The self-destructive financial tool

Apr 23, 2010

In this issue:
» The dangers of high finance
» Is GDP growth rate of 8% plus too optimistic?
» 56 Indian companies in world's most powerful list
» Indian IT making a comeback
» ...and more!

There are two key lessons to be drawn from the global financial meltdown. Old lessons that financial wizards always seem to forget. Firstly, that financial markets are inherently unstable. Even though academics have proclaimed otherwise for years. Secondly, financial innovations are means to an end. Not an end by themselves.

Take derivatives for example. By their very design, they tend to keep accumulating. Investment bankers can create layers upon heavy layers of derivatives on a basic asset like a house. Making the financial system unstable if anything were to go wrong with the basic asset itself. Moreover, the objective of all financial instruments is to help real world activity. Business, housing, shopping, travel etc. Derivatives tend to slip into a world where they exist merely for generating fees and commissions.

For this reason regulators must be especially strict with derivatives. Whether they are used for currencies, stock market portfolios, bonds or housing. Sadly, the regulators in the large developed markets have not yet learnt these lessons. Derivatives can cause large sudden changes when you least expect them to. The key to keeping a tab on them is transparency. Although so far India's record has been very good on this front, it not because we are especially transparent. It is just that their use is still not as widespread in India. If and when derivatives really take off in India, our regulators have their task cut out.

 Chart of the day

Source: IMF

The International Monetary Fund (IMF) has come out with a revised outlook for GDP growth this year and next. It is now more optimistic than before about the world economy. As the chart of the day shows, the IMF expects the emerging world to greatly outperform the developed world. No surprises in that. What is notable is that India has received the highest upward revision of 1.1% for FY10. In contrast, China has not been revised at all. The US FY10 forecast has been revised upwards by 0.4%. Everyone, from the RBI to the IMF seems to be gung ho about India's GDP growth.

Speaking of India's GDP growth. True, India's growth is picking up pace after shaking off the global crisis, but is the Indian economy really likely to grow by 8% plus in FY11? An interesting article in the Mint cites that this could turn out to be a tad too optimistic. After all there are certain challenges that India must face. The first is the ballooning fiscal deficit. For this to come down, Indian exports will have to be cheaper. Which means that the rupee will have to depreciate. But that has not been the case. In fact, the rupee has appreciated 15% in FY10. Another problem is that there has been a surge of capital inflows. Ideally, the RBI can intervene and sterilize these inflows. But then it is constrained to do so because the government's borrowing programme has to be financed. Private consumption demand could also be slower due to wearing off of the one-time effects of the Sixth Pay Commission awards and the farm debt waiver. It is also likely to weaken in response to rising prices of manufactured goods. Therefore, the idea is that GDP growth of 6.5-7% would have been more realistic. This would have enabled the central bank to tackle inflation more rigorously. For the time being, however, one will have to wait and watch how RBI's projections pan out.

As individuals, all of us have our own set of dreams. MBA aspirants dream of joining Ivy League Schools. Aspiring actors dream of becoming the next superstar. Whereas budding cricketers set their eyes on becoming the next Tendulkar or the next Dhoni. Similarly, businesses also see a lot of dreams. Featuring in the prestigious Forbes magazine would certainly vie for the top position.

Increasingly though, more and more Indian companies are seeing this dream of theirs getting fulfilled. Fifty-six to be precise. Yes, that's right. As many as 56 Indian companies have been named amongst the world's 2000 most powerful companies by the famous magazine Forbes.

The magazine has ranked these companies after taking into account their sales, profit, assets and market value. Interestingly, India was amongst the countries that gained the maximum ground in the list. We won't be surprised if it keeps doing so given the growth that lies ahead of the Indian economy. As one way to participate in the success story of these companies is to follow the underlying business of important companies and invest when opportunity presents itself.

This is something banks in India seem to be fixated with. As if cheap liquidity overseas did not teach them a lesson. The Indian entities seem to be keen to get a first-hand experience of subprime default. As much as the RBI disapproves of mispriced loans, banks are eager to cash in on them. Termed as 'teaser loans' to attract borrowers with temporary low rates, these assets could be the bone of contention for banking sector in the long run. But who's listening? After SBI and HDFC, ICICI Bank has cited its intent to carry on with the cheap rates for home loans. This will not only pressurise the bank's margins in the near term. It will also undo the asset cleaning that the bank has painstakingly undertaken.

Food inflation has crept up for the week ending 10th April. On the back of rising essential items, food inflation came in at 17.65 % compared to 17.22% the previous week. While food inflation is expected to soften by the middle of next month as the rabi crop arrives in the market, all eyes are on the monsoons. A normal monsoon will be a deciding factor in bringing down food prices as good rainfall will help douse inflation expectations. This rise in food inflation prompted RBI to hike key policy rates to squeeze money supply to prevent the spilling over of food inflation to WPI (whole sale price index). However, if food inflation continues to rise, overall inflation is certain to move higher.

India's leading conglomerate Wipro declared its FY10 results today. The company clocked in a decent topline and bottomline growth of 6% YoY and 18% YoY respectively. Despite the headwinds of currency volatility, the company managed to post an impressive performance in the challenging business environment of FY10. With FY10 results, Wipro today joined its peers TCS and Infosys, in announcing that the Indian IT industry is sturdy enough to tackle global economic crises. The Indian IT sector is seeing a comeback in demand from markets like North America and Asia Pacific. However, verticals like manufacturing, telecom and hi-tech and geographies like Europe and Middle East still look troubled. Going forward, given their focus on high-end IT services, we expect Indian IT mega vendors to win market share from global MNCs like Accenture and IBM. It will take a little while though.

Meanwhile, the Indian markets had a good day at the office. At the time of writing, the BSE-Sensex was up by about 112 points. Banking and engineering heavyweights were in the positive, while auto and software majors were in the red. Most of the other Asian markets closed in the red, while Europe has opened on a strong note.

 Today's investing mantra
"The best way to think about investments is to be in a room with no one else and just think. And if that doesn't work, nothing else is going to work." - Warren Buffett

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5 Responses to "The self-destructive financial tool"


Apr 26, 2010

thanks for this issue
its really useful as i am an c.a. student.



Radhakrishna Rao

Apr 23, 2010

Nice analysis of the Financial derivatives. Everybody should be on guard for their investments( especially). One mans business intelligence turns to be deceit later. So neutral Umpire is essential in the Game of investment.

Keep it up rational analysis of world events



Apr 23, 2010

Some see logic some don't. And actually a majority don't. That is why we have more derivatives trading than actual investments. Coming to Forbes. It has been releasing different rankings for years. Look at the brighter side. The report is based on some logic, some numbers. It will have some positive effect leading to more FDI in India in the medium to long run. When our kids grow up they may have enough and more opportunities here in India and may not want to work in US or UK. Wouldn't that be economically and culturally better for India. Well, there are many other positives but for the moment, even if India gives a magazine like Forbes a reason to increase their circulation, it is credible indeed.
PS: I think 56 are from 2000 companies and just 2 from 200 :)


Shekhar Vaidya

Apr 23, 2010

I think there is a grave error in the article. While there is no doubt that fiscal deficit is a cause for concern, how this will be covered by increased exports is not clear. What increased exports will cover is the current account deficit. While appreciation of rupee against $ will not help increased exports, what we should be concerned about is the relative exchange rate vis-a-vis other competing countries for our exports. If their currencies also appreciate in similar proportion against $, our exports can continue to boom. It would really be a case of $ depreciating against all trading partners. e.g. Chinese Yuan seems due for appreciation any time now.


V S Gurumani

Apr 23, 2010

One cannot but be hugely amused by these rankings going under the name of 'most powerful', 'most admired', 'best places to eat in', 'most influential', etc. Surprising that Forbes also has fallen into this trap. One remembers when Parveen Babi made it to the cover of the Time magazine issue on Indian cinema as the face of Indian cinema! 56 out of 200 most powerful companies in the world are in India!? Give all of us a break. You can do better than waste our time dishing this out and also trying to find a logic to it. What other logic is there than simply boosting their circulation?

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