative inputs while perceptions of market participants, environment feel etc could be some qualitative inputs in trying to decide. The fundamental question is - How does one test asset markets for the presence of Knightian uncertainty? The answer to this question will also tell us whether or not to trade.

Private Money & The Sovereign Debt Crisis...

It has been nearly two years since the global sovereign debt crisis entered the mindshare of people worldwide in full force. The trigger for it was the revelation that Greece had falsified its budget figures and its deficit was nearly twice of what the previous Government had projected. Since then, reams of newsprint and millions of blogs, reports and articles have been dedicated to various aspects of the sovereign debt crisis.

The global monetary system has evolved over the past 40 years, since the time the US President Richard Nixon broke the US dollar from the Gold Standard (which had been established by the Bretton Woods agreement in 1944). Effectively, the value of the US dollar was backed only by the US Government.

Modern currency systems are what are called fiat systems; Each country adheres to a particular currency because the currency is declared to be the legal tender for that country by its government. So long as all the users (consumers) of money have faith in the government, they will continue to use the currency. Monetary standards stick so long as people believe in them. Consequently, the economic claims on all the resources of that country (whether held by domestic or international entities) are denominated in the currency of that country.

Money is a meta-asset; All other assets are denominated in it. It is a store of value. Additionally, it has its own supply and demand. In that sense, it is as much of a goods as any other. However, each currency is a monopoly of the government issuing it. This monopoly over the issuance of currency lowers the borrowing costs of the sovereign entity. All other credit curves and spreads get priced off the sovereign yield curve. Theoretically, the sovereign can avoid defaulting on its liabilities by issuing more currency (which will, no doubt, reduce the value of the currency issued by it)

Most of the major economies of the world have engaged at least in some form of monetary and fiscal profligacy. It is important to note that this is not a trend which developed post the Great Recession of 2008. Such profligacy had been in place even before 2008. No doubt, it exacerbated post the Crisis. The US, UK, China, India & some countries in Europe have all tested the bounds of fiscal and monetary expansion in one form or the other.

Because of this, firstly, the sovereign entities in most major countries no longer possess healthy balance sheets. They are running high debt/GDP ratios and fiscal deficits. The outlook for revenue growth correspondingly is weak. Secondly, in case of the countries with central banks which have engaged in monetary expansion (notably the US, UK & China), the credibility of the monopoly supplier of money has been lost. Hence, money declines in value.

In such a situation, the fiat money system at some point of time may get tested. Entities may start questioning as to why the sovereign should continue to retain a monopoly over the standard for valuing economic claims.

In this context, I came across an interesting paper titled the "Denationalisation of Money" by the Nobel Laureate, Professor Friedrich Von Hayek, first published by the Institute of Economic Affairs in 1976:

http://www.iea.org.uk/publications/research/denationalisation-of-money

While I haven't gone through the paper fully, I quote a couple of lines from the introduction which summarize the core idea:

"Professor Hayek is arguing that money is no different from other commodities & that it would be better supplied by competition between private issuers than by a monopoly of Government...Competitive currencies would remove the power of Government to inflate the money supply..."

Its a radical idea, no doubt. It strikes at the very roots of our economic system. One advantage of private money would be that sovereign risk would get priced appropriately. It would no longer by subsidized by the currency issuance monopoly enjoyed by sovereign entities.

Professor Hayek, however, may not have envisaged the massive expansion in the monetary and credit base that has taken place since 1971 (this is only my opinion; I have not read enough of his works to make that claim). Given the amount of financial assets outstanding in the world (going by McKinsey Global Institute estimates, it would be at least 4 times the world GDP, or at least 280 trillion dollars) I cannot conceive of a private entity which would have the balance sheet to meet the world's thirst for money. Therefore, even in the next 5 to 10 years, it is difficult to expect any sort of shift towards private money. If anything, post the Recession, the involvement of governments across economies has become even more pervasive than before.

However, if such a direct move towards private money is not possible, one should see entities with relatively strong credit fundamentals and real assets enjoying a premium for their financial assets. This has already been happening. Their financial assets will act as a proxy for any money which could be issued by them. Examples include the German government and certain US & Japanese corporations. Over a long period of time, the idea of private money may gain further acceptance.

What is more likely, however, in my opinion, is that healthy private entities may backstop government liabilities, either by force (PIMCO & Carmen Reinhart have elaborated at length on this topic, which they term financial repression: http://www.pimco.com/EN/Insights/Pages/A-New-Era-of-Global-Financial-Repression.aspx ) or willingly, in exchange for super-normal benefits

Till then, unfortunately, we are stuck with the dollars of the world!

Debt In India - How Much?

Post the sub-prime crisis and the subsequent recession of 2008-09, it has been fashionable for us Indians to pat ourselves on our back and state that we do not have the kind of debt levels that the US does. Therefore, we believe, that we should be far less vulnerable to bubbles & financial crises. Financial institutions in India are not allowed to indulge in complicated structures or off-balance sheet derivatives the way the US and UK did.

Indians culturally and historically have had an aversion to borrowing money. We are a saver nation, with the savings rate at nearly 34% according to the latest Economic Survey. A 2010 report on Debt & De-leveraging by the McKinsey Global Institute reinforces this belief, projecting total debt to GDP for India (across all 4 sectors - government, corporates, banks, consumers) at 130% of GDP; A far cry from the US at nearly 300% or Japan at a whopping 460%.

While this makes us all feel nice, there are a number of points worth noting.

Firstly, it is not correct to directly compare a developing economy's debt levels with those of a developed economy. A developing economy makes the transition to a developed economy through investment growth and capacity creation. These investments have to be financed. Such financing will happen through a mixture of both debt and equity, but both represent the creation of liabilities. Thus, a growing economy will generally tend to increase its debt levels as it aims to make the transition to a mature economy. In that sense, debt to GDP alone is a poor indicator of desirable leverage levels.

The second, and far more important point in my opinion, is the question of how much debt in India is outside the formal financial system. If one thinks of how much financing in India takes place informally, the numbers can be mind-boggling.

The biggest contributor to informal debt (for want of a better word), of course, is black money. Every sector in India, particularly the "softer" ones which either do not require heavy bank lending or which involve a lot of corruption in smooth functioning, has a significant component of black money. Black money financing happens by wealthy individuals, criminals, businessmen, politicians - the list is endless. Certain sectors such as real estate and education are particularly amenable to black money. I am not sure whether one can put a number to the amount of black money lending, but intuitively it would be fairly high. Further, black debt contributes to white GDP, but does not get counted in the debt to GDP ratio.Clearly, then, the debt to GDP ratio is understated.

Apart from black money, there are several channels of informal lending. Moneylenders in both villages and cities lend to a wide section of people in need of financing, at exorbitant rates. The reason they exist is because the formal financial system is unable to service such people for one reason or the other - cost, documentation, risk-taking capacity, distribution and so on.

In addition to moneylenders, there are other avenues of informal credit. Much of the FMCG & unorganized retail industries, for example, work on informal credit. It's as much a trade finance issue as it is of marketing and distribution.

Going further, smaller linkages are too many to enumerate. Think about the maids in your home, who perpetually borrow the odd 2000-3000 rupees. Or the taxi driver, who's taken an informal loan from the taxi fleet owner and has to pay back by driving it.

I do not mean to say that leverage in India is on the same scale as the western world. But it is clear that reported figures of debt do not paint a complete picture because the extent of what is getting missed is quite large. Once we have a measure of such debt, we can try to draw some inferences as to how sustainable the debt levels in India really are. 

Currency Returns & Inflation

Recently, I came to know of  a practice by a bank where in they lend silver to their clients. This set off a number of questions in my mind. One of these questions is - does inflation completely explain currency returns in a multi-currency world? And if not, how does one quantify and characterize the non-inflation component of currency returns?

The standard definition of money (and which I believe is still relevant) is that it acts as a measure and store of value. The food we eat, the clothes we wear, the gadgets that we use all have a certain value associated with them, which we can denominate in terms of money. Such denomination makes it easier to buy and sell all goods and services since we have a common reference point.

From this follows the concept of inflation. Because the demand and supply of each good and service varies over a period of time, so does it's price. Hence, at different points of time, the quantity of each good and service that a fixed amount of money can buy is different. This is known as inflation.

In a normal growing economy, prices of goods and services will have a tendency to increase over a period of time. Inflation is positive. Positive inflation represents a decrease in the purchasing power of a currency. If prices keep increasing, one can buy fewer goods and services with the same amount of money.

Now, when one looks upon the amount of money that one has, inflation becomes a measure of its returns. For example, consider that you have one note of 100 rupees. Assume you keep it as it is, stowed safely in your locker. Assume you can buy 4 apples with it, each costing 25 rupees. Now one year passes. Apples now cost 50 rupees. So you can buy only 2 apples with it. Inflation is 100% (because what cost 25 rupees earlier now costs 50 rupees). Then, the return on your currency holdings is exactly equal to -100% (the negative of the inflation)

If there was only one economy in the world and only one currency, inflation and the return on that currency would be the same. Of course, ideally to measure inflation perfectly, one would need to determine the price of each good and service that can be bought or sold. Then one can calculate inflation over one year as the prices of all goods and services now, divided by the prices of all goods and services one year back. Of course, the prices will need to be multiplied by the quantity of each good or service as well. The "basket" should be as broad as possible. So far so good.

Now comes the fun part. When you have multiple economies and currencies, as we do in the world today, what happens? Does the return on one currency still equal the inflation in that currency?

Consider an Indian consumer.  His currency is the Indian rupee. Previously, when India was a completely closed economy, the basket of goods and services that he could buy with that currency was restricted to Indian goods and services. Now, however, since India is a relatively more open economy, he can buy certain goods from other parts of the world as well, say China, US, Europe and so on. Thus, to compute inflation now for India, one must look at the global basket of goods and services that Indians can buy and note price rises in each of them. Since these prices will all be denominated in different currencies, they will need to be converted to Indian rupees. Of course, this is much easier said than done, since a number of difficulties are bound to arise.

Now when you think about it, it's not necessary that inflation will completely explain the returns in the rupee. Exchange rates between countries are affected by a number of factors, broadly categorized as trade transactions and capital flows.

Let us consider a simplified example. Assume there are only two countries in the world - the US and India. The USD-INR exchange rate is 50. An Indian consumer can buy a certain basket of goods with his stock of Indian rupees. Assume that the inflation in India is 10% and that in the US is 2% and the Indian consumer spends half of his total money on Indian goods and the other half on US goods. The effective inflation for him would be 6% (taking a weighted average) but only if the exchange rate remains constant. However, the exchange rate will not remain constant because of a multitude of reasons.

The concept of interest rate parity will come in here. In simple terms, interest rate parity tries to account for different rates of inflation in different currencies and says that the exchange rate between two currencies adjusts to account for the difference in inflation rates. So in the above example, if the USD-INR rate one year back was 50 and inflation rates are 10% and 2%, the new rate will adjust to 54 (reflecting the difference of approximately 8%). In such a scenario, inflation will completely explain currency returns.

The problem is that interest parity does NOT always hold. Or rather, we have to be careful in the way we use interest rate parity. Interest rate parity only accounts for the relative changes in purchasing power between two currencies OVER A PERIOD OF TIME. It doesn't account for other factors that cause changes in the CURRENT exchange rate. The exchange rate changes because of reasons other than expected inflation differentials. These include trade and capital flows, economic fundamentals, monetary and fiscal policy, degree of openness of an economy and so on. If this happens, then the return of a particular currency will not be fully explained by inflation. Of course, one would need to do a lot of work and account for a lot of factors before concluding the same.

Now, finally, coming to the link with lending and borrowing.

When one lends money, the interest rate or yield charged perform a function analogous to price. When one looks at the loan as an asset, it has two components that generate return:
- The loan itself i.e. credit as an asset
- The currency in which the loan is denominated

Now the yield (or price) will be a function of supply and demand for both the components i.e. the supply and demand for credit, and the supply and demand for the currency.

The supply and demand for the currency will be influence by a number of factors. The primary supply will get dictated to a large extent by the monetary authority i.e. the central bank, its base interest rates and so on. The demand will be a function of several factors.

Usually, the compensation which is charged by the the lender for lending under the second component (currency), is the expected inflation. However, as we have discussed, the value of the currency over a period of time may not be determined by inflation alone.

Now, if it is true that inflation does not completely explain returns in that currency, then when a lender lends to a borrower, in addition to expected inflation, there should be an adjustment in the yield reflecting that portion of expected returns on the currency which is not explained by inflation.

Also, the non-inflation portion of expected returns can be both positive or negative. Thus, un-hedged lenders in a currency should usually demand a risk premium for a currency that is more volatile against other currencies, to compensate for this two way risk.

A lot of work on this area remains to be done. Comments & feedback most welcome.

Farewell to Cheap Capital - MGI Report

Another interesting report by the McKinsey Global Institute:

http://www.mckinsey.com/mgi/publications/farewell_cheap_capital/index.asp

As they rightly point out, interest rates in the developed world have largely been falling over the past 30 years. (The US 10 year Treasury yield graph from the late 70s till now is a beautiful representation in that respect). Yields and inflation in a reasonably long period such as this should be a function of the capacity of the economy to produce goods and services versus the demand for them.

The more the investment demand, the higher should be the interest rates. However, as capacity and infrastructure keep getting created, the long term supply will catch up with the long term demand thereby causing interest rates to fall over a period of time. (It is important to note that the use of the term investment is in the economic sense i.e. capital expenditure, rather than financial investments).

Keeping this in mind it is not difficult to understand why interest rates have trended lower in developed countries in tandem with greater capacities and efficiencies and lower inflation.

One may thus view the entire leveraging cycle from 2000 to 2007 and the subsequent Great Recession as a failure of the world to improperly allocate capital - a large amount of capital was forced upon those economies which were already saturated and did not require expansion.

I wish MGI had elaborated more on what they see as the drivers for their projected investment boom in emerging economies.

My own belief is that it is increasing openness and interconnectedness amongst economies which acted as the catalyst for latent demand in emerging economies, led by China, to be tapped. The flow of capital took place from the developed markets in a relatively stable post-Cold War era from the 1990s which saw many economies opening up. Amongst the significant developments which gave a fillip to trade, capital and speculative flows, one can trace the following particularly in and around the year 2000:

1) China's accession to the WTO
2) The Commodity Futures Modernization Act which excluded OTC derivatives from the purview of the CFTC
3) The repeal of the Glass-Steagall Act (which used to keep commercial banking and investment banking activities separate)
4) The formation of the Euro which caused nominal yields to decline across previously high yield economies such as Greece
5) The dominance of Tech & Finance in the global economy: Both Tech & Finance have one thing in common - they lack physical form unlike most other goods and services. Thus, their pricing is less dependent on marginal cost compared to other goods and services. Consequently, speculation, liquidity and the like have a multiplier effect on these two sectors and valuations get affected drastically.It's all in the air!

If one expects the broad trend of globalization to continue, then it is acceptable to imagine that sustained investment demand will continue. But I am not amongst those who believe that the investment boom will dwarf anything that we have seen before.

I am more comfortable with view of rising interest rates from the supply side. That is, the developed world's stock of savings will decline, putting upward pressure on interest rates.Two strong reasons why this may happen (as has been mentioned in the report as well) are:

1) Sovereign debt - The developed world governments are stuck with massive amounts of debt, all ranging between 70% to 200% of GDP. It will take a long time to reduce this stock. Without economic growth, they will find the going tough. In fact, most governments do not even expect to have a budget surplus before 2013 / 2014, which means the numbers will keep rising till then before they have a chance of reducing.

2) Demographics - As the average age of people in developed economies rises, more and more people will retire and start drawing down on their savings without replenishing them. Thus, the savings rate as a percentage of income starts declining (Japan is the best illustration in this regard - the savings rate has decline over the past two decades from 18% to just 3%). With less savings available, there is less capital for people to borrow and hence they have to pay a higher price (interest rates in this case)