Instruments causing 'mass destruction' in India? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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Instruments causing 'mass destruction' in India? 

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In this issue:
» Real estate to remain a preferred investment option
» Over capacity may haunt auto
» Americans are now saving at a faster pace
» IEA cuts its forecast for oil demand
» ...and more!!


00:00
 
The worst ever global financial crisis since the Great Depression revealed many culprits, the main ones being the derivative instruments introduced by overzealous bankers which were so complex that it left everyone scratching their heads. One of these toxic instruments have been credit default swaps (CDS) which have been largely blamed for the state that the world economy finds itself in. So bad has their damage been that, experts are demanding a ban on the issuance of CDS, including George Soros, the billionaire investor. What's more, legendary investor Warren Buffett has also condemned derivatives of all sorts branding them as 'weapons of mass destruction'.

And yet the RBI is contemplating launching CDS in India and is seeking views from banks on the same! Readers would do well to recall that RBI under the able leadership of the former governor Mr. Y.V. Reddy made sure that India was largely unscathed from the crippling effects of the global financial crisis. Yes, India has not been completely immune and the economy has slowed down but what needs to be noted is that the Indian banking system is robust whereas the same cannot be said of banks in the US and Europe which had to rely on government support to remain alive. And the credit for the same goes to Dr. Reddy, who despite receiving flak for his conservatism, nevertheless, stuck to the principles of good solid policy making on the monetary front.

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The RBI (now under Mr. Subburao) apparently views the availability of the CDS as one of the important pre requisites for developing a healthy corporate bond market. We are not so sure as the events have painfully pointed out. Why introduce an instrument whose downsides more than offset the upsides and whose mere existence has been criticized the world over? We wonder what Dr.Reddy would have to say on this issue?

01:12
 
The US dollar and its importance in the global economy has been the subject of much debate ever since the global crisis erupted. Will the dollar rise or will it lose its value is the million dollar question that is being contemplated. As reported on Bloomberg, there are people in some quarters who see the dollar strengthening as much as 17% in the second half as the US recovers from the recession faster than Europe. That may be true. Though the genesis of the crisis lies in the US, Europe appears to have been hit harder than its American counterpart as a result of which the outlook for the euro and the pound does not appear too bright. At the same time, US' massive deficits and printing of more money to come out of the slump puts the dollar in a tight spot indeed! So, where is the dollar headed? One will have to wait and see.

01:55
 
Although most of the real estate companies suffered their worst nightmare in recent times, if a leading daily is to be believed, the sector is likely to be remain a preferred investment option for many more years to come. And the reasons are not difficult to find. A huge unmet demand, rising income levels, easy availability of finance and one of the most preferred investment option with yield ranging between 11% and 15%. Not to mention the recent spate of reforms, most prominent among which was the opening up of the sector to FDI and private equity firms. However, as the recent events indicated, these reforms can very well turn into a nightmare if greed and ambition get the better of developers. Thankfully, sanity has prevailed this time around as the focus has now shifted to selling current inventories and focusing more on medium-income, middle class households where the potential could be huge. Efforts are also being made to go beyond the metros and tap the smaller towns.

02:41
 
Whenever one talked about the Indian auto industry, the talk mainly veered towards demand side issues like demographics, infrastructure, income levels, availability of finance etc. It rarely touched upon supply side factors like excess capacity. Perhaps it had to do with the fact that the Indian car market over the past few years was fortunate enough to have its capacity grow more or less in line with demand. However, the realities of a cyclical industry seem to be now dawning upon the players. As per a leading daily, with the Indian car market growing by a mere 0.13% in FY09 and most of the Indian players creating significant new capacities, excess capacity is likely to persist in the market for some years to come. To be more specific, while India would be capable of producing 5.4 m cars a year by 2014, domestic demand is likely to edge up to between 3.5 and 4.8 m units. Will this mean pressure on profitability of car companies? Well, we might have to wait and watch.

03:16
 
The credit crisis has given the citizens of America quite a rude shock, or so it seems. As per a Bloomberg report, their long drawn spending binge may be finally over, and Americans are now anxiously saving at the fastest pace in 15 years. The household savings rate rose to 6.9% in May, the highest since December 1993. This same rate was zero as recently as April 2008.

Renowned economist Nouriel Roubini has forecasted that the savings rate will ultimately reach 10% to 11%. But what's most important about this is the pace at which it happens going forward. If this rise happens too fast and within a short time, it may cause a drastic collapse in consumption in turn further aggravating the recessionary environment in the country. On the positive side, the bigger cash reserves will lessen the US's dependence on investment by China and other foreign countries to finance economic growth.

Between 1960 and 1990, the average American household saved about 9% of their after-tax income. This habit was broken in the 1990s as they saw their wealth build up in other ways like buoyant stock prices and soaring home values. With stocks getting squashed like flies and house prices spiraling downwards by the day, it was indeed a rude awakening for most Americans. Now, as American business struggle to cope up with the loss of their beloved spendthrift American customers, the slackening demand scenario may not get better in a hurry.

04:06
 
There may be talks of green shoots in the global economy but the International Energy Agency (IEA) has painted a somewhat gloomy picture. As reported on Bloomberg, it has cut five-year forecasts for global crude demand because of the economic slump and is of the opinion that consumption will not regain last year's levels until 2012. For instance, in 2008 consumption was pegged at 85.8 m barrels a day and it is only in 2012 that the consumption will rise above what was witnessed in 2008 at 86.8 m barrels a day. This means that the repercussions of the global economic crisis will be felt for a long time given how deep the crisis has been and demand is likely to get severely impacted.

Interestingly, the IEA is of the opinion that the drop in oil consumption has postponed the threat of a potential supply shortfall. The question that arises then is where would oil prices head. It would seem that a slowdown in pickup of oil demand would probably keep prices low. But in the longer term, supply side issues still persist in the form of depleting oil fields, not much improvement in technology in terms of extracting oil and alternate sources of energy not making too much of a headway. And of course, there is always the possibility of geo-political factors having a significant impact on the direction of oil prices. Which is why despite the current recession, in the longer term, the movement of crude prices moving upwards seems like a more likely scenario.

04:50
 
After opening in the positive, the Sensex steadily lost ground as the day progressed to end the session deep in the red. Losses were particularly seen in stocks from the metals and capital goods spaces. On the global front, while key Asian indices closed in mixed, European indices are also witnessing a mixed trend currently.

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3 Responses to "Instruments causing 'mass destruction' in India?"

Sritanu Chatterjee

Jun 30, 2009

Dear Sir,

CDS bashing has become very popular among politicians, investors and journalist. CDS was first introduced in US for corporate bonds which were mostly in the speculative grade. To have a good Corporate Bond market, two things are essential - rating agencies and insurance against default of those bonds. Investors(domestic and foreign institution) can invest in these bonds depending on the ratings provided by those agencies. Now rating agencies have their own problem. They can only change the grading of the bonds once or twice in a year. What does an investor do ? CDS market will provide much better confidence to the investors. Also it will be easier for small and medium companies to attract long term investors. CDS has become a problem for ABS or RMBS. Not for corporate bonds. Still now investors have much confidence on CDS market for corporate bonds. I can share with you a good document on this written by a noted journalist in Financial Times.

I would appreciate your counter arguments also.

Regards,
Sritanu

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Pankil Kumar Shah

Jun 30, 2009

I think the paragraph that contains the global energy demand, the quantity of barrels should be 86.8 million barrels/day instead of 86.8 barrels per day.
Thanks.
Pankil.

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dinesh

Jun 30, 2009

Nice wrap up!

Though its true that George Soros in a recent FT article has criticized CDSs and so did Warrent Buffet in his 2002 shareholder letter on derivatives, however one must not forget that both of them had bought and sold huge amounts of derivatives in past!

Hence more prudence by enterprising investors and effective regulation are need for the hour instead of out rightly rejecting derivatives/CDS. Defensive investors ofcourse need not worry about these financial instruments and would be in much better position to stay clear of all such complex products.

There are many aspects of derivatives and CDSs which need answers:

1. According to the International Swaps and Derivatives Association, for the first time since 2001 interest rate and currency hedging has declined in second half of last calender year due to credit crunch. Not only their volume has declined but their cost has increased significantly. Against this backdrop, currency and now interest rate derivatives have been introduced in India recently. It is too early to evaluate their success due to short time data hence now RBI's mulling over introducing CDS is not only bold but could also prove fatal both because of timing (credit crunch and cost esclation) and lack of analysis of recently introduced derivatives.

2. Today's ET's lead article on CDS explaining how by having CDS one assumes "only" market risk and avoids credit risk is misleading. Assuming market or price fluctuation risk is in now way smaller risk than credit risk.

Exhibit: We are all witnessing how large airlines across the world betting on oil prices are sinking in deep red. Some have even filed for bankruptcy. Ditto for companies in software, textile and export oriented sectors betting on currency. How CDS would solve this problem, one wonders.

3.There is a huge debate going on in US on OTC derivatives, CDSs and need for converting them to exchange traded instruments. Do we have the system in place to deal with these issues?

4. Just like banking and FIs need to update their systems and procedures for market's proposed extended hours so will be the need for educating them on CDSs. Can we expect PSU banks/entities to learn these instruments fast enough to avoid systemic failures given their past record?

5. Economists in one of its recent articles wrote:

"Supporters of the market point to the value of CDSs in reducing the cost of capital"

Reducing cost of capital is great but at what cost? AIG has been bailed out. GM and Lehman couldnt escape. All these were big names who failed largely because of CDSs/derivatives.

Hence, we need a clear roadmap for intoducing more and more derivatives (including CDSs). Effective regulation, prudence by investors, conservative policy by RBI, easing of credit crunch to lower cost of derivatives and central clearing mechanism are my top 5 requisites i would like to see in such a roadmap.

Best wishes

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