These toxic instruments are entering India - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

These toxic instruments are entering India 

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In this issue:
» India still attracts a lot of interest
» CDS set to make their India debut
» Real estate's woes persist
» FM's plea to corporates
» ...and more!

Interest in India is still intact. Well that's true, billions of dollars of outflow in recent months notwithstanding. If the turnout in the recent equity conferences on India is any indication, the country does not seem to have fallen way off the radar of foreign investors. Quite a few international financial majors that have their stock broking arms in India have held their India centric conferences both in India as well as abroad and the response, as per a leading business daily, has been quite impressive. Corporates, hedge funds and long-only investors emerged as the major participants in these events.

Although conscious of the fact that valuations in the country have turned quite attractive, these investors wanted to wait for macro stability to emerge before they could start investing in India again. The credit related fire that has singed major economies across the world has also impacted India. But thanks to its relatively lower dependence on exports and a strong internal market, the economy is still expected to pull it through with growth in the region of 6% to 7%. This coupled with cheap valuations is likely to attract foreign investors sooner than later.

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While India will still be able to grow its GDP at a positive rate, UK may not be that lucky. One of Europe's and the world's largest economies has joined the ranks of countries like Germany and Japan to experience a fall in GDP. The country's GDP is expected to shrink in the current quarter as well and also in the first three quarters of the next year, before making a gradual recovery in the last quarter of 2009. It should be noted that in order to prevent the slump in GDP, the country's central bank had recently cut interest rates by a record 150 basis points (1.5%). However, it failed to have the desired impact. Although the fast waning inflation is expected to give the bank another shot at interest rate reduction, a near term recession seems to have been already baked in the cake.

Talking of recession, it all began in the US financial markets, where widespread use of OTC (Over-The-Counter) derivatives left a gaping hole in the balance sheet of financial institutions. Little surprise, these derivatives are termed as weapons of mass destruction by Warren Buffett. However, the Indian government does not seem to be in a mood to paying heed to this danger. Credit Default Swaps (CDS), a very popular as well as controversial derivative instrument that insures creditors against defaults on loans could be traded in India as early as next year. In order to ensure that these instruments do not create the same havoc as they have done in the west, the swaps will be traded on the exchange and not on the telephone driven OTC market, as they have thus far traded in OTC markets across the world.

This is likely to lead to a better price discovery. Nevertheless, these instruments still have a lot of speculative component in them, giving rise to their toxicity. What else could explain the huge surge in outstanding contracts on CDS that stood at nearly five times the outstanding principal of corporate bonds worldwide by the end of 2007?

Although use of derivatives is known to be an effective risk hedging mechanism, its misuse in recent times has led to billions of dollars of wealth go up in smoke. It is important that Indian regulators and users of such instruments take note of the same.

One thing that has been hard to miss these days is the rapid decline in the fortunes of the real estate sector. Once touted as the next big thing in the Indian economy, the industry players are now finding it hard to even sustain themselves amidst an environment of both liquidity crunch as well as high interest rates. Further proof of the same came when Mr. K. P. Singh, the chairman of India's largest realtor DLF chose to speak on the sidelines of the India Economic Summit. Lack of demand has forced the company to not only defer some of its projects but also lay off some of its workforce.

Mr. Singh further opined that ideal interest rate for the sector to find genuine buyers should be in the region of 7%, a number that is way off the mark from the current interest rates prevailing in the country. He however refused to believe that the current real estate prices are inflationary. We do not know which region Mr. Singh is referring to, because as far as Mumbai is concerned, prices do seem to be quite inflationary.

We are definitely not talking through our hats and are instead referring to a story published in leading business daily. As per the daily, the five National Textile Corporation mill land deals that changed the complete landscape of the real estate scene in Mumbai have mostly run into troubled waters. At all of these places, either the work has stopped or the customers have been demanding a significant downward revision in rentals. Little wonder, the BSE-Realty Index has lost nearly 90% of its value since the start of the calendar year.

While Indians are finding it hard to secure homes for themselves, South Koreans seem to be going all out for food security. The country and the island nation of Madagascar are around 6,500 miles apart. But that has not stopped the former to touch base at the latter in search for more food.


As reported by Financial Times, the South Korea based Daewoo Logistics has secured 1.3 m hectares (around 3.2 m acres or 140,000 square feet; half of Madagascar's arable land) of farmland in Madagascar on a 99 years lease to grow food crops for its own consumption. Such is the need for developing countries to maintain food security for their citizens. Daewoo plans to ship the maize and palm oil harvests from these farmlands back to South Korea.

Officials from the company have indicated that it will develop the arable land for farming over the next 15 years by using labour from South Africa. Output from these farms is expected to replace about half of South Korea's maize imports. This move from Daewoo comes at time when food prices have already crashed by about half from their highs achieved earlier this year. Countries however remain concerned about long-term supplies, India included.

The concern that is plaguing India's finance minister though is of a different kind. It is about India's economic growth. This has even forced him to make a plea to Indian companies to lower their prices. The plea has however been met by a firm rebuke from some companies, with the majority themselves being in a tight spot. Mr. Chidambaram asked hotels, airlines, real estate companies, car makers and two-wheeler makers to cut the prices of their products and services in order to boost sagging demand and thus give a fillip to the Indian economy.

On hearing this request, the managements of most companies were expectedly found cribbing about things like the rise in operating costs, deteriorating margins, elusive and expensive corporate credit, tight consumer credit conditions and the like.

But on the positive side, the minister has said that he would be open to looking at a cut in the excise duty, which currently stands at 14%. Well this conundrum seems to have a parallel in the classic case of what comes first, the chicken or the egg. So in this case the question seems to be; what comes first? Conditions improving leading to price cuts, or then price cuts leading to improved conditions...

Although excise cuts may be a farfetched idea, what certainly seems to be coming the corporates' way is an interest rate cut. Atleast if the government continues to have its way with the RBI. The Finance Minister has recently discussed measures with the RBI governor to infuse Rs 800 bn more into banking system. This can call for another round of steep rate cuts after the ones exercised earlier this month.

The RBI is expected to announce the rate cuts going forward in an effort to ease liquidity and reduce borrowing costs to counter slowing economic growth. The government has proposed a 0.5% to 1% cut in the cash reserve ratio (CRR), the repo rate, the reverse repo rate and the statutory liquidity ratio (SLR). Measures like providing additional liquidity to non-banking finance companies (NBFCs) that depend on banks for cheaper funds are also under consideration.

It is important to point out that while the public sector banks have responded to the government's call by lowering their benchmark prime lending rates (PLRs), the private sector entities are yet to yield to the same. The latter have sought further clarity on the trend in interest rates in the wake of cooling off of inflationary pressures.

The country's private sector bankers may not be showing optimism. But there are other people in India who are showing it in plenty. A survey conducted by a US based staffing services firm Manpower, whose India business has grown 50% this year has ranked India as the most optimistic market for new jobs. As per the firm, although some slowing down in ITeS (IT enables services) and finance sectors in the short-term would be seen, growth would return by mid-summer when effects of stimulus packages announced by multiple countries start showing. Comforting news indeed in the current depressed times.

Falling crude prices however, are causing a lot of discomfort for oil companies. These companies incur capital expenditure when price is expected to rise and pull back when price is expected to decline. New deep sea projects cost between US$ 60 to US$ 90 per barrel produced. Hence they become viable only when crude price beyond a certain threshold is used in the financial projections.

No wonder then, upstream companies are holding back their expansion plans after the commodity has crashed to nearly 1/3rd of its July 2008 peak. As per Financial Times, the consensus among 27 national oil companies from 23 countries is that it will fall to about US$ 40 per barrel, before bouncing back to around US$50 to US$ 55 per barrel.

In the meanwhile, after showing signs of breaking away from the trend of sell off witnessed in most Asian markets, the Indian markets eventually succumbed, with the Sensex ending lower by more than 2%. Chinese markets emerged as the only silver lining among major Asian indices today, edging higher by an impressive 6%.

The European indices are also submerged in a sea of red currently. Volatility was the order of the day in the US markets yesterday as stocks went on a roller coaster ride, jumping on positive news flow while retreating on negative ones. They nevertheless managed to close in the positive. Crude oil however edged lower, once again spooked by demand related worries.

04:52  Today's investing mantra
"Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns." - Warren Buffett
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