»5 Minute Wrap Up by Equitymaster

On This Day - 26 JUNE 2013
Will government wait for 1991 like crisis to respond?

In this issue:
» The bubble that can put the dot com era to shame!
» China seeing a spike in credit default swap (CDS) spread
» Will US immigration bill erode India's GDP?
» How are emerging market funds reacting to end of QE?
» ...and more!

Not many of us understood the proportion of economic crisis that India went through in 1991. As a result, to compare the current situation to 1991 we would need to take the help of statistics. But ask someone who has had a first-hand experience of both, and the reply could well be startling! We recently had an opportunity to pose a question in this regard to the Chief Economist of one of India's largest PSU banks. 'This is worse than 1991' was the reply that came to us even before we could finish the question.

Now it is not as if 1991 was the last crisis that came India's way. But thanks to the prudence of Reserve Bank of India (RBI) and some key learning on external debt, the East Asian crisis in 1997-98 hardly impacted India. The same can be said about 2008. However, as Indian policy makers chose to ape the US, Europe, China and Japan, all learning went out of the window. The result being that India may be one of the worst hit when the balance of payment (BoP) crisis hits Asian nations this time around!

Allow us to back this argument with more statistics. In 1991, the proportion of India's short-term debt to foreign exchange reserves was a gargantuan 146.5%! The debt service ratio was 35%. So that we never revisit these figures, in the decade that followed, the government and the central bank put a lid on short-term debt. It raised maturities for foreign borrowings by Indian corporates and made policies in favour of long term funds (FDI). The scenario changed dramatically 2002 onwards. From a low of 5.1% in FY03, short-term debt to reserves rose to 14.8% in FY09 and ballooned to 31.1% in December 2012.

Another key indicator, the import cover of foreign exchange reserves, i.e. ratio of a country's imports to its reserves, is not in a very comfortable position either. Readers will recall that India's import cover had gone down to three weeks when the country had to pledge gold with IMF. The same now stands at 6.5 months from 15 months in May 2008, when the economy, capital flows and the rupee were much stronger.

The RBI is this time in a denial mode about the possibility of India revisiting a 1991 like crisis. The government on the other hand has its sight firmly focused on the 2014 elections. Industries across sectors are facing unprecedented challenges in sustaining growth and profitability. And global investors are hardly finding Indian investments very lucrative from risk-reward perspective. The proverbial ball therefore seems to be in nobody's court! Should investors therefore wait for a crisis situation to unravel before expecting some corrective action?

Do you think the government will wait for a full blown debt crisis to respond with reforms? Please share your comments or post them on our Facebook page / Google+ page

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 Chart of the day
Is Rs 60 per dollar set to become the new normal in terms of India's exchange rate? Ex RBI governor Dr Bimal Jalan believes that the 35% depreciation of rupee versus dollar over past two years can be blamed squarely on policy deficit. If the country continues to import without focusing on exports and trade balance, its BoP situation is bound to go out of hand. Once the trade deficit situation is checked, it would automatically ease pressure on the external debt situation.

Source: Trent

Given that we know so much about human nature now than we did before, is it possible to do away with asset bubbles and their subsequent busts? Certainly not we believe. As long as there will be greed and fear, there will be bubbles and their destructive aftermaths. In fact, a few bubbles are building up even as we speak. An economic advisor who answers to the name of Mike Shedlock invites us to take a look at one such bubble that can put even the dot com era to shame.

Turns out that day traders in Japan never had it this good before. What has led to the opening of the flood gates is deregulation of margin trading whereby investors can borrow three times as much as their brokerage account balances! What more, they can easily turn over their loans when they exit a trading position. Just to put things in perspective, one of the day traders out there leveraged his US$ 4.5 m in cash into as much as US$ 67 m in daily stock bets! It is not uncommon to find day traders buying and selling between US$ 80 m to 100 m worth of stocks every day.

Needless to say, this is a dangerous trend and something somewhere will certainly go wrong. In fact something has already seriously gone wrong if Shedlock is to be believed. All we have to do is just wait for the dust to settle.

In the global economy there is one indicator that is widely used to understand the credit risk in a particular country. This is called the credit default swap (CDS) spread. CDS is essentially a financial agreement by which the seller of the agreement will compensate the buyer in case of a loan default or any other such adverse credit event. So if the CDS spread increases it means that the seller is demanding a higher compensation for providing the risk cover. Or that the risk of default is increasing. Therefore increasing CDS spreads is treated as an indicator of an upcoming credit crisis. And this indicator suggests that there is a trouble brewing in our neighbouring nation - China. Because the CDS spread for China has spiked by most since the collapse of Lehman Brothers. The spread has gone up by 55% over the past few days. This has many to wonder if the credit bubble created by China's shadow banking network is about to pop. The country has so many layers of financing other than its banks that it had sent credit risk in the country soaring. And as China slowed down in the wake of the global crisis, the credit risk posed by the multiple layers was getting worse. If the CDS spread increase is anything to go by, then the country is on a brink of a credit crisis. We all hope that the government would take all measures to prevent this from happening. But what if China has a financial crisis? Can the unstable global economy withstand such a blow?

When the US Fed announced its intention of tapering down its QE program, stock markets across the world reacted negatively. This was hardly surprising. Since the rally in these markets was fueled by the Fed's easy money policy, once they were deprived of steroids, prices were bound to fall. In this regard, equity funds of emerging markets seem to have borne most of the brunt. According to funds tracking company EPFR Global, over US$ 3 bn has flown out of emerging markets equity funds during the week ending June 19. In this, India has not been spared either. As the article on Firstpost states, FIIs pulled out US$ 580 m from the Indian market during the week. Among many other factors, FII flows play quite a considerable role in influencing the movement of stock indices. Whether the US Fed will walk the talk and actually withdraw QE remains doubtful. But in the event that it does, Indian stock markets will certainly get impacted. But then it would present a very good opportunity to pick up some good quality stocks at attractive prices.

The real estate sector is one of the most important sectors in an economy. The fact that this sector accounts for 8% of India's GDP underscores the point. The demand for some major commodities such as cement, aluminium, steel and copper is linked to the growth of the real estate sector. As such, the drastic slowdown in real estate has impacted many of these businesses. With the persistent economic slowdown, high interest rates, heavily indebted real estate firms, etc. the revival of the sector may take some time. Also, it is important to note that there exists a maze of regulations involved in any housing project which leads to significant delays. It is true that there is a huge pent up demand for housing. And this does provide an assurance about the long term growth potential of the sector. However, several policy issues and regulatory hurdles need to be resolved to boost the sector.

India has witnessed a major shift from being a farm based economy to service based economy, of which IT sector is a key pillar. However, if a report from JP Morgan is to be believed, the Indian economy is likely to get another jolt by virtue of its high reliance on the blue eyed industry.

As per the report, if US immigration bill gets passed in its current form, it is likely to erode India's GDP. In a bid to protect jobs, the US bill suggests a hike in the visa fees. If the bill gets passed, it will mean a huge addition to costs for Indian IT companies and hence a threat to their business. But this is not all. There is more to this issue than meets the eye. This is because of the multiplier effect that the software sector has on the economy. If the IT industry gets impacted, the other ancillary industries like travel, transportation, hospitability and real estate will also be dragged down. The report estimates the overall loss to the GDP to be around 0.3% - 0.4% in FY15.

While there is nothing final yet, if the worse does happen, the IT industry is likely to react by changing the hiring policies and the way the business is done. While such changes have already started taking place, all adaptations take time. In the meantime, the Indian economy does have serious reasons to worry.

Profit booking in telecom, auto and commodity heavyweights has kept the key indices in Indian equity markets closer to the dotted line today. The BSE Sensex was trading higher by around 30 points at the time of writing. While the other major Asian markets closed a mixed bag, markets in Europe have opened in the positive.

 Today's investing mantra
"I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn't make any sense to me." - Warren Buffett

  • Warren Buffett - The Value Investor

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